Investing in Indonesia (Part II)
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Worldview’s last piece on Indonesia highlighted the historical development of Indonesia’s economy and the success of its export-led growth model in spite of high corruption levels, legacy state-controlled enterprises, and political uncertainty in the aftermath of the Asian currency crisis and subsequent rise of Indonesian democracy. This follow-up article covers the recent performance of Indonesia’s equity and currency markets, putting Indonesia’s phenomenal gains in greater context.
Indonesia’s primary equity index is the Jakarta Composite Index (JCI), which hovers at close to 3500 at the time of this writing, a little less than 10% below its all-time high. For US retail investors, two ETFs offer exposure to Indonesia’s market: Van Eck’s Market Vectors Indonesia Index ETF (IDX) and iShares’ MSCI Indonesia Investable Market Index Fund (EIDO). Wisdom Tree was reported to have a currency ETF in development for tracking the Indonesian rupiah (IDR), but this project appears to be on hold.
Figure 5 shows the MSCI Gross Total Return USD Index for Indonesia and several other major emerging-market and global indices. The chart suggests that global indices can be broken down into roughly three clusters by returns: 1) US and global-market returns, lying at the bottom of the chart; 2) an emerging-market cluster, composed of China, India, BRIC, EM, and Asia-ex-Japan indices; and 3) emerging-market superperformers, which include Brazil and Indonesia.
Brazil’s and Indonesia’s equity markets have grown spectacularly since they bottomed out in the 2008 financial crisis. At the time of this writing, the two have reached similar levels on the chart at similarly outstanding growth rates; however, the JCI also has the distinction of being nearly 20% above its pre-crisis high, whereas most markets are only now just returning to their pre-crisis highs, if that. Even ever-popular Brazil is still 13% below its high-water mark on MSCI’s total-return basis. Table 2 shows the dates of pre-crisis highs (weekly close data) and lows, as well as crash depths and percent recoveries from the crisis lows.
Table 2: Crisis Data for Indonesia and Comparative Cases
As Table 2 reveals, the emerging markets all collapsed to roughly the same degree—to about 70% below their pre-crisis peaks—but their subsequent performance has been markedly varied: Indonesia has more than quadrupled off the lows; Brazil has tripled; the US has doubled; and China and India have grown by 125% and 162%, respectively. Investors’ post-crisis allocations have dramatically affected post-crisis results, even among the emerging markets.
Figure 6 presents a total risk-return chart comparing Indonesia’s risk-return features against other emerging-market and world-market indices. Indonesia’s total return is only slightly less than Brazil’s and in line with its lower total risk. In fact, Indonesia, India, and Brazil have exhibited roughly similar Sharpe ratios (0.623, 0.604, and 0.627, respectively) over the 1999–2011 period, substantially higher than those of China (0.358), the US (0.082), and the MSCI All Country World Index (ACWI) (0.173). Only the MSCI BRIC Index has a higher Sharpe ratio (0.715), a result of the diversification benefits of investing across major emerging markets.
Figure 7 plots the realized returns of different indices versus their realized betas to the ACWI. The security market line passing through cash and the ACWI index helps highlight the degree to which realized returns have come from sources unrelated to world equity performance (i.e., alpha), and shows that Indonesia has delivered large quantities of alpha (21.6% annually) from January 1, 1999, to February 18, 2011. Brazil has generated similar levels of alpha (20.3% annually) over the same period, but with roughly twice the level of systemic (i.e., beta) risk. The MSCI BRIC has also produced substantial alpha (12.3% annually), but also with relatively high levels of systemic risk.
Despite the claim made by some observers that emerging-market returns are simply a levered play on global growth, these results show that some equity markets, such as Indonesia and India, actually have less global systemic risk than either the United States or the global indices as a whole.
Table 3 presents quantitative features of the MSCI USD Total Return Indices in greater detail. Indonesia’s high alpha and moderate to low beta are due in part to its relatively low correlation to global markets (r=+0.371 versus the ACWI). Indeed, Indonesia has the lowest correlation to the global index of any market in the table. Its substantial domestic economy, serving 240 million residents, and relative energy independence allow the economy and company revenues to fluctuate independently of the world market. Strategic trade integration to deliver raw materials to China and assembled manufactures to the US and Australia also helps diversify its sources of foreign revenue.
Table 3: Quantitative Data for Indonesia and Other Market Indices (01/99-02/11)
The substantial realized alpha in Indonesia does come with a fair degree of Indonesia-specific market risk, as shown by the high level (35.9%) of nonsystemic risk (using the ACWI as the benchmark) in Table 3. The information ratio, or realized alpha per unit of nonsystemic risk, still ranks quite high in the table, although Brazil and the diversified MSCI BRIC still offer more. This means that although there is substantial portfolio alpha available to investors from Indonesia, it helps to have a larger risk budget, or, for benchmarked managers, a higher tracking error in order to take advantage of it.
Compared to the BRICs, Indonesia’s total market capitalization is low: its 2010 market capitalization to GDP ratio (taken from the data in Table 1 [in Part I of this article]) is about 17%, compared to 30% for India, more than 50% for China, Brazil, and Malaysia, and more than 100% for Australia and the US. This suggests that there is substantial room for the market to grow, even if Indonesia’s overall growth rates were to slow. On the flip side, it also implies that liquidity can be an issue at times, and may explain part of the unusually high return rates.
