Institutional Investor: Inflation the only blot on Indonesia’s landscape

Institutional Investor, May 2011

Indonesia has emerged as one of the world’s most exciting economic growth stories. For many years considered a laggard to Asian growth and opportunity, it now finds itself at the convergence of a perfect set of investor criteria: politically stable; full of resources; given resilience by a strong domestic growth story; and now on the cusp of a ratings upgrade that would take it that crucial step from sub-investment to investment grade.

It’s a far cry from the Asian financial crisis, when Indonesia was the most badly hit of all Asian economies, with a plunging currency and an arguably botched IMF attempt to fix it. In the late 1990s everything had to be rebuilt: the entire banking system had to be rescued and reshaped; the country had to try to build a functioning democracy after more than two decades of dictatorship under Suharto; and an enormously disparate country of 17,000 islands and (today) 240 million people had to be brought together.

There was at least five years of pain. “But when it started to happen, we saw serious progress on all fronts: monetary, fiscal and governance,” says Yougesh Khatri, southeast Asia economist for Nomura. “By 2003 you had the gelling of political stability, much of the disruptive part of decentralization [the passing of some power from Jakarta to the regions] was behind them, there was clear progress on fiscal consolidation, banks were freeing themselves of government debt, and the balance sheet – for households, corporates and banks – began to improve.” All those attributes stayed in place right up to the global financial crisis, from which Indonesia emerged largely unscathed. “The economic fundamentals heading into the crisis were pretty damn good,” says Khatri. “They weathered the storm very well: it’s largely a domestically-oriented economy, they don’t rely on export-driven growth and they also have commodities.”

And so we have Indonesia today: coming out of the crisis largely unscathed, its status compared to other nations is unrecognisable from 12 years ago. More and more fund managers and economists consider it a fifth BRIC alongside the more feted economies of China, India, Brazil and Russia. There has scarcely been a better time to be a resource-rich nation: although Indonesia consumes much of its own oil and gas (it is the only OPEC member to be a net importer of oil), it is a major exporter of coal and has plentiful amounts of tin, bauxite, silver, copper, nickel and gold, among other things.

On top of that, demographically, it is in what Khatri calls “a sweet spot in a number of senses.” According to Nomura’s research, if one uses a criterion of US$3000 disposable income for the household as a definition of the middle class, then Indonesia has already moved from 1.6 million such people in 2004 to 50.4 million in 2009. That’s already an extraordinary pace of growth, but there’s more to come: Nomura believes the figure will be 149.7 million by 2014. If the criterion is US$5000 disposable income, then there will be a tenfold increase – from 9.9 million to 96.3 million – between 2009 and 2014. That in itself is plenty to drive a domestic economy, but additionally, Indonesia is heading in to a sweet spot in terms of the labour force as well.

This is good news for local business, particularly banks. “Indonesia right now is at a pretty interesting juncture,” says Pahala Mansury, chief financial officer of Bank Mandiri. That US$3,000 number cited by Nomura “is the point where, if you look at other economies around the world, people are going to be more ready to consumer a larger number of consumer durables. We can see it in the development of consumer finance in Indonesia, for example: up to September of last year our consumer loans grew 32% year on year.”

All of these things have caught the attention of credit rating agencies, which have been reacting to them in various ways. The most bullish is Fitch, which already rates Indonesia BB+, just one step below the crucial investment grade rating of BBB-. In February, it changed its outlook on that rating to positive from stable. Andrew Colquhoun, head of Asia Pacific sovereign ratings at Fitch, said at the time: “The positive outlook reflects Fitch’s view that Indonesia’s favourable macroeconomic prospects are likely to see the credit profile strengthen further over the next 12 to 18 months, despite near-term risks from inflation and potentially volatile capital flows.”

Moody’s, too, has Indonesia one notch below investment grade (it is rated Ba1 on the Moody’s scale), following an upgrade in January based on Indonesia’s economic resilience and improving public debt position. Standard & Poor’s is the laggard, at BB, one notch behind its peer rating agencies, but that too represents a recent upgrade and the rating is on a positive outlook.

What difference does an upgrade make? Usually, it cheapens a country’s cost of funding and increases investor interest; but this is a particularly significant jump. “This is the critical one: it’s not just an incremental change in ratings,” says Khatri. Many fund managers have a constraint that they can only buy investment grade bonds, in which case Indonesia would become open to investment from them. Those funds that automatically track investment grade markets would need to follow it too.

That said, Indonesia doesn’t really need much more in the way of foreign portfolio funds right now. In fact, if anything, it has started to become concerned by them. Foreigners held 30.8% of all rupiah government bonds as of January, and also poured money into the stock market throughout 2009 – driving it to a record high – before starting to pull back earlier this year. (Separately, and symbolically, Bank Indonesia said foreign currency reserves passed US$100 billion for the first time in March.)

These foreign flows have added to growing fears about the inflationary environment, and also the consequences if fickle foreigners were to start pulling all that money out of the market again. Most of Asia is worried about inflation, particularly as it relates to food and fuel. In that respect, Indonesia had started to seem tardy in raising interest rates before finally doing so on February 4 for the first time in more than two years after inflation reached a 21-month high. Perversely, part of the reason for not having raised rates before now was because the higher yield would then have attracted more foreign capital inflows, which would have exacerbated the fear of them leaving again. BI also increased reserve requirements for banks and tightened rules on foreign exchange holdings.

