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Indonesia's COVID-19 Struggle


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Indonesia's COVID-19 Struggle

(Editor's Note: This cross-practice report includes views expressed by our Asia-Pacific economics team. While these can help to inform the ratings process, sovereign and other ratings are based on the decisions of ratings committees, exercising their analytical judgment in accordance with publicly available ratings criteria. This report does not constitute a rating action.)

A COVID-19 resurgence is exacerbating downside pressures for Indonesia's economy and credit conditions. S&P Global Ratings believes a delayed economic recovery will drag on revenue for banks, most corporate sectors, and the government budget. Existing credit buffers on ratings will be chipped away if ongoing lockdowns are prolonged.

In our view, recently reinstated national movement restrictions may be lifted in a month. However, the degree of uncertainty is high, given extremely contagious variants (such as Delta), limited vaccine coverage in the population, and vaccine shortages.

A favorable external setting is offsetting some of the domestic pain. Strong goods exports through most of the first-half of 2021, higher commodity prices, and more positive demand conditions will help limit economic and revenue fallout.

Meanwhile, selective extension of credit by both banks and capital markets to Indonesian corporates means refinancing conditions will remain tight. This and the slower recovery could widen divergence in credit quality among Indonesian corporates. Mobility-sensitive sectors such as retail, cyclical transportation, and tourism could see problems compounding.

The COVID resurgence could derail financial institutions' recovery and higher restructured loans could emerge. Although profit margins remain resilient, the big test on asset quality will come when regulatory forbearance measures are withdrawn in early 2022.

Macroeconomic Outlook: 2021 Growth Forecast Revised To 3.4%

The recent escalation in the pandemic is weighing on Indonesia's economic recovery. This COVID-19 wave is more severe than earlier outbreaks in the country and could have material implications on the operating capacity of the economy due to mitigation measures and voluntary social distancing. We lower our economic forecast for 2021 to 3.4% from 4.4% earlier, while 2022 growth will be higher on base effects at 5.6% from 5.2% earlier. Our downside forecast for 2021 is 2.3%, under a more onerous set of assumptions.

Chart 1


We expect Indonesia to stick with a targeted approach to lockdowns and other pandemic management. This approach over 2020 allowed spending and production to hold up well relative to other markets in the region, mostly due to limited fallout in mobility.

Chart 2


Under our new baseline, we assume mobility declines to be about 30% below normal and that lockdown measures introduced on July 3 will be in place for a month. This decline is comparable with levels seen one month after peak lockdown last year. Mobility then recovers gradually to 5% below normal by end-October. Nonetheless, the severity and the speed of the current wave heightens policy uncertainty. In our downside scenario, mobility declines to about 30% below normal for two months and recovers more slowly to 5% below normal by end-January 2022.

We see both our baseline and downside scenarios as translating into a shock on private demand. That said, we also assume that lockdowns this year will be about half as costly as last year's. This is based on the experience of other second-wave economies that adapted to mobility restrictions.

Because several global economies are recovering, Indonesia's exports will be more resilient. Meanwhile, falling domestic demand will lead to a drop in imports, so net exports will provide some cushion for growth. We also assume moderate additional monetary easing that won't be reversed until 2022.

The fresh downturn will exact larger medium-run costs. By the end of 2023, output will be 1% lower than our previous baseline, and more than 2% lower in the downside scenario. The private demand shock hurts the labor market, which will lead to weakness in household balance sheets. These balance sheet costs on both firms and households will take time to repair.

Sovereign: Delayed Recovery Will Widen Deficits

A weaker economic recovery will weigh on the government's fiscal performance this year. This could stymie the pace of fiscal consolidation heading into 2022, depending on the severity of the deceleration. As a result of weaker economic conditions amid the severe virus outbreak, we forecast the general government's deficit at 6.0% of GDP in 2021, versus the government's budgeted 5.7% shortfall. The higher deficit this year will largely be the result of a weaker revenue recovery than previously anticipated.

Under our new base case, we do not envisage a significant impact on Indonesia's medium-term fiscal framework, which is critical for the sovereign ratings at the current level (BBB/Negative/A-2). Although Finance Minister Sri Mulyani has indicated that the government may program in a 2022 fiscal deficit near the top end of its range, at around 4.8% of GDP, officials have also maintained their intention to slash the deficit beginning in 2023.

Reining in the deficit to 3% of GDP or below from 2023 onward will nevertheless be challenging, in our view, and highly dependent upon the economy's recovery pace over 2022-2024. While the government has mooted additional revenue generating measures that would support a faster pace of deficit consolidation, it will be difficult to implement these until the recovery is on a much stronger footing.

