Assessing The Key Risks To The Growth Boom

BMI View: Indonesia's growth boom is built on solid foundations and we expect it to continue over the coming years. That said, risks are growing, the most pressing of which is a deterioration in global credit markets that could force up local borrowing costs. As such, we forecast real GDP growth of 6.1% this year, versus an estimated 6.2% in 2012 and consensus expectations of 6.3% growth.

Indonesia's economic growth boom since the Asian Financial Crisis has been impressive, with real GDP growth averaging 5.4% per annum since the recovery began in 2000. Corporate profits (as measured by the companies on the Jakarta Composite Index) have grown by an average annual rate of 22% over this period, even accounting for the 60% peak-to-trough decline seen in the GFC. This has allowed Indonesia's GDP (in US dollar terms) to rise faster than any other country in the region (with the exception of Myanmar) over this period.

Remarkable Growth Performance
% Nominal GDP Growth In US Dollar Terms

We expect 2013 to be another good year for Indonesian growth, but caution that a disruption in global credit markets poses a large risk to the Indonesian economy, particularly given the recent collapse in the current account. We forecast real GDP growth of 6.1% this year, versus an estimated 6.2% in 2012 and consensus expectations of 6.3% growth. We believe that 6%+ can be maintained over the coming years, notwithstanding the growing risks.

What's Behind The Growth Boom?

With commodity-related exports accounting for over 60% of total exports, Indonesia has certainly benefitted from the commodities boom over recent years. However, this by no means entirely explains the country's improving economic fortunes in recent years. Relative political stability, an improving regulatory environment, sound monetary and fiscal policy (and thus a lack of distortionary bubbles), and supportive global credit markets have all played their part. This combination of supportive factors has unlocked private sector profit potential, resulting in a doubling of private capital spending over the past decade in real terms.

Nicely Balanced
Indonesia - Trade Balance Breakdown, IDRmn

Unlike the growth that we have seen in China over the past decade (the third best performer in terms of GDP growth in US dollar terms), we believe that Indonesia's growth is sustainable. We see few signs of major malinvestment threatening Indonesia's long term growth outlook, and expect relative financial stability to reign. Below we outline Indonesia's growth drivers and identify key risks that could derail this growth.

Commodity Prices: Not The Be All And End All

Indonesia has undoubtedly benefitted from the commodities boom, with commodity-related exports increasing 30% faster than non-commodity exports since 2005. The weakness in export prices seen in 2012 was a clear blow to the economy, with total exports falling 6% over the full year, exposing the current and fiscal accounts and leading to a weakening of the rupiah. Commodity imports still make up a relatively low share of total imports (at just 30%), so a declining commodity import bill in 2012 offered little respite.

While continued declines in commodity export prices pose a risk to Indonesia's growth story, this risk is not critical. The economy held up strongly in 2012, in spite of this external shock, and we believe that this could be the case going forward. Furthermore, looking at Indonesia's terms of trade chart, we could see some sort of mean reversion over the coming years following several years of deterioration.

A Terms Of Trade Bear Market
Indonesia - Citigroup Terms Of Trade Index

Political Stability: Not To Be Taken For Granted

A return of political instability is perhaps the largest threat to Indonesia's medium-term economic outlook. President Yudhoyono's Democratic Party (PD)'s prospects ahead of 2014's elections continue to shrink owing to successive corruption scandals, and the potential for a more populist regime to rise in prominence is growing. Specifically, a large risk comes from a continuation in the resource nationalism that we have seen over the past 12 months. Should this continue, it could undermine opportunities not only in the commodities space but also deter foreign investors from entering other areas of the economy.

Reform Agenda: Steady Progress

Indonesia's business environment has improved markedly over recent years, albeit from a very low base. The central and local governments have cut red tape and eased the costs associated with business activity by making regulatory practices more efficient. According to the World Bank's Doing Business Report 2012 Indonesia, represented by Jakarta, is among the top 50 economies improving the most to close their gap with the top performers globally, and among the top five within the East Asia and the Pacific region.

To cite a few examples, business start-up times have been cut dramatically over the past five years, as has the time dealing with construction permits. Tax rates have been reduced, and, just as importantly, online systems for filing taxes have cut the time it takes to pay taxes by more than half. The Heritage Foundation's Index of Economic Freedom corroborated the broad improvement seen in Indonesia's business environment. The country score has risen steadily since the GFC, increasing from 53 in 2009 to 57 today, helping the country close the gap with the world's freest economies.

