B sian Insights - DBS Bank...DBS Asian Insights COUNTRY BRIEFING 09 02 Indonesia What’s Holding Back Growth? Maynard Arif Head of Research DBS Vickers Securities Indonesia [email protected]

DBS Group Research • August 2015DBS Asian Insights09n

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COUNTRY BRIEFING

IndonesiaWhat’s Holding Back Growth?

DBS Asian Insights COUNTRY BRIEFING 0902

IndonesiaWhat’s Holding Back Growth?

Maynard Arif Head of ResearchDBS Vickers Securities [email protected]

Gundy CahyadiEconomistDBS Group Research [email protected]

Edward TanuwijayaResearch AnalystDBS Vickers Securities [email protected]

Chong Tjen-SanAnalystAllianceDBS Research [email protected]

Production and additional research by:Asian Insights Office • DBS Group Research

go.dbs.com/research @dbsinsights [email protected]

Chien Yen Goh Editor in ChiefJonathan Gonzalez Lead EditorGeraldine Tan EditorMartin Tacchi Art Director


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Introduction

Economic Growth Dismal Performance or Overly Optimistic Targets?

Economic Slowdown and Concomitant Factors

Investors Still Invested… For Now

Moving Away From Commodities

Structural Bottlenecks Attracting Investment and Sustaining Infrastructure

Infrastructure to Ease Regional Disparities

Pushing for Infrastructure Projects

Conclusion

Notes


Introduction resident Joko Widodo’s government took office in October 2014 amid hopes of change and calls for reform. Driven by President Widodo’s promise to launch a multitude of much-needed structural reforms, the new administration was tasked with restoring economic growth and sustaining a favourable business environment.

The first ten months in power were indeed distinguished by historic reforms: Fuel subsidies were cut, assistance to the poor was increased, and investment licensing was streamlined. But a year in, even the President’s closest allies must admit that many key areas have stalled and that much remains to be done to improve the country’s economic performance.

Overall, observers and policymakers alike wonder how President Widodo’s government plans to accelerate the pace of structural reform while addressing immediate on-the-ground economic challenges.

This report will first examine Indonesia’s current economic performance against some of the overly optimistic targets that have been set. The difficult transition away from the over-reliance on commodities and its on-the-ground impact on key provinces will be of particular interest. The various challenges the government is facing in attracting and directing investments will then be analysed in light of the many structural bottlenecks choking infrastructure projects.

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Indonesian President, Joko Widodo

Economic Growth Dismal Performance or Overly Optimistic Targets?

he government’s desire to see Indonesia return to growth of 7% a year, a rate that it has not reached since the mid-1990s, has not yet materialised. GDP growth was a mere 4.7% in the first half of 2015, the slowest since 2009. Further moderation in GDP growth cannot be ruled out for the rest of the year,

an outlook that puts the government under mounting pressure to address the slowdown and its concomitant factors.

Economic Slowdown and Concomitant Factors

The Indonesian rupiah has continued to steadily weaken against the US dollar and has reached record lows not seen since the beginnings of the Asian Financial Crisis of 1997/1998. As of July 2015, the rupiah was the second worst-performing Asian currency after the Malaysian ringgit, a trend that severely dampens the government’s ambitions to use big-ticket infrastructure projects to boost the economy and causes purchasing power to drop. So much so that consumption and sales remained weak even throughout the 2015 Lebaran season, a festive period that normally spurs consumer spending.

Private consumption is increasingly crucial for overall GDP growth but it has been softening since 2012. Some of the high frequency data suggest modest consumption ahead: The retail sales index is still growing at around 15%, income growth is likely to remain decent at around 10%, and core inflation is stable at 5%. But other signs are disconcerting. In the first half of 2015, auto sales were down by 18% on-year, two-wheel vehicle sales fell by 25%, monthly imports trended at about 20% lower compared to January 2014, exports are likely to fall by close to 5% this year, and rising food and energy costs deterred consumer spending, especially on discretionary items.

The government has implemented new measures to boost GDP growth. Among other things, the government has issued new regulations to cap prices of food and basic goods during peak demand periods. The authorities have also pushed for lower lending rates for small and micro enterprises. Meanwhile, Bank Indonesia (BI) has also eased its macro-prudential rules in a bid to boost loan growth. These measures are, however, unlikely to lift demand by much as long as fiscal spending continues to disappoint.

The pace of fiscal spending has been lacklustre. Through June 2015, capital expenditures (capex) have only reached less than 15% of the full-year target. If things were to stay the same, total capex spending may reach only 60% of this year’s 275 trillion rupiah target. It could be argued that the government’s targets were overly optimistic to begin with (Diagram 1).

