Indonesia

Highlights Indonesian domestic demand is struggling amid tight policy setting. Exports will weaken too, as the Chinese money and credit impulses have rolled over. Slowing Chinese impulses are negative for the rupiah as well. An impending change in the central bank mandate will also add to currency weakness. This warrants that equity investors stay short/underweight this market. Foreign investors in local currency bonds should downgrade Indonesia from overweight to neutral within an EM portfolio. Sovereign (USD) bond investors, however, should stay overweight given the orthodox fiscal policy. Feature Economic recovery in Indonesia is underwhelming. Stocks will therefore continue to be weak in absolute terms and underperform their EM peers (Chart 1). The main cause of the tepid recovery is very tight monetary and fiscal policies being pursued by the authorities. Even though the policy rate has been reduced over the past year, bank lending rates have not budged much – especially after adjusting for inflation. Borrowing costs in real terms remain around 10% – a very steep rate for an economy that is struggling, and much higher than in other ASEAN countries (Chart 2). Chart 1Indonesian Stocks Are Relapsing Again... Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish Chart 2...As The Economy Is Struggling In The Face Of Very High Real Interest Rates... Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish   Chart 3...And An Elusive Fiscal Support Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish Making matters worse, fiscal support has also been mediocre. At 15% year over year, fiscal spending growth has not been nearly enough to offset the effects of debilitating lockdowns. What’s more, the goal of the finance minister’s proposed budget is to narrow the fiscal deficit from its current 6.5% to 5.7% of GDP for 2021; and to 4.8% of GDP in 2022. What this entails is that the cyclically-adjusted fiscal thrust over the next year and a half will be a negative 1.3% of GDP, as per the IMF projections (Chart 3). To put it differently, the economy does not have much to look forward to in terms of fiscal backing. As expected, such restrictive policy is proving to be too onerous for the economy to overcome: More than a year after the pandemic hit, retail sales volumes are still contracting. Low levels of consumer confidence indicate that they remain wary of spending. Vehicle sales are well below the pre-pandemic levels. So is vehicle production. (Chart 4). Consistently, loan demand is also very weak. Bank credit for both consumption and production purposes (for both working capital and capital investment purposes) is shrinking (Chart 5). Chart 4Both Consumption And Production Levels Remain Very Weak... Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish Chart 5...Amid A Contraction In Bank Credit For All Activities... Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish   Chart 6...Leading To Disinflationary Pressures Taking Hold... Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish In terms of vaccination, Indonesia still has a long way to go. As of May 19, only 8.5% of the population have gotten their first vaccine shot, and only 3.4% have gotten both doses. That means it will be several months before the economy can fully re-open. Weak domestic demand has enabled disinflationary pressures to take hold. Core CPI continues to move down and is undershooting at 1.2%, well below the central bank’s target of 2% to 4% (Chart 6, top panel). The GDP deflator is in outright deflation (Chart 6, bottom panel). Furthermore, the economic impact of the new Omnibus Law, which the parliament passed late last year, will take time to bear fruit. While the net effect of the new law will be positive for the economy in the long run, it’s unlikely to have a material bearing over the next year or so. We have detailed some salient features of the law in Box 1.   Box 1 Salient Features Of Indonesia Omnibus Law, 2020 The stated goal of the Omnibus Law is to boost investments and create jobs by streamlining the rules and simplifying the licensing process. These new laws should incentivize entrepreneurs and investors to invest more in the country. Notably, Indonesia’s capital spending relative to economic output has already been quite high – averaging at 32% of GDP over the past decade. This is lower than only China and India. That said, the bulk of that capex has been spent on building (75%), rather than on plants and machinery (10%). The Omnibus Law has now made it easier for foreigners to invest in the country in all but six industries. That should improve the quality of capital expenditures. It should also boost FDI inflows into the country, which have faltered in the past five years. All this will be a net positive for the economy and for stock markets over the next few years. But it will take considerable time for the authorities to implement all the provisions of this wide-ranging law effectively. As such, there is unlikely to be any major market impact over the coming months. Some of the salient features of the law are: The corporate income tax rate has been lowered from the current 25% to 22% in 2022, and to 20% beginning in 2025. A sovereign wealth fund has been created with about US$ 5.1 billion to attract investments and support the economy. The number of industries that was barred from receiving foreign investments has been reduced from over 300 to just 6 (gambling, chemical weapons, industrial chemicals, illegal drugs, endangered fish and corals). Foreigners can now own 100% of equity in these crucial sectors: Health, Energy and Mineral Resources, Transportation, Telecommunications and IT, Trading, Construction, Plantation and Agriculture. The hiring process of foreign workers in Indonesia has been eased. Violators of competition laws will be subject to unlimited fines now (so far capped at about $ 180,000), but rarely a prison sentence. Entrepreneurs will not need any minimum amount of capital (so far about $3,500) to start a limited liability company anymore. Besides, in the case of micro and small businesses, such companies can be established by just one person.  Employers now can terminate employees with a 14-day written notice, and without prior labor court approvals – the latter was the case so far. Termination entitlements have also been reduced to about half the previous levels. Minimum wage requirements based on sectors/industries have been abolished; and new requirements based on provinces/cities have been introduced. There will also be no fine for entrepreneurs who are late in paying wages. A new social security program (Job Loss Security) has been created wherein Indonesian employees will receive a monthly cash benefit for six months. Bond Bullish Tight monetary and fiscal policies, weak domestic demand, and undershooting inflation – this is a bullish cocktail for domestic bonds. As expected, bonds are outperforming domestic stocks in total return terms (Chart 7). Local investors should stay long bonds, and overweight bonds over stocks in a balanced portfolio. For foreign investors of Indonesian local currency bonds, however, the matter is more nuanced. This is because a major part of the Indonesian domestic bond returns emanates from rupiah returns. Even the relative return (versus the EM benchmark) is highly reliant on the rupiah performance (Chart 8). Chart 7...And Producing A Bullish Backdrop For Bonds Versus Equities Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish Chart 8Yet, Foreign Investors In Domestic Bonds Should Be Wary Of The Currency Risk Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish Going forward, the rupiah outlook is less sanguine. That means foreign investors in local currency bonds should consider paring back their allocations to Indonesia.   Currency Risks Part of the reason for a less sanguine rupiah outlook is a structural issue in Indonesia. The other part is a cyclical one. Chart 9Very High Real Rates In Indonesia Have Discouraged Equity Investors Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish The bulk of the portfolio inflows that Indonesia has been able to attract over the past decade is in the form of debt inflows, rather than equity inflows (Chart 9). The reason is simple: high real interest rates attract fixed income investors but discourage equity investors due to their negative impact on economic growth and corporate profitability. But this has also created an unhealthy dependence on debt inflows: it has incentivized the authorities to keep real interest rates high – so that they can continue to attract enough financing for the government and defend the currency. In addition, the central bank (Bank Indonesia) also has little incentive to reduce interest rates anyway. That’s because the current mandate of the central bank stipulates price stability, via securing exchange rate stability as its sole objective. Lowering interest rates can make local bonds less attractive for foreign fixed income investors, prompting them to dump bonds and thereby cause a currency sell-off. Since that will jeopardize its mandate, the central bank is reluctant to cut rates. The economy, on the other hand, clearly needs lower real rates to help it grow out of the recession and a weaker currency could help kickstart the recovery. This has put the authorities in a bind as the central bank’s current mandate means they are unlikely to facilitate this. That mandate, however, can change soon. The government has introduced a new parliamentary bill for expanding the central bank objective to include economic growth and employment, in addition to price stability. Given the president himself backs the new bill, odds are that it will be passed by parliament sooner rather than later. Chart 10A Slowing Credit And Fiscal Impulse In China Is A Bad Omen For Rupiah Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish If the bill is passed, it will send signals to the markets that the days of maintaining very high real rates are likely over. This will surely prompt some foreign investors in domestic bonds to head for the exit, causing a sell-off in the rupiah and pushing up bond yields. This warrants a cautious approach on the part of foreign bond investors at the moment. Notably, the share of foreign investors’ holdings of Indonesian domestic bonds, at 23%, is one of the highest in EM. In addition, foreign investors also have a cyclical reason to be wary of the rupiah in the months ahead. China’s credit and fiscal impulse has rolled over decisively. Odds are that in the near future, it will have a negative impact on several commodity prices and currencies of commodity-producing countries, including the rupiah (Chart 10).   Sovereign Credit All in all, a questionable outlook for the rupiah has made the job of international fixed income investors more complicated. We provide the following observations to help guide them through the nuances: In the case of Indonesian sovereign USD bonds, the ebbs and flows of the excess return (versus US Treasury) are highly dependent on the rupiah’s strength. If and when the rupiah weakens, the excess returns are also expected to decelerate. Chart 11Indonesian Sovereign Excess Returns Will Likely Decelerate But Not Contract Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish That said, the excess returns are unlikely to turn negative in the months ahead. If history is any guide regarding excess returns turning negative, it would require a 10%+ sell-off in the rupiah – an unlikely event (Chart 11). Besides, Indonesian sovereign spreads will also stay tight given the country’s fiscal orthodoxy. Thus, despite limited potential gains, it still makes sense for absolute return investors to stay long Indonesian sovereign credit for now. Similarly for asset allocators, it makes sense to stay overweight Indonesian sovereign credit in an EM credit portfolio. A possible EM growth wobble (arising from the Chinese growth deceleration) could prove to be a tailwind for Indonesia’s relative performance. This is because investors now deem Indonesian bonds as one of the safest within the EM space – an upshot of pursuing years of orthodox policies. Chart 12Indonesian Sovereign Bonds Now Outperform EM During Risk-Off Periods Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish This was evident in early 2020 when Indonesian sovereign credit massively outperformed their EM peers during the COVID-19 related risk-off phase (Chart 12, top and middle panels). In the past, Indonesia typically underperformed during such risk-off phases (e.g. GFC in 2008 and taper tantrum in 2013). A corollary to this regime change is that Indonesia’s relative sovereign credit performance (versus overall EM) has decoupled from the rupiah – another departure from the past. While the rupiah remains a cyclical currency, the significant improvement in the country’s creditworthiness has turned it into a defensive play within EM credits. Hence, a moderate fall in the rupiah is not a risk factor for relative performance (Chart 12, bottom panel). The bottom line is that it makes sense for both absolute return investors and asset allocators to stay bullish on Indonesian sovereign credit. Stock Bearish The only area of the economy that has shown some promise so far is exports – which have recovered above pre-pandemic levels. This is mainly due to a surge in commodity prices, which led to an impressive 25% year-on-year growth in Indonesia’s exports to China – the destination of 22% of the country’s exports. Indonesia’s exports to China consist of mainly mineral products and base metals which make up 30%, and 25% of total exports to China respectively. But as alluded to earlier, the recent weakness in the Chinese credit and monetary impulses indicate that Chinese imports in general, and commodity imports in particular, will likely slump going forward. Historically, a slowdown in Chinese credit and monetary impulses did not augur well for Indonesian exports (Chart 13). What’s more, those weakening impulses will also likely lead to lower commodity prices ahead. Since Indonesia is a commodity producer, Indonesian stock prices usually benefit when global commodity prices rise. But this time the headwinds emanating from tight domestic policies have been too severe for them to benefit much from the commodity price surge (Chart 14). In any case, a dissipating commodity tailwind will just add to the woes of Indonesian stocks. Chart 13A Roll Over In Chinese Money And Credit Impulse Will Weaken Indonesian Exports... Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish Chart 14...And Soften Commodity Prices, Which Is Bearish For Indonesian Stocks Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish The bearish sentiment in the Indonesian equity market is palpable. It’s hardly a surprise that the country has witnessed incessant net equity outflows since the beginning of the year. Bottom-up analysts are paring back their earnings forecast for Indonesian stocks. Chart 15 shows that every month, more firms are facing a downward revision in their expected earnings than the number of firms facing an upward revision. This is in contrast with the overall EM, where a higher number of firms is seeing an upward revision. Bank stocks, the sole engine of this bourse for the past seven years, are facing a headwind – as contracting bank credit is set to hurt their earnings. Banks are also staring at rising non-performing loans. This is because many borrowers will fail to honor their repayment obligations in the face of a prohibitively high real borrowing cost amid weak income and revenues. Rising NPLs will force the banks to make higher loan loss provisions, which will diminish banks’ earnings further. Sensing the inevitable, bank stocks failed to breach the previous (pre-pandemic) highs and have begun to fall in absolute terms (Chart 16). They are also underperforming the rest of the EM banks. Notably, Indonesian bank stocks are also quite expensive compared to their EM counterparts. Their growth and earnings outlook certainly do not warrant a hefty 130% premium at this moment. Investors should brace for a sizeable correction in Indonesian bank share prices. Chart 15Analysts Are Paring Back Indonesian Stocks' Earnings Forecasts Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish Chart 16Bank Stocks Are Breaking Down As Bank Credit Is Shrinking And NPLs Are Rising Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish   Stock prices of Indonesian non-financial firms and small caps, which are on the receiving end of very high real borrowing costs, are also not in a position to rise given the subdued economy. In fact, those stocks are also breaking down in a well-established downward channel (Chart 17 and Chart 18). Chart 17Bear Markets Have Resumed For Non-Financial Stocks And... Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish Chart 18...Small Caps As They Struggle With High Borrowing Costs And Low Growth Indonesia: Stay Bond Bullish, Stock Bearish Indonesia: Stay Bond Bullish, Stock Bearish The bottom line is that the underperformance of Indonesian stocks has further to run. Investment Conclusions Subdued growth in this economy and an impending relapse in commodity prices will herald a weakness in the rupiah. A probable change in the central bank’s mandate to target growth and employment besides inflation will exacerbate the exchange rate weakness. This calls for staying underweight Indonesian stocks in an EM equity portfolio for now. In the case of dedicated EM sovereign bond (dollar-denominated) portfolios, asset allocators should stay overweight Indonesia. However, in the case of EM local currency bond portfolios, an expected currency volatility warrants that investors pare back their exposure to Indonesia and downgrade this market from overweight to neutral relative to its EM peers.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com  

Highlights Years of extremely high real borrowing costs have decimated Indonesian firms’ return on capital. But tight money constraints have also forced them to improve their operating efficiency meaningfully. A cut in real rates to realistic levels will rotate Indonesia’s equity leadership to non-financial sectors. Equity investors should continue underweighting this bourse but put it on an upgrade watch list. Bond investors should overweight Indonesia in an EM portfolio. Feature Indonesian stocks have gone nowhere for the better part of a decade. Relative to its EM benchmark, they have been down (Chart 1). This is surprising given that the country grew at a robust 5% + pace during this period. So, what’s ailing this stock market? More importantly, when and how can this bourse break free? A Tale In Two Parts A malaise that has plagued Indonesian markets for so long stems from a form of financial unfairness that the country’s borrowers have been subjected to: too high real borrowing costs, for much too long – both in absolute terms and relative to their ASEAN peers (Chart 2). This has stymied Indonesia’s domestic demand, and in turn, the profitability and share prices of its non-financial firms. Chart 1Indonesian Stocks Have Underperformed For A Decade Despite Robust Growth Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 2Indonesia: The Economy Has Been Plagued By Sky-High Borrowing Costs Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   The origin of secularly high Indonesian interest rates in general, and bank lending rates in particular, is rooted in the country’s inflationary past in the 2000s. Back then, CPI would often flare up to double digits, which would in turn induce the central bank to keep rates consistently high as they feared runaway inflation. In the 2010s, however, inflationary pressures gradually dissipated, giving way to disinflationary forces. Both headline and core CPI has stayed below the central bank’s target since 2015 – a target that itself has been falling sequentially. Last year, they fell below the targeted lower band. The GDP deflator is now in outright deflationary territory (Chart 3). Despite the sea-change in the inflation backdrop in the 2010s, the authorities continued with a rather tight monetary policy. That is, policy rates did not keep pace with falling inflation. As a result, real policy rates kept inching up throughout the decade (Chart 4). Chart 3Inflation Has Given Way To Disinflationary Forces... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 4...But Policy Rates Didn't Follow Suit, Leading To Rising Real Rates... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   What’s more, banks have been reluctant to pass on the policy rate cuts to their lending rates in the past couple of years. The result has been consistently high real borrowing cost – banks’ prime lending rate hovering around double digits – for firms and households. Bank's lending rates – in both nominal and real terms –are much higher compared to their peers elsewhere in ASEAN (Chart 4, bottom panel and Chart 2, bottom panel). Chart 5...And Benefitting Lenders At The Expense Of Borrowers Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Over time, high real borrowing costs led to an effectively two-tiered stock market. While banks benefitted immensely from the consistently high interest income; non-financial sectors, facing dwindling revenues and high borrowing costs, were hamstrung by the same. The dichotomy has become more entrenched since 2016 when inflation dropped another notch. All this has led to diverging stock performances: bank stocks soared, massively outperforming the rest of the Indonesian markets. They, in fact, also outperformed other EM banks. Non-financial sectors, on the other hand, languished. As did the Indonesian small cap index – where non-financial firms make up 87% of the market cap (Chart 5). This diverging performance of banks and non-banks stocks is quite unusual. Since banks are by far the main source of financing for non-financial firms in Indonesia, their performance is usually leveraged to the performance of their clients (i.e., borrowers). If borrowers/non-bank companies do not do well, it is equally hard for their banks to do well. In this light, the diverging performance is indicative of an unlevel playing field: where one sector (banks) benefits at the expense of the other. Hamstrung By Elevated Borrowing Costs High borrowing costs in real terms will have unintended consequences going forward. What’s more, such settings will eventually prove counter-productive even for the banking sector. Very high real borrowing costs is distressing the financial health of Indonesian firms. Their interest expenses as a share of revenues and operating profits have been rising sharply in recent years (Chart 6). This is weighing on their net profit margins. Notably, rising interest costs is not a result of a surge in borrowing. Bank credit in Indonesia has been flat since 2013 at a rather low level of 35% of GDP. Bank credit to all private and public non-financial corporations has stayed flat at an even lower 17% of GDP (Chart 7). Chart 6Firms' Interest Expenses Relative To Sales/Earnings Have Risen A Lot... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 7...Even Though Their Borrowings Have Stayed Under Control Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   The non-financial corporations’ other domestic and foreign indebtedness (e.g., debt securities issued and foreign bank borrowing) amount to another 15% of GDP. Thus, the total indebtedness of all non-financial corporations amounts to about 32% of GDP, which has hovered around the same level since 2015 and is not alarming (Chart 7, bottom panel). The main reason why non-financial firms’ profitability drifted down is that their nominal sales decelerated meaningfully, but some costs (specifically, borrowing costs) did not. The sales growth rate of the listed non-financial firms has been lower than the banks’ actual lending rates for the past several years. This clearly led to a massive blow to their return on capital (Chart 8). Over time, persistently high real borrowing costs will result in a rising number of firms being rendered unviable. Real domestic demand will decline, which will cause further disinflation, and nominal sales of these firms will further decelerate. Eventually, companies will struggle to pay down their debts. During a downturn, whether caused by a pandemic or by regular business cycles, the problem will become more acute. In short, persistently high real lending rates will eventually come back to haunt banks. Notably, banks’ NPL ratio was rising even before the pandemic-related recession hit (Chart 9). Going forward, they are slated to rise more as firms’ sales have plummeted. For now, various Covid-19-related loan and interest repayment moratorium measures until March 2021 could mean that the reported NPL figures would artificially stay low. But eventually, the true extent of NPLs will become apparent, which will weigh on bank profits. Chart 8Decelerating Sales Amid High Borrowing Costs Decimated Firms' Return On Capital Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 9Struggling Firms Will Cause Further Rise In Banks' Bad Loans Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   Unrealistically high real lending rates can backfire for banks in other ways too. High real lending rates would lead to an ‘adverse selection’ of borrowers. That is, only borrowers with a tolerance for very high risk would be willing to borrow at such high rates. This is not a sustainable business model for banks in the long term. As for listed non-financial firms, since the ratio of their foreign indebtedness to total indebtedness is already very high – more than half of the total debt (Chart 7, before), there is little room for them for further foreign borrowing (and in taking on more currency risks). As such, they are squarely dependent on local borrowing, and therefore on local interest rates, for future growth. Real borrowing costs of the order of 10% is extremely restrictive for any economy to overcome, let alone one flirting with recession. From a macro perspective, the only way for Indonesia to boost growth now is by significantly reducing real borrowing costs:  large policy rate cuts and incentivizing banks to bring down the lending rates. The upshot of monetary easing will be currency depreciation. The latter will help boost inflation, contributing to lower real interest rates. Rising Distortions Elsewhere Chart 10Falling Return On Capital Has Discouraged Equity And FDI Inflows To Indonesia... