Indonesia’s economy: Asia, only more so

Chris Wright

Asiamoney, June 2011

Indonesia’s economy behaves like an exaggerated version of Asia’s. All of the themes of the broader continent are played out to a magnified degree in Indonesia. Growth, the shift to domestic consumption, the power of commodities, inflation, central banks playing catch-up, infrastructure bottlenecks, the boon and threat of foreign fund flows – all of them are present across Asia, but are more acute in Indonesia.

First, the good news. “The vital signs for the Indonesian economy are at their strongest in the last decade, and the fundamentals are improving,” says Agus Martowardojo, Indonesia’s Minister of Finance, who answered questions from Asiamoney at the Asian Development Bank meeting in Hanoi in May.

He is, unarguably, right. Indonesia passed through the global financial crisis with barely a glancing blow. GDP grew 6.1% in 2010 and Agus expects it to by 6.4% this year and is targeting 7.2-7.7% by 2014. The rupiah has not only become strong – twice as strong against the dollar as at the end of the Asian financial crisis in 1998 – but stable too, steadying between Rp8,600 and Rp9,000, a level that troubles some exporters (see roundtable) but gives the country greater economic heft. International reserves are at their highest level in the country’s history, crossing a symbolic US$100 billion threshold earlier this year, having trebled since 2005.

One of the reasons that things are looking brighter is because Indonesia is, to a large degree, the engine of its own growth, and so less troubled by global economic travails. Whereas China has a stated policy of shifting from an export economy to one driven by domestic demand, Indonesia is already there. “For Indonesia, the core of the virtuous cycle is a revival in domestic demand,” says Agus. “Consumption is up to 60% of GDP.” On top of that, there’s the fact that where Indonesia does export, it does so chiefly with commodities, whose prices have risen dramatically in recent years. “We are buffered by our large natural resources and our geographical position,” Agus says. “We are well positioned to serve demand for those natural resources not just from China but increasingly from India.” On the back of these drivers, the country’s balance sheet has started to look rather impressive: public debt of 26% of GDP, compared to 86% in 2000; a fiscal deficit that has not exceeded 2% at any point in the last 10 years; and a falling cost of capital.

Perhaps the most promising barometer of Indonesia’s economic improvement comes from the rating agencies, and in this respect Indonesia stands at a pivotal moment. When Standard & Poor’s upgraded Indonesia’s long-term foreign currency sovereign credit and debt ratings from BB to BB+ in March, with a positive outlook, it meant that all three major international rating agencies had moved the country to just one notch below investment grade. Moody’s upgraded it to Ba1 on its scale in January; Fitch, which already had Indonesia at BB+, moved its outlook on that rating from stable to positive in February. For any one of the three, the next upward revision will make Indonesia investment grade. None of these agencies has had such a high rating on Indonesia since the Asian financial crisis in 1997. If it happens, then a host of fund managers who are prohibited from investing in sub-investment grade paper will be able to invest – not just in Indonesia itself, but issuers who have been constrained by the sovereign ceiling.

So what’s the dark side? There are three things that concern people both inside and outside Indonesia to varying degrees.

The first is inflation. This is the one that has the greatest likelihood of derailing an investment grade upgrade; it turns up in every comment the agencies make. When Andrew Colquhoun, head of Asia Pacific sovereign ratings at Fitch, announced Fitch’s upgrade in outlook in February, this is what he said: “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.” And when Standard & Poor’s followed in March, its credit analyst Agost Benard added: “The positive outlook reflects the likelihood of an upgrade if inflation is tamed while balance sheet improvements continue.” Other analysts and agencies add similar caveats to their otherwise positive assessments of the country.

Agus does not believe there is a major problem. “Even though there is pressure from commodity prices, specifically food, core inflation has been relatively stable,” he says. “We are confident the government will be able to retain inflation within the target for 2011.” That target is 5.3% and not everyone agrees with him: Fitch, which calls inflation “a near-term risk to economic prospects”, estimates it will average 6.5% in 2011, while the year-on-year CPI figure for January was worse still, at 7.1%.

Part of the problem foreign economists have with this view is that Bank Indonesia has never seemed to be in a hurry to change monetary policy to avoid inflation getting worse, relying on exchange rate movements rather than rate hikes to fix the problem.  Earlier this year Nomura predicted three rate hikes, in April, May, and June; well, the first two didn’t happen, and it seems unlikely that the third will despite hawkish language in BI’s monthly statements. “It appears that any meaningful tightening action will only come after an upside surprise in inflation, not before,” says Wellian Wiranto at HSBC in Jakarta. “The fact that the statements in previous months had been carrying equally hawkish tones [to the May statement, when rates stayed flat] without leading to any significant rate hikes leaves us rather unsure that this one portends anything different soon.” Wellian highlights the dangers in just using currency appreciation rather than rates to curb inflation; for a start, since Indonesia is mainly a domestic economy, currency strength has a limited impact, except to hit exporters. “We continue to think that raising policy rates earlier rather than later still looks to be the most prudent course of action.”

Wellian’s is a common view. Prakriti Sofat at Barclays Capital says “the need for policy tightening remains”, and has a base case of a further 50 basis points of rate hikes. “But the risks are squarely tilted towards BI doing less and rate hikes being pushed out.” But it’s not a universal view. At RBS, Chia Woon Khien, managing director and head of local markets strategy for Emerging Asia, argues that the interest rate is already reasonably high because of the way the central bank has behaved over recent years. “They’ve been very prudent,” she says. “Before Lehman, they never hiked rates like crazy, so during Lehman, they did not need to cut massively like Korea, India or China, which had to do a U-turn and today have ended up with inflation problems. Indonesia has been flat throughout this whole period, so the level of interest rates, to me, is not exceptionally low.”

