Indonesia’s new dawn

CFA Magazine, February 2012

In a world with very little good news for investors, Indonesia was a rare exception in 2011. Whether you were a debt or equity investor, you would have come out comfortably in front – not easy in a year in which emerging market equity benchmarks dropped 20% through the year.

It’s all a far cry from the time, not so long ago, when Indonesia was a pariah among surging Asian economies. No country suffered more in the Asian financial crisis of 1997 to 1998, when the rupiah suffered a sevenfold decline in a matter of weeks; no country, in the late years of that decade, was more closely associated with corruption, inefficiency and opacity, as the final years of the Suharto dictatorship gave way to an uncomfortable new democracy.

Today, everything has changed. Susilo Bambang Yudhoyono, who became Indonesia’s elected president in 2004 and won a second term in 2009, is now seen as the embodiment of a model new democracy, cited as an example that other neighbours might follow. These days, when people talk about political risk, it’s in that SBY can only serve two terms. The fact that he, a former army general, could come to be seen in this way is emblematic in itself of Indonesia’s transition: while it hasn’t moved as far from its military roots as it would like to convey, it has moved far enough to make a difference.

Beyond the politics, it’s the financial condition of the country that’s really changed. Most analysts project 6-6.5% annual GDP growth over the next two years, but that in itself is nothing special in Asia: China and India routinely hit higher, and even Vietnam, but the latter in particular does so without a structurally sound economy. But look at Indonesia’s foreign exchange reserves, negligible at the time of the Asian financial crisis but US$111.3billion at the end of November 2011. Look at how Indonesia’s net external debt has fallen from 140% in 2001 to around 30% today, while general government debt has fallen from 80% of GDP to about 25% in the same period. Indonesia has run a basic balance surplus (current account balance plus net foreign direct investment) for over a decade now, and the banking sector, while hardly a regional champion, is no longer the clogged liability it was a decade ago.

And best of all, more than any other major economy in Asia, it is heavily insulated from external shocks. Indonesia is primarily a domestic story, not an export one; 65% of total GDP is domestic, and it ranks second lowest for gross exports to GDP in the region after India. “So despite the problems in Europe, I think the Indonesian economy growth will continue to be robust,” says Ferry Wong, Indonesia strategist at Citi in Jakarta (his call for 2012 is 6.3% growth).

[Subhead]International money floods in…

International investors have recognised this for some time, resulting in very high levels of foreign ownership of stocks and bonds – a potential headache too, discussed in more detailed below. But particular attention has been focused on the rating agencies, because by the middle of last year all three of the major global agencies rated Indonesia just one notch below investment grade. The case for an upgrade, and the resulting impact on capital flows, has been hotly discussed not just in Indonesia but among portfolio managers worldwide. In December, Fitch was the first to move, upgrading Indonesia to BBB-. “We are expecting Moody’s and S&P will follow in the first half of this year,” says Wong. “If you look at all the macro indicators for Indonesia, we should be investment grade.”

Some of this upgrade is already in the price on both the debt and equity side, but not completely. “The practical impact will be that the cost of funds will come down,” says Wong. “I am not talking about the government bond yield; that has already taken into account an investment rating upgrade. But corporate bond yields will come down.” Government bond yields have fallen from10.1% to 6%  – lower than Italy – in the last two years but corporate bond yields have dropped just 150 to 200 basis points, Wong says, a discrepancy that is likely to be corrected, to the great enthusiasm of debt portfolio managers. An expected increase in corporate issuance, reflecting the fact that more portfolio managers can buy investment grade credit than non-investment grade, ought to drive yields down still further.

“Foreign ownership of government bonds is about 30%, but if you look at corporate bond ownership, it is only 5.1%,” says Wong, citing September numbers. “With the rating upgrade there will be more foreigners; that should impact corporate borrowing too, because if more companies are issuing bonds, the banks have to lower their lending rates as well.” All of this ought to be good news for Indonesian corporate performance and therefore the broader economy.

[Subhead]…but what if it leaves?

However, the influx of money into Indonesian debt has been something of a mixed blessing, because for as long as it has been coming in, investors have been worrying about the consequences of it moving out again. It’s a fact of life that, when things go wrong in the west, money flees emerging markets even if they are the stronger economies; it’s just the way capital behaves in a risk-off environment. Indonesia has experienced severe capital flight on several occasions in the past, most recently in 2008, and the experience is never pleasant. And in September, with conditions in Europe turning noticeably worse, it started to happen again.

