Insights
Global Macro Trends Volume 3.5 • June 2013
Indonesia: Transitioning Potential Into Reality
Indonesia: Transitioning Potential Into Reality
KKR Global Macro & Asset Allocation Team Henry H. McVey Head of Global Macro & Asset Allocation +1 (212) 519.1628
[email protected]
In a world increasingly starved for growth, we believe Indonesia has several substantial macro tailwinds that will continue to drive its GDP higher – and potentially with lower than average volatility. However, recent economic growth has come at a significant cost, and in our view, the country now needs to address the notable increases in both its fiscal and current account deficits. If the country can successfully address these challenges, then we think Indonesia could represent one of the more compelling opportunities in the global capital markets over the next five to seven years.
David R. McNellis +1 (212) 519.1629
[email protected] Frances B. Lim +1 (212) 519.1630
[email protected] Rebecca J. Ramsey +1 (212) 519.1631
[email protected]
“ Unity in Diversity ” Main Office Kohlberg Kravis Roberts & Co. L.P. 9 West 57th Street Suite 4200 New York, New York 10019 + 1 (212) 750-8300 COMPANY Locations USA New York, San Francisco, Washington, D.C., Menlo Park, Houston Europe London, Paris Asia Hong Kong, Beijing, Singapore, Dubai, Tokyo, Mumbai, Seoul Australia Sydney © 2013 Kohlberg Kravis Roberts & Co. L.P. All Rights Reserved.
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Mpu Tantular Hindu Priest (14th Century)
When I first went to Indonesia in 1995, I trekked to Bukit Lawang in northern Sumatra with my best childhood friend to see orangutans in the rainforest. To this day, it remains one of the highlights of my international travels. My next trip to Indonesia was in 2001, and I spent the lion’s share of my time in Bali with my wife snorkeling and surfing near the beautiful beaches and then hiking upland in the country’s lush rainforests. So as one might imagine, when I touched down in the country’s largest city, Jakarta, a few weeks back, to tackle an agenda that was 100% work-related, the tall buildings, traffic and crowds were all certainly a shock to my previous memories. So, I guess there is—indeed—a reason that Indonesia’s national motto, which is taken from a 14th century poem, is “Unity in Diversity.” Importantly, though, Indonesia’s breadth of offerings is not limited to just geography; it also applies to the country’s rich backdrop of religious, ethnic, cultural and commercial diversity. Nonetheless, this trip too was quite memorable as I left the country with a sound understanding of why Indonesia is becoming such an important linchpin in the meteoric rise of the overall Southeast Asia region in the global economy. Indeed, using both its “unity” of purpose and “diversity” of resources, Indonesia now boasts an economic trajectory that is on pace to become a top-10 economy by 2030. Potentially more important to investors is that Indonesia’s consumer economy could become the third largest by 2050, trailing only China and India. But to fully understand what is changing in Indonesia, our recommendation is that folks need to get out of Jakarta, the nation’s capital and economic power (e.g., Jakarta accounts for 20%+ of GDP growth1), and spend time in cities like Surabaya and Medan. Why? Because we believe it gives an investor a true appreciation for the smaller, but faster growing and more dynamic parts of the country’s economy. Moreover, by visiting existing ports, roads and retail outlets in these smaller cities, an investor gains a better understanding of how even small improvements in technology, education, and infrastructure can materially accelerate improvements in the country’s GDP per capita. However, economic success in recent years has come at a significant cost. After more than a decade of notable discipline surrounding macro-related matters, Indonesia is now one of the few Asian emerging market (EM) countries with both a fiscal and current account deficit, with India being the only other major EM country with this ‘distinction.’ A key culprit for this conundrum is the country’s fuel subsidy program. All told, the government now spends 3.7% of total GDP on fuel subsidies to placate an increasingly vocal voting base2. In our view, this type of policy is extremely shortsighted and has already begun to create significant currency and inflation concerns. By overspending on fuel subsidies, the country is also misdirecting its limited government monies away from the infrastructure, healthcare and education initiatives that the country desperately needs to
fulfill its long-term potential. This viewpoint is not to be under-estimated, we believe, as history shows that such misguided spending can often act as a cancer, destroying both long-term productivity and potential growth. Given these substantial macro cross-currents, I thought it might make sense to detail some of my impressions from my recent trip. They are as follows: Favorable Demographics Will Likely Drive Further Increases in GDP per Capita Similar to India, Turkey and Brazil, Indonesia is one of the demographic ‘elite’ countries, with 50% or more of its population under the age of 30 (Exhibit 17). 