Indonesian economy to face another blue year

By Goei Siauw Hong

JAKARTA (JP): After a strong performance in the first half of 1997, the market faces a significant decline due to the regional currency crisis.

Starting with the devaluation of the Thai baht, the currency crisis spread across Southeast Asia and to South Korea. The devaluation of the Thai baht resulted in a series of devaluations, which also affected the rupiah.

The first impact of the currency crisis was tight liquidity resulting from the government's effort to defend the rupiah.

The second wave of the liquidity crunch came as a result of a crisis of confidence from both local and foreign investors. As the currency declined, investors left Indonesia and tried to save their wealth by borrowing U.S. dollars. The situation was worsened by rumors of bank closures, conversion of deposits into bonds, President Soeharto's health and political risks.

The Jakarta Stock Exchange's (JSX) composite index declined from its peak of 740 in early July to its current level of less than 400.

Despite the significant fall in the index, it is believed the market still contains risk if the currency crisis is not solved quickly. At least for the first nine months of 1998, we expect the market to decline further due to high-profile bankruptcies and earnings disappointments.

In addition, as long as there is instability in currency exchange rates, foreigners will continue to stay away from the market due to the uncertainty of a return on their investment in U.S. dollars. The instability of the rupiah will also put pressure on interest rates, which will be detrimental to the market.

Impact

There are few problems created by the rupiah's sharp depreciation on corporate balance sheets and in profits and losses. Foreign exchange loans are the main source of problems.

The first problem is created by the fact that most big Indonesian companies borrow offshore loans in order to reduce their borrowing costs from the past. Most of these companies have not hedged their borrowings as hedging would reduce the benefit of borrowing in U.S. dollars.

The practice of borrowing unhedged dollars has been going on for at least 5 years, and most companies benefited due to a stable annual 5 percent depreciation of the rupiah to the U.S. dollar.

However, this practice lacks discretion as it does not consider the match between assets/revenue and liabilities. The sharp depreciation of the rupiah has resulted in a significant increase in corporate borrowings in terms of rupiah.

The conversion of long-term debt into short-term debt and the increase in interest payments could result in significant corporate bankruptcies early next year if efforts to roll over these debts fail.

With a significant demand for U.S. dollars created by corporations paying their U.S. dollar denominated debt and interest, it has been a difficult task for the government to maintain the stability of the rupiah.

Few companies have prudent policies regarding U.S. dollar exposure and how to hedge their foreign exchange exposure. However, even these companies will not be free from the impact of the rupiah's depreciation since most only hedge the principal.

Consequently, interest payments will increase significantly since their payments are in U.S. dollars. For companies, which only hedge the principal, interest rates will practically double due to an almost 100 percent depreciation of the rupiah.

Another impact of the crisis is that demand for nonessential goods will decline. The currency's depreciation will result in an increase in inflation, especially in imported goods. As inflation rises, purchasing power will decline and consumers will have a limited ability to purchase nonessential goods. For this reason, it is expected that the retail sector will face a significant slowdown next year.

The biggest decline in demand, however, will be experienced by the property and automotive sectors. Demand in these two sectors depends on the availability of credit and the interest rates.

The decline in demand will be magnified by a confidence crisis experienced by potential buyers. Since the two sectors offer big- ticket items, demand will decline if consumers are not certain about their future incomes.

Production costs will rise while prices increase.

Most Indonesian companies have high import content. Consequently, production costs will rise significantly. Under normal circumstances, where a cost increase was in line with general inflation and a purchasing-power increase, companies had the opportunity to increase sales prices in order to pass on the cost increase.

However, the cost increase due to the rupiah's depreciation is huge and purchasing power will decline due to the economic slowdown. Therefore, companies will have difficulty in increasing sales prices in order to pass on the increase of production costs.

As a result of an increase in production costs, we expect the gross profit margin at companies, which import raw materials and sell their finished products in Indonesia, will decline. The impact of this gross profit margin decline in companies' net profits depends on two factors: the net profit margin of the company and the extent of import content.

The lower the net profit margin of the company, the bigger the impact of the gross profit margin erosion. And the higher the import content, the higher the earnings decline.

Companies with a low return will have difficulty in expanding. For a long time, Indonesian corporations have enjoyed low interest due to the ability to borrow offshore loans and a stable currency depreciation.

By borrowing in U.S. dollars at a cost of 9 percent to 10 percent, plus the rupiah's annual depreciation of 5 percent, the effective borrowing cost of many companies was about 15 percent. This facility will not be available anymore as the currency has been allowed to float by the government. Companies which borrow in U.S. dollars will have to hedge their position, thus eliminating the arbitrage opportunity in interest.

Foreign investors' willingness to provide equity for companies with low return was the reason behind the ability of these companies to expand. Many Indonesian companies generate a return on equity of less than 15 percent (the deposit rates before the currency crisis).