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates The distortions caused by persistently high real rates can be seen elsewhere in the economy. Indonesia has been receiving a meager amount of foreign equity portfolio inflows (Chart 10). The reason for this is that foreign capital tends to flow into those countries where return on capital is high and/or rising. A diminishing return on capital in Indonesia has discouraged foreign equity capital inflows. Crucially, as we argued above, although Indonesian banks have been profitable, their business model of the past several years is not sustainable. Besides, bank stocks have rallied a lot and are expensive. As such, they are no longer as attractive an investment for foreigners. Gross FDI inflows into the country have also slowed since 2015 (Chart 10, bottom panel) – coinciding with the drop in return on capital. Indeed, the stock of foreign direct investments in Indonesia, relative to its GDP, has fallen sharply over the past few years. In short, foreign equity portfolio and direct invest flows have been measly due to falling rates of return on capital. An inability to attract foreign capital inflows, in turn, can weigh on the currency. To be sure, this has indeed been the case for Indonesia: the rupiah has depreciated in tandem with falling return on capital (Chart 11). What has complicated matters more for Indonesia is that of all the international capital inflows the country has managed to attract in recent years, the majority have been in the form of credit, not equity (Chart 12). This is not surprising as creditors prefer high real rates while equity investors dislike high real interest rates. Chart 11...Putting Downward Pressures On The Currency Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 12Higher Dependence On Debt Borrowing Has Incentivized Indonesia To Keep Real Rates High Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   However, rising reliance on foreign debt inflows has incentivized the authorities to keep real interest rates high so that they can continue to attract enough financing for the government and defend the currency. In other words, it has encouraged a vicious cycle of high real rates; lower return on capital; lower equity and FDI inflows, but more debt inflows; and continued high real rates. A Window Of Opportunity Chart 13Years Of Hard Budget Constraints Have Forced Firms To Improve Operating Efficiency... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Indonesia needs to and can break free from this vicious cycle. In fact, years of tight money policy has laid the groundwork for its non-financial sectors to take off.  As we have argued in the previous report, while cheap money and ample stimulus can be good for share prices in the near to medium-term; excessive stimulus and easy money policies – we refer to these as soft-budget constraints – bode ill for share prices in the long term. Conversely, hard-budget constraints usually force companies into restructuring, deleveraging and cutting wasteful expenditures, and make them leaner and more efficient. In the long run, hard-budget constraints can create conditions for a bull market. Given that Indonesian non-financial firms have been facing years of hard-budget constraints, there are indeed signs that their efficiency is improving. Operating profit margins (EBITDA) have been rising over the past several years. Consistently, operating cash flows relative to sales have also steadily gone up.  These are clear indications of improving operating efficiency (Chart 13, top panel). Non-financial firms’ leverage levels have also stayed under control. The debt-assets and debt-equity ratios have fluctuated within their historical range over the past 10 years (Chart 14). The rising trends of EBITDA and operating cash flows relative to ‘enterprise value’ indicate that the firms’ profitability and valuations have also improved (Chart 13, bottom panel). In other words, firms are now generating much higher operating cash flows and operating profits relative to the price one would need to pay to acquire them. Incidentally, enterprise value is a more comprehensive measure of firm value than is market capitalization, as the former includes the value of firms’ debt and cash balances too, in addition to equity.1  This is to say, save for the exorbitant financing costs and the consequences thereof, Indonesian non-financial firms are not in bad shape. Borrowing cost is the main reason why the firms’ net profit margins have fallen in recent years despite rising operating margins (Chart 15). Chart 14...And Keep Leverage Under Check Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 15Improving Operating Margins Are Weighed Down By Exorbitant Financing Costs Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   This also means that if and when real borrowing costs decline meaningfully, Indonesian non-financial firms will be in a position to take advantage of it. Their net profit margins will rise, and with that, the odds of more capital spending, future growth and potentially higher share prices. Banks Might Need To Foot The Bill For any meaningful easing of interest expense burden for non-financial firms, the real lending rates need to be reduced by several hundred basis points. This obviously cannot be achieved by reduction of policy rates alone – which is currently at 3.75%. The only other way is to encourage the banks to reduce their lending rates even more than policy rate cuts. This can be done by, say, lowering risk weights to loans meaningfully. It will reduce banks’ capital cost per unit of loans (i.e., banks will have to set aside a lower amount of capital for their loans); and therefore incentivize them to reduce their lending rates so that they can grow their loan books and take advantage of lower capital cost. The secular bull market in Indonesian bank stocks were afforded by the hefty net interest margins they enjoyed for years – both in absolute terms and compared to their peers elsewhere (Chart 16). That said, their share price swings actually depended on the ebbs and flows of banks’ net interest margins (NIM) (Chart 17). As such, any meaningful cut in banks’ NIM will not only weigh on bank share prices, it could cause a rotation of equity leadership from banks to non-banks stocks. Chart 16Steep Net Interest Margins Led To Indonesian Bank Stocks' Bull Run Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 17A Fall In Banks' Net Interest Margins Will Rotate Equity Leadership To Non-Bank Stocks Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates     Investment Conclusions Equities Investors, therefore, should be watching for any whiff of policy change. A meaningful departure from the current monetary policy of imposing high real interest rates on the economy will help usher in a new bull market in Indonesian non-financial stocks, which have languished for several years. That said, we still do not see any concrete signs of change in that policy. Indeed, the central bank’s focus remains on controlling inflation and stabilizing the rupiah. This does not suggest that the authorities are about to adopt a regime of low real borrowing costs for non-banks. Until that happens, this bourse will find it hard to outperform an EM portfolio on a sustainable basis. Investors should continue underweighting this bourse within an EM equity portfolio for now; but put it on the upgrade watch list. Currency The rupiah is likely to stay steady for now. The reason is that the recent improvements in trade and current account balances will likely linger as domestic demand, facing high real interest rates, remains lackluster. A relatively steady current account would obviate the need for strong foreign capital inflows to sustain a stable exchange rate. Crucially, the introduction of the Omnibus Law, while the details are not yet finalized, is likely to encourage capital inflows on the margin. We will discuss the full implication of the Omnibus Law in a subsequent report. Suffice it to say, both current and capital account dynamics are likely to keep Indonesia’s balance of payments afloat – which is supportive of the currency. That said, any whiff of a change in policy toward a lower real rate regime will dramatically change the exchange rate outlook. Should the central bank begin to cut interest rates by any meaningful measures (upwards of 100 basis points), the currency will lose its appeal of the high carry and will depreciate. But as we argued above such a policy shift is not imminent. Fixed Income Chart 18Investors Should Upgrade Indonesian Local Currency Bonds To Overweight Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Fiscal deficits have surged to 5% of GDP – as expenditures were raised to cope with the fallouts of the pandemic last year, even as revenues dropped. Going forward, however, fiscal policy will be tightening. In other words, fiscal thrust would be negative in 2021 and probably in 2022, as projected by the IMF. This does not augur well for economic growth. Tight monetary and fiscal policies, weak domestic demand and undershooting inflation represent a bullish cocktail for domestic bonds (Chart 18). Besides, the yield curve has steepened to its highest level in a decade suggesting that the long end of the yield curve offers good value (Chart 18, bottom panel). Dedicated fixed income investors should upgrade Indonesian local currency bonds to overweight in an EM portfolio. Consistently, we are closing our short position in domestic bonds. As to sovereign credit, we are upgrading it to overweight too as a stable currency and prudent fiscal policy bode well for sovereign credit. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1  Enterprise Value = Stock market capitalization plus short and long term debts minus cash and cash equivalents.

China: The Recovery And Equity Dichotomy China’s economic recovery has been gathering steam, and policymakers have become reasonably confident about the growth outlook. In fact, transaction activity in the property market has recovered to year-ago levels, auto sales and construction starts have bottomed following a 18 to 20-month contraction (Chart I-1). In line with this economic revival, authorities issued a statement following last week’s Politburo meeting contending that monetary policy should aim “to maintain adequate growth of money supply and credit.” This statement is a change in the monetary policy stance in May when the stated objective was to “significantly accelerate the growth rate of broad money supply and total social financing relative to last year.” This change in language highlights that authorities have become more comfortable with the recovery and are now becoming a bit concerned about amplifying credit and property market excesses. There will be no additional stimulus forthcoming, but policy tightening is not in the cards. In short, there will be no additional stimulus forthcoming, but policy tightening is not in the cards. Policymakers will therefore be in a wait-and-see mode for now, monitoring how economic conditions improve as the enacted stimulus works its way into the economy. Odds are high that the business cycle recovery will continue in China for now. Chart I-2 shows that the amount of credit and fiscal stimulus has been considerable, and that broad money and bank assets impulses remain in uptrend. All these should support the recovery into early next year. Chart I-1China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway Chart I-2China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy As to the risks to Chinese growth emanating from depressed demand in the rest of the world, they are not substantial. First, global demand has already bottomed. Second, China’s total exports account for 17% of GDP, while investment expenditures and consumer spending account for 42% and 38% of GDP, respectively (Chart I-3). Hence, rising capital expenditures and household spending will offset the drag from exports. Finally, China exports many household and medical goods that are currently in very high demand worldwide due to the lockdowns and the pandemic. As a result, Chinese exports have recently done a bit better than global shipments in volume terms (Chart I-4). Chart I-3China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports Chart I-4Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments As to domestic growth drivers, output has been rising faster than consumer demand. Furthermore, capital spending and production by state-owned enterprises has been much stronger than that of private enterprises. However, with the stimulus in full force, both consumer demand and private investment will pick up in the second half of this year. An Equity Market Dichotomy Chart I-5Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks On the surface, the strong rally in Chinese equity indexes has validated the economic recovery thesis. However, a closer examination of the equity performance of various equity sectors reveals that the rebound in cyclical sectors has been rather tame and that the large gains in the equity indexes have been primarily due to tech and new economy businesses, benefiting from working and shopping from home, and to health care stocks (Chart I-5). Chart I-6 illustrates that industrials, materials, autos and real estate stocks are only modestly above their March lows. More importantly, large bank stocks trading in Hong Kong are reaching new lows in absolute terms (Chart I-6, bottom panel). Chart I-6China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks Is such lackluster performance by Chinese cyclical stocks a warning sign to its business cycle recovery? Not necessarily. In our opinion, poor performance of cyclical stocks and banks in China reflects the long-term ramifications of repeated episodes of credit frenzy. A credit-driven growth recovery is always a double-edged sword for both borrowers and creditors. Companies that borrow and invest in new projects accumulate debt. Critically, it is unclear whether these investments will produce new recurring cash flows that would allow the debtors to service their debt. Hence, many companies that take on more debt and invest in financially non-viable projects undermine shareholder value. China has again doubled down on the same policies it has been deploying since the 2008 Lehman crisis. Namely, it has encouraged another boom in money and credit creation, as well as in infrastructure investment. Another outcome of this is that excess money creation leaks into the property market, further fueling the real estate bubble. As for banks, if debtors are unable to service their debt, bank shareholders will be at risk too. This does not mean that banks will be liquidated, but that their shareholders will be diluted. It is critical to put this round of stimulus into perspective: it comes amid already elevated debt levels, following a decade-long credit frenzy and a two decade-long capital spending boom (Chart I-7). Therefore, we doubt that the latest round of investments will be able to substantially increase shareholder value. On the whole, we believe the rally in Chinese stocks outside secular growth plays – such as Alibaba, Tencent – is cyclical not structural. The basis is that while more credit produces a cyclical recovery, it often undermines shareholder value. Chart I-6 on page 4 illustrates that Chinese cyclical stocks and bank share prices have been flat-to-down in the past 10 years despite recurring stimulus.   