Indonesia macro: Tipping point?

12.03.14 / Author: Tim Burroughs, Asian Venture Capital Journal

Indonesia appears to have weathered the worst of its recent economic storms, but the route towards long-term sustainable growth has yet to be mapped out. PE investment theses rely on sensible navigation.

Foreign investors don’t care for governments that flip-flop on policy. The Indonesian authorities first indicated that they would restrict outbound shipments of unprocessed minerals several years ago, but offered no further details. Then, in December, the world’s largest exporter of nickel, tin and thermal coal passed legislation banning all mineral-ore shipments from mid-January onwards.

Global miners were up in arms, claiming breach of contract. Last minute compromises emerged as certain partially-processed ores, or concentrates, were switched to a progressive tax rather than an outright ban. There were also concessions for those who pledged to build downstream smelting plants in the country. As recently as last week the government was saying tax could still be reduced.

The lack of certainty for foreign investors comes at a time when global commodity prices are weakening and Indonesia appears to be emerging from a period of macroeconomic volatility. As one industry participant puts it, “No one wants to contemplate spending hundreds of millions of dollars on building a smelter.”

Economists do not expect the measures to have a debilitating impact on the country: Citi issued guidance that it would add no more than 0.3% to the current account deficit, less than half the previous projection. Similarly, most private equity investors say they have little direct exposure to the sector.

But the export ban does offer insights into attitudes towards industrial and investment policy, and it asks questions about the country’s ability to wean itself off the commodities cycle and achieve long-term sustainable growth. Indonesia is poised for parliamentary elections in April and a presidential poll in July. This is a country, still smarting from its economic bruises, in a state of flux.

“Things are better than they looked in July or August of last year but the underlying issue in Indonesia right now is that the country consumes more than it makes so the current account deficit has been revisited,” says Aditya Srinath, head of Indonesia research at J.P. Morgan. “How do you manage that in the short term and have policies focusing on the mid to long term?”

Twin troughs

Indonesia’s economic problems have two principal origins. First, the commodities cycle turned. Exports, of which natural resources account for more than half, peaked at $53.6 billion in the third quarter of 2011 but then embarked on a general downward trend.

As exports fell, imports remained resolutely high. Indonesia slipped into a trade deficit in the second quarter of 2012 and the gap widened over the 12 months that followed. The situation was exacerbated by Indonesia’s rising fuel demands – the country is a net importer of oil – and the ongoing policy of fuel subsidies. By not passing on the burden to consumers through higher prices, demand remained high even as the depreciating rupiah pushed up costs.

Second, in May of last year talk of quantitative easing in the US shook emerging markets.

Indonesia’s current account deficit, already struggling due to weak commodities exports, rose from -1.1% at the end of 2011 to -4.4% in the second quarter of 2013. The Jakarta Composite Index slumped and the rupiah went into freefall, losing more than a quarter of its value against the US dollar over the course of 2013 to go beyond IDR12,100 by year-end, as capital took flight.

“They were out of position, with a current account deficit and a macro policy framework that was perceived as overly rigid,” says Ben Bingham, the IMF’s resident representative in Jakarta. “Fiscal and monetary policy were both stuck, and the currency was coming up on a perceived red line of IDR10,000. There was also concern about rigidity in the bond market because Bank Indonesia was intervening in the bond and foreign exchange markets.”

Industry participants highlight a host of smaller contributing factors, ranging from new leadership at the central bank to policy inertia – including but not restricted to the mineral export ban – spooking foreign investors.

The government responded by tugging hard on levers that previously seemed stuck. Monetary policy has become more flexible, while on the fiscal side policy makers have become more proactive, notably cutting fuel subsidies despite public opposition. Bond yields and exchange rates are now moving with greater flexibility and the rupiah has regained some of its lost ground.

The current account deficit narrowed to -2.2% at the end of 2013, although this was largely due to a spike in exports as companies rushed out commodities shipments ahead of the mineral exports ban.

