S&P: Ratings On Indonesia Affirmed At ‘BB+/B’; Outlook Remains Positive

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OVERVIEW

  • In our view, Indonesia’s fiscal framework has improved, which should improve the quality of public expenditure and lead to more predictable fiscal outcomes.
  • However, fiscal performance has not improved in tandem for cyclical and structural reasons.
  • We are therefore affirming our ‘BB+’ long-term and ‘B’ short-term sovereign credit ratings on Indonesia. We are also affirming our ‘axBBB+/axA-2’ ASEAN regional scale ratings on Indonesia.
  • The positive outlook reflects the possibility that we may raise the ratings if the improved fiscal framework indeed delivers better fiscal performance, such that deficits decline and borrowings remain low.

RATING ACTION

On June 1, 2016, S&P Global Ratings affirmed its ‘BB+’ long-term and ‘B’ short-term sovereign credit ratings on the Republic of Indonesia. We also affirmed our ‘axBBB+/axA-2’ ASEAN regional scale ratings on Indonesia. The outlook on the long-term rating is positive.

RATIONALE

The ratings on Indonesia balance the country’s low per capita income plus middling fiscal and external indicators, against improved policy and institutional settings, credible monetary policy, and buoyant economic growth.

After free and fair parliamentary and local assembly elections in July 2014, the Indonesian Democratic Party of Struggle (PDI-P) administration has improved fiscal flexibility by reducing energy subsidies (principally on gasoline, diesel, and electricity) and by tightening revenue administration.

The government has spent the resultant savings from these initiatives on energy and transport infrastructure and targeted social programs. The government is also taking steps to improve Indonesia’s business climate by streamlining regulations and business licensing, cutting red tape, reforming tax incentives for foreigners, upgrading infrastructure, and promoting labor market flexibility. In addition, the government strengthened rules for procurement and licensing, expanded financial interest disclosure for members of parliament, and appointed ministers based on merit in order to improve public administration.

We believe these reforms will promote greater policy flexibility and responsiveness. Over time, these measures should raise public sector savings, which in turn should help to contain current account deficits and a slow erosion of external liquidity metrics. Thus, we do not expect a reoccurrence of the delays seen last year in the execution of the spending program on public infrastructure.

Similarly, we expect the government to overcome its apparent hesitancy to allow domestic gasoline prices to fully track international prices. Over the rest of this government’s term, we expect the administration to further improve critical infrastructure, address legal and regulatory uncertainties, and tackle bureaucratic obstacles and entrenched patronage in order to lift Indonesia’s growth potential and its creditworthiness. Hence, we maintain our positive outlook on the rating.

Indonesia’s low GDP per capita, which we estimate at US$3,600 in 2016, is a rating constraint, suggesting past policies have not delivered prosperity for this resource-rich country. Indonesia is a major commodity exporter of natural gas, coal, palm oil, and petroleum.

Its growth slowed to an estimated 4.8% in 2015, from 5% in 2014, because of weaker export prices, lower demand from China, and bans on exports of partially processed minerals (including copper, nickel, zinc, and bauxite ore). We expect GDP to expand by about 5% (3.7% in GDP per capita terms) in 2016, supported by public sector investment, which we estimate to rise by about 6%. Our projection is for Indonesia’s GDP annual growth to average 5.5% over 2016-2019 (4.2% in GDP per capita terms).

Bank Indonesia (the central bank) modestly loosened monetary policy by 75 basis points over January to May to 6.75%. Consumer price inflation is low at 3.6% for the 12 months to April 2016–within the target range of 4% plus or minus 1 percentage point. These data points suggest high real rates, which will make achieving this year’s growth difficult while ensuring a more sustainable economic performance and keeping the current account in check.

We base our expectation of Indonesia’s budgetary performance on the government’s target of keeping general government fiscal deficits below 3% of GDP and borrowings below 60% of GDP. The fuel subsidy reforms, if carried through, should create additional room for the government to raise social and capital spending, although we note that lower oil revenue has substantially offset gains from the subsidy reforms to date. Better revenue performance should also come from improving tax compliance and higher non-oil revenues (mainly through higher excise taxes on tobacco and luxury goods).