Finally, the near-term risks for Chinese stocks do not stem from the domestic economy, but from geopolitics and a correction in US FAANG stocks. President Trump may escalate the confrontation with China in order to “rally the nation behind the flag” if his polling does not improve ahead of the November elections. Chart I-8 illustrates that the Americans’ view of China has deteriorated significantly in recent years. This might be exploited by President Trump to boost his re-election chances. A heightened confrontation could produce a correction in Chinese stocks. Chart I-7China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger Chart I-8Americans’ Perception Of China Has Deteriorated In Recent Years China, Indonesia And Turkey China, Indonesia And Turkey Also, if the FAANG mania is either paused or reversed, then Chinese tech and mega-cap stocks will correct, pulling down the broad Chinese equity indexes. Bottom Line: The current round of stimulus in China has made the credit, money and property excesses even larger. As we have written over the years, easy money and credit generally fuel a misallocation of capital. Ultimately, this slows productivity growth on the macro level and destroys shareholder value on the company level.   Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Nevertheless, given that the cyclical recovery in China will endure for now, we continue overweighting Chinese investable stocks within an EM equity portfolio. Finally, we are closing our short CNY/long USD position given the change in our USD outlook on July 9. This position has produced a 4.2% loss since its initiation on December 9, 2015. A Stress Test For Bank Stocks Chart I-9China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Chart I-9 demonstrates that the risk-weighted assets of smaller banks have risen much faster, and are presently larger, than those of large banks. We have performed a new stress test for both the Big Five and small & medium listed banks. Concerning large banks, our base-case scenario calls for risk-weighted non-performing assets to rise to 13% of total. Accordingly, their equity will be diluted by 46% if they were to provision for these losses (Table I-1). Consequently, the true (adjusted) price-to-book (PBV) ratio will be 1.1. Assuming that the fair value of these large banks corresponds to a PBV ratio of one, then Big Five banks remain moderately (10%) overpriced. For small banks, our baseline scenario assumes a risk-weighted non-performing asset ratio of 13%. If these banks were to provision for these write offs, their equity will be diluted by 61%, pushing the adjusted PBV ratio to 2 (Table I-2). If we use a PBV fair value ratio of 1.3, then small and medium listed banks are substantially overpriced. Table I-1Stress Test Of 5 Large Banks China, Indonesia And Turkey China, Indonesia And Turkey Table I-2Stress Test Of The Other 25 Listed Medium & Small Banks China, Indonesia And Turkey China, Indonesia And Turkey Chart I-10Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Bottom Line: Chinese banks stocks could rebound, but their structural outlook has deteriorated further following another round of credit binge. Among banks stocks, we reiterate our strategy of favoring large banks over smaller ones (Chart I-10).  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  Lin Xiang, CFA Research Analyst linx@bcaresearch.com Indonesia: Struggling To Recover Indonesian stocks and the rupiah have rebounded in line with global risk assets. However, the rebound might be waning. The rupiah has begun weakening anew against the US dollar despite a major weakness in the latter. Relative to EM, Indonesian equities are underperforming again (Chart II-1). Chart II-1Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Crumbling Economic Activity And Insufficient Stimulus Indonesia is experiencing its worst recession since the Asian Crisis in 1997. Consumer income has dwindled and consumer confidence collapsed (Chart II-2, top panel). In turn, passenger car and truck sales have contracted by 90% and 84%, respectively, from a year ago (Chart II-2, second and third panel). Meanwhile, domestic cement consumption plunged by 17% (Chart II-2, bottom panel). In the meantime, the Coronavirus pandemic is not subsiding and will continue weighing on the Indonesian economy. The authorities have been attempting to prop up domestic demand. Yet the total fiscal stimulus announced so far – which amounts to $48 billion or 4.3% of GDP – is unlikely to be enough, given the harsh nature of this recession. For instance, the commercial banks loan impulse has already dipped to -2.7% of GDP (Chart II-3, top panel). Provided that demand for credit stays weak and banks continue to be reluctant to lend, the credit impulse will drop even further. As a result, the negative credit impulse will offset the fiscal thrust. Chart II-2Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Chart II-3Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High   On the monetary policy front, Bank Indonesia (BI) has been aggressively cutting its policy rate and injecting banking system liquidity into the market. The BI has been also purchasing government bonds on the secondary and primary markets, de facto conducting quantitative easing. Still, the ongoing monetary easing has not translated into lower lending rates for the real economy. In particular, although the BI lowered its policy rate by 200 basis points since July 2019, bank lending rates have only fallen by 100 basis points (Chart II-3, middle panel). This is a major sign that the monetary transmission mechanism is broken. Furthermore, the commercial banks’ lending rate, in real (inflation-adjusted) terms, remains elevated (Chart II-3, bottom panel). This is severely hurting credit demand (Chart II-3, top panel). The deflationary pressures on the Indonesian economy are intensifying. As a result, the deflationary pressures on the Indonesian economy are intensifying. The top panel of Chart II-4 shows that the GDP deflator is flirting with deflation. Meanwhile, both core and headline inflation have undershot the central bank’s target (Chart II-4, bottom panel). Bottom Line: Very low inflation and crumbling real growth have caused nominal GDP growth to drop below borrowing rates (Chart II-5). This is hitting borrowers’ ability to service their debt and is leading to swelling non-performing loans (NPLs). Chart II-4Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Chart II-5Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates   Bank Stocks Remain At Risk The outlook for bank stocks that make up 48% of the Indonesia MSCI equity index is bleak. Chart II-6 shows that non-performing loans and special-mention loans (which are composed of doubtful loans) were rising before the pandemic shock. This has forced commercial banks to boost their bad loans provisioning, which has hurt their profitability. Additionally, Indonesian commercial banks’ net interest margins (NIM) have been falling sharply (Chart II-7). This has occurred because, on the revenues side, interest earnings have mushroomed as debtors have halted their interest payments while, on the expenditures side, commercial banks were forced to keep on paying interests to depositors. To protect their profitability, commercial banks have kept their lending rates stubbornly high. However, doing so will end up backfiring – as elevated lending rates punish borrowers and end up causing NPLs to rise, leading to more profit weakness. Chart II-6Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Chart II-7Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling   Crucially, Bank Central Asia and Bank Rakyat – which now account for a whopping 37% of the Indonesia MSCI market cap – are vulnerable. Both commercial banks are heavily exposed to state-owned enterprises (SOE) and small and medium (SME) companies. Particularly, 40% of Bank Central Asia’s loan book is linked to SOEs and government-led projects across electricity, ports, airports and cement among other sectors. Meanwhile, 68% of Bank Rakyat’s loan book is leveraged to the SME sector and 20% to large companies, including SOEs. Worryingly, both SOEs and SMEs have been undergoing stress. Their profitability and debt servicing ability were questionable even before the COVID-19 pandemic. State-Owned Enterprises (SOEs): The debt servicing ability for these companies has deteriorated. The debt-to-EBITDA ratio has risen considerably while the EBITDA coverage of interest expenses is set to fall from already low levels (Chart II-8). Small & Medium Enterprises (SME): The debt serviceability of the top 40% of the MSCI-listed small cap stocks is also deteriorating. The top panel of Chart II-9 shows that these companies’ debt-to-EBITDA has risen substantially, and that the EBITDA-to-interest expense ratio has plunged (Chart II-9, bottom panel). Chart II-8Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Chart II-9Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity   Chart II-10Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps All in all, both Bank Central Asia and Bank Rakyat are set to experience a considerable new NPL cycle emanating from the poor profitability of SOEs and SMEs. Importantly, Bank Central Asia and Bank Rakyat’s respective NPLs at 1.3% and 2.6% were relatively low at the start of this year and have much room to rise. Neither are their valuations appealing. At a price-to-book value of 4.4 Bank Central Asia is expensive. As for Bank Rakyat while its multiples are not as high as Bank Central Asia’s (which is trading at a price-to-book value of 1.8), it is not particularly cheap either, considering its enormous exposure to Indonesia’s struggling SME sector.  Bottom Line: The outlook for bank stocks is murky (Chart II-10). Apart from banks, the rest of the Indonesian stock market has been performing very poorly and there is no obvious evidence that this will change (Chart II-10, bottom two panels). Investment Conclusions Continue underweighting the Indonesian stock market. Bank stocks remain at risk. Moreover, there is evidence that retail investors have been active in the stock market as of late. When the stock market does relapse, retail investors will likely rush to sell their holdings, thereby magnifying the equity selloff. Dedicated EM local currency bonds and credit portfolios should continue underweighting Indonesia. Investors in Indonesia’s corporate US dollar bonds should tread carefully as the largest issuers are those SOEs that have experienced deteriorating creditworthiness. Chart II-11Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies If the US dollar continues to depreciate, the rupiah could stabilize and rebound but it will underperform other EM and DM currencies. Return on capital (ROC) is the ultimate driver of EM currencies. Given the magnitude of the recession Indonesia is in and the slow recovery it will experience, its ROC will remain weak. This will weigh on the rupiah (Chart II-11). We continue shorting the rupiah against an equally weighted basket of the euro, Swiss franc and Japanese yen. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Turkey: The Ramifications Of A Money Plethora Turkey is facing another currency turmoil. At the core of significant currency depreciation pressures is an overflow of money. Chart III-1 demonstrates that narrow money (M1) and broad money (M3) are booming at 90% and 50%, respectively, from a year ago. These measures exclude foreign currency deposits. Bank loan annual growth has surged to 45% and commercial bank purchases of government bonds are skyrocketing (Chart III-2). Chart III-1Turkey's Money Overflow Turkey's Money Overflow Turkey's Money Overflow Chart III-2Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks     In turn, the Central Bank of Turkey’s (CBRT) funding of commercial banks has surged (Chart III-3). By providing ample liquidity the CBRT has enabled commercial banks to engage in a credit frenzy and levy of government debt. The latter has capped local currency bond yields at a time when the private sector and foreign investors have been reluctant to finance the government bond given its current yields. At the core of significant currency depreciation pressures is an overflow of money. Consistent with this expanding money bubble, inflation in Turkey remains in a structural uptrend (Chart III-4). Core and service sector consumer price inflation is close to 12% and will rise even further due to the overflow of money in the economy. Besides, residential property prices are already soaring, in local currency terms, as residents are fleeing from liras. Chart III-3Central Bank's Funding Of Banks Central Bank's Funding Of Banks Central Bank's Funding Of Banks Chart III-4Structurally Rising Inflation Structurally Rising Inflation Structurally Rising Inflation   Still, the central bank refuses to acknowledge these inflationary pressures and to tighten its policy stance. Monetary authorities remain well behind the inflation curve. The policy rate, in real terms (deflated by core CPI), is -2%. In the past, when real policy rates have dropped to this level, the exchange rate has often tumbled, as in 2011, 2013, 2015 and 2018 (Chart III-5). Chart III-5Numerous Headwinds For The Lira Numerous Headwinds For The Lira Numerous Headwinds For The Lira In regard to balance of payments, the current account deficit is widening again due to the plunge in exports and tourism revenues and the recovering imports (Chart III-5, bottom panel). Historically, a widening current account deficit has weighed on the currency. Lastly, the central bank is not in the position to defend the exchange rate much longer. Not only has it depleted its own reserves but it has also used up $70 billion of commercial banks deposits and entered a $55 billion foreign exchange swap. Hence, its is massively short on US dollars. Bottom Line: As part of our broader currency strategy, on July 9, we replaced our short Turkish lira versus the US dollar position with a short in TRY versus a basket of the euro, CHF and JPY. This switch has proved to be very profitable and we continue recommending it. Consequently, investors should continue underweighting Turkish stocks, local currency bonds and credit markets relative to their EM counterparts. Fixed-income investors should consider betting on higher inflation expectations, i.e. going long domestic inflation adjusted yields and shorting nominal yields. