By HENRY H. MCVEY Jun 27, 2013

In a world increasingly starved for growth, we believe Indonesia has several substantial macro tailwinds that will continue to drive its GDP higher – and potentially with lower than average volatility. However, recent economic growth has come at a significant cost, and in our view, the country now needs to address the notable increases in both its fiscal and current account deficits. If the country can successfully address these challenges, then we think Indonesia could represent one of the more compelling opportunities in the global capital markets over the next five to seven years.

When I first went to Indonesia in 1995, I trekked to Bukit Lawang in northern Sumatra with my best childhood friend to see orangutans in the rainforest. To this day, it remains one of the highlights of my international travels. My next trip to Indonesia was in 2001, and I spent the lion’s share of my time in Bali with my wife snorkeling and surfing near the beautiful beaches and then hiking upland in the country’s lush rainforests.

So as one might imagine, when I touched down in the country’s largest city, Jakarta, a few weeks back, to tackle an agenda that was 100% work-related, the tall buildings, traffic and crowds were all certainly a shock to my previous memories. So, I guess there is—indeed—a reason that Indonesia’s national motto, which is taken from a 14th century poem, is “Unity in Diversity.” Importantly, though, Indonesia’s breadth of offerings is not limited to just geography; it also applies to the country’s rich backdrop of religious, ethnic, cultural and commercial diversity.

Nonetheless, this trip too was quite memorable as I left the country with a sound understanding of why Indonesia is becoming such an important linchpin in the meteoric rise of the overall Southeast Asia region in the global economy. Indeed, using both its “unity” of purpose and “diversity” of resources, Indonesia now boasts an economic trajectory that is on pace to become a top-10 economy by 2030. Potentially more important to investors is that Indonesia’s consumer economy could become the third largest by 2050, trailing only China and India.

But to fully understand what is changing in Indonesia, our recommendation is that folks need to get out of Jakarta, the nation’s capital and economic power (e.g., Jakarta accounts for 20%+ of GDP growth1), and spend time in cities like Surabaya and Medan. Why? Because we believe it gives an investor a true appreciation for the smaller, but faster growing and more dynamic parts of the country’s economy. Moreover, by visiting existing ports, roads and retail outlets in these smaller cities, an investor gains a better understanding of how even small improvements in technology, education, and infrastructure can materially accelerate improvements in the country’s GDP per capita.

However, economic success in recent years has come at a significant cost. After more than a decade of notable discipline surrounding macro-related matters, Indonesia is now one of the few Asian emerging market (EM) countries with both a fiscal and current account deficit, with India being the only other major EM country with this ‘distinction.’ A key culprit for this conundrum is the country’s fuel subsidy program. All told, the government now spends 3.7% of total GDP on fuel subsidies to placate an increasingly vocal voting base2. In our view, this type of policy is extremely shortsighted and has already begun to create significant currency and inflation concerns.

By overspending on fuel subsidies, the country is also misdirecting its limited government monies away from the infrastructure, healthcare and education initiatives that the country desperately needs to fulfill its long-term potential. This viewpoint is not to be under-estimated, we believe, as history shows that such misguided spending can often act as a cancer, destroying both long-term productivity and potential growth.

Given these substantial macro cross-currents, I thought it might make sense to detail some of my impressions from my recent trip. They are as follows:

Favorable Demographics Will Likely Drive Further Increases in GDP per Capita Similar to India, Turkey and Brazil, Indonesia is one of the demographic ‘elite’ countries, with 50% or more of its population under the age of 30 (Exhibit 17). 2012 GDP per capita was just $3,596, 3/5 the level of China and only 1/3 the level of Brazil (Exhibit 22). The good news is that the gap is now narrowing as Indonesian GDP per capita (in USD) has compounded at an annual growth rate of 18% between 2005 and 20113, and we look for a further 40% aggregate increase from 2012 to 2017. Given such strong tailwinds, Indonesia is projected to be the fourth biggest consumer economy in the world by 2030 versus just 18th today (Exhibit 10). Within this consumer market, we see health and beauty, transportation, leisure, and education/training all as attractive markets.

High Corporate Sector Profitability in Fast Growing Region of the World Indonesian companies are highly profitable, ranking among the most lucrative in Asia. In fact, return on equity for the Indonesia index of publicly traded companies is around 21.5% versus 16.5% for Thailand and 13.5% for Malaysia4. In our view, strong profitability represents not only sound execution but is also reflective of the positive macro tailwinds that Indonesia enjoys by being part of the fast-growing Southeast Asian region. Already, 70% of Indonesia’s exports now stay within Asia, which is significant as the OECD is projecting middle class consumers in the region to increase by a staggering 515% to 3.2 billion by 2030 versus 525 million in 2009.

Despite Strong Growth, Credit Penetration and Government Leverage Are Still at Attractive Levels Even with a 20% CAGR over the past five years, domestic credit to the private sector in Indonesia was just 33% of GDP versus 55% for India and 130% for China in 2012 (Exhibit 13). This low ratio is important because it means that demand has not been artificially pulled forward, and as such, the marginal return on credit growth is still quite high. Meanwhile, gross government leverage as a percentage of GDP fell to just 24% in 2012 from 95% in 2000 (Exhibit 14), suggesting that the government can and probably should spend more, particularly on social services and infrastructure. Overall, Indonesia’s debt statistics are even more impressive when matched against the backdrop of country’s strong 6% annualized real GDP growth rate (Exhibit 8). What they suggest — and the numbers seem to bear out — is that the country’s average annual productivity is quite strong and likely to remain so. All told, over the last five years productivity has been 4.4%, compared to 1.6% in a country like Brazil.5

However, There Are Definite Signs of Economic ‘Slippage’ In 2012, Indonesia ran a 2.7% current account deficit, while its fiscal deficit reached negative 2.1% versus a mandatory legal limit of 3.0%6. In 2013, the issues surrounding these deficits have only gotten more challenging. Twin deficits are rare in fast growing economies, and as such, they often portend an imminent ‘adjustment’ period, including currency weakness and/or inflation headwinds. Given that the Fed may now be finally withdrawing excess liquidity, Indonesia may be forced to make adjustments to its deficits precisely at a time when its cost of capital is now almost certain to rise. Exacerbating the issue is the country’s large fuel subsidy program, which now totals around 3.7% of GDP. To put this in perspective, the outlay for its current fuel subsidy program is almost equal in both absolute dollars and as a percentage of GDP to what the government now spends on public healthcare and education programs combined7. We certainly acknowledge that the government is now in the process of reigning in spending on fuel subsidies, but – unfortunately – it appears that the monies will be redirected towards other programs that keep its imbalances at notable levels.

