Indonesia
A Higher Growth Entry Point into 2H09
August 12, 2009

By Chetan Ahya , Deyi Tan | Singapore & Shweta Singh | India

2Q09 GDP Beat Expectations

Indonesia's 2Q09 GDP, which was released yesterday, shows the economy rising +4.0%Y. This is slower than the +4.4%Y in 1Q09 but higher than consensus and our expectations of +3.8%Y and brings 1H09 growth to 4.2%Y. Seasonally adjusted numbers are not officially released, but based on our calculations, 2Q09 GDP rose at a 5.1%Q seasonally adjusted annualized rate (versus +4.0% in 1Q09).

In terms of growth mix, deceleration was seen on the domestic demand front. Domestic demand (excluding inventories) rose at a slower +5.3%Y (versus +6.2%Y in 1Q09). Specifically, fixed capex slowed further to +2.7%Y versus the double-digit momentum seen in 2008. Consumer spending slipped somewhat to +4.8%Y (versus +6.0%Y in 1Q09). Public spending maintained double-digit momentum at +17.0%Y (versus +19.2%Y in 1Q09), possibly on election-related spending. Meanwhile, on the external front, less bad export declines were seen at -15.7%Y (versus -18.7%Y in 1Q09). Imports also registered less bad contractions and contributed to some restocking in the economy.

High-Frequency Indicators Are Turning Around

While 2Q09 GDP came in higher than our expectations, high-frequency indicators are also showing signs of turnaround as follows:

•           Consumer-related: Retail sales (+3.9%Y, 3MMA in June 2009 versus -15.6%Y, 3MMA in December 2008) and passenger car sales (-24.7%Y, 3MMA in May 2009 versus -26.6%Y, 3MMA in April 2009) have picked up gradually from their recent lows. Meanwhile, consumer sentiment has improved consistently and reached 110.1, 3MMA in July (the highest since January 2004) after hitting the January 2009 low of 93.2, 3MMA.

•           Industrial-related: Industrial indicators tell a similar story, with improvement/less negative declines in high-frequency indicators such as electricity consumption (+4.2%Y, 3MMA in June 2009 versus -0.8%Y, 3MMA in March 2009), cement consumption (-7.9%Y, 3MMA in June versus -10.9%Y, 3MMA in May) and industrial production (+1.8%Y, 3MMA in May versus -1.0%Y, 3MMA in January).

•           Trade: The external sector exhibits second-order derivative improvement observed broadly in both oil and non-oil & gas exports post the January 2009 trough. With relatively stable commodity prices and bottoming out of the global economic conditions, we expect this trend to continue more evidently.

Revising Our GDP Growth Forecasts Higher

Indeed, the sentiment support provided by the bilateral/ multilateral currency swap agreements, standby loan facilities and benign global risk appetite environment have helped to contain currency volatility in Indonesia. Currency volatility, a function of the open capital account convertibility, tends to have ripple effects on asset markets and liquidity conditions, and the latter two also reverberate back to currency and then inflation and interest rates, creating a vicious loop. In this regard, reduced currency vulnerability in this cycle has helped to put a floor on macro momentum.  With 2Q09 GDP at 4%Y, setting the entry point into 2H09 higher than what was penciled into our model, and high-frequency indicators showing signs of turnaround, we are adjusting higher our 2H09 and 2010 trajectory, bringing forecasts from +3.7%Y to +4.4%Y for 2009 and from +5.0%Y to +5.5%Y for 2010. With the sub-par global external environment expected for 2010, we believe that investors should continue to favor economies such as Indonesia, which have an autonomous domestic demand story. Indeed, we believe that a confluence of the following factors will continue to underpin stronger medium-term growth potential for Indonesia (see Indonesia Economics: Adding Another I to the B-R-I-C Story? June 12, 2009):

•           Further structural decline in cost of capital: The macro balance sheet improvement - such as the reduction in public debt, external debt and corporate balance sheet - should continue to fuel the virtuous cycle of capital cost reduction as the macro risk premium declines. Indeed, public debt had been consistently repaid and stands at 35% of GDP in 2008 (versus the high of 93.3% in 1999). External debt has been similarly reduced from 156% of GDP in 1998 to 29.4% in 2008. Compared with 1997, when corporate credit stood at 47.5% of GDP, corporates are now less geared up at 14.8% of GDP. To be sure, the issue regarding Indonesia's balance sheet was not solely the level of leverage per se but also the structure of funding. Recall that even though government debt was low at 23.4% of GDP pre-1998, funding has been entirely external and the sharp rupiah depreciation during the currency crisis had led government liabilities to balloon. In this regard, President SBY's indication in the 2010 Budget speech to finance the 2010 budget deficit domestically should reduce the reliance on external funding. This should help to reduce macro volatility brought about by currency vulnerability and further support the capital cost decline.

