Episode 5: Indonesia: infrastructure and interconnectivity

Gareth Leather is an Asia economist at Capital Economics. Leather joined Capital Economics in July 2011 as a member of the emerging Asia team. Leather has been covering Asian economies for over 10 years, most recently at the Economist Intelligence Unit where he worked for five years as a senior economist. Leather holds an economics undergraduate degree from Warwick University, and a master’s degree in Asian Studies from the School of Oriental and African Studies.

Josef Pilger

Global pension and retirement leader, EY

Josef Pilger leads EY’s global pension and retirement business working across EY’s financial services and government and public sector practice. He is passionate about building better stakeholder and retirement outcomes by improving governance, strategy, investments, growth, engagement and policy transformation. Working across 30 countries with pension and financial services boards, executives, governments and policy makers, he learned to navigate unchartered waters. As previous pension trustee and working with boards in several countries Pilger learned the importance of purpose, good governance, a members’ best interest culture as well as rigorous risk and conflict management and fit for purpose oversight to deliver predictable outcomes. He has come full circle on investments. Successfully building, evolving and governing growing direct investment portfolios across different regions, countries, asset categories and themes became his passion again as it maximizes retirement assets as ultimate member outcome.

Text transcript

[Yaelle]: Hello, my name is Yaelle Gang and I’m the editor of Canadian Investment Review.

[Martha]: And I’m Martha Porado, associate editor of Canadian Investment Review and Benefits Canada.

[Yaelle]: Thanks for joining us for Pension Passport, where we’ll connect with investment experts from around the world to zero in on different countries and explore their economies, investment opportunities and risks for pension plans.

[Martha]: In this episode we’ll be exploring the Indonesian economy.

[Yaelle]: Indonesia is the largest economy in Southeast Asia and has seen impressive growth since the Asian financial crisis. In fact, GDP per capita has risen by 70 per cent in the past two decades and according to the World Bank, Indonesia’s economic outlook is positive, with domestic demand being a major driver of growth.

The FTSE Russell classifies Indonesia as a secondary emerging market, whereas MSCI puts it at emerging market status.

Now enough facts from me, let’s hear from the experts.

Please join me in welcoming Gareth Leather, Asia Economist from Capital Economics. Gareth joined Capital Economics in July 2011 as a member of the emerging Asia team. Gareth has been covering Asian economies for over 10 years, most recently at the Economist Intelligence Unit, where he worked for five years as a senior economist. Gareth holds an economics undergraduate degree from Warwick University and a Master’s degree in Asian studies from the School of Oriental and African studies. Welcome Gareth, where are you calling in from today?

[Gareth]: We’re based in London.

[Yaelle]: Great, thank you. So to get started, Indonesia as the fourth most populous country in the world, just held a general election. What happened in the election and what does it mean for the country? Can you give us a bit of background on Indonesia’s political history?

[Gareth]: Yes, so, Indonesia’s now a relatively established democracy. Over the past 20 years they’ve held a number of general elections, each of which has passed relatively smoothly and I think this is quite an encouraging trend especially given what’s been happening elsewhere in the region where you’ve been seeing a backsliding kind of towards a strong man rule especially in the Philippines but also in Thailand.

So I think from that aspect it’s a quite encouraging recent development in Indonesia.

In terms of the most recent election, what we saw was the re-election of Joko Widodo for a second and final five-year term. His comfortable margin of victory, he beat Subianto Prabowo by about 10 percentage points suggests that voters are broadly happy with him and the progress that’s been made and reform over the past few years. But I think the big difference between now and five years ago was investors, I think, would risk getting a little bit carried away in what he might achieve- expectations are now much more realistic and I think probably what we’ll see over the next few years is further progress in infrastructure and steps to reduce red tape. But I don’t think his presidency is likely to be the kind of transformative kind that I think some people at least were hoping five years ago.

[Martha]: And how would you describe Indonesia’s economy relative to others in Asia and more globally?