Hard Place to Do Business According to the World Bank’s Ease of Doing Business Index for 2012, Indonesia is ranked 128 out of 185 economies, slightly better than Brazil and India but more difficult than China. Importantly, this ranking could fall further after it was announced that foreigners owning local mines must “sell back” their properties to locals by 2018. We also heard repeated concerns from business executives about the growing power of labor and its impact on operating results, margins and operating flexibility in particular. Finally, as has been consistently documented in the press, corruption remains an ongoing issue in Indonesia that foreign investors must consider carefully.

Need to Translate Recent Commodity Economy Into a ‘New’ Services-based Economy In our view, the country can move faster to capitalize on the significant opportunity to leverage its recent ‘commodity dividend’ into other areas of the economy, including services and infrastructure. At the moment, Indonesia has just 39% of its industry in services versus 56% in India and 68% in Brazil (Exhibit 16). The risk of missing this opportunity is significant as the economy still has 35% of total employment related to agriculture; moreover, 74% of the increases in exports in 2011 were driven by price, not volume (Exhibit 46). Recent results seem to reflect this view as real 1Q13 GDP fell to 6.0% y/y from 6.8% in 4Q2010, driven largely by declines in the prices of coal, crude oil, palm oil and rubber8. And with China now shifting its growth priorities towards less capital-intensive growth, there is already heightened risk that Indonesia may have already missed its window of opportunity.

So what is our bottom line on Indonesia? Simply stated, in a world where it is increasingly hard to find growth, we think that Southeast Asia, Indonesia in particular, represents one of the more compelling long-term investment destinations. Unlike many of the larger and higher profile EM countries, Indonesia has a more balanced economy, its debt load is lower, and its resource base is richer in many instances than some higher profile emerging markets like China, India, and Brazil. And with reasonable productivity, Indonesia’s GDP growth should shine bright on both a relative and absolute basis.

Exhibit 1

Indonesian Equities Have Re-rated Since 2004

Data as at May 31, 2013. Source: Factset Aggregates.

Exhibit 2

But Indonesian Equities are No Longer Cheap

Data as at May 31, 2013. Source: MSCI, Factset.

In the near-term though, there are several reasons why some patience and skepticism is required. Public valuations are now rich in many instances at a time when significant wage growth is beginning to pressure margins. And with U.S. interest rates rising, the competition for capital is now going up, and it is likely to pressure emerging market currencies and interest rates in the future. Finally, we think GDP growth in Indonesia is likely to disappoint in the near-term, driven largely by lower commodity prices and weaker export growth.

Exhibit 3

Given the Country’s Imbalances, the Indonesian Rupiah is Now Beginning to Depreciate

Data as at June 18, 2013. Source: Bloomberg.

Exhibit 4

Its Sovereign Bonds Are Now Too Under Pressure

Data as at June 20, 2013. Source: Bloomberg.

On the private side, the story is even more complex. From our vantage point, a local presence is likely required, but so too is a regional one to be able to compare and contrast both macro and micro influences affecting current investment decisions and business trends across the region. Also, given that the cost of capital is now so low relative to history, private equity firms should bring more than just their capital base; they should be good partners with strong operational capabilities and industry expertise. Equally as important, private equity investors may need to work harder with the local communities in which they invest to navigate the secular trend towards increasing government intervention, nationalism and income equality.

Exhibit 5

Large Subsidies and Weak Tax Collection Have Widened Indonesia’s Imbalances

Data as at June 19, 2013. Source: Departemen Keuangan, Biro Pusat Statistik, IMF WEO, Haver Analytics.

Exhibit 6

Indonesia Has Rigid Employment Policies

Data as at December 31, 2008. Source: OECD. To find out more about the methodology used to calculate the OECD employment protection indicators, see

GDP: Consistently Strong

In a world of increasing macroeconomic instability, the speed and – potentially more importantly – the steadiness – of Indonesia’s growth rate is a notable point of distinction. In 2012, for example, the country maintained a 6.2% growth rate, despite the fact that exports were actually negative for the first time in eight years (Exhibit 8).

And over the last 12 years, the country has had among the lowest volatility and cyclicality of GDP in the major economies we follow. One can see the stability and breadth of recent economic trends in Exhibits 7 and 8 below.

Exhibit 7

Relatively Low Volatility for High Single Digit GDP Growth

Data as at April 16, 2013. Source: IMF estimates, KKR Global Macro & Asset Allocation calculation.

Exhibit 8

Despite the Net Export Drag, Real GDP Was 6.2% in 2012

Data as at May 6, 2013. Source: Biro Pusat Statistik, Haver Analytics.

A major reason for Indonesia’s success is that the economy is not too dependent on one sector or product. In particular, the Indonesian economy has its own vibrant domestic consumption economy. By comparison, many emerging markets we visit are either overly reliant on low-end exports and/or high fixed investment. If there is a shortcoming in GDP composition, we would argue that it is the government’s low spending ratio. As one can see in Exhibit 9, Indonesia’s government contribution to GDP substantially lags that of its peers.

Exhibit 9

Indonesia Has a Relatively Balanced Economy...

PPP=purchasing power parity. Data as at June 4, 2013. Source: Instituto Brasileiro de Geografia e Estatística, India Central Statistical Organization, Biro Pusat Statistik, and China National Bureau of Statistics.

Exhibit 10

…And By 2030 Should House the World’s Fourth Largest Consumption Market

Top 10 Countries: Middle Class Consumption
(Trillions of 2005 PPP dollars)
















































































PPP = purchasing power parity. Data as at January 2010. Source: Brookings Institution, OECD Development Centre Working Paper No.285 DEV/DOC (2010).

