Indonesia Banking Outlook 2014: A Weakening Rupiah And Increasing Interest Rates Could Expose Credit Vulnerabilities

Primary Credit Analysts: Cheul Soo Cho, CFA, Hong Kong (852) 2533 3559; cheulsoo.cho@standardandpoors.com Ivan Tan, Singapore (65) 6239-6335; ivan.tan@standardandpoors.com Secondary Contact: Geeta Chugh, Mumbai (91) 22-3342-1910; geeta.chugh@standardandpoors.com

Table Of Contents
Rupiah Depreciation And Rate Hikes Will Hurt Companies More Than Banks Indonesian Banks Have Grown Rapidly Even As Credit Fundamentals Remain Weak Indonesian Bank Ratings Can Likely Withstand The Fed's Tapering Related Criteria And Research

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Indonesia Banking Outlook 2014: A Weakening Rupiah And Increasing Interest Rates Could Expose Credit Vulnerabilities
Headwinds from several directions could buffet Indonesia's banking sector in 2014 and test its resilience. Standard & Poor's Ratings Services believes that the U.S. Federal Reserve's planned tightening of its monetary stimulus will reduce capital flows to Indonesia, hurting the Indonesian economy. And rising interest rates, a depreciating currency, and a slowing economy do not bode well for Indonesian companies' performance, in our opinion. These factors could weigh on the asset quality and financial profiles of Indonesian banks, especially given banks' history of rapid lending growth in a context of low income and weak payment culture and rule of law. However, we maintain our stable outlook on Indonesia's banking sector. Our Banking Industry Country Risk Assessment of Indonesia and ratings on Indonesian banks already factor in the sector's weaknesses. Banks continue to face high economic risk arising from Indonesia's low per capita income, rigid labor markets, and other constraints, which limit the country's flexibility to deal with sudden economic shocks. In addition, weaknesses in payment culture and adherence to rule of law could significantly weaken creditors' ability to enforce their rights. Nonetheless, we expect most rated banks to maintain solid business positions, sound capitalization, and good funding and liquidity profiles in 2014. We believe Indonesia's real economy could adjust to a gradual tapering of bond purchases in the U.S., and our baseline forecast of stable GDP growth of 5.6% in 2014 would still support borrowers' ability to make their debt payments. Overview The U.S. Federal Reserve's tapering of its bond-purchase program will weaken the Indonesian rupiah and increase interest rates. This will stretch the ability of companies and indebted households to meet financial obligations, in our view. A history of rapid credit growth amid weak credit fundamentals could further weaken banks' asset quality. However, in our base case, we maintain our stable outlook on Indonesian banks because our assessment already factors in the sector's credit weaknesses.

Rupiah Depreciation And Rate Hikes Will Hurt Companies More Than Banks
The Fed's May 2013 announcement that it would consider trimming its bond-buying program hit Indonesia's economy particularly hard, resulting in a significant weakening of the rupiah. We believe Indonesia is vulnerable to such moves by the Fed because the country is a net external borrower, and we expect its current account to remain in deficit for the next several years. Rupiah interest rates have risen sharply since the Fed's announcement last May (see chart 1). And rupiah bond rates, which are influenced by the central bank's policy rates, have also climbed steeply during the period. The central bank

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Indonesia Banking Outlook 2014: A Weakening Rupiah And Increasing Interest Rates Could Expose Credit Vulnerabilities

has raised policy rates by 175 basis points (bps) to 7.5% since May 2013, despite its forecast of an economic slowdown, partly to defend its currency. This translates into higher funding costs for Indonesian companies.
Chart 1

Rupiah depreciation will put pressure on Indonesia's corporate sector, in our view. Indonesian companies borrow in U.S. dollars without fully matching assets in that currency, which creates an asset-liability currency mismatch. And in some sectors, companies' revenues are in rupiahs while costs are in dollars, giving rise to an operating currency mismatch. The agricultural product processing, metals, and airlines sectors are more vulnerable to a weakening local currency for these reasons. We estimate that sectors that are at risk from a rupiah depreciation account for about 25% of total bank loans. Indonesian banks' general practice of matching their foreign currency assets and liabilities should largely absorb the impact of the rupiah depreciation and higher rates. Banks' total net open position (net foreign currency liabilities as a percentage of total equity) has remained low over the years and was just above 2% as of year-end 2012. We expect the ratio to remain at this level over the next 12-24 months. A net open position of 2% suggests that rupiah depreciation itself should not be a big direct threat to the banking system. Foreign currency liabilities account for only about 10% of banks' total liabilities.

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Indonesia Banking Outlook 2014: A Weakening Rupiah And Increasing Interest Rates Could Expose Credit Vulnerabilities

But Indonesian banks may take a mild hit from rising interest rates because of their sizable government bond holdings. Banks hold Indonesian rupiah (IDR) 300 trillion in government bonds, of which IDR181 trillion are classified as trading or available-for-sale securities, which expose banks to price fluctuations.

