INDONESIA

Indonesia dominated the Asian dollar capital markets this week, with a well-received $1 billion sovereign sukuk rapidly (some would say alarmingly so) followed by another $1 billion benchmark from state electricity company Perusahaan Listrik Negara (PLN).

The seven-year sukuk was priced on Tuesday morning Asia time and gave a clear demonstration of how positively Indonesia is now seen in world markets. It priced at 4% (strictly speaking this is a profit rate rather than a yield, since this is an Islamic security), the tight end of 4-4.125% guidance. It was widely agreed that the tight pricing reflected an assumption that Indonesia, rated Ba1/BB+/BB+, with a positive outlook in Fitch and S&P’s cases, will be upgraded one more notch to investment grade. It formed a sharp contrast with the 6.29% Italy paid for a Eu3 billion five-year bond on Monday – Italy is rated A2 by Moody’s.

“The good news is in the price with regards to the rating,” said one banker. “Indonesia certainly trades like an investment grade sovereign. People feel very positive about how the future looks down there. But an upgrade is not going to result in a dramatic tightening of yields again; ratings need to catch up with reality.”

Those close to the deal say it attracted a $6.5 billion order book. “4% was an excellent outcome for them considering their last deal was 8.8% in 2009,” said one. “Seven years is a respectable maturity profile. Everybody is pretty happy with that.” The choice of maturity reflects the fact that Middle East investors, who were key to the transaction, prefer shorter-dated bonds, ideally five years; since the issuer wanted funding of up to 10 years, seven was seen as a sensible compromise. Middle East investors accounted for 30% of the deal, and had been a clear target, with a roadshow that visited Riyadh, Doha, Dubai and Abu Dhabi. Indonesian investors took 12%, the rest of Asia 32%, the US8% and Europe 18%. Funds took 59% of the deal. Citi, HSBC and Standard Chartered were lead managers.

It is harder to demonstrate that the deal’s success was down to a growing conventional investor appetite for sukuk, though some believe that it was a contributory factor. “There was a strong bedrock of interest from Middle East and Asian sukuk-specific funds, but conventional players also recognised the quality of the issuer,” said one person close to the deal, who estimated that 40% of the book were conventional investors but stressed there was some guesswork in that number.

The PLN deal was a $1 billion 10-year offer which priced on Wednesday morning Asia time, led by Barclays Capital and Citi as joint bookrunners. It priced at a yield of 5.625%, the tight end of 5.625%-5.75% guidance (a coupon of 5.5% with notes reoffered at 99.054). Some in the market considered this cheap, particularly in light of the sovereign sukuk; but S&P rates it one notch below the sovereign at BB (unlike Moody’s and Fitch, who have it at Ba1 and BB+ respectively), suggesting a slightly weaker credit than the sovereign, in addition to which the PLN deal carried a longer tenor. It is the lowest coupon PLN has ever paid for a dollar bond and represents a 150 basis point spread over comparable-tenor conventional sovereign debt.

Despite its proximity to the sovereign deal – something another banker in the market described as “breathtaking arrogance in timing” – it attracted considerable interest, with $5.5 billion of orders from more than 200 accounts. Those close to the deal say it was not simply a method of mopping up excess demand from the sukuk, since the two were marketed in very different ways as reflected in PLN’s final distribution: European investors took 21% and US investors 35%, far higher than in the sukuk, while the Middle East was not a significant source of demand for PLN. Fund managers accounted for 64%, insurers and pension funds 19%, banks 7%, private banks 6%, and central banks and others 4%.

Those close to the deal say the timing was partly coincidence; a necessary revision to the documentation had only come through late on Monday New York time, and the bond was issued swiftly thereafter to take advantage of a brief window. It did, though, probably have an impact on the aftermarket performance of the sukuk, which started out trading up and dropped below par in the wake of the PLN issue (which traded up).

Structurally, the deal was interesting because it did not use a special purpose vehicle, as most Indonesian companies do and as PLN previously has. The SPV structure avoids a withholding tax charge, but PLN’s government ownership rendered that somewhat irrelevant. Ditching the SPV opened it up to a greater range of investors, according to people close to the deal.

IILM

The International Islamic Liquidity Management Corporation, a body designed to issue short term Shariah-compliant instruments to foster better liquidity management among Islamic banks, will issue its first bonds within “the first six months” of 2012, according to Dr Zeti Akhtar Aziz, Governor of Bank Negara Malaysia.

Dr Zeti was interviewed on Tuesday in Kuala Lumpur, one day before a crucial IILM board meeting that was expected to move the body closer to its first issuance. She said the meeting should approve the parameters for issuance, including allocation of assets against which the issuance will take place, and the appointment of primary dealers who will make the market. “We are very close,” she said.

In the wake of the financial crisis, many Islamic finance leaders – Zeti prominent among them – conducted a study of the industry to establish what risks it faced and what to do about them. The lack of liquidity was one of the main findings and led to the formation of the IILM in late 2010. “We saw during this crisis that liquidity became an important issue,” she said. “With the internationalization of Islamic finance, cross-border flows require short term instruments to effectively manage, not only in stressful conditions but in normal times.”

Zeti said there will be a program of issues like to be around $2 billion to $3 billion apiece, with regular issues through the year. A first issue will be smaller, “to test the system”. Issues can come in a number of currencies but are initially expected to be in dollars; the first, pilot issue, is certainly expected to be in the US currency. “They will be high quality short-term liquid instruments and will be in demand by other funds managing portfolios – even conventional,” she said.

Issuance will be from IILM itself, which is a corporation established and backed by 12 central banks (Indonesia, Iran, Kuwait, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey and the UAE) and two multilaterals (the Islamic Development Bank and the Islamic Corporation for the Development of the Private Sector) as shareholders. It is understood that a formal rating will soon be announced for IILM, a vital precursor to issuance and something Zeti described as “a long process”.

The need for IILM is likely to become particularly acute if world capital markets lock up in the wake of problems in Europe. “Almost the entire world uses Treasury bills: they are highly traded and can be used to manage the liquidity of any portfolio or any financial business,” she said. “For Islamic finance, there is no sovereign that issues short term paper of that nature, and therefore IILM was established. It took us two years of work.”

Other founders agree the start line is near but that there is more to be done. “We are still crossing the Ts and dotting the Is,” said Malam Sanusi Lamido Sanusi, Governor of the Central Bank of Nigeria. “There are still issues in terms of the rulings of the Shariah Council on what we can and can’t do and how it will be structured. We’re still going through the process of structuring IILM to get the kind of rating we would like to have. It will take a little time for us to be out there.”

NIGERIA

Nigeria is set to become a fixture in the Asian debt capital markets with plans for a Malaysia-domiciled benchmark sukuk and possibly a dim sum bond next year.

In an interview in Kuala Lumpur, Malam Sanusi Lamido Sanusi, Governor of the Central Bank of Nigeria, said the country had been receiving advice from HSBC and CIMB on a sukuk, although the banks had not been formally appointed onto a deal. “We would like to see if we can issue a sukuk next year,” he said, probably in the second half. “We think that anything from five to seven years should be good for an initial offering, with the amount $700 million to a billion. That gives the kind of liquidity you want, and it also fits the tenor for most of the Arab funds who are not interested in 10-year instruments” – a consideration which also affected the choice of tenor in this week’s Indonesian sukuk (see separate story).

“The European funds tend to go for longer tenors, the Arabs for shorter, but given where Europe is, it makes a lot of sense to structure something to the areas that have a lot of liquidity,” he said.

But although Middle East investors would be targeted, Sanusi said the sukuk would “most likely” be issued out of Malaysia. “The central bank of Nigeria has had a very strong relationship with Bank Negara since I became governor,” he said, partly because Nigeria had recovered from a domestic banking crisis by studying Asian responses to the financial crisis there and had decided Malaysia was the best role model. “The Malaysian Islamic finance market is obviously the most advanced at the moment in terms of product, size and innovation, and the natural place to be.”

As with many sovereign sukuks, the hope in Nigeria is that it would prompt corporate issuers to follow. “Capital markets generally work better if you have a sovereign benchmark, that’s my view.” He also said that sukuk markets appeared to show better pricing than conventional finance. “Italy is paying 7%, so if Indonesia can raise at 4.125%, that’s a reflection of the liquidity in the sukuk markets. There is increasing interest: once conventional fund managers accept sukuk it is almost a no-brainer, as a sukuk targets both conventional and Islamic investors so you’ll probably have tighter pricing.”

He said the likely projects that would underpin the sukuk would be infrastructure, and could include aviation assets.

Sanusi also said that Nigeria’s recent decision to put 5-10% of its reserves into RMB could pave the way to a dim sum bond. The shift in reserves, he said, “is a strategic decision and recognizes the fact that China has become a major trading partner for us. It recognizes the possibility of Chinese investments in infrastructure coming in to Nigeria, and opens up for me, from a central bank perspective, the possibility of coming to the RMB market for dim sum borrowing.”

He said there was a natural argument for RMB funding. “Think of it theoretically. If we agree to accept RMB in payment for oil sales to China, you immediately generate RMB cash flows. If you have long term contracts to supply crude oil to China, you could securitize those, and raise dim sum bonds; that pays for what infrastructure investments you require from China.

“You hedge the currency risk, you get finance, and come to a very liquid market where the yields are lower and the spreads tighter than you would get in Europe at this point in time.”

A wish to avoid risk-averse European investors as a source of funding appears to be driving these moves towards Asian markets. “It is extremely important for the country to look to Asia as one likely source of borrowing,” he added. “That’s why the sukuk market in Malaysia and dim sum market in Hong Kong are markets we believe Finance [the Ministry of Finance] should be looking at.”

BEA

The Bank of East Asia’s China subsidiary has issued RMB3 billion of financial bonds in China’s interbank bond market – the second tranche in a RMB5 billion program, following a RMB2 billion launch in March.

The interest rate was set at 4.81% for the two-year bonds, which provides a reflection of how market sentiment has changed through the year; the first tranche, with the same tenor, priced at 4.39%, albeit for a larger volume.

The joint lead managers on the deal were ICBC, CICC, UBS Securities and Bank of Communications, with CICC as bookrunner. They sold the bonds only to institutional investors.

Southeast Asian nations are braced for volatile capital flows caused by problems in developed world economies, but insist they are now strong enough to deal with them.

“We are seeing very significant surges in capital outflows and reversals,” said Dr Zeti Akhtar Aziz, Governor of Bank Negara Malaysia. “Previously it destabilized us quite significantly. But in the current environment we are seeing these flows are better intermediated by emerging economies.”

In Indonesia, Rahmat Waluyanto, in the debt management office of the Ministry of Finance, said foreign ownership of bonds had fallen from 35.4% to 33.6% in the space of the last week, but said net inflows into the government bond market stood at $5.5 billion year to date. “There is no reversal yet: the real money accounts still stay,” he said. “We have the capacity to withstand flows.”

In 2009, deleveraging by international investors led to the withdrawal of large sums from Asian markets, particularly Korea and Malaysia. “Our currency depreciated to levels we haven’t seen for a long time, and our reserves declined by 25 to 30 billion dollars,” Zeti said. “But we could take it in our stride.” Around 20% of Malaysian government bonds are foreign-held. Emerging markets generally have been heavy recipients of foreign capital since the 2008 global financial crisis, but Asian nations worry about the impact of sudden reversals during times of macroeconomic stress.