The revised 2015 budget assumes total revenues of 1,762 trillion rupiah, of which tax revenues represent 85% (or 1,489 trillion rupiah). This tax revenue target represents a 30% jump over the 1,143 trillion rupiah collected in 2014, yet up until June 2015 the government only managed to get about a third of its full-year tax revenue target. Such a


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The paceof fiscal

spending has been lacklustre

shortfall in revenue collection will have implications for expenditure; spending may have to be reduced by up to 220 trillion rupiah (2% of GDP) as a result.

The breakdown of the tax revenue target makes it even clearer that the government may be overly optimistic. Income tax collection from the non-oil & gas sector and value-added tax revenues typically make up 75% of total tax revenues. In the 2015 budget, income tax collection in the non-oil & gas sector is expected to increase by 37% while value-added tax revenues are expected to rise by 42%. These targets are very high from a historical perspective. Total tax revenue growth averaged 8% in 2013-2014, about half the 15.6% average pace in 2008-2012. The last time tax revenue growth surpassed 30% was in 2008. But that was when commodity prices were significantly higher than today.

Raising corporate and income tax rates is unlikely now, given the further drag on growth that this would likely cause. While there have been discussions over new policy measures to increase tax revenues, any formal changes to the current tax laws have yet to take shape.

The government’s 30% tax revenue growth target is based partly on more efficient tax collection. The focus is to prevent under-reporting of taxable income among households and corporates; a challenging but not impossible task. Efficiency improved when President Susilo Bambang Yudhoyono first took office in 2004, which saw tax revenues grew by an average of 20% per year in 2005-2007 – relatively high by historical standards. If we assume an 8% tax revenue growth this year (average for 2013 and 2014), the total revenue shortfall would be about 280 trillion rupiah. It would appear that the government


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Note: numbers in parenthesis represent growth targets for 2015.Source: CEIC and DBS Group Research

Diagram 1 - 2015 Tax Revenue Target

has little choice but to cut expenditure targets for 2015 or it will risk seeing fiscal deficit jump to as much as 4.4% of GDP.

Some tinkering with the fiscal deficit target appears likely. The legal limit is currently 3% of GDP but the deficit has not surpassed 2.5% of GDP for more than ten years. Widening the deficit to 2.5% of GDP from the current 1.9% target would allow an additional 60 trillion rupiah of red ink. Even if measures were set to allow this, the government would still need to cut expenditure by 220 trillion rupiah to keep the deficit below 2.5% of GDP.

With subsidy spending unlikely to be trimmed further, cuts would need to come mostly from personnel, material, and/or capital expenditure. Of these, the budgeted increase in capital expenditure is the highest (a jump of practically 100%), and thus, the one most at risk (Diagram 2). Plainly, cutting investment would represent yet another drag on GDP growth both in the near and medium term.

Investors Still Invested… For Now

It’s not all bad news; despite fears to the contrary, more funds are coming into Indonesia than going out. Net foreign inflows into equities remained positive in the first half of 2015 at around US$0.3 billion. Foreign purchases of Indonesian government bonds reached US$6 billion in the first half of 2015, about the same pace as in 2014. Since January 2014, foreigners have been net buyers of Indonesian government bonds every month except for December 2014 and March 2015.


Diagram 2 - Central Government Expenditure Target

Source: CEIC and DBS Group Research

Even if the rupiah is at its weakest against the US dollar since 1997-1998, Indonesia today is definitely far removed from the Asian Financial Crisis. The public debt / GDP ratio is at 25%, down sharply from close to 100% in 2000. More importantly, foreign reserves coverage of short-term external debt is still above 200%, compared to an average of about 50% in the 3-year period prior to 1997. Non-performing loans (NPL) in the banking system are about 2.4% at present, compared to 10% prior to the 1997-1998 crisis.

Even the capital account (C/A) deficit is more sustainable today than in 1997. The C/A deficit has averaged about 3% of GDP in the past three years, similar to the average seen in the three-year period before 1997. But net foreign direct investment (FDI) is now running at about 2% of GDP, compared to 0.8% of GDP back then. Given the higher proportion of long-term financing of the C/A deficit, risks are more manageable now. This is not to say that policymakers can afford to be complacent. Further narrowing of the C/A deficit is warranted (based on net FDI trends, 2% of GDP seems more sustainable).

