Last week, Asia Confidential looked at the rise and fall of China, and how investors had gone from excessive optimism to seemingly excessive pessimism. China market valuations had already largely discounted a hard economic landing and it wouldn't take much for a bounce to take place. Well, China was the best performing major Asian market in local currency terms over the past week on the potential for new easing measures. Whether a China market bottom is in though is far too early to tell.
In this post, I'm going to explore an Asian market - Indonesia - where investor sentiment has turned the other way, from excessive pessimism to optimism. It was only nine months ago when Indonesia was deemed part of the "fragile five" economies most vulnerable to QE tapering in the U.S. Post that, Indonesia's currency fell more than 30% and its stock market tanked as panic set in. But the lower currency helped steady the ship, lowering the country's large current-account deficit by making exports cheaper in foreign markets and imports more costly.
Now there are hopes that Indonesia's economy is set for another upswing as interest rates and inflation fall. And there are high hopes that the country's presidential front-runner, Joko Widodo, or Jokowi as he's known to locals, can help spur growth by delivering on desperately-needed infrastructure investment. Both of these things have helped make Indonesia one of the world's best performing stock markets year-to-date, up 23% in U.S. dollar terms. That's right: one of the "fragile five" has killed it in 2014. Unsurprisingly, stockbrokers have been falling over themselves to upgrade Indonesia.
The big question is: will the outperformance continue? The odds would seem to be against it. Risks from a China economic bust are likely under-estimated. As are the difficulties facing the incoming president in implementing reform. And with Indonesia trading at 15x this year's earnings, a 32% premium to Asia-ex Japan, there appears to be plenty of room for disappointment.
You've come a long way, baby
On March 14, Megawati Sukarnoputri, a former Indonesian president and head of the main Opposition Party, the Indonesian Democratic Party of Struggle (PDI-P) anointed Jakarta governor, Jokowi, as her candidate for president. Jokowi is Indonesia's most popular politician by a distance. Barring a miracle, he will be Indonesia's new president, taking over from Susilo Bambang Yudhoyono (SBY), who's been in power since 2004.
The task facing Jokowi can best be understood via a brief journey through modern Indonesian history. The up-and-coming Indonesia that we know today really came out of the ashes of the 1997 Asian crisis. I don't say "ashes" lightly. It's hard for outsiders to comprehend the impact that period had on Indonesia, and Asia more broadly. It was far worse than the 2008 impact on the developed world. Indonesia's currency fell more than 70% during the period. GDP declined 14%. Inflation peaked near 70%.
Moreover, the country's brutal dictator of 32 years, Suharto, was forced to resign after widespread riots. At that time, the riots against minority Chinese were vicious in the extreme. And the riots which subsequently spread across the country were some of the most primitive and mind-boggling in modern times. If you don't believe me, read In The Time Of Madness.
Coming out of the crisis, political instability reigned. A serious of weak presidents followed. And political power was deliberately de-centralised so regional provinces had a greater say in their own development. This was both good and bad. It led to economic growth being more evenly spread. But it also resulted in corruption being pushed out into the provinces, where it flourished.
Anyhow, the economy gradually healed, helped by the start of the commodities boom. In 2004, a portly, former military man, SBY, came to power. He got in due to his strong military background, yet clean, corruption-free reputation. It also helped that Indonesian women thought he was good-looking too. There were high hopes for SBY's first five-year term, and he largely delivered. Economic growth took off as the mining boom went stratospheric. There were signs though that reforms weren't happening quickly enough. Infrastructure spend waned and an initial crackdown on corruption petered out.
Your author arrived in Indonesia in 2006, and lived there for 18 months. One of the first things that I noticed upon arrival was the thriving democracy. It seemed political protesters took to the streets every second day. The downside of that was the notoriously bad Jakarta traffic got that much worse. SBY can take a lot of credit for the political stability and thriving democracy which ensued.
SBY's second term is widely regarded as a disappointment. Little has been achieved. With commodity prices falling, economic growth has flagged. Corruption remains as entrenched as ever. Infrastructure remains the worst of any major country in Asia. Critics can be harsh on SBY as they fail to recognise the difficulties of running a minority government in Indonesia. That doesn't excuse the lack of reform impetus, however.
The expectation is that Jokowi can kick-start change.
Joining the "fragile five"
Mid-last year, Indonesia was caught in the middle of the storm surrounding emerging markets. It was triggered by the U.S. Federal Reserve flagging cutbacks to its stimulus program. The prospect of higher yields in developed countries such as the U.S. made investors reluctant to pour money into emerging markets.
The money drained out of emerging markets who were considered most at risk. Large current-account deficit countries, including Indonesia, were targeted. Famously, Morgan Stanley dubbed Indonesia, along with India, Brazil, Turkey and South Africa the "fragile five" - countries with large current-account deficits which were most vulnerable to so-called QE tapering. The Indonesian rupiah sank more than 30% as a result. Commentary at the time talked of a 1997 re-run.
