An almost life-size statue depicting a 10-year-old Barack Obama, was unveiled in the Indonesian capital, Jakarta, on Thursday, Dec 10, 2009. The US president was born in Hawaii and lived in Indonesia for four years in the 1960s with his mother and Indonesian stepfather. The young Obama, was known to as "Barry" - - a name he didn't like. Obama's mother Ann Dunham worked at the Ford Foundation, which was headed by Peter Geithner, father of current Treasury Secretary, Tim Geithner. Photo: Jakarta Post

Indonesia, the world's biggest Muslim country and one of the world's biggest democracies, is likely to emerge as an Asian Tiger story more similar to India than China.

The 230 million population of the former Dutch ruled East Indies, incorporating the fabled Spice Islands, may not be able to reach India-type GDP growth of 8-9% soon, according to Morgan Stanley economists. Indonesia has not yet cleared all the hurdles to be in India and China's league. However, Chetan Ahya and Sumeet Kariwala 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.

They 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 (return on equity) spreads over the cost of capital.

Why Has the Cost of Capital Been High?

The economists say 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 of 1997. 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 or 6.75% (2009 estimate). These are the highest spreads among banks in the region.

What Will Bring Down the Cost of Capital?

The economists 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% (Q309). 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

The Morgan Stanley economists 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. Similarly, capital inflows into India have risen sharply. The economists 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 (capital spending) 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, MS believes 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

The economists say 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," the economists say.

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," according to the economists.

Bottom Line

In the short term, Indonesian markets appear cyclically overheated, but MS believes 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. The spread between ROE and cost of capital is likely to increase significantly over the next three to four years. In this environment, rate-sensitive sectors - - such as financials, consumer (discretionary spending) and property - - should benefit from structurally higher demand growth. The key risk to the positive view on Indonesia would be any unexpected turn in the political environment.