2012 GDP per capita was just $3,596, 3/5 the level of China and only 1/3 the level of Brazil (Exhibit 22). The good news is that the gap is now narrowing as Indonesian GDP per capita (in USD) has compounded at an annual growth rate of 18% between 2005 and 20113, and we look for a further 40% aggregate increase from 2012 to 2017. Given such strong tailwinds, Indonesia is projected to be the fourth biggest consumer economy in the world by 2030 versus just 18th today (Exhibit 10). Within this consumer market, we see health and beauty, transportation, leisure, and education/training all as attractive markets. High Corporate Sector Profitability in Fast Growing Region of the World Indonesian companies are highly profitable, ranking among the most lucrative in Asia. In fact, return on equity for the Indonesia index of publicly traded companies is around 21.5% versus 16.5% for Thailand and 13.5% for Malaysia4. In our view, strong profitability represents not only sound execution but is also reflective of the positive macro tailwinds that Indonesia enjoys by being part of the fast-growing Southeast Asian region. Already, 70% of Indonesia’s exports now stay within Asia, which is significant as the OECD is projecting middle class consumers in the region to increase by a staggering 515% to 3.2 billion by 2030 versus 525 million in 2009. Despite Strong Growth, Credit Penetration and Government Leverage Are Still at Attractive Levels Even with a 20% CAGR over the past five years, domestic credit to the private sector in Indonesia was just 33% of GDP versus 55% for India and 130% for China in 2012 (Exhibit 13). This low ratio is important because it means that demand has not been artificially pulled forward, and as such, the marginal return on credit growth is still quite high. Meanwhile, gross government leverage as a percentage of GDP fell to just 24% in 2012 from 95% in 2000 (Exhibit 14), suggesting that the government can and probably should spend more, particularly on social services and infrastructure. Overall, Indonesia’s debt statistics are even more impressive when matched against the backdrop of country’s strong 6% annualized real GDP growth rate (Exhibit 8). What they suggest — and the numbers seem to bear out — is that the country’s average annual productivity is quite strong and likely to remain so. All told, over the last five years productivity has been 4.4%, compared to 1.6% in a country like Brazil.5 However, There Are Definite Signs of Economic ‘Slippage’ In 2012, 3 Ibid.2.
1 Data as at March 6, 2013. Source: Badan Pusat Statistik.
4 Data as at May 31, 2013. Source: MSCI, Factset.
2 Data as at May 31, 2013. Source: Departemen Keuangan, Biro Pusat Statistik, IMFWEO, Haver Analytics.
5 Data as at December 31, 2012. Source: Biro Pusat Statistik, Instituto Brasileiro de Geografia e Estatística, Haver Analytics, KKR GMAA calculation.
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Indonesia ran a 2.7% current account deficit, while its fiscal deficit reached negative 2.1% versus a mandatory legal limit of 3.0%6. In 2013, the issues surrounding these deficits have only gotten more challenging. Twin deficits are rare in fast growing economies, and as such, they often portend an imminent ‘adjustment’ period, including currency weakness and/or inflation headwinds. Given that the Fed may now be finally withdrawing excess liquidity, Indonesia may be forced to make adjustments to its deficits precisely at a time when its cost of capital is now almost certain to rise. Exacerbating the issue is the country’s large fuel subsidy program, which now totals around 3.7% of GDP. To put this in perspective, the outlay for its current fuel subsidy program is almost equal in both absolute dollars and as a percentage of GDP to what the government now spends on public healthcare and education programs combined7. We certainly acknowledge that the government is now in the process of reigning in spending on fuel subsidies, but – unfortunately – it appears that the monies will be redirected towards other programs that keep its imbalances at notable levels. Hard Place to Do Business According to the World Bank’s Ease of Doing Business Index for 2012, Indonesia is ranked 128 out of 185 economies, slightly better than Brazil and India but more difficult than China. Importantly, this ranking could fall further after it was announced that foreigners owning local mines must “sell back” their properties to locals by 2018. We also heard repeated concerns from business executives about the growing power of labor and its impact on operating results, margins and operating flexibility in particular. Finally, as has been consistently documented in the press, corruption remains an ongoing issue in Indonesia that foreign investors must consider carefully. Need to Translate Recent Commodity Economy Into a ‘New’ Services-based Economy In our view, the country can move faster to capitalize on the significant opportunity to leverage its recent ‘commodity dividend’ into other areas of the economy, including services and infrastructure. At the moment, Indonesia has just 39% of its industry in services versus 56% in India and 68% in Brazil (Exhibit 16). The risk of missing this opportunity is significant as the economy still has 35% of total employment related to agriculture; moreover, 74% of the increases in exports in 2011 were driven by price, not volume (Exhibit 46). Recent results seem to reflect this view as real 1Q13 GDP fell to 6.0% y/y from 6.8% in 4Q2010, driven largely by declines in the prices of coal, crude oil, palm oil and rubber8. And with China now shifting its growth priorities towards less capital-intensive growth, there is already heightened risk that Indonesia may have already missed its window of opportunity. So what is our bottom line on Indonesia? Simply stated, in a world where it is increasingly hard to find growth, we think that Southeast Asia, Indonesia in particular, represents one of the more compelling long-term investment destinations. Unlike many of the larger and higher profile EM countries, Indonesia has a more balanced economy, its debt load is lower, and its resource base is richer in many instances than some higher profile emerging markets like China, India, and Brazil. And with reasonable productivity, Indonesia’s GDP 6 Ibid.2. 7 Ibid.2. 8 Data as at May 6, 2013. Source: Bloomberg.
