On India's Trail?
December 10, 2009
By Chetan Ahya | Singapore & Sumeet Kariwala | India
Summary
We believe that in many ways Indonesia is likely to emerge as a story more similar to India than China. To be sure, we are not making a case for India-type GDP growth of 8-9% soon. Indonesia has not yet cleared all the hurdles to be in India and China's league. However, we expect its sustainable growth rate to accelerate to the 6.5-7% range over the next 3-4 years compared to the trailing average of 5.5% over the last five years (see Indonesia Economics: Adding Another ‘I' to the B-R-I-C Story? June 12, 2009).
We see the development of Indonesia's macro economy and corporate sector reflecting India's trend from 1999 to 2005. The most important similarity will be the potential decline in the cost of capital and therefore a rise in corporate ROE spreads over the cost of capital. We have been arguing for some time that Indonesia will show a structural decline in the cost of capital over the next three years. We believe that this trend will result in a virtuous cycle - boosting corporate profits, investment and GDP growth. The key risk to our thesis would be any unexpected turn in the political environment.
Why Has the Cost of Capital Been High?
Indonesia has suffered from a high cost of capital over the last few years due to the lack of macro stability in the aftermath of the Asian Financial Crisis. The nation's level of financial leverage was manageable pre-1997, but high dependence on external debt meant that, post-crisis, the debt/GDP ratio shot up as the currency depreciated (after the removal of the currency peg to the USD) and GDP declined. External debt, as a percentage of GDP, rose from 48% in 1996 to 155% in 1998. Moreover, there were signs of increased misallocation of capital in the corporate sector pre-crisis. The political environment had also become less supportive at the time.
A weak political environment, high ratios of public and external debt to GDP and poor corporate balance sheets have caused Indonesia's exchange rate to remain highly volatile since the 1997 crisis. This, in turn, resulted in higher inflation and higher policy rates. Moreover, unlike India and China, Indonesia has a relatively open capital account for its resident population. When an external event has caused some exchange rate volatility, residents have only added to that volatility by moving their rupiah bank deposits into dollar deposits. Exchange rate volatility and frequent macro shocks meant higher credit costs for the banking system. Banks have been persistently maintaining high net interest margins, partly to cover for high credit costs and uncertainty in the interest rate environment. The average net interest margin for the top four banks under Morgan Stanley's equity coverage is 675bp (2009 estimate). These are the highest spreads among banks in the region.
What Will Bring Down the Cost of Capital?
We expect that an improved political environment, along with steady repair and restructuring of the government, banking system and corporate sector balance sheets, should now help to reduce the cost of capital on a structural basis.
Improved political environment: Since the presidential elections of 2004, the political environment in Indonesia has been improving steadily. Technocrats, who have focused on improving macro stability, have managed key ministerial positions in charge of the formulation of macroeconomic policies since 2004. A stronger political mandate in the 2009 general elections is ensuring continuity in that effort.
Macro stability: Over the last few years, the government has been able to improve Indonesia's macro balance sheet. The Asian Financial Crisis meant that a bad leverage structure - high dependence on external debt - became the problem of leverage levels. Over the last few years, the government has been cutting its debt relative to GDP. The ratio of public debt to GDP declined to 35% in 2008 from the peak of 93% in 1999; external debt fell to 29% of GDP in 2008 from 155% in 1998. The government has reduced the share of external debt in public debt to 45.7% in 2008 from 100% in 1997. Moreover, local borrowing now largely funds the government's fiscal deficit. Indeed, the fiscal deficit has been maintained at very low levels - in the range of 0.5-1.7% over the last five years.
The current account has largely been in surplus since 1999. Unlike India and China, Indonesia has favorable advantages: a strong resource base and structurally higher commodity prices. These factors increase the nation's export revenues and sustain the current account surplus.