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Chart II-1Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Indonesian stocks and the rupiah have rebounded in line with global risk assets. However, the rebound might be waning. The rupiah has begun weakening anew against the US dollar despite a major weakness in the latter. Relative to EM, Indonesian equities are underperforming again (Chart II-1). Crumbling Economic Activity And Insufficient Stimulus Indonesia is experiencing its worst recession since the Asian Crisis in 1997. Consumer income has dwindled and consumer confidence collapsed (Chart II-2, top panel). In turn, passenger car and truck sales have contracted by 90% and 84%, respectively, from a year ago (Chart II-2, second and third panel). Meanwhile, domestic cement consumption plunged by 17% (Chart II-2, bottom panel). In the meantime, the Coronavirus pandemic is not subsiding and will continue weighing on the Indonesian economy. The authorities have been attempting to prop up domestic demand. Yet the total fiscal stimulus announced so far – which amounts to $48 billion or 4.3% of GDP – is unlikely to be enough, given the harsh nature of this recession. For instance, the commercial banks loan impulse has already dipped to -2.7% of GDP (Chart II-3, top panel). Provided that demand for credit stays weak and banks continue to be reluctant to lend, the credit impulse will drop even further. As a result, the negative credit impulse will offset the fiscal thrust. Chart II-2Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Chart II-3Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High On the monetary policy front, Bank Indonesia (BI) has been aggressively cutting its policy rate and injecting banking system liquidity into the market. The BI has been also purchasing government bonds on the secondary and primary markets, de facto conducting quantitative easing. Still, the ongoing monetary easing has not translated into lower lending rates for the real economy. In particular, although the BI lowered its policy rate by 200 basis points since July 2019, bank lending rates have only fallen by 100 basis points (Chart II-3, middle panel). This is a major sign that the monetary transmission mechanism is broken. Furthermore, the commercial banks’ lending rate, in real (inflation-adjusted) terms, remains elevated (Chart II-3, bottom panel). This is severely hurting credit demand (Chart II-3, top panel). As a result, the deflationary pressures on the Indonesian economy are intensifying. The top panel of Chart II-4 shows that the GDP deflator is flirting with deflation. Meanwhile, both core and headline inflation have undershot the central bank’s target (Chart II-4, bottom panel). Bottom Line: Very low inflation and crumbling real growth have caused nominal GDP growth to drop below borrowing rates (Chart II-5). This is hitting borrowers’ ability to service their debt and is leading to swelling non-performing loans (NPLs). Chart II-4Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Chart II-5Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates   Bank Stocks Remain At Risk The outlook for bank stocks that make up 48% of the Indonesia MSCI equity index is bleak. Chart II-6 shows that non-performing loans and special-mention loans (which are composed of doubtful loans) were rising before the pandemic shock. This has forced commercial banks to boost their bad loans provisioning, which has hurt their profitability. Additionally, Indonesian commercial banks’ net interest margins (NIM) have been falling sharply (Chart II-7). This has occurred because, on the revenues side, interest earnings have mushroomed as debtors have halted their interest payments while, on the expenditures side, commercial banks were forced to keep on paying interests to depositors. To protect their profitability, commercial banks have kept their lending rates stubbornly high. However, doing so will end up backfiring – as elevated lending rates punish borrowers and end up causing NPLs to rise, leading to more profit weakness. Chart II-6Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Chart II-7Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling   Crucially, Bank Central Asia and Bank Rakyat – which now account for a whopping 37% of the Indonesia MSCI market cap – are vulnerable. Both commercial banks are heavily exposed to state-owned enterprises (SOE) and small and medium (SME) companies. Particularly, 40% of Bank Central Asia’s loan book is linked to SOEs and government-led projects across electricity, ports, airports and cement among other sectors. Meanwhile, 68% of Bank Rakyat’s loan book is leveraged to the SME sector and 20% to large companies, including SOEs. Worryingly, both SOEs and SMEs have been undergoing stress. Their profitability and debt servicing ability were questionable even before the COVID-19 pandemic. State-Owned Enterprises (SOEs): The debt servicing ability for these companies has deteriorated. The debt-to-EBITDA ratio has risen considerably while the EBITDA coverage of interest expenses is set to fall from already low levels (Chart II-8). Small & Medium Enterprises (SME): The debt serviceability of the top 40% of the MSCI-listed small cap stocks is also deteriorating. The top panel of Chart II-9 shows that these companies’ debt-to-EBITDA has risen substantially, and that the EBITDA-to-interest expense ratio has plunged (Chart II-9, bottom panel). Chart II-8Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Chart II-9Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity Chart II-10Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps All in all, both Bank Central Asia and Bank Rakyat are set to experience a considerable new NPL cycle emanating from the poor profitability of SOEs and SMEs. Importantly, Bank Central Asia and Bank Rakyat’s respective NPLs at 1.3% and 2.6% were relatively low at the start of this year and have much room to rise. Neither are their valuations appealing. At a price-to-book value of 4.4 Bank Central Asia is expensive. As for Bank Rakyat while its multiples are not as high as Bank Central Asia’s (which is trading at a price-to-book value of 1.8), it is not particularly cheap either, considering its enormous exposure to Indonesia’s struggling SME sector.  Bottom Line: The outlook for bank stocks is murky (Chart II-10). Apart from banks, the rest of the Indonesian stock market has been performing very poorly and there is no obvious evidence that this will change (Chart II-10, bottom two panels). Investment Conclusions Continue underweighting the Indonesian stock market. Bank stocks remain at risk. Moreover, there is evidence that retail investors have been active in the stock market as of late. When the stock market does relapse, retail investors will likely rush to sell their holdings, thereby magnifying the equity selloff. Chart II-11Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies Dedicated EM local currency bonds and credit portfolios should continue underweighting Indonesia. Investors in Indonesia’s corporate US dollar bonds should tread carefully as the largest issuers are those SOEs that have experienced deteriorating creditworthiness. If the US dollar continues to depreciate, the rupiah could stabilize and rebound but it will underperform other EM and DM currencies. Return on capital (ROC) is the ultimate driver of EM currencies. Given the magnitude of the recession Indonesia is in and the slow recovery it will experience, its ROC will remain weak. This will weigh on the rupiah (Chart II-11). We continue shorting the rupiah against an equally weighted basket of the euro, Swiss franc and Japanese yen.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com

Feature In this report, we determine which South and Southeast Asian countries are better equipped to endure the COVID-19 pandemic. Answers to this question combined with our macro fundamental analysis lead us to recommend which countries to favor or avoid. We assess several factors in regard to the COVID-19 shock: (1) the healthcare capacity in each country, (2) the COVID-19 containment measures that have been implemented, and (3) the magnitude of fiscal and monetary stimulus packages that have been announced. We conclude that EM equity investors should keep an overweight position in Thai equities and a neutral one in the Malaysian stock market. Indian, Indonesian and Philippine stock markets, on the other hand, warrant an underweight stance. Healthcare System Capacity The COVID-19 virus can cause individuals with underlying medical conditions and already in poor health, as well as those above a certain age, to become seriously ill when infected. These patients will require the kind of special medical attention  – such as ventilation – that is only provided in a hospital’s intensive care unit (ICU). A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks overburdening the health care system. This would be a social catastrophe. A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks over¬burdening the health care system. Therefore, a key measure of the current coronavirus crisis is the relation between a population’s risk of developing critical illness from COVID-19 infections and a country’s intensive care unit (ICU) availability. We assess the risk of COVID-19 infections developing into critical illnesses in ASEAN countries and in India by gauging (1) the prevalence of diabetes in the population and (2) the share in population of people above the age of 60. Chart I-1 and Chart I-2 illustrate these factors separately. Chart I-1ASEAN & India: Population With Diabetes COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-2Population Above 60 Years Old COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities In addition, we combine these two risk variables to calculate the risk of critical illness. This measure is shown in Chart I-3. The measure shows that the population of both Malaysia and Thailand carry the highest risk of developing critical illnesses from COVID-19, owing to Malaysia’s high prevalence of diabetes and to Thailand’s rapidly aging population. Meanwhile, that risk is somewhat lower in India and dramatically lower in both the Philippines and Indonesia.  The next thing to look at is each country’s ICU capacity. Chart I-4 shows the number of ICU beds available per 100,000 people. Thailand has the highest number and Malaysia the second highest. On the other hand, India, Indonesia and the Philippines all have lower rates of ICU capacity. Chart i-3The Risk Of Critical Illness From COVID-19 COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-4Intensive Care Unit (ICU) Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Finally, we compare the risk of critical illness in each country to its available ICU capacity. Chart I-5 shows a scatter plot between these two variables. The risk of critical illness is shown on the Y-axis and the availability of ICU beds per 100,000 people is plotted on the X-axis. Thailand and Malaysia both have the highest risk of critical illness but also a large number of available ICU beds. India, Indonesia and the Philippines have lower average risk of critical illness but also far fewer ICU bed availabilities. Chart I-5The Risk Of Critical Illness Versus ICU Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities It is also important to note that Malaysia has the highest relative number of medical doctors per 10,000 people in the region (15 versus an average of 8). Furthermore, both Malaysia and Thailand appear to be performing many more COVID-19 tests. That in turn should help slow the spread of the virus and avoid overwhelming health care systems of Malaysia and Thailand. Bottom Line: Thailand and Malaysia have decent healthcare care capabilities relative to the threat of critical illness among their populations. India, Indonesia and the Philippines, on the other hand, seem relatively unprepared to weather this outbreak. Containment Response The magnitude and effectiveness of social distancing measures implemented is a critical means of protecting a country’s health care system. Indeed, the sooner such measures are put into place, the earlier the threat of the pandemic is likely to subside. This will then allow a country to normalize its economic activities sooner.  