Productivity needs to be raised and the government can do more to attract FDI. FDI not only provides stable financing, it can also facilitate transfers of technology and know-how. Total FDI this year is likely to be slightly lower than the US$28.5 billion seen in the previous two years. Considering that investors’ sentiment on the economy has worsened since last year, the slight moderation in FDI may not be that bad after all. Infrastructure-related sectors saw an increase in investments but manufacturing was hit quite significantly, especially the auto sector. FDI into the auto sector averaged US$480 million per quarter in the first half of 2015, 25% lower than the average seen in 2012-2014, amidst a slump in auto sales this year.

A sustained fall of FDI into the manufacturing sector is generally a negative sign for Indonesia’s competitiveness, especially since the economy is still struggling to shift away from its reliance on commodities.

Moving Away From Commodities

Indonesia abounds with natural resources, but the unique nature of its geography coupled with unreliable infrastructure make their exploitation challenging in many parts of the country. A lack of investment, protectionism, and an unwieldy regulatory environment are all inhibiting the sector from reaching its full potential. These difficulties have been compounded in recent months by low commodity prices and modest investment both in the public and private sectors, thus pushing the government to drop commodities as the main engine of growth and move the economy towards industrial production and investment.

Transitioning away from the reliance on commodities is proving to be a much more painful process than previously expected. The adverse impact of low commodity prices is particularly felt in East Kalimantan, which is the third largest province in Indonesia1. The province is the sixth largest contributor to the national GDP and one of the regional


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economies that is the most dependent on its natural resources – particularly coal, oil, and natural gas.

During the coal boom of 2009-2012, Balikpapan and Samarinda were two bustling cities in East Kalimantan. In 2015, the end of the coal boom and the overall low commodity prices had a significant negative impact on the province’s revenues (Diagram 3).

55% of Indonesia’s thermal coal output comes from East Kalimantan. Given the bleak picture for thermal coal, it is hardly surprising to see activities greatly slowing down in the region. Coal production dropped to 120 million tonnes in 2014, from a peak of 165 million tonnes in 2013. Most of this drop came from small IUP2 holders and some illegal miners.

Most of the large miners are not cutting output in 2015, as they tend to have economies of scale, lower production costs, and a healthy balance sheet to deal with the current low coal prices. Their cash cost is low enough to allow them to remain profitable although the coal price has dropped by 20% on-year to hover at US$58 per ton (a level last seen in 2009).

Capacity utilisation has clearly fallen in the past year. Many subcontractors declare operating only 12 hours per day, compared to 24 hours a few years ago. Big mining contractors have either laid off or put a number of their employees on paid leave in the past several months. Utilisation rate for heavy equipment is currently below 50%. Given no growth in output and a large supply of heavy equipment in the market, demand for equipment is pretty much non-existent, even for second-hand equipment that is now priced as little as 20% of its original value.


Indonesia abounds

with natural resources

Diagram 3 - East Kalimantan GDP Growth, 2014-2015 (year-on-year)

Source: National Statistics Bureau (BPS), DBS Vickers

More disconcertingly, consumption growth was not spared. The gap in minimum wage between East Kalimantan and Jakarta has been widening over the past few years (Diagram 4), a trend that is further exacerbated by the fact that prices of staple foods (instant noodles, coffee, flour, etc.) are about 10% more expensive than in Jakarta.

Generally speaking, the gap in GDP per capita between Jakarta and Indonesia as a whole is huge; in 2013, GDP per capita in Jakarta stood at US$11,901 while it was US$3,449 in the rest of Indonesia. The gap in labour cost between West and East Java (two of the more developed regions in the country) was a startling 40% in 2014, while gaps in minimum wage between Jakarta and other regions remain significant (2.7 million rupiah in Jakarta versus an average of 1.6 million rupiah in the rest of Indonesia).

Consumer discretionary players in East Kalimantan are particularly vulnerable to slower (or even negative) same-store sales growth in the region. Indonesia’s largest retailer by market capitalisation, Matahari Department Store (MDS), has three stores in Balikpapan and Samarinda’s main retail malls. Same-store sales growth at MDS hit a 4-year low recently, led by its stores in Kalimantan (estimated minus 7.5% same-store sales growth in the first quarter of 2015).

Clearly, East Kalimantan personifies the struggles that Indonesia is facing while moving away from its over-reliance on commodities. It is a typical example of consumption growth being adversely affected by falling export earnings.


