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While core inflation surprised to the upside earlier this week, registering 5.15% y/y compared with consensus expectations of 4.6% (and the first 5% plus month since June 2009), most economists still believe that Bank Indonesia (BI) will likely keep its 6.75% policy rate unchanged when it meets today given its habitual emphasis on inflation-oriented policy and price stability which, despite the aforementioned rise remains “comfortably within its 2011 target band of 4-6%” per Barclays. This is good news for equities given investors’ apparent indifference towards an ever-lingering backdrop of corruption (one oft-cited reason, interestingly, for India’s hitherto under-performance) in the name of consumer-lead high growth (BI 2011 estimate of 6.5%) and low inflation. That said, BI’s alleged counter-cyclical bend my be tested sooner rather than later, and not just because a (suddenly easing?) China may be ready to re-inflate the commodity world just in case (or because) Ben Bernanke won’t/can’t; a shrinking current account surplus (as a % of GDP) is on one hand symptomatic of a, dare we suggest it, ‘safe’ and relatively decoupled haven/engine for growth (which coincidentally is also a proxy on EM-Asian demand given that roughly one-third of exports are destined for China, Singapore and South Korea), but also of an increasingly wage and price-sticky environment that should accelerate an already chugging, self-fulfilling feedback loop of liquidity, currency appreciation and inflation expectations that will ultimately test a given central bank’s resolve to slow down the ride just as it really starts to get going. Yet as the number of high-net worth individuals is set to triple by 2015, staying ahead of the [yield] curve will require a completely new paradigm lest credit-induced bubbles begin to loom, a feat which won’t be made any easier if political and corporate crookedness is at all endemic.
FT’s Kevin Brown echoes some of the points we made regarding crude palm oil and specifically the fundamentals underlying the case for a secular bull market ahead. That said, he writes, while margins are fat at the moment for producers like Siam Darby and Golden Agri-Resources–the world’s first and second biggest listed producers respectively–given spot prices, production costs may be set to soar in the coming years as an increasing lack of plantable land in both Malaysia and Indonesia is leading to another bout of African land and resource grab–“not suprising since the Asian industry got its start by importing plants from Africa back in the 1960s”–in which development costs will increase. Nevertheless expect Siam’s talks with Cameroon (a country that has explicitly made palm oil production and research an investment priority) to ultimately succeed, while Golden Agri, fresh off its Liberian-deal last fall, will likely continue expansion as [African] governments are “eager for export revenues and jobs for unemployed workers.” But how this all factors into equity risk premiums is another matter. Meanwhile, a piece today touches on the same, broad theme, as US buy-out giant Carlyle is set to launch a $750m Africa fund, though in fairness the group’s co-founder and managing director (and former Jimmy Carter-adviser) David Rubenstein has been an African-bull for some time now. “The majority of Americans don’t pay enough attention to Africa,” one source close to Carlyle said. “It has been China that has been the catalyst for economic activity in Africa.” Rubenstein, by the way, is still long-term positive on his firm’s MENA investments, including presumably last year’s foray into Saudi Arabia.
Robust consumption (global demand has doubled over the past decade) for crude palm oil and its underlying derivative products such as cooking oil, cosmetics, toiletries, and industrial cleaning agents (i.e. all fairly demand sticky goods) led by China and India (5%/annum growth over the past four years, propelled of late by government restocking in the face of inflation-induced reserve releases, in the former and 16% y/y in the past five years for the latter, augmented partially by a lagging domestic peanut oil sector) coupled with La Nina-related, mediocre crop yields in Argentina (the third largest exporter of soybeans and the top exporter of soybean oil) and El-Nino related low yields in Malaysia (which, coupled with Indonesia, supplies roughly 90% of global palm oil production) may help sustain futures prices in the short-term. Analysts point to Singapore-listed Golden Agri-Resources, for one, as a firm that will likely continue to benefit. Barclays projected “global stocks could fall to around 4.5 weeks of consumption–the lowest level in over 30 years” and will rebound only to the degree that governments in Malaysia and Indonesia resist meddling with price controls and export restrictions (to assuage the retail sector they already control prices and subsidize VAT) and weather patterns comply (historically, “yields [should] improve in the second half of 2011 as El Nino’s lagged impact wears off and drier weather allows harvesting and transportation to return to normal operations”). To that end, ECM Libra, an investment bank, notes that an examination of atmospheric indicators such as the Southern Oscillation Index (SOI) and its inverse relationship with the monthly change in Malaysian palm oil production is positive in terms of the probability of near-term yields mean-reverting (“January saw the SOI index trending down to 19.9 from a high of 27.1; to note, the 27.1 reading was the highest La Nina reading since 1973). That said, as with many food commodities a bona fide secular bull market (as in price inflation) in palm oil may be in the making due to notable structural restraints (in addition to the aforementioned Asian demand dynamic): Malaysia’s future yield prospects relative to current ones look dim, while environmental concerns–namely a two-year moratorium on deforestation based in part on Indonesia’s bilateral treaty with Norway–may interminably hamper Indonesian output (though per Greenpeace said edict in reality has far more bark than bite).
