Does History Risk Repeating for Indonesia?

I’ve been cautious on Indonesia since late 2012, terming the country a ‘macro accident waiting to happen’ and moving underweight local equities in late Q1, but a late 1990s style capital flight crisis looks very unlikely unless local policymakers again display remarkable incompetence. So far, despite several missteps, they have retained credibility. Back in the 11th December weekly looking at Indonesia’s generous minimum wage hikes, I noted that: In 2013, there is a growing risk that either inflation lets rip or the trade deficit turns ugly. In either case, BI would be forced to hike rates to defend the IDR. Brazil offers a cautionary tale of excessive domestic consumption growth gone horribly wrong, in the absence of structural reform and infrastructure investment, with a crashing currency as the solution.’ 

And that just about sums up the past few months; the country’s GDP growth fell to 5.8% in Q2, and with a surge in inflation to 8.6% last month, sustained IDR weakness and overall a broad stagflation trend, echoing the pattern from India to Brazil in recent years. This is partly the result of the ‘terms of trade shock’ for commodity exporters, a key macro investment theme which is the flipside of China’s new lower trend growth rate.

Rising consumer spending has been a key pillar of Indonesia’s growth acceleration in recent years, alongside burgeoning natural resource exports, but the latter has been badly affected by the slowdown in China. The impact of this slump alongside the recent 75bps BI rate hikes is beginning to damage broader confidence in the economy and will dampen growth in domestic private consumption, the crux of the bull case. The IMF has recently estimated that each percentage point fall in Chinese trend GDP growth could cut as much as half a percentage points from Indonesian growth, via the commodity export impact.

International financing costs for local corporates are rising as markets anticipate a tightening of US monetary policy reflected in 10-year sovereign yields breaking 8%, a level at which as highlighted in recent notes inflation risks are fully priced in and which has attracted opportunistic foreign buying. Import costs, notably for capital goods, have been pushed up by the rupiah’s depreciation of nearly 9% against the dollar over the past year while business leaders also fear growing political interference in the economy ahead of the presidential election next year. Both factors are capping investment growth, critical to avoid an Indian stagflation style outcome.

Private consumption is still strong, boosted by those minimum wage hikes, expanding 5.1% y/y in Q2. However, investment growth slowed to 4.7% y/y from 5.8% in Q1, accounting for most of the overall slowdown and has now fallen for four consecutive quarters in an echo of India’s structural growth slowdown/supply side inflation crisis. Base-year effects skewed investment, which slowed in y/y terms to 4.7%, but bounced 3.1% q/q seasonally adjusted following a flat quarter in Q1. Policy makers have indeed now given up on supporting the IDR, which has broken decisively through 10,000 versus the USD and saw its worst monthly performance since 2009 in July, adding to inflation upside risks.

Are there echoes of the 1997/8 backdrop in Indonesia’s current outlook? Yes, to the extent there are also echoes of that period across much of Emerging Asia, after a period of rapid credit/GDP, real estate and wage growth with record carry trade driven foreign capital inflows across the region and wider GEM starting to reverse. Global funds pulled $3.6 billion from Indonesian stocks and bonds in the three months through July, amid a general GEM rout on USD strength; globally, this has been a year for a ‘barbell’ strategy of developed and frontier equity markets, with the BRICs a horror story and ASEAN markets turning volatile, with the JSE struggling to rebound from the Q2 selloff.

Longer term, like say Mexico, Indonesia offers a compelling secular consumer income EM growth story, but while Mexico has begun radical structural reforms and an ambitious multiyear investment program under its new government and is attracting a surge in manufacturing FDI, any sustained equity re-rating seems unlikely until the commodity/China growth cycle bottoms out and we have clarity on whether post-election policy making will continue along the recent haphazard but on-going reformist path. A 15x current year forward JSE multiple looks full until at least some of the macro uncertainties clear.