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Source: National Statistics Bureau (BPS), DBS Vickers

Diagram 4 - East Kalimantan Minimum Wage, as % of Jakarta’s (2009-2015)

Structural BottlenecksAttracting Investment and Sustaining Infrastructure

uring the APEC CEO Summit of November 2014, President Widodo urged APEC business leaders to support Indonesia’s economic development by increasing foreign direct investment (FDI). Greater foreign investment can provide the funding required for the country’s infrastructure overhaul and at the same time,

enhance the technological know-how needed to raise domestic productivity.

Better infrastructure will certainly help to unlock Indonesia’s potential, as bigger airports, more efficient ferry terminals, and more roads provide better linkages between cities for people and goods to travel.

However, foreign investors are not entirely clear if the current administration is committed to its blueprint to leverage infrastructure projects as engines of economic growth.

Infrastructure to Ease Regional Disparities

Better infrastructure networks have an impact on the way FDI reaches the country; they can reduce traveling time and logistic costs and make it easier for companies to relocate their production centres away from Jakarta and West Java. The proportion of FDI coming into Indonesia is still highly skewed toward Java, although the disparity has gone down in recent years (Diagram 5).

Unfortunately, the progress of many infrastructure projects, even those already started before the Widodo administration, are more often than not stalled by red tape, land clearing


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Diagram 5 - FDI by destination, 2005-2014 (% of total FDI to Indonesia)

Source: CEIC, DBS Vickers

Better infrastructure will certainly

help to unlock Indonesia’s potential


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obstacles, and budget issues. The government needs to start delivering on its promises and be more aggressive in ensuring effective fiscal spending.

The current budget deficit targets of 1.9% of GDP for 2015 and 2016 seem to be too conservative, considering the need to help arrest the slowdown in GDP growth. Even with a fiscal deficit of 2.5% of GDP, the government still needs to lower its planned expenditures by some 2% of GDP this year. Given Indonesia’s relatively low public debt-to-GDP ratio, there is actually room for the government to run a bigger deficit this year.

Under the 5-year plan, the government targets some US$450 billion worth of projects, spread across almost equally between 2015 and 2019 (Diagram 6). About 60% of the investment requirements are expected to go into building new road networks, power generation, as well as strengthening maritime transportation.

Diagram 6 - Infrastructure Investment Requirements 2015-2019, by source of funding (trillion rupiah)

Source: Bappenas, AllianceDBS, DBS Vickers

Sector Central Government

Regional Government

SOE Private Total

Roads340.0 200.0 65.0 200.0 805.0

Railways150.0 - 11.0 122.0 283.0

Sea Transportation498.0 - 238.2 163.8 900.0

Air Transportation85.0 5.0 50.0 25.0 165.0

Land Transportation

50.0 - 10.0 - 60.0

Urban Transportation

90.0 15.0 5.0 5.0 115.0

Electricity100.0 - 445.0 435.0 980.0

Oil and gas3.6 - 151.5 351.5 506.6

Information and Communication Technology

12.5 15.3 27.0 223.0 277.8

Water Resources 275.5 68.0 7.0 50.0 400.5

Clean Water and Sewage

227.0 198.0 44.0 30.0 499.0

Public Housing 384.0 44.0 12.5 87.0 527.5

Total Infrastructure

2,215.6 545.3 1,066.2 1,692.3 5,519.4

a new push for the launch and

completion of infrastructure is needed to revitalise the

sector

Indonesia currently ranks 53rd (out of 160 countries) in the World Bank’s Logistics Performance Index, with below-average scores in three out of six categories and ranking below emerging ASEAN peers (Thailand, Vietnam, and Malaysia)3. Clearly, a new push for the launch and completion of infrastructure is needed to revitalise the sector and fully harness its economic potential.

Pushing for Infrastructure Projects

There are some signs of accelerated infrastructure development in Indonesia. A first step was to remove the subsidy for RON88 (gasoline) fuel and fixing the subsidy for diesel at 1,000 rupiah/litre effective January 2015. The move aimed to save more than 200 trillion rupiah annually, a large part of which was to be channelled into infrastructure development.

Next, the government realised that the fastest way to boost infrastructure was to inject capital into infrastructure-related state-owned enterprises (SOEs) to enhance their individual financial capacities, a move that has many SOE contractors eyeing strategic capital injections from the government in 2016. The government is also planning to reduce dividend pay-outs by infrastructure-related SOEs, which would further boost their growth.