It appears that the Philippines and India have enacted the most stringent social distancing measures. Both announced complete lockdowns and called in their respective national armies to intervene. Malaysia has also announced extremely inhibitive measures and their enforcement has been quite successful. In Thailand, while the authorities have not imposed a complete lockdown, they have placed curfews and checkpoints that are subject to extension. Thai authorities have also warned that more restrictive measures could be imposed if residents do not comply. Indonesia, on the other hand, has been much softer on enforcement and is reluctant to introduce additional measures due to its economic concerns. Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Remarkably, the effectiveness of the measures can be quantitatively assessed via Google’s COVID-19 mobility tool and TomTom’s traffic congestion data. The average of all Google’s mobility variables, as of April 5, has declined most significantly in the Philippines, Malaysia, and India, relative to baseline values (Chart I-6).1 Likewise, TomTom’s traffic congestion data for the major cities in these same countries’ shows a similar decline during average peak hours over the first two weeks of April 2020, relative to the same period in 2019 (Chart I-7). Chart I-6How Effective Are Social Distancing Measures? COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-7Decline In Traffic From ##br##A Year Ago COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Bottom Line: The Philippines, India, and Malaysia have imposed the most effective and successful social distancing measures. This is then followed by Thailand. Indonesia on the other hand has not been as effective in this aspect. Fiscal And Monetary Stimulus Table I-1Stimulus Packages So Far Announced COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities The magnitude of the stimulus plans announced by each country is also important. Once the pandemic subsides and social distancing measures are relaxed, countries with a larger stimulus package in place should experience a faster economic recovery. Table I-1 shows the size of the overall stimulus packages announced so far. Malaysia and Thailand have the largest overall stimulus packages to the tune of 16% and 14% of GDP, respectively. India, Indonesia and the Philippines fall well short of these levels. Regarding monetary policy, central banks in all these countries have been cutting policy rates and injecting local currency liquidity. However, some of the programs announced by some of the central banks stand out: The Bank Of Thailand will inject 400 billion baht ($13 billion or 2% of GDP) into the corporate bond market. The central bank is also allocating 500 billion baht ($15 billion or 3% of GDP) of soft loans to small-and mid-sized companies.2 The central bank of the Philippines will be purchasing 300 billion pesos worth of government bonds ($6 billion or 1.6% of GDP) under a 3- to 6-month repurchase agreement to aid government efforts in countering the pandemic. Bank Indonesia may also begin buying government bonds (recovery/pandemic bonds) directly from the primary market. Details are not yet clear but the Indonesian government plans to issue $27 billion worth of these bonds and the central bank might emerge as the largest buyer. Similarly, the Reserve Bank of India has been injecting liquidity and purchasing government bonds for some time now. For instance, it announced a 1 trillion rupees injection in February – or $13 billion – via the long-term repo operation channel. It is now infusing an additional 1 trillion rupees through the same channel. It will also continue purchasing government bonds and securities to keep liquidity aflush and suppress market interest rates. Crucially, Governor Shaktikanta Das indicated that the RBI might even be forced to purchase government bonds directly from the primary market and that all options – including non-conventional ones – are on the table. Bottom Line: Both Thailand and Malaysia have so far announced larger overall stimulus packages than Indonesia, the Philippines and India have. This combined with their better health care capacities, suggests that the Thai and Malaysian economies will recover more quickly than they will in India, Indonesia and the Philippines. Conclusions Having considered risk of critical illness, the ICU availability and general medical capacities, the effectiveness of social distancing measures, and the stimulus packages each country has announced, Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Despite their elevated risk of critical illness, both countries have decent healthcare system capacities. Additionally, Malaysia has put in place very effective social distancing measures. Meanwhile, Thailand is placing curfews and monitoring developments very closely. Finally, both countries have enacted massive stimulus packages that will aid in the recovery of their economies later this year.  Notably, Thailand and Malaysia have been running current account surpluses for a long period of time whereas India, Indonesia and the Philippines generally run current account deficits. This, in turn, will allow the former to implement much larger overall stimulus packages than the latter, without risking major currency depreciation. Despite strong and successful social distancing efforts, India and the Philippines are hampered by a weakness in their health care infrastructures. They also are unlikely to be able to provide a large enough stimulus without subjecting themselves to significant currency depreciation. Additionally, India also has an elevated critical illness risk. Finally, Indonesia is likely to emerge from the crisis in the weakest position. Its healthcare system capacity is weak, the social distancing measures it implemented are insufficient and its enforcement has been lax. Indonesia is likely to emerge from the crisis in the weakest position. The government has also been timid about enacting significant stimulus given that it runs a large current account deficit. Moreover, it is unwilling to tolerate any further large currency depreciation due to the elevated foreign currency debt that Indonesian companies and banks carry. The latter stands at  $124 billion in the form of both bonds and loans. Investment Strategy Chart I-8Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets The following is our strategy recommendations for each country: Thailand: Our equity overweight stance on this bourse has been significantly challenged since early this year (Chart I-8). However, Thai stocks seem to be holding up at an important technical support level in relative terms.       Furthermore, as of December 2019, the ownership of the country’s local currency bonds was low at 17% (i.e. even before the global sell-off commenced). Further selling by foreigners should therefore be limited, which should reduce renewed depreciation pressures on the Thai currency. We recommend that respective EM portfolios keep an overweight position on Thai equities, sovereign US dollar and local currency bonds. Malaysia: On the one hand, Malaysian stocks have been underperforming EM benchmarks since 2014. Also, foreign ownership of Malaysian local currency bonds has declined from 34% in 2016 to 25% as of December 2019. This limits the possibility of future foreign selling. On the other hand, the economy was facing severe deflationary pressures even before the COVID-19 shock occurred. The latter will only reinforce these deflationary dynamics. Considering the positives and the negatives together, we recommend a neutral allocation to Malaysia within an EM equity portfolio. The Philippines:  Philippine stock prices relative to EM seem to have broken below a critical support level that will now act as resistance (Chart I-9). Moreover, local currency government bond yields have risen sharply (Chart I-10 and Chart I-11). This does not bode well for real estate and bank stocks that account for a very large market-cap chunk of the Philippine MSCI Index (46%). Critically, government expenditures were strong even before the COVID-19 pandemic occurred and it was only a matter of time before that contributed to higher imports. Now that exports are crashing - due to collapsing global demand - and imports are likely to remain high because of even higher government spending/fiscal stimulus, the current account deficit will widen substantially. This will cause the peso – which has been holding up so far – to depreciate significantly. Stay underweight on this bourse and local currency government bonds relative to their respective EM benchmarks. We also recommend keeping a short position on the Philippine peso versus the US dollar. Chart I-9Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Chart I-10Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Chart I-11...And Relative To Their EM Peers ...And Relative To Their EM Peers ...And Relative To Their EM Peers India: We discussed India in detail in a recent report. We recommend an underweight position amid the pandemic. In previous years, private banks lent enormous amounts to consumers via mortgages and consumer loans/credit cards. Therefore, the performance of both sectors has been contingent on the health of the Indian consumer sector. However, the outlook for the Indian consumer has worsened dramatically because of the unprecedented income hit households will suffer from the lockdown. Moreover, social safety nets and health care capacities (as mentioned above) are very weak in India. Indonesia: We also discussed Indonesia in detail in a report published on April 2. In recent years, the Indonesian bourse benefited from lower US interest rates and ignored deteriorating domestic fundamentals and lower commodities prices. Global investors’ increased sensitivity to individual EM fundamentals amid this pandemic will only make Indonesia’s weakest spots – like its exposure to commodities and its anemic domestic demand – more apparent. With global growth being very weak, commodities prices will remain low – reinforcing currency depreciation and pushing corporate bond yields higher. Combined with relapsing domestic growth, the Indonesian bourse will likely continue underperforming. Bottom Line:  Within an EM equity portfolio, we are keeping an overweight position on the Thai stock market. We also recommend keeping Malaysian equities on neutral. Our equity underweights are India, Indonesia, and the Philippines. In terms of fixed income markets, we recommend overweighting Thai, Malaysian and Indian local currency bonds and US dollar sovereign bonds. We recommend underweighting Indonesian and Philippine local and US dollar sovereign bonds.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 The baseline is the median value between January 3 and February 6. Our average calculation includes retail & recreation, grocery & pharmacy, parks, transit stations, and workplaces. It excludes the residential variable. 2 Note that this is part of the stimulus shown in Table 1.

Chart II-1Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian stock prices are in freefall - both in absolute terms and relative to EM - with no visible support (Chart II-1). We recommend that investors maintain an underweight position in both Indonesian equities and fixed-income and continue to short the rupiah versus the US dollar. We explain the reasoning behind this recommendation below. First, the key vulnerability of Indonesian financial markets is that they had been supported by massive foreign inflows stirred by falling US interest rates, despite deteriorating domestic fundamentals and falling commodities prices. We discussed this at length in our previous reports. However, the COVID-19 pandemic has brought these weak fundamentals to light. The latter have overshadowed falling US interest rates (Chart II-2) triggering an exodus of foreign portfolio capital and a plunge in the exchange rate. Currency depreciation has in turn mounted foreign investors losses resulting in a vicious feedback loop. As of the end of February, foreigners held about 37% of local currency bonds. Meanwhile, they held 56% of equities as of last week. Ongoing currency weakness and continued jitters in global financial markets will likely generate more foreign capital outflows.                    Second, the Indonesian economy - both domestic demand and exports - were already weak even before the breakout of COVID-19 occurred (Chart II-3).  