Banking sector and corporate sector restructuring: The banking sector has been persistently maintaining conservative balance sheets over the last few years. Banks' loan/deposit ratios are reasonable; ROEs average around 25% (2009 estimates); and capital adequacy ratios (Tier 1 ratio) of the top banks average 15% (3Q09). The ratio of bank credit to GDP has remained around 19-26% for the last 10 years.
The corporate sector has also de-levered its balance sheet and has been focusing on improving productivity. The sharp depreciation in the exchange rate during the Asian Financial Crisis had caused the ratio of corporate sector net debt to equity to balloon to 262% in 1998 from 72% in 1995. However, this has been reduced to 37% in 2008.
Increased Confidence Among International Investors and Non-Residents
We expect improving political and macro stability to bolster the confidence of international investors and non-resident Indonesians. Capital inflows and remittances are likely to improve. For example, in India remittances from non-resident Indians (NRIs) have been rising - from US$16 billion in the financial year ending March 2003 to US$53 billion in F2010, on our estimates. Similarly, capital inflows into India have risen sharply. We believe that Indonesia will definitely see an improvement in remittances and capital inflows, even if the trends may not be of the same magnitude. Moreover, as the local population gains confidence in the currency and repatriates international wealth, this should help to reduce the cost of capital further.
Private Corporate Sector to Get a Boost
Currently, well-entrenched companies are able to access capital at a reasonable cost. A structural decline in the cost of capital in the banking system would allow the private sector - particularly small- and medium-sized enterprises - to operate on a level playing field. Moreover, international investors should also begin to provide risk capital to the SMEs to grow faster. The spread between ROE and cost of capital would likely rise further. The corporate sector should gradually be attracted to increased investment as a percentage of GDP - lifting the GDP growth trend from the trailing five-year average of 5.5% to higher sustainable growth of 6.5-7%.
India has shown a similar trend. Just as India was forced to initiate structural reforms to improve macro stability following its 1991 balance of payments crisis, Indonesia was forced to initiate structural changes after 1997. By 2002-03, India's external balance sheet had improved significantly; FX reserves reached US$75 billion by March 2003 and the capital inflows had surpassed US$10 billion per annum. The corporate sector had also made a major improvement in its productivity, cutting its debt/equity ratio to 25% in 2003 from 75% in 1996. The cost of capital fell sharply; yields on 10-year government securities declined from 11.5% in January 2001 to 5.5-6.0% in 2003. Banks' lending rates followed the trend, opening up a big gap between corporate sector ROE and cost of capital.
This excess ROE attracted new investment from both the domestic private sector and foreign investors, pushing up India's investment relative to GDP. Indeed, private corporate capex shot up from 6.8% of GDP in F2004 to 15.9% in F2008. India's GDP growth also moved up from 5.8% on average in F1999-F2004 to the 7-9% range. Corporate profits have increased sharply relative to GDP, while market cap has risen to 104% of GDP currently from 36% in September 2003.
Incidentally, Indonesia's market cap as a percentage of GDP is currently similar to India's 2003 level of 40% as compared with India's 104% and China's 97%. As in India, we believe that new private sector companies will emerge and change the constitution, depth and breadth of the Indonesian markets over the next 10 years.
Reaching 8-9% GDP Growth - Not Easy for Indonesia
Indonesia has a lot of other similarities with India apart from the trend in macro balance sheet changes. Indonesia, like India, has a benign trend in demographics with a falling age dependency ratio. It also has a democratic political set-up, which implies that the role of government and state-owned enterprises would be low. We are very confident in our view that Indonesia will see a trend similar to India's in terms of the cost of capital and rise of the private corporate sector. We do believe, however, that Indonesia has some structural deficiencies compared to India, which means that its growth will accelerate more slowly.