Indonesian Banks Have Grown Rapidly Even As Credit Fundamentals Remain Weak
Without proper credit risk management, rapid loan growth can lead to weaker asset quality for banks. Bad loans could rise, given banks' increased exposure to higher-yield but riskier loans, in our opinion. The Indonesian banking sector grew at a compounded annual growth rate of about 23% in 2006-2012, a period in which the central bank significantly lowered its benchmark interest rates after they peaked at 12.75% in 2006. The sheer number of financial institutions in Indonesia, many of which are small, strains regulatory resources and hampers effective supervision, in our view. Smaller banks in particular often have rudimentary risk management and weak corporate governance. And history has shown that they don't fare well when credit cycles turn sour. We think that this group of banks is more vulnerable to a buildup of credit risks at a time of rapid loan growth. Indonesia's banking system is highly fragmented with 120 commercial banks, and the top five banks account for almost half of the system's total loans (as of June 30, 2013). One risk is already emerging: "Special mention loans"--or loans up to 90 days past due but yet to turn bad--have increased marginally since 2011. We expect these loans to increase further going forward because borrowers are increasingly experiencing repayment difficulties. In contrast, the ratio of reported nonperforming loans (NPLs) declined to 1.9% in 2013 from 6.1% in 2006, partly reflecting the denominator effect of rapid loan growth and recent approvals for state-owned banks to write-off long standing NPLs. We expect credit losses for Indonesian banks to increase over the next few years, given that interest rates rose nearly 175 bps in 2013 and will likely increase by 25 bps in 2014, and that the economy is showing signs of slowing down. In the past, falling interest rates and robust GDP growth of more than 6% in 2010-2012 largely supported Indonesian banks' asset quality (see chart 2).

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Indonesia Banking Outlook 2014: A Weakening Rupiah And Increasing Interest Rates Could Expose Credit Vulnerabilities

Chart 2

Leverage in the system--as measured by the ratio of credit to GDP--has been rising steadily since 2009 (see chart 3). Loans have consistently expanded faster than the country's nominal GDP growth, spurred by favorable monetary conditions, such as low interest rates and positive investor sentiment. Also, since most loans in the system are floating rate, borrowers' repayment obligations will increase in line with the interest rates.

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Indonesia Banking Outlook 2014: A Weakening Rupiah And Increasing Interest Rates Could Expose Credit Vulnerabilities

Chart 3

We expect Indonesia's low income levels to continue to constrain the private sector's debt capacity. We project Indonesia's per capita GDP at US$3,458 for 2013, a relatively low level globally despite a decade of moderately strong growth, during which real per capita GDP increased an average of 4.7% each year. At current income levels, Indonesian borrowers have a limited ability relative to their wealthier regional peers to maintain creditworthiness in the face of economic difficulties coupled with rising interest rates. We also believe long-standing weaknesses in the country's payment culture and legal infrastructure could undermine creditor rights and recovery efforts. For instance, according to the World Bank's "Doing Business Report 2013," Indonesia's ranking for resolving insolvency dropped to 148 from 142 over the past two years mainly due to the time it took to close a business (5.5 years) and the country's low recovery rate for defaulted assets of just 14.2%.

Indonesian Bank Ratings Can Likely Withstand The Fed's Tapering

Our base-case scenario assumes that Indonesia's positive economic growth, which we forecast to be stable at 5.6% in 2014, should continue to help borrowers meet their debt payments. We also believe that the Fed will taper its bond purchases gradually, which will provide enough time for Indonesia's real economy to adjust. We therefore maintain our stable outlook on Indonesia's banking sector. The solid business position, sound capitalization, and good funding and

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Indonesia Banking Outlook 2014: A Weakening Rupiah And Increasing Interest Rates Could Expose Credit Vulnerabilities

liquidity profile of most rated Indonesian banks support our view. Major economic shocks, however, could trigger downgrades. Indonesian banks are still exposed to high economic risk, in our opinion. The country's low per capita income (by international standards) limits its ability to fend off economic shocks. Infrastructure shortfalls, corruption, and rigid labor markets could also restrain economic development. We have already factored the sector's credit weaknesses into our Banking Industry Country Risk Assessment of Indonesia.
Table 1

Key Indicators Of Selected Indonesia Banks

Gross nonperforming assets/customer loans + other real estate owned (%) Net nonperforming assets/customer Total loans + other real Tier 1 capital loans/customer estate owned (%) ratio (%) deposits (%)

Return on average assets (%) Stand-alone Issuer rating credit profile PT Bank Danamon Indonesia Tbk. PT Bank Mandiri (Persero) PT Bank Negara Indonesia (Persero) Tbk. PT Bank Rakyat Indonesia (Persero) Tbk. BB/Stable/B bb

2013 2.53

2012 2.70

2013 3.34

2012 3.33

2013 0.70

2012 0.81

2013 18.22

2012 18.35

2013 138.13

2012 131.23

BB+/Stable/B

bb+

2.54

2.61

4.35

4.93

0.95

1.43

13.47

13.60

86.89

82.16

BB/Stable/B

bb-

2.53

2.23

4.55

5.29

1.64

2.08

14.68

14.83

88.18

81.82

BB+/Stable/B

bb+

3.67

3.66

3.56

3.79

0.00

-0.29

16.07

15.50

93.35

81.48

Note: 2013 data is for the first half of the year; and 2012 data is for the full year.

Table 2

Banking Industry Country Risk Assessment

Country Government support Indonesia Highly supportive BICRA group Anchor rating Group 7 bb

Economic risk factors and descriptors Economic risk Economic resilience Economic imbalances 7 Very high risk Intermediate risk

Industry risk factors and descriptors Industry risk 7

Institutional framework Very high risk Competitive dynamics Systemwide funding High risk Intermediate risk

Credit risk in the economy Very high risk

Related Criteria And Research

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Indonesia Banking Outlook 2014: A Weakening Rupiah And Increasing Interest Rates Could Expose Credit Vulnerabilities

Related Criteria
Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

Related Research
Banking Industry Country Risk Assessment: Indonesia, Sept. 19, 2013 Rising Credit Risks Could Reveal Vulnerabilities In Indonesian Banks, June 30, 2013

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