[Gareth]: Yes sure, so it’s the fifth biggest economy in the region – over a trillion dollars just a little bit behind South Korea. The big size is largely due to the fact that it’s got a big population of over two hundred million people. That’s actually relatively poor. It’s got a GDP per head of just three thousand U.S. dollars, which makes it one of the least developed countries in the region.

[Yaelle]: And, so what are some of the most important risks for foreign investors to keep in mind about the country?

[Gareth]: Yes, so the economy’s actually performed reasonably well over the past few years, growing at around five per cent or so. However the decent performance of the economy has met some large vulnerabilities and the main one of these is the big and expanding current and trade account deficit. And what that means is it makes the currency, the rupiah, quite vulnerable to sudden shifts in global risk appetite.

The other concern is, of course, the relatively high level of foreign currency debt in the country, which is the equivalent of about 30 per cent of GDP. And so that means the country is very vulnerable to sudden sharp falls in the currency and this is continues to kind of weigh on the concerns of policy-makers. So for example, last year the central bank hiked interest rates six times to support the currency, which was weakening against the U.S. dollar and now that I think is the key vulnerability that investors need to be aware of.

[Martha]: And are there areas investment-wise such as infrastructure for example where Indonesia has a lot of room to grow?

[Gareth]: Yes, so I think there’s two areas really that Indonesia needs to focus on over the coming years. One of these as you mentioned is infrastructure – that relative to other parts of the region it has got quite poor level of infrastructure. It takes quite a long time to transport goods by sea, the roads are always clogged up and this is the big criticism that foreign investors have of Indonesia. Now fortunately, the government’s been making some decent progress on this. Since Joko Widodo was elected in 2014, infrastructure spending has been increasing by double digit rates each year and it obviously it’s got a long way to go but if that trend continues then it’s quite encouraging.

I think related to that as well is the potential for Indonesia’s manufacturing sector. As the trade war between China and the U.S. has heated up, it’s led to or certainty kind of, were lots of reports about countries leaving China, looking for countries to escape the tariffs. And one of the countries, which is doing quite well out of this is Vietnam, but there’s no reason really why Indonesia, with its relatively low labour costs, large and expanding workforce, couldn’t also benefit.

I think there’s a couple of things though that Indonesia needs to get right if it is to benefit from this. One of these is the infrastructure. As I mentioned earlier there are some encouraging signs that progress is being made in the right direction. The other is the labour market. It’s very inflexible and in particular, it’s very expensive to hire workers. Now because it’s expensive to hire workers, companies are wary of hiring them in the first place, which means that manufacturing has struggled in recent years to really establish itself.

[Yaelle]: Thank you. So what are some of the challenges for investors who may be looking to the Indonesian market?

[Gareth]: Yeah, so I think the big challenge in addition to infrastructure and labour market reform, which I already mentioned, is red tape. Now there has been some encouraging progress here over the past few years. The steps have been taken to make it easier for foreign companies to open up businesses and get access to the electricity grid and so on.

But Indonesia still performs really quite poorly on a lot of these measures especially relative to other parts of the region. So I think any progress that could be made here will be quite encouraging but it’s certainly a big concern for foreign investors that are looking to establish operations in Indonesia.

[Yaelle]: Wonderful, thank you so much.

I’d now like to introduce Josef Pilger, he joins us from EY and is calling in from Australia. Welcome Josef.

[Josef]: Good evening.

[Yaelle]: Good evening. So I’d like to start by asking about how you’d characterize Indonesia’s growth potential. Where’s the country likely to be in 10 years? And what is likely to drive that growth?

[Josef]: Let me start with one probably bold statement. I think we need to disrupt our own views about Indonesia. When we think about Indonesia we think about the old Indonesia as a third world country. But now it’s the third largest democracy globally. It’s the 16th largest economy globally, with a GDP of more than a trillion dollars already. It’s almost as big as Australia. Almost, almost as big as Canada. And it will be in five years’ time from now it’s expected to be bigger than Canada.