Figures 8 and 9 show valuation figures for the five single-country markets on February 18, 2011, relative to their historical ranges over the last decade. Due to data limitations, some countries have longer available histories than others. Figure 8 charts trailing P/E ratios, while Figure 9 shows current dividend yields. These figures indicate that most countries are close to their recent historical averages, although Indonesia’s P/E ratio is a little high and its dividend yield a little low, suggesting that it is mildly overvalued right now. A comparison of median P/E and dividend figures (not shown) as opposed to ordinary means reveals that both Indonesia and Brazil are relatively overvalued for their historical averages, the US and India are undervalued, and China is undervalued based on P/E ratios but overvalued based on dividend yields.
Figure 8: Current Trailing P/E versus Historical Ranges—Five Markets
Figure 9: Current Dividend Yields versus Historical Ranges—Five Markets
Figure 10 plots the value of the rupiah in US dollars and euros from January 1, 1999, to February 18, 2011. Inflationary episodes in the 1980s and a dramatic loss of purchasing power during the Asian crisis—in which the rupiah traded as low as Rp 16,800 per USD—have reduced the currency to a tiny fraction of what it was earlier in the century. Presently, $1 will fetch about Rp 8,900. Since everyday transactions at this rate can easily run into the millions or billions of rupiah, Bank Indonesia, the nation’s central bank, is developing plans to reissue the currency in new denominations, removing three zeros; however, this process is moving slowly and may not be completed until late in the decade. This would not be a revaluation of the currency, but rather a redenomination of currency units to facilitate trade.
Although the absolute exchange rate might make the rupiah appear weak on the surface, the currency has been remarkably stable over the last ten years, particularly when compared to the dramatic 80% collapse seen at the height of the 1997-98 currency crisis. Bank Indonesia currently follows an inflation-targeting regime, rather than an official peg or fixed-rate policy versus the US dollar, but Figure 10 clearly suggests that the bank considers the dollar exchange rate a key input into monetary policy, presumably because the dollar is a major reference point in measuring inflation.
Since 2001, Rp 10,000 has oscillated between $1.00 and $1.20, averaging about $1.10. Given Indonesia’s past hyperinflationary episodes, and with the Asian crisis still in recent memory, this kind of stability is a prudent measure for a country that generally wants to encourage foreign investment. During the 2008 financial crisis, the rupiah lost about 25% of its value against the dollar and about 17% against the euro. This was mostly the result of a global risk-off trade and flight to US Treasury securities, as shown by the difference between depreciation versus the dollar and versus the euro. Today, however, the rupiah has largely returned to its pre-crisis exchange rates.
Indonesia’s banking authorities have introduced more capital controls to regulate the sudden inflows and outflows of currency. Foreign exchanges in amounts over $100,000 US per month are no longer permitted for individuals, and companies must demonstrate a connection with underlying goods and services to exceed this amount. In addition, only spot market trades are permitted for amounts over $100,000 US. Introduced in October 2008, these controls did serve to stem the initial rupiah freefall in the global financial crisis.
There are many reasons to be optimistic about Indonesia and include it in a global or emerging-market portfolio. At the fundamental level, the economy is running on all cylinders, even if it is not growing as fast as China’s or India’s (though it is growing faster than Brazil’s). Democracy seems to be consolidating, although one can expect separatist movements to flare up from time to time. The fact that the island of Java is the most populated and developed will help keep the economic engine running even in the face of occasional separatism on the other islands.
Still a major issue, corruption may be responsible for continued nervousness about investing in Indonesian public companies. Regulators are still uncertain whether portfolio investment (as opposed to foreign direct investment) is good for the country, their doubts fueled by memories of the Asian currency crisis of the 1990s. This means that policymakers may be willing to flirt with additional capital controls on foreign investment. These two issues are probably the fundamental reasons for the apparent discount on Indonesian equities.
From a portfolio-construction perspective, Indonesia offers a substantial source of alpha, resulting from its domestic earnings growth and the low correlations of its markets with global benchmarks among emerging markets of its size and sophistication. Indeed, the correlation is so low that its beta to the ACWI is less than one. Nonetheless, the Jakarta Composite Index is still highly volatile, and a portfolio manager needs to have a large enough risk budget in order to take full advantage of the available alpha.
It is always risky to assume that the future will be a continuation of the recent past, but there are no major reasons to suppose that Indonesia’s prospects will diminish substantially in the near future or that investors will suddenly lose interest in expanding beyond the BRIC-work. Although inflation is heating up across the world, Indonesia is insulated from major fuel price disruptions and has a central bank tuned to inflation targets. Equity valuations do look mildly overvalued by historical standards, but not grossly so, and the growth in fundamentals is still there. Thus, future returns may not be quite as spectacular as the recent past, but they should still be relatively attractive.
In a globalized world, it may be true that no market is an island, but Indonesia could well turn out to be an investor’s favorite archipelago.
–Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Global Research and Consulting, an independent consulting firm specializing in macro strategy, including quantitative, emerging market, and SRI research.