Both policymakers said their countries had specific reasons for being more resilient to capital flight. Zeti in Malaysia cited more resilient financial institutions, more developed financial markets, higher reserve levels and a more flexible exchange rate. “The central bank also has a wider number of instruments to absorb them and to sterilize some inflows so they don’t lead to the formation of asset bubbles,” she said.

Waluyanto said Indonesia was protected by its large foreign exchange reserves (which passed US$100 billion for the first time earlier this year), a widening domestic investor base, including retail investors and the growth of pension funds and insurance, and a measure called the bond stabilization framework. He said this involves strategies to anticipate negative impacts of sudden reversals, including buybacks of government securities by his office, the coordinated purchase of government securities by state-owned corporations, and using cash surpluses with the approval of parliament to buy into the market.

However Zeti said Malaysia is still not ready for full currency liberalization. Although foreign exchange in Malaysia is much liberalized since the Asian financial crisis, with no restrictions on inflows or outflows by residents and non-residents, the ringgit has not been internationalized in a way that would allow access to the currency in offshore markets. “At this stage, our assessment is that the internationalization of the ringgit should not be hastened,” she said. “The benefits must outweigh the costs. In an environment of highly volatile global financial markets, opening the ringgit offshore market could increase the risk of significant disruptions in our domestic financial markets.”

She set out the pre-conditions to internationalizing the currency: a stronger domestic foreign exchange market, with enough market players and products to promote two-way flows; capacity among domestic companies and investors to manage foreign exchange exposures; and better risk management and corporate governance practices.

Zeti said inflation had largely ceased to be a pressing issue for Asian central banks. “As commodity prices stabilized, which was a major factor from the supply side producing higher inflation, demand has slowed globally. This will limit inflation, so most central banks have paused their increases in interest rates.” Bank Negara hiked rates in four steps from 2% to 3% from late 2010, “to normalize interest rates and adjust the degree of monetary accommodation,” but ceased in July “given the increased uncertainties and the significantly heightened risks to growth.”

Zeti said she expected emerging markets to continue to grow, but at a slower rate due to the global economy. “In emerging markets we are doing better [than the west] but we are going to see moderation in our growth.” Malaysia’s economic growth was just 4% year on year in the second quarter of 2011, though Zeti has said she expects full year growth of at least 5%.

For central bank governors in Asia, “the biggest challenge is to have price stability in an environment of sustainable growth. You have rising prices, and at the same time you also have risks to growth, and those risks have become higher because of what is happening around the world.”

Of all the stars in southeast Asia, Indonesia is shining  today – and represents the most remarkable turnaround of all Asean nations. But is it sustainable?

In the Asian financial crisis Indonesia was arguably the nation that suffered most, facing a sevenfold devaluation of its currency in a matter of days. This is where the most infrastructure projects fell through, the most bonds defaulted. And, following a period of dictatorship with a long and unsteady transition into democracy, it would remain a risky place for investors to consider putting money for much of the subsequent decade.

In the last five years, though, everything has changed. Susilo Bambang Yudhyono has now been President of Indonesia since 2004, and the 2009 election that put him back into power for a second five-year term has become seen as a model for a democracy in Asia. Political stability has helped, but plenty else has gone right too: a surfeit of coal and other resources at a time when China’s growth has put a considerable premium on those commodities; a largely domestically-driven economy at a time when export-led nations have been badly hit by problems in the developed world; and growing foreign inflows encouraged by the country’s resurgent story.

Today, economic indicators paint a very positive picture. GDP grew 6.1% in 2010, the government expects 6.4% for 2011 and 7.2-7.7% by 2014. The rupiah is strong and steady. International reserves are at record highs, passing US$100 billion earlier this year. Public debt to GDP is just 26%, down from 86% in 2000, and the fiscal deficit has not passed 2% of GDP at any point in the last 10 years.

“We have been a major cheerleader of Indonesia for several years,” says Taimur Baig, economist at Deutsche Bank. “Rightfully, as one of the largest Asean countries, it is finally emerging as a place of tremendous growth potential. The country is benefiting from political stability, abundant natural resources, a favourable demographic dynamic, and crucially, prudent economic management.”

It’s no surprise that in this environment, there is widespread discussion of a ratings upgrade – and what a key upgrade it would be. All three major international agencies rate Indonesia exactly one notch below investment grade, with a positive outlook. The next upgrade makes Indonesia, officially, investment grade, and that, in turn, completely changes the scale and composition of international investors who can invest in the country under their own internal guidelines.

“Our forecast has been, and remains, that we will see at least one of the rating agencies upgrade to investment grade status before the end of the calendar year,” says Robert Prior-Wandesforde at Credit Suisse. “Fitch will most likely be first, but all three will get there by the middle of next year. It’s a question of when, not if.”

He and others believe Indonesia will deserve its big moment when it happens. “It’s a reflection of a dramatic and impressive improvement in many of the fundamentals of the Indonesian economy since the Asian crisis,” he says. “We’ve seen huge balance sheet restructuring, both private and public sector.”

And, crucially, with such a strong domestic consumption story, it is barely vulnerable to external shocks. “Countries like Malaysia, Thailand and Singapore have a far greater correlation to the way the US evolves than Indonesia does,” says Baig. “As we are looking at increasing risks in western economies, the country that stands out would be Indonesia.”

There are often considered to be three flies in the ointment, or at least things to keep an eye on. One is inflation, but as the world economy has slipped in recent months, that appears to have become less of a worry: core inflation, on latest available numbers, stood at 4.5%, which is no great concern.

Another is the risk of foreign outflows. Around 35% of Indonesian local currency government debt is now held by foreigners, a reflection of the country’s economic fundamentals and attractive yield in an appreciating currency. But what if it flies out again, as has happened before? “It’s certainly a high number,” says Tai Hui at Standard Chartered. “Within the Asian region, it’s one of the highest levels of foreign bond ownership. But when we talk to foreign investors, they say: tell me somewhere else with this sovereign credit background and a high single digit yield? The fundamental story is too attractive, and the outlook too positive, for many people to give up their position in Indonesia.”

The government’s debt management office believes it has contingency measures in place to deal with an outflow if it happens, though it has clearly yet to be tested. And it argues – and analysts agree – that the composition of foreign debt-holders has improved over the years, and is now much more long-only than the leveraged investors and hedge funds who were widespread holders four years ago. “There has been a sea change in the profile of those investors,” says Baig. “Having said that, one third of domestic debt issuance held by non-residents is not a healthy statistic.”

The third is infrastructure, as it is in the Philippines. For years it has been clear that infrastructure represents a damaging bottleneck to Indonesian growth; it is also, Hui argues, one of the reasons inflation can rise suddenly. “The two issues go hand in hand,” he says. “Lack of infrastructure directly contributes to inflation, because it means costs all the way through the supply chain – trucks, ferries – go up.”

The government has set great store in a new piece of legislation, the Land Acquisition Bill, which is supposed to alleviate one of the problems in getting infrastructure projects underway, particularly highways. One of the biggest bottlenecks in Indonesian infrastructure development is that in trying to secure the land to build on, disputes often arise, and they can take many years to get through the courts. The new Bill, if passed, cancels land rights in public infrastructure areas with owners compensated, and any disputes over that compensation must be ruled upon by a court within 30 days.

That said, while the government has been championing this legislation all year, at the time of writing it still had not passed parliament and was rapidly running out of time to do so before parliament goes into recess. Still, it has been signed by the president, which was seen as the most likely obstacle, so it does appear to be a question of if not when. “It will happen, but whether it does so before they adjourn for the end of the year is debatable,” says Prior-Wandesforde.

And will it change infrastructure development in Indonesia? “To be honest, I’m not as convinced as some,” says Prior-Wandesforde. “It will take time for it to start working efficiently and it will depend how precisely it is drafted.” He also urges some caution about enthusiasm for Indonesia generally. “I sense a euphoria around Indonesia right now, that it can do no wrong, with forecasts saying it will grow at 7%. While it has made substantial improvement, there is not enough progress in key areas such as the labour market to generate the kind of investment necessary to achieve 7% growth.”

While Indonesia clearly still has challenges, there is no denying the progress it has made through the ranks of southeast Asian economies in recent years, and its immediate future looks very bright.

For many years, Indonesian energy and resource companies were the dominant part of Asia’s high yield sector. They remain a powerful group. But lately, issuance has tailed off and been comfortably trumped by Chinese real estate.

It’s true that there have been big deals from Indonesian high-yield credits, but the biggest have been from the sovereign (which raised $2.5 billion in 10-year funding at the end of April) and a quasi-sovereign (state energy group Pertamina, which brought 10- and 30-year deals of $1 billion and $500 million in the same week in May), both rated a single notch below investment grade and likely to be upgraded, rather than the pure corporate high yield issuers the market has long been associated with. If those sovereign-linked deals are removed, the total high yield issuance from Indonesia this year is just $425 million: $125 million from real estate group Lippo Karawaci in February, and $300 million from Indika Energy, the natural resources group, in April.

“The entire sector is under $3 billion,” says Simon Moore, credit analyst for non-Japan Asia at Credit Suisse, referring to outstanding Indonesian coal high yield bonds. “A large real money account outside the region could theoretically buy up the whole market if it wanted to.” There is about five times more outstanding in Chinese real estate dollar bonds alone.

This scarcity value is one reason that Indonesian bonds are trading exceptionally well. “Everyone loves Indonesian coal, and the bonds trade like it,” Moore says. “The market has priced in an enormous amount of good news. It’s fundamentally a great story, but at some point you have to ask yourself: are these bonds looking a bit rich? Bumi [Resources] is now trading at 6.5% but was in double digits not long ago.”

Herman van den Wall Bake, head of global risk syndicate for Asia at Deutsche Bank, agrees. “Indonesia has been the flavour of the last year and a half,” he says. “If you look at where the sovereign funded itself two years ago, it was at 10.75%; its last exercise was at 5.1%. It has literally halved its cost of funds, it is on the cusp of investment grade and there is tremendous liquidity onshore.”

Indeed, this onshore liquidity is a large part of the reason that issuance has slowed: bank capital is so readily available, and so cheap, that there is little obvious need to go offshore anyway. The situation of Buma Resources, explained in an issuer profile and in the issuer roundtable elsewhere in this guide, is a case in point. “Buma did a deal a year and a half ago in double digits, and just refinanced with a loan at a spread over 375 basis points over libor for seven years,” says van den Wall Bake. “These are tremendous savings relative to where funding was two years ago. So in the near term, borrowers will find that financing themselves in the loan market is more attractive.”

But there are other, structural reasons too, and one is a change to withholding tax laws. Indonesian issuers have typically set up an offshore SPV, often in the Cayman Islands, Singapore or the Netherlands, and generally in a place with a taxation treaty with Indonesia. That treaty, until 2010, usually required a 10% gross-up. The bond would be issued from the SPV and then lent inter-company into the operating company in Indonesia. Then, in 2010, Indonesia announced that for corporate issuers launching bonds in this way, they were required to get a certificate of domicile of all bond holders – clearly impossible – or gross up to 20%.

In the case of the Buma acquisition, for example, this triggered a tax call on its bonds. The situation ended well enough for investors: while Buma could theoretically have gone back and tax-called everyone at 100, it instead did so at 106 and won 97% participation in its offer.

