Moody s Baa3 / S&P BB+ / Fitch BBB- 1 Economy: Agriculture 14%, Industry 41%, Services 45%

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1 Indonesia Summary Moody s Baa3 / S&P BB+ / Fitch BBB- 1 Economy: Agriculture 14%, Industry 41%, Services 45% Indonesia s economy is the largest in Southeast Asia, and the country has strong growth potential given its size and abundant natural resources. Years of high growth have led to a tripling of GDP in US dollar terms during the past decade. Public finances are solid, with small fiscal deficits, low public debt levels, and manageable financing needs. The external side has improved with a low current account deficit, comfortable levels of foreign reserves, and a more flexible exchange rate. The 2014 elections, which proceeded peacefully and fairly, consolidated political stability, although Indonesian institutions remain weak, with endemic corruption. Relative to other large emerging markets countries such as Brazil and Turkey, Indonesia s political conditions are currently more stable, and President Joko Widodo is gradually moving forward with important economic reforms. The focus of attention in the medium term is the 2019 presidential election. Mr. Widodo is the favorite to win, however, a tight race might result in a slower pace or partial reversal of recent market-friendly reforms. Economic Indicators F 2018F Population (Millions) GDP per Capita (USD) 3,688 3,533 3,373 3,614 3,584 3,594 Nominal GDP (USD Billions) Real GDP (%) Year-End CPI (%) Fiscal Balance (% of GDP) Interest (% of Revenues) FC Debt/Public Debt (%) Government Debt (% of GDP) Government Debt (% of Revenue) Current Account (% of GDP) FDI (% of GDP) External Debt (% of GDP) Foreign Reserves/External Debt (%) Foreign Reserves (Mo. of imports) Foreign Reserves (% of GDP) As of November Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Lazard, Haver Analytics, IMF, Indonesian Central Bank 39

2 Lazard Emerging Markets Debt Rating History Following is a history of the country s foreign and local currency ratings by the major agencies dating back to 2000, demonstrating the country s improvement in fundamentals. We have also included the spread history for the country s hard-currency external debt against the JP Morgan Emerging Markets Bond Index Global Diversified and the local yield against the JP Morgan Global Bond Index Emerging Markets. Rating History Hard Currency Local Currency BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC BBB BBB- BB+ BB BB- B+ B B- CCC Moody s S&P Fitch Moody s S&P Fitch As of December Performance represents past performance. Past performance is not a reliable indicator of future results. Source: Bloomberg, Fitch, Moody s, Standard and Poor s Bond Spreads 1200 Local Yield Indonesia 2010 EMBIGD Indonesia 2010 GBI-EM Global Div As of December Performance represents past performance. Past performance is not a reliable indicator of future results. Source: JP Morgan 40

3 Indonesia Strengths Large, Diversified, and Resilient Economy Indonesia maintains promising growth prospects after years of high growth. The country is Southeast Asia s largest and most closed economy; trade equals 45% of GDP, a factor that makes it less sensitive to global conditions. Growth has averaged 5.6% over the past 15 years, both before and after the global financial crisis, with some of the lowest volatility in emerging markets. It is expected to continue posting similar growth in the years to come with the International Monetary Fund expecting growth to average 5.4% from 2018 to Domestic consumption from a large population and favorable demographics will continue to be key drivers of growth. Other big drivers include investment and a diversified export base. In the medium to long term, high investment and low GDP per capita should continue supporting Indonesia s growth. A savings rate higher than 30% of GDP, versus 20% on average for emerging markets, has enabled the country to respond to shocks and grow without generating excessive imbalances. The resilience of Indonesia s economy was evident during the global financial crisis Indonesia was the only economy in the G20 that recorded positive growth in 2009 at 4.7% as well as during the more recent bout of emerging markets growth deceleration. Solid Public Finances and Low Debt Levels Indonesia s public finances are another key strength and have improved significantly over the past decade. This gives the country an enviable fiscal position despite the recent widening of fiscal deficits. Strong economic growth and low fiscal deficits resulted in a dramatic decline in the public debt burden until 2012, and debt levels have registered only a mild increase since. Public debt is expected to come in at around 31% of GDP in, about one-third of the post-asian crisis ratio of 100% in The government also made major improvements in the quality of expenditures by reducing subsidies, which peaked at close to 6% of GDP in 2008, giving more room to increase infrastructure spending that is urgently needed. On the revenue side, the government surprised the market on the upside with a tax-amnesty program that started in mid-july 2016 and ended in March. Additionally, investment expenditures have recently been below the government s targets. A major anchor for fiscal responsibility is a constitutional limit on the fiscal deficit set at 3% of GDP. 3 The fiscal deficit is estimated to be 2.7% of GDP and the government is targeting a deficit of 2.2% or Political Stability Indonesia is among the most diverse countries in the world, with around 300 different ethnic groups and languages. 4 It is also a young democracy, where the first direct presidential elections occurred in 2004; there was military rule for most of the previous 30 years. There are still demands for independence in some provinces, where secessionists have been encouraged by East Timor s 1999 success in breaking away. Considering these factors, and the presence of militant Islamist groups, the country is remarkably stable politically. Indonesia held parliamentary elections in April 2016, and a new president was elected in July Former Governor of Jakarta Joko Widodo, affiliated with the Indonesian Democratic Party (PDI- P), an opposition group running on an anti-corruption campaign, won. Widodo is making progress in reforming the economy, for example removing fuel subsidies and increasing the tax base. However, the 2016 Jakarta gubernatorial election, which saw a Muslim candidate unseat the heavily favored Christian incumbent, could represent a test of religious and ethnic tolerance, forcing the government to lose focus on market-friendly reforms. 41

