FACTBOX-Key political risks to watch in Indonesia

JAKARTA May 31 (Reuters) - Strong growth and political stability made Indonesia southeast Asia's most attractive investment destination last year, but the outlook is threatened by a struggle between reformers and powerful vested interests.

Top reformer Sri Mulyani Indrawati's decision to quit last month (May), fed up with the pressure from the political old guard, was a setback. But her successor as finance minister, Agus Martowardojo, is no pushover, so prospects for continuing her work and achieving an investment grade credit rating are strong.

The benchmark stock index .JKSE has surged 144 percent from its Oct. 28, 2008 low and reached an all-time high on May 4. The rupiah IDR= has strengthened from 12,600 per dollar in November 2008 to trade at about 9,000 in April-May but has weakened as investors, nervous about the euro zone, fled riskier assets.

The sovereign credit default swap spread IDGV5YUSAC=R, which had tightened to around 161 basis points in April, has now widened to 197, mainly due to euro zone tremors.

Following is a summary of key Indonesia risks to watch:

* GOVERNMENT EFFECTIVENESS IN DRIVING REFORM

President Susilo Bambang Yudhoyono, re-elected with a strengthened mandate last July, is widely seen as a progressive, market-friendly reformer. Many investors hoped the pace of reform would pick up in his second term after he chose Boediono, an economist, as vice president; gave two reformist technocrats -- Indrawati and Mari Pangestu -- key cabinet posts; and picked Kuntoro Mangkusubroto to head a new presidential delivery unit.

Instead, his second term got off to a bad start. Boediono and Indrawati -- who had made many enemies among opponents of reform, including Aburizal Bakrie, the businessman who heads the Golkar Party -- came under attack for their decision to rescue a small lender, Bank Century, during the 2008 crisis. [ID:nJAK447688]

A parliamentary inquiry into the case dragged on for months, distracting the government, but failed to undermine the two reformers. Yudhoyono expressed full support for Boediono and Indrawati, who had backed the bailout to avoid a collapse of confidence in the financial sector. [ID:nJAK443320]

However, the political pressure clearly took its toll on Indrawati, who accepted a job at the World Bank. Soon after she quit, Yudhoyono gave Bakrie a new post as coalition manager, raising questions over his commitment to reform. [ID:nJAK299378]

Yudhoyono has shown a preference for incremental reforms rather than bold and controversial action, disappointing some investors. However, progress is slowly being made. In March, Boediono announced a new team to oversee reform of the bureaucracy, a positive sign for foreign investors, while Mangkusubroto has introduced regular progress reports on ministers and their projects. [ID:nJAK226817]

Also, healthy fundamentals and a large and growing domestic consumer base still provide reasons to invest in Indonesia even if reform progress is slower than had been hoped.

What to watch:

-- Opponents of reform, including those within Yudhoyono's ruling coalition, will probably try to block pro-investment policies such as changes to the tough labour laws and cuts in energy subsidies. [ID:nJAK427204]

-- So far there is no evidence that Bakrie's new post gives him more powers to try to block reform. Despite Indrawati's departure, prospects for reform under Martowardojo remain reasonably strong. As head of Bank Mandiri (BMRI.JK), he took on powerful tycoons and forced them to repay their debts. He was quick to reiterate his commitment to sound macroeconomic policies and to continuing Indrawati's reforms. [ID:nJAK135796]

-- Progress with tax cases, particularly those involving Bakrie's companies. [ID:nJAK389318]

-- The future of the coalition. The Bank Century inquiry strained relations between Yudhoyono's Democrats and coalition partners Golkar, many of whose members oppose reform, and the PKS, an Islamist party which sometimes takes a nationalist, anti-Western stance. With Indrawati's departure, relations may improve, allowing the coalition to function more effectively.

* CORRUPTION AND GOVERNANCE

Corruption emerged as a defining issue at the start of Yudhoyono's second term, with popular anger mounting over a power struggle pitting the respected Corruption Eradication Commission (KPK) against the attorney-general's office and police. The KPK has made significant progress in investigating corrupt officials, but this stirred powerful opposition. Yudhoyono has vowed to back the anti-corruption drive but his slow response to the KPK scandal disappointed many Indonesians who wanted bolder steps.

Under Mangkusubroto, the presidential delivery unit and legal task force has begun tackling legal reform, for example exposing graft in the prison system and investigating officials suspected of perverting the course of justice.

What to watch:

-- Who heads the KPK next. A new chairman will be chosen soon to replace Antasari Azhar, who was jailed for murder. With the KPK still under attack from vested interests, it's important the job goes to someone with impeccable credentials. [ID:nJAK149966]

-- Effectiveness of the presidential delivery unit in tackling legal reform and other issues that deter investors.

-- Pace of reform of Indonesia's civil service, police and courts. Yudhoyono's cautious response to the power struggle over the KPK suggests he will move much more slowly than markets had hoped, confirming his reputation for preferring gradual change to bold, sweeping reform. Investors betting on more decisive reform during Yudhoyono's second term have had to adjust expectations.

* HOT MONEY AND CAPITAL CONTROLS

The rupiah was Asia's best-performing currency in 2009 with a gain of 17 percent against the dollar, threatening Indonesia's export competitiveness but helping to contain imported inflation.

The rally continued for much of this year too, prompting the central bank to intervene to stem the rupiah's gains as it traded around 9,000 per dollar. More recently, the sell-off in the rupiah and other Asian currencies prompted the central bank to intervene again by selling dollars.

Such capital flows are closely watched by the authorities. Memories are still raw of the 1998 Asian crisis, which was widely blamed in Indonesia on foreign "hot money" being yanked from the country. Late last year the senior deputy governor said Bank Indonesia was studying the possibility of curbing foreign ownership of its short-term debt or SBIs, sparking speculation about tighter capital controls. Instead, in March, it began reducing the frequency of auctions for one-month SBIs, so foreign investors have shifted into three-month paper. [ID:nJAK197199]

What to watch:

-- Data on exports and speculative inflows, and whether the central bank's measures for SBI auctions has the desired effect of reducing volatile short-term capital inflows. If problems arise, controls may be tightened. Draconian measures that send investors fleeing to the exits are unlikely -- measures would be aimed at directing flows, rather than halting them, so any negative impact on asset prices would be muted. However, the issue can still spook markets -- the rupiah suffered its biggest one-day sell-off in nine months last November due to mixed signals on capital controls. [ID:nHKG263506]

* SECURITY

Suicide bombings at two luxury hotels in Jakarta last July were the first major terror attacks in Indonesia since 2005 and raised concerns that the threat from militants was again on the rise. Since then, the killings of Noordin Mohammad Top and, more recently, the bomb-making expert Dulmatin, have significantly reduced that threat. But some risk persists.

Earlier this year, police discovered a new network of armed Islamist militants operating a secret training base in Aceh in Sumatra province. The group was plotting to assassinate Yudhoyono and government officials at an independence day celebration, and wanted to create an Islamic state, police said. [ID:nJAK214087]

What to watch:

-- Ability of militants to regroup and launch more attacks. Particularly if remaining militants are able to establish firm enough links with al Qaeda or allies in Southeast Asia to secure sustained funding, expertise and recruits, the threat may be far from over. But Indonesia's markets have proven highly resilient to militant attacks. Unless there is a significant and sustained deterioration in security, or militants reignite sectarian unrest, any sell-off would be limited and brief. [ID:nSP545301]

(Editing by Andrew Marshall)