“People have now taken the view that things have stabilized,” says Patrick Walujo, co-founder and managing partner at Northstar Group, a Singapore-headquartered PE firm with interests in Indonesia. “One of the most important things is how the government has responded to the depreciation. The central bank and Ministry of Finance have done a pretty good job.”

Confidence in Indonesia’s ability to absorb volatility is not shared by all private equity investors.

Sentiment has improved on emerging markets globally and Tom Lembong, co-founder of Quvat Management, says this has been Indonesia’s savior, at least for now, with the government already preoccupied with the elections. He is concerned about external pressures from China, Japan and the US, as well as the impact on small businesses of tighter rupiah liquidity that has come as by-product of exchange rate stabilization.

“Another IMF bailout in 2014 or 2015 should not be discounted,” Lembong adds.

Worst case, best case

Nuclear options like bailouts aside, GPs operating on a 5-7 year timeframe are not overly concerned by short-term fluctuations.

However, the investment environment has to a certain extent tracked macro and political developments. Industry participants describe a market characterized by excessively high valuations in the first half of 2013 and excessively high volatility in the second half. Now there is hesitancy, particularly among the foreign investors, due to uncertainty about the impending elections.

According to AVCJ Research, PE investment came to $657 million last year, marginally up on 2012 but that period saw the lowest level of activity since 2007. It is worth noting that Indonesia is a notoriously lumpy market, with 1-2 major deals able to move the needle significantly.

Several managers they say were not surprised by the macroeconomic headwinds and prepared accordingly.

Quvat’s Lembong notes that 65% of his firm’s portfolio by net asset value comprises companies with US dollar-denominated revenues, while 70% of financial instrument are either in US or Singapore currency. The remainder are rupiah-revenue companies in the consumer sector with good pricing power and hence the ability to keep price increases in line with currency fluctuations.

Nevertheless, there is only so much that can be done to offset the damage created by currency devaluation. “In 2013, the currency went from IDR9,700 to more than IDR12,000 – that is very hard for any portfolio to stomach,” says Kay Mock, co-founder at Saratoga Capital. “If you have a portfolio with an average age of three years delivering 25% in local currency terms, you adjust for US dollar and you are only looking at a mid-teens return.”

The flip side of this argument is that those with dry powder are now well positioned to make new investments at attractive valuations. Mock admits that Saratoga’s investment pace has been slow since the firm reached a final close on its third fund in May 2012, with only about 25% of the corpus deployed. However, he hopes the next 12 months will be more active in the firm’s chosen sectors of infrastructure, natural resources and consumer.

“The Indonesian market was trading at 17x price-to-earnings (P/E) while China was at 10x P/E,” adds Ben Gray, co-managing partner at TPG Capital. “With the major correction happening there you will probably see more interesting deal activity. As a US dollar investor it’s going to be more attractive now than 18 months ago.”

Furthermore, the long-term fundamentals that underpin most private equity investment theses for Indonesia remain true: a youthful population still some way off the dependency ratio challenges faced by China; a growing middle class and rising household expenditure across the board; and the need for consolidation in developing services industries.

Commodities yoke

Indeed, the tumult of 2013 saw GDP growth slow to 5.78% from 6.25% the previous year, but Indonesia continues its unprecedented run of 47 quarters with growth in excess of 4%. The question economists ask is how long this can last without long-term economic reform.

In recent speeches, Chatib Basri, the minister of finance, has said that Indonesia must shake itself free from an unfavorable economic equilibrium. In the absence of the previous tailwinds – specifically strong global commodity prices and cheap credit – delivering GDP growth of more than 6% is likely to trigger current account deficit problems while 5% is too low. The policy goal he advocates is developing the country’s non-commodity export base.