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growth should shine bright on both a relative and absolute basis. Exhibit 1
Indonesian Equities Have Re-rated Since 2004 Indonesia: Forward Price-to-Earnings 18 16
May-13 15.3
+1 14 12 Avg, 11.2
10 8
-1
6 4 01
02 03 04 05
06 07 08 09
10
11
12
13
Data as at May 31, 2013. Source: Factset Aggregates.
Exhibit 2
But Indonesian Equities are No Longer Cheap Indonesia: Trailing Price-to-Book 6.0 5.0
May-13 3.9 +1
4.0
Avg, 2.8
3.0 2.0
-1 1.0 0.0 91
93
95
97
99
01
03
05
07
09
11
13
Data as at May 31, 2013. Source: MSCI, Factset.
In the near-term though, there are several reasons why some patience and skepticism is required. Public valuations are now rich in many instances at a time when significant wage growth is beginning to pressure margins. And with U.S. interest rates rising, the competition for capital is now going up, and it is likely to pressure emerging market currencies and interest rates in the future. Finally, we think GDP growth in Indonesia is likely to disappoint in the nearterm, driven largely by lower commodity prices and weaker export growth.
Exhibit 3
Exhibit 5
Given the Country’s Imbalances, the Indonesian Rupiah is Now Beginning to Depreciate
Large Subsidies and Weak Tax Collection Have Widened Indonesia’s Imbalances
Indonesian Rupiah Spot Exchange Rate (USDIDR)
Indonesia: Fiscal Balance % of GDP (Left) Indonesia: Government Revenue % GDP (Right) Indonesia: Government Expenditure % GDP (Right)
8500 8700 8900 9100
2
25
1
20
0
15
-1
10
-2
5
-3
0
Weaker Rupiah
9300 9500 9700 9900 10100
2012
2010
2008
2006
2004
2002
2000
1998
Data as at June 18, 2013. Source: Bloomberg.
1996
Jan-12 May-12 Sep-12 Jan-13 May-13
1994
Sep-11
1992
10500 Jan-11 May-11
1990
10300
Data as at June 19, 2013. Source: Departemen Keuangan, Biro Pusat Statistik, IMF WEO, Haver Analytics. Exhibit 4
Its Sovereign Bonds Are Now Too Under Pressure
Indonesia Has Rigid Employment Policies
YTD Change in 10-Year Govt Yields (bp) 175 Indonesia
China
Korea
Malaysia
Singapore
OECD Employment Protection Index, 2008 (Scale 0-6, a higher score indicates more restrictions)
Thailand
3.5
100
3.0
75
2.5
50
2.0
25
1.5
0
1.0
-25
0.5
On the private side, the story is even more complex. From our vantage point, a local presence is likely required, but so too is a regional one to be able to compare and contrast both macro and micro influences affecting current investment decisions and business trends across the region. Also, given that the cost of capital is now so low relative to history, private equity firms should bring more than just their capital base; they should be good partners with strong operational capabilities and industry expertise. Equally as important, private equity investors may need to work harder with the local communities in which they invest to navigate the secular trend towards increasing government intervention, nationalism and income equality.
Turkey
Data as at June 20, 2013. Source: Bloomberg.
0.0 Mexico
Jun-13
Indonesia
May-13
Greece
Apr-13
China
Mar-13
India
Feb-13
U.S.
-50 Jan-13
Brazil
125
U.S.
Russia
150
Exhibit 6
Data as at December 31, 2008. Source: OECD. To find out more about the methodology used to calculate the OECD employment protection indicators, see www.oecd.org/employment/protection.
GDP: Consistently Strong In a world of increasing macroeconomic instability, the speed and – potentially more importantly – the steadiness – of Indonesia’s growth rate is a notable point of distinction. In 2012, for example, the country maintained a 6.2% growth rate, despite the fact that exports were actually negative for the first time in eight years (Exhibit 8).