4 Lazard Emerging Markets Debt Weaknesses Fragile External Balance Indonesia experienced a large reversal of its current account position since the pre-financial crisis period but it has finally showed signs of improving. The current account balance shifted from a 2.4% surplus at the end of 2007 to a 3.1% deficit in The deterioration was largely driven by a drop in exports. The deficit has improved in recent years and is projected to be 1.8% at the end of. External debt as a share of GDP is low at around 35%, but as a share of exports of goods and services, it has reached nearly 185%. Weak Infrastructure Indonesia has significant infrastructure limitations. It is ranked 81st out of 142 countries in terms of infrastructure by the World Economic Forum (WEF). The quality of roads, ports, and electricity supply is low. Public investment is among the lowest in the region at around 3% of GDP, one-third that of Malaysia and India. 5 Part of this is due to poor budget execution. Rapid investment growth seen in recent years has been driven by the commodity sector, but investment in public infrastructure remains poor although improving. Corruption Corruption is another major issue in Indonesia, with the country ranking in the bottom third of most indices and the majority of Indonesians reporting rampant corruption among police, the judiciary, and political parties. 6 Owing to these factors and a relatively inflexible labor market, Indonesia ranks poorly in ease of doing business indicators, near the bottom in areas such as starting a business and enforcing contracts. 7 Monetary and Exchange Rate Policy Inflation/Monetary Policy Bank Indonesia (BI), Indonesia s Central Bank, has a single mandate: to maintain rupiah stability. This single objective in practice has two aspects: maintain price stability (the inflation mandate) and contain exchange-rate volatility. BI operates under an inflation-targeting framework. The inflation target range for 2015 was set at 4.0% ±1%, measured as an average over the calendar year. The target range will decline to 3.5% ±1% in 2018 and 2019 and 3.0% ±1% in 2020 and beyond. In addition to the monetary-policy objectives, BI is also tasked with maintaining financial stability. Policy decisions are carried out by the Board of Governors, consisting of the governor, senior deputy governor, and four deputy governors. All board members are appointed for a five-year term and cannot be removed unless they resign or under certain special circumstances (i.e., permanently incapacitated, convicted of a felony, declared bankrupt, absent for three consecutive months without reasonable cause, etc.). The members of the board of governors can serve no more than two consecutive terms in the same position. BI has several tools to implement monetary policy. During 2016, BI switched from the BI reference rate to the 7-day reverse repurchase (repo) rate as the main policy interest rate. The 7-day reverse repo rate is the rate relevant for open-market operations carried out by BI. At the same time, BI uses standing liquidity facilities for managing the overnight interbank market liquidity. It does so by setting the deposit and lending rates, thus defining the interest-rate corridor around the policy rate. Usually the lending rate defines the top of the corridor, and the deposit rate defines the bottom of the corridor. When evaluating the mon- 42