But it complicates things enormously for issuers. “As is usual with these things, as the law comes out, banks find ways to structure around it,” says one issuer. “But the Indonesian government will see through that.” This is another reason that some borrowers prefer bank lending: straightforward and transparent from a tax perspective.

And in the meantime it creates an impediment to issuance. “It is a continuing challenge for the bond market in Indonesia: how to structure around the withholding tax gross-up,” this observer says.

Another issue is a rule by Indonesian regulator Bapepam about what it calls “material transactions”. These require issuers to get shareholder approval before they launch a deal, including pricing and a fairness opinion. “That has put a number of deals on hold,” says Matthew Sheridan, partner at Sidley & Austin.

Set against this, though, is the fact that Indonesian companies do clearly need capital. “Indonesian issuance has been predominantly related to natural resources,” says Eric Greenberg, managing director, financing group and head of leveraged finance in ex-Japan Asia at Goldman Sachs. “That trend is going to continue so long as energy and commodity prices remain high, prompting companies to expand production and to extract resources at higher prices which makes sense with the higher sales price. The need for capital expenditure and acquisitions or expansion is going to drive demand for financing.”

And the clamour from investors to get exposure to Indonesia is only going to increase as the macroeconomic situation around it continues to become more robust. A large part of this is the likely upgrade to investment grade for the sovereign at some point in the future. When Standard & Poor’s upgraded Indonesia to BB+ with a positive outlook in April, it meant that all three agencies were exactly one notch below investment grade. “Our view is that at least one [rating] agency will raise Indonesia to investment grade by the end of the year,” says Moore.

That is a big theme that will have a major impact on the way that foreign institutional capital – already extremely active in Indonesia, accounting for more than 30% of the local rupiah government bond market – behaves towards the country. But the weight of capital still might not be enough to coax new issuers if they can get what they need at home. “One thing that is critical is that Indonesia is a credit upgrade story, which has a positive impact on pricing for Indonesian corporates who want to tap high yield,” notes Paul Au, head of Asian debt syndicate at UBS. “But with the withholding tax situation, it’s a cost consideration: if there is cheaper funding onshore, why go offshore?”

While Pertmina is not everybody’s idea of high yield, the fact that it is rated BB+ and still managed to secure a book of more than $5 billion for a 30-year deal at just 6.625% demonstrates how investors feel about credit in the country. And it’s notable that this appetite remains despite the fact that there are major issues, discussed in more detail in the structuring and restructuring chapters, about what happens if an Indonesian deal runs into trouble, including issues about court impartiality and sponsor behaviour during restructurings.

In short, if Indonesian issuers want to launch more high yield deals, they’ll get the funds they need. It’s just that right now, they may have better options at home.

Indonesia’s economy is buzzing, its budget flush with foreign inflows and its currency soaring – all of which represents both opportunities and challenges for the finance arms of Indonesian corporates. Asiamoney brought together treasurers, CFOs and CEOs from a diverse range of Indonesian companies in a roundtable sponsored and developed by Bank Negara Indonesia.

PARTICIPANTS

Djaja Tambunan, Chief Financial Officer, PT Antam, a leading mining company

Ketuk Budi Wijaya, President Director, Lippo Karawaci, the real estate arm of the Lippo group

ANS (Steve) Kosasih, Finance Director, Perum Perhutani, the largest state-owned forestry enterprise in Indonesia

Wisnu Kuncoro, President Director, Energy Solution, a Krakatau Steel subsidiary

Abubakar Zaini, Finance & Administration Director, Energy Solution

Tiorida, Finance & Accounting Manager, PT Cikarang Listrindo Power Company

Kemal Imam Santoso, Deputy President Director, Askes, a social health insurance company serving 1,100 hospitals, clinics and pharmaceutical companies and with 18 million civil servant members.

Krishna Suparto, Managing Director, Bank Negara Indonesia

Iwan Kamaruddin, General Manager, Transactional Banking Services, Bank Negara Indonesia

ASIAMONEY

I wanted to start with the broader picture of Indonesia: one of the most vibrant economies in the world. How is that economic dynamism affecting the finance functions of your companies?

Djaja Tambunan, Antam: Indonesia is well positioned for growth. It’s gone through a phase of recession fairly unscathed. Antam covers the whole of the country, from gold reserves in Sumatra to bauxite in Kalimantan, a gold refinery in West Java and Nickel operations in eastern Indonesia. For a company like us, with a diverse range of businesses and locations, trying to understand where our money is at any point in time, and how to deploy it and manage the liquidity properly, is a challenge. It’s not because the banks don’t provide the services. But the infrastructure, particularly in technology, is a challenge: there are over 17,000 islands, not all of which are linked through high speed cable. So if we want to reconcile our positions in terms of cash, treasury and liquidity management it becomes a challenge for the banks.

Ketuk Budi Wijaya, Lippo Karawaci: Lippo Karawaci was established after we merged eight companies in 2005. We became a broad-based property company. We manage 25 malls across Indonesia, and in three to four years will add 20 more hospitals and 50 malls. So the management of these operations has become double, triple what it was in 2005. We deal with more than 100,000 residents and many projects: right now we have six new hospitals and four malls under construction. Our 25 malls account for 2.2 million square metres of gross floor area – 25% of the total mall space in Indonesia – and we have more than 10,000 people working with us. So given the diversity and geographical  spread  of our projects, cash is king. We have to manage our cash very carefully.

When we moved from our old bank, Lippo, and sold it to Khazanah, we were dealing with new guys – strangers. Before, we were complacent, just dealing with a bank like our cashier: transfer this and that amount and we will follow with the documentation later. But dealing with new banks, everything changed. We combined our internal treasury process with the cash management processes, and outsourced some of the job to BNI. The treasurer is very happy with the process and we keep introducing BNI to other subsidiaries now.

Asiamoney: Steve, what’s happening in the forestry sector?

Steve Kosasih, Perum Perhutani: Indonesia has grown bigger and better. The rupiah is getting stronger, which is tough if you are selling commodities. It would be nice if our commodity prices had also increased, as they have for Antam, but in Perum Perhutani, where most of our end product goes for export, we have to find ways to be able to be creative in our sales and marketing so as to meet our revenue targets, because the same amount of dollar gets a different amount of rupiah these days.

We would like to have our liquidity faster. We are quite a labour-intensive company: we manage 25,000 people across 2.4 million hectares of forestry. We are industrializing our company now and going upstream a bit because we need to get better revenues for our bottom lines; and when it comes to dealing with third parties, liquidity is king. That’s where BNI and we need to talk: there is a need for more products. I would also like to see all the money in one pot. Basically we manage an integrated cash management solution with BNI.

Krishna Suparto, BNI: One important thing Steve has said is that aside from cash collection and payment, he looks at governance. That’s a very important step. He doesn’t want money and accounts to be unaccounted for everywhere. That’s a solution we discuss.

Wisnu Kuncoro, Energy Solution: We are an energy company, a subsidiary of Krakatau Steel, and take care of their energy needs. Sources of energy have become important in Indonesia recently: the demand is higher than the supply and it is very hard to find primary energy. Krakatau Steel itself has high consumption of electricity compared to other industrials, and because of this scarcity it has decided to change from gas-based to coal-based technology, as we believe gas will be hard to find in the near future. Our position as an energy company is struggling because of this availability of primary energy; so in the near future we will develop combined cycle capacity of 120MW, and make a joint venture with a Korean company to build a co-generation power plant with a capacity of 200MW.

Previously we had no interest burden from debt. But we believe that as the economic situation in Indonesia becomes better and better, with higher liquidity, a strengthening rupiah and many dollars coming into the country, it’s very easy to find money now. It’s a convenient time to make capital expenditure.

We have to do some housekeeping, and one of the most important areas is to strengthen our position in collecting and distributing our money. We have a scenario to create direct links between customers and suppliers, and we hope it can be done through BNI’s transactional banking team.

Tiorida, Cikarang Listrindo: Similar to Energy Solutions, our company is one of the independent power producers in Indonesia. We supply power to industries in Jakarta. Our capacity is 650MW and is growing to 750MW. Most of our customers are export-oriented. For our connections we use a virtual account, which allows the company to gain better collection and enhanced reconciliation and reporting capabilities and services from the bank.

Asiamoney: The insurance sector must be an area of enormous potential and growth.

Kemal Imam Santoso, Askes: Askes may not be the right company to represent the insurance sector in Indonesia because we are social insurance. But that is the most beautiful thing, because the first line of our P&L is fixed: our revenues come from the government. However, due to changes in the government system – so that the local authorities play a more major role and pay the civil servants – premium collection has become a different ballgame. 50% is paid by the federal government, and for those civil servants who work in local government, the rest of the premium is paid by them. Before this, collection premium went through just one authority; now it’s going through about 417.

On the cash management, we are trying to have a much better platform in managing claims. Liquidity is the most important thing. We need to mitigate claims and set aside reserves; we manage the funds we receive in premiums and try to get the best out of the cash, while maintaining liquidity as well. So cash management plays three important roles.

First and foremost is good corporate governance and transparency. Second is maintaining liquidity. And third is the yield. Other than that, we are trying to find an efficient way to manage all our floating cash. So we are moving from a traditional model, whereby each regional office is allocated some cash, and are trying to pull it all together into one.

Another challenge is security, of course. We are still in this ambience of: if I’m not holding the cheque, I’m not sure where that money is going. Although internet penetration is doubling or tripling every year in this country, that ambience is still there.

With the government commitment towards more transparent budget management, state owned enterprises will play a very important role in executing the political commitment to management of cash in this country. We face an interesting situation. A lot of cash management in government institutions is quite rigid, whereas corporations have more room to maneuver in managing their cash better. I would say more and more government programs will be carried out by corporations.

Another point is reporting to the public. Cash management provides you a report as and when you want, in the middle of the night. It’s much easier: you don’t have to get people together for three days and nights to reconcile a number.

One area that is going to be interesting is IT security. Askes is a social health insurance company, not an IT company and we have no appetite to go into IT. It is very inefficient to do everything internally: it’s a burden to our capex. We want to focus on our core competence and outsource IT, treasury – if I can even outsource payroll I will do so. Then we can focus on risk management actuaries, and managing costs – that’s it.

Asiamoney: Krishna, we’ve heard six client views about what they want. As a service provider, what do you think?

Krishna: It’s interesting to hear CFOs wanting support to know where and when their money is, and wanting to be in their core competencies and letting banks be their partners. And the idea of going beyond cash management in partnership – that’s in line with our business model and strategy, we want to continue in that direction. Corporate governance is another important area. We have one client, an educational institution, which has never received an unqualified opinion [a key accounting recognition]. We helped to consolidate their accounts – hundreds of them – and set up collection, payment and reporting. And last year they got an unqualified opinion for the first time. That’s something we hope for: not just financial benefits, but other areas that improve continuously around governance.

Iwan Kamaruddin, BNI: From our area of service focus in transactional banking, everything we’ve heard is what we live for now in BNI – continually seeking ways to assist our clients achieve their business and operational goals. We have heard much of the purported strategies: let us focus on our core competencies. Companies want to get away from the nitty gritty of time-consuming processes, and move to more controls and analysis. If a partner bank can assist with effective outsourcing, they can become a strategic partner to help achieve the goals of the company.

