Indonesian Political Risk Rising

new indonesia

Bank Indonesia surprised markets with a 25 bp cut last week.  With a lukewarm growth outlook, we think easing will continue in Q4.  Rising political risk bears watching.

POLITICAL OUTLOOK

In February, regional elections were held across the country.  Jakarta’s vote was the most closely watched, which went to a run-off in April.  The surprise winner was Baswedan, beating incumbent Purnama (also known as Ahok).  Baswedan was backed by the right-wing Gerinda Party, the party of Subianto.  Subianto was Jokowi’s opponent in the 2014 election, and so Baswedan’s victory in Jakarta bodes ill for Jokowi’s reelection prospects.

President Joko Widodo (Jokowi) is in the middle of his 5-year term, with the next elections to be held in 2019.  Jokowi’s record so far has been mixed.  After early success in cutting fuel subsidies, Jokowi has struggled to push through deeper structural reforms.  Jokowi’s PDI-P and its allies do not have a majority in parliament.

Mining company Freeport McMorAn just ceded control of the world’s second largest copper mine to the Indonesian government.  Freeport agreed to reduce its stake in the Grasberg copper and gold mine to 49% (from over 90% currently) in exchange for operating rights lasting until 2041.

It’s unclear how long the company will retain operational control.  Nor is it clear how much it will be paid by the government for giving up its majority stake.  While this deal will end a dispute that’s been simmering since January, there are still many issues still to be settled.  Furthermore, the deal will likely raise concerns regarding the playing field for foreign investment.

Indonesia is near the middle of the pack in World Bank’s Ease of Doing Business rankings (91 out of 190 and improving from 106 in 2016).  The best categories are getting electricity and credit, while the worst are registering property and enforcing contracts.  Similarly, it comes in near the middle of the pack in Transparency International’s Corruption Perceptions Index (90 out of 176 and tied with Colombia, Liberia, Morocco, and Macedonia).

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast by the IMF to accelerate modestly to 5.2% in 2017 from 5.0% in 2016, picking up to 5.4% in 2018.  GDP rose 5.0% y/y in both Q1 and Q2, and so we see slight downside risks to the growth forecasts.

Price pressures are falling, with CPI decelerating to 3.9% y/y in July from 4.4% in June.  This is the lowest rate since March and back in the bottom half of the 3-5% target range.  August CPI data is due out next Monday.  The central bank sees inflation around 4% this year and between 2.5-4.5% next year.

This supports the case for lower rates, and we believe Bank Indonesia will cut 25 bp again in Q4.  This month’s 25 bp cut to 4.5% was the first since October 2016, and another cut at the next policy meeting September 22 is probably too soon.  Perhaps a cut at the October 19 or November 16 is more likely.

Fiscal policy has remained prudent.  The budget deficit came in at an estimated -2.4% of GDP in 2016, down from -2.6% 2015.  It is expected to widen to around -2.7% of GDP in 2017.  Subsidy costs have fallen but Jokowi may rely more on government spending to stimulate the economy.

The external accounts are starting to worsen slightly.  The trade balance moved into deficit in July for the first time since 2015, bringing the 12-month total surplus down to $12.2 bln from $13.1 bln in June.  The current account deficit was about -2% of GDP in 2016, and is expected to remain near there in 2017 and 2018.

Foreign reserves continue to rise to all-time highs.  At $127.8 bln in July, they cover nearly 7 ½ months of imports and are 3 times larger than the stock of short-term external debt.

INVESTMENT OUTLOOK

The rupiah has lagged after a strong 2016.  Last year, IDR rose 2% vs. USD and was behind only the best performers BRL (+22%), RUB (+20%), ZAR (+13%), COP (+6%), and CLP (+5.5%).  So far in 2017, IDR is up 1% YTD and is ahead of only the worst EM performers HKD (-1%), PHP (-3%) and ARS (-9%).  Our EM FX model shows the rupiah to have NEUTRAL fundamentals, so this year’s underperformance is likely to ebb a bit.

USD/IDR has traded largely in the 13200-13400 range this year.  A break above the 13400 area is needed to set up a test of the January high near 13500.

Indonesian equities are underperforming in EM after a strong 2016.  In 2016, MSCI Indonesia rose 12% vs. 7% for MSCI EM.  So far this year, MSCI Indonesia is up 13% YTD and compares to 27% YTD for MSCI EM.  This underperformance should ebb, as our EM Equity model has Indonesia at a NEUTRAL position.

Indonesian bonds have outperformed.  The yield on 10-year local currency government bonds is about -118 bp YTD.  This is behind only the best performers Argentina (-176 bp), and Brazil (-131 bp).  With inflation likely to remain low and the central bank likely to continue easing, we think Indonesian bonds can continue outperforming.  Foreigners continue to buy local currency bonds, holding about 40% of the total amount outstanding.

Our own sovereign ratings model shows Indonesia’s implied rating steady at BBB/Baa2/BBB.  Even after S&P recently upgraded Indonesia to investment grade BBB- to match the other two agencies, we believe these ratings are still seeing some upgrade potential.