Bearish Near-Term Construction Outlook In Full-Flight
BMI View: As expected, quarterly data on Indonesia's construction sector was supportive of our view that there is limited scope for construction growth in 2013 and 2014 to outperform its 2012 level. Furthermore, the downside risks we had previously highlighted - namely a deepening fiscal deficit (brought on by ballooning subsidies), rising inflation, bottlenecks in project execution and the 2014 presidential elections - are manifesting and are set to adversely affect near-term construction activity. As such, we have revised down our construction growth forecasts in 2013 and 2014, with growth reaching 6.7% in 2013 (previously 7.4%) and 6.3% (previously 6.9%) in 2014.
In our July 2013 analysis of Indonesia's construction sector ( see 'Risks Manifesting In Near-Term Construction Outlook', July 15 2013), we reiterated that we were relatively optimistic towards the near-term outlook for Indonesia's construction sector, but there was limited scope for construction growth in 2013 and 2014 to outperform its 2012 level. This view continues to play out. Preliminary data from Statistics Indonesia shows that real growth for the construction sector reached 6.9% year-on-year (y-o-y) in Q113, while growth in Q113 was revised down from 7.2% y-o-y to 7.0% y-o-y. Both growth rates were lower than their respective quarters in 2012, when construction growth was 7.2% y-o-y in Q112 and 7.0% y-o-y in Q212.
|In Line With Expectations|
|Indonesia - Construction Real Industry Value Data (At 2000 Constant Prices), By Quarters|
As we move forward, we continue to see limited scope for construction growth in 2013 and 2014 to outperform its 2012 level. In fact, recent developments have once again prompted us to revise down our construction growth forecasts in 2013 and 2014. Construction growth in 2013 and 2014 is now forecast to reach 6.7% (previously 7.4%) and 6.3% (previously 6.9%) respectively.
|Indonesia Construction Real Growth, Old And New Forecasts, % chg y-o-y|
Monetary Conditions Turning Non-Conducive
We had previously highlighted that there is growing potential for the benchmark interest rate in Indonesia to be hiked before the end of 2013. This has taken place. Since the start of June 2013, Bank Indonesia has hiked its benchmark interest rate by 150 basis points (bps) to bring it from 5.75% to 7.25%. These moves have been aimed at controlling inflation, which has risen aggressively in recent months due to record-low interest rates (since February 2012), electricity and fuel prices hikes in 2013, as well as a sharp depreciation in the Indonesian rupiah. Electricity prices have increased by 15% in 2013 to date, while, at the time of writing, the rupiah had depreciated by 12.7% against the US dollar since June 2013.
|Indonesia - Policy Rate, % & Headline CPI, % y-o-y (LHS); Exchange Rate, IDR/US$ (RHS)|
With interest rates set to remain elevated until early 2014 (we expected the benchmark rate to remain at 7.25% through to end-2013), this means that construction companies operating in Indonesia are set to face higher borrowing costs over the rest of 2013, which could deter them from taking on new projects and carrying out capital-intensive construction works.
In addition, we expect the Indonesian rupiah to remain weak - at around the current level of IDR11,700/US$ - through to the end of 2013. This means that the cost of importing building materials and equipment will remain higher than before until at least early 2014, further deterring companies from taking on projects and carrying construction works. To be sure, Tri Widjajanto, chairman of the National Construction Service and Development Board (LPJKN), said in September 2013 that many projects, especially road improvements, were delayed as the prices of asphalt has skyrocketed (about 36% of Indonesia's supply of asphalt is imported), with other building materials like concrete and ready-mix concrete also experiencing a 20% increase in prices (according to Jakarta Post).
Ballooning Deficit Prompts Capital Expenditure Cuts
On top of rising borrowing costs, we believe capital investment is also being hampered by a weak fiscal position, driven in no small part by costly subsidies. In 2012, President Yudhoyono announced that his government would boost capital spending (which includes infrastructure spending) by 14.9% to IDR194trn in 2013. However, the latest release on Indonesia's government budget revealed that capital spending would only increase by 9.3% to IDR184trn in 2013. This is likely to translate to a slower rate of construction growth than previously planned for 2013 and 2014.
|Indonesia - Central Government Capital Expenditure Budget Allocation, IDRtrn|
This reduction in capital spending also supports our initial doubts over the government's ability to simultaneously support its capital expenditure and subsidy programmes. Even though the government has carried out electricity and fuel price hikes to curb electricity and fuel usage in 2013, the ongoing decline in domestic oil production and the increase in oil imports (which are more expensive) means that the government is likely to have paid more for subsidies in 2013 ( see 'Current Account In Uncharted Territory, But Gradual Recovery Seen' September 9 2013). This failure to keep subsidies in check is threatening to push Indonesia's fiscal deficit above its legally-imposed threshold of 3.0% of GDP for 2013. As such, we believe the government will be obliged to cut capital spending. Going forward, we believe that there is a potential for further cuts in capital spending. Presidential elections are due in 2014 and the ruling Democratic Party could look to increase welfare spending so as to secure a favourable result in the elections.