In August, foreign ownership of Indonesian local currency government bonds had peaked at an exceptional 36%. “Then, in September, you had a bout of broad Asian currency weakness following an escalation of risks in Europe, and in particular bailout fears for Greece,” recalls Andre de Silva, head of Asia Pacific rates at HSBC. “You saw a correction in bond yields in Indonesia.” But the worst did not happen. “Because the central bank showed strong conviction in stepping into the FX and bond market to the tune of $10 billion, using its reserves to defend the currency, it prevented a much more dramatic outflow,” de Silva says. “While we did see outflows, to just below 30%, things have stabilised and inflows have been incrementally increasing.” Today they stand at around 31%. “The overall message of last year is: yes, there were some periods of volatility and net liquidation, but in the context of past precedents they were extremely minor. Bond performance says it all: in our own index, Indonesian bonds returned 21.5% from a local currency standpoint in 2011. That’s three years in succession of 20% plus returns in that market.”

The difference from previous withdrawals was, one, that there is more long-term money involved in Indonesian debt than the flight and speculative capital it attracted in the past; and two, the presence of reserves give the country muscle.

Rahmat Waluyanto is the man in charge of Indonesia’s debt capital markets and its bond issuance programs; he is in the debt management office of the government. He feels the country came through that test very well. “I’m very positive,” he says. “We see capital inflows are still going on. What we’ve witnessed is the domestic market becoming more resilient. When foreign investors sold off Rp30 trillion rupiah of bonds in September, they came back in one week.” Yields rose only 50 basis points during that time, he says, and flattened again within days. “Those two things indicate that the confidence of investors in Indonesia is stronger.”

[Subhead]Waiting for the shock

What about if Europe really does turn bad? Could Indonesia withstand that? “We are already prepared for any potential crisis,” he says. “We have a crisis management protocol, integrated between the central bank and ministry of finance. We have a bond stabilization framework. And we have allocated in the budget funds for risk mitigation.” There is also a food access program ready for any increase in food prices. And, in the newfound glow of rating agency upgrades, Indonesia will front-load its bond issuance while times are relatively good. “We plan to make the most of the momentum from the upgrade, both in domestic and international bond issuance,” he says. Far from outflows, he instead expects inflows, not just into investment portfolios but to the real sector in FDI.

By and large, strategists and analysts agree that Indonesia can deal with external shocks. “Like most Asian bond markets it is susceptible to [shocks], but I think it would be limited,” says de Silva. “The central bank has shown its cards in both the FX and bond market, so it would be contained, rather than a re-run of substantial net liquidations of the past. If there is any correction, if the yields got to 7.5%, it would be an opportunity to go back in and reinvest.” Wong agrees that “the central bank has become more experienced at facing inflows and outflows from foreigners,” and points not only to the forex reserves but bilateral agreements with China, Japan and Korea, among others, which add further sturdiness. “If the problems in Europe get considerably worse, that’s a problem for every country in the world. But Indonesia should be able to defend its currency and economy relatively better than other countries.”

On the equity side, the local stock market rose 6.4% in US dollar terms in 2011, far outpacing most emerging markets. Is there any value left? “Indonesia’s still going to have a pretty good year,” says Andrew Swan, head of Asian equities at Blackrock. “You’re starting to see some progress on the political front: the Land Acquisition Bill has just passed and, while it doesn’t necessarily mean the infrastructure spend kicks off, at least it’s a step in the right direction.”

[Subhead]The infrastructure question

The legislation Swan refers to is supposed to address Indonesia’s Achilles heel: infrastructure development. This has been seen as the weak link in Indonesia’s economic growth potential for decades now, and through one false dawn after another, it never seems to get much better. Jakarta’s roads are close to gridlock at times; airports, highways, ports and power need investment; but inertia, corruption and confusion keep foreign investors away.

The Land Acquisition Bill deals with a problem particularly relevant to highways. If the state tries to secure land for projects, and it is challenged, then getting through the courts can take far longer than the actual construction would have done. The bill makes this court process far quicker and gives the state greater power; in theory, it removes one of the major bottlenecks. Also, once the government has acquired 50% of the land necessary for a project, it can start work.

Wong says the bill “should expedite infrastructure spending,” and notes some key projects underway: construction is intended to start on a mass rapid transit system in Jakarta in November. “I believe infrastructure will start kicking in pretty fast over the next six to 12 months.”