•           Positive ‘fillip' from politics: Despite Indonesia's political history of authoritarian regimes and fairly short democratic experience, the recent elections have reinforced the political foundation stone of democracy. Indeed, April's parliamentary elections nearly tripled the vote share of President SBY's Democrat Party, making it the largest party in the parliament, and July's presidential elections strengthened President SBY's mandate. The political regimes in Indonesia in the 20th century had been non-conducive to institution-building, but the democratic movement since 1998 has transitioned the economy into a structure where decisions are increasingly taken by institutions in a more transparent manner. Continued stability in this framework following the 2009 elections should help to cement this positive trend, particularly as the pro-reform presidential mandate of SBY now has a similarly strong backing from his own party in the parliament.

•           Demographics and commodities present a natural advantage: Demographics and commodities remain favorable for Indonesia. We believe that the demographic dividend will continue to be reaped as Indonesia's dependency ratio will not reach the bottom seen in China or other Asian economies, and the decline in the dependency ratio would also stretch out further, reaching a bottom of 42.7% only in 2025. Additionally, commodity resources should provide a natural advantage in terms of the income stream they yield. Indonesia is the one of the top two global exporters in coal, natural gas and crude palm oil. In addition, it is a net exporter of metal ores such as tin and nickel.

Near-Term Inflation More Benign than Expected

Just as potential currency vulnerability has been backstopped by the currency swap agreements and benign global risk appetite, which helped to put a floor on macro momentum, import-led inflation has also been lower than expected. Indeed, the USD-linked commodities account for 13% of the CPI basket, and a 1% depreciation in currency adds 0.13pp to headline inflation. Additionally, near-term inflation pressures have been lower than trend amid the base effects of the retail fuel price hike in late May 2008. As such, we found it necessary to revise downwards our 2009 inflation forecast from 6.0%Y to 4.8%Y. Although we believe that inflation levels will edge structurally lower in Indonesia, we think that the current run-rate of 2.7%Y in July 2007 is an artificially depressed level. Hence, while we are revising downwards our 2010 inflation forecast from 6.5%Y as well, we still think that inflation would edge up to 6% in 2010 from 4.8% in 2009 as base effects wear out. Our 2010 forecast assumes that retail fuel prices remain unchanged. However, if commodity prices go higher than the US$75-80/bbl average as priced in by the futures curve for 2010, we suspect that Indonesia will be more likely to hike retail fuel prices compared to Malaysia as the latter tends to be more accommodative on the fiscal front (see ASEAN MacroScope: Oil Sensitivity - Who Gains and Who Loses, August 7, 2009). On monetary policy, we expect a 150bp policy rate normalization to pan out in 2H10.

Bottom Line

Higher-than-expected 2Q09 GDP data and a second-order derivative improvement in high-frequency indicators suggest that the worst is behind us and also set the entry point in 2H09 higher than what was penciled into our model. We are revising upwards our GDP forecasts from +3.7%Y to +4.4%Y for 2009 and from +5.0%Y to +5.5%Y for 2010. Meanwhile, near-term inflation has turned out more benign than expected amid lesser import-led inflation and base effects. We are revising downwards our inflation forecasts from +6.0% to +4.8%Y for 2009 and from +6.5%Y to +6.0%Y for 2010.

Mexico
Auto Recovery
August 12, 2009

By Luis Arcentales | New York

Among Latin American economies, none has been hit as hard by the global slump as Mexico, in great part because of its strong links to the US economy, ranging from ties on the industrial front to remittances and FDI - the US accounted for US$119 billion or 54.5% of total FDI inflows since 1999.  And within Mexico's struggling industrial complex, where the link to the US is strongest, no area has suffered more than the auto sector.  Indeed, the magnitude of the adjustment on the auto front is nothing short of staggering: light vehicle production collapsed by 42.9% in the first half of the year and total exports from the auto sector contracted by 40.6% in value in the same period from a year earlier.  In fact, we estimate that the slump in the transportation sector - despite representing less than 3% of the economy - directly knocked off nearly 1.5pp from total GDP growth in 1H09.     

But relief is on its way, courtesy of a sharp snapback in US auto production.  Our US economists, Dick Berner and David Greenlaw, point out that following July's 45% production jump from June levels - and considering planned increases for August and September - 3Q real vehicle output is likely to soar by almost 50% from the previous quarter (see US: Roaring Out of Recession in 3Q, August 3, 2009).  This upturn follows aggressive efforts by automakers that have successfully brought motor vehicle inventories in line with sales. Importantly, while the strong revival in the July-September period is likely to fade in 4Q09, the tripling of the ‘cash for clunkers' program to US$3 billion combined with dealer incentives should help demand sufficiently to prevent a significant output payback.  Indeed, our US team points out that auto dealers are already reporting shortages of some models of fuel-efficient cars.