Some of the areas where Indonesia lags behind India are:
a) Foundation of democratic political systems: India has a longer history of sustaining stable democracy. The key test of the strength of a stable political system is that it allows smooth transition of power from one leader and party to another. India did endure a challenging period of unstable coalition during 1996-99, but it has remained stable since then. Indonesia has made the transition to a stable democratic political system, but it is still relatively young. In this context, the 2009 general elections verdict was a strong signal that the country is moving in the right direction.
b) Talent supply: This is one of most serious gaps in Indonesia. For historical reasons, the tertiary education institutions are not as strong as those in India and China. This gap is evident in the quality and quantity of tertiary graduates. This is also a constraint in the context of the entrepreneurial talent.
c) Institutional capability: India has an experienced bureaucracy (a legacy of British systems) and a strong regulatory system which has been strengthened to manage the private sector. This has been critical, as India's economy remains driven by the private sector, unlike some emerging market economies, where the role of the government is still high.
We believe that Indonesia, with its democratic set-up, may have to choose a more private sector-driven model. It will, therefore, need to strengthen its institutional capability to enable transparent and effective decision-making by the private sector. For instance, despite its strong bureaucracy, India took time before it achieved success in setting up a regulatory system related to public-private partnerships (PPP) in order to kick-start infrastructure investment. Indonesia has been trying to push infrastructure investment through a PPP framework but has not yet achieved any success there.
Bottom Line
In the short term, Indonesian markets appear cyclically overheated, but we believe that, from a medium-term perspective, the nation's economy and markets will go through a major structural change over the next few years, offering attractive investment opportunities. We think that the spread between ROE and cost of capital is likely to increase significantly over the next three to four years. In this environment, we believe that rate-sensitive sectors - such as financials, consumer (discretionary spending) and property - should benefit from structurally higher demand growth. The key risk to our positive view on Indonesia would be any unexpected turn in the political environment.
For details, see Asia Pacific Economics: Indonesia on India's Trails? December 8, 2009.
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Tweaking Outlook Following Large Downward Revision
December 10, 2009
By Takehiro Sato & Takeshi Yamaguchi | Tokyo
GDP revised down: Reflecting mainly capex/inventory, Jul-Sep GDP was revised down sharply, to annualized +1.3% in the second preliminary from +4.8% in the first preliminary. The release of F2008 SNA statistics, which preceded the quarterly GDP release, also contained a downward revision for F3/09, to -3.7% from -3.2%. Although both data sets are retroactive, the downward revision for Jul-Sep has a carry-over impact in F3/10. We thus lower our outlook on technical grounds, to +0.4% (down 0.2pp) for 2010 and to +0.5% (down 0.1pp) for F3/11.
Downward revision for Jul-Sep due mainly to capex: The December 3 MoF Corp Stats release prompted a steep downward revision to capex, to an annualized -10.6% from the first preliminary +6.6%. Although supply-side data (domestic capital goods shipments) underpinning the first preliminary release were firm, demand-side data (capex based on corporate stats) were very weak. We suspect that domestic capital goods shipments data may have been overstated because of goods whose final destinations are abroad. Although capex contracting to depreciation levels argues against a major decline, we still think recovery momentum is likely to be weak.
Worsening deflation reconfirmed: The domestic demand deflator was revised down to -2.8%Y from the first preliminary -2.6%Y, and the GDP deflator has been revised into negative territory, to -0.5%Y from +0.2%Y. Nominal GDP has been negative for six straight quarters, starting Apr-Jun 2008. Allowing for the lag before a worsening output gap affects prices, deflation could keep worsening until 1H10 at least.
Our outlook remains cautious vis-à-vis the market: We have reviewed our outlook in light of the retroactive data revisions. As mentioned earlier, we revise down modestly for 2010 and F3/11 to reflect a carry-over impact. We are more cautious than the market because we see an economic dip in Jan-Mar and Apr-Jun 2010. The Economy Watchers Survey DI released on December 8 recorded its steepest-ever drop, increasing the probability of our forecast of two successive quarters of negative growth in 1H10.
