Euroweek Indonesia report: financial institutions

Euroweek, September 2013

During the Asian financial crisis, Indonesia’s banking system was arguably the weakest link. No other banking sector in the region collapsed with quite the misery of Indonesia’s, and probably no other country’s took so long to fix afterwards.

But fixed it eventually was, and today, banking in Indonesia is seen as a symbol of resilience rather than nervy exposure.

“A lot of parallels have been made between now and the Asian financial crisis,” says Su Sian Lim, Asean economist at HSBC. “But one of the main differences is that back then the banking sector was a very weak point in the chain. That’s not the case anymore: balance sheets are much stronger, debt levels have fallen significantly, NPLs are in the single digits, and by and large the big banks are very well capitalised. At this point, I’m not seeing any flashing red signals on the banking side.”

Indeed, all the numbers support Lim’s view. According to Tjandra Lienandjaja at Mandiri, capital adequacy ratios for the system stand at 17 to 18%. “The top banks’ average CAR is well above the minimum standards of the central bank, or even Basel 2 or 3.” He says margins average 5.7 to 5.8% in the industry, NPL levels are on average below 2%, and coverage is over 100%.

Two things have changed since the bad old days of the late 1990s. One is a considerably more vigilant stance by Bank Indonesia, the central bank, and in particular, restrictions on loan to deposit ratios, which Lyris Koh, credit analyst for Asia ex-Japan financial institutions at Barclays Capital, says now stand at less than 100 system-wide on both a local and foreign currency basis.

Secondly, borrowers themselves have changed. “A lot of industrial companies in Indonesia are not as aggressive as they were in the past in terms of getting growth, partly because they learned a lesson in 1997, and also because of regulation,” says Tjandra. “Now the average net gearing ratio in Indonesian companies is low: around 30%, compared to close to 100% in past years.”

In particular, they have changed their attitude to foreign currency borrowing. “In the past, people would just borrow any type of currency without any underlying transaction,” he says. “Now it is very different. That’s why, in 2008 and 2009, Indonesian banks weathered the crisis. This time around they will do so again.”

That said, there is no doubt that the great times of buoyant economic expansion in Indonesia are giving way to more troubled times; as the economic overview chapter illustrates, there are real problems to deal with in the current account deficit, among other areas. But that’s not the same as some of the economic crises the country has had to navigate in the past.

“I think you have to make a distinction between economies moving to recession, and economies that are slowing,” says Koh at Barclays. “We are entering a more challenging period in Indonesia, but economic growth is still 5 to 6%. From an asset quality perspective, it would not be a surprise to see an uptick in NPLs in Indonesian banks, but we look at it as more of a normalization in the credit cycle. NPL ratios cannot stay at 1.9% forever.”

So where to grow? “For a number of banks, the focus is to grow retail and SME businesses, and the currency need for these customers is rupiah,” says Madhur Mehta, regional head of FIG capital markets for southeast Asia at Standard Chartered. “With credit to GDP currently in the low 30% range, there is an opportunity to increase credit in the country. Most major banks have strong tier one ratios and CAR and thus are in a good position to expand.”

Koh at Barclays also highlights retail. “Indonesian banks have been trying to increase their exposure to the retail sector, especially in mortgages,” she says. “It makes sense given the longer term structural story behind Indonesia, and the under-penetration of mortgages.”

There is also the buffer of strong numbers to protect them as they expand. “Even though the net interest margins of banks may decrease with competition, they are still high compared to some other countries in the region,” says Mehta. The profitability of banks, he adds, assists with strengthening capital generation, creating good reserves that will help with any problems that arise when expanding in a less certain market. “The relatively high capital ratios of the banks should be able to withstand a potential downturn in asset quality, if that should happen.” Add to that the fact that the NPLs are at historic lows, and provisioning in high.

“On balance, given the operating environment, liquidity and capital strength of banks and credit growth, the banking sector should remain stable,” Mehta says.

Set against that, other parts of Indonesian banking will clearly slow. Anything related to commodities is under pressure, as commodity prices themselves have fallen and the key customer – China  – has not only experienced slowing growth but has changed the composition of that growth away from investment and towards domestic consumption, for which commodities are not so essential. Indeed, all investment lending is likely to decline. “Given that we are entering a more challenging environment and economic growth is slowing, investment-related lending will also slow,” says Koh. “It is a natural part of the cycle.”

Still, there is a sense that the market has already priced that in, and brokers are beginning to look at brokers opportunistically. Nomura, for example, in its most recent Asean strategy note, felt banks – trading below their long-term averages – were oversold in Indonesia. “Overall, we think significant portions of the Indonesian market may have already priced in the concerns about currency weakness and its impact on economic growth and corporate profitability, and we see opportunities in banks,” it said.

And as the box on funding shows, exposure to US dollars – or any other currency – appear to have declined in recent years, which is useful at a time of a declining rupiah. “I have not been made aware of any concerns that would imply NPL ratios are on the rise,” says Herman van den Wall Bake at Deutsche Bank. “This is more a balance of payments and FX correction rather than anything specific. Indonesian banks’ loan books have very little dollar exposure from a liability standpoint, and most of their creditors are onshore. I don’t’ see the banking sector is under material stress.”

