The Indonesian conundrum

The Indonesian economy is showing remarkable resilience and growth. But its resources sector and the banking system are under increasing stress.

At the time of writing (mid-March) the Jakarta Composite Index had hit 4,677, up some 10 percent for the year and 10 percent off its historical high from May 2013. Even the Indonesian rupiah has managed, for the time being at least, to buck its depreciating trend shared with emerging market currencies against the US dollar. In a recent report, analysts at JPMorgan upgraded their rating on Indonesian stocks to “overweight”.

What is causing this positive sentiment? The general macroeconomic environment is not as bad as people assumed it would be. Both inflation and the current account deficit, which were seen as too high and as signs of impending macroeconomic stress, have come down somewhat since the beginning of the year. The economy posted its largest trade surplus in two years in December 2013.

In addition investors have reacted favourably to the economic policy plan announced by the government for Q1 2014 which will increase the attractiveness for foreign companies to re-invest profits in the country. At the same time consumer confidence surveys show positive trends.

As a backdrop to this, presidential elections take place in July. Yet Indonesia benefits from its political situation being viewed favourably when compared to Thailand.

On the other hand you have the (admittedly watered down) restrictions on commodity exports in response to falling prices for mineral ores and a push to retain the greater value-added refining activity onshore.
However even this modified plan has negatively impacted the resources sector sentiment. This is a sector that can ill-afford uncertainty given global weakness. The country too cannot afford doubts around this sector given its critical importance for taxes, royalties, jobs and foreign direct investment.

Other developing countries can attest to this maxim: combining weak global pricing with regulatory uncertainty and a belief that rules may be changed arbitrarily and contracts opened up for renegotiation can spell disaster, and the situation can move from bad to awful very quickly.

So you have a situation that could easily reignite a currency crisis and exacerbate the current account deficit. The rupiah is at risk if the trade balance goes into deficit. Combine this with deferred investment due to the political change and a slowing economy and suddenly things do not look as rosy as recent positive news suggests.

Finally you have a banking system ripe for consolidation: there are currently more than 150 banks including state regional banks. Smaller banks are being forced into consolidation mode by the need to raise capital driven by new domestic banking laws and the impact of international regulatory changes via Basel III.

The central bank, Bank Indonesia, has also been pushing for a slowdown in rapid personal debt growth especially in sectors such as mortgages, vehicle loans and credit cards. This has been done by forcing banks to tighten their lending terms.

Lastly, the NPL levels within Indonesian banks have steadily been increasing in terms of both stressed loans and written off loans.

So you have an economy where credit availability from the banks is beginning to reduce.

This creates a definite opportunity for a nimble private debt investor to pick sectors and particular companies or financing verticals and start to build a portfolio to benefit from this confluence of events. For example some Asian funds have already been investing successfully via relatively short-term senior secured high yield loans to certain resources companies, usually to complete capex and take them to a stage where production ramps up and local bank finance is finally available. Another area of interest has been mezzanine lending to larger and more fully operational resources players.

In addition other private debt investors have begun talking to local banks about acquiring distressed loan portfolios. Given the capital requirement pressure and upward movement in NPAs this an opportunity set that will continue to grow.

Real estate lending continues to be dominated by the local banks. However if a significant economic slowdown takes hold the real estate sector will always suffer and banks will reduce their risk appetite for the sector. This in the medium term therefore holds potential for private debt funds.

The potential risk / return trade off in Indonesia is interesting given the relatively low profile it currently holds for private debt players.