|Dampening Capital Spending|
|Indonesia - Budgeted & Actual Fuel Subsidy Expenditures, IDRbn|
Mixed Progress With Infrastructure
Overall progress with infrastructure development in Indonesia continues to be lacklustre in 2013, prompting us to once again revise down the sector's short-term growth outlook (which in turn affected construction activity). Real growth for Indonesia's infrastructure sector is forecast to reach 6.1% in 2013 (previously 7.1%) and 5.9% in 2014 (previously 6.7%).
|Indonesia Infrastructure Real Growth, Old And New Forecasts, % chg y-o-y|
Although we have seen a number of large-scale infrastructure projects move forward since the start of 2013 - namely the US$4bn Kalibaru port project in Northern Jakarta and Jakarta's first mass rapid transit and monorail projects - we have also seen a number of large-scale projects fail to advance. The U$4bn Central Java coal-fired power plant, the largest public-private partnership (PPP) project awarded by Indonesia thus far, has yet to start construction works, despite being awarded as far back as October 2011. About 15% of the land needed for the project has not been acquired yet, preventing the projects from reaching financial closure. In addition, several toll roads, scheduled to start construction works in 2013, have not completed land acquisition and permit clearances.
A key example is the six PPP toll road projects in Jakarta. These projects were awarded in September 2012, but the Jakarta provincial government, led by governer Joko Widodo (commonly referred to as Jokowi), has yet to issue an environmental permit for the projects. Jakarta had stated in July 2013 that discussion on the toll road projects will only be conducted after the city's urban railway projects have started construction works. Given that there is a possibility for Jokowi to contest for the presidential elections in 2014, further delays to the toll road projects are likely if there is a change in Jakarta's political environment.
Another indicator of the country's progress with infrastructure is its PPP programme. Out of the 70 PPP projects listed in its PPP Report in March 2013, only nine were awarded at the time of writing, with just one project - the Nusa Dua-Ngurah Rai-Benoa toll road project in Bali - completing construction works.
Business Environment The Threat
We believe the primary reason for this lackluster performance in infrastructure development is the failure to resolve outstanding business environment issues. Even though the government is hiking electricity prices (making it more financially viable to operate power plants) and had launched a new land acquisition bill in August 2012 (which took effect in early 2013), several other regulatory reforms are still needed to reduce red tape in Indonesia. The country needs to boost its institutional capacity to carry out the level of detail desired by the private sector during the pre-construction stage (e.g. feasibility studies, documentation, and public consultation). Indonesia also needs to resolve several regulatory bottlenecks that continue to delay infrastructure projects in Indonesia. They include:
A lack of coordination among government agencies, ministries, and sub-sovereign governments;
Slow progress in determining spatial planning;
A lack of institutional capacity to resolve contract disputes;
A lack of legal rights to safeguard the interests of the private sector;
Licensing and permit issues at the central and sub-sovereign government level, such as overlapping central government and regional regulations.
|Still In Need Of Other Reforms|
|Indonesia - Key Indicators For Construction Project Completion|
These issues, particularly the lack of human resources to boost institutional capacity, could take many years to be resolved and will continue to hamper infrastructure development for the foreseeable future.
Growing Policy Uncertainty
Besides the lack of regulatory reforms, infrastructure and construction development has also become increasingly hampered by uncertainty surrounding government policy.
In our view, the reform credibility for President Susilo Bambang Yudhoyono's administration has been considerably undermined over the past two years, beginning with his party's failure to implement all-but-guaranteed fuel subsidy reductions in Q212. The administration's policy shortcomings did not end there, as evidenced by the constant regulatory changes in the mining sector ( see 'Economic Woes To Derail 2014 Minerals Export Ban', August 28 2013). This lack of policy stability has undermined confidence in the mining sector and is dampening related investment activity. This will in turn affect investment in mining related infrastructure such as ports, railroads, and even roads.
We believe that this constant change in mining polices has undermined confidence in the mining sector as a whole. This could dampen investment in Indonesia's coal mining sector, as the financial viability of coal mining projects in Indonesia are being dampened by an increase in coal supply from other countries. This would in turn affect investment in mining related infrastructure such as ports, railroads, and even roads.
We believe the uncertainty in government policy is likely to continue in 2014 and this would adversely affect infrastructure activity for the year. General and presidential elections are scheduled to take place in 2014 and they are a key risk to political stability and pro-business reforms. Economic woes, high inflation and a spate of high profile corruption cases have severely eroded support for Yudhoyono's Democratic Party, with a survey conducted by Saiful Mujani Research & Consulting in 2013 suggesting that support for the party has collapsed from 20.8% in 2009 to just 8.3%. This makes it highly unlikely that the party will be able to recover ahead of legislative elections in April 2014 and this increases the likelihood for a more protectionist and potentially nationalist candidate - namely Prabowo Subianto - to accede to the office ( see '2014 Elections Still A Mystery As Factors Conspire Against Democratic Party', September 11 2013).
Infrastructure investors could therefore wait for greater political clarity before taking on new projects. Furthermore, most governments typically put on hold key decisions on large-scale infrastructure projects (such as project awards and approvals) until the after the ballot box.