The land acquisition bill, meanwhile, is being continuously revised to prevent the many land disputes that have already delayed important public projects. The new land acquisition law (Law No 2/2012) provides better clarity on the timeline of land acquisition for public projects. But there were still some limitations, including the following:

1) The process could still take up to 583 days to complete

2) No guarantee that targeted land would be approved by the governor and/or the courts (in case the affected party objects)

3) On-going projects for which more than 75% of the land had been acquired is subject to the old land bill, while other on-going projects (less than 75% of land acquired) must start the whole process again under the new bill

4) Funding for the land acquisition must wait for disbursement of the state budget (APBN), which is typically time-consuming.

The latest revisions to the land bill (Perpres 30/2015) address issues 3 and 4:

1) All on-going projects for which the land acquisition stage has not been completed can use the new land bill and resume from the implementation stage (implying 178-294 working days remaining) and not have to start from planning and preparation stage.


2) Project owners can finance the land acquisition to speed up the process, while waiting for the state budget (APBN).

So far this year, there have been some positive signs with four ground-breaking mega projects launched by President Widodo (up until May 2015, Diagram 7).

The first mega-project is the 1 million low-cost housing. The first stage involves the building of two towers in Ungaran and Semarang in Central Java. The second project is the Trans-Sumatra toll road. The total length of this toll road is 2,600km, but the four first sections will be the priority (Palembang-Indralaya, Bakauheni-Terbanggi Besar, Pekanbaru-Kandis-Dumai, and Medan-Binjai) and are targeted to be completed by 2019. The Trans-Java toll road is the third project with the Ngawi-Kertosono section recently being launched. The last mega-project is the 35,000 MW power plant projects, for which the first stage included launching 2,000 MW in various locations (Yogyakarta, West Java, South Sulawesi, and South Sumatra).

The main litmus test for the government this year is the long-delayed construction of a US$4 billion coal-fired power plant in Batang. The start of this project has been delayed since


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Diagram 7 – Key Planned Infrastructure Projects (as of end-May 2015)

Source: Bappenas, AllianceDBS, DBS Vickers

Project Name Potential Beneficiaries Completion Date

Value (trillion rupiah)

1 million low-cost housingCement companies

- -

Trans-Sumatra toll road

Jasa Marga Persero Tbk PT

2025 300

Waskita Karya Persero Tbk PT

Wijaya Karya Tbk PT

Wijaya Karya Beton Tbk PT

Trans-Java toll roadJasa Marga Persero Tbk PT

construction companies 2018 51.6

35,000 MW power plant projects

Wijaya Karya Beton Tbk PT

2019 1,080Pembangunan Perumahan Tbk PT

April, due to red tape and land dispute issues. This coal-fired power plant will be the largest in Southeast Asia. Undertaken by PT Bhimasena Power Indonesia, a joint venture between PT Adaro Energy Tbk, Itochu Corp, and Electric Power Development Co Ltd (J-Power), the project is undertaken under a Build-Operate-Transfer (BOT) model.

These changes are positive, but it remains to be seen whether they are sufficient to speed up the land acquisition process on the ground and whether or not key projects that were supposed to start in March-April of this year will finally see the light of day.



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Conclusion t is clear from the current economic difficulties Indonesia is going through that the Widodo administration must avoid a looming downward spiral. Pragmatic measures are urgently needed to maintain financial system stability and revive GDP growth while successfully shifting the economy away from its over-reliance on commodities.

Despite these challenges, most foreign investors remain engaged thanks to the long-term potential of the economy. Whether this potential is fulfilled or not will be determined by President Widodo’s capacity to consolidate his political authority in the next few months.

Indeed, the country’s poor economic performance is corroding President Widodo’s initial popularity, as he faces increasing criticism from both friends and foes for his inexperience on the national political scene and for his perceived lack of direction. One year on, the shakier the economic environment gets, the shakier Widodo’s political authority.

One important obstacle he must overcome in the second half of 2015 is the composition of his cabinet, which comprises a mix of technocrats and politically-connected figures. As of August 2015, President Widodo replaced several ministers in his cabinet, including those in charge of key economic portfolios, sending a clear signal that he is pushing for more to be done in the economic sphere.

This strategy alone may not necessarily accelerate the pace of reform or revolutionise the direction of policies, but it will buy the government enough time to transition into more solid foundations.

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the shakier the economic environment gets, the shakier Widodo’s political authority

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Notes[1] 127,265.52 km² of land and 25,656 km² of marine area.[2] Izin Usaha Pertambangan, mining operation permit.[3] World Bank, International LPI Global Rankings, http://lpi.worldbank.org/international/global

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B sian Insights - DBS Bank...DBS Asian Insights COUNTRY BRIEFING 09 02 Indonesia What’s Holding Back Growth? Maynard Arif Head of Research DBS Vickers Securities Indonesia [email protected]