Indonesia and Philippines face investment-grade hurdles

Agost Benard, associate director of sovereign ratings at Standard & Poor’s, discusses when Indonesia and the Philippines may be upgraded, which sovereign is most likely to make investment grade first and what stands in their way.

The Philippines and Indonesia are both rated BB+, a notch away from the investment-grade rating category of BBB- or above. But both sovereigns still have to contend with credit weaknesses that are keeping them in the speculative-grade category. Agost Benard, associate director of sovereign ratings at Standard & Poor’s, addresses the issues.

The rating outlook on Indonesia is positive, compared with stable for the Philippines. Does this mean Indonesia will be upgraded sooner?
Not necessarily. The next rating action on Indonesia could be an upgrade, but we could also revise the outlook back to stable. A positive outlook indicates that there is more upward than downward pressure on the rating and that there is at least a one-in-three chance of an upgrade. A stable outlook indicates that risks to the ratings are balanced. For issuers that we rate in the speculative-grade categories, the outlook covers a period of six-to-18 months.

Ratings trends
Ratings trends (click to enlarge)

Following a long period of rating stability, why has Standard & Poor’s upgraded the Philippines twice in a relatively short time span?
We rated the government BB+ from 1997-2002. By 2002, political risk in the Philippines had deteriorated under the administration of President Estrada, leading to a lowering of our rating on the government. The long-term foreign currency rating stayed at BB- for nearly seven years until the end of 2010, after which we raised it twice to the current level of BB+. Improvements in the Philippines’ political backdrop and policy setting motivated our latest actions. These improvements allowed the government to continue with fiscal consolidation process, narrow the fiscal deficits, reduce its reliance on foreign savings, and rationalise the public sector.

The Arroyo administration (2001-2010) began fiscal reforms about eight or so years ago. But key components — such as expanding the revenue base, reducing tax evasion, and privatising the electricity sector — progressed slowly. This was due to a fractious political environment, in which most legislative activity was highly politicised and beset with delays.

How does Standard & Poor’s reconcile the apparent stalling of the government’s reform agenda with the positive rating outlook on Indonesia?
Our positive outlook on the rating recognises ongoing improvement in the Indonesian government’s balance sheet and the country’s income metrics. A modest improvement in the country’s political and policy dynamics — combined with Indonesia’s other credit attributes — could lead to an upgrade. We raised the sovereign rating in 2011 to BB+ from SD (selective default) in 2002.

We believe the perception that the government’s reform agenda has stalled stems from the lack of policy initiatives to promote long-term growth during President Yudhoyono’s second term (2009 to present) and from a slew of measures or policy proposals that appear to be anti-foreign investor, ad hoc in nature, and not conducive to efficient allocation of resources. The perception also derives from the government’s abandonment of a planned electricity tariff rise and its inability to implement planned cuts to fuel subsidies in the face of rising oil prices. More recently, rising trade deficits have only added to this less favourable view.

How does the Philippines’ political and policy environment compare with Indonesia’s?
Since the last elections in 2010, the Philippines’ political environment has stabilised relative to its own recent experience. As a result, legislative efficiency has improved, enabling the current administration to narrow the fiscal deficit and spend more on much needed infrastructure. By contrast, policy momentum in Indonesia appears to have stalled. To some extent, the momentum reflects the electoral calendar with presidential and parliamentary elections scheduled for 2014 in Indonesia and not due until 2016 in the Philippines. In addition, our assessment of the countries’ political settings takes into account institutional quality and stability, the regulatory and business environment, and data transparency and reliability, which evolve only over longer periods of time.

How do the economic, fiscal and external positions of these two sovereigns compare?
The Philippines’ established credit strengths are its robust external profile, highlighted by a small external liability position (on an international investment position basis) and strong liquidity ratios. The country also has a track record of moderately strong growth with low variability, albeit slower than what might be expected at this income level. Factors that constrain the ratings are the Philippines’ weak fiscal profile and the high interest burden on its public debt, due to a narrow revenue base and the large portion of expensive commercial debt.

One of Indonesia’s main credit strengths is its fiscal management, which has improved the government’s balance sheet. In addition, its economy has grown robustly over the past decade. Indonesia’s per capita real GDP expanded by an annual average of 4.2% over the past 10 years, well above the Philippines’ comparatively moderate 2.7%. A decade ago, Indonesia’s per capita GDP stood at $928, just below the Philippines’ $1,014. But by 2011, Indonesia’s per capita GDP rose to $3,600 against the Philippines’ $2,330, illustrating their disparate growth rates.

For both sovereigns, though, their low per capita income levels remain a rating constraint. The wealth levels in Indonesia and the Philippines imply a low revenue base for the government to draw on, significant human and physical capital shortcomings, and hence less fiscal and political flexibility to modify policy to avoid default in the event of adverse economic developments.

Credit strengths and weaknesses
Credit assessment (click to enlarge)

How long does it usually take for sovereigns to be upgraded to investment grade from BB+?
On average, it takes 2.5 years for a rating to move to BBB- from BB+. However, the factors underlying the rating could improve slowly over time, with stagnation or reversal possible in some respects, while others features could improve faster. So there can be large diversions from the average of 2.5 years. For example, it took two years for Azerbaijan, South Africa, and Mexico to reach investment grade, compared with 10 months for Brazil and 11 months for Bulgaria.

Standard & Poor’s often mentions Indonesia’s shallow domestic markets as a key credit constraint. Is this also a constraint for the Philippines, and why hasn’t Indonesia made more progress in deepening its domestic markets?
Indonesia’s domestic capital market is relatively undeveloped. This is a structural weakness that hinders the efficient allocation of savings and makes the country more reliant on external borrowing than would otherwise be the case. This reliance is reflected in the external leverage of the government and corporate sector, with public sector net external debt standing at 10% of current account receipts (CAR) and 32.5% for the corporate sector.

The public sector in the Philippines is a net external creditor with net external debt at –32% of CAR and corporate sector external leverage at a modest 6.8% of CAR. Indonesia’s stock of outstanding local currency bonds as of June 2012 is 13.3% of GDP, down from 27% a decade ago. Within that, the corporate bond market’s size relative to the economy is virtually unchanged, at 2% of GDP. By contrast the Philippines’ bond market is nearly three times larger, at 36% of GDP, within which corporate bonds account for 5% of GDP, up from 1% in 2002. Local currency government bond bid/ask spreads — a rough indication of market efficiency and liquidity — are 30bp (bp) in Indonesia, compared with just 5bp in the Philippines.

Developing capital markets needs a concerted effort, beginning with the creation of the requisite legal infrastructure. Indonesia’s domestic capital market hasn’t developed. That’s partly because the country’s high interest rate environment made foreign-exchange borrowings more attractive, and partly because the building of capital market infrastructure has not received sufficient attention from policymakers. This apparent lack of policy focus on capital markets, in turn, likely stems from Indonesia’s traditional reliance on concessional external financing of its fiscal deficits. The corporate sector on the other hand tends to use retained earnings, or bank borrowings, as local firms leverage on established ties with banks.

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