We estimate the fiscal deficit at 2.7% of GDP in 2016, compared with 2.5% in 2015, and to average about 3% of GDP over 2016-2019. We expect heavy infrastructure spending of a quasi-fiscal nature by government-owned enterprises (such as PT Perusahaan Listrik Negara, Perusahaan Daerah Air Minum, and PN Hutama Karya) to amount to another 2% of GDP on average annually over 2016-2019.

S&P Global Ratings estimates the fiscal deficit to result in net general government debt of 25% of GDP in 2016, rising modestly to about 27% in 2019. We project the ratio of general government interest expense to revenue to remain above 10% for the forecast horizon. Broader credit conditions, however, cast a shadow on the sovereign’s credit profile. The credit quality of the corporate sector has been declining since the end of 2014 with balance sheets deteriorating across sectors.

That trend accelerated since 2015 because sustained capital investment coincided with a softer consumer sentiment and commodity price falls. As a result, revenue growth slowed and operating cash flows declined while debt servicing requirements remained high. We currently have a negative rating outlook on just under a third of corporate credit ratings in Indonesia–a universe that spans private and government-owned companies of different sizes across sectors, and we have taken over a dozen negative rating actions on the rated corporate sector since 2014 (see “Related Research” below for a sample).

At the same time, the banking system’s nonperforming loans (NPLs) rose to 2.8% as of March 2016, from an historical low of 1.8% in 2013. Special mention loans, an indicator of potential credit stress in the banking system, stood at about 5.8%. We believe the special mention loans are a potential source of additional NPLs. The government relaxed its guidance on classifying restructured loans in August 2015.

A growing number of rated Indonesian companies are also starting to face liquidity or refinancing-related risks from a rapid rise in foreign borrowing between 2011 and the first half of 2014. Their ability to refinance at manageable costs will remain exposed to investor sentiment. The credit quality of state-owned companies continued to deteriorate in 2015 following large debt-funded infrastructure investment.

We estimate that the aggregated net debt of listed Indonesian public enterprises nearly doubled between 2010 and 2015. That said, the government will make cash injections in some public enterprises and we expect the cash flow and capitalization of those public enterprises to be sufficient to carry the burden of weaker profitability stemming from this infrastructure expenditure.

Accordingly, we have not worsened our assessment of public finances for these contingent fiscal risks, given the size of the financial and public enterprise sectors, and the government’s room to maneuver within the boundaries set out in our criteria.

Regarding the country’s external accounts, we expect Indonesia’s liquidity to weaken, reflecting the corporate sector’s dependence on foreign funding, combined with limited hedging of foreign currency debt, rising refinancing risks, and persistent U.S. dollar nominal strength (although in real effective terms the rupiah is about 8% higher than in September 2015). Notwithstanding the government’s goal of keeping the current account deficit low, we expect the deficit to average just under 3% of GDP over 2016-2019 due to a recovery in domestic demand.

Bank Indonesia’s foreign reserves exceed US$100 billion or over six months of current account payments as of April 2016. The authorities have undrawn contingent financing facilities of US$77 billion through the Chiang Mai Initiative Multilateralization and through bilateral swap arrangements with the People’s Bank of China, among others.

OUTLOOK

The positive outlook signals that upward pressure on the ratings still persists over the next 12 months. We could raise our ratings on the government this year or next if the improvement in institutional settings, particularly its fiscal framework, delivers better quality spending, deficits on a declining trend, moderate government debt, and limited contingent fiscal liabilities. Full and timely execution of the government’s fuel subsidy reform would be one step in this direction.

On the other hand, we may revise the outlook to stable if problems in the banking or public enterprise sectors fester, reform momentum slows or stalls, fiscal metrics do not improve, or the trend in weakening external liquidity does not abate.

 

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S&P: Ratings On Indonesia Affirmed At ‘BB+/B’; Outlook Remains Positive

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