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and over the last 12 years, the country has had among the lowest volatility and cyclicality of GdP in the major economies we follow. one can see the stability and breadth of recent economic trends in Exhibits 7 and 8 below.
exhIbIt 9
Indonesia Has a Relatively Balanced Economy... GDP Composition (2012)
exhIbIt 7
60
Relatively Low Volatility for High Single Digit GDP Growth
Stdev of Real GDP 2000 to 2012 (%)
6
India
Indonesia
35 28
Turkey Singapore
5
China 48
Real GDP vs. Volatility
21 20 9
4
34
20
14
1 3 Korea
3
Cambodia Consumption
Brazil
2
China
European Union Indonesia 0
2
4
6
Government
Investment
-1 -6 Net Exports
PPP=purchasing power parity. data as at June 4, 2013. source: Instituto brasileiro de Geografia e estatística, India central statistical organization, biro Pusat statistik, and china national bureau of statistics.
Laos
1 0
8
10 exhIbIt 10
Average Real GDP 2013 to 2018 (%)
data as at april 16, 2013. source: ImF estimates, KKr Global macro & asset allocation calculation.
…And By 2030 Should House the World’s Fourth Largest Consumption Market ToP 10 CoUnTRIeS: MIDDle ClASS ConSUMPTIon (TRIllIonS of 2005 PPP DollARS)
exhIbIt 8
Despite the Net Export Drag, Real GDP Was 6.2% in 2012
2009
2020
2030
1
u.s.
4.4
chIna
4.5
IndIa
12.8
2
JaPan
1.8
u.s.
4.3
chIna
10.0
3
GermanY
1.2
IndIa
3.7
u.s.
4.0
4
France
0.9
JaPan
2.2
IndonesIa
2.5
5
u.K.
0.9
GermanY
1.4
JaPan
2.3
4
6
russIa
0.9
russIa
1.2
russIa
1.4
2
7
chIna
0.9
France
1.1
GermanY
1.3
0
8
ITalY
0.7
IndonesIa
1.0
meXIco
1.2
9
meXIco
0.7
meXIco
1.0
braZIl
1.2
10
braZIl
0.6
u.K.
1.0
France
1.1
World
21.3
World
35.0
World
55.7
Indonesia: Real GDP Y/y (%) Statistical Discrepancy Gross Fixed Capital Formation Private Consumption
Net Exports Government Real GDP
Fiscal stimulus and strong credit growth off set weak external conditions
8 6
-2
Net exports a drag to growth for the first time in eight years
-4 00
01
02
03
04
05
06
07
08
09
10
11
12
data as at may 6, 2013. source: biro Pusat statistik, haver analytics.
a major reason for Indonesia’s success is that the economy is not too dependent on one sector or product. In particular, the Indonesian economy has its own vibrant domestic consumption economy. by comparison, many emerging markets we visit are either overly reliant on low-end exports and/or high fixed investment. If there is a shortcoming in GdP composition, we would argue that it is the government’s low spending ratio. as one can see in Exhibit 9, Indonesia’s government contribution to GdP substantially lags that of its peers.
6
Brazil 57 56
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PPP = purchasing power parity. data as at January 2010. source: brookings Institution, oecd development centre Working Paper no.285 deV/doc (2010).
As these cities become more modern, we believe it will continue to drive productivity levels higher. Third, the manufacturing sector has become more formidable as the country transitions from low-end manufacturer (food processing and clothing) to higher value-added products like equipment and machinery.
Exhibit 11
Productivity in Indonesia Is Relatively High Indonesia: Real GDP Y/y (%) Real GDP
2012
2009
2003
2000
1997
1991
President Susilo Bambang Yudhoyono 2004-current
1994
1988
1979
1998 Habibie 1999 Wahid 2001 Megawati
1982
1976
1970
1973
1967
1964
1961
President Suharto 1968-1998
1985
12 10 8 6 4 2 0 -2 -4 -6 -8 -10 -12 -14
Productivity
2006
Labor Force
(1) Real GDP as of 2012. Source: Biro Pusat Statistik, Haver Analytics. (2) Population estimates as of May 11, 2011. Source: United Nations World Population Prospects, Haver Analytics.
Importantly, Indonesia has also been able to grow its economy without the use of significant leverage from either the government or private sector. One can see this in Exhibits 13 and 14. These low leverage ratios are hugely important for several reasons. First, in terms of downside protection, the low level of credit gives us comfort that strong underlying GDP trends will not be overshadowed by de-leveraging in any part of the economy. Second, no sector of the economy appears to be over-earning by using credit to facilitate strong growth. Third, leverage levels are so low that there is actually the potential to help improve the build-out of key industries like housing, which can serve as an important cornerstone in the trend toward urbanization/GDP per capita. Exhibit 13
Credit Penetration Is Low… 2012 Domestic Credit to Private Sector % GDP U.S.
203
Japan
Exhibit 12
Growth in Smaller Cities Will Outpace Jakarta GDP compound annual growth rate 2002-10 Jakarta
5.8
Large middleweights cities 5million-10million
6.7
Midsized middleweights cities 2million-5million Small middleweight cities 150,000-2million Other cities