Indonesia is part of what economists call the MINT countries – so Mexico, Indonesia, Nigeria and Thailand and it’s expected to be the next wave of strategic growth. The country is on a strategic and systematic path to evolve and become the fifth largest economy globally with a very, very simple aspiration. It wants to evolve into the creative economy. It’s already amongst the top five investment destinations amongst emerging markets. When you look a little bit beyond that, the growth is essentially driven by three components.

One is macroeconomic stability. The second one is commodity prices and the third one is domestic demand. Domestic demand is an important one when you think about it that this country already has 270 million people, it’s expected to continue to grow to about 300, 320 million people. But it also does have a couple of strategic advantages: a young population, more than 60 per cent of people are between 16 and 35 years old, making it about roughly an average age of about 28.

I think Canada has an average age of, give or take, 41 years. So this is a demographic dividend already that you can see.

But, also a couple of other elements to wrap up. It does have a lot of different resources and has benefitted from a resource boom and ranging from aspects such as gold and oil to what we probably know around the world and most of us use frequently- palm oil.

But it has become a low middle-income country. It’s no longer in our old-world definition an emerging country. And when you look at the economy a little bit more closely it’s already a diversified economy. It’s not an agricultural economy anymore. Forty-three per cent of the economy is service-driven. And last but not least, it also benefits tremendously because it’s a country driven by 1,700, give or take, different islands. It’s tremendously driven by connectivity – interconnectivity that’s been built through infrastructure and other elements.

[Martha]: Okay, that’s a fantastic overview. So given that emerging markets typically pose a number of challenges for investors, one of which is usually access, are there issues with access to Indonesia and how does that play out?

[Josef]: I think the country has been trying to make tremendous progress on the World Bank index of easy of doing business with. So before 2016, it wasn’t even amongst the top 100. But it has dramatically increased its sophistication – moved from 91st place to 72nd place in terms of easy to do business with. But what they still create is, it still creates a certain amount of legacy – a legacy in terms of corruption, a legacy in terms of government bureaucracy and also a legacy of missing infrastructure. So a big element of strategic access is infrastructure- but also when you look at the . . . in a normal investment sense, many organizations look at aspects such as political track record- the country has tremendous progress made over the last decade or so but they still are a certain amount of political bias that we all have towards the country.

Currency is another aspect that often creates a limitation or barrier because who around the world does have a ten or twenty-year horizon or perspective of how the Indonesian rupiah is going to develop? Not many organizations really see that and have that expertise. But lastly, and most importantly, is our own biases and legacies that we all have and the lack of track record that the country has.

So those are a variety of different explicit barriers and implicit barriers. And those implicit barriers as I mentioned are in our minds and our own biases where we still see Indonesia as an emerging market.

[Yaelle]: Thank you. So you just spoke about infrastructure and an earlier guest spoke about that as well. What specific opportunities for investment exist in the area of infrastructure?

[Josef]: Let me start from a pretty high level. The country has developed some pretty good internal capabilities to deal with infrastructure and has done a lot of infrastructure investment itself. But just to give you some very, very hard facts – the next plan between 2020 and 2024 is a need for about $441 billion in infrastructure. And the largest demands essentially reside around two aspects: 56 per cent is focused on power – the generation of power for the large population. And the second largest is 32 per cent is focused on transport. You remember I said earlier the country has 1,700 islands – so a huge need to overcome this regional spread is focused connectivity – creating that connectivity. But really boiling it down a little bit more clearly: just for 2019 the goal is to create more than 1,000 km of toll road. The country wants to create 10 new integrated tourism areas. For people on this side of the world, our valley is our second home for vacation, so they want to create another ten of these destinations or another 15 new airports or 25 new seaports. So a tremendous amount of infrastructure aspects. And on top of that, of course, the social infrastructure- things like hospitals and schools.

[Martha]: Okay, and looking at a couple of other asset classes, are there opportunities that you would highlight in private equity or debt?

[Josef]: I would say yes and no and let me give you a little bit of colour towards my answer. The economic growth of the country in itself obviously provides opportunities in other asset classes as well. But when you look at the capital market itself, the capital markets and the sophistication is modest, but on the other hand, the country has about 124 million in corporate companies and the large variety of small and medium-sized enterprises is concentrated on about 120 state-owned enterprises and has done very limited amount of privatization and listings.

