SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION?

Takeaway: A likely Joko Widodo victory + improving cyclical GIP fundamentals are supportive of remaining long Indonesian capital and currency markets.

On JAN 30th of this year, we published a note titled “SQUIRREL HUNTING WITH INDONESIA, PHILIPPINES AND NEW ZEALAND” in which we advocated for investors to get long of Indonesian capital and currency markets on a directionally positive intermediate-term GIP outlook amid a likely bearish-to-bullish TRADE & TREND reversal on our proprietary factoring.

Since then, the iShares MSCI Indonesia ETF has appreciated +20.1%, which compares to a sample mean of +14.8% across the 24 country-level ETFs we track throughout the EM space. Additionally, the Indonesian rupiah (IDR) has appreciated +4.5% vs. the USD since then, which compares to a sample mean of +2.9% across the 21 currencies we track across Asia and Latin America.  

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - EM Divergence Monitor

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - FX

Rather than book yet another round of alpha on the long side of emerging markets in 2014 (after having been the bears in 2013), we are content to keep this research idea “on”, given that we anticipate further upside from here.

Looking to the cyclical side of the trade, our predictive tracking algorithm pegs the Indonesian economy squarely in Quad #1 (i.e. growth accelerating as inflation decelerates) for the current quarter. Assuming this forecast is correct, this would mark the third straight quarter of decelerating inflation amid tougher compares and marginally less annualized currency debasement. Bank Indonesia’s +175bps of rate hikes from JUN ’13 to NOV ’13 are clearly bearing fruit.

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - INDONESIA

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - CPI

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Indonesia’s stronger growth profile for the third quarter is supported by easier compares and improving manufacturing and industrial production trends.

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - MANUFACTURING PMI

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - INDUSTRIAL PRODUCTION

Looking to the structural side of the trade, we think investors are likely to continue paying up for a probable victory by Jakarta Governor Joko Widodo come Wednesday’s presidential election. Recall that the IDR declined -6.7% vs. the USD from its YTD high in early-APR through late-JUN on the specter of über-nationalist candidate Prabowo Subianto closing the gap on “Jokowi” in the polls.

Fast forward to today, the latest polling results from Lingkaran Survei Indonesia put Jokowi squarely in first place at 47.8% vs. 44.2% for Prabowo. Polls are what they are, however – i.e. occasionally inaccurate – so we’ll gladly wait for official confirmation come Wednesday.

While both candidates are more-or-less singing the same song with respect to their vision for economic policy (e.g. increased infrastructure spending, reduced fuel subsidies, increased oil & gas exploration, increased assistance to the agriculture sector and further crackdowns on graft), how they plan to get there quickly became a hot-button topic amongst international investors. Specifically, Prabowo is pledging to allocate resources in a more nationalist, authoritarian regime similar to the one he served under during the oft-maligned “New Order” administration led by former President Suharto.

Contrast Prabowo’s pledge with Jokowi’s insistence on cutting red tape and improving both the transparency and efficiency of government processes and it’s easy to see what makes the latter candidate more popular with global capital allocators.

Regardless of who wins Wednesday’s elections, the country doesn’t have all that much hay to bale on the reform front. The county’s fiscal policy is something to be admired globally – even amongst its Asian peers. Years of relatively tight fiscal policy have left the country with a pristine sovereign debt/GDP ratio of 26.1%, which is the second-lowest in all of Asia. It’s central government budget balance/GDP ratio of -1.4% is the third tightest in Asia behind only Taiwan and South Korea.

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - BUDGET BALANCE

That being said, however, the country is an emerging market, which, almost by definition, means it has a number of things it needs to improve upon before becoming competitive at the highest level internationally. Such low-hanging fruit include, but are not limited to:

  • Promoting FDI: Indonesia’s stock of FDI is a paltry 2.2% of GDP, which lags regional peers Thailand (3.3%) and Singapore (21.4%), the both of which have more open economies. Increased FDI would help shift Indonesia’s export base towards more value-added goods, at the margins, which may help to narrow the country’s bloated current account deficit (latest: -3.2% of GDP). Currently, natural resources account for roughly 65% of Indonesian exports.
  • Reducing Fuel Subsidies: Indonesia currently spends just over 55% of public expenditures on fuel subsidies. While reducing those subsidies would be inflationary in the short term, it would likely be disinflationary over the long term to the extent the currency rallies on improved BoP dynamics via reduced imports of fossil fuels. That’s not a given though; paring back fuel subsidies has been all but impossible for Indonesian policymakers to do since the aforementioned Suharto was overthrown amid mass protests of said subsidy reductions.
  • Promoting Infrastructure Development: While Indonesia has certainly improved in this area in recent years, the country still ranks only 61st in the quality of its infrastructure, which is often cited as a critical factor in perpetuating both structurally elevated inflation and structurally depressed FDI. Ranking 61st in this critical category for economic development is simply not good enough for the world’s 16th largest economy at PPP.
  • Reducing Graft and Cutting Red Tape: According to the World Economic Forum’s 2013-14 Global Competitiveness Report, “Corruption” and “Inefficient Government Bureaucracy” are Indonesia’s #1 and #2 most problematic factors for doing business. Both candidates have promised varying ways to attack both issues: Jokowi via increased funding for the state’s anti-graft agency and actually cutting said red tape; Prabowo via increasing pay for civil servants (to reduce their need to steal) and re-centralizing central government power.

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - CURRENT ACCOUNT BALANCE

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - GCR  1

Source: World Economic Forum 2013-14 Global Competitiveness Report

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - GCR  2

Source: World Economic Forum 2013-14 Global Competitiveness Report

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - GCR  3

Source: World Economic Forum 2013-14 Global Competitiveness Report

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - GCR  4

Source: World Economic Forum 2013-14 Global Competitiveness Report

It’s worth noting that our proprietary EM Crisis Risk Index sees Pillar I and Pillar IV as Indonesia’s key areas of risk, which is perfectly in line with the areas for improvement listed above:

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - SUMMARY TABLE

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - PILLAR I

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - PILLAR IV

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - EXPLANATION TABLE

Regardless of who wins the upcoming election, it’s unclear if either candidate has the political backing to enact sweeping reforms – particularly in short order. Specifically, Prabowo’s Gerindra party only controls 13.04% of seats in the lower house of parliament; pairing that up with coalition partner Golkar pegs his baseline backing at only 29.29% of total seats. Still, that is more than the 19.46% of seats Jokowi’s PDI-P party currently holds. As such, investors would be remiss to expect anything but piecemeal reform(s) in the coming quarters given the mixed legislative landscape – irrespective of Wednesday’s outcome.

SHOULD YOU CHASE INDONESIA THROUGH THE ELECTION? - Indonesia Parliment

Source: Wikipedia

All told, we think a likely Joko Widodo victory and improving cyclical GIP fundamentals are supportive of remaining long Indonesian capital and currency markets. Email us if you’d like to dig in further.

Welcome back to the grind,

DD

Darius Dale

Associate: Macro Team