Philip McNicholas, director, Asian sovereign ratings at Fitch, and somebody key to the recent upgrade, is not quite so certain. “If you look at the history of legislation that gets passed in Indonesia, typically afterwards there’s quite a lag time while people work out the implementation,” he says. “But it’s a good sign. People have been waiting for this to come through for some time, and it takes make things much easier on the government spending side insofar as a large part of the reason for Indonesia’s fiscal prudence has been its inability to execute as well as desired from capital spending plans.” Consequently, if Indonesia does get infrastructure spending underway, does that mean the government’s fiscal discipline will slip? Fitch does warn about some fiscal slippage as a consequence of improved infrastructure, but McNicholas argues that it should be accompanied by GDP growth which justifies it. “So long as the money is allocated to projects that are growth-enhancing, I wouldn’t see that as a negative but a long-term structural positive for the country.”

[Subhead]Inflation and corruption

Other potential headwinds have diminished; all last year, the biggest concern was about inflation, but that was largely neutered by the global slowdown and nobody is talking much about it now. Indonesia does heavily subsidise fuel, and there’s always the potential for a change in that approach with a knock-on effect in inflation, but that aside it is an issue for another day. “In a supply-constrained economy, it’s always going to be something in the background that BI [the central bank] will have to monitor,” says McNicholas. “But we feel much more comfortable with the overall policy framework, and if inflation does reach uncomfortable levels, the central bank will act to tighten and get it under control.”

One problem that doesn’t go away is corruption. “Governance is always an issue when it comes to Indonesia,” says McNicholas. “One thing we note is that reform momentum is stalling a little and slowing up, but we don’t see it as an outright reversal.” The governance of parties – including SBY’s, which is far from exempt from criticism – will become a more pressing issue as we move closer to the next election in 2014.

Though distant, the election does have the potential to rattle markets, with a new president required. “We’re a bit worried about that: some of the candidates on the table lack credibility,” says Chua Hak Bin, head of emerging Asia economics at Bank of America Merrill Lynch. “That will be the big issue two and a half years from now. But unless somebody is so radical that they change policies dramatically, the worst case is that it will probably muddle through.” One school of thought is that the current government hasn’t actually done a great deal, other than to ensure political stability; the rest has been a function of being commodity-rich, domestically driven, and benefiting from China’s resource needs. “There are times,” says one foreign diplomat, “that I feel Indonesia gets a bit too much praise.” A banker adds: “Has SBY really accomplished that much? Even without the government moving too much, the economy can still run at 6% regardless.”

Wherever the praise should go, Indonesia has emerged as an unexpected leader in Asian economic and market performance. If there’s a question, it’s why it’s not doing even better. “One thing Indonesia hasn’t succeeded in doing is driving growth up to the 7 or 8% range,” says Chua. But in this environment, perhaps that’s asking too much. “For Indonesia, 6 to 6.5% seems a comfortable range where inflation isn’t a risk, and there is prudence on the fiscal side as a result. It was the best performing bond market for Asia last year and one of the best stock markets; the companies and banks are delivered; we’re fairly optimistic. They seem to be able to run at 6% with one hand tied behind their back on infrastructure.” With that hand untied, perhaps this is the moment when Indonesia does take its place as the fifth BRIC, with growth rates and opportunity to match its more feted regional peers of China and India.

BOX: Making the Grade

Fitch upgraded Indonesia by a crucial single notch in December putting it into the investment grade category. Why? Here’s what Fitch said:

• The upgrade “reflects the country’s strong and resilient economic growth, low and declining public debt ratios, strengthened external liquidity and a prudent overall macro policy framework.”
• It projects more than 6% annual GDP growth to 2013. “Indonesia’s domestically oriented economy and success in delivering growth without creating external imbalances or a reliance on short-term financing suggests economic growth prospects should prove resilient to external shocks.”
• It talked about “strengthened external buffers,” chiefly reserve accumulation.
• But there were “long-standing structural weaknesses”, including “a narrow fiscal revenue base, low average income, and problems affecting the business climate including poor physical infrastructure and corruption.”
• And the banking system isn’t great. “Although the system remains primarily deposit funded, deposit growth has lagged behind both nominal GDP and credit growth. While not an imminent risk to system stability or the sovereign credit profile due to the system’s small size, small domestic financial markets and interbank lending activity provide limited financing flexibility.”

Moody’s and Standard & Poor’s both rate Indonesia one notch below investment grade; both are widely expected to upgrade it this year.