5 Indonesia etary policy stance, it is useful to take into account that a 1% real policy rate is considered neutral by the BI board. BI s track record in meeting its inflation target has been mixed, but its commitment to the target has been strong. Since 2010, headline inflation has exceeded the target by 0.9% on average, i.e., at the upper end of the tolerance band. But this has not been consistent over time in 2010 through early 2013, inflation was oscillating symmetrically around the central target, but in the aftermath of the taper tantrum, starting in May 2013 and through 2015, inflation exceeded the upper bound of the target, in large part due to pass-through from currency depreciation. Between May 2013 and December 2015, the rupiah depreciated by a cumulative 40%. Additional drivers of inflation volatility have been the food and energy/ utility components. However, the government s decision in late 2014 to remove subsidies on fuel in order to reduce the fiscal burden has been helping reduce inflation volatility because fuel prices are no longer adjusted in abrupt one-off moves, but on an ongoing basis, in line with global energy prices. BI s response to the inflationary pressure from sustained depreciation of the currency was to hike rates 175 basis points in late 2013 and maintain this tight policy stance until late In this context, despite challenges in achieving the inflation target over due to external shocks, BI demonstrated a clear commitment to the inflation-targeting regime. During, BI was able to meet the inflation target and ease monetary policy. At the time of writing, headline and core inflation were towards the lower end of the target range at 3.7% and 3.0%, respectively. The main drivers for stable and low inflation are currency stability, prudent monetary policy, and somewhat weaker-than-expected economic growth. The currency has been largely stable during, with a 1.5% nominal depreciation at the time of writing and a 3.5% real effective exchange rate depreciation, mainly owing to the appreciation of the currencies of Indonesia s trading partners. The combination of a stable currency in and a 5.5% appreciation in 2016 has largely removed the exchange-rate pass-through as the chief driver of inflationary pressure. In addition, lack of demand-side inflationary pressure as growth remains close to trend and the reduced pressure from regulated prices have helped. In this context, BI was able to ease monetary policy by 50 basis points, fine tuning the neutral stance taken in Looking ahead, we expect limited inflationary pressures and monetary-policy stability. We expect inflation to remain subdued, at close to 3.0% 3.5% in While growth is close to trend, we do not expect demand-side inflationary pressure, as we expect the output gap to remain close to neutral. Given this benign backdrop for inflation we expect BI to keep rates unchanged at 4.25%. Exchange Rate Policy The IDR has traded in a managed floating exchange-rate regime since BI intervenes in the spot market and through derivatives, aiming to tame volatility and to prevent excessive real effective exchange-rate appreciation. Indonesia has limited foreign exchange controls, and the IDR is a nondeliverable currency, traded on a nondeliverable forward basis offshore. The IDR is best understood in the context of balance-of-payments dynamics. After peaking at a 2.8% of GDP surplus in 2006, Indonesia s current account balance saw a major reversal, sliding to a deficit of 3.9% of GDP in the third quarter of The reversal was driven by the trade balance, as both the non-oil and gas balance and the oil and gas balance shifted from surplus to deficit positions. Falling export prices, particularly for Indonesia s key export commodities (coal, oil and gas, palm oil, rubber, and copper), as well as declining volume growth as Chinese demand weakened, have hurt the country s export performance and pose 43

6 Lazard Emerging Markets Debt challenges for its external and exchange-rate outlook. Meanwhile, strong domestic demand, thanks to accommodative fiscal, monetary, and credit policies, kept import demand strong in the post-crisis period and up to With FDI averaging 1.2% 1.5% of GDP since 2010, the large current account deficit in 2013 was not sustainable. This was exposed during the taper tantrum in mid-2013 and the subsequent decline of oil and gas prices in As a result of those external shocks, the IDR depreciated by a cumulative 40% in the period, and the economy slowed, weakening import demand. This combination of economic slowdown and currency depreciation helped steadily reverse Indonesia s current account deterioration, with the deficit stabilizing in the -1.5% to -2.0% of GDP range since the first quarter of Meanwhile, FDI has picked up since the taper tantrum, averaging between 2.5% 3.5% of GDP since Thus, Indonesia s basic balance the part of the current account shortfall not covered by FDI is now roughly in balance. Indonesia remains vulnerable to an external funding shock, albeit less so than in recent years. Looking ahead to 2018, we expect IDR stability with the risk of a mild appreciation. This outlook is driven by three factors: accommodative global financial conditions, continued recovery in global trade and growth, and portfolio investment inflows as investors take advantage of relatively higher interest rates. 44

7 Indonesia Inflation USD/IDR Inflation Reference Rate As of December Source: Bloomberg REER REER Median since Dec 1999 Median last 10 yrs Median last 5 yrs As of December Source: JP Morgan, Lazard 45

