For a while now, we have been highlighting the key difference between our bullish thesis on Indonesia macro versus consensus - we see improvement in the macro balance sheet driving a structural decline in the cost of capital. While Indonesia saw a prohibitively high credit cost post the Asian Financial Crisis, increasing access to relatively cheaper capital will encourage private-sector entrepreneurship and unleash the 6-7% growth potential of the economy in the medium term. However, we have discussed less in detail that the key factor in the macro balance sheet revamp has been the ongoing fiscal consolidation. To be sure, Indonesia was not running profligate fiscal policies prior to the Asian Financial Crisis; public debt stood at low levels of around 24% of GDP in 1996-97.
However, public debt was funded by external creditors due to easy money flowing into the economy. This disproportionately high share of unhedged external funding threw the balance sheet into disarray when the rupiah depreciated from 2,450 in June 1997 to a peak of 14,900 in June 1998, as the currency crisis unfolded. As a result, public sector debt ballooned to a peak of 93.3% of GDP in 1999.
The government subsequently ran conservative fiscal policies. Together with the swing in current account balance from a deficit to surplus position, improvement in political climate and reduced currency volatility, this led to a lower macro risk premium and hence lower cost of capital. Now, Indonesia's sovereign debt ratings are only a few ranks shy of investment grade, and barring a recurrence of severe global risk-aversion, we think that a further upgrade looks likely in the next 6-12 months.
Indeed, this is a self-reinforcing virtuous circle. A lower cost of capital reduces the debt repayment burden, which in turn hastens public balance sheet repair and so on. Indeed, public sector debt had fallen to 35% of GDP as of end-2008, a lower level than other ASEAN economies such as Thailand (38.1%) and Malaysia (41.6%).
Not only is the repair in the public sector balance sheet leading to an ongoing structural decline in the cost of capital, we think that past fiscal austerity has also renewed the ability of the government to leverage its finances to play a bigger role in economy-building. The 2010 Budget still shows the government running a prudent fiscal policy, expecting a fiscal deficit of only 1.6%, or possibly 2% of GDP. In this regard, we think there is room for the government to ramp up expenditure momentum and harness the fiscal strength that has accumulated during the past few years.
A Need for Further Ramp-Up in Development Expenditure
Helped by rising commodity prices and accelerating growth, total public sector (central, province, district government) revenue (as a percentage of GDP) has risen from 15.2% in 2000 to 22.0% in 2008. However, the need for fiscal consolidation post-Asian Financial Crisis means that the rise in public sector expenditure (as a percentage of GDP) had to be slower than the rise in government revenue. Indeed, total public sector government spending has risen, but to a lesser extent, from 16.2% of GDP in 2000 to 21.0% in 2008. The increase in development expenditure (as a percentage of GDP) at the district government level (from 0.8% in 2000 to 2.3% in 2008) helped to make up for the slower pace of pick-up at the central government and province government levels. As a result, development expenditure share (as a percentage of total government expenditure) has risen from 18% in 2000 to 27% in 2008. However, development expenditure share is still below the 50% level seen in 1994.
Indeed, Indonesia continues to suffer from infrastructure bottlenecks. The latest World Economic Forum Competitiveness Report (2009) ranked Indonesia as 84th, below other emerging markets such as China (#46), Brazil (#74) and India (#76) among others. Soft infrastructure facilities like education and healthcare also remain a weak link. Indeed, Indonesia has one of the lowest ratios of public expenditure on education as a percentage of total expenditure in the Asia region - the latest ratio was 16.9% for Indonesia as compared to 27.0% for Thailand (as per World Bank data).
Development Spending Can Enhance the Virtuous Circle
Our medium-term growth outlook of 6-7% has been predicated primarily on the structural decline in the cost of capital. However, the growth cycle could be enhanced by a step-up in development spending, which would help to resolve existing bottlenecks. Moreover, such developmental expenditure also tends to have a higher multiplier effect compared to current expenditure. The last administration under President SBY and Vice President Kalla had attempted to jump-start development spending in the form of infrastructure by putting out for tender, under the public-private partnership (PPP) framework, 91 projects worth US$22.5 billion in the 2005 Infrastructure Summit. The list was shortened to 10 projects worth US$4.4 billion in the 2006 Infrastructure Forum. However, we understand that none of the PPP projects eventually materialized. Land acquisition issues, the lack of consistency in regulation at the central and regional government levels, the lack of separation in functions such as policymaking, regulating, contracting & operating and the credit quality of the SOE counterparty (i.e., the buyer of the infrastructure services) are some of the structural impediments.