From the transaction point of view, on questions like how can we make our collection faster, we want to provide tools so companies can manage the top as well as the bottom line. We should be able to take manual processes away from them and help them focus on risk management, not collection and reconciling. We are investing in technology, people and processes to address the points being made around the table.

Asiamoney: Outsourcing involves building new relationships and trust with banks. What’s involved and how do you mange it?

Abubakar Zaini, Energy Solution: Most of our cash is in a pool where we work with another bank. Hopefully in the near future we can increase our cooperation with BNI on cash management. We are ready to start with banks to improve our cash management processes, because previously we did all the payments manually.

Tiorida: We only use limited outsourcing. Our main focus is on collections. [PLEASE ADD TO THIS IF YOU WOULD LIKE]

Djaja: I was just listening to Steve saying: cash is king. I remember during the economic crisis in 2008 saying: cash is no longer king. Cash is God. We were facing tremendous pressure especially since  our cash cost for Nickel  was higher than its market price, hence  we had to conserve our cash. In the old days, many companies were very comfortable doing Banking transactions  manually; most of us at this table have come from global banks, and all of us have encountered this. I believe BNI understands this and is now telling its clients to improve efficiency and move away from executing transactions manually using better communication systems. Banks want to help take care of payroll, payments, and reconciliation where possible.

Antam is has  on nine separate subsidiaries and five business units in various parts of the country. Educating staff in terms of using electronic banking as a means of executing transactions is a challenge, and if it doesn’t start from the top, people don’t get used to seeing that it’s going to improve things. BNI will need to face the challenge of educating its client base, for example by saying: we have a platform to allow things like supply chain management to help with your business.

For example, some companies are  rated better than others, which means they are able to attract  better terms and conditions when they borrow. On the other hand suppliers  in the same supply chain may be rated lower than the buyer  and may not have access to cheap funding. Supply chain financing combines the two, so if a client like Antam has a number of customers or suppliers to deal with, BNI would be able to integrate the supply chain system within one platform. Banks get access to customers they didn’t have before, and the ability to provide funding to a customer they didn’t know;  while Antam helps to facilitate the supply chain link.

Asiamoney: We’re hearing of a need for communication around security. What’s your response?

Iwan: When we speak of technology there’s no going around the topic of security. It’s a high priority for us because technology is going to be the biggest enabler for the success of the business. Our number one priority has been to ensure the channels of communication around a tech solution are secure. Yes, education is important, but the security part has to come through that education, because before a client wants to use a system he has to have full assurance that there are no problems with security. Because of the central bank’s involvement in all the things we do, we have to satisfy them that we have a robust security platform before we can go to clients.

Djaja: People know you’ve invested millions of dollars in the security system. That’s not what I get worried about. I get concerned when people have a secure password, but often pass it on to subordinates when they are too busy to use it. Managing transparency and good governance are still at an early stage in our society.

Krishna: We are a permissive society.

Djaja: We often hear people say:” I’m too busy to go to the ATM, here’s my card and PIN, can you (to secretary/staff) help pick up my money. Many executives ask their secretaries or drivers to pay the phone bill and give them the access code. This is what needs to  be more controlled.

Krishna: It’s a good comment. We are not talking about physical hardware and firewalls, but a mentality. There are very strong and strict standards, with interim spot checks, but alongside the physical security is the mentality switch.

Iwan: We’re speaking of accessibility to critical information. Banks can do so much: recently we’ve had increased requests from clients to share what banks are doing to safeguard the assets they have in the bank. We have spot audits, we check on activity of accounts, we validate and make sure that usage and verification of systems is under control. But it all boils down to the owner of the access being responsible for that. If they misuse that or are careless, there’s little the bank can do.

Asiamoney: Djaja mentioned supply chain financing – a hot topic. What are you doing in that area?

Krishna: It’s a big buzzword now and we are working hard on it. We know that our clients will continue to become more sophisticated and will have multiple choices of raising funding, whereas once it was only the bank. We see that. We are going through the supply chain, giving credit to companies within it, because we know that so long as they have good performance they will continue to get business, and when they do, we will do more financing and more transactional work for them. That’s our business model.

Kemal: We get cash from the federal government, but through four or five different banks. The collection of premium would be very efficient if we were getting the cash from the government through this backbone [supply chain management]. We wouldn’t have to go into the painful detail of reconciliation – let the banks handle that. This is an area where BNI can play a much more important role. That would be an area where cash management can go above and beyond its current platform: it would solve 70% of my problems already.

Ketut: We employ a lot of people and have so many projects, it’s a huge operation. BNI can go to our contractors and finance our projects through them – this is what they are doing now. We open the books. When I come to BNI, I say: anything you need to know, ask me – don’t ask my subordinates. We see an opportunity for them to tap our contractors, our suppliers, our customers.

We use a broad range of services from transactional up to risk management. On outsourcing, when we merged the eight companies our mindset had already changed: there would be no strong IT guys in our organization. In Indonesia we’re gadget guys, we buy a lot of computers and software, but often it’s just duplicating, computerizing our bad processes. Outsourcing was from the beginning a mindset instilled in our organization. We said: no major recruitment in IT. Everything you need, your outsource it. What you keep inside is only project management. What I need to know is, how much is payroll per month? I don’t need to send the cheque myself.

Steve: As with any other company that produces goods not services, the supply chain is key. A large chunk of our costs is in logistics, and that really costs a lot: the opportunity losses, the dead money piling up in stocks. In the past – and still a bit today – we have had money waiting in our partner for five months, during which time its value might decrease, particularly given the decreasing value of dollars. We need the money faster and that can only happen if our logistics are financed properly.

There are three things about Perhutani. Firstly, when we cut logs, it has definitely got to be done in-country because we cannot export logs. The process from procuring the logs until sale takes a long time. If you could shorten it with logistics financing it would be a good solution. Secondly, the products we do export directly, two weeks or a month of delayed payments are bad for out logistics because we need cash. We need a lot of money for payrolls: 63 billion rupiah per month. That’s why we need more money and faster.

Third, when we provide raw materials to our partners and they sell the end products, we have to wait for them to take the raw material, turn it into something sellable and sell it. Only then will the money come to us. That’s time-consuming and value-decreasing – and that is why supply chain financing is one of the key things in the entire cash management system.

Iwan: What we see from companies, especially when they are led by CFOs with a good background in finance, is a demand for more sophisticated service integration. It’s a lot to do with how things can work automatically within systems: how to bring the grand strategy, speed and collection with issues of geography and network into one system. We are trying to find a model or platform that is workable. What Indonesia presents to most people is the challenge of geography and network.

Djaja: Let me give an example of technology and how it’s changed. Not long ago, our suppliers or contractors  would come in and submit a physical bid. This manual process  took up a lot of time and efficiency. We said we wanted to do things differently  so people could put their bids in electronically. Many  customers at the time said they couldn’t do it since they did not have access to computers. So we said, OK, we will help by setting up PCs in our offices so suppliers could come in and submit their bids electronically on our premises to reduce fraud and improve transparency. Well, people eventually liked it since there was  less paperwork, and  more transparent .  We eventually  linked this with our   accounting system to suppliers could track their payment on line. And the fantastic thing is, the people who used to line up to use our computers eventually opted to buy and install their own computers to avoid lining up.

Krishna: That’s very interesting – a social mindset change.

Djaja: It’s like when people say they’re used to signing the chequebook, but then realize they are spending 30 minutes looking for the chequebook and have to do 3,000 of them in a month. A lot of senior people in companies are not comfortable dealing with electronic banking. But I  think this is going to help them in the long run. Banks have to say: don’t be afraid, this is not going to bite you, it will make your life easier.

Kemal: The most important thing is if the consumer can see an immediate reward, it’s a quick win. We are an impatient people. In our case, we hook up about 300 doctors in the centre of Java who set up a network with us. We have installed a system where they key in everything and they can monitor how many are coming to this or that doctor. And the instant reward is they can see how many members are under his or her management. They feel secure and certain. And the minute we explain this to doctors, they quickly set it up.

Asiamoney: How does the energy sector use technology?

Wisnu: Our industry is a bit different to those that produce goods; we get raw materials then produce electricity. But IT still plays an important role for us, especially to help us to automate our processes. We have an internal IT system for planning, procurement, logistics and finance, through our sister company, Krakatau Information Technology. Over the last 10 years we have always had complaints from suppliers over the period of paying the invoice. It used to take three or four weeks, but we put in a policy to ensure every invoice would be paid in less than two weeks by introducing technology. We can then reduce our cost of procurement because suppliers know that in two weeks they will be paid. Also, for industrial customers, we are preparing a pre-paid method for electricity, and IT can help us manage those needs.

Asiamoney: Some of you have raised the point of foreign inflows, and the change in the exchange rate. How does this affect your jobs?

Steve: With the decreasing value of dollars, what we need to go is get rupiah as fast as possible. But sadly most of our income is dollars. The rupiah is good for Indonesia but not good for exporters. You need to mitigate the currency risk.

We are trying to improve on two sides. One, on the LC, we are trying to do zero financing. Two is the logistics part. When we hand over our raw materials to our partners, before they can be produced as finished goods and sold as export products and we get the money – which will take five months – our counterpart will need to issue a bank guarantee for the raw materials. We don’t want the guarantee for the raw materials but for the portion of the money we are going to get. We need everything to be rupiah-based, because our P&L is in rupiah and out bottom line is in rupiah. No matter how good the dollar is, at the end of the day we need to report to the government in rupiah.

It’s easy to sell commodities, but commodities have no loyalty, no brand. And if you don’t use coal, you won’t get power, but you can live without wood. So we have to use a smart way of penetrating the industry. We are going into a new business now: forestry chemicals, using the pine saps. These are the rising stars of the business, almost 50-50 in terms of revenues. Their dollar values are going down but the value of the forest chemical product was $700 and is now $2800 – it’s up four times in three years. And it is almost guaranteed not to go down because production will always be below the level of demand. We are building essentials to produce the derivatives of these pine tree saps – a huge investment – but it’s fully integrated, and we can do a lot of it with the banks.

Asiamoney: The exchange rate must be a big issue for Antam – dealing in a volatile commodity which is priced in dollars, which are themselves volatile.

Djaja: The most important thing is the ability to hedge when required.  Bank Indonesia now restricts the use of  exotic derivatives. In a way that’s good, because it means there is less room for  speculators out there. But on the other hand you are left with very few options for hedging: that is plain vanilla hedging  for both  currency and interest rate exposure..

Antam is a dollar earner. As the rupiah continues to strengthen that’s good for the average Joe on the street but for exporters like us, we do feel the pain.  From a revenue perspective we may be growing from year to year, but from a currency perspective we get hammered when the rupiah starts strengthening.

Ketut: Our debt is in dollars. We sell homes and services in rupiah but we have a US$400 million bond outstanding, and we don’t have any opportunity to sell in dollars. Sometimes we hedge, and we have a fund to use in case of emergency; we put some of our dollars in Singapore, because we have some logistics there too.

We have an asset-light strategy. As a property company we are scared of accumulating assets while at the same time accumulating debts; usually the property companies get hit first in a crisis as they cannot service the interest, never mind the principal. So we are carefully managing our exposure in foreign currencies. A lot of my shareholders complain: why do you hedge it? But in Indonesia it’s only in the last year and a half that the money keeps flowing in. That is not sustainable in my view. I’m still scared. If it is not hedged, maybe you need to appoint another CEO, because I couldn’t sleep at night.