The government announced an additional stimulus package on December 8. However, given that delivery of measures in the first supplementary budget was halted, we estimate that the second supplementary budget for F3/10 will add only 0.2pp to GDP, despite its ¥7.2 trillion scale. We think that a mild economic downturn before Upper House elections in July 2010 could strengthen the government's reliance on monetary policy: we would look for a series of new easing measures from the BoJ, starting with expanded quantitative easing and followed in order by guiding market interest rates temporarily lower, increasing its purchases of JGBs, and clarifying its commitment to policy duration.
If this scenario materializes, we would look for a weak yen impact accompanying a widening gap between domestic and overseas interest rates to fuel an export-driven rebound in the economy from 2H10 into 2011. Allowing for trends in foreign economies, we thus modestly revise up our outlook for 2011 and F3/12, to +1.5% and +1.6%, respectively.
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A Closer Look at Dubai's Debt
December 10, 2009
By Mohamed Jaber | Dubai & Paolo Batori | London
This is a summary of UAE: A Closer Look at Dubai's Debt, December 7, 2009.
The Dubai government's announcement on November 25 that it intended to restructure the debt of Dubai World and its subsidiary Nakheel took investors by surprise. Although the markets' initial sharp reaction has since subsided, significant uncertainty remains due to the dearth of information regarding the scale and scope of the emirate's debt problems. This event has particularly shone the light on Dubai's fiscal standing against the background of its significant public sector debt. We attempt to assess the extent of this debt and its potential burden on the emirate's finances. We also evaluate the current pricing of Dubai's credit in relation to its peers based on current market valuations.
Government Debt
The direct non-bank liabilities of the Dubai government currently amount to about US$18.7 billion. Prior to 2008, these debts were not economically significant as they were limited to a US$0.41 billion dollar bond. However, since April 2008, the government has raised an additional US$18.3 billion worth of non-bank debt. Little is known about the uses of these funds, other than that about US$15 billion of the newly raised debt has been earmarked to the Financial Support Fund (FSF).
One of the FSF's central roles is to provide financial support and liquidity on a commercial basis to the government and the government-related entities (GREs) that are deemed to be of strategic and developmental importance to Dubai. In fact, its establishment back in July had served to further blur the line between the government's explicit versus implicit support for GREs.
Overall, Dubai's direct and contingent debt liabilities are estimated to stand at around 50% of GDP. In both absolute and relative terms, this level of debt is not necessarily a cause for concern and is lower than the regional average. However, one also needs to consider the potential contingent liabilities of the Dubai government. Given the strategic significance of some of its GREs, it is difficult to see the government leaving them to fend for themselves. As such, we estimate that the government's implicit guarantee of these institutions would add contingent liabilities of about US$20 billion to its existing debt burden, thereby raising its debt (both direct and contingent) to GDP ratio to about 50%. Again, this level, although high, is not alarming by regional or even international standards.
The market's appetite for Dubai's sovereign debt very much depends on how the current situation is handled. Going forward, we believe that the Dubai government will need to tap credit markets for additional funding. This may be necessary in order to finance development expenditures and shore up the standing of some of the emirate's most strategic GREs. As a result, we expect the government's direct, non-contingent debt to increase by about 27pp to 51% of GDP by 2011. However, the ability of the Dubai government to raise additional debt on somewhat favorable terms will depend on how successful it is in managing the current debt restructuring process. It is difficult to over-emphasize the need for a timely resolution of Dubai World's debt problems. A protracted negotiation process that leaves creditors with a significant loss would not be in the emirate's interest. Neither would be the lack of timely disclosure of other potential debt challenges affecting Dubai's GREs. We believe that a clear and well-communicated government strategy to deal with the debt situation is imperative at this stage in order to quell rampant market speculation and limit the long-term reputational damage to the emirate's credit standing. Moreover, ring-fencing the troubled debt of various GREs would help to limit the impact of the current crisis on entities that have a solid business model and are able to shoulder additional debt.