As equity holders, investors should be rewarded the additional risk by investing in equity. Few Indonesian companies are able to provide this risk premium. However, this luxury will disappear as investors will scrutinize the return provided by these companies before they make their financial decision.

With the unavailability of this cheap borrowing facility, companies with low return on equity will not be able to expand. In addition, many of these low-return companies need additional equity due to the deterioration of their balance sheets as a result of the rupiah's depreciation.

Equity investors will be less willing to provide additional equity for companies with low return on equity. With the difficulty of raising equity, many of these companies risk going bankrupt.

The monetary crisis will affect most of the country's business sectors.

Automotive

This year's strong car and motorcycle sales will not repeat next year. It is estimated the auto market will decline from an estimated 380,000 cars in 1997 to 190,000 cars in 1998 or a 50 percent year-on-year decline. Motorcycle sales will also decline by 15 percent to 20 percent in 1998.

The biggest problem for automakers, however, is the increase in production costs. Over 60 percent of car components are still imported and the current economic situation will limit sales prices. A significant gross profit margin decline is expected for Astra and a potential loss for next year. The outlook for the industry will be negative next year.

Banking

With the currency's depreciation and high interest rates, the biggest issue for the banking sector is its nonperforming loans. The rupiah's depreciation causes investors, who borrow in U.S. dollars (which accounts for about 30 percent of bank loans), to default as their collateral is below the value of their loans.

The high interest rates will also make the rate of defaults higher, making banks' assets deteriorate. If the currency crisis does not end in 1998, we will see a lot of banks in a technical bankruptcy situation.

Building materials

There are three problems with cement companies: a decline in demand due to a slowdown in construction, additional supplies becoming available next year, and a high gearing level. It is predicted there will be a 15 percent oversupply of cement in 1998, which will have to be exported.

However, competition with other Southeast Asian countries, such as Thailand, will make the export market very competitive.

A significant profit decline with potential losses in this sector is unavoidable. Despite share prices in this sector being corrected significantly, this sector is not recommended for investors who have less than a 3-year time horizon as oversupply will continue to place pressure on profitability.

Tobacco

This sector is defensive. A decline in demand will be limited due to the addictive nature of cigarettes. Gudang Garam is in a better position than H.M. Sampoerna, which faced a sales decline in Dji Sam Soe and A-Mild.

Gudang Garam's balance sheet is also relatively stronger compared to Sampoerna. However, the biggest risk in the sector is an excise tax increase. Excise tax accounts for about 50 percent of the goods' cost and the government is likely to increase the excise tax significantly due to pressure on its budget as the income tax will decline.

Infrastructure

Toll road demand is relatively defensive as proven by data from Thailand. CMNP also has high cash balances and a strong balance sheet. In addition, its costs are mainly depreciative, which are noncash costs. Therefore, it has a strong cash flow. Overall, it is one of the most defensive counters on the JSX. The biggest risk with CMNP is political uncertainty, as it is perceived to be closely linked to the first family.

Telecommunications

This is another defensive sector. The biggest risk with PT Telkom is the KSO renegotiation, which will have to take place due to the rupiah's depreciation. The KSO renegotiation could change the present value of Telkom's cash flow. Indosat is more defensive and is quasi-exported, since a significant portion of its earnings are denominated in U.S. dollars.

Retail and consumer

The retail and consumer sectors will also face a significant decline next year. Hero's high value is not justified by growth. Its sales growth will continue to be slower than operating expenses, resulting in an operating margin squeeze.

Matahari faces a high risk of slower sales and high U.S. dollar exposure from its rental payments. However, its cost- cutting measures and funds from the rights issue will help to contain the impact. On the balance sheet, Matahari is also stronger following the rights issue.

The best company in the retail sector is Ramayana, which has a net cash position, solid management and high return on equity.

Indofood's biggest problem is its huge forex debt exposure, which could wipe out its equity if the currency does not appreciate against the dollar.

Plantations

A defensive sector in the sense that it is export-oriented. The biggest threat to plantation companies, however, is the government regulation which tries to keep inflation low by imposing export quotas and export taxes on palm oil. Given the export demand for both Astra Agro Lestari and London Sumatera, both counters should enjoy the currency's depreciation.

Market trend

The market is expected to continue its decline for at least six to nine months. The biggest risk ahead is corporate bankruptcies and earnings disappointments which will not be reflected in the companies' earnings until the 1997 results are announced.

Short-term investors should not be in the market long as the chance for losing money is much greater than the probability of winning. Overall, investors will lose money from the index decline. The only way to make money in the short term is to play a technical rebound. However, this is a very risky game.

With significant risk involved at this time, it is recommended that long-term investors play only with defensive stocks, such as export-oriented companies and the small-ticket, consumer-item sector.

It is also important to look at a company's balance sheet. Only companies with a strong balance sheet and relatively little U.S. dollar debt exposure will survive the crisis.

The writer is head of research with PT Crosby Indonesia.