Exhibit 11

Productivity in Indonesia Is Relatively High

(1) Real GDP as of 2012. Source: Biro Pusat Statistik, Haver Analytics. (2) Population estimates as of May 11, 2011. Source: United Nations World Population Prospects, Haver Analytics.

Exhibit 12

Growth in Smaller Cities Will Outpace Jakarta

Source: McKinsey Global Institute “The archipelago economy: Unleashing Indonesia’s Potential” dated September 2012.

Another key attribute of the economy is that Indonesia is blessed with strong productivity (Exhibit 11). While it certainly may not feel that way when stuck in one of Jakarta’s well-documented traffic jams, Indonesia’s productivity growth is notably above other emerging market countries, including India, Malaysia, Philippines, Vietnam, Brazil and Mexico. We link the strong productivity to several things. First, there is an ongoing shift from a rural to an urban population, which provides an inherently attractive productivity tailwind. Second, as we mentioned earlier, a lot of the fastest growing parts of the country are smaller cities outside Jakarta where the introduction of basic services like the Internet, water infrastructure and public transportation are all helping to drive growth (Exhibit 12). As these cities become more modern, we believe it will continue to drive productivity levels higher. Third, the manufacturing sector has become more formidable as the country transitions from low-end manufacturer (food processing and clothing) to higher value-added products like equipment and machinery.

Importantly, Indonesia has also been able to grow its economy without the use of significant leverage from either the government or private sector. One can see this in Exhibits 13 and 14. These low leverage ratios are hugely important for several reasons. First, in terms of downside protection, the low level of credit gives us comfort that strong underlying GDP trends will not be overshadowed by de-leveraging in any part of the economy. Second, no sector of the economy appears to be over-earning by using credit to facilitate strong growth. Third, leverage levels are so low that there is actually the potential to help improve the build-out of key industries like housing, which can serve as an important cornerstone in the trend toward urbanization/GDP per capita.

Exhibit 13

Credit Penetration Is Low…

Data as at 3Q2012. Source: Bank for International Settlements, Respective National Statistical Agencies.

Exhibit 14

…As Is Government Leverage

Data as at April 16, 2013. Source: IMF WEO, Haver Analytics.

Our trip also left us with the distinct impression that there is a major opportunity to make the country’s remaining agricultural sector more productive. As Exhibits 15 and 16 illustrate, agricultural employment accounts for a full 35% of total employment, but just a modest 15% of total GDP. Importantly, the government is starting to do its part, pushing heavily for improved farming techniques, including fertilizer improvements and more sophisticated seeding. Rice is still the country’s staple crop, but given surging demand, the country is still a net importer as at 2012. The country is also now the world’s second largest producer of palm oil, and it is also among the leaders in rubber production.

There is also significant opportunity for GDP growth in the country’s services sector. As Exhibit 16 shows, Indonesia’s services sector is still relatively small at 39% of GDP. By comparison, China, India and Brazil all have services sectors that are between 6 to 29 percentage points of GDP higher than Indonesia. A key reason is that credit penetration is relatively low, and with low credit penetration and a modest GDP per capita, the country’s retail and lending segments of the services market are still in their infancy relative to many other emerging market countries.

Exhibit 15

The Agriculture Sector Is Still Relatively Large…

Data as at December 2009-2012. Source: World Bank, Haver Analytics.

Exhibit 16

…While the Services Sector Is Relatively Small

Data as at April 15, 2013. Source: Biro Pusat Statistik, India Central Statistical Organization, China National Bureau of Statistics, IMF, Haver Analytics.

So while there is more work to be done in terms of more focused government spending and the need to energize the private sector to do more in partnership with the government on the infrastructure front, we believe the Indonesia GDP growth story is not likely to suffer the same significant slowdown in GDP that we are seeing in India, China and Brazil. To be sure, export growth linked to commodities and international trade is likely to disappoint in the near-term, but wages are rising, spending is growing, and GDP per capita is ticking higher. Equally as important, the country already has enough internal demand to make it less dependent on the global economy to meet its growth forecast. As a result, we think that the long-term outlook for the country makes it an attractive destination for emerging market-oriented growth capital.

Consumption: Demographic Tailwinds Are Favorable

Some people want it to happen, some wish it would happen, others make it happen. Basketball star Michael Jordan

When it comes to consumption, which is already the largest part of the Indonesian economy at 56%, there is no question that Indonesia is in the Michael Jordan “make it happen” category. Indeed, as Exhibit 17 shows, Indonesia has not only a young population but also a growing one, with huge consumption potential. Importantly, this trend is likely to gain momentum because, as we show on Exhibit 18, Indonesia’s working population is not likely to peak until 2036. And unlike a country like China, which needs to encourage savers to spend, Indonesia has a pretty good balance between savings and consumption.

Exhibit 17

A Young and Growing Population, Fourth Largest in the World

Data as at September 26, 2012. Source: United Nations World Population Prospects, Haver Analytics.

Exhibit 18

The Demographic Dividend Crests in 2036

Data as at September 26, 2012. Source: United Nations World Population Prospects, Haver Analytics.

In aggregate, Indonesia’s middle class is expected to grow to 95-125 million people, or 35-45% of the total population by 2030 versus 45 million, or 18% of the total population today (Exhibit 20). And if one has the time and patience to look out to 2050, Indonesia will have the third largest middle class population in the world, behind only China and India (Exhibit 21).

Exhibit 19

The Current Middle Class Is Only About 45 Million…

Source: HSBC report “Consumer in 2050” dated October 2012.

Exhibit 20

…But it Is Growing Rapidly

Source: Article by Asosiasi Pengusaha Indonesia dated October 8, 2012 quoting Deputy Finance Minister Mahendra Siregar.

Exhibit 21

By 2050, Indonesia Will Have the Third Largest Middle Class Among Emerging Markets

Source: HSBC report “Consumer in 2050” dated October 2012.

Exhibit 22

GDP per Capita Should Grow by 40%, or 7.4% Annually, Over the Next Five Years

Data as at April 16, 2013. Source: Biro Pusat Statistik, IMF, Haver Analytics.