Foreign fund flows into Indonesia are very tempting. But we have to manage our debt carefully.

Djaja: Everyone believes that  the economic environment is very conducive: the economy picking up, good liquidity, no issues like the US and Europe. But what always concerns me is the possibility of another  recession,- even though  Indonesia has gone through several recessions and the  the rupiah moved  from 2500 to 17,000 in a matter of  days. We live in volatile times, but there are certain tools that banks can provide to mitigate some of that risk.

Asiamoney: Krishna talked about wanting to understand the role of the CFO. Has the role of the finance function changed, even though the financial crisis didn’t really hit here?

Ketut: I think the role of the CFO is more critical now. We handle many of our assets through a trust [a REIT] in Singapore so we can tap the costs of finance there, which are much lower. We have to push assets into that trust. This is a critical task for a CFO: packaging assets, injecting them and building new projects.

Abubakar: The main problems for are exchange rate risk, and how to generate funding at a lower rate. For me, the toughest job is to get lower cost of funds for the company, especially to finance expensive projects. In our case there is a mismatch between our revenues and costs because we have to buy gas from PGN in dollars and we get our revenue in rupiah. In future we will negotiate with our customers to convert our revenues into US dollars. Indonesia is a volatile country: maybe at the moment it’s stable, but crisis could return again.

Djaja: The role of the CFO has never really changed, to be honest. I always tell my board members: my role is linked to all of you, whether HR, CSR, project financing or the CEO. The CFO is a partner, a supportive model.

It’s changing in Indonesia. It used to be that the finance director was simply responsible for payments and receivables. The CFO now has a more strategic role to play.

Steve: As business expands, the strategic part that used to be handled exclusively by the CEO is being shifted a bit to the CFO. I’ve seen more and more companies where the CFO is the business and investment head, handling new capital expenditures and investments. The CEO role is so strategic and political nowadays: he is the icon of the company and the CFO runs the business. It might not be suitable for the accountant type who used to be the CFO in the old days. Sometimes we can save a company, or make it more profitable, just by doing great finances.

Krishna: I think fundamentally the role has changed. Initially it was a bean counter, but now it’s a strategic role in creating shareholder value and facing the investor base. It’s very important we help companies go to the next level. It’s a continuous challenge and a moving target.

Asiamoney, June 2011

Indonesia’s economy behaves like an exaggerated version of Asia’s. All of the themes of the broader continent are played out to a magnified degree in Indonesia. Growth, the shift to domestic consumption, the power of commodities, inflation, central banks playing catch-up, infrastructure bottlenecks, the boon and threat of foreign fund flows – all of them are present across Asia, but are more acute in Indonesia.

First, the good news. “The vital signs for the Indonesian economy are at their strongest in the last decade, and the fundamentals are improving,” says Agus Martowardojo, Indonesia’s Minister of Finance, who answered questions from Asiamoney at the Asian Development Bank meeting in Hanoi in May.

He is, unarguably, right. Indonesia passed through the global financial crisis with barely a glancing blow. GDP grew 6.1% in 2010 and Agus expects it to by 6.4% this year and is targeting 7.2-7.7% by 2014. The rupiah has not only become strong – twice as strong against the dollar as at the end of the Asian financial crisis in 1998 – but stable too, steadying between Rp8,600 and Rp9,000, a level that troubles some exporters (see roundtable) but gives the country greater economic heft. International reserves are at their highest level in the country’s history, crossing a symbolic US$100 billion threshold earlier this year, having trebled since 2005.

One of the reasons that things are looking brighter is because Indonesia is, to a large degree, the engine of its own growth, and so less troubled by global economic travails. Whereas China has a stated policy of shifting from an export economy to one driven by domestic demand, Indonesia is already there. “For Indonesia, the core of the virtuous cycle is a revival in domestic demand,” says Agus. “Consumption is up to 60% of GDP.” On top of that, there’s the fact that where Indonesia does export, it does so chiefly with commodities, whose prices have risen dramatically in recent years. “We are buffered by our large natural resources and our geographical position,” Agus says. “We are well positioned to serve demand for those natural resources not just from China but increasingly from India.” On the back of these drivers, the country’s balance sheet has started to look rather impressive: public debt of 26% of GDP, compared to 86% in 2000; a fiscal deficit that has not exceeded 2% at any point in the last 10 years; and a falling cost of capital.

Perhaps the most promising barometer of Indonesia’s economic improvement comes from the rating agencies, and in this respect Indonesia stands at a pivotal moment. When Standard & Poor’s upgraded Indonesia’s long-term foreign currency sovereign credit and debt ratings from BB to BB+ in March, with a positive outlook, it meant that all three major international rating agencies had moved the country to just one notch below investment grade. Moody’s upgraded it to Ba1 on its scale in January; Fitch, which already had Indonesia at BB+, moved its outlook on that rating from stable to positive in February. For any one of the three, the next upward revision will make Indonesia investment grade. None of these agencies has had such a high rating on Indonesia since the Asian financial crisis in 1997. If it happens, then a host of fund managers who are prohibited from investing in sub-investment grade paper will be able to invest – not just in Indonesia itself, but issuers who have been constrained by the sovereign ceiling.

So what’s the dark side? There are three things that concern people both inside and outside Indonesia to varying degrees.

The first is inflation. This is the one that has the greatest likelihood of derailing an investment grade upgrade; it turns up in every comment the agencies make. When Andrew Colquhoun, head of Asia Pacific sovereign ratings at Fitch, announced Fitch’s upgrade in outlook in February, this is what he said: “The positive outlook reflects Fitch’s view that Indonesia’s favourable macroeconomic prospects are likely to see the credit profile strengthen further over the next 12 to 18 months, despite near-term risks from inflation and potentially volatile capital flows.” And when Standard & Poor’s followed in March, its credit analyst Agost Benard added: “The positive outlook reflects the likelihood of an upgrade if inflation is tamed while balance sheet improvements continue.” Other analysts and agencies add similar caveats to their otherwise positive assessments of the country.

Agus does not believe there is a major problem. “Even though there is pressure from commodity prices, specifically food, core inflation has been relatively stable,” he says. “We are confident the government will be able to retain inflation within the target for 2011.” That target is 5.3% and not everyone agrees with him: Fitch, which calls inflation “a near-term risk to economic prospects”, estimates it will average 6.5% in 2011, while the year-on-year CPI figure for January was worse still, at 7.1%.

Part of the problem foreign economists have with this view is that Bank Indonesia has never seemed to be in a hurry to change monetary policy to avoid inflation getting worse, relying on exchange rate movements rather than rate hikes to fix the problem.  Earlier this year Nomura predicted three rate hikes, in April, May, and June; well, the first two didn’t happen, and it seems unlikely that the third will despite hawkish language in BI’s monthly statements. “It appears that any meaningful tightening action will only come after an upside surprise in inflation, not before,” says Wellian Wiranto at HSBC in Jakarta. “The fact that the statements in previous months had been carrying equally hawkish tones [to the May statement, when rates stayed flat] without leading to any significant rate hikes leaves us rather unsure that this one portends anything different soon.” Wellian highlights the dangers in just using currency appreciation rather than rates to curb inflation; for a start, since Indonesia is mainly a domestic economy, currency strength has a limited impact, except to hit exporters. “We continue to think that raising policy rates earlier rather than later still looks to be the most prudent course of action.”

Wellian’s is a common view. Prakriti Sofat at Barclays Capital says “the need for policy tightening remains”, and has a base case of a further 50 basis points of rate hikes. “But the risks are squarely tilted towards BI doing less and rate hikes being pushed out.” But it’s not a universal view. At RBS, Chia Woon Khien, managing director and head of local markets strategy for Emerging Asia, argues that the interest rate is already reasonably high because of the way the central bank has behaved over recent years. “They’ve been very prudent,” she says. “Before Lehman, they never hiked rates like crazy, so during Lehman, they did not need to cut massively like Korea, India or China, which had to do a U-turn and today have ended up with inflation problems. Indonesia has been flat throughout this whole period, so the level of interest rates, to me, is not exceptionally low.”

“They do need to hike,” Chia adds. “But I don’t think there’s this big risk everybody is talking about.”

The second challenge concerns fund flows. Indonesia’s strong fundamentals have attracted a lot of foreign money into Indonesia, both on the equity and the debt side, so much so that it has started to create concerns about what happens if it all leaves again. Over 30% of Indonesian rupiah government bonds are held by foreigners.

The Indonesian position has been, firstly, to put an understandably positive spin on this. The high ownership “basically reflects investors’ confidence on Indonesia’s long term economic fundamentals,” says Rahmat Waluyanto, Director General of Debt Management in the Ministry of Finance. “Yes, we are also very aware of any potential reversal risk. But we are very ready to prevent such an event happening.”

Both Rahmat and Agus say there are measures in place to deal with any outflows. The country has devised a bond stabilization framework, including crisis management measures established between state-owned financial companies and the central bank, to insulate the country from any shocks caused by a departure of funds. It’s not entirely clear how this framework will operate, but it doesn’t appear to mean capital controls in the conventional sense: it seems that money won’t be stopped from leaving, but rather that there are contingencies to deal with it if it happens.

In any case, Rahmat stresses that the composition of foreign money in the debt markets is important. “Most of those foreigners are buy and hold or real money account investors and are holding long tenors of bonds,” he says. According to his office, 70% of all foreign bond holdings are in maturities of five years or greater.

The third challenge – and stop us if you’ve heard this before – is infrastructure. For decades now, infrastructure has been identified as the biggest hurdle that must be surmounted for Indonesia to realise its potential, and little has changed over the years. “To be frank with you, the bottleneck [stopping] our economic growth achieving 7% or higher is infrastructure, so it is a national priority,” says Bambang Brodjonegoro, head of the Fiscal Policy Office within the Ministry of Finance.

More than any other area, the problem has been most evident in highways. That’s because highways involve the greatest amount of land and the greatest variety of owners of it. If a highway developer wants to build on land and the owner won’t sell, or a dispute arises over the sale, that can mire development for years.

In order to address this, the government has set great hopes on its Land Acquisition Bill, which was in parliament at the time of writing. Under this new law, land rights in public infrastructure areas will be cancelled, and owners compensated (one can see why such a law is going to involve a certain amount of controversy and parliamentary debate). Where disputes do arise, a court must rule on them within 30 days – and this would be the truly transformative element.

Agus is open about the problems that exist without the law. “If we review PPP projects in Indonesia for the last eight years, we have to admit that no one can be executed,” he says. “One of the main obstacles is land acquisition.”And where is the bill up to? “The government has already reached consensus with parliament that we will have a special law for land acquisition. We believe by the end of the third quarter, we will have that law.

“With that law, we are confident that infrastructure projects can be executed faster.”

Agus speaks of other priorities for Indonesia. “Our medium term strategy aims to harness the whole growth potential of our provincial regions to spread the benefits of growth and development more easily,” he says. Indonesia is establishing six economic growth corridors to do so, he says. Ideally, Indonesia will attract private sector participation into ports, power plans and other infrastructure development across Indonesia.

