Improved infrastructure needed to spur growth
David O'Brien, Jakarta
The editorial of April 27, 2004, titled Polls Bouy Economy, discussed macroeconomic stability in light of the polling process to date. It is certainly true that at the macro level analyzed there has not been any "melt down".
However the analysis settled on relatively simple measures of performance that do not reflect the ongoing lack of activity in the "real" sector of Indonesia. This sector needs to be reinvigorated to promote sufficient growth so as to absorb the millions of unemployed and underemployed.
To achieve this requires investment in industries that are export focused and can leverage Indonesian competitive advantage. Associated investments in infrastructure will have the double benefit of boosting employment and enhancing the efficiency and competitiveness of the Indonesian market and its production of goods and services.
A surging Jakarta stock market (JSX) has been largely influenced by the decline in interest rate yields and a shift of capital by investors from term deposit to equities. The last two years have seen a decline in interest rates for term deposits from 16 percent to 6 percent. A similar flood of investment is occurring in relation to the property sector, particularly retail commercial and apartments. Investors remain predominately domestic and the investments can be considered somewhat speculative in nature.
The substance underpinning the current buoyancy is what should be of concern to economic managers. The fact is that the investment remains mainly domestic in nature, has a speculative aspect to it and is largely built on economic growth fueled by consumer demand. This consumer demand is being stoked by a corresponding boom in consumer credit.
It has been estimated by Morgan Stanley that more than 80 percent of growth in the Indonesian economy is attributable to private consumption for 2003 and 2004. Lending is concentrated to this market which is fueling the current cycle.
The fall in interest rates has resulted in pressure on banks to manage a revenue line that was previously being maintained by rolling over high interest bearing recapitalization bonds. The answer to date has been consumer credit.
Consumer credit provides a larger margin than commercial lending and risk assessment is easier and least costly (albeit the unsecured nature means the actual risk is higher). Consumers are drawn to the credit on offer as rates have not seemed so affordable since pre crisis.
In fact the decline in inflation means that real interest rates may have in fact increased. With inflation at 5 percent the real interest rate on a credit card is running at 10 percent+.
This boom in consumer credit is leading to a starvation of capital to the commercial sector and an unbalanced portfolio for banks. The recent quarterly results from Bank BCA show a net interest margin (NIM) of 5.2 percent. A benchmark group of 15 overseas banks with an average market value of US$102 billion including Citigroup, Lloyds, HSBC, Barclays, Deutsche Bank, Toronto Dominion, Bank America and Wells Fargo is generating an average net margin of 2.44 percent. Other Indonesian banks such as Danamon and Mandiri are both also well above the international benchmark.
A NIM nearly double the international average could be indicative of a lack of competition or a reliance on riskier lending, or maybe a combination of both. Such a concentration in this sector has the potential to harm longer term returns. A balanced portfolio of corporate and consumer lending will allow risks and rewards to be better shared and more balanced longer term performance. The rush to a particular sector could result in deterioration in credit quality at a subsequent cost.
The concern is that banks are not optimally fulfilling their role as a channel for recycling capital from savers to borrowers. The focus at present seems to be rewarding shareholders and this may be a function of the privatization cycle in the sector.
Also on April 27, 2004 the Post identified issues related to commercial rule of law interpretations. On this particular day they related to Prudential Life Assurance, the latest bank frauds and land swap deals. The impact on potential investment cannot be underestimated.
Of particular concern is the lack of reform in the bankruptcy laws. Indonesia's business image is seriously tarnished when a profitable company with strong balance sheet can be declared insolvent as a result of a single agent's legal action. On the same day are the stories of alleged fraudulent banking practices and questionable land swap deals. The international investor reading his The Jakarta Post on the flight from Singapore may decide to get the first flight back!
Bankruptcy laws should operate to ensure that capital allocation remains optimal. Firms that have failed as a result of poor management, shift in markets etc. should be liquidated and allow assets to be liquidated or recycled under new management. Capital is therefore allocated where it is most productive.
There is a need for balance between the position of debtor and creditors to aid such market optimization. This lack of clarity in the rule of law is a major impediment to expansion of the real sector to grow the Indonesian economy.
Local capital markets need strengthening in conjunction with that of the legal and regulatory environment. Wherever financial markets are absent or repressed, savings go unused, productive economic opportunities go unrealized and risks go undiversified. Robust local capital markets are required to assist in financing the enormous level of investment required. A greater ability to raise local funds will reduce exposure to exchange rate risk. Raising finance locally has the added benefit of reducing the potential for capital flight and its associated impact on exchange rates.
The local capital markets have a capacity to fund infrastructure as can be seen by the amount of mall and apartment development in the large cities of Indonesia. This is being driven, as the economy is as a whole, by retail spending. If this sector is overdeveloped and returns fall and real interest rates are stable at 2 percent investors will be attracted to such a stable investment that infrastructure offers.
That is strong, measurable cash flows with a lower level of risk than other asset classes due to higher predictability of cash flows. Improvements in the performance and accountability of the funds management business and institutional investors (pension and insurance companies) will provide liquidity to the sector. Infrastructure is in fact more favorable an investment in a developing country as it offers growth prospects in addition to a stable high yield that is the major offering in established economies.
The aim of infrastructure is to support the efficient use of capital resources.
Indonesia has the opportunity to follow Thailand up the value chain from contract clothing and footwear manufacture to this more value added area.
Adequate infrastructure is a key to ensure cost competitiveness in this area with tight supply chains. Indonesia can enhance its competitiveness with efficient transport infrastructure supported by reliable gas and electric supplies as key inputs transformed by a healthier, better educated work force.
Unfortunately there is not a "quick fix" solution to these issues. Let us hope for ongoing stability through the balance of the electoral cycle to provide a platform for a new leader to address the economic issues in a visionary manner.
The writer is Technical Advisor of the CSA Advisory