How bad is inflation? The consumer price index grew 7.02% year on year in January; Fitch, which calls inflation “a near-term risk to economic prospects”, estimates it will average 6.5% in 2011. Set against that, most forecasts for GDP growth are in the 6.5 to 7% range, after reaching 6.1% in 2010; President Yudhyono hopes to grow at an average of 6.6% (and create more than 10 million jobs) through to the end of his term in 2014. Balancing the two will be key to Indonesia’s mid-term progress and any home of an upgrade. For Khatri, “the base line is three more rate hikes in April, May and June, but with the backdrop of uncertainty in the Middle East and Japan, we might see some deferrals.” Deutsche also expects three more, but in April, July and the fourth quarter. The central bank is aided somewhat by a rising currency in fending off inflation, though naturally that has the potential to dampen export growth. This is, it should be said, the same conundrum most major emerging Asian nations are wrestling with.

It is in a better position than some, since it is insulated from rising global commodity prices by the fact that it has so many of its own. “Indonesia’s rich commodity base makes it one of the better hedged economies in the region to deal with an oil price shock,” says Deutsche economist Taimur Baig, noting that Indonesia imports refined oil while exporting crude oil and gas. Coal miners like Kaltim Prima, Adaro Energy and Straits Asia Resources are becoming increasingly well-known among world institutional investors as heavy-duty miners and major suppliers to the global coal market. On top of that, Pahala at Mandiri hopes this year’s harvest will help with inflation pressures, and notes the government is planning to temporarily allow imported foods to come into Indonesia more freely and allowing the rupiah to appreciate, dampening the impact of imported food inflation.

As for worries about foreign bond holdings, Ferry Wong, analyst at Macquarie in Jakarta, argues one has to consider long-term and short-term government debt separately. He says that when widely admired finance minister Sri Mulyani Indrawati resigned last year, 25% of short term government bond money left the country, whereas on long-term holdings, outflows were very low. “Short-term bonds are much more prone to flight,” he says. “But even in May last year when all that money left, within a week the market was relatively strong again. The government is in a much stronger position now: if you have US$102 billion in foreign exchange holdings it’s not too much of a problem if even $6 or 7 billion flow out of the country.” Pahala adds: “The pressures of managing capital inflows will probably not be as significant as we saw in 2010. We should not be overly concerned about that at this point, particularly with the slowing of some growth in Asia, including concerns about China and the unfortunate situation in Japan.”

Inflation apart, Indonesia has other challenges too: corruption, while widely felt to have improved, is still an issue; tax collection is flawed; and – the one thing everyone highlights – progress on infrastructure development simply never seems to be sufficient no matter how many task forces, agencies and initiatives are set up to move it along.

“The only major drawback for Indonesia is still the infrastructure,” says Ferry Wong at Macquarie. “Inflation and the fuel subsidy are challenges, but not so much of an issue as the government can absorb high oil prices. Infrastructure is the main problem.”

The latest movement in this direction is a proposed Land Acquisition Bill, which should help the government accelerate infrastructure projects. One of the long-standing hold-ups in infrastructure development, in particular on highways, is disputes over the land those highways will pass through. The bill means that land rights in public infrastructure corridors will be cancelled and owners compensated; if there’s a dispute, a court will rule on it within 30 days. By contrast, if often takes at least two years to clear land through these disputes, considerably longer than it actually takes to build a road in the first place. Wong hopes the bill, which is in parliament now, will pass soon, hopefully in the first half of the year.

It remains to be seen if it will make a big difference; it is often said that progress on infrastructure could add a couple of percentage points to GDP growth numbers, taking it from being just a high-growth Asian economy to something comparable with China. “The impact will be the cost efficiency, in terms of distribution costs,” says Wong. “The Indonesian economy will grow at a more optimal level. Right now it cannot grow at more than 7% because of the infrastructure bottleneck. With significant infrastructure projects, it will be easier for businesses to expand, and FDI will come in in a more aggressive form.”

Additionally, something odd has happened to the previously burgeoning privatisation program. Last year, in common with the rest of the region, the appetite for equity fund raising appeared insatiable, and the government took advantage of this to launch (or re-launch) an ambitious series of sales of public assets. They didn’t all go well, and the $524 million privatisation of national airline Garuda particularly didn’t go well. On February 11, the stock started trading and promptly fell 23% – not coincidentally, to roughly the level the bookrunners had recommended the deal be priced at. By March they were 30% down.

In March, deputy minister for state-owned enterprises Pandu Djajanto said he had asked permission from parliament to list only one more state-owned enterprise in 2011 – when there had previously been talk about listing up to 10. (The one survivor is expected to be Semen Baturaja, the cement company.) While global market uncertainties haven’t helped, Garuda is surely in the mix. Indonesia still has over 140 state-owned companies generating as much as 40% of national GDP, and many of them need reform.

Still, infrastructure and privatisation are the outliers; everywhere else, Indonesia’s story is relentlessly positive. The Asian financial crisis seems a long time ago now.