Though the performance in the US and Mexican auto sectors has diverged at times in recent years, the link between them remains strong.  After all, the US accounted for 71.3% of total cars exported by Mexico in 1H09, representing over 55% of total light vehicle production.  And including parts and trucks, the US bought a significant 82.0% of total Mexican auto sector exports (US$14.0 billion).  For example, in 2H05 and into 2006, output from Mexican automakers surged while their US counterparts stagnated; rather than a structural change in the relationship between both countries' industrial sectors, however, this reflected a one-off boost after some of Mexico's most important automakers completed major investment projects and started making a series of new models.  In the current cycle, in fact, auto production in both countries has plunged in a synchronized fashion.

The recent downshift in Mexican manufacturing has been in large part a consequence of the auto sector.  To be fair, no industry group has been spared from the slump in external and domestic demand: out of 21 major industrial sectors, 95% posted annual declines in 2Q, compared to 87% in 1Q and 81% in 4Q08.  But the auto sector - which represents around 15% of manufacturing - has had a disproportionate impact, accounting for just over 51% of the 15.1% annual decline in total manufacturing so far this year. 

Our calculations suggest that autos knocked off 1.5pp from the expected 9.4% 1H contraction in GDP.  By 3Q, however, the drag from the auto sector should ease to about a third of the 1H pace, assuming that Mexico follows a similar path as the one implied by our US team's vehicle output guidance.  

Even before the recent indication of a sharp ramp-up in assemblies, there were signs that the worst of the auto sector adjustment had run its course.  First, despite the dislocations related to the bankruptcies of GM and Chrysler in 2Q - combined they represented 29% of the Mexican car market - overall production managed to remain essentially unchanged relative to 1Q at near 300,000 units, once seasonally adjusted.  Indeed, output from other automakers rose over 20% in 2Q from the previous quarter, fully offsetting the 38% seasonally adjusted contraction from GM and Chrysler, based on our calculations.  It is worth highlighting that Mexico has so far been largely spared from major plant closings by the two Detroit automakers, despite suffering from widespread technical stops, which pushed their combined output down 68% in 2Q from a year earlier.   

Second, despite the sharp contraction in US demand, Mexico has gained significant market share.  In the first five months of the year, US imports of motor vehicles, bodies and parts plunged by 51% from a year earlier, while purchases from Mexico contracted by a more modest 40%, according to our calculations.  In turn, this translated into a meaningful market share gain of nearly 5pp so far in this year compared to 2008, in part reflecting Mexico's model mix but also the positive impact of the weaker peso.  Indeed, the market share gains are not limited to the auto sector: even excluding oil and autos, the participation of Mexican industrial exports jumped by over 0.7pp to 9.3% in the first five months of the year - a level not seen since 2002.    

Last, broader indicators also suggest that industry is on the mend, though it has yet to reach the point of stability. Various qualitative surveys have clearly turned the corner, echoing the encouraging trend in the US ISM manufacturing index, which in July (48.9) rose to the best level since last August.  Moreover, the central bank's industrial survey suggests that the inventory overhang is improving: in May the number of captains of industry reporting excessive inventories dipped to levels not seen since 3Q08.  An alternative measure of participants reporting higher finished-goods inventories compared to the previous month, meanwhile, dropped to historically low seasonally adjusted levels.  And as far as hard data go, after the elimination of nearly one out of every eight jobs over the course of the 12 months ending July 2009, the pace of job losses in industry is slowing. 

A Note of Caution

The improvement in the outlook for the US economy, and manufacturing in particular, is welcome news to Mexico's hard-hit economy.  Even if the eventual recovery turns out to be modest - following the outsized near-term boost from the auto sector and the normalization in services after flu-related dislocations - we have no doubt that Mexico will benefit from a turnaround in the US economy.  

However, rather than its growth outlook, Mexico's greatest near-term challenge seems to be its fiscal accounts, which on their current path may be heading towards unsustainable deficits over the medium term as oil output continues to decline (see "Mexico: The Fiscal Straightjacket", EM Economist, July 17, 2009).  Therefore, we are concerned that avoiding fiscal deterioration would require politically difficult efforts to constrain expenditure growth and/or push for a new tax reform in the midst of what remains a severe recession.  Insofar as better near-term economic news, higher oil prices and the recent re-affirmation of the sovereign credit outlook by a major rating agency reduce the urgency of policymakers to advance the tax reform - and the broader reform agenda - then Mexico may not be able to fully capitalize on the improving US outlook. 

Bottom Line

The improvement in the outlook for the US economy, and manufacturing in particular, is welcome news to Mexico's hard-hit economy.  After a wrenching contraction since late 2008, Mexico's manufacturing sector is poised to benefit from the surge in US auto production.  But even if the near-term boost from the auto sector morphs into a broader US industrial recovery, insofar as Mexico fails to advance its reform agenda, it may not be able to fully capitalize on the improving US outlook.