One other development over the last 10 years has been the increasing involvement of foreign institutions in Indonesia. Although this appeared to take a step backwards in late July when DBS pulled a $6.5 billion bid for Bank Danamon Indonesia – a step that DBS CEO Piyush Gupta said put DBS’s Indonesian ambitions back by five years – the fact is that foreigners are still very heavily represented in Indonesia. Danamon itself is still majority-owned by Fullerton Financial Holdings, an arm of Temasek, Singapore’s state investment entity; Bank Niaga is owned by Malaysia’s CIMB, and Bank International Indonesia by Maybank; HSBC controls Bank Ekonomi, and Standard Chartered, Bank Permata. Last year a change in ownership rules limited foreigners to a 40% stake but that still leaves room for considerable operational involvement, if not outright control. Furthermore, the change does not apply retroactively, leaving HSBC, Standard Chartered and CIMB with their ambitions intact.

“With many Indonesian banks in the hands of foreigners, they do look at companies differently now,” says Tjandra at Mandiri, which remains very much Indonesian. “There are some changes in how they look at loan approvals, for example.”

And these foreigners see Indonesia as a vital part of their regional strategy, particularly the Malaysian institutions. In its interim results announced on August 26, CIMB group said that Indonesia accounted for 31% of group profit before tax, more than three times the contribution of Singapore and Thailand combined. For Maybank, its Indonesia business provided a 27.2% annualised loan growth in the second quarter of financial 2013, more than double the rate anywhere else in the group, Malaysia included. Both these institutions see particular synergy in Islamic finance: they have honed their skills in Malaysia, the most sophisticated Islamic banking industry in the world, and can now roll out those abilities in a country with a vastly greater Muslim population than Malaysia’s, and with largely untapped potential for growth.

BOX: INDONESIAN BANK FUNDING

Indonesian banks have been infrequent issuers in the dollar markets in recent years. There have only been four in the last two years: senior dollar deals of $500 million apiece for Indonesia Eximbank in April 2012, Bank Negara Indonesia a week later, and Bank Rakyat Indonesia in March 2013, and then a $365 million deal for Ottawa Holdings, which is a funding vehicle for Bhakti Investama, on May 9. None have followed since Ben Bernanke’s May 22 comments on tapering, and none are particularly likely to in the near term.

“FIG issuance has been very quiet this year,” says Herman van den Wall Bake at Deutsche Bank. “And given the market correction, I would not expect to see them lock in funding in the near term. They will wait for spreads to compress before entertaining coming back to the market. The loan market hasn’t corrected anywhere near as much as the bond market, so it wouldn’t make sense for them to lock in term funding.”

It wasn’t always like this. “Around eight to 10 years ago, we saw a number of banks come to the international markets to raise Tier 2 offerings in dollars, but since 2006 we haven’t seen any,” says Madhur Mehta, regional head of FIG capital markets for South East Asia at Standard Chartered. Instead, they have tended to shift to rupiah markets for tier two, mainly for cost reasons and also to avoid a currency mismatch.

But on top of that, Indonesian banks have had scant need for capital markets funding at all recently. Partly, Mehta says, this is because internal profit generation has helped them to increase capital ratios, reducing the need to raise sub debt. But it’s also about the manageable level of loans relative to deposits, says Lyris Koh at Barclays Capital. “Loan to deposit ratios are still less than 100, so banks can fund themselves with deposits, although the competition has become more intense,” she says.

While funding made sense for BNI last year, when it drew $3 billion of demand for its first global issue in six years, that happened during an environment in which investor ardour towards Indonesia and its credits was intense. It paid 4.375% for its five-year funds, the tight end of guidance, and 129 basis points over the benchmark sovereign credit, which was considered tight but still sold because of its scarcity value. A deal like that simply would not take place today.

It is the same story, and perhaps worse, in local currency debt. There, government five-year debt has gone from 4.5% before Bernanke’s comments in May to as wide as 8% before tightening to 7.6% at the time of writing, with issuers expecting to price around 150 basis points wide of that, or 300 for subordinated debt, one local banker in Jakarta explains. “A lot of issuers have not yet accepted the price, and until they do, I do not see any issuer coming to the market,” says the banker. “For bank issuance, I don’t think we will see any this year.”

With little pressure for new funding and no major wall of redemptions due, banks can afford to stay away for a while, though they must return eventually. “Banks will continue to access the US dollar markets, although unlikely at a very frequent pace, and it will depend on the bank customers’ needs for US dollar borrowings,” says Mehta.

That latter point is important: the need for dollars among Indonesian banks appears to be declining. “When we talk to Indonesian banks they always tell us: we like to lend dollars to institutions that have a natural hedge,” says one banker. “They learned from the Asian crisis.” And if the best margins are to be found in rupiah business, that’s going to be a priority for the foreseeable future.

This, in turn, has some positive associations. If Indonesian banks are not borrowing dollars then they are not badly exposed to the sharp decline in the rupiah that has taken place since May, and since July in particular. This is perhaps the single biggest difference between today’s environment and the Asian financial crisis: the lack of unhedged currency exposure at a time of a declining local currency.

It may be that Basel 3, with its requirement around net stable funding ratios, will prompt issuance of longer-term US dollar debt, but that is likely to be some years away. “Indonesian banks will be back in dollars, but they’re never going to be like the Koreans, or even the Thais,” says one banker. “Indonesians are once in 18-to-24 month issuers.”

“Indonesia’s banking system is relatively fragmented, but if you talk about the bigger commercial banks, they are very well capitalised. One of the key strengths of the Indonesian banking system is how well capitalised it is.”