Given its strong demographic profile and shifting economic drivers, we expect the trend towards rising GDP per capita to maintain strong momentum over the next five to seven years. At the moment, urbanization is only around 51-52% of the total population (Exhibit 23). We believe this can easily continue to increase on an annual basis by 70-80 bps, reaching 57% percent over the next five to seven years. So unlike the “catch-up” in urbanization that some are forecasting in India or the rebalancing that some are forecasting in China, the Indonesia story is really about staying the course, including steadily lifting GDP per capita via urbanization efforts in many of its smaller cities.

Exhibit 23

Urbanization Moving in Sync with China

Data as at March 18, 2013. Source: World Bank, Haver Analytics.

Exhibit 24

Given Current Urbanization Trends in Indonesia, GDP per Capita Can Still Move Higher

Data as at April 16, 2013. Source: World Bank, Biro Pusat Statistik, India Central Statistical Organization, China National Bureau of Statistics, Fundaçâo Instituto, Banco Central do Brasil, IMF, Haver Analytics.

Overall, as we look ahead, our base view is that demographic trends, including the sizeable increase in the country’s middle class through 2030, are likely to make Indonesia one of the most compelling consumer growth stories in the global economy. Importantly, the country does not need to rely on a lot of external macro forces to be successful. Rather, it just needs to focus on two goals, both of which we think are achievable. First, it should execute on building out basic goods and services, including infrastructure, education, and healthcare. Second, the country should then allow its demographic forces to help drive its economy away from more traditional agriculture and commodities toward more services and value-added exports.

Industry: Focus on Middle Class Beneficiaries

As part of our trip to Indonesia, we spent time talking with leading executives and senior government officials about which sectors would benefit from the ongoing changes we are seeing in the country’s demographic profile. To be sure, no one knows exactly how a doubling of the country’s middle class will exactly play out over the next decade, but we do believe that one can make reasonable assumptions – often using historical comparisons – to forecast which sectors are likely to be the star performers. Not surprisingly, many of the industries we view favorably are in the consumer part of the economy. Importantly, this viewpoint is consistent with our approach to other leading emerging economies, though – as we discuss below – every country has political, economic and social nuances to which one must pay attention.

To this end, we spend time in this section highlighting macro-related trends that we think may benefit certain micro-related sectors, including education and training, healthcare, retail, and housing/financial services. Please note, however, that we address the Indonesian infrastructure opportunity in our savings and investment section, given that it includes a large degree of government involvement.

Education and Training One of the great ironies of visiting an emerging market like Indonesia these days is that, despite its booming labor force growth, there is still a shortage of skilled laborers in many sectors of the economy. At the moment, the unemployment rate in Indonesia is just 5.9%, down from 8.5% five years ago.9 However, after talking with leading executives across a variety of sectors in Jakarta, we strongly feel that the unemployment rate understates what we think is a large and growing issue: the ability of many businesses to find local workers with the required technical expertise to compete in an increasingly competitive economy. To remain competitive as well as to drive further long-term economic growth, our strong view is that Indonesia needs to immediately invest much more aggressively in higher-level education and vocational industry training initiatives.

Our research shows that Indonesia faces multiple issues in the area of higher education. As we show in Exhibit 25, education spending in Indonesia is still well below many of its emerging market peers on a per capita basis. Probably more important though, to us is that only 7% of adults complete post-secondary education (Exhibit 26).

Exhibit 25

Public Spending on Education Is Just 3% of GDP…

UNESCO statistics as at December 31, 2010, except China per OECD 2008 estimate. Source: UNESCO, OECD.

Exhibit 26

…and Higher Education Is Lacking

Source: JPMorgan Education in Brazil report dated February24, 2011; UNESCO Global Education Digest 2010.

One alternative that an increasing number of affluent Indonesians are choosing is to send their kids to the United States or Europe for higher education. However, this approach clearly does not address how the country will deal with the 50 million or more middle class Indonesians who are eager to improve their standing in the global workforce. If there is an encouraging trend, we think that it is linked to the fact that more students are beginning to again embrace vocational programs (Exhibit 27). Importantly, we view the trend towards greater participation in higher education and vocational training as secular, not cyclical, and one that is likely to be a major opportunity for private capital, which can help to expedite certain aspects of this growth, including facilities, publishing, education and technology.

Exhibit 27

Of Late, More Students Have Enrolled in Vocational Training

Data as at December 31, 2009. Source: Newhouse and Suryadarma, 2009 (based on Susenas).

Healthcare Without question, after our most recent trip to Indonesia, we think that healthcare demand can grow materially faster than GDP per capita over the next 5-10 years. Key to our thinking is that GDP per capita in Indonesia is historically at a level where we typically see private sector practices start to emerge and take share from crowded government-run facilities. Because there is no real regulation of pricing and quality of services, the opportunity for quality private companies to build a loyal following over time is significant. Moreover, as more citizens enter the ‘formal’ workforce through increased urbanization, healthcare spending, particularly with scale providers, should benefit smartly. We also heard on our trip that more foreign healthcare doctors and providers may gain access to the country over the next three to five years, which should help to improve the levels of spending and healthcare services throughout the country.

Against this backdrop, we expect healthcare as a percentage of GDP to increase meaningfully over time too. This statement is actually not that radical, given that Indonesia allocates among the lowest amount of money as a percentage of GDP to healthcare. Indeed, as Exhibit 28 shows, healthcare spending as a percentage of GDP is less than 1%, which compares unfavorably with Brazil and Turkey and even India.

Exhibit 28

Health Care Spending Should Rise…

Data as of 2011. Source: World Bank, Haver Analytics.

Exhibit 29

…As We Now Expect the Informal Economy To Begin to Shrink More Quickly

Source: International Labour Organization (ILO): Statistical update on employment in the informal economy (Geneva, June 2012); National statistical offices,

Exhibit 30

Healthcare Facilities and Services Are Deficient

Data as at April 17, 2013. Latest available data per respective country as per the World Bank. Source: World Bank, Haver Analytics.