While there is a risk posed by a new national government, we do not expect to see the trend of regulatory pragmatism be reversed anytime soon, with local officials increasingly aware of the positive impact that these reforms have had on local tax revenues and economic growth.

Fiscal And Monetary Policy: Can Crowding Out Be Kept To A Minimum?

Tax reforms to widen the government's revenue base have been instrumental in boosting revenues over recent years and allowing the government to lower its debt level. Natural resource-related revenues have also grown strongly thanks to the commodity boom, but their share of total revenues have halved over the last year, reflecting the structural improvement seen in the tax take. On the revenue side, despite the continued lack of willingness to push through fuel price reforms, total expenditures as a share of GDP has averaged a respectable 18% over the past five years, and debt-to-GDP has continued its retreat. Indonesia's fiscal accounts are in pretty good shape, and this will continue to facilitate private investment over the coming years by keeping crowding out to a minimum.

Reasonable Real Rates
Indonesia, China - Real Interest Rates

Prudent monetary policy has also had a large part to play in keeping government bond yields low. Interest rates have generally been above Bank Indonesia's base rate over the past decade and the lending rate has generally exceeded nominal GDP growth. With the exception of late-2011 when we believe that BI was too aggressive with its rate cutting policy, they have generally acted prudently. While M2 growth has been a little high over recent years, total credit as a share of GDP had grown only marginally, and is not showing any warning signs as of yet. With property bubbles springing up in a number of countries across the region, we take comfort in the lack of speculative activity going on in the country's real estate market compared with its regional peers.

No Sign Of Credit Excesses Or Corporate Stress

We believe that prudent monetary and fiscal policy has prevented the build-up of excesses and speculative bubbles that have characterised China's growth story over recent years. While we do not dispute that these are certain excesses in some areas of the economy, on the whole, there are few signs that the capital spending of recent years has been driven by flawed price signals and prone to widespread losses. On the contrary, the corporate sector is in rude health. This contrasts greatly with the situation we see in China at present, where a huge credit bubble appears to be in its final stages and evidence of corporate stress is already clearly showing.

Leading The Pack
Return On Assets, %

Using corporate data from stocks listed on the Jakarta Composite Index, return on assets is showing no sign of easing. The 12% figure is among the highest in the region, almost triple that seen in China. Going beyond this, Indonesian corporates appear to be showing high quality earnings. By this we mean that companies are boasting strong cash flows, with operating cash flows exceeding net income by a strong margin. Again this contrasts with China (as represented by the Shanghai Composite Index), where cash flows have lagged earnings potentially reflecting rise in receivables and accounting gimmicks inflating earnings.

Quality Earnings
Indonesia, China - Operating Cash Flows / Earnings

Uniquely Exposed To Global Risks

Looking at the composition of GDP by expenditure, it appears as though Indonesia is relatively insulated from external forces, with private consumption representing the lion's share of GDP at 55%. However, the economy is highly exposed to global credit conditions. This became abundantly clear in 2009 when the Indonesian rupiah collapsed and local bond yields soared. Since then, the external debt position has strengthened and we are not expecting a perfect storm in global capital markets. That said, Indonesia is once again at risk from a freeze up in global debt markets. The local bond market is increasingly at the mercy of external demand, with foreigners holing 33% of total bonds. Regarding external debt, the global reach for yield has pushed the 5-year CDS spread to near record lows of 130 basis points. This has come at a time when Indonesia's current account deficit is hitting all-time highs, suggesting that any flare-up in global risk aversion could send local interest rates soaring and the currency plunging, both to the detriment of domestic demand.

Below Consensus But Still Bullish

Growth should continue to perform strongly in comparison with regional peers in 2013. Business confidence is on the up according to a number of surveys, with the recent CPA Australia-Pacific small business survey showing Indonesian firms as being by far the most optimistic in the region. Likewise, consumer confidence is also booming according to official sources. Our infrastructure team holds a bright outlook for the construction sector thanks in part to continued progress on the public-private partnership front. We also expect to see a broad-based recovery in exports as the regional growth rebound continued until H213.

Confidence Is Up
Indonesia -

That said, we remain concerned by the unique threat posed by renewed weakness in global credit markets, which could once again undermine the country's growth prospects in the near term. As such, the balance of risks favours being below consensus in our 2013 real GDP growth forecast, and we are calling for 6.1% growth versus Bloomberg estimates of 6.3%.

This article is tagged to:
Sector: Country Risk
Geography: Indonesia

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