8 Lazard Emerging Markets Debt Country Background Size Capital Population 1,904,569 KM 2 (15th) Jakarta Million Religion Muslim 87.2%, Protestant 7.0%, Roman Catholic 2.9%, Hindu 1.7%, Other 1.2% Median Age 30.2 Years Literacy Rate 95.4% Independence 17 August 1945 Political System Government Leadership Next Election 2019 Legislative Branch Presidential Republic President Joko Widodo Bicameral Assembly Economy Agriculture 14.0%, Industry 40.8%, Services 45.3% Labor Force Agriculture 32.0%, Industry 21.0%, Services 47.0% Merchandise Exports Mineral Fuels, Animal or Vegetable Fats (Includes Palm Oil), Electrical Appliances, Rubber, Machinery Export Partners China 11.6%, United States 11.2%, Japan 11.1%, Singapore 7.8%, India 7%, Malaysia 4.9%, South Korea 4.8% Currency Indonesian Rupiah (IDR) As of November Source: CIA 46

9 Indonesia Country Timeline 1945 The Japanese help independence leader Sukarno return from internal exile and declare independence The Dutch recognise Indonesian independence after four years of guerrilla warfare. 1950s Maluku (Moluccas) declares independence from Indonesia and fights an unsuccessful separatist war Western New Guinea, or West Papua, held by the Netherlands, is placed under UN administration and subsequently occupied by Indonesian forces. Opposition to Indonesian rule erupts Failed coup: In the aftermath, hundreds of thousands of suspected Communists are killed in a purge of leftists which descends into vigilantism Sukarno hands over emergency powers to General Suharto, who becomes president in March West Papua formally incorporated into Indonesia, becoming Irian Jaya Province Portugal grants East Timor independence Indonesia invades East Timor and incorporates it as a province Asian economic crisis: Indonesian rupiah plummets in value Protests and rioting topple Suharto; B J Habibie becomes president Ethnic violence breaks out in Maluku. Free elections are held in Indonesia. East Timor votes for independence in UN-sponsored referendum, after which anti-independence militia go on the rampage. East Timor comes under UN administration. Abdurrahman Wahid (Gus Dur) becomes president Ethnic violence in Kalimantan as indigenous Dayaks force out Madurese transmigrants. Mass political demonstrations by Wahid s supporters and opponents. IMF stops further loans citing lack of progress in tackling corruption East Timor becomes independent. Constitutional changes are seen as a step towards democracy. For the first time, voters will be able to elect a president and vice president. Bomb attack on the Kuta Beach nightclub district on Bali kills 202 people, most of them tourists.muslim Cleric Abu Bakar Ba asyir is arrested shortly after the bombings. He is accused of plotting to overthrow the government as the alleged spiritual leader of Jemaah Islamiah (JI), the group thought to be behind the Bali bombing First-ever direct presidential elections. Former general Susilo Bambang Yudhoyono unseats incumbent Megawati Sukarnoputri. More than 220,000 people are dead or missing in Indonesia alone after a powerful undersea earthquake off Sumatra generates massive tidal waves. The waves devastate Indian Ocean communities as far afield as Thailand, India, Sri Lanka, and Somalia Court finds Muslim cleric Abu Bakar Ba asyir guilty of conspiracy over 2002 Bali bombings, sentences him to two-and-a-half years in jail. He is freed in June A powerful earthquake off Sumatra kills at least 1,000 people, many of them on the island of Nias. The quake triggers tsunami alerts around the Indian Ocean Deadly protests at a major US-owned gold and copper mine in Papua province follow attempts to remove illegal prospectors from the site. Powerful earthquake and tsunami kill thousands of people on Java President Susilo Bambang Yudhoyono wins re-election.twin suicide bomb attacks on the JW Marriott and Ritz-Carlton hotels in Jakarta kill nine people and injure scores of others Parliament approves a major petrol and diesel price hike to cut the ballooning fuel subsidy, sparking violent protests. 47

10 Lazard Emerging Markets Debt 2014 Joko Widodo is declared the winner in the presidential election Islamic State media claim responsibility for coordinated attacks near a popular shopping center in central Jakarta. Jakarta s Christian Mayor Basuki Tjahaja Purnama is jailed for two years for blasphemy. Source: BBC Notes 1 As of December. 2 As of October, Source: Haver Analytics, IMF. 3 Indonesia: Staff Report for the 2013 Article IV Consultation, IMF Country Report No. 13/362, December 2013, 4 CIA World Factbook: Indonesia, CIA, accessed on 24 November 2015, 5 As of October, Source: Haver Analytics Corruption Perceptions Index, Transparency.Org, accessed on 4 October, 7 Economy Rankings, Doing Business, accessed on 24 November 2016, rankings. 48

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