Doing so, he knows, is going to take something of a shift in efficiency and professionalism in state institutions. “In order to improve the investment climate we will intensify the bureaucratic reform agenda to improve governance,” he says. “We understand the importance of efficient bureaucracy to our credibility. The Ministry of Finance is at the front of public sector reform in Indonesia, moving from a compliance-based administration to a professional one, accountable to the public.”

Long-time Indonesia-watchers may roll their eyes at this, feeling they have heard it before. But the big difference now, compared to in the past, is that Indonesia can speak from a position of uncommon strength, stability and justified optimism.

Box: Indonesia in the debt markets

One can see what institutional investors make of Indonesia’s health by looking at the country’s fortunes in the international debt markets between late April and late May.

First, in New York hours on April 27, the Republic of Indonesia priced a US$2.5 billion 10-year global bond, one of the largest single-tranche issues ever in Asian bond markets.

The deal, lead managed by Deutsche Bank, JP Morgan and UBS, came with a coupon of just 4.875% and yielded 5.1% at launch, the lowest coupon the country has ever paid on dollar debt. If there was a complaint, it was that they could have seized the opportunity to secure longer-term funding too.

Then, in May, Pertamina, the state-run energy company, launched a 10-year of its own: a US$1 billion global bond that marked its international capital markets debut. And then, galvanized by its success, it did what investors had hoped the sovereign would do, and came back later the same week with much longer-dated paper: a US$500 million 30-year deal.

All deals were extremely popular: the first Pertamina bond, lead managed by Citigroup, Credit Suisse and HSBC, was seven times covered, and the sovereign raising attracted a US$6.9 billion book from close to 300 accounts. The fact that Pertamina is seen as a proxy for the sovereign, and therefore should benefit if Indonesia itself is upgraded to investment grade, counted in the deal’s favour: Pertamina’s Ba1/BB+/BB+ ratings exactly match those of the sovereign.

All the deals sold well internationally; more than 40% of the Pertamina transactions went to investors in the US, with Asian and European buyers well represented as well. Long-only money – funds and asset managers – dominated both deals.

For Rahmat Waluyanto, who heads Indonesia’s debt capital markets programs, it all points towards an upgrade. “Indonesia has already been perceived as having an investment grade rating by the market, as indicated by the CDS [credit default swap] rate and its bond price,” he says. “We just need to convince the agencies such as S&P that we are able to manage inflation and to secure funding from domestic market sources.”

“The investment grade rating is just within reach.”

Indonesia’s finance minister believes a crucial new law, one he hopes will galvanize the country’s flagging infrastructure sector, will be passed in the third quarter of this year.

The development of infrastructure is widely seen as the biggest impediment to Indonesia growing from its solid growth rates today – 6.1% GDP growth in 2010, and an average of 5.7% a year since 2006 – to being a true leader in global growth. “To be frank with you, the bottleneck [stopping] our economic growth achieving 7% or higher is infrastructure, so it is a national priority,” said Bambang Brodjonegoro, head of the Fiscal Policy Office within the Ministry of Finance.

One of the biggest problems, particularly endemic for highways, is disputes over the rights to the land the highways will pass through. This has stopped development and impeded a public-private partnership (PPP) infrastructure program taking root. “If we review PPP projects in Indonesia for the last eight years, we have to admit that no one can be executed,” said Agus Martowardojo. “One of the main obstacles is land acquisition.”

To counter this, a draft law, the Land Acquisition Bill, was put into parliament earlier this year. The bill – naturally somewhat controversial among Indonesian landowners – means that land rights in public infrastructure will be cancelled and owners compensated. Vitally, where disputes arise, a court must rule on them within 30 days. This is in sharp contrast to the situation today where disputes often take two years or more, sometimes longer than building the road itself.

Asked about the bill’s progress by Emerging Markets, Agus said: “The government has already reached consensus with parliament that we will have a special law for land acquisition. We believe by the end of the third quarter, we will have that law.

“With that law, we are confident that infrastructure projects can be executed faster.”

Analysts say progress here is vital for the broader economy. “The only major drawback for Indonesia is still the infrastructure,” said Ferry Wong at Macquarie. “Inflation and the fuel subsidy are challenges, but not so much of an issue, as the government can absorb high oil prices. Infrastructure is the main problem.” Mr Wong said that infrastructure development would have spillover effects into the economy such as encouraging greater and more confident foreign direct investment.

In every other respect, the Indonesian economy is humming: a commodity rich economy in a demographic sweet spot; a stable democracy with vibrant domestic consumption and record high foreign currency reserves that passed US$100 billion earlier this year. “The vital signs for the Indonesian economy are at their strongest in the last decade, and the fundamentals are improving,” Mr Agus said. He is targeting growth rates of as much as 7.7% annually by 2014. Rating agencies, most recently Standard & Poor’s in March, have been upgrading the country, with all three international agencies rating it just one notch below investment grade. There are only two concerns: inflation and the danger of a sudden outflows of foreign capital.

“Even though there is pressure from commodity prices, specifically food, core inflation has been relatively stable,” Mr Agus said. “We are confident the government will be able to retain inflation within the target for 2011.” That target is 5.3% and not everyone agrees with him: Fitch, which calls inflation “a near-term risk to economic prospects”, estimates it will average 6.5% in 2011.

Indonesia is wary of the dangers of foreign fund flows out of its bond markets, but is capable of handling the threat, according to the most senior figure in the country’s debt management arm.

Rahmat Waluyanto, Director General of Debt Management in the Ministry of Finance, told Emerging Markets that the high level of foreign ownership of Indonesian rupiah government bonds – over 30% – “basically reflects investors’ confidence on Indonesia’s long term economic fundamentals. Yes, we are also very aware of any potential reversal risk. But we are very ready to prevent such an event happening.”

Waluyanto’s confidence stems from the composition of foreign engagement in the markets, and his own policies. “Most of those foreigners are buy and hold or real money account investors and are holding long tenors of bonds,” he said, adding that 70% of foreign bond holdings are in maturities of five years or greater. “I’ve heard that many of those are Indonesian money kept in overseas accounts.”

In terms of policy, he believes a newly-established bond stabilization framework – which includes crisis management measures established with state owned financial companies and the central bank – will insulate the country from shocks, as will a steady deepening of the domestic bond market.

Waluyanto also argued for Indonesia to be granted investment grade status by the world’s major credit rating agencies, all of whom have the country exactly one rung below that level today. “Indonesia has already been perceived as having an investment grade rating by the market, as indicated by the CDS [credit default swap] rate and its bond price,” he said. Japan’s credit rating agency gave Indonesia an investment grade rating two years ago, he said. “We just need to convince the agencies such as S&P that we are able to manage inflation and to secure funding from domestic market sources.”

The point on inflation will be crucial, having been highlighted by all international rating agencies in their most recent upgrades. Standard & Poor’s, the most recent to upgrade in March, said that high inflation and vulnerability to external shocks posed a hurdle to a further upgrade. “The positive outlook reflects the likelihood of an upgrade if inflation is tamed while balance sheet improvements continue,” said S&P credit analyst Agost Benard in announcing the March rating change. Inflation remains the core concern of sovereign analysts too. “We believe that core inflation will continue to drift towards 5%,” said Barclays Capital analyst Prakriti Sofat on Tuesday. “This suggests that the need for policy tightening remains.”

Despite that, Waluyanto said: “The investment grade rating is just within reach.” From his perspective, an upgrade would mean cheaper funding. “We expect that we can attract more long-term investors so that we can be sustained to finance more infrastructure projects more efficiently.”

Improved sentiment towards Indonesia was illustrated by last week’s successful US$2.5 billion 10-Year bond from the Indonesian sovereign, although Mr Waluyanto said part of the strategy of this bond was to allocate more than usual to domestic investors – three times higher than in previous issues. “This is due to extra US dollar liquidity in the domestic market, as well as a result of heavy capital inflows,” he said. “We created price tension by allocating more to local investors.” The bond achieved an all-time low yield for national 10-year funding.

Mr Waluyanto also said that Indonesia was making progress in developing its sukuk market, the Islamic equivalent of a bond; Indonesia has historically lagged Muslim neighbor Malaysia considerably in this field. He said his office was preparing two new types of sukuk: one using government projects as underlyings, and one to finance new infrastructure projects.

Indonesia has emerged as one of the world’s most exciting economic growth stories. For many years considered a laggard to Asian growth and opportunity, it now finds itself at the convergence of a perfect set of investor criteria: politically stable; full of resources; given resilience by a strong domestic growth story; and now on the cusp of a ratings upgrade that would take it that crucial step from sub-investment to investment grade.

It’s a far cry from the Asian financial crisis, when Indonesia was the most badly hit of all Asian economies, with a plunging currency and an arguably botched IMF attempt to fix it. In the late 1990s everything had to be rebuilt: the entire banking system had to be rescued and reshaped; the country had to try to build a functioning democracy after more than two decades of dictatorship under Suharto; and an enormously disparate country of 17,000 islands and (today) 240 million people had to be brought together.

There was at least five years of pain. “But when it started to happen, we saw serious progress on all fronts: monetary, fiscal and governance,” says Yougesh Khatri, southeast Asia economist for Nomura. “By 2003 you had the gelling of political stability, much of the disruptive part of decentralization [the passing of some power from Jakarta to the regions] was behind them, there was clear progress on fiscal consolidation, banks were freeing themselves of government debt, and the balance sheet – for households, corporates and banks – began to improve.” All those attributes stayed in place right up to the global financial crisis, from which Indonesia emerged largely unscathed. “The economic fundamentals heading into the crisis were pretty damn good,” says Khatri. “They weathered the storm very well: it’s largely a domestically-oriented economy, they don’t rely on export-driven growth and they also have commodities.”

And so we have Indonesia today: coming out of the crisis largely unscathed, its status compared to other nations is unrecognisable from 12 years ago. More and more fund managers and economists consider it a fifth BRIC alongside the more feted economies of China, India, Brazil and Russia. There has scarcely been a better time to be a resource-rich nation: although Indonesia consumes much of its own oil and gas (it is the only OPEC member to be a net importer of oil), it is a major exporter of coal and has plentiful amounts of tin, bauxite, silver, copper, nickel and gold, among other things.

On top of that, demographically, it is in what Khatri calls “a sweet spot in a number of senses.” According to Nomura’s research, if one uses a criterion of US$3000 disposable income for the household as a definition of the middle class, then Indonesia has already moved from 1.6 million such people in 2004 to 50.4 million in 2009. That’s already an extraordinary pace of growth, but there’s more to come: Nomura believes the figure will be 149.7 million by 2014. If the criterion is US$5000 disposable income, then there will be a tenfold increase – from 9.9 million to 96.3 million – between 2009 and 2014. That in itself is plenty to drive a domestic economy, but additionally, Indonesia is heading in to a sweet spot in terms of the labour force as well.

This is good news for local business, particularly banks. “Indonesia right now is at a pretty interesting juncture,” says Pahala Mansury, chief financial officer of Bank Mandiri. That US$3,000 number cited by Nomura “is the point where, if you look at other economies around the world, people are going to be more ready to consumer a larger number of consumer durables. We can see it in the development of consumer finance in Indonesia, for example: up to September of last year our consumer loans grew 32% year on year.”