Chart II-2Indonesia: Falling US Rates Stopped Mattering Indonesia: Falling US Rates Stopped Mattering Indonesia: Falling US Rates Stopped Mattering Chart II-3Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak   Chart II-4Indonesia: Struggling Under High Lending Rates Indonesia: Struggling Under High Lending Rates Indonesia: Struggling Under High Lending Rates With imposition of social distancing measures, output and nominal incomes will contract (Chart II-4). Third, the nation’s very underdeveloped health care system makes it more vulnerable to a pandemic compared to other mainstream EM countries. For example, the number of hospital beds per 1000 people - at 1.2 - is among the lowest within the mainstream EM universe. We discuss this issue for EM in greater detail in our most recent weekly report. In brief, it will take a longer time for this nation to overcome the pandemic and get its economy back on track. Fourth, Indonesia - as with many EM countries - is short on both social safety programs and fiscal stabilizers that are available in North Asian countries, Europe and the US. Moreover, the country lacks the administrative system needed to promptly execute fiscal stimulus. Besides, the economic stimulus announced by the Indonesian authorities is so far insufficient to meaningfully moderate the economic blow. The government announced a fiscal stimulus that barely amounts to 1% of GDP. This will do little to counter the recession that the nation’s economy is now entering. On the monetary policy front, though the central bank has been cutting policy rates and injecting local currency liquidity into the system, this will only help reduce liquidity stress. It will not directly aid ailing households and small businesses suffering from an income shock. Critically, prime lending rates have not dropped despite dramatic cuts in policy rates (Chart II-4). Meanwhile, the government’s decision to grant a debt servicing holiday to borrowers will only help temporarily. These borrowers will still need to repay their debts at some point down the line. Given the magnitude and uncertain duration of their income loss, there is no guarantee they will be in a position to service their debt after the pandemic is over. Eventually, Indonesian commercial banks will experience a large increase in non-performing loans (NPLs). Chart II-5Bank Stocks - Last Shoe To Drop - Are Unraveling Now Bank Stocks - Last Shoe To Drop - Are Unraveling Now Bank Stocks - Last Shoe To Drop - Are Unraveling Now Overall, the plunge in domestic demand combined with the fall in global trade and commodities prices entails that Indonesia is heading into its first recession since 1998. Given Indonesia has for many years been one of the darlings of EM investors, a recession in Indonesia and global flight to safety herald continued liquidation in its financial markets. Both local government bond yields and corporate US dollar bonds yields are breaking out. Rising borrowing costs amidst the recession will escalate the selloff in equities. Remarkably, non-financial stocks and small-caps have already fallen by 40% and 55% in US dollar terms, respectively (Chart II-5, top two panels). It was banks stocks – which comprise 35% of total market cap – that were holding up the overall index (Chart II-5, bottom panel). Given banks will likely experience rising defaults as discussed above, their share prices have more risk to the downside. Bottom Line: Absolute return investors should stay put on Indonesian risk assets for now. We maintain our short position on the rupiah versus the US dollar. EM-dedicated equity investors should keep underweighting Indonesian equities within an EM equity portfolio. Meanwhile, EM-dedicated fixed income investors should continue to underweight Indonesian local currency bonds as well as sovereign and corporate credit. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com

Highlights Please note that we published a Special Report early this week titled Brazilian Banks: Falling Angels, and an analysis on India. Please also note that we are publishing an analysis on Indonesia below. Given uncertainty over the depth and duration of the unfolding global recession, a sustainable equity bull run is now unlikely. It is still early to lift EM equity and EM credit allocations from underweight to overweight within global equity and global credit portfolios, respectively. EM currencies and EM fixed-income markets will remain under selling pressure. Feature The question investors now face is whether the recent rebound will endure for a few months or it will just be a bear market rebound that is already fading. BCA’s Emerging Market Strategy service believes it is the latter. EM and DM share prices will likely make new lows.  A Tale Of Two Charts Chart I-1and I-2 overlay the current S&P 500 selloff with the market crashes of 1987 and 1929, respectively. The speed and ferocity of the current selloff is on a par with both. In 1987, following the 33% crash, share prices rebounded 14% but then relapsed without breaking below previous lows (Chart I-1). That was a hint that US share prices were entering a major bull market that indeed ensued. We do not know if the S&P 500 will make a lower low, but a retest of the recent lows is very likely. In 1929, US share prices collapsed by 36% over several weeks. Then, the overall index staged an 18% rebound within a couple of weeks, rolled over and plunged to new lows. The magnitude of the second downleg was 27% (Chart I-2). Chart I-1S&P 500: Now Versus 1987 S&P 500: Now Versus 1987 S&P 500: Now Versus 1987 Chart I-2S&P 500: Now Versus 1929 S&P 500: Now Versus 1929 S&P 500: Now Versus 1929   Fast forward to today, the S&P 500 plummeted 34% in a matter of only four weeks and then staged a 17.5% rebound in only a few days. We do not know if the S&P 500 will make a lower low, but a retest of the recent lows is very likely. In fact, we are assigning a higher probability to share prices in EM and DM breaking down to new lows than for the recent lows to hold. Chart I-3S&P 500: Now Versus 1929-32 S&P 500: Now Versus 1929-32 S&P 500: Now Versus 1929-32 Readers may question why we are comparing the current episode with the 1929 bear market. The argument against this comparison stresses that policymakers made numerous mistakes between 1929 and 1932, refusing to ease policy even after the crisis commenced. That led to debt deflation and a banking crisis, which in turn produced a vicious equity bear market of 85% lasting 3 years. At present, authorities around the world have reacted swiftly, providing enormous fiscal and monetary stimulus. We agree with this reasoning, but our point is as follows: Due to the US’s ongoing aggressive and timely policy response, stocks will avoid the protracted second phase of the 1930-‘32 bear market when share prices plummeted by another 80% (Chart I-3). Nonetheless, the US equity market could still repeat what occurred in the initial part of the 1929 bear market, as illustrated in Chart I-2 and Chart I-3. The Fundamentals The basis for our expectations of continued weakness in share prices is as follows: The selloff in the S&P 500 began from overbought and expensive levels (Chart I-4). The duration of the selloff so far has been only four weeks. We doubt that such a short, albeit vicious, selloff was enough to clear out valuation and positioning excesses. For example, even though by March 24 net long positions in US equity futures had dropped significantly, they were still above their 2011 and 2015/16 lows (Chart I-5). Chart I-4S&P 500: Correcting From Expensive Levels S&P 500: Correcting From Expensive Levels S&P 500: Correcting From Expensive Levels Chart I-5Net Long Positions In US Equity Indexes Futures Net Long Positions In US Equity Indexes Futures Net Long Positions In US Equity Indexes Futures   Besides, US equity valuations are still elevated. The cyclically adjusted P/E ratio for the S&P 500 – based on operating profits – is 25 compared with its historical mean of 16.5, as demonstrated in the top panel of Chart I-4. While this valuation model does not take into account interest rates, our hunch is as follows: facing such high uncertainty over the profit outlook, investors will require higher than usual risk premiums to invest in equities. In short, the ongoing profit collapse and the extreme uncertainty over the cyclical outlook heralds a higher risk premium. The discount rate – which is the sum of the risk-free rate and risk premium – presently should not be lower than its average over the past 20 years. We are experiencing a sort of natural disaster, and there is little policymakers can do amid lockdowns. Natural disasters require time to play out, and financial markets are attempting to price in this downturn.  Most stimulus measures taken worldwide to boost demand will only gain traction after the lockdowns are over. At the moment, global output and demand remain in freefall. The recovery will be hesitant and is unlikely to be V-shaped for two reasons: (1) social distancing measures will be eased only gradually; and (2) the lost household income and corporate profits from weeks and months of shutdowns will continue to weigh on consumer and business sentiment and their spending patterns for several months. China’s economy is a case in point. Both manufacturing and services PMIs for March posted readings in the 50-52 range. These are rather underwhelming numbers. Following stringent lockdowns in February when the level of economic output literally collapsed, only 52% of companies surveyed reported an improvement in their business activity/new orders in March relative to February. Chart I-6Our Reflation Confirming Indicator Is Downbeat Our Reflation Confirming Indicator Is Downbeat Our Reflation Confirming Indicator Is Downbeat If true, these PMI readings imply a level of output and demand in China that is still well below March 2019 levels. It seems China has not been able to engineer a V-shaped recovery in demand and output. Therefore, the odds are that, outside China, economic activity will come back only slowly. This entails that some businesses will not reach their breakeven points anytime soon, and that their profits will be contracting for some time to come. We do not think this is reflected in today’s asset prices.       Finally, our Reflation Confirming Indicator – which is composed of equally-weighted prices of industrial metals, platinum and US lumber – is pointing down (Chart I-6). Bottom Line: This bear market has been ferocious, but too short in duration. It is unlikely that share prices have already bottomed, given uncertainty over the depth and duration of the unfolding global recession. EM Versus DM: Stay Underweight Chart I-7EM Versus DM: Relative Equity Prices EM Versus DM: Relative Equity Prices EM Versus DM: Relative Equity Prices EM stocks have failed to outperform DM equities in the recent rebound. As a result, EM versus DM relative share prices are testing new lows (Chart I-7). Odds are that EM will underperform DM in the coming weeks or months. Outside North Asian economies (China, Korea and Taiwan), EM countries have less capacity to deal with the COVID-19 pandemic than advanced countries. First, health care systems in developing countries are far less equipped to deal with the pandemic than DM ones. Chart I-8 shows the number of hospital beds per 1,000 people in India, Indonesia, Brazil and Mexico are significantly lower than in Europe and the US. Chart I-8Many EMs Have Poor Health Infrastructure Downside Risks Prevail Downside Risks Prevail Second, EM ex-North Asian economies lack both the social safety net of Europe and the US’s capacity to inject large amounts of fiscal and monetary stimulus into the system. With the US dollar being the world reserve currency, the US has no problem monetizing its public debt and fiscal deficits. The same is true for the European Central Bank (ECB). If current account-deficit EM countries following in the footsteps of the US and monetize fiscal deficits/public debt, their currencies will likely depreciate. Last week, the South African central bank announced that it will buy local currency government bonds to cap their yields and inject liquidity into the system. This is of little help to foreign investors in domestic bonds because the rand has continued to sell off, eroding the US dollar value of their government bond holdings. Hence, the foreign investor exodus from the local currency bond market will likely continue. The same would be true for many other EM countries if they contemplate QE-type policies. Most stimulus measures taken worldwide to boost demand will only gain traction after the lockdowns are over. Third, unlike the Fed and the ECB, EM ex-North Asia central banks have limited capacity to alleviate funding stress for their companies. The Fed is also purchasing investment-grade corporate bonds and is setting up structures to channel credit to companies. All of this will marginally help ease financial and credit stress in the US. In contrast, central banks in EM ex-North Asia are unlikely to adopt similar policies on a comparable scale as the US. While DM countries do not mind seeing their currencies depreciate, authorities in many developing countries are fearful of further depreciation. The latter will inflict more stress on EM companies and banks that have large foreign currency debt. We will publish a report on EM foreign currency debt next week. Further, corporate bonds in DM are issued in local currency, allowing their central banks to purchase corporate bonds in unlimited quantities by creating money “out of thin air.” Chart I-9EM Performance Correlates With Commodities EM Performance Correlates With Commodities EM Performance Correlates With Commodities In contrast, outside of China and Korea, the majority of EM corporate bonds are issued in US dollars. This means that to bring down their corporate US borrowing costs, central banks in developing countries need to spend their finite US dollar reserves. Finally, commodities prices are critical to EM financial markets’ absolute and relative performance (Chart I-9). The outlook for commodities prices remains dismal. As the global economy has experienced a sudden stop, demand for raw materials and energy has literally evaporated. Liquidity provisions by the Fed and other key central banks may at a certain point help financial assets but will not help commodities. The basis is that demand for equities and bonds is entirely driven by investors, but in the case of commodities a large share of demand comes from the real economy. In bad times like these, central banks’ liquidity provisions can at a certain point persuade investors to look through the recession and begin buying financial assets before the real economy bottoms. In the case of commodities, when real demand is collapsing, financial demand will not be able to revive commodities prices. Bottom Line: It is still early to lift EM equity and EM credit allocations from underweight to overweight within global equity and global credit portfolios, respectively. Technicals: Old Support = New Resistance? Calling tops and bottoms in financial markets is never easy. When formulating investment strategy it is helpful to examine both market price actions and other subtle clues that financial markets often provide. The global equity index and global industrial stocks have rebounded to levels that acted as supports during previous selloffs. We have detected the following patterns that suggest the recent rebound is facing major resistance, and new lower lows are likely: The global equity index and global industrial stocks have rebounded to levels that acted as supports during previous selloffs (Chart I-10). Unless these equity indexes decisively break above these lines, the odds favor retesting their recent lows or even falling to new lows. Many other equity indexes and individual stocks are also displaying similar technical patterns. The Korean won versus the US dollar as well as silver prices exhibit a similar technical profile (Chart I-11). Chart I-10Ominous Technical Signals Ominous Technical Signals Ominous Technical Signals Chart I-11New Lows Ahead New Lows Ahead New Lows Ahead   Global materials have decisively broken below their long-term moving average that served as a major support in 2002, 2008 and 2015 (Chart I-12). The same multi-year moving average is now likely to act as a resistance. Hence, any rebound in global materials stocks – that extremely closely correlate with EM share prices – is very unlikely to prove durable until this support-turned-resistance level is decisively breached. US FAANGM (FB, AMZN, APPL, NFLX, GOOG, MSFT) equally-weighted stock prices have dropped below their 200-day moving average that served as a major support in recent years (Chart I-13). They did rebound but have not yet broken above the same line. Odds are that this line will become a resistance. If true, this will entail new lows in FAANGM stocks. Chart I-12Global Materials Broke Below Their Long-Term Defense Line Global Materials Broke Below Their Long-Term Defense Line Global Materials Broke Below Their Long-Term Defense Line Chart I-13FAANGM: Previous Support Has Become New Resistance FAANGM: Previous Support Has Become New Resistance FAANGM: Previous Support Has Become New Resistance   Bottom Line: Various financial markets are exhibiting technical patterns consistent with retesting recent lows or making lower lows. Stay put. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Indonesia: A Fallen Angel Chart II-1Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian Equities Are In Freefall In Absolute & Relative Terms Indonesian stock prices are in freefall - both in absolute terms and relative to EM - with no visible support (Chart II-1). We recommend that investors maintain an underweight position in both Indonesian equities and fixed-income and continue to short the rupiah versus the US dollar. We explain the reasoning behind this recommendation below. First, the key vulnerability of Indonesian financial markets is that they had been supported by massive foreign inflows stirred by falling US interest rates, despite deteriorating domestic fundamentals and falling commodities prices. We discussed this at length in our previous reports. However, the COVID-19 pandemic has brought these weak fundamentals to light. The latter have overshadowed falling US interest rates (Chart II-2) triggering an exodus of foreign portfolio capital and a plunge in the exchange rate. Currency depreciation has in turn mounted foreign investors losses resulting in a vicious feedback loop. As of the end of February, foreigners held about 37% of local currency bonds. Meanwhile, they held 56% of equities as of last week. Ongoing currency weakness and continued jitters in global financial markets will likely generate more foreign capital outflows.                    Second, the Indonesian economy - both domestic demand and exports - were already weak even before the breakout of COVID-19 occurred (Chart II-3).  Chart II-2Indonesia: Falling US Rates Stopped Mattering Indonesia: Falling US Rates Stopped Mattering Indonesia: Falling US Rates Stopped Mattering Chart II-3Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak Indonesia: Domestic Demand Was Weak Before COVID-19 Outbreak   Chart II-4Indonesia: Struggling Under High Lending Rates Indonesia: Struggling Under High Lending Rates Indonesia: Struggling Under High Lending Rates With imposition of social distancing measures, output and nominal incomes will contract (Chart II-4). Third, the nation’s very underdeveloped health care system makes it more vulnerable to a pandemic compared to other mainstream EM countries. For example, the number of hospital beds per 1000 people - at 1.2 - is among the lowest within the mainstream EM universe. We discuss this issue for EM in greater detail in our most recent weekly report. In brief, it will take a longer time for this nation to overcome the pandemic and get its economy back on track. Fourth, Indonesia - as with many EM countries - is short on both social safety programs and fiscal stabilizers that are available in North Asian countries, Europe and the US. Moreover, the country lacks the administrative system needed to promptly execute fiscal stimulus. Besides, the economic stimulus announced by the Indonesian authorities is so far insufficient to meaningfully moderate the economic blow. The government announced a fiscal stimulus that barely amounts to 1% of GDP. This will do little to counter the recession that the nation’s economy is now entering. On the monetary policy front, though the central bank has been cutting policy rates and injecting local currency liquidity into the system, this will only help reduce liquidity stress. It will not directly aid ailing households and small businesses suffering from an income shock. Critically, prime lending rates have not dropped despite dramatic cuts in policy rates (Chart II-4). Chart II-5Bank Stocks - Last Shoe To Drop - Are Unraveling Now Bank Stocks - Last Shoe To Drop - Are Unraveling Now Bank Stocks - Last Shoe To Drop - Are Unraveling Now Meanwhile, the government’s decision to grant a debt servicing holiday to borrowers will only help temporarily. These borrowers will still need to repay their debts at some point down the line. Given the magnitude and uncertain duration of their income loss, there is no guarantee they will be in a position to service their debt after the pandemic is over. Eventually, Indonesian commercial banks will experience a large increase in non-performing loans (NPLs). Overall, the plunge in domestic demand combined with the fall in global trade and commodities prices entails that Indonesia is heading into its first recession since 1998. Given Indonesia has for many years been one of the darlings of EM investors, a recession in Indonesia and global flight to safety herald continued liquidation in its financial markets. Both local government bond yields and corporate US dollar bonds yields are breaking out. Rising borrowing costs amidst the recession will escalate the selloff in equities. Remarkably, non-financial stocks and small-caps have already fallen by 40% and 55% in US dollar terms, respectively (Chart II-5, top two panels). It was banks stocks – which comprise 35% of total market cap – that were holding up the overall index (Chart II-5, bottom panel). Given banks will likely experience rising defaults as discussed above, their share prices have more risk to the downside. Bottom Line: Absolute return investors should stay put on Indonesian risk assets for now. We maintain our short position on the rupiah versus the US dollar. EM-dedicated equity investors should keep underweighting Indonesian equities within an EM equity portfolio. Meanwhile, EM-dedicated fixed income investors should continue to underweight Indonesian local currency bonds as well as sovereign and corporate credit. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Indonesian commercial banks have been the only leg holding up the Indonesian stock market (Chart II-1). However, their cyclical outlook is uninspiring as their share prices risk selling off. The critical issue is that lending rates in the Indonesian economy are too high for borrowers. Hence, banks are facing a lose-lose dilemma: Either bank lending rates will have to drop, squeezing Indonesian commercial banks’ net interest rate margins, or non-performing loans (NPL) will mushroom as debtors cannot afford such high borrowing costs. In both cases, bank profits will suffer. Both of these scenarios are bearish for commercial banks’ share prices. Given that banks account for 47% of the overall MSCI Indonesia stock market capitalization and the rest of the equity market has been struggling due to worsening corporate profitability, the outlook for this bourse is downbeat. We continue recommending underweighting Indonesian stocks within an EM equity portfolio. The Indonesian economy is facing strong deflationary pressures. Both headline and core consumer price inflation have dropped to the bottom of the central bank’s inflation target band (Chart II-2, top panel). Meanwhile, corporate pricing power as measured by the GDP deflator has weakened significantly (Chart II-2, bottom panel). Chart II-1Indonesia: Financials Are The Only Sector Rallying Indonesia: Financials Are The Only Sector Rallying Indonesia: Financials Are The Only Sector Rallying Chart II-2Indonesia: Inflation Is Undershooting Indonesia: Inflation Is Undershooting Indonesia: Inflation Is Undershooting   Disinflationary forces have caused the nation’s nominal GDP growth to plummet dangerously below bank lending rates (Chart II-3). This makes it more difficult for borrowers to service their debt and will ensure rising NPL in the banking system. Crucially, it also discourages new credit demand. The top panel of Chart II-4 shows that bank loan growth is decelerating. Chart II-3Borrowing Costs Are Excessive Borrowing Costs Are Excessive Borrowing Costs Are Excessive Chart II-4Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates Although the central bank has cut its policy rate by 100 basis points in 2019, bank lending rates dropped by only 17 basis points and currently stand at 10.2% in nominal terms (Chart II-4, middle panel). In real (inflation-adjusted) terms, bank lending rates remain very elevated (Chart II-4, bottom panel). Consistent with excessive borrowing costs, both the consumer and business sectors are struggling: Retail sales (excluding vehicles) volume growth is hovering around zero (Chart II-5, top panel). Retail sales of specific items are contracting (Chart II-5, middle panel). Meanwhile, motorcycle and car unit sales are shrinking (Chart II-5, bottom panel). Industrial activity is also lackluster. Freight traffic is very weak, capital goods imports are contracting and domestic cement consumption remains anemic (Chart II-6). Consistently, EBITDA of non-financial publically-listed companies is flirting with contraction (Chart II-7). Chart II-5A Major Deceleration In The Consumer Sector A Major Deceleration In The Consumer Sector A Major Deceleration In The Consumer Sector Chart II-6Indonesia: Industrial Activity Is Subdued Indonesia: Industrial Activity Is Subdued Indonesia: Industrial Activity Is Subdued   Overall, the Indonesian economy needs much lower lending rates and a fiscal boost. The government is focused on keeping the budget deficit in check and no major fiscal stimulus should be expected. Therefore, monetary policy/lower interest rates should be the only source of stimulus. With rate cuts by the central bank failing to translate into much lower bank lending rates, the sole viable option for authorities is to force commercial banks to reduce their lending rates. This strategy appears to be already in place, as demonstrated by President Joko Widodo’s November speech where he explicitly encouraged commercial banks to lower their lending rates. Such moral suasion or regulatory push by the authorities will likely intensify in the coming months. Doing so, however, will squeeze commercial banks’ net interest rate margins and hit banks’ profits (Chart II-8). Alternatively, if banks refuse to drop their lending rates meaningfully, their NPL will proliferate, damaging their profits.  Chart II-7Indonesia: Corporate Profits Are About To Contract Indonesia: Corporate Profits Are About To Contract Indonesia: Corporate Profits Are About To Contract Chart II-8Commercial Banks' Net Interest Margins Will Fall Commercial Banks' Net Interest Margins Will Fall Commercial Banks' Net Interest Margins Will Fall   Importantly, Indonesian commercial banks are expensive with a PBV ratio of 2.7; therefore, banks’ share prices will be extremely sensitive to negative news regarding their profit growth outlook. Investment Recommendations Chart II-9Indonesian Stocks Relative To The EM Equity Benchmark Indonesian Stocks Relative To The EM Equity Benchmark Indonesian Stocks Relative To The EM Equity Benchmark Equity investors should continue underweighting this bourse. Chart II-9 shows that relative equity performance versus EM is teetering. Our short position in the rupiah versus the US dollar remains in place but we are instituting a stop point at 13500 USD/IDR to manage risks. The basis for rupiah depreciation is as follows: In an economy that is facing unbearable high real borrowing costs and no willingness or ability to stimulate fiscally, the currency will likely serve as an adjustment valve. It will probably depreciate to boost exports and encourage import substitution as well as generate inflation. Critically, when the economy is stumbling due to excessive real interest rates, the latter do not typically engineer currency appreciation. In fact, the currency tends to depreciate rather than appreciate in cases when the return on capital is below borrowing costs. Indonesia fits this profile very well. Consistent with our expectations for currency depreciation, we continue underweighting Indonesian domestic bonds and sovereign credit within their respective EM benchmarks. We will alter this stance if our stop on the rupiah is triggered. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com