The policy rhetoric coming from the new government suggests that some of the key areas of focus would be on infrastructure building (in three aspects - physical infrastructure, institutional/soft infrastructure and social infrastructure) and the reform of the subsidy system from a broad-based to a more ‘means-tested' one. Indeed, Indonesia's retail fuel prices are marked to a crude oil price of around US$50/bbl, and streamlining of such subsidy expenditure should free up more fiscal resources towards developmental expenditure. At the peak, energy subsidies stood at 4.5% of GDP in 2008. As highlighted above, reforms in the areas of structural impediments would be the key for further development spending progress. We will continue to monitor the efforts on that front.
How Much Spending Room Does the Government Have?
We think there is definitely fiscal wherewithal for a ramp-up in spending on the developmental front, given the reduction in public debt as well as the declining proportion of routine expenditures such as debt interest payments and subsidies. Indonesia's public debt level of 35% of GDP is significantly below the globally acceptable benchmark range of 45-60%.
Hence, we see no need for further reduction of the public debt to GDP ratio. If we were to assume that the government intends to keep the public debt to GDP ratio stable at 35%, the primary balance (which is total fiscal balance excluding debt interest repayments) can go down to -3.7% of GDP in 2010, from around -0.4% of GDP in 2009. This would imply that the total fiscal deficit could go from around -2.4% of GDP in 2009 to -5.6% of GDP in 2010. Assuming that government revenue stays constant (as a percentage of GDP), this means that the government could lift expenditure further - by at least 3% of GDP. In fact, the room for further expenditure expansion is likely greater as we believe that the debt to GDP ratio can be raised by 5-10% without causing any concerns for the rating agencies.
As a general rule of thumb, the lower the effective interest cost and the higher the nominal GDP growth rate, the more expansionary a primary balance policy can be pursued. The historically high proportion of external public debt has led policymakers to target zero external funding for the 2010 Budget. If the domestic market were to remain the key source for funding, and with Indonesia typically running moderate current account surplus, we believe that the expansion in primary deficit will have to be pursued in a gradual fashion to enable orderly adjustment of domestic liquidity conditions.
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Worse to Come
November 19, 2009
By Oliver Weeks | London
While Ukraine's real economy is benefiting from global recovery, its political tensions and lack of government funding options leave it still particularly fragile, in our view. The IMF has softened on Mr Strauss-Kahn's statement that cooperation is suspended until after the elections, and the PM has achieved unexpected deals on previous IMF tranches. However, we continue to think that another disbursement under the current government is unlikely. Even if the controversial law on social standards were to be rescinded, several other loan conditions - including a gas price hike and a realistic 2010 budget - look unlikely to be addressed before the election, in our view. The Fund is demanding consensus and cooperation among lawmakers, which no longer looks possible in the current set-up. We still think that sovereign default and a new gas crisis are both unlikely, but see a significant risk that it takes longer than the market expects to form a new government and reach a new IMF deal. In the meantime, we believe that FX reserves are now adequate to ward off another devaluation spiral, but are likely to fall alarmingly low by 2Q10.
Some progress, externally driven: Despite minimal compliance with IMF recommendations, Ukraine has seen some progress from the 1Q09 trough. A recovery in steel export prices, down 6% from September's highs but still up 50% from March's lows, has led a significant rebound in industrial production and GDP, largely independent of government action. The Industry Ministry reports average capacity utilization in mining and metallurgy up from 34% in November 2008 to almost 70% currently. GDP is up 5.2% seasonally adjusted between 1Q and 3Q on our (non-annualized) estimates, while industrial production has risen 11% seasonally adjusted between June and October. Recovering exports and the import collapse brought by a 60% UAH depreciation during 4Q08 have brought the current account rapidly to balance. The financial account remains well in deficit, at US$1.4 billion in September, driven primarily by locals moving cash holdings to FX. The NBU estimates foreign debt due in 2010 at US$24 billion, but rollover rates on foreign debt have proved higher than many initially feared. In September these stood at 57% for the financial sector, but 123% for non-financial corporates, whose actual foreign debt appears to have been initially overestimated. NBU FX intervention was down to only US$303 million in October. After US$12.5 billion of IMF disbursement, FX reserves stand at US$27.7 billion, worth 17 months of average monthly FX intervention in the last 12 months and a significant cushion. The weakness of the USD and appreciation of the RUB and EUR also help to reduce depreciation pressure on the UAHUSD axis. With election campaign funding also usually bringing capital inflows, we think it will still be possible to resist the UAH going through 10.0 to the USD.
