South East Asia Focal In Emerging Markets And Indonesian Economic Decline
Emerging market hardship may be expressing a larger influence on global market dynamics than generally reported. Where we see preferred stocks taking a nose dive against common stocks, interest rates continuing to increase and, of course, emerging market currency declines; we also see global equity markets high, but finding more headwinds to push higher.
May, 2013 time frame points to a generally recognized "shift" attributed to comments of Federal Reserve tapering of QE. Other dynamics also appear to be at work, pointing to issues outside of Europe.
South East Asia holds interesting events. Point of interest is Indonesia. It boasts the largest economy in South East Asia at $878B USD GDP in 2012, and eclipses a combined Thailand and Singapore GDP of just under $700B USD. Indonesia's GDP growth rate has been stellar with an annual growth rate of 6.5% coming out of global recession and extending through late 2011. 2012 saw policy propositions that looked protectionist and such appearances frosted investment. GDP has been in decline for last four quarters putting in a Q2 2013 growth rate of 5.81% versus a Q1 rate of 6.03%.
We have witnessed a 70 basis point decline in Indonesian GDP, which previously enjoyed exponential growth. While GDP declines, foreign currency debt, or external debt, have increased. Data shows external debt challenges GDP at $251B USD. External funding of high emerging market growth is not only routine, but contains its own boom and bust cycles.
Indonesia's External Debt, Declining Currency And Rising Bond Yields
External debt is composed of obligations denominated in foreign currency. Resultantly, Indonesia needs reserves of foreign currency to service its external debt. Two problems are developing which raise concerns. First, Indonesia's non-convertible currency, the rupiah, is in depreciation declining 7% this year to lows last observed in 2009, amid the financial crises. Second is an exhausting of Indonesia's foreign currency reserves. Now at $92.7B USD, these reserves have dramatically declined and are also approaching lows witnessed during the financial crises. Reserve declines have followed Bank Indonesia's, Indonesia's central bank, efforts to support rupiah. Now, Bank Indonesia has essentially no choice but to allow market determination of rupiah value.
Feeding problems is a declining GDP amid a July inflation rate of 8.61%, highest rate in four years. Suggestion is that inflation isn't demand driven, or the product of a fast moving economy. Rather, inflation appears to be arising from rupiah weakness. For example, exports are down 4.5% y/y for 15 months of consecutive decline. Retail sales started trending down mid 2012 reaching a y/y low of 8% first part of 2013. While June numbers show a 14.8% growth rate, inflation may drive the number, especially in view of fuel price spikes due to elimination of a fuel subsidy.
Attending inflation is a rise of Indonesia's 10 year government bond yields. Now at 8.13%, Indonesian yields have increased 264 basis points since March 31, 2013 when yields were 5.49%. Contrast this with Thailand's 10 year which is now at 3.99% moving from a March 31 3.42% to increase 57 basis points. Singapore, now at 2.48% rose to this level starting from a March 31 1.367% level to see a rise of 111 basis points.
Just as Indonesian bonds have exceeded peer group bonds in rising yields, they have also exceeded peers in the rate of their widening spread against Bunds and Treasuries. Indicated is an obvious and dramatic increase in Indonesian risk premiums, amid a slowing Indonesian economy.
Indonesia's Balance of Payments Deficit Reveals Macroeconomic Concern
Most troubling for Indonesia is their global balance of payments, pattern of increasing external debt, and abysmally low foreign exchange reserves. For balance of payments, Q1 2013 saw a current account deficit---meaning more imports and therefore domestic expenditure as opposed to income---of -$5.27B. Capital/financial account---which is money invested in Indonesia and therefore income---also saw a deficit of -$1.37B. This resulted in Indonesia using more of its foreign exchange reserves to finance not only a current account deficit, but also a capital/financial account deficit. Consequence was a drain in foreign exchange reserves of $6.62B, yielding the $92.7B in reserves. Down from a 2012 average of just below $115B.
