Indonesia at BB+? Deutsche Bank makes the case

Indonesia's economy has developed significantly since the Asian financial crisis. Steady domestic growth, fiscal conservatism and a functioning local capital market has helped outlast a global recession that many thought would engulf the archipelago. Martin Hohensee, Deutsche Bank's head of fixed-income research in Asia, thinks Indonesia can today be considered a BB+ credit; two notches above its current rating of BB- at Standard & Poor's and Ba3 at Moody's. He shares his views with FinanceAsia.

What makes you see Indonesia as a BB+ credit?
We think the question is not so much whether Indonesia is an improving credit but one of how good it has become. The ratings agencies have recognised Indonesia's achievements in recent years, however we think upgrades have not kept pace with improvements. Based on quantitative comparisons with 60 other countries over the past seven years, we find Indonesia's current ratings of BB-, Ba3 and BB at S&P, Moody's and Fitch respectively, inconsistent with current measures of creditworthiness. On qualitative measures, we have seen a steady improvement under President Susilo Bambang Yudhoyono's administration and we expect to see more of the same in its second term.

Economic performance aside, Indonesia has demonstrated strong fiscal and monetary management over the past several years. The fact that government finances have remained firmly intact over the past two years, despite a period of surging oil prices and a global recession, is testament to the progress Indonesia has made towards ensuring fiscal stability.

With a less highly leveraged economy than some of its neighbours, growth didn't suffer greatly during the crisis as the economy was less susceptible to the squeeze in global credit markets. Another positive for fiscal stability is the apparent ease with which energy prices were increased by 30% in May last year. As retail energy subsidies remain a key variable in Indonesia's fiscal profile (industrial prices have been fully liberalised) the ability to pass through cost increases when fiscal pressure becomes too great is extremely important.

Indonesia's fiscal consistency has not only been noteworthy for is resilience to the credit crunch and high oil prices, but also for remaining largely stable, while other Asian governments were expanding fiscal stimulus. We expect Indonesia to contain its deficit to well within the current target of 2.5%, with primary surpluses reducing the country's debt-to-GDP ratio, currently down to around half of its 2002 level and well below the median for similarly rated countries.

The need to diversify sources of funding was a key lesson from the Asian financial crisis -- how does Indonesia look now in this regard?
Combined with its stable deficit, Indonesia's financing risk is clearly being well-managed, with a broad range of funding options available to the government. Indonesia already has an established track-record issuing G3 bonds and a vibrant local currency bond market. This has been broadened to retail, global and local sukuk bond issuance, and Indonesia also sold a wrapped yen bond this year.

It is also important to note that as the financial crisis moved towards its nadir in October 2008, the Ministry of Finance secured lines of credit from multilateral creditors as a contingency against being frozen out of offshore capital markets. While none of these credit lines have been drawn down, this facility demonstrates a proactive policy approach that we believe sets Indonesia apart from many other BB rated countries.

How important is tax reform to maintaining Indonesia's fiscal position?
Increasing tax revenues is important and steps are being taken towards reform. Efforts are currently underway to improve administration, systems and bring a larger proportion of the population from the informal sector to the formal sector. While reform is an ongoing process, we expect revenues to improve in the meantime as income from gas and oil taxes rise in line with a recovery in global commodity markets.

Regardless, it is important to point out that given Indonesia's aggressive debt reduction in recent years, the country's debt servicing burden is currently in line with like-rated countries.

What about monetary stability? Does Indonesia's external balance position present a risk?
Indonesia has had some success at dampening inevitable capital outflows through conservative monetary policy and by maintaining confidence with its fiscal policy. While the credit crisis was a challenge, with $4.5 billion in portfolio outflows in the fourth quarter of 2008 alone, we think the central bank struck a good balance between spending reserves to keep the currency stable and allowing it to weaken enough to absorb the economic shock (the rupiah fell 24% during this period).

Capital flows have since turned positive, with $2 billion of inflows reported in the first quarter this year. This will undoubtedly have increased in the second quarter as investor sentiment globally has improved since then, while reserves have returned almost to their pre-crisis levels.

It is fair to say that vulnerability to capital outflows could represent a potential weakness in Indonesia's credit profile, however we see some significant trends offsetting this weakness. First, an improvement in the structural trade balance, which has seen non-oil mineral exports growing 50% year-on-year through most of 2008. Second, like government debt, external debt has also declined by around 50% since 2002. Combined, these effects bring Indonesia's ratio of external debt-to-current account receipts to below the median for BB rated countries.

Going forward, we see an improving investment climate as being a key contributor to changes in Indonesia's external balance.

How do you see the investment climate in Indonesia and how will this relate to its credit profile?There are plenty of pessimists out there about the investment climate in Indonesia, but there may also be some cause for optimism. If we overlay an Organisation for Economic Cooperation and Development survey on regulatory openness with a UN survey on attractiveness as an FDI [foreign direct investment] destination, we find only four countries in the world that are considered both more open and more attractive a destination: Germany, the US, the UK, and Brazil.

And as President Yudhoyono's government has shifted its attention from fiscal consolidation to growth, some steps have been made towards improving the investment climate. The Investment Law of 2007, which was designed to put foreign and domestic investors on an equal footing and to streamline investment approvals, was seen as a solution for attracting additional capital towards developing the country's infrastructure.

Indonesia's efforts at tackling corruption, in particular the establishment of the Corruption Eradication Commission in 2003 and the Corrupt Crimes Court in 2004, have contributed to Indonesia steadily improving in Transparency International's Corruption Perceptions Index in recent years. In view of the anti-corruption stature of President Yudhoyono's election campaign, we see this issue as remaining very much at the forefront of the government's agenda.

How is the market currently valuing Indonesia's debt?
While there are of course technical factors that play a role, a quick comparison of current prices shows the market has taken a more positive view on Indonesian credit. Although the view differs slightly between cash bond and CDS [credit default swaps] markets, both indicate that Indonesia's debt, while still reasonably priced in our view, is trading at a higher credit rating [than its actual rating].

Indonesian bonds for example are trading more like a BB+ credit, if compared to the spreads on other emerging market bonds, across all durations. In five-year CDS, Indonesia is trading more like a BBB- credit.

While it is important to consider that the negative basis between Indonesian bonds and CDS does not always reflect fundamentals, the market's view that Indonesia has improved up the ratings scale is clear.

Over the longer term, if we extrapolate the pace of recent improvement into the future, it may not be completely unreasonable for President Yudhoyono's government to set an ambitious goal of earning an investment grade rating before it finishes its term in 2014.