Exhibit 31

Indonesia’s Healthcare Spending Is Among the Lowest in Emerging Markets

Data is 2009 or latest available year. Source: Organization for Economic Co-operation and Development (OECD), Factbook 2011: Economic, Environmental and Social Statistics - ISBN 978-92-64-11150-9 - © OECD 2011.

Looking ahead, our base view is that as wealth accumulates, a growing percentage of the urban population will migrate towards private clinics and hospitals. This trend is playing out nicely in almost all the emerging markets we visit, and as such, we expect to see similar momentum in Indonesia in the coming years. Importantly though, the Indonesian government’s shift towards more of a decentralized structure since 2001 likely means that the private sector may become more influential sooner in the process than in other EM countries. Separately, we also expect overall healthcare volumes to increase, which should create opportunity for scale players in the healthcare supply industries, including testing and preventative practices.

Retail/Restaurants/QSR In theory, a thriving consumer benefits companies that sell clothes, food and other sundry goods to shoppers. But as one can see in Exhibit 32, the overall retail market in Indonesia is largely unsaturated. And if we use Indonesia’s grocery retailing as a proxy for overall retailing, one can see in Exhibit 33 that it is also quite immature. All told In fact, Indonesia’s convenience stores, hypermarket stores and department stores only represent around 2-4% of total retail sales. In other developing markets, by comparison, sales comprise around 10% of total retail sales10.

Exhibit 32

The Indonesian Market Is Still Young and Far From Saturated

Source: The 2011 A.T. Kearney Global Retail Development Index,

Exhibit 33

Services as a Percentage of GDP Are Still Small as the Basic Retail Segment Is Far From Fully Developed

Source: JPMorgan “Indonesia Retailers: Organizing the shelf, filling the shopping basket” dated March 10, 2013, Euromonitor.

Against this backdrop, we think private equity currently represents a more elegant way to access retail trends. Specifically, our view is that local QSRs (quick service restaurants), bakeries and snack-foods all represent interesting private equity investment opportunities, particularly when there are generational shifts in private company ownership or industry leaders with management teams who are eager to consolidate a greater proportion of their industries.

Housing and Financial Services As a former financial services analyst, I always view the banking sector as the ‘life blood’ of any economy. The good news for Indonesia – which was confirmed on our visit – is that the banks are in great shape. Moreover, while there is a state-run component to part of the banking sector, it pales in comparison to what we see in many of the larger emerging economies. Overall, credit losses are low, margins are strong and growth is enviable.

Looking at the details, credit penetration in total in Indonesia is just 32% of GDP, of which mortgage penetration is just 5% of GDP (Exhibit 34). Separately, total insurance penetration remains relatively low by global standards in Indonesia. Measured by gross premiums written as a percentage of GDP, penetration is only 1.7% overall, compared with the world average of 6.6% in 2011 (Exhibit 35).

Exhibit 34

Credit Penetration Is Low…

Data as at 2012 or latest available. Source: Respective national statistical agencies.

Exhibit 35

…As Is Insurance Penetration

*Insurance penetration defined as gross insurance premiums written as a percentage of GDP. Source: World Insurance in 2011, Swiss Re Sigma.

Exhibit 36

Interest Rates Are Now At 6.00% from 12.75% in 2005…

Data as at June 13, 2013. Source: Bank Indonesia, Bloomberg, Haver Analytics.

Exhibit 37

…Fueling Credit Growth, Which Remains Strong at 23%

Data as at January 31, 2013. Source: Bank Indonesia, Haver Analytics.

Exhibit 38

The Loan Loss Ratio Appears to Be Structurally Much Better Since the Asian Financial Crisis

Data as at April 17, 2013. Source: World Bank, Haver Analytics.

However, our conversations with senior executives in the financial services industry lead us to believe that credit growth is now finally percolating among a broader base of consumers, as wages grow and urbanization begins to further accelerate. Consistent with this view, our research shows that housing is still a small part of the market that is starting to grow nicely. For example, when I was in Surabaya, I visited a large community development of maybe 60-70 three and four bedroom houses being built with compelling amenities, many of which would be similar to a standard western-style dwelling. No doubt, the community I visited was more the exception than the rule (and we saw plenty of shanty huts to confirm this viewpoint), but it certainly provided me with a window on why I think housing and mortgage-related activity can be a more meaningful part of the economy.

If there is an issue, it is that the banking system’s loan-to-deposit ratio is moving up rather quickly (Exhibit 39). One sharp executive with whom we spoke believed that lack of government spending on real investments was part of the problem. Key to his thinking is that capital that traditionally might flow through the banking system via consumer deposits to help finance productive long-term investments was currently being misallocated towards more consumption-oriented programs, including subsidies. We tend to concur with this logic, particularly as the country’s deposit-to-GDP ratio is now the lowest in the Asia (Exhibit 40).

Exhibit 39

Loan-to-Deposit Ratio Has Risen to 84% From 54% Over the Past 10 Years

Data as at March 6, 2013. Source: Bank Indonesia, Haver Analytics.

Exhibit 40

Indonesia Suffers From Too Few Deposits, Not Too Many Loans

Data as at January 31, 2013. Source: Bank Indonesia, Biro Pusat Statistik, People’s Bank of China, China National Bureau of Statistics, Monetary Authority of Singapore, Singapore Department of Statistics, Reserve Bank of India, India Central Statistical Organization, Banco Central do Brasil, Instituto Brasileiro de Geografia e Estatística, Haver Analytics.

Overall, though we view the financial services system positively, and we think the publicly traded banks, while expensive, may represent valuable assets for investors looking to participate in the Indonesian growth story that we are forecasting. For private investors, we think insurance, payments, trade finance and other lending vehicles are all worthy of consideration.

The Role of Government in the Economy: More and Less Required

For every benefit you receive, a tax is levied. Ralph Waldo Emerson

Given that the country must try to absorb an additional 50 million ‘new’ middle-classers between now and 2030, there are clearly significant opportunities for the government to help ensure that Indonesia’s GDP-per-capita story maintains its current momentum. Beyond the fuel subsidy issue that we have already flagged, the government also needs to address the small size of its tax revenue base. Indeed, as we show in Exhibit 41, Indonesia’s tax revenue base at 15-17% of GDP definitely appears low versus other countries. Put another way (and contrary to what Ralph Waldo Emerson suggested), it appears that Indonesia is actually one of the few countries where for every benefit one receives, a tax is actually not necessarily levied.