Quasi-Government Debt
There are no official estimates of the debt owed by Dubai's GREs. Calculating the overall size of their debt liabilities is further complicated by a number of factors, including: (i) the complex organizational structure of Dubai's quasi-sovereign holdings; (ii) the lack of transparency regarding operations of its mostly unlisted companies; and (iii) the lack of data on bilateral, non-disclosed loans extended to these entities. Nevertheless, we rely on publicly available information to derive an estimate of the value of the GRE's outstanding bonds and loans. We then adjusted these estimates in an attempt to account for non-reported debt.
In total, we believe that the debt of Dubai's GREs currently stands at around US$89 billion, or 116% of the emirate's GDP. The debt is split among the emirate's three largest holding companies, with Dubai World and the Investment Corporation of Dubai accounting for the largest shares, although the latter arguably holds a number of companies with high franchise values. The GRE's disclosed debt is also held by a diverse group of investors, with about one-third held in bonds and the rest in loans. International banks hold about 44% of total GRE debt, versus 13% for UAE banks. Moreover, about 24% of this debt is set to mature by end-2010, with another 24% maturing in 2011. In sum, Dubai's public sector debt - which includes that of the government and its related entities - is estimated at around US$108 billion, or 140% of GDP. However, these estimates may overstate the real debt burden on the public sector, since they don't take into consideration the assets held by these GREs, on which there is unfortunately little information.
It is likely that other GREs will also announce debt restructuring plans over the near term. The high leverage of many of Dubai's government-related entities and their significant exposure to real estate and financial assets that have underperformed since 1H08 make it likely that further restructuring of GRE debt may be needed. The absence of detailed financial statements for these companies makes it difficult to accurately assess their financial soundness. Nevertheless, we tried to derive a guesstimate of the value of the debt that may need to be restructured by first examining the GRE's outstanding obligations and then subjectively assigning a probability of restructuring to them based on anecdotal evidence. In the process, we developed three different scenarios based on the increasing likelihood of debt restructuring of the GREs:
Scenario 1: Assumes that only the recently announced Dubai World debt will be rescheduled.
Scenario 2: Adds to scenario 1 the assumed rescheduling of the debt of Istithmar, Drydocks, Dubai Financial Group, Dubai Holding Investment Group (holding company level) and Dubai International Capital (holding company level).
Scenario 3: Adds to scenario 2 the assumed rescheduling of the debt of Dubai Holding (holding company level), Dubai Holding Commercial Operations, Bourse Dubai and Dubai Sukuk Center Limited (DIFC).
Dubai's Fiscal Position
Given the attention afforded to Dubai's debt overhang, it may be useful to examine its fiscal standing and assess the impact of this debt burden on its finances.
Dubai's fiscal revenues are dependent on fee and oil income. As of 2008, tax income - mainly related to customs fees and limited corporate taxes (e.g., tax on foreign bank income) - accounted for no more than 23% of overall government revenues. Conversely, proceeds from oil exports made up around 26% of government revenues. Non-customs fees - including those levied on road use and real estate - accounted for about 45% of total fiscal revenues. The latter are estimated to have dropped by about 15% in 2009, mainly due to the: (i) significant decline in Dubai's real estate sector in 2009; (ii) slowdown in domestic spending; (iii) negative population growth; and (iv) lower oil prices.
We expect fiscal expenditures to decline in 2010. Government expenditures, which had expanded at an average annual rate of about 48% during 2007-08, are estimated to have increased by about 10% in 2009. We believe that the government's finances will likely be strained next year due to tighter funding channels and a continued need for government support for some of the emirate's most strategic GREs. As such, we expect public spending to decline by about 6% next year. Current expenditures, which make up about 60% of government spending, should drop slightly in 2010, while development expenditures will likely experience a sharper decline on the back of tighter financing. On balance, we expect the fiscal accounts to register a deficit of about 4.5% of GDP in 2009 and 2.9% in 2010.