Q2 2013 data released August 16 showed a dramatic current account deficit increase to -$9.85B. Capital/financial account actually showed a surge in foreign investment, but not enough to finance current account deficit. Capital/financial account showed a positive $8.196B. Still foreign exchange reserves made up the difference by declining another $2.477B.
Further rupiah depreciation resulted given balance of payment news with spot prices being at a 2.5% premium against the 1 month non-deliverable rupiah forward contract (NDF) at 10.636/USD and spot at 10.373. Last week, Indonesia's 10 year bond yield increased over 60 basis points.
Indonesian Steps To Solve A Looming Currency/Economic Dilemma
Trouble arises from Indonesia's foreign debt exposure and its cost against a declining rupiah, compounded by declining foreign exchange reserves. Now, accumulation of foreign exchange reserves is becoming much more expensive for Indonesia. Declining rupiah and increasing domestic bond yields are driving inflation, and potentially a liquidity if not solvency problem.
Theoretically, Indonesia could issue more domestic bonds to build foreign currency reserves. Such a proposition confronts already high and increasing costs of borrowing compounded with rupiah now subject to market pricing. Markets aren't fond of rupiah or Indonesian bonds.
Monetary policy solutions by Bank Indonesia look cautious and perhaps dubious by possibly worsening problems. While key interest rate in Indonesia has been raised in response to inflation and in effort to support rupiah, declining growth makes further interest rate increases dangerous to sustaining growth, especially given foreign debt exposure. Last week, Bank Indonesia ordered increases in bank reserves. Indonesia last increased bank reserves in 2010 due to inflation resulting from a hot economy.
Now, Indonesia's economy is cold. But, Indonesian banks must increase their secondary reserves (government bonds and Bank Indonesia certificates) to 4% versus a previous 2.5%. Further, banks must reduce their loan to deposit ratio of 100% to a range of 78% to 92%, depending on risk composition.
Indonesia's Balance Sheet Mismatch of Maturity and Currency
While measures increasing bank reserves look to address inflation and improve bank capital, they are essentially a removal of liquidity in a system that already is demonstrating liquidity risk. Balance sheet mismatching shows two themes that attend emerging market crises: 1) maturity mismatch by using short term lending to fund long term projects; and 2) currency mismatch by using foreign currency denominated loans to fund rupiah generating projects that don't earn foreign exchange.
Indications of mismatches noticed in past experience exist today. Nature of modern banking is to use short term deposits to fund long term loans thereby arbitraging the yield curve. However, Indonesian yield curve can be inclined to flat, hurting banking margins. If Indonesian banks borrow at Indonesian rates, spreads between funds borrowed and lent can be small to flat. Resulting implication is Indonesia's external debt is driven by seeking lower interest funding offshore for domestic loans.
For instance, on August 31, 2012 the spread between Indonesia's 1 year bond versus its 10 year bond was 1.37%. By January 31, 2013 the spread declined to .48%. Spread rose to 1.36% in April but is back in decline showing a current spread of .98%.
Bank Indonesia reports external debt by distinguishing short term and long term debt. Short term is less than one year, while long term debt is greater than one year. According to Bank Indonesia, most external debt is attributed to private sources and is at least one year or more and accordingly characterized as long term. Indonesian loan funding at one year developed country rates against the Indonesian 10 year rate allows Indonesia's banking system and lenders to escape the Indonesian flat yield curve. But, foreign currency risk gets magnified. Then comes a re-weighting of risk for banking assets and reductions in capital asset adequacy ratios for Indonesian banks when global economic weakness shows.
Still, short term external debt held by private sector is at $36.26B according to Bank Indonesia and long term debt at $95.28B. Showing is 38% of Indonesia's external debt is less than one year, versus majority of Indonesia's capital projects of at least 10 years.
Given foreign currency depletion on balance of payment reports, Indonesia has not garnered sufficient industry to raise foreign currencies against loss of domestic currency due to excessive imports. Without creating commerce that accumulates foreign currency, Indonesia's funding of its growth looks very vulnerable to currency risk, maturity risk in down cycles and a longer term condition. A condition of financing growth still reliant on external sources.
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