So what should happen? We believe that the government needs to do more to expand its base of eligible employees, so that it can fund more social programs and infrastructure. A way to accomplish this without massively raising taxes is to expand the taxable base of ‘qualified’ individuals. As one can see in Exhibit 42, the informal sector of the economy in Indonesia is outsized, which dents the country’s ability to properly capture tax revenues.

Exhibit 41

Revenue Collection as a Percent of GDP is Extremely Low…

Data as at April 16, 2013. Source: IMF WEO estimates for 2013.

Exhibit 42

…Due to the Large Informal Sector

Data as at April 16, 2013. Source: “Statistical update on employment in the informal economy” by International Labour Organization (ILO) Department of Statistics dated June 2012,, and IMF WEO estimates for 2013.

Interestingly, almost every business leader, politician or regulator with whom we spoke indicated that the current fiscal policies, including a small tax base and outsized subsidies, were detrimental to the long-term health of the country. However, with a strong economy, low unemployment, and a small deficit in absolute terms, there is no longer a catalyst for action the way there has been in the past during periods of economic strife. Also, given that the government by law can’t have more than a 3% fiscal deficit, many people feel that this is not a situation that will quickly spiral out of control.

Our experience however, suggests a more cautious approach to these issues is likely warranted. Key to our thinking is what we are seeing unfold in both India and Brazil. Similar to Indonesia, both of these countries have incredible demographic backdrops. Unfortunately, poor macroeconomic choices have left these countries with slower than expected growth but higher than expected inflation. The major issue, we believe, is that in both instances the government over-stimulated economic growth via short-term fuel subsidies and one-off social spending after the 2008 Great Recession. Sound familiar? Last year in fact, Brazil grew just 0.9% year over year versus a peak of 6.1% in 2007, while India grew 6.2% versus a peak of 6.5% in 201111. Importantly, recent trends have continued into 2013, with both countries disappointing badly again in 1Q13.

So where do we go from here? Our base view is that, as Indonesia becomes more developed, some of the headwinds created by such a large informal economy could start to dissipate. Also, as GDP per capita continues to increase, the absolute base of tax revenues should grow commensurately. However, the recent trend towards increased government intervention is certainly worthy of investor attention. In particular, while government support of labor is important in any developing country, there is a growing risk that the government may overstep its boundaries, driving up the country’s cost of capital and driving out the foreign direct investment that is necessary to fund many of its growth initiatives.

Exports and Imports: Period of Transition

From almost any vantage point, Indonesia has a strong trade business. The country is rich in key natural resources, including coal, copper, oil, gas, palm oil and rubber. All told, two-thirds of the total exports come from commodity related sources, while about two-thirds of imports come from non-commodity related items (Exhibits 43 and 44).

Another key insight we learned during our trip is that multinational firms are increasingly viewing Indonesia as not only a destination for product but also as a hub for their Southeast Asian businesses. This strategic positioning is significant, in our view, and is likely to further accelerate foreign direct investment into important areas like manufacturing.

Exhibit 43

Two-Thirds of Indonesia’s Exports Are Commodity Related…

Data as at May 01, 2013. Source: Bank Indonesia, Haver Analytics.

Exhibit 44

…While One Third of Indonesia’s Imports Are Commodity Related

Data as at May 27, 2013. Source: Bank Indonesia, Haver Analytics.

However, growth in the export economy in Indonesia has been too reliant on higher commodity prices, not on productivity gains in the sector. According to work done by my colleague Frances Lim, a full 74% of the total export increase in 2011 came from price, not volume (Exhibit 46). This total is significant as commodity exports represent 60-70% of total export volume (Exhibit 43). One can also see from this chart that 2012 is actually not that much of an outlier. By comparison, more than 60% of the country’s imports are non-commodity related, with machinery and transport equipment accounting for nearly half of that total (Exhibit 44).

Exhibit 45

Indonesia’s Exports Have Been Commodity Dependent…

Data as at May 9, 2013. Source: Morgan Stanley Research, CEIC Data.

Exhibit 46

…But Export Growth Has Primarily Been From Price Appreciation

Data as at May 30, 2013. Source: Bank Indonesia, IMF, Haver Analytics.

In our humble opinion, Indonesia has not moved fast enough yet to leverage its recent success in commodities to further buttress the other parts of its economy. Now, with China slowing and coal and palm oil prices having fallen by 20% or so, many parts of its export economy are now feeling the pinch. In fact, in 2012 exports were actually negative. That’s the bad news (Exhibit 46).

The good news is that there are signs that the situation is turning more positive, and we actually have confidence that the government and private sectors are working together to build momentum in the manufacturing export sector. Interestingly, we heard first hand during our last China visit that manufacturers are now consistently seeing parts of their value-chain being transferred to Java from Southern China. This trend is particularly acute with foreign corporations in the areas of transportation equipment and machinery. All told, at the end of 2012, this segment accounted for 15% of FDI (Exhibit 48). International investors have clearly taken note of this trend, as foreign direct investment has ballooned in recent months.

Looking ahead, we think the export-related manufacturing story in Indonesia is sustainable, though our thinking is that the country should do even more to diversify its export economy. If it can, then it will be one of the few emerging market countries with not only a broad-based consumer economy but also one that can compete actively in a global trade market in one of the fastest growing regions in the world.

Exhibit 47

Foreign Direct Investment Remains Strong…

Data as at 1Q2013. Source: Bank Indonesia, Biro Pusat Statistik, Haver Analytics.

Exhibit 48

…Particularly In Manufacturing

Data as at March 31, 2013. Source: Bank Indonesia.

Savings and Investment: More Infrastructure Needed

An important piece of any macro puzzle we review when doing country-level research is the relationship between savings and investment. If a country doesn’t save enough, it usually can’t afford to spend enough on the investment required to drive long-term, sustainable growth. Importantly, in the emerging markets, the key to investment is usually the infrastructure part of the investment spend. Though it is now changing, this is an area where Indonesia has chronically underspent. In fact, infrastructure spending has been tracking at only 3-4% of GDP12. In the years prior to the Asian Financial Crisis, Indonesia was spending 7%, more comparable to the current 6-8% in India and nearly 10% in China, according to the Public Works Ministry (Exhibit 49).