Indonesian government bonds (INDOGB) delivered a total return of 28% in 2010 from rates (23%) and FX (5%). The front-end of the curve, however, looks especially vulnerable as Bank Indonesia’s (BI) recent 25bp rate hike looks to [finally] mark the end of a hitherto dovish monetary policy in the face of three consecutive months now of rising inflation expectations. Barclays, for one, expects headline inflation to rise to 7.5% in Q1 (the latest 7% y/y inflation in December breached the 4-6% target) “given high global food commodity prices, persistent wet weather and recent IDR weakness.” And while BI’s latest statement mentioned the additional need to “strengthen the rupiah exchange rate,” which in theory would help shore price pressure short of policy rate meddling, analysts note that “strong domestic demand means that the current account surplus will shrink in 2011 to 0.5% of GDP from 1.1% last year, providing lesser fundamental support for the rupiah.” Further complicating that dynamic is the possibility of government capitulation on fuel subsidies in March which would be inflation-positive but otherwise currency-negative; regardless, headline inflation is such that most banks are looking for three further BI rate hikes (75bp total) as well as some form of additional capital controls (likely only extending the holding period for central bank notes, or SBI to three months from one, however) and it is unclear to what extent this is already priced in.
Moreover, JP Morgan points out that the INDOGB trade “still retains a certain charm”. For one, a growing supply thanks largely to domestic banks aggressively cutting their bond portfolios in order to support credit growth can effectively be sterilized by the government’s cash surplus (recent trends have seen the government consistently deliver realized budget deficits far lower than planned ones as it undershoots on expenditure disbursals). Second, high yields coupled with a growing sense that policy tightening is now receiving deserved attention and the relative lack of onerous capital controls seen elsewhere may see offshore investors increasingly up-duration and support the long-end of the curve in an overall flattening effect. This effect will be augmented if in fact headline inflation is tamed as the year progresses; to this extent, long-end investors should eye the quality of the impending spring harvest season and the aforementioned March fuel-subsidy decision vis a vis headline inflation as well the state of underlying, core price pressures to monitor the BI’s effectiveness. Finally, consider the below “Big Mac” chart from The Economist on inflation which measures the gap between a country’s average annual rate of burger inflation and its official rate and thus implies the degree to which a given government is understating “true” inflation. Was BI right to be dovish after all?
A protracted, La Nina-related wet season cut Indonesia’s thermal coal exports (the country is the world’s largest exporter) by 15 percent in 2010 (though the overall industry’s capex was up 18% yoy, suggesting the potential for increased volume capacity), hurt output in other key producing regions such as Queensland, South Africa and Colombia and will give miners “the upper hand over the utilities in the next round of annual contracts negotiations,” as many analysts predict rising thermal coal prices against the backdrop of tightening supplies coupled with feverish and price-sticky demand from developing countries. In India and China, for instance, roughly 67% of primary energy used comes from coal (versus a developed country average of 20%). Indonesia is a bit more oil-intensive (at a tremendous subsidized cost) though the idea going ahead, per Bukit Asam, is to “burn more [coal] to make up for falling crude oil production from aging fields.” Taken together this points to a quick study of the Indonesian coal sector. ITMG, for one, looks cheap. It trades at a multiple of 10x versus the sector average of 14x and per J.P. Morgan analysts will be least affected by the state possibly implementing a price cap on domestic sales and/or the ministry level’s recent announcement of a potential export ban of coal with a calorific value (CV) less than 5,600kcal by 2014, given ITMG’s high-CV coal (6,200kcal/kg) and low-volume government sales (5% of sales). Moreover, per CIMB, “the company is strongly geared to price upside as a substantial portion of its volume (75%) is still exposed to index and spot prices.” On that note, the overall sector is priced “implying unrealistically low (thermal) coal prices of US$75-85/ton” whereas the FT writes that even conservative traders put impending contracts at about $130.