Interest burden would get heavier under our downside scenario

Indonesia's sovereign rating would face more downward pressure if the economic recovery stalls such that the government's fiscal position worsens beyond our current base case projections. A more protracted downturn would further stretch Indonesia's fiscal position.

Higher deficits and a lower revenue base would place additional pressure on Indonesia's interest burden and debt metrics, which are weaker than they were prior to the pandemic. If Indonesia's growth slowed to 2.3% in 2021 (our downside estimate), the general government shortfall may rise to 6.3% of GDP this year and finish the next at 4.7%. The higher 2022 deficit would be driven by a lower existing revenue base established this year, as well as the slower economic recovery next year. These higher near-term deficits would make future consolidation more difficult, because the government could be wary of undermining the nascent recovery by withdrawing fiscal support too quickly.

Exports buffer domestic difficulties

Indonesia's current account receipts have bucked the domestic trend so far this year, benefiting from higher commodity prices and generally stronger demand conditions in the global economy. Goods exports from January through April were 26.3% higher than in the corresponding period in 2020. Should this trend continue, it would help to stabilize Indonesia's external position, potentially leading to a faster decline in the ratio of its net external indebtedness compared to its current account receipts.

While there is some risk that a more prolonged national COVID outbreak would disrupt the production of goods for export, we believe that external demand conditions and commodity prices will be more important determinants of Indonesia's trade performance over the next two to three years. Should these improvements to Indonesia's external settings come to fruition over this period of time, this would help to offset the impact of a more prolonged fiscal recovery on Indonesia's overall sovereign credit profile.

Corporates: Credit Quality Is Still Far From Stabilizing

A slower pace of economic expansion will drag on the recovery of Indonesia's corporate sector. Nearly 40% of outstanding ratings on rated nonfinancial entities remain on negative outlook or CreditWatch with negative implications as of July 12, 2021. While lower GDP growth will compound the corporate sector's troubles, we do not expect resultant credit metrics to deteriorate to such an extent as to warrant widespread and immediate rating actions.

The nearly 40% proportion is off the highs of about 50% seen at the end of 2020 but it has been above 35% since late 2019 and remains above the 20% average of the past five years (see chart 3).

Our ratings and outlook distribution had assumed further downside in credit quality for the rest of 2021 despite a gradual recovery in macroeconomic conditions at the beginning of the year.

Chart 3


Of our public ratings on Indonesian companies (excluding government-related entities), about 50% are at the 'B' rating level and below. At this rating level, liquidity and access to funding (rather than operating performance or broader macroeconomic considerations) are the overriding credit considerations.

Thinning liquidity and refinancing risk also explain the negative outlooks for a little over half of the outstanding corporate ratings on negative outlook and more than two-thirds for private companies. Banks and capital markets are likely to stay selective in extending credit, with shortening windows for weaker issuers seeking to tap U.S.-dollar bond markets. Negative headlines on Indonesia's economic performance and the prospects of extended lockdowns will further complicate refinancing.

The negative outlook on our Indonesia sovereign rating is the main driver of the negative outlook on rated Indonesian government-related entities.

Beyond the rated corporate sector, our lower GDP growth for 2021 is likely to interrupt slowly improving revenue and profit growth observed in real estate and consumer products. Mobility-related, confidence-sensitive, and working-capital intensive sectors (e.g., retail, consumer, real estate, cyclical transportation, tourism, lodging and entertainment, construction, and light manufacturing) are likely to be hardest hit by extended lockdowns. Non-discretionary consumer products, food retail, telecommunications and electricity production are more resilient sectors.

Indonesia Inc.'s credit situation contrasts with the gradually stabilizing trend elsewhere in Asia Pacific, especially in China. The proportion of entities on negative outlook or Credit Watch negative was about 18% in Asia Pacific, about half as low as Indonesia's.

Infrastructure: Utilities And Transportation Infra Are Less Exposed

Power utilities:  We estimate power demand growth for power will be no more than 5% in 2021, or lower in the downside economic scenario. A high dependence on subsidies and likely lower capital expenditure (capex) should protect the credit profile of the utilities. Ongoing economic softness may result in continuing hesitation in increasing tariffs, making timely subsidy payments crucial for cash flow of regulated utilities like Perusahaan Perseroan (Persero) PT Perusahaan Listrik Negara (PLN).

Indonesia's power demand was resilient in 2020 despite COVID restrictions, with only a 1% fall. A nearly 8% increase in residential demand offset an almost equal fall in business (commercial) and industrial sectors. We believe tighter restrictions on mobility may result in similar trends in 2021, with stronger residential demand. See chart 4 for power demand trends from 2018-2020.