But one does not need to be a macro person to know Indonesia lacks in infrastructure. A ‘quick’ trip in from the Jakarta airport, which is usually filled with gobs of traffic and several random phone disconnections, reminded us of the infrastructure challenges the country faces. This is not ‘new’ news. What did surprise us, however, was when multiple executives with whom we spoke told of pumping water to their homes in Jakarta, as it was still not provided to them by the government.

Exhibit 49

Infrastructure Spending Lagging Even India...

Data as at December 31, 2012. Source: CEIC Data and Morgan Stanley Research.

Exhibit 50

…But Estimates Are For It to Increase From Here










2010-2015 CAGR

















































































As a % GDP









Data as at May 11, 2011. Source: Morgan Stanley Research, “Indonesia Infrastructure: A US$250bn Opportunity” dated May 11, 2011 by Deyi Tan. e = Morgan Stanley Research estimates; f = Morgan Stanley Research forecasts.

Exhibit 51

China Leads the World in Both Rate of Savings and Investment % of GDP

Data as at April 16, 2013. Source: IMF WEO estimates for the year 2013.

Exhibit 52

…But Investment per Capita Still Lags Behind Brazil and China

Data as at April 16, 2013. Source: IMF WEO estimates for the year 2013.

According to an optimistic report by the global investment bank Morgan Stanley, the country will spend $250 billion over the five-year period ending in 201513. If correct, then annual infrastructure spending would rise to around 6% of GDP, up from 4% in 2010, with electricity and roads accounting for over 50% of the total incremental increase (Exhibit 50). That is the good news.

The bad news is that—to date—almost all infrastructure plans are well behind schedule. The government’s medium-term plan, which called for 70% of the $150 billion allocation to be invested in infrastructure from 2010-2014 to come from the private sector, has not happened. The Public Works Ministry acknowledged that its Private Partnership Plan (PPP) has not worked, and it is now aggressively making changes to improve the situation, including more government funding and greater economic incentives for the private sector.

Interestingly, the lack of infrastructure investment is not linked to either a low savings rate or lack of external capital. As Exhibits 53 and 54 show, Indonesia actually has both. What has happened though, is that a lot of the private sector capital went into higher return mining investments and less into basic infrastructure services required to meet the needs of the country’s booming middle class. Also, as we mentioned earlier, government revenues are light relative to many economies, so the government contribution to infrastructure spending has been limited.

There are also some historical ‘quirks’ worth considering. Specifically, Indonesia was ruled by the Dutch from 1826 to 1949 and as history has demonstrated, Dutch-occupied countries enjoyed much less infrastructure build-out than those overseen by countries like the United Kingdom. Second, similar to Brazil, Indonesia has a varied terrain that has historically prevented it from making sweeping cross-country (or even cross island) investments. Third, as we mentioned above, execution between the government and private sector has been disappointing, a trend that has been exacerbated by a more decentralized government structure that has made it harder to get things done.

Exhibit 53

A High Savings Rate Is Needed to Support Investment…

Estimates for 2013. Data as at April 16, 2013. Source: IMF WEO April 2012.

Exhibit 54

…But Foreign Direct Investment Is Needed Too

Data as at 1Q2013 or latest available. Source: Bank Indonesia, Malaysia Department of Statistics, Bank Negara Malaysia, Central Bank of the Philippines, Singapore Department of Statistics, Monetary Authority of Singapore, Bank of Thailand, Asian Development Bank, General Statistics Office of Vietnam, International Monetary Fund, Haver Analytics.

Looking ahead, our conversations with both the government and private sectors lead us to believe that we are close to a bottom in terms of missed infrastructure execution. In recent weeks, the government has been revamping its strategy for working with the private sector, and our discussions in Jakarta with a variety of infrastructure folks leads us to believe that expectations have been lowered to a much more appropriate level. Moreover, we see increased private sector interest in allocating capital towards shipping, roads, tolls and power. These initiatives will certainly not happen overnight, but we believe that expectations are now more realistic, return targets are more reasonable, and the government’s sense of urgency is now heightened.

Capital Markets, Currency and Inflation Outlook: A Potential Near-Term Achilles Heel?

As investor interest in Indonesia has grown, its capital markets have developed considerably. In particular, as we show in Exhibit 55, its market capitalization as a percentage of GDP is now much more on par with the average of its Asian peers. This re-rating makes sense, given the country’s strong growth, high profitability and powerful demographics. However, we believe that the equity story is far from over (Exhibit 56), particularly if the government can reign in its deficits.

Exhibit 55

Indonesian Market Cap Percentage of GDP Has Slowly Converged With Asian Average

Data as at March 31, 2013. *GDP-weighted average of China, S. Korea, Indonesia, Taiwan, Thailand, Malaysia, Philippines, Vietnam, and Singapore. Source: Bloomberg, IMF, Haver Analytics.

Exhibit 56

Indonesia Market Cap Percentage of GDP Is Above China and Vietnam, But Far Below Many Other Asian Peers

Market Cap, % of GDP (3/31/13)




























Data as at March 31, 2013. Source: Bloomberg, IMF, Haver Analytics.

On the fixed income side, the story is more complicated. Indonesia relies heavily on foreign investors to cover its fiscal deficit (Exhibit 57). Until recently, this dependence was not really an issue. However, as tightening cycles occur in areas like the United States or Europe, then Indonesia could face some serious headwinds. Exacerbating the issue is that Indonesia has only around $100 billion in reserves14. As we show in Exhibit 58, its external foreign debt relative to its reserves is second to only Korea in the Asian markets.

Exhibit 57

There is High Foreign Ownership of Indonesian Bonds...

Data as of April 30, 2013. Source: Indonesia Directorate General of Debt Management. Bank Negara Malaysia, Bank of Thailand, Haver Analytics.

Exhibit 58

…and the Short-term External Debt Load Is High

Data as at March 19, 2013. Source: World Bank, Haver Analytics.