Jakarta-based PT Panin Sekuritas, whose Panin Dana Maksima fund has returned an annualized 45 percent over the past five years, noted to Bloomberg last week that inflation concerns were “overstated” and that consumption growth was “likely to hold up” in 2011 even in the face of potential rate hikes. Jakarta’s Composite index has risen roughly 42 percent this year, making it the best performer among Asia’s 10 biggest indices. Higher inflation, however, would dampen domestic spending which accounts for roughly two-thirds of output, as would a rate increase–the central bank has kept benchmark rates at a record low at 6.5 percent for 16 months, effectively underpinning demand. Headline inflation rose to 6.3% y/y in November (from 5.67 in October and exceeding the Bank’s stated target of 4-6% in 2010 and 2011) on the back of higher global food commodity prices which many analysts expect to remain elevated, at least until spring harvesting. To that extent, the current La Niña weather pattern’s heavier-than-usual rainfall may likely prove a boon to future harvests, meaning a further uptick in inflation may not necessarily force the Bank’s hand. Analysts with Barclays add that ideologically the Bank is not likely to aggressively tighten policy as it “has a bias to use liquidity management tools rather than the policy rate. This is driven by BI’s concerns that a rate hike would further widen interest rate differentials and attract additional ‘hot money’ inflows.” That said, last week’s decision by lawmakers to approve a government proposal to gradually limit the sale of subsidized fuel in 2011 will have inflationary effects not only on headline numbers, but also on “core” measures via transport related feed through. As the WSJ wrote, said reform was much needed as it will boost [the country’s] ability to finance badly needed projects to upgrade its transportation and other infrastructure, which could increase Indonesia’s attractiveness as an investment destination.” Barclays sees a 50-80bp uptick on a staggered basis, which may even be on the high end when compared with other estimates. Yet no matter what, somewhat slower growth appears in the cards and most 2011 GDP estimates have been slightly revised accordingly. Nevertheless FDI flows from China and India especially are robust on the back of manufacturing and resources, and most analysts expect a sovereign upgrade in 2011. How this translates into the yield spread, which recently hit a three-year low of 402 bp against U.S. treasuries (10-year spread) against the backdrop of the aforementioned inflation issue will be interesting.
The plight and root cause of surging physical rubber prices in Thailand (the world’s largest producer with 31% of global natural rubber output), Malaysia and Indonesia, as well as rubber futures across various exchanges, somewhat echo that of the cocoa industry in the Ivory Coast: persistent underinvestment in the past and thus a continual dependence on aging infrastructure (i.e., rubber-yielding trees planted in the 1980s and thus just beginning to enter the stage of declining yields, per Macquarie, an investment bank) and a stable-to-shrinking supply of agricultural land–is finally translating into increased volatility in quality and yield. Coupled with ever-changing weather patterns and voracious demand from emerging markets for tires, condoms and gloves–led by China, whose tire consumption according to the FT grew 57% y-o-y for 1H2010 per Pirelli–and prices are likely to stay trending upward. The cash price in Thailand gained 1.6 percent to 130 baht ($4.40) per kilogram this week, just shy of the record 130.55 baht on April 27th. Yet “prices may surge above 150 baht by the end of this year as demand remains robust while supply is limited,” said Supachai Phosu, the country’s deputy minister of agriculture and cooperatives. Chinese demand, by the way, is likely to increase its upward rate of acceleration, if for other reason than the continuation of a government subsidy for fuel-efficient cars and also the enduring prospect of further surprise rate hikes underpinning current consumption.
Interesting column about Indonesia from last week’s NYT. Aubrey Belford writes:
“Its low debt, high growth and a sense of optimism compare favorably with a mood of despondency in developed markets like the United States, Japan and Europe. The huge consumer market in the country, accounting for more than two-thirds of G.D.P., has largely been credited for maintaining growth. Although the global economic crisis crimped confidence, Indonesia’s relatively young population of 240 million and government stimulus policies, as well as a popular program of direct cash transfers to the poor, have kept consumption humming.”
While aiming to increase its FDI by almost three-fold in the next five years by in-part relaxing investment rules, the central bank is also engaged in a delicate balancing act of inviting capital inflows (its benchmark rate is 6.5 percent) while tempering potential outflows. With Japan’s 0.1 percent borrowing rate looming nearby, for instance, the negative carry is the largest in the region, per Morgan Stanley. The investment bank is in fact one of the country’s biggest cheerleaders at the moment (“Indonesia and India remain two of our long-term favourite selections,” gushed Henry H. McVey, Managing Director and Head of Global Macro and Asset Allocation for Morgan Stanley Investment Management, last month).