All of these things have caught the attention of credit rating agencies, which have been reacting to them in various ways. The most bullish is Fitch, which already rates Indonesia BB+, just one step below the crucial investment grade rating of BBB-. In February, it changed its outlook on that rating to positive from stable. Andrew Colquhoun, head of Asia Pacific sovereign ratings at Fitch, said at the time: “The positive outlook reflects Fitch’s view that Indonesia’s favourable macroeconomic prospects are likely to see the credit profile strengthen further over the next 12 to 18 months, despite near-term risks from inflation and potentially volatile capital flows.”

Moody’s, too, has Indonesia one notch below investment grade (it is rated Ba1 on the Moody’s scale), following an upgrade in January based on Indonesia’s economic resilience and improving public debt position. Standard & Poor’s is the laggard, at BB, one notch behind its peer rating agencies, but that too represents a recent upgrade and the rating is on a positive outlook.

What difference does an upgrade make? Usually, it cheapens a country’s cost of funding and increases investor interest; but this is a particularly significant jump. “This is the critical one: it’s not just an incremental change in ratings,” says Khatri. Many fund managers have a constraint that they can only buy investment grade bonds, in which case Indonesia would become open to investment from them. Those funds that automatically track investment grade markets would need to follow it too.

That said, Indonesia doesn’t really need much more in the way of foreign portfolio funds right now. In fact, if anything, it has started to become concerned by them. Foreigners held 30.8% of all rupiah government bonds as of January, and also poured money into the stock market throughout 2009 – driving it to a record high – before starting to pull back earlier this year. (Separately, and symbolically, Bank Indonesia said foreign currency reserves passed US$100 billion for the first time in March.)

These foreign flows have added to growing fears about the inflationary environment, and also the consequences if fickle foreigners were to start pulling all that money out of the market again. Most of Asia is worried about inflation, particularly as it relates to food and fuel. In that respect, Indonesia had started to seem tardy in raising interest rates before finally doing so on February 4 for the first time in more than two years after inflation reached a 21-month high. Perversely, part of the reason for not having raised rates before now was because the higher yield would then have attracted more foreign capital inflows, which would have exacerbated the fear of them leaving again. BI also increased reserve requirements for banks and tightened rules on foreign exchange holdings.

How bad is inflation? The consumer price index grew 7.02% year on year in January; Fitch, which calls inflation “a near-term risk to economic prospects”, estimates it will average 6.5% in 2011. Set against that, most forecasts for GDP growth are in the 6.5 to 7% range, after reaching 6.1% in 2010; President Yudhyono hopes to grow at an average of 6.6% (and create more than 10 million jobs) through to the end of his term in 2014. Balancing the two will be key to Indonesia’s mid-term progress and any home of an upgrade. For Khatri, “the base line is three more rate hikes in April, May and June, but with the backdrop of uncertainty in the Middle East and Japan, we might see some deferrals.” Deutsche also expects three more, but in April, July and the fourth quarter. The central bank is aided somewhat by a rising currency in fending off inflation, though naturally that has the potential to dampen export growth. This is, it should be said, the same conundrum most major emerging Asian nations are wrestling with.

It is in a better position than some, since it is insulated from rising global commodity prices by the fact that it has so many of its own. “Indonesia’s rich commodity base makes it one of the better hedged economies in the region to deal with an oil price shock,” says Deutsche economist Taimur Baig, noting that Indonesia imports refined oil while exporting crude oil and gas. Coal miners like Kaltim Prima, Adaro Energy and Straits Asia Resources are becoming increasingly well-known among world institutional investors as heavy-duty miners and major suppliers to the global coal market. On top of that, Pahala at Mandiri hopes this year’s harvest will help with inflation pressures, and notes the government is planning to temporarily allow imported foods to come into Indonesia more freely and allowing the rupiah to appreciate, dampening the impact of imported food inflation.

As for worries about foreign bond holdings, Ferry Wong, analyst at Macquarie in Jakarta, argues one has to consider long-term and short-term government debt separately. He says that when widely admired finance minister Sri Mulyani Indrawati resigned last year, 25% of short term government bond money left the country, whereas on long-term holdings, outflows were very low. “Short-term bonds are much more prone to flight,” he says. “But even in May last year when all that money left, within a week the market was relatively strong again. The government is in a much stronger position now: if you have US$102 billion in foreign exchange holdings it’s not too much of a problem if even $6 or 7 billion flow out of the country.” Pahala adds: “The pressures of managing capital inflows will probably not be as significant as we saw in 2010. We should not be overly concerned about that at this point, particularly with the slowing of some growth in Asia, including concerns about China and the unfortunate situation in Japan.”

Inflation apart, Indonesia has other challenges too: corruption, while widely felt to have improved, is still an issue; tax collection is flawed; and – the one thing everyone highlights – progress on infrastructure development simply never seems to be sufficient no matter how many task forces, agencies and initiatives are set up to move it along.

“The only major drawback for Indonesia is still the infrastructure,” says Ferry Wong at Macquarie. “Inflation and the fuel subsidy are challenges, but not so much of an issue as the government can absorb high oil prices. Infrastructure is the main problem.”

The latest movement in this direction is a proposed Land Acquisition Bill, which should help the government accelerate infrastructure projects. One of the long-standing hold-ups in infrastructure development, in particular on highways, is disputes over the land those highways will pass through. The bill means that land rights in public infrastructure corridors will be cancelled and owners compensated; if there’s a dispute, a court will rule on it within 30 days. By contrast, if often takes at least two years to clear land through these disputes, considerably longer than it actually takes to build a road in the first place. Wong hopes the bill, which is in parliament now, will pass soon, hopefully in the first half of the year.

It remains to be seen if it will make a big difference; it is often said that progress on infrastructure could add a couple of percentage points to GDP growth numbers, taking it from being just a high-growth Asian economy to something comparable with China. “The impact will be the cost efficiency, in terms of distribution costs,” says Wong. “The Indonesian economy will grow at a more optimal level. Right now it cannot grow at more than 7% because of the infrastructure bottleneck. With significant infrastructure projects, it will be easier for businesses to expand, and FDI will come in in a more aggressive form.”

Additionally, something odd has happened to the previously burgeoning privatisation program. Last year, in common with the rest of the region, the appetite for equity fund raising appeared insatiable, and the government took advantage of this to launch (or re-launch) an ambitious series of sales of public assets. They didn’t all go well, and the $524 million privatisation of national airline Garuda particularly didn’t go well. On February 11, the stock started trading and promptly fell 23% – not coincidentally, to roughly the level the bookrunners had recommended the deal be priced at. By March they were 30% down.

In March, deputy minister for state-owned enterprises Pandu Djajanto said he had asked permission from parliament to list only one more state-owned enterprise in 2011 – when there had previously been talk about listing up to 10. (The one survivor is expected to be Semen Baturaja, the cement company.) While global market uncertainties haven’t helped, Garuda is surely in the mix. Indonesia still has over 140 state-owned companies generating as much as 40% of national GDP, and many of them need reform.

Still, infrastructure and privatisation are the outliers; everywhere else, Indonesia’s story is relentlessly positive. The Asian financial crisis seems a long time ago now.

Best bank in the Asia region: CIMB Islamic

With activity in the Gulf having been so subdued since the Dubai near-default in 2009 – and, more recently, upheaval in the Middle East – the bank that leads the way in Asia has its strongest ever claim to be leading the way worldwide too. Step forward CIMB Islamic, whose market share as an underwriter of global Islamic sukuk, based on Dealogic’s numbers, hit a remarkable 24.2% in the 2010 calendar year.

Sukuk are clearly not the only way one should judge an Islamic bank, but they provide the most international comparable criterion for influence in the global Islamic markets. And apart from being pm the most deals, and dominating global volume, it was on the deals that mattered. It was, for example, the only regional lead manager (the others were Barclays Capital and HSBC Amanah) on the pivotal US$1.25 billion five-year sovereign sukuk from Malaysia in May, which was the largest ever dollar sovereign to issue Islamically, and came in the middle of the sovereign debt crisis in Europe, hitting a $6 billion order book with more than a quarter of demand coming from the Middle East.

CIMB Islamic is full service, from investment banking to consumer banking and asset management, discussed in more detail in the Malaysia award. But the asset management arm in particular cements the sense of an institution that is regional more than local. CIMB’s Islamic asset management offering runs alongside the CIMB-Principal Asset Management business, jointly owned by CIMB and the vast 130-year-old US house. And almost everything it announces these days has a regional bent: the absorption of Thailand’s BT Asset Management into the CIMB-Principal business in August, allowing CIMB to sell a full range of mutual funds into Thailand, including Islamic; the launch of the CIMB Islamic Global Commodities Equity Fund last year, which gave exposure to Shariah-compliant global equities benefiting from commodity demand. It is one of the world’s leading Islamic asset managers.

While many of its most notable efforts have been domestic, some of them have a global impact. CIMB Islamic CEO Badlisyah Abdul Ghani was instrumental in the development of the Bursa Suq Al-Sila’, the world’s first Shariah-compliant commodity trading platform, which is attempting to streamline commodity trading – and, through it, bank liquidity – across the Islamic world. As a lender, some of its most significant deals have been for multinationals, notably a 12-year $100 million loan, structured around the bai’ al-inah form, for Hewlett Packard in October. And then there are the bricks-and-mortar investments CIMB has built in the Islamic world, from its Bank Niaga stake in Indonesia to its ventures in Bahrain and Brunei. Malaysia wants to be a global hub for Islamic capital, and CIMB more than any other Malaysian bank is its flag-bearer.

Best bank in Malaysia: CIMB Islamic

CIMB Islamic continues to impress in domestic Islamic banking in Malaysia. There are banks that can compete on branches, or assets, or number of mutual funds, or research, or advisory, but it would rarely be the same bank twice. What stands apart with CIMB Islamic is that it is either the leader or a close second in every area from investment banking to consumer and asset management.

We don’t yet have the 2010 full-year numbers, but as of September 30 CIMB Islamic had RM34.8 billion in total assets, a 27.4% increase in just nine months, and entirely in keeping with the stellar growth of a business that had just RM0.5 billion as recently in 2005. Deposits (R0.4 billion in 2005, RM21.25 billion in September) tell a similar story, but actually one can look at any metric in the business – total gross financing, home financing, hire purchase – and see the same picture. And that’s just the consumer side.

In investment banking, CIMB clearly stands supreme in sukuk – with its role on the US$1.25 billion sukuk for the Malaysian sovereign, discussed above, the clear standout – but is also powerful on the equity side, with Shariah-compliant deals including Petronas Chemical Group and JCY International during 2010. It continues to win the important domestic sukuk deals too: a bookrunner role on a RM1.1 billion sukuk for Pembinaan BLT, a state-backed issuer, in January is illustrative.

Whether in esoteric capital markets or mum-and-dad personal finance, CIMB continues to innovative. The ijarah concept is gaining in popularity in Malaysia – previously it was mainly a Gulf staple – and in 2010 CIMB applied it to home financing for the first time in Malaysia, through its Ijarah Property Financing-I product. Its RC-I CM product is a Shariah-compliant revolving credit facility based on commodity murabaha. And then there’s the excellence in Islamic asset management, discussed in more detail in the regional award, as is the bank’s support for the Bursa Suq Al-Sila’ commodity trading platform. In credit cards, financing, wealth management, transaction banking and treasury there is a full-service range of products available and most of them have included some market firsts.