So in a way, what we’re seeing increasingly, the focus through infrastructure growth has gone through the state-owned enterprise and the government as a majority. So in a way there are existing new opportunities with regards to partnerships with those state-owned enterprises. But also thinking about these organizations have loaded on a lot of debt on infrastructure. So being able to think about debt investments, thinking about other opportunities to work in aspects such as asset recycling. So really focusing on infrastructure investments and other investments that have been made earlier and using them as private equity structures or debt structures. But in a nutshell the answer is yes, there are tremendous opportunities on the back of it, but they’re probably still lagging behind a little bit due to the lower capital market maturity.

[Yaelle]: Thanks, so with that mixed bag in mind, what would be your biggest piece of advice for a pension plan considering allocating to Indonesia?

[Josef]: I think, let me frame that a little bit simplistically. To me, Indonesia is too big to ignore. If you follow the logic that the country’s going to be the fourth or fifth largest economy in the world – so bigger than a country like France, about the direction of a country like the U.K. or Germany, then to me it’s too big to ignore. And when I personally relay that back to countries like Canada or Australian pension plans who have generated a tremendous amount of benefits for their members and for the country by investing in alternative assets and leveraging their patient capital, I think to me the aspect is it’s too big to ignore as an intergenerational investor. But what is required is a number of very simple aspects. And to me let me point out four or five points.

Number one, being clear about the objectives and your evolution path. It is still a country that is, as you described a mixed bag, offers tremendous opportunities and if I think about that the country needs $1.7 trillion in the next decade in infrastructure investment, this is likely to pay off and pay off big. But it needs to be clear as to what is your objective in this country? Is it a growth play? Is it a strategic growth play? Or is this a revenue play and a return play now? And probably the answer is it’s a strategic growth play. But really being able to be clear about the objectives and the evolution path. As the country evolves what is your play in that country and how do you evolve it as well?

The second part to me is quite often quite important and where many organizations make big mistakes. And that is developing adequate internal capabilities to manage both the risk and the opportunities. And when I personally reflect back on a global pension study that we did last year for asset owners, a big, big, big, big gap is people going into some of these countries either by desire or by finding new opportunities and being pushed there, without necessarily building those internal capabilities.

And those capabilities also need to cascade up to board and executive level – really being able to measure adequately. And then the third aspect for me is going wide open with your eyes and really being able to leverage the existing risk mitigation mechanisms. And what I mean by that is a country like Indonesia has done a tremendous amount of progress working with multilateral development banks, for example, to work on reasonably unique guarantees to overcome some of those barriers that we articulated. But to me I think the last point is, when I reflect back on how many of the leading Canadian or Australian pension plans have really entered similar countries in the past, it’s very often worked with other creative partnerships or collaboration models with local firms in entering those existing markets.

And I think the reason why to me this is quite important is really being able to navigate the current barriers, better being able to influence where the country’s going and maybe even accelerate some of those policy reforms and changes to overcome and overcome these first and being able to build their confidence and being able to shape some of those outcomes.

[Yaelle]: Wonderful Josef, thank you so much for joining us and for sharing some of your thoughts.

[Martha]: Before we head out, here’s a quick spotlight of what a Canadian pension fund is doing in Indonesia. In 2017, the Canada Pension Plan Investment Board entered an agreement to invest alongside Ivanhoe Cambridge with real estate logistics specialist Logos in the Logos Indonesia logistics venture, focused on developing and acquiring modern logistics facilities in Indonesia. The CPPIB announced it would initially commit $100 million U.S. in equity for an approximate 48 per cent stake in the logistics venture.

[Yaelle]: Thanks Martha and thank you listeners for exploring Indonesia with us here on Canadian Investment Review’s Pension Passport. Don’t forget to tune into our next episode which is available on www.investmentreview.com/podcasts. Thank you.

[Martha]: That’s all for now and as they say in Indonesian, Selamat Tinggal.