To that extent, per Chetan Ahya and Sumeet Kariwala, two of the firm’s economists, Indonesia has myriad similarities with India apart from the trend in macro balance sheet changes (namely, its ratio of public debt to GDP declined to 35% in 2008, from a peak of 93% in 1999). Like India, it 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. Specifically, they note:
“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.”
Following on the heels of Bank Indonesia, which set a one-month minimum holding period for investors, South Korean regulators recently set limits on banks’ currency-derivative positions. The Economist points out that far from making the country’s currency market less stable, however, South Korea’s introduction of capital controls may not only ease pressure on the Bank of Korea to keep benchmark rates low, but also could help tame a historically volatile currency. Volatility has stemmed not only from the relentless, accommodative monetary policy from the world’s largest central banks in the U.S., Japan and Europe, but also from fervent de-leveraging from local and foreign banks during the Lehman debacle and, more recently, the European debt crisis, as overseas investors pulled money en masse.
Per Businessweek, Indonesia’s rupiah and South Korea’s won were Asia’s top two performers last year, rallying 16 percent and 8 percent respectively against the dollar, but this year, the won has been the region’s biggest loser, dropping 4.9 percent to 1,216.40 per dollar as of a week ago (the rupiah had risen 2.4 percent this year to 9,167). But with the recent yuan decision coming from China (which likely had far more to do with combating inflation than any kind of Geithner-inspired capitulation), analysts are bullish won going forward, and have a further arrow in their quiver if volatility indeed proves lessened (the currency rose on the day of the news). Barclays, for instance, predicted a 2.5% appreciation in the KRW earlier this week. And to the extent that it can keep some form of its hitherto ‘highest beta in EM Asia’ status, capital controls aside, that number may ultimately prove to be on the conservative end.
Per The Economist, Indonesia is likely to remain at “the heart of an Asian coal boom” given the fact that: (i) the quality of its coal is second to none and is thus eagerly sought even by net exporters such as China; and (ii) for coastal power stations in China, India, Japan and South Korea, “it is often cheaper to import coal by sea from Indonesia than from mines in the interior.” While not environmentally optimal, coal remains plentiful and cheap, two fundamental facets behind the International Energy Agency’s (IAEA) conclusion in November that global demand for coal will increase by 1.9%/year until 2015, placing its growth among fossil fuels second only to natural gas. And absent any kind of universally enforceable carbon tax, UBS analysts note, exports to China and India will see the largest percentage increases.
Moreover, the near-term cash flows of at least some firms may also have an implicit sovereign guarantee given their explicit value, which also provides them with an alternative source of financing. For example, Bumi Resources, Indonesia’s publicly listed and biggest miner by production, became the country’s fourth dollar denominated debt issuer this year when it sold $1.9 billion worth of debt at 12% in September to China’s CIC sovereign wealth fund, which the firm used to pare debt and boost investments. And last month, Bumi announced it would seek to raise $300 million from the sale of seven-year convertible bonds at 12%. A month earlier, Adaro Indonesia, the country’s second biggest producer which, along with Bumi, says it will double capacity by 2012, issued $800m in senior notes at an annual yield of 7.625% (two points lower than when it went to the market in 2004) and maturing in 2019. Interestingly, three-quarters of demand came from U.S. and European investors. And before Adaro, Indo Integrated Energy II, a unit of PT Indika Energy, sold $230 million of seven-years at 9.75%, while PT Bukit Makmur Mandiri Utama, the country’s second biggest coal contractor, offered 11.75% for $600 million of bonds maturing in four and five years.
Analysts at the time of Adaro’s issuance noted that most Indonesian miners would need to give between 9-10% on their coupons, meaning Bumi’s 12% on its upcoming seven years seems particularly high, particularly given the notes’ possible conversion to equity and CIC’s vested interest in the firm. Per Edwin Sinaga, president director of PT Finacorporindo Nusa, a Jakarta-based brokerage firm, “Bumi was forced to offer a relatively high interest rate because investors were aware of its high level of debt.” Other analysts have questioned whether Bumi has the assets remaining to properly secure further debt. Markets reacted poorly to the announcement of further debt, and Bumi remains below its 52-week high established in September. Going forward, it will be interesting to see if the market is properly pricing Bumi’s questionable capital structure.
JGW
Frontier Markets 