For all that, investment banking is still seen as CIMB Islamic’s strongest suit, and in that respect its immediate prospects are somewhat dependent on both the debt and equity markets, and their appetite for new issuance. But Badlisyah Abdul Ghani runs a business that has consistently stayed ahead through innovation and steady growth, and has seen off tougher markets than this one.

Best bank in the Middle East; Best bank in Saudi Arabia: Al Rajhi Bank

The world’s biggest Islamic bank, Al Rajhi continues to be considered the leader not only in Saudi Arabia but the Middle East region. It is, by Islamic banking standards, vast: at the end of 2010 it had total assets of SR184 billion, upon which it generated profits of SR5.1 billion for the first three quarters of its 2010-11 financial year. Its three million customers give it half of the national consumer finance market in Saudi Arabia.

Al Rajhi was, until very recently, just a Saudi Arabian story, but that changed in 2006 when it moved into Malaysia. It did so in a big way, and has 20 branches already, with plans to open many more. Unlike Kuwait Finance House – its obvious rival for the title of best bank in the Middle East – Al Rajhi opted to go into Malaysia with a full service offering, with all of its core banking products including retail. It is a grand ambition that can only be attempted with deep pockets.

With critical mass attained in Malaysia, Al Rajhi has now turned its attention to its own region, with approval gained in 2009 to open branches in Kuwait and Jordan. Kuwait has been the first to get underway, and again Al Rajhi says it has gone in to “serve all the needs of its retail and corporate clientele,” suggesting a full service offering in due course. In 2010 Al Rajhi announced plans to open five branches in Jordan within a year.

Still, there’s no question Al Rajhi is chiefly a Saudi story; the reason it qualifies for a regional award is in large part because Saudi matters more than almost all other Middle Eastern markets put together. Within that market, Al Rajhi excels on every metric: assets, profitability, headcount, customer base, branches, points of sale and lending.

More than sheer scale, it continues to launch new products and be innovative. Cash management and trade finance services, both undergoing electronic revamps, had excellent years in 2010. And the bank led a new Shariah-compliant bond, sukuk al-amanah Li al-Istithmar, in Malaysia. This is worth looking at in some detail: Al Rajhi was a lead manager on this RM5 billion debt programme by Cagamas, the Malaysian national mortgage company, starting with a RM1 billion print. It was structured in such a way as to be tradable in the Middle East, which generally takes a more conservative stance towards sukuk than do the Malaysian markets. Correspondingly, 33% of the deal went to the Middle East, much higher than usual. This raises big possibilities for further cross-border, cross-tradable deals.

Al Rajhi is, too, one of the strongest players in asset management in Saudi Arabia, although the stand-out in that area is NCB Capital and its Al-Ahli range.

Best bank in Qatar: Qatar Islamic Bank

QIB is the clear leader in Islamic banking in Qatar: impeccably connected to the state and top institutions, and with a critical mass that is going to be tough for anyone to compete with domestically.

Islamic banking is relatively powerful in Qatar: 31% of the total market, accounting for QR149 billion in total assets as of December 2010. Within that, QIB accounts for 35% of the Islamic pool, and 11% of the total banking assets of Qatar overall (and 30% of financing).

The bank has built its name on project and real estate financing, both in the public and private sector. It has funded many of the significant infrastructure and real estate projects in Qatar in recent years, including a record QR4 billion syndicated Islamic facility for the Qatari Diar development group; financing for Qatar Airways; a 25-year US$250 million facility to build a power and desalination plant, and US$150 million on a similar financing for the construction of the RAF A1 desalination project; financing for Qanat Quartier, within the landmark Pearl development; and The Gate construction project, a mixed use real estate project in Doha’s West Bay.

But in recent years it has grown considerably in consumer business too, having moved from one branch in 1983 and eight in 2005 to 28 today and 35 by 2012.  A recent example of innovation in this area was its Hemaya investment product, a Shariah compliant investment vehicle that has proven enormously successful in Qatar.

Like several other of the bigger Gulf institutions, QIB has sought to expand beyond its home boundaries in recent years. It is the key shareholder in Asian Finance Bank, one of the three Gulf institutions that went into Malaysia with full-service licences in the middle of the last decade (the others are KFH and Al Rajhi); it is also a key shareholder in Arab Finance House, in Lebanon; and has interests in Indonesia, Yemen, Syria and the UK, as well as plans in France, Turkey and Kazakhstan. It has also signed a memorandum of understanding with Woori in Korea and BPCE in France.

QIB has the best possible local backers, since the QIA – the country’s sovereign wealth fund – is now the bank’s largest shareholder. This will help strategically and in expansion. It also has muscle: authorized capital of QR2.1 billion at the end of 2010; QR51.8 billion of assets (32% year on year growth); customer deposits and absolute investment deposits of QR30.3 billion (up 49%); and a financing portfolio of QR29.3 billion, up 30%. Return on average equity was 17.9% in 2010, and capital adequacy stands at 17.4%.

This strength helped QIB launch its debut international sukuk in 2010, a US$750 million deal that attracted some US$6 billion of demand.

Best bank in United Arab Emirates: Dubai Islamic Bank

You wouldn’t call Dubai Islamic Bank a business that is shooting the lights out, but it’s still the obvious leader in UAE Islamic banking. Where other Islamic banks around the world boast double digit growth rates, often more than 20%, DIB’s deposits are steady and assets (at just under AED90 billion) growing around the 7% mark annually. But then again, this is the first true fully-fledged Islamic bank, formed back in 1975, so perhaps it’s unreasonable to expect lung-busting growth every year.

It tells you something that, after the AED806 million profit number, the first figure DIB highlights in its 2010 results announcement is provisions, bulked up by AED864 million over the year. That’s a reflection of a crushingly difficult business environment in Dubai, though most in business there feel is a feeling the worst is over. Still, in that environment DIB logged a net operating income (before those provisions) of just under AED 1.9 billion, showing that the well-established core businesses continue to do what they’re meant to.

The simple things worked for DIB in 2010: a focus on balance sheet strength and growth in the retail franchise. DIB upped its presence to 68 branches nationwide in 2010, with six new ones during the year, serving 1.2 million customers in a country whose rather fluid population is usually around the four million mark. Retail accounted for 49% of group revenues in 2010. Perhaps the most salient figure on the whole DIB balance sheet at the moment is the capital adequacy ratio of 17.8% under Basel II, a key differentiator in these uncertain times. Both Moody’s and Fitch upgraded their outlooks on the bank in 2010 (it publicly parted ways with S&P) and at the time of writing it was believed to be the only major bank in Dubai with a stable outlook from both.

Like many of the highlighted Middle East banks in this report, DIB has impeccable connections: its chairman is Mohammed Ibrahim Al Shaibani, whose day job is director-general of His Highness The Ruler’s Court of Dubai. And it’s also in a position to take advantage of lower asset valuations and grow where prudent, which it did in 2010 by increasing its stake in Tamweel, the Islamic home finance provider, to 58%, becoming the majority shareholder. And even in a conservative year, there was still scope for innovation: DIB was behind Emirates REIT, Dubai’s first real estate investment trust, and launched a new personal financing product, Al Islami Salam Finance, and a host of takaful products. Finally, its Dar Al Sharia consultancy and advisory subsidiary has gone from strength to strength, under the guidance of UAE uber-scholar Hussain Hamed Hassan.

Best bank in Kuwait: Kuwait Finance House

By far the biggest Islamic institution in Kuwait, KFH is also one of the Middle East’s few true international players. The regional award is always a choice between KFH and Al Rajhi.

KFH has grown steadily over the last decade, outpacing its native Kuwait. Its asset base, which stood at KD2.4 billion in 2001, was KD12.5 billion by the end of 2010, making for an annual average growth rate of 18.1%. Deposits are up fourfold, to KD7.6 billion, over the same period, and shareholders’ equity six times over to KD1.29 billion, an 18.3% annual growth rate. Net profits have been less dramatic in their growth rate, but have nevertheless doubled over the last decade and stood at KD106 million in 2010.

Bader Abdul Muhsen Al-Mukhaizeem, the chairman and MD, described 2010 as a year of “consolidation and cohesion” for KFH, as it was for many in the Gulf. It shifted investment – both in terms of its own portfolio and its offerings to customers – towards fixed income, low risk, high-liquidity opportunities; it continues to build its consumer business, launching a new family card, the Al-Ousra, in 2010; and it is a long-standing leader in real estate and aviation finance. It is considered to have one of the best electronic systems in the region, manifesting itself both at the treasury level and the individual, with various new smart mobile offerings launched during the year; it’s also evident in revamped credit procedures, anchored around a new documentary credit system called Trade Wind.

Just as Al Rajhi has opened in Kuwait in 2010, so its regional rival is doing the same in reverse. Saudi Kuwait Finance House is up and running and has received a licence to provide a SR500 million real estate investment fund. KFH has long-standing strength in Turkey, which it continues to build upon, launching a new gold investment fund through the Istanbul stock exchange during 2010. It also has branches in Germany and Dubai, as well as its KFH Malaysia and Bahrain businesses, which have eight branches apiece.

KFH is the second-largest Islamic bank worldwide by assets, and continues to impress in the region for its financial strength. Fitch gives it an A+ long-term rating, S&P A-, and Moody’s Aa3. Capital adequacy ratios (14.22% total, and 14.15% tier one, as of December 2010) are down slightly from 2009 but still well above the regulatory minimum of 12%.

BRUNEI: Bank Islam Brunei Darussalam

Competition is not especially fierce in Brunei, the less so since two of the main Islamic banks in the country, Islamic Bank of Brunei and Islamic Development Bank of Brunei, merged to form Bank Islam Brunei Darussalam. BIBD wins the title: in a small country, 14 branches and 600 staff is plenty enough to be dominant. Add its two subsidiaries – Takaful BIBD, which offers Islamic insurance, and BIBD Al-Tamwil, which offers hire purchase financing for vehicles and consumer products – and the group has more or less cornered the market.

For a modest domestic customer base, BIBD is pretty much full service. Its BIBD Securities arm handles brokerage to help its nationals invest in Shariah-compliant equities in Kuala Lumpur and Singapore; its investment banking division has been building an asset and fund management team steadily since the merger; and it offers corporate advisory, wealth management, investment and retail services.

There are more dynamic institutions in the Islamic world than BIBD: the most recent financial statements on its web site date from 2008 and its news section is a host of releases on blood donation campaigns and Toy Story 3 promotions. But still, BIBD is in an interesting place. Brunei has long since wished to diversify away from oil, and set up its Brunei International Financial Centre in 2000, where growth has been modest but the penetration of Islamic banking has been around 40% of total assets – much higher than most other nations. Since the announcement of a banking and insurance order in 2006, and a takaful order in 2008, the legislative environment is now in place, and there is a Shariah financial supervisory board now established at a state level. If Brunei does succeed in making itself a hub for Islamic capital, then nobody is better placed for the opportunities than BIBD.

The bank is also growing steadily. In January it reported a 14.8% rise in profits for the previous financial year to B$101.99 million (though it tells you something that the figures from that January AGM were from 2009). It has B$4.42 billion in total assets, and it has been appointed as a joint lead on some significant sukuk issues by issuers including Islamic Development Bank and General Electric Capital