In our view, the Indonesian capital markets face several issues through which investors should work. First, though they have corrected somewhat in recent weeks, both debt spreads and equity trading multiples in Indonesia are quite rich relative to both history and their peer group. So, everything needs to continue to go right for it to persist in maintaining such premium valuations. Second, Indonesia is likely going to feel some notable impact from the country’s reduction in its fuel subsidy over time, as we believe that ultimately it is a fuel price increase that may cause inflation to rise. According to the investment bank Morgan Stanley, every 10% rise in retail fuel price would add 80 bps to headline inflation, with a 22-44% increase adding 290 bps, bringing headline inflation to mid-8% territory15. Not surprisingly, a reduction in the fuel subsidy may also act like a tightening, denting consumption on the margin. Third, interest rates are moving in line with the U.S. and on the verge of causing a tightening cycle.

Looking ahead, we think the country’s upcoming election, its subsidy/inflation issues, and the ‘tapering’ of Quantitative Easing in the U.S. are likely to increase the volatility of its capital markets, and we would not be surprised to see the country struggle a little in terms of raising capital and/or see some renewed pressure on its currency. History shows – time and time again – that capital flows into the emerging markets can reverse quite quickly, particularly at a time when the United States begins to raise rates. Already, in early June, as an example, the country decided not to issue bonds at certain maturities because there was a lack of investor demand at rates the government deemed acceptable.

Exhibit 59

The Financial Markets in Indonesia Have Room to Grow

Source: World Bank, Asia Development Bank AsiaBondsOnline

Longer-term though, we remain optimistic for two important reasons. First, we think that the size of the overall Indonesian capital markets still has significant potential for appreciation. As we show in Exhibit 59, there is still a lot of running room for Indonesia to grow its market capitalization as a percentage of GDP, and given that GDP growth is likely to remain strong over the coming five to seven years, in our view, there is the potential to succeed both ways (i.e., a rising percentage of GDP in a rising GDP environment).

Second, Indonesia’s liquid capital markets are actually reflective of the economy, which differentiates it from many of other large EM markets. In the case of a country like Brazil, by comparison, large state-run companies dominate the index, which often leads to lower returns and lack of focus on burgeoning consumer trends. In fact, one can see that in Exhibit 60, Indonesia is actually overweight consumer stocks. In China, by comparison, consumer stocks are less than three percent of the composite index. And in the financial arena, we believe Indonesia actually has well-run banks that are not overly swayed by government influences.

Exhibit 60

Compared to Global Peers, the Indonesian Market Is Heavily Overweight Financials and Consumer Discretionary, and Underweight IT, Energy and Industrials

% Index Weight

Indonesia % Over/(Under) Weight

MSCI Indonesia




vs. MSCI AC World

Consumer Discretionary






Consumer Staples






























Info Tech












Telecommunication Services












Data as of March 31, 2013. Source: MSCI, Factset.


From almost any vantage point, Indonesia has emerged as a rising global economic power. Importantly, in a world increasingly starved for growth, Indonesia has some substantial macro tailwinds that will continue to drive its GDP higher – and potentially with lower than average volatility. Against this backdrop, industries like education, healthcare/wellness, and transportation/logistics all are expected to grow meaningfully above global GDP for the next five to 10 years and represent interesting long-term investment opportunities for both public and private investors.

However, the next ten years may not be as easy as the past ten, and there is increasing risk that Indonesia missteps, similar to what we have seen recently in other emerging markets like China, India and Brazil. In many instances, it is poor decision-making at the government level – often to curry favor with certain private sector influences – that may slow economic growth and earnings trajectories. In particular, if the country continues to run with strong growth using a twin deficit strategy, then we believe the currency will need to adjust downward, which could add pressure to an already high inflation backdrop. And given that the U.S. may be closer to ending its powerful run of Quantitative Easing, there is now greater implied risk in both the funding and currency markets than there has been for the past several years.

Indonesia should also ensure that GDP-per-capita, which is currently around $3,600, continues to increase at the substantial rate we and others are forecasting (Exhibit 22). To do so however, it immediately needs to make the necessary investments in infrastructure and education that keep productivity above wage growth. In addition, it needs to work even harder to effectively transition the economy into high value-added industries and services in the formal economy from agriculture and other parts of the informal economy. If it can do these things, then this country could represent one of the more compelling opportunities in the global capital markets over the next five to seven years.


  • 1 Data as at March 6, 2013. Source: Badan Pusat Statistik.
  • 2 Data as at May 31, 2013. Source: Departemen Keuangan, Biro Pusat Statistik, IMFWEO, Haver Analytics.
  • 3 Ibid.2.
  • 4 Data as at May 31, 2013. Source: MSCI, Factset.
  • 5 Data as at December 31, 2012. Source: Biro Pusat Statistik, Instituto Brasileiro de Geografia e Estatística, Haver Analytics, KKR GMAA calculation.
  • 6 Ibid.2.
  • 7 Ibid.2.
  • 8 Data as at May 6, 2013. Source: Bloomberg.
  • 9 Data as at March 31, 2013. Source: Biro Pusat Statistik.
  • 10 Source: JPMorgan “Indonesia Retailers: Organizing the shelf, filling the shopping basket” dated March 10, 2013, Euromonitor.
  • 11 Data as at May 29, 2013. Source: Instituto Brasileiro de Geografia e Estatística, Central Statistics Office, India, Haver Analytics.
  • 12 Data as at May 11, 2011. Source: Morgan Stanley Research, “Indonesia Infrastructure: A US$250bn Opportunity” dated May 11, 2011 by Deyi Tan. e = Morgan Stanley Research estimates; f = Morgan Stanley Research forecasts.
  • 13 Ibid.12.
  • 14 Data as at March 31, 2013. Source: IMF, Haver Analytics.
  • 15 Retail prices for gasoline and diesel to be hiked from Rp4,500/litre to Rp6,500/litre and Rp5,500/litre, respectively. This represents increases of 44% and 22%. Source: Morgan Stanley “Indonesia Economics: Retail Fuel Price Hike – What If?” by Deyi Tan dated May 23, 2013.

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