Disruptive gas dispute looks unlikely: We also still think that a repeat of last January's disruptions to European gas supply is unlikely. Meeting the gas import bill will not be straightforward. Naftogaz's structural funding deficit continues to worsen. In September household and utility prices were only 26% and 36% of a rapidly rising import price, and a domestic price hike remains unlikely before the election. While the gas import bill in 1Q-3Q was US$5.8 billion, in the same period Naftogaz collected the equivalent of US$3.4 billion from domestic customers, including from the sale of domestically produced gas. However, state FX funds remain available to pay for gas. The October payment, US$480 million, came from an IMF special SDR allocation worth US$2.1 billion, which can be used without breaching IMF program reserve floors. The bills for November and December gas, due seven days after the end of the month, thus look comfortably manageable to us. January's bill will be harder, particularly as we expect a price hike of around 35%. Under the current contract, prices will reset in line with average fuel oil and gasoil prices over the previous nine months, and the current 20% discount is due to expire. However, that there is no formal contract expiry this year makes brinkmanship look less likely. The 25 bcm now in storage in Ukraine exceeds current annual consumption, allowing the price shock at least to be smoothed. Meanwhile, the gap between spot and contract prices in Europe gives Gazprom every incentive to avoid supply disruptions that might allow European consumers to justify buying less than contracted amounts. This gives Ukraine leverage it may be tempted to exploit, but both leading presidential candidates now have constructive relations with the Russian government that they are unlikely to want to risk. In return for a waiver of take or pay fines, and possibly a further concession on price, we would expect Ukraine to use existing FX reserves to meet monthly gas payments until the IMF returns.
But stronger external position is a mixed blessing: A more comfortable balance of payments position, apparently lower gas risk, a less threatening Russia, and recovery among Ukraine's neighbors are mixed blessings, however. The moral hazard pressure on the IMF and EU to turn a blind eye to government non-compliance has fallen as contagion risk declines. Meanwhile, the cost of the FX and balance of payments adjustment on the domestic economy has been huge. Non-payments on FX loans in the banking sector have reached levels which risk normalizing non-payment even among some solvent borrowers. Officially reported NPLs are at 8.9%, though the IMF sees sub-standard, doubtful and loss loans already at 30%. Morgan Stanley bank analysts Ronny Rehn and Hadrien de Belle see NPLs reaching 35%, and loan losses of 25%. Aggregate bank credit and profitability data are boosted only by directed state bank loans to Naftogaz, on which the NBU has ruled reserves are not required. Progress on state-led bank recapitalization has been slow, while Fitch has estimated that the banking system needs another UAH100 billion of new capital, based on problem loans reaching 40% and loan losses of 28%. With the loan to deposit ratio currently at 228% and bank loans to GDP at 81%, a genuine resumption of domestic credit still looks very distant to us. Meanwhile, a relatively severe swine flu outbreak should further constrain recovery, while poor weather conditions suggest that this year's grain harvest will be down almost 20% on 2008. The main macro casualty of the import collapse, however, and the most immediate constraint on growth is the government's fiscal position.
Primary problem remains fiscal: Even if gas costs are met from FX reserves, it is much harder to be optimistic about the fiscal outlook. Unlike a gas deal, fiscal progress also requires co-operation from parliament. Analysing budget execution is made difficult by reduced disclosure and concerted efforts to bring forward revenue and delay due tax refunds. The Treasury reported state revenue in January to October as just 0.9% below its ten-month plan, yet it was 40% below the annual plan. The 2009 budget still assumes real GDP growth of 0.4%, while -15% is more probable for us. The official general government deficit in 1Q-3Q was UAH25 billion, while the budget estimates sovereign debt amortization for the year at UAH45 billion. However in 1Q-3Q domestic debt outstanding rose UAH41 billion, and the budget also received US$4.6 billion directly from the IMF - underlining the magnitude of off-budget commitments. At end-September, government deposits at the NBU stood at just UAH6.9 billion. (The 2008 average was UAH21 billion.) The current pace of revenue and spending would imply a state budget deficit of at least UAH50 billion for 4Q even without implementation of the minimum wage hike and other pre-electoral spending rises, implying a broad 2009 public sector deficit of slightly over 10% of GDP. Clearly social spending will be prioritized in the next three months, at the expense of tax refunds and most other items, but from February wage and pension arrears may start to build.
