Macro: Indonesia’s growth story

Just as the US and European nations live under the threat of further sovereign downgrades, Indonesia is on the way up, its risk profile now deemed to be on par with that of India. Rewind to 1998 and the country was in default, having seen its economy crumble under the weight of the Asian financial crisis, and destined to spend over a decade below investment grade.

The upgrade - confirmed by Fitch Ratings in December and matched by Moody's one month later - is a reward for consistent economic performance. Indonesia's GDP growth has regularly topped 6% in recent years and the one year when it didn't, in 2009, the country still outperformed everyone in the G20 bar China and India. In 2011, economic growth reached a 15-year high of 6.5%.

Indonesia also won admission to the "trillion-dollar club" last year as GDP in purchasing power parity terms reached $1.1 trillion. This puts it alongside the G8 and BRIC nations.

"The perception of many people offshore is that Indonesia is a small market, but it's not," says Patrick Alexander, managing director of Batavia Investment Management. "It's the largest economy in Southeast Asia and it's a trillion-dollar economy now, way bigger than countries like Vietnam and so on."

Unlike many nations in Southeast Asia, Indonesia's size means that growth can largely be sustained by domestic consumption and investment rather than exports. Consumption, which accounts for over two-thirds of GDP is buoyed by helpful demographics: 44% of the 250 million population lives in towns and cities, and the urbanization rate is 1.7% per year; 14% of the population is considered as middle-class, and this is expected to double in five years.

Yet in the fourth quarter of 2011, investment surged 11.4% year-on-year, the first double-digit increase since 2008. More importantly, the investment contribution to overall economic growth surpassed that of consumption. This uptick in investment - perhaps a sign that infrastructure deficiencies are being addressed - should stand Indonesia in good stead while its neighbors face headwinds from external markets.

"The domestic demand base is strong and the country is less export-driven compared to Malaysia, Vietnam, Thailand and Singapore," said Helmi Arman, Citibank's Indonesia economist. "It used to be a point of weakness, but it is now a point of strength during volatile global conditions."

Speeding up

However, amid the promising outlook, there are also skepticisms from some analysts who question the country's infrastructure, corruption and slow bureaucracy.

"Infrastructure should ideally grow faster than GDP because we need to catch up from the inadequacies in the previous 15 years when the government went on austerity plans to cut spending," says Wellian Wiranto, Asia investment strategist at Barclays Wealth. "So far the key concern for Indonesia is not about having the resources - It already has the resources, it's more about how to unlock them."

Arman shares a similar view, adding that Indonesia can only sustain annual growth of 6.5-7% provided infrastructure build-out speeds up and the manufacturing sector continues to invest in new capacity.

Batavia's Alexander, who has lived and worked in Indonesia for 25 years, believes corruption in Indonesia is a bit over-labeled because most of investments in the country are in private sectors. The problem, however, lies in the fact that growth is slower than it should be. "Public investment has been too little and too late; if the country grows properly, it should be expanding as fast as China and India at a rate of 7.5%."

The government has not turned a blind eye to its infrastructure inadequacies, and has taken steps to facilitate investment in the space. Last December, the House of Representatives approved the long-awaited land acquisition bill, which if implemented correctly, should allow the government to accelerate road, port and airport projects. Although change will be not seen overnight, the move has created another catalyst to the economy by breaking the bottleneck in the country's infrastructure development.

The sovereign upgrades - Standard & Poor's is expected to follow Fitch and Moody's in due course - have prompted a fresh burst of investor interest in the country, not least because it means capital can be deployed more efficiently.

"Eventually the rating will help to make borrowing cost more sustainable," says Arman, who expects to see an even better rating if Indonesia's reform agenda progresses well and income levels continue to rise. "The government, however, has to compliment this with a better financial system instead of just deepening the financial market, in hope of develop a well functioning market to accommodate the economic growth."

Open the floodgates

According to the Organization for Economic Co-operation and Development (OECD), Indonesia only recorded foreign direct investment (FDI) inflows of $4.9 billion in 2006. Last year, inbound investment reached $20 billion, a fourfold increase. The bulk of this capital targets natural resources, notably mining and metals. Barclays' Wiranto argues that the elevation to investment grade should see more investment across a wider range of sectors.

"The absence of an investment grade rating was a barrier for investors but now it has been removed," Citibank's Arman adds. "We have been seeing a pick up in foreign direct investment into the country, not just towards the natural resources and manufacturing sectors, but also a number of retailers coming and expanding their franchise in Indonesia."

Alongside growing FDI, more local, regional and global private equity funds have turned their attention to the country. According to an Ernst & Young survey conducted last year, 33% of Southeast Asia-focused private equity investors singled out Indonesia as their primary investment destination, followed by Vietnam (21%) and Singapore (21%) and Malaysia (17%).

"When you look at Indonesia's political stability, broad-based economic growth and population size, there is no surprise to the general consensus that Indonesia currently offers the best value," says Luke Pais, Ernst & Young's ASEAN private equity leader.

Exotic market

While the attraction is clearly there, Indonesia is in many respects no different from China and India. It is complicated, relatively immature in private equity terms, and requires an on-the-ground presence to deal with bureaucracy and manage the networks of relationships that drive much economic activity.

"Indonesia is repairing a lot lately, but it is still a new story to a lot of global investors, especially to private equity firms who have headquarters far in New York or London," says Wiranto. "People still have fairly on-the-surface type of questions about the country, but we expect these questions to be less exotic but more interesting overtime."

Batavia's Alexander, however, points out that the history of private equity in Asia has told investors that one cannot correlate high economic growth with good private equity returns because PE players often rush into a market based on broad economic trends without taking the trouble to understand it.

"I don't try to invest on broad macro trends such as natural resources and infrastructures - sectors which people eyeing from a distance are talking about - because they are never as easy as it sounds, given the level of regulation and government intervention," says Alexander. He prefers to focus on particular opportunities tied to expectations of burgeoning middle-class growth, notably the consumer, financial services, healthcare, education and logistics industries.

Ernst & Young's Pais adds that although local entrepreneurs and business leaders are rapidly becoming more conscious of the benefits of private equity in fostering growth, it is still a relatively new concept compared to markets like China and India.

"Businesses need to undergo some transformation in order to prepare themselves to access international markets, investor networks and in a lot of instances," he says. "The private equity funds position themselves as the catalysts for change."

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• Topics
• Investments
• Southeast Asia
• Economy
• Indonesia