“They do need to hike,” Chia adds. “But I don’t think there’s this big risk everybody is talking about.”

The second challenge concerns fund flows. Indonesia’s strong fundamentals have attracted a lot of foreign money into Indonesia, both on the equity and the debt side, so much so that it has started to create concerns about what happens if it all leaves again. Over 30% of Indonesian rupiah government bonds are held by foreigners.

The Indonesian position has been, firstly, to put an understandably positive spin on this. The high ownership “basically reflects investors’ confidence on Indonesia’s long term economic fundamentals,” says Rahmat Waluyanto, Director General of Debt Management in the Ministry of Finance. “Yes, we are also very aware of any potential reversal risk. But we are very ready to prevent such an event happening.”

Both Rahmat and Agus say there are measures in place to deal with any outflows. The country has devised a bond stabilization framework, including crisis management measures established between state-owned financial companies and the central bank, to insulate the country from any shocks caused by a departure of funds. It’s not entirely clear how this framework will operate, but it doesn’t appear to mean capital controls in the conventional sense: it seems that money won’t be stopped from leaving, but rather that there are contingencies to deal with it if it happens.

In any case, Rahmat stresses that the composition of foreign money in the debt markets is important. “Most of those foreigners are buy and hold or real money account investors and are holding long tenors of bonds,” he says. According to his office, 70% of all foreign bond holdings are in maturities of five years or greater.

The third challenge – and stop us if you’ve heard this before – is infrastructure. For decades now, infrastructure has been identified as the biggest hurdle that must be surmounted for Indonesia to realise its potential, and little has changed over the years. “To be frank with you, the bottleneck [stopping] our economic growth achieving 7% or higher is infrastructure, so it is a national priority,” says Bambang Brodjonegoro, head of the Fiscal Policy Office within the Ministry of Finance.

More than any other area, the problem has been most evident in highways. That’s because highways involve the greatest amount of land and the greatest variety of owners of it. If a highway developer wants to build on land and the owner won’t sell, or a dispute arises over the sale, that can mire development for years.

In order to address this, the government has set great hopes on its Land Acquisition Bill, which was in parliament at the time of writing. Under this new law, land rights in public infrastructure areas will be cancelled, and owners compensated (one can see why such a law is going to involve a certain amount of controversy and parliamentary debate). Where disputes do arise, a court must rule on them within 30 days – and this would be the truly transformative element.

Agus is open about the problems that exist without the law. “If we review PPP projects in Indonesia for the last eight years, we have to admit that no one can be executed,” he says. “One of the main obstacles is land acquisition.”And where is the bill up to? “The government has already reached consensus with parliament that we will have a special law for land acquisition. We believe by the end of the third quarter, we will have that law.

“With that law, we are confident that infrastructure projects can be executed faster.”

Agus speaks of other priorities for Indonesia. “Our medium term strategy aims to harness the whole growth potential of our provincial regions to spread the benefits of growth and development more easily,” he says. Indonesia is establishing six economic growth corridors to do so, he says. Ideally, Indonesia will attract private sector participation into ports, power plans and other infrastructure development across Indonesia.

Doing so, he knows, is going to take something of a shift in efficiency and professionalism in state institutions. “In order to improve the investment climate we will intensify the bureaucratic reform agenda to improve governance,” he says. “We understand the importance of efficient bureaucracy to our credibility. The Ministry of Finance is at the front of public sector reform in Indonesia, moving from a compliance-based administration to a professional one, accountable to the public.”

Long-time Indonesia-watchers may roll their eyes at this, feeling they have heard it before. But the big difference now, compared to in the past, is that Indonesia can speak from a position of uncommon strength, stability and justified optimism.

Box: Indonesia in the debt markets

One can see what institutional investors make of Indonesia’s health by looking at the country’s fortunes in the international debt markets between late April and late May.

First, in New York hours on April 27, the Republic of Indonesia priced a US$2.5 billion 10-year global bond, one of the largest single-tranche issues ever in Asian bond markets.

The deal, lead managed by Deutsche Bank, JP Morgan and UBS, came with a coupon of just 4.875% and yielded 5.1% at launch, the lowest coupon the country has ever paid on dollar debt. If there was a complaint, it was that they could have seized the opportunity to secure longer-term funding too.

Then, in May, Pertamina, the state-run energy company, launched a 10-year of its own: a US$1 billion global bond that marked its international capital markets debut. And then, galvanized by its success, it did what investors had hoped the sovereign would do, and came back later the same week with much longer-dated paper: a US$500 million 30-year deal.

All deals were extremely popular: the first Pertamina bond, lead managed by Citigroup, Credit Suisse and HSBC, was seven times covered, and the sovereign raising attracted a US$6.9 billion book from close to 300 accounts. The fact that Pertamina is seen as a proxy for the sovereign, and therefore should benefit if Indonesia itself is upgraded to investment grade, counted in the deal’s favour: Pertamina’s Ba1/BB+/BB+ ratings exactly match those of the sovereign.

All the deals sold well internationally; more than 40% of the Pertamina transactions went to investors in the US, with Asian and European buyers well represented as well. Long-only money – funds and asset managers – dominated both deals.

For Rahmat Waluyanto, who heads Indonesia’s debt capital markets programs, it all points towards an upgrade. “Indonesia has already been perceived as having an investment grade rating by the market, as indicated by the CDS [credit default swap] rate and its bond price,” he says. “We just need to convince the agencies such as S&P that we are able to manage inflation and to secure funding from domestic market sources.”

“The investment grade rating is just within reach.”