The truth is the Morgan Stanley tag was always nonsense. Indonesia was never that vulnerable. Slowing growth was naturally going to reduce its current account deficit anyway. The lower currency, combined with higher rates, accelerating that happening. By the end of 2013, Indonesia actually ran its biggest monthly trade surplus in two years. And GDP in the fourth quarter accelerated to 5.7%, boosted by exports. Government policy helped, particularly the decision to raise the price of subsidised petrol and diesel. That tightened demand for oil, which accounted for 23% of imports.
Thus ended Indonesia's fling with fragility.
The Jokowi effect
Like SBY, Jokowi will come to office with high expectations as a new kind of leader, untainted by corruption. He is different from the typical politician. He was a furniture salesman before becoming mayor of Solo, a small city in central Java. Jokowi was well liked in Solo after streamlining the business environment, pushing through a number of reforms, particularly in local healthcare, and resisting corruption. He won re-election as mayor of Solo with 90% of the vote in 2010.
Since becoming Jakarta governor in September 2012, Jokowi has primarily focused on local issues. He's taken a hands-on approach to fixing problems associated with traffic jams, seasonal flooding and poor housing.
He's tried to get infrastructure projects moving again in the capital. He's begun construction of a monorail and pushed through the commencement of a metro train system, which had been delayed for years. Jokowi has also pursued less business friendly policies. He approved a huge 44% rise in the minimum wage. And he opposed the fuel subsidy cuts.
Jokowi's time as governor suggests he's a pragmatic politician who can get things done. But above all, he's a populist. That's reflected in him joining a political party (PDI-P) best described as centre left/socialist.
It's important to realise that Jokowi's presidential powers are likely to be limited. Unlike India which also has an election this year, Indonesia's presidential system is built on a distinct separation of powers. SBY's second term has stalled partially due to the open warfare between the president, the parliament and courts.
Also unlike India, Indonesian political issues are resolved through consensus rather than inter-party conflict. That means parliament rarely takes votes as issues are decided behind closed doors with minimal accountability. In short, Jokowi will probably have to deal with a large, unwieldy cabinet composed of many different parties. A further impediment will be that the PDI-P has no natural political partners due to historical differences and/or its aggressive stance against corruption. Jokowi's ability to push through reforms will be challenging, to say the least.
Consequently, whether Jokowi ushers in a new era of business-friendly economic policies remains an open question. Some of his key initial priorities should be keeping the current-account deficit in check, cracking down on corruption, attempting to attract foreign domestic inflows and launching some large infrastructure projects.
On the latter, Indonesia's traffic problems are legendary and are undoubtedly among the world's worst. In Jakarta, getting through four business meetings in a day is difficult. And you're likely to spend around half your time in traffic. Indonesia spends just under 5% of GDP on infrastructure, down from 9.5% pre-Asian crisis. The country's ratio of road distance to land area is one of the lowest in Asia. As is the ratio of railway to land area. Research by the Japanese International Cooperation Agency suggests that Jakarta faces complete gridlock by 2020, unless the transport network vastly improves.
The inadequate infrastructure impedes Indonesia's economic growth, which has consistently trailed other large Asian countries such as China and India over the past decade. It also results in higher inflation (increased transport costs translating to higher consumer prices) than neighbouring countries.
Indonesia's fiscal constraints mean Jokowi's capacity to launch large-scale infrastructure projects will be restricted. He'll need private sector money and that could take some time. Jokowi should be helped by some broader economic tailwinds, however. After the recent fuel price rises, inflation is expected to fall towards 4% by the second half of the year. And sell-side economists forecast interest rate cuts of up to 100 basis points by this time too. That should help consumption growth.
On the other hand, we think the potential economic impact on Indonesia from a China downturn are being underestimated. It's true that Indonesia has one of the lowest exports to GDP ratio in Asia (25%). And that China only accounts for 11% of the exports, behind Asean at 22% and Japan 16%. But taking those statistics and assuming that China doesn't matter to Indonesia would be a huge mistake. China is Asean's largest trading partner by a long way. A weaker China will hurt Asean, and Japan for that matter. The knock-on effects to Indonesia may be significant.
That's not to mention the possible ramifications for a weaker yuan. China's yuan appreciation has hurt its manufacturing competition vis-a-vis Asean. A reversal of yuan strength could again turn the tide in China's favour, at the expense of Asean, including Indonesia. Finally, more than 50% of Indonesia's exports are commodity-related. China is the marginal price-setter for most commodities given it's their largest consumer. Decreasing commodity demand impacting prices would directly hit Indonesian exports.
In sum, there appear significant risks to Indonesia's economic outlook from Jokowi disappointing on the overly-high expectations of him as well as the impact from a more serious China downturn. At 15x forward earnings, a large premium versus the region, these risks don't seem priced in. Looking across Asia, South Korea and China, both priced at close to 8x earnings, or an almost 50% discount to Indonesia, would appear to offer better value for long-term investors.