With a boost from expectations of a ratings lift to investment grade, Indonesia is looking to capitalise on its new-found popularity without jeopardising stability.
Indonesia has been a top draw in the regional debt markets for investors eyeing its imminent elevation to an investment-grade credit rating. However, South-East Asia’s biggest economy has to wean itself off its dependence on foreign investors and put growth on a higher trajectory if it wants to remain popular in the bond markets.
“The Indonesia rating upgrade story is on track, but there are hurdles, like raising GDP growth rates to a higher trajectory due to infrastructure constraints and reducing the country’s dependence on portfolio inflows to fund the government financing,” said Pradeep Mohinani, credit analyst with Nomura International.
Asia received another reminder of the power of foreign investors this month when yields on Indonesian bonds spiked due to fund outflows and a rush for dollar funding.
In the first three weeks of September, the 10-year bond yield rose 50bp to 7.3% and the rupiah currency fell 4%. Despite the sell-off this month, foreign investors still hold a high 33.6% of the Indonesian Government’s rupiah bonds, up from around 18% at the end of 2009.
A low debt-to-GDP ratio and a very evenly paced debt maturity schedule weighs in the country’s favour, but Jakarta will have to address these other vulnerabilities if the country is to lift its game.
“It certainly is a crowded trade. One third of the government bonds are held by foreigners and, if this bout of investor risk aversion persists or deteriorates, these holders could then take profit on their holdings as they see both the bond market and currency turning weaker,” said Boon Peng Ooi, chief investment officer, fixed income, at Prudential Asset Management (Singapore).
Before the sell-off, Indonesian bond yields hit record lows this month, with the 10-year one falling to 6.45%, down 120bp since the start of the year. As Europe’s turmoil intensified, investors started to book profits on one of the rare winning trades in financial markets this year.
Some stability has returned, but investors are worried about the return of such selling pressure.
“While it is remarkable how well it has held up, what is worrying is how quickly that could change if we get a big sell-off in emerging markets. The resultant spike in interest rates could hurt growth,” said Mohinani, adding that the country was vulnerable to such sudden reversals of flows, which could have a destabilising effect.
In the first three weeks of the month, foreign holdings of rupiah-denominated government bonds declined by Rp13.2trn (US$1.5bn). At 33.6%, foreign ownership is only slightly down from the record high of 35.6%, but analysts are worried about another wave of selling.
“While there have been no fundamental changes from a macro perspective to justify an exit from the bond market, participants could remain concerned over the crowded positioning,” said RBS analyst Teck Wee Yeo.
Foreign holdings of the government’s domestic debt have risen sharply in recent years as the world’s fourth most populous nation rode the growth stemming from domestic demand. Investors are attracted to the high yields in its domestic bond market with the currency’s appreciation providing the kicker.
In 2010, the rupiah rose 5% and yields dropped an astounding 250bp to give investors total returns of 28.6% in the local currency bond markets.
Even before local currency bonds became popular, foreign investors were already piling into the improving story of the Repubic of Indonesia, which returned to international bond markets in 2004 after an absence of nearly six years following the Asian financial crisis.
Since then, Indonesia, which graduated from an IMF bailout programme in 2003, became a regular visitor to the international bond markets. It has sold global bonds every year since 2004 and raised more than US$7bn as investors tapped into its domestic growth- and commodity-led story.
Its success as an issuer can be measured in the variety of currencies, structures and tenors. It began with the sale of a 10-year bond in 2004, but, in the following year, it capitalised on investor demand with the sale of a 30-year bond in the dollar bond market.
It has looked beyond the dollar-denominated bond market in tapping bond investors in world’s third-largest economy. Having completed two successful Samurai issues, it is eyeing its third offering of yen-denominated bonds in 2012.
Indonesia, which is also the world’s most populous Muslim nation, has also leveraged on Islamic finance to attract petrodollars into its fast-expanding economy.
In 2009, it made its inaugural global sukuk offering using the ijarah structure. This structure used a real estate sale-and-leaseback format between Indonesia and a special purpose vehicle the government established for the purpose of issuing such bonds.
Indonesia’s recent track record of successful bond issues has also gone hand in hand with its steady progress to the coveted investment-grade status.
All three global rating agencies have placed Indonesia’s ratings a notch below investment grade. Standard & Poor’s and Fitch have a positive outlook, while Moody’s has a stable outlook on their respective ratings.
An investment-grade rating will allow Indonesia access to investors barred by mandate from buying junk-rated debt, lower its borrowing costs and put it on par with BRIC countries, such as Brazil and India.
In April, Fitch said Indonesia’s prospects of securing an upgrade to an investment-grade rating of BBB– or above would receive a boost from sustained economic growth and an ongoing strengthening of the sovereign’s external balance sheet.
Indonesia’s forex reserves are at a record high of US$124.5bn and its economy is moving along at a brisk pace.
The G20 member’s economy expanded a robust 6.5% in the second quarter on the back of export income and faster investments that may potentially shield the country in the next few quarters from a darkening global outlook.
It has plans to raise GDP growth to 6.7% next year, but analysts say it has to step up spending on infrastructure if it is to move to a higher growth trajectory.
“At the per capita GDP levels, the domestic-led demand growth story has helped Indonesia through the global financial crisis. Nonetheless, Jakarta has to invest in infrastructure to raise the growth rate from the 6% band to the 8% range,” said Mohinani.
