Improved infrastructure needed to spur growth

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