In a recent Bits & Pieces report, CLSA highlighted the positive effect that a rate cut might have in Indonesia. The case for Indonesian stocks looks compelling at first glance:
- Inflation remains subdued at only 4.1% YoY (compared to a target range of 3-5%)
- Reforms may reduce infrastructure and labour market bottlenecks in the economy
- The currency has depreciated substantially since 2011
- The unemployment rate is still above
I think such views are misguided. First, the commodity boom driven by unsustainable Chinese demand is largely over. Second, Indonesia’s investment boom since 2011 was driven by yield-seeking foreign capital and is also not sustainable. Third, it may take a decade or more to see real effects from labour market or land reforms, and they also face significant hurdles.
The credit cycle
Credit grew 2x faster than nominal GDP since the peak of the commodity super cycle in 2011. This raises the question of potential misallocation of capital and banking system instability. Credit growth is after all one of the best predictors of financial crises.
Bulls would argue that loan penetration is low and has room to grow. What they are missing is that Indonesia’s deposits/GDP ratio is one of the lowest in the world, due to low savings rates, immature banking system and a wealth disparity. An economy short on deposits tends to lead to a highly profitable banking system. But a reliance on wholesale funding also causes instability and recurring financial crises.
The reasons why I think the potential for loan growth is limited:
- A loan-to-deposit ratio at a ten year high of 90%
- Average lending rates of 12% and 20-30% for “microloans” limit the scope of creditworthy borrowers
- Rates are too high compared to nominal income growth
- Bank Indonesia’s concern about a depreciating currency means there is limited potential to lower rates.
Indonesia’s current account deficit ballooned from 2011 due to a worsening terms of trade and an investment boom financed by foreign capital. The current account deficit of 3% of GDP compares to the 4% deficit experienced before the Asian Financial Crisis.
Long periods of current account deficits tend to lead to big devaluations. Whether four years is enough to cause the Rupiah to slide significantly is unclear. The inflection point will come when foreign investors are no longer willing to finance Indonesia’s current account deficit. There are reasons to believe the time has now come, given poor global liquidity and the recent US rate hike. Ballooning credit spreads is a sign that the cycle has turned. That Japanese carry trades into Turkey have been reversing since late 2014 is another sign that QE-induced carry trades have already peaked. Indonesia appears to have had the highest bond inflows in Asia over the past ten years. In my view, this raises the question of what a reversal may look like.
On a real effective exchange rate basis, the Rupiah appears to be fairly valued.
Then again external debt has more than doubled since the global financial crisis, giving rise to an “inverted” national balance sheet.
If the Rupiah does starts to slide, Bank Indonesia is faced with a difficult choice. If it raises the BI rate to defend the currency, the country will likely slide into a recession. If it does not raise interest rates, the currency will slide lower and a forced deleveraging of (primarily US Dollar) foreign loans will worsen domestic liquidity.
The credit cycle is already in its 9th inning in my view. Loan growth numbers are down to roughly 10% YoY. Average lending rates are 12%. NPL and special mention loan ratios are inching upwards, indicating roll-over of loans. Money growth is therefore not enough to cover debt service, and the Indonesian economy is already in deleveraging mode. Incentives to borrow (measured by a Wicksellian spread of roughly 0%) are weak as well.
So who will be hurt this time?
Coal miners, for one. China’s coal demand is falling. Its energy consumption/GDP is already twice as high as the United States. It is unlikely that India will be able to pick up the slack.
Property companies have also extended themselves. Most borrow in US Dollar due to an immature syndicated loan market. CFO’s prefer to borrow at 6% in US Dollar instead of 13% in Rupiah due to the boost in earnings it provides. There are signs of excesses in the property market. Land prices have skyrocketed in parts of Surabaya and Jakarta, seemingly driven by mining profits and land speculation. The number of completions of 200m+ buildings was the second highest in the world in 2015.
Several of the major property companies are reclaiming land outside of Jakarta to build luxury condos. The availability of condos is far lower than say Bangkok, so long-term demand may be there. Residential property construction/GDP of 4% is far below China’s 12%. But building Sentosa-style fantasty islands is expensive and it is not clear whether the demand is there just yet.
Let’s review the potential for reforms that could lead to a structurally lower inflation rate and a sustained increase in credit/GDP: Cutting fuel subsidies helped reduce the government’s budget deficit but reduced household spending. A legislation change that would make land appropriation easier would be a boon for the economy given significant bottlenecks. Foxconn recently discarded its investment plans in Indonesia due to a difficulty of securing land. Jokowi’s plans for a “one-stop service” for authorization of investments into the country would reduce red tape and corruption. In the meantime, the government is spearheading infrastructure investments financed by a record high budget deficit of 2.6%. Jokowi’s power is limited by a fragmented House of Representatives, and even limited power within his own party PDI-P. In the near term, Indonesia remains a commodity exporter and exposed to the ebbs and flows of global liquidity.
Indonesian stocks are somewhat expensive at a PE ratio of 15x. The major banks trade at PB ratios of 3x and PE ratios of 10-12x peak earnings given the turn in the NPL cycle from 2014 onwards. Such up-cycles tend to last for 4-5 years on average.
I believe that the end of the commodity super cycle and a reliance on foreign capital to fund growth is likely to lead a cyclical downturn. Given poor global liquidity I think shorting Indonesian stocks could be timely as well. In my view, shorting the currency against the US Dollar or Euro should provides a good risk-reward. Another option is to short US Dollar-denominated ETFs with Indonesian stocks such as EIDO or IDX.