Institutional Investor Asean report: Indonesia

Institutional Investor, September 2011

Of all the stars in southeast Asia, Indonesia is shining  today – and represents the most remarkable turnaround of all Asean nations. But is it sustainable?

In the Asian financial crisis Indonesia was arguably the nation that suffered most, facing a sevenfold devaluation of its currency in a matter of days. This is where the most infrastructure projects fell through, the most bonds defaulted. And, following a period of dictatorship with a long and unsteady transition into democracy, it would remain a risky place for investors to consider putting money for much of the subsequent decade.

In the last five years, though, everything has changed. Susilo Bambang Yudhyono has now been President of Indonesia since 2004, and the 2009 election that put him back into power for a second five-year term has become seen as a model for a democracy in Asia. Political stability has helped, but plenty else has gone right too: a surfeit of coal and other resources at a time when China’s growth has put a considerable premium on those commodities; a largely domestically-driven economy at a time when export-led nations have been badly hit by problems in the developed world; and growing foreign inflows encouraged by the country’s resurgent story.

Today, economic indicators paint a very positive picture. GDP grew 6.1% in 2010, the government expects 6.4% for 2011 and 7.2-7.7% by 2014. The rupiah is strong and steady. International reserves are at record highs, passing US$100 billion earlier this year. Public debt to GDP is just 26%, down from 86% in 2000, and the fiscal deficit has not passed 2% of GDP at any point in the last 10 years.

“We have been a major cheerleader of Indonesia for several years,” says Taimur Baig, economist at Deutsche Bank. “Rightfully, as one of the largest Asean countries, it is finally emerging as a place of tremendous growth potential. The country is benefiting from political stability, abundant natural resources, a favourable demographic dynamic, and crucially, prudent economic management.”

It’s no surprise that in this environment, there is widespread discussion of a ratings upgrade – and what a key upgrade it would be. All three major international agencies rate Indonesia exactly one notch below investment grade, with a positive outlook. The next upgrade makes Indonesia, officially, investment grade, and that, in turn, completely changes the scale and composition of international investors who can invest in the country under their own internal guidelines.

“Our forecast has been, and remains, that we will see at least one of the rating agencies upgrade to investment grade status before the end of the calendar year,” says Robert Prior-Wandesforde at Credit Suisse. “Fitch will most likely be first, but all three will get there by the middle of next year. It’s a question of when, not if.”

He and others believe Indonesia will deserve its big moment when it happens. “It’s a reflection of a dramatic and impressive improvement in many of the fundamentals of the Indonesian economy since the Asian crisis,” he says. “We’ve seen huge balance sheet restructuring, both private and public sector.”

And, crucially, with such a strong domestic consumption story, it is barely vulnerable to external shocks. “Countries like Malaysia, Thailand and Singapore have a far greater correlation to the way the US evolves than Indonesia does,” says Baig. “As we are looking at increasing risks in western economies, the country that stands out would be Indonesia.”

There are often considered to be three flies in the ointment, or at least things to keep an eye on. One is inflation, but as the world economy has slipped in recent months, that appears to have become less of a worry: core inflation, on latest available numbers, stood at 4.5%, which is no great concern.

Another is the risk of foreign outflows. Around 35% of Indonesian local currency government debt is now held by foreigners, a reflection of the country’s economic fundamentals and attractive yield in an appreciating currency. But what if it flies out again, as has happened before? “It’s certainly a high number,” says Tai Hui at Standard Chartered. “Within the Asian region, it’s one of the highest levels of foreign bond ownership. But when we talk to foreign investors, they say: tell me somewhere else with this sovereign credit background and a high single digit yield? The fundamental story is too attractive, and the outlook too positive, for many people to give up their position in Indonesia.”

The government’s debt management office believes it has contingency measures in place to deal with an outflow if it happens, though it has clearly yet to be tested. And it argues – and analysts agree – that the composition of foreign debt-holders has improved over the years, and is now much more long-only than the leveraged investors and hedge funds who were widespread holders four years ago. “There has been a sea change in the profile of those investors,” says Baig. “Having said that, one third of domestic debt issuance held by non-residents is not a healthy statistic.”

The third is infrastructure, as it is in the Philippines. For years it has been clear that infrastructure represents a damaging bottleneck to Indonesian growth; it is also, Hui argues, one of the reasons inflation can rise suddenly. “The two issues go hand in hand,” he says. “Lack of infrastructure directly contributes to inflation, because it means costs all the way through the supply chain – trucks, ferries – go up.”

The government has set great store in a new piece of legislation, the Land Acquisition Bill, which is supposed to alleviate one of the problems in getting infrastructure projects underway, particularly highways. One of the biggest bottlenecks in Indonesian infrastructure development is that in trying to secure the land to build on, disputes often arise, and they can take many years to get through the courts. The new Bill, if passed, cancels land rights in public infrastructure areas with owners compensated, and any disputes over that compensation must be ruled upon by a court within 30 days.

That said, while the government has been championing this legislation all year, at the time of writing it still had not passed parliament and was rapidly running out of time to do so before parliament goes into recess. Still, it has been signed by the president, which was seen as the most likely obstacle, so it does appear to be a question of if not when. “It will happen, but whether it does so before they adjourn for the end of the year is debatable,” says Prior-Wandesforde.

And will it change infrastructure development in Indonesia? “To be honest, I’m not as convinced as some,” says Prior-Wandesforde. “It will take time for it to start working efficiently and it will depend how precisely it is drafted.” He also urges some caution about enthusiasm for Indonesia generally. “I sense a euphoria around Indonesia right now, that it can do no wrong, with forecasts saying it will grow at 7%. While it has made substantial improvement, there is not enough progress in key areas such as the labour market to generate the kind of investment necessary to achieve 7% growth.”

While Indonesia clearly still has challenges, there is no denying the progress it has made through the ranks of southeast Asian economies in recent years, and its immediate future looks very bright.