When Standard & Poor’s upgraded Indonesia’s sovereign credit rating to BB+ in April, it meant all three mainstream ratings agencies had the country at just one notch below investment-grade level.
And the country’s rating outlook is “positive,” according to both S&P and Fitch, increasing market optimism that an investment grade rating will be reached by 2012 or even as early as this year.
Sovereign credit ratings evaluate a country’s ability and willingness to repay debt. It also tells investors about the credit risk in a given country.
A high rating means that the country’s credit-worthiness is strong and the risk of debt default is low. Ratings agencies usually assess countries based on economic, financial and political variables.
Indonesia’s improved macroeconomic stability has been cited by ratings agencies as the key factor behind its upgrade. This includes declines in public debt and a rising stock of foreign currency reserves.
Reflecting lower credit risks, an upgrade in a sovereign rating can help emerging economies like Indonesia borrow funds more easily and cheaply in the international capital market.
Indeed, foreign purchases of Indonesia’s financial assets, including debt securities, has been very strong since 2009, on the back of favorable risk-return dynamics in the country, in combination with abundant liquidity in global financial markets.
The easing of funding conditions can boost leverage and economic growth.
In Indonesia, there is significant scope for leveraging. By the end of last year, outstanding bank loans were equivalent to only 27 percent of the country’s nominal gross domestic product, far lower than the ratios in China (120 percent), India (80 percent) and other Asian economies.
Bond market capitalization as a percentage of Indonesia’s GDP was also fairly low at near 20 percent. So it is easy to anticipate that easier financing conditions and declining capital costs could provide an important catalyst to spur economic growth.
A higher sovereign rating may also strengthen investors’ confidence in a country, translating to larger amounts of foreign direct investment. And Indonesia’s rising rating should augment its existing competitiveness in attracting FDI, such as a strong consumer base, cheap labor costs and rich natural resources.
Indeed, Bank Indonesia statistics show that FDI increased to $3.7 billion in the fourth quarter of 2010, exceeding the peak level of $3.4 billion prior to global economic downturn in the third quarter of 2008.
A sovereign rating upgrade leads to an improvement in a country’s finances. But when it comes to the real sector investment made by foreign companies, the sovereign rating may not be the biggest factor.
Multinational companies in Indonesia still confront many business barriers, such as weak infrastructure, labor market rigidness and legal uncertainties.
Much still needs to be done to ensure that business hurdles will be removed and capital inflows will be directed into productive areas of the economy.
There are positive signs in this direction, including the Finance Ministry allocating more money for infrastructure this year and a land-acquisition bill aimed at easing construction that has been submitted to lawmakers.
Pro-business reforms are crucial in order to boost the long-term real-sector investment that could boost Indonesia’s growth potential.
Tieying Ma is an economist with DBS Group Research.
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