“First, this would alleviate the balance of payments constraint,” adds the IMF’s Bingham. “Second, because manufacturing tends to be relatively labor intensive it will enable the economy to generate employment and address the problem of underemployment in the labor force. Only one third of the labor force has formal sector employment. Two thirds – or 60 million people – are either in the informal sector in agriculture or in urban informal services.”

He stresses that domestic demand pillar would remain a significant part of the story, but it would be supplemented by an export pillar that is employment generating. Of the ASEAN Five countries – Indonesia, Malaysia, Philippines, Singapore and Thailand – Indonesia accounts for half the cumulative labor pool but only 15% of manufacturing exports. It ships only slightly more goods than Vietnam and less than half that of Thailand and Malaysia.

The policy requirements to deliver the Holy Grail of 6% growth plus macro stability, Bingham explains, are infrastructure that supports Indonesia’s cost competitiveness in exports and an outward rather than inward-focused attitude towards trade and investment.

This is not hugely dissimilar from the perspectives shared by private equity managers. “Between 2008 and 2013 the economy grew 5-6% and there was practically no structural reform. You will continue to get that without any reform because of the private sector,” says Quvat’s Lembong.

While he notes the fundamentals of the growth story remain, the rapid consumer expansion of recent years will moderate, with certain segments proving defensible. The next wave of successful investments, meanwhile, will come in non-commodity exports.

Hendrik Susanto, managing director at Ancora Capital, agrees that 5.5% growth is the base case scenario, potentially rising to 7% within a couple of years pending the election of a proactive president, backed by a strong government, who is able to implement the right set of initiatives. His long-term policy priority is infrastructure.

“The land reform law has been passed but they need to come up with schemes to build more roads, railroads, airports and sea ports,” Susanto says. “The private sector has been getting by despite the lack of infrastructure but at some point it will choke because you have less than 1,000 kilometers of toll roads, for example.”

Long-term game

There is already significant political impetus behind infrastructure improvement. The more challenging area is re-orienting trade and investment policy at senior level.

The mineral export ban is, in Bingham’s view, emblematic of an administration that is looking to shore up a commodities-driven domestic economy rather than seeking to become globally competitive in other areas. He places other legislation, covering everything from industry and trade to banking and plantations, in the same basket.

Recent remarks delivered by Basri and other technocrat officials represent merely the seeds of a change in thinking – understandable given the government has spent the last nine months preoccupied with macroeconomic stability.

J.P. Morgan’s Srinath argues that progress is already being made on the manufacturing side, with job growth in this area outpacing overall job creation in the last five years. His preferred policy package covers broader ground, including measures to redress the import-export balance and ease pressure on the balance of payments deficit, while simultaneously optimizing conditions for foreign direct investment.

The mineral export ban is therefore understandable in the context of boosting export values but unfortunate in its timing and execution, leaving investors with little clarity on tax treatment.

However, in other areas the government is seen as increasingly business-friendly. One GP highlights the decision to reverse a look-through provision introduced in 2012 that would have allowed the regulators to levy tax on sales of shares in Indonesian companies by investors acting through offshore holding structures.

Meanwhile, Northstar’s Walujo welcomes government efforts to address fuel subsidies and ease commodity imports by substituting foreign diesel with bio-diesel produced from domestic palm oil plantations.

There is no quick fix and another global macroeconomic shock would likely throw a still precariously balanced Indonesia back into chaos. But there is a sense of incremental progress, with Bingham of the IMF expecting the focus on structural reforms to intensify. “Slowing to 5% is okay for a while but if it becomes an entrenched part of the economic outlook people will focus on that issue.”

And it is not an issue PE can avoid. Although the Indonesia consumption story remains alive and well, it is not immune to the pressures on the broader economic model. In this sense the 2014 political agenda, to the extent that it touches on industrial policy and long-term sustainable growth, is worth watching.

“Indonesia is going through a period of huge economic expansion, imbalances build up and we are now in a period of adjustment,” says J.P. Morgan’s Srinath. “Will consumption growth fall if you allow these economic imbalances to build up even further? No question about it.”