The burden of debt-servicing will likely increase over the medium term. We also attempt to assess the impact of servicing the debt on the emirate's finances. In order to perform this exercise, we assume that: (i) the government will only be responsible for servicing its direct debt obligations, not those of its GREs; (ii) the government will need to raise an extra US$20 billion during 2009-11 to finance expenditures and shore up the finances of highly strategic GREs; and (iii) the average cost of financing will remain below market levels, mainly thanks to subsidized financing from the federal government and the emirate of Abu Dhabi. Assuming a full roll-over of debt at maturity, debt servicing expenses are expected to rise from about 7% of total expenditures in 2009 to around 22% in 2011, somewhat in-line with other oil-importing Middle Eastern countries. If we were to take into consideration the government's contingent liabilities vis-à-vis its most strategic GREs, the toll of servicing the debt on government finances would necessarily be higher.
Estimating the Fair Value of Dubai's Credit
Goals of Our Scenario Analysis
The goal of this analysis is to give a quantitative frame of reference, to reconcile different markets (corporate, sovereign and global EM markets) in a context of high volatility and uncertainty. Therefore, investors should be aware that our conclusions have to be considered as indications of fair value, based on the below-listed assumptions, which could reveal themselves as strong in some peculiar market situation.
Given the anticipated debt restructuring and the recent volatility in Dubai fixed income markets, we undertook a macro/debt scenario analysis in order to:
1) assess if Dubai 5Y CDS is in line with a diversified sample of other emerging markets countries based on straightforward credit metrics (in this case external debt/GDP);
2) assess if Dubai CDS and the Nakheel bond are pricing in a homogenous market/debt restructuring scenario;
3) determine a short-term fair value range for Dubai CDS; and
4) determine a medium-to-long-term target range for Dubai CDS.
Methodology and Assumptions
First, we regressed the total external debt/GDP ratio and the 5Y CDS level for 33 emerging countries to, broadly, estimate fair value levels for Dubai implied by our macro scenarios.
Second, we used the three different debt-restructuring scenarios outlined above to estimate the magnitude of external debt burden going forward. Scenario 1 assumes a debt restructuring of US$26 billion. Scenario 2 assumes US$34.7 billion and Scenario 3 US$46.7 billion.
Third, given concerns among investors relative to the effective value of the implicit sovereign protection of GREs, we have analyzed a debt scenario which sees Dubai ring-fence its debt and the debt of its most strategic entities - what we term the Last Line of Debt restructuring scenario (LLD).
Fourth, we have assumed several haircuts on any potential restructuring.
Assumptions: 1) The relationship between total external debt and GDP remains stable over time. The R-squared of our binomial regression is 0.56.
2) The sample of emerging countries is representative of the EM world as a whole.
3) External debt/GDP is one of the main drivers of spreads and can be considered as a good proxy of credit risk.
4) Gross external debt/GDP, we find, is a good proxy of perceived credit risk. Net external debt/GDP may have been a better gauge, had it not been for the lack of data.
Conclusions and Strategy Implications
Assuming a scenario of 50% of haircut (which is also what seems to be priced in for the Nakheel 2009 bond), we draw the following conclusions for the 5Y Dubai CDS:
• The current level looks in line with the haircut projected by the Nakheel 2009 bond and the rest of the EM sovereign
5-year CDS spectrum;
• The CDS spread is currently positioned above the upper limit of the short-term interval of confidence (based on our macro and restructuring assumptions). Therefore, it offers value if our baseline scenario (scenario 2) and our assumptions were to materialize. In which case, it could converge towards 300-350bp in the short term; and
• If we assume that, at the extreme scenario, Dubai will take a tough line with investors exposed to the quasi-sovereign assets (LLD scenario), the CDS spread should converge towards 175-225bp in the medium-to-long term. However, if this situation were to materialize, we cannot rule out an increase in short-term volatility, as investors' willingness to finance that particular emirate/region could temporarily fade.
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