JAKARTA -- Since global index provider Morgan Stanley Capital International warned early this year that it might downgrade the Indonesian stock market, authorities have been implementing reforms to restore investor confidence - while also maneuvering in ways that worried market participants.

MSCI is "trying to intimidate us," Indonesia's President Prabowo Subianto said on Oct. 21. "We are not afraid." Prabowo was reacting to MSCI's unexpected further downgrade, which sparked concerns that capital outflows from Indonesia would accelerate.

"Despite the announced reforms, significant concerns remain around market dysfunction, including continued suspected coordinated trading behavior and lack of evidence of meaningful enforcement," MSCI said on Oct. 16 as it launched consultations to propose reclassifying Indonesia as a standalone market.

In January, MSCI warned Indonesia that if reforms did not proceed, it would downgrade the country's market classification from emerging markets to frontier markets. The latest announcement represents a further downgrade. Indonesia could possibly now be classified alongside war-torn Ukraine and Palestine.

As a standalone market, Indonesian stocks would be excluded from various MSCI indices used as benchmarks by pension funds and other investors. Goldman Sachs said in its research note on Oct. 25, that a complete removal of Indonesian stocks from MSCI indexes could trigger about $5.6 billion in passive fund outflows.

The Jakarta Composite Index (JCI) fell sharply after MSCI's announcement. The Indonesia Stock Exchange (IDX) benchmark the same day closed down 11.5%, reportedly marking the largest points drop in 28 years. Selling of government bonds also surged, which pushed up the yield on 10-year government bonds above 7.5% last Wednesday, its highest level since October 2022.

Increasingly concerned Indonesian authorities have stepped up efforts to reform the market. Since the year's start, these measures have included changing share ownership disclosure requirements from 5% to above 1% and raising free-float requirements from a minimum of 7.5% to 15%.

When IDX President Director Jeffrey Hendrik spoke to Nikkei Asia on Sept. 1, he said: "Based on what MSCI disclosed in its report, it is clear that the company appreciates my efforts at IDX and explicitly states that we are heading in the right direction." "Since mid-July, the feedback has become far more positive than before," he said. "If all goes well, we should see positive results in November or earlier." He also mentioned that IDX will continue monitoring companies with 10 trillion rupiah ($550 million) market caps on a quarterly basis to detect high saving concentration shares, and will exclude those shares from IDX flagship indexes as announced afterward.

In late September, IDX scrapped the minimum share price of 50 rupiah to 1 rupiah, in order to reflect market valuations for the listed companies more precisely.

The series of reforms failed to improve investor sentiment and led to stricter criteria from MSCI.

Later in the week that the consultation was announced, the Financial Services Authority (OJK) began to extend its enforcement efforts to some of Indonesia's biggest business groups.

OJK imposed a fine of 1.5 trillion rupiah on a company without specifying its name, that illegally inflated the stock price of Dian Swastatika Sentosa, a major energy firm in the Sinarmas Group. A geothermal power plant operator under the Barito Pacific conglomerate Barito Renewables was also fined for illegally allocating shares during the initial public offering.

While authorities continue their efforts to improve transparency, experts said contrary trend has been observed among listed companies, such as engaging in unfair stock trading based on their relationships with government officials.

An economist, speaking to Nikkei Asia on condition of anonymity, said that the fact that certain companies have avoided fines imposed by the OJK constitutes "a legitimate regulatory 'red flag' requiring further explanation." In September, 30% of shares in Indonesian coal miner Bayan Resources were acquired by Jhonlin Baratama, a company owned by politically connected tycoon Andi Syamsuddin Arsyad, known as Haji Isam.

In a disclosure to the IDX, Bayan said its founder Low Tuck Kwong and his daughter, Elaine Low, had agreed to sell shares worth 26.1 trillion rupiah to Jhonlin Baratama, priced below the market price by nearly 80%.

Early that month, Bayan had declared a force majeure, exempting itself from its obligation to supply coal to domestic and international customers, citing delays in government approval of revisions to its production plan for the remainder of the year. This was after the government, concerned about rising coal prices -- coal being one of the country's major exports -- had instructed mining companies to cut production.

Market skepticism grew when the government approved Bayan's revised production plan immediately after the sale was announced.

Haji Isam was widely reported as one of Prabowo's biggest financial backers in the 2024 presidential campaign. Speculation spread that discussions regarding the share acquisition gained momentum after Low sought cooperation from Arsyad, who has influence with the government.

Bhima Yudhistira, executive director of the Center of Economic and Law Studies told Nikkei Asia that the transaction bears "strong signs of political interference," suggesting a hostile takeover is possible just because someone is close to the president. "It will inevitably affect MSCI's assessment of minority investor protection," he said.

Another representative from an Indonesian securities company, who also asked for anonymity, said the transaction between Haji Isam and Bayan has "significant weight" on MSCI's decision as it serves as "a prime case study for the exact structural 'market dysfunction' global investors are fleeing from." George Xu, a director of Asia-Pacific Sovereign Ratings at Fitch Ratings, one of the global credit index companies that revised Indonesia's sovereign rating outlook this year, expects the authorities to implement further measures to improve market governance and functioning in the coming weeks, although these measures alone are unlikely to completely eliminate investor caution.

The possibility of reclassification to standalone market could weigh further on already fragile investor sentiment, he said, which could lead to "further deterioration in governance, could add pressure on the sovereign rating," as well as "weigh on Indonesia's medium-term growth prospects with negative spillovers to the credit profile if weaker investor confidence materially deters [foreign direct investment] inflows."