Chart 4


Ports:  Even in a downside scenario, port sector volumes will likely show positive growth, though full recovery will be delayed to 2022. Low and improving leverage and the ability to delay capex provide ample headroom to withstand some cash flow weakness. The rated port sector has an average ratio of debt to EBITDA of 3x-4x. The sector perennially underspends on capex, with Indonesian rupiah (IDR) 3 trillion spent in each of the past two years (against company targets of IDR5 trillion-IDR6 trillion per year). The port sector has shown resilience worldwide with global volumes exceeding our expectations thus far in 2021.

We believe the Indonesian government's plan for the consolidation of the maritime sector, and its resulting form and capital structure, will be a bigger determinant of credit profile than temporary growth shocks.

Financial Institutions: Higher Restructured Loans Are Likely

Our negative outlook on the banking sector reflects continued downside pressure on banks' asset quality. Restructured loans grew to about 18% of total loans in 2020 and could inch up this year due to COVID escalation. Regulatory forbearance allowing restructured loans to be classified as performing until end-March 2022 will mitigate immediate damage to bank financials. We anticipate reported nonperforming loans (NPLs) will remain range-bound at 3%-3.5% in 2021.

Underlying deterioration in asset quality could become more apparent in 2022 after the expiry of regulatory relaxation. We estimate that 10%-15% of restructured loans are vulnerable, which could translate to a 1.5-3 percentage point increase in NPLs. The recent resurgence in COVID could further weaken asset quality and push the migration of weak loans to NPLs toward the higher end of the range.

Table 1

Restructured Loans Could Rise To 25% Of The Total
2019 2020 2021f Comments
(Previous base case) (Revised base case) (Downside scenario)
Real GDP, year-on-year change (%) 5.0 2.1 4.4 3.4 2.3 Indonesia banks will be laggards and recover to pre-pandemic level of performance by 2023.
Nonperforming loans* (% of gross loans) 2.5 3.1 3.0-3.5 3.0-3.5 3.0-4.0 We are expecting only a modest increase in reported NPL due to regulatory forbearance which lasts until March 2022. Our downside scenario assumes severely distressed borrowers that cannot be saved or restructured.
Restructured loans (% of gross loans) 5* 18.0 15-20 15-22 18-25 Prolonged pain likely for vulnerable SME segments, particularly the retail-orientated ones which are dependent on mobility and foot traffic.
Credit cost§ (as a % of gross loans) 1.8 3.2 2.5-3.0 2.5-3.0 2.8-3.2 Provisioning costs to remain elevated, but unlikely to reach peak levels seen in the 2020 recession. Banks have been making pre-emptive provisioning with average coverage increasing to 220% in 2020 from 148% in 2019, reducing the need for further large outsized provisioning.
*Average of 10 largest Indonesia banks. §Average of rated Indonesia banks. F--Forecast. SME--Small and midsize enterprises. Source: S&P Global Ratings estimates, banks disclosures.

Ratings on Indonesian banks continue to be underpinned by strong capital and provisioning buffers.   Capital and provisioning buffers built up over the years should support Indonesian banks through the economic downturn. The banks' average Tier-1 capital ratio of 22.2% and capital adequacy ratio of 24.0%, as of March 2021, were among the highest in the region. Internal capital generation should support capital positions despite a likely decline in net profit, offset by muted loan growth which we forecast at 0%-3% in 2021 (versus a contraction of 2.4% in 2020).

Selective lending.   We expect banks to remain cautious and selective in granting loans and extending working capital lines. The recovery in revenues and profit in Indonesia's corporate sector will be uneven heading into the second half of 2021. We are observing accelerating marketing sales at real estate developers and strengthening profits at most commodity producers. At the same time, operations remain tough in the consumer discretionary and retail sectors, which are dependent on consumer confidence.

Profitability will be suppressed, reaching pre-COVID levels only after 2023.   The combination of low loan growth and elevated credit costs may crimp the revenues of Indonesia banks until after 2023. Interest margins will also be constrained by multiple policy rate cuts and interest rate discounts given to debtors. We forecast return on assets will decline to 2% in 2022, versus a pre-COVID average of 2.5%. Even so, Indonesia banks will continue to rank among the most profitable in the region by a considerable margin.

Editing: Cathy Holcombe

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This report does not constitute a rating action.

Primary Credit Analyst:Eunice Tan, Hong Kong + 852 2533 3553;
Economics:Vishrut Rana, Singapore + 65 6216 1008;
Sovereigns:Andrew Wood, Singapore + 65 6239 6315;
Corporate:Xavier Jean, Singapore + 65 6239 6346;
Infrastructure:Abhishek Dangra, FRM, Singapore + 65 6216 1121;
Financial Institutions:Ivan Tan, Singapore + 65 6239 6335;
Additional Contacts:Shaun Roache, Singapore (65) 6597-6137;
Geeta Chugh, Mumbai + 912233421910;
Christine Ip, Hong Kong + 852 2532-8097;

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