Alternative deficit funding highly expensive: While several countries are now running wider fiscal deficits, in Ukraine's case funding this will become unusually difficult. The Finance Ministry issued T-bills yielding almost 30% in late October when it had no other options for meeting a roll-over spike. Such levels will both prove expensive to maintain and crowd out any lending to the private sector. However, subsequent offers around 20% have so far met minimal demand. The Ministry has proposed CPI and FX-linked issues to reduce yields, but these seem unlikely to reduce costs materially. A planned €500 million from the EC looks unlikely in the absence of IMF approval. Further monetization looks inevitable to us. Already the NBU has acquired UAH28 billion of this year's government bond issuance, with most of the rest held by state banks and Naftogaz (foreign demand has been non-existent). New government spending plans, UAH9.8 billion for the Euro 2012 football championship and UAH1 billion for swine flu, are ‘financed' from NBU profits that the NBU does not expect to make, implying further emission. So far, inflation, while high, continues to slow, and M2 is down 1.4%Y. However, full monetization of a UAH50 billion deficit would raise the monetary base 28%. With UAH demand likely to prove fragile, we expect to see some reacceleration of inflation in the coming months, with further depreciation pressure on the UAH. FX reserves remain adequate to lean against this in the context of a balanced current account. We do not expect an inflation-depreciation spiral, but reserve depletion is likely to become a growing concern and, in the IMF's absence, NBU restrictions on the FX market are already tightening further.
Election delay may be long and expensive: While a short-term budget gap may be manageable, we remain concerned that political delays after the elections risk turning out expensively long. Given the destructiveness of relations between the current PM and president, echoed in hostility between the NBU and Finance Ministry, the presidential election is effectively a pre-condition for progress. However, a long inter-regnum would be hard to afford. The first round election on January 17 will almost certainly be followed by a second vote, likely around February 21. (Official results will take a further ten days.) Current polls give Victor Yanukovych a comfortable lead, but with Yulia Tymoshenko's support rising the outcome is likely to be close, and may well then be subject to challenge and fraud allegations. We do not expect unrest, given the unpopularity of all candidates. But once there is a victor he or she will then have to select a prime minister to be confirmed by a parliament that in its current set-up has proved incapable of forming a stable majority. A new president may be tempted to call early parliamentary elections, possibly to coincide with municipal elections in May. Tymoshenko's position on this remains unclear but Yanukovich has now confirmed that he would prefer to dissolve the Rada. Technically, this would likely require blocking parliament from convening for at least a month. While again a positive long-term step, it would risk delaying formation of a government into 2H10, while FX reserves continue to bleed. It is not certain that a new parliament would be more effective than the current one, but it seems likely that a government formed on the basis of the current Rada would be unstable and would struggle to support the difficult spending decisions the IMF would require. With the current IMF program anyway close to expiry, a new government is likely to need to negotiate a new program, based around a new 2010 budget. We would expect either next president eventually to sign a new IMF deal, but under Yanukovich there may be slightly greater delay, given weaker existing relations with the Fund and the doubts some in his party have expressed about the need for a program. Unless steel prices keep rising, we estimate that FX reserves could be around half current levels in the absence of an earlier IMF deal.
Debt still manageable, but likely to be a better time to buy: Sovereign and state guaranteed debt at the end of September stood at a relatively modest UAH279 billion, 32% of GDP. (Naftogaz restructuring will have added a further 1.5% of GDP.) While yields on recent T-bill issuance have raised concerns of a 1998 GKO-type bubble, at the end of September only 3% of sovereign debt was in T-bills. 53% of debt was to multilateral institutions or other sovereigns, mainly at below-market rates. An immediate explosion in debt service costs looks unlikely to us. However, to put the fiscal position back on a sustainable path will require aggressive cuts to the current 2010 budget draft. The World Bank estimates that the current draft would imply a deficit over 8% of GDP even assuming gas prices are raised and before the cost of minimum wage and pension hikes (estimated at UAH20-70 billion, depending on whether the law is changed to limit indexation to low wage workers). The official 4% of GDP deficit projection is based on a superficially reasonable 3.7% real GDP growth and 9.7% inflation, but these are based off still highly unrealistic assumptions for 2009, with nominal GDP assumed 15% higher than we expect. The Rada has just proposed a further UAH157 billon of unfunded spending commitments. Inserting more realistic assumptions will be a painful political challenge that may take some months to agree. The next sovereign Eurobond maturities are JPY35 billion in December 2010 and US$0.6 billion in March 2011, by which time we do expect a new IMF program to be in place. However, rising debt service costs and falling reserves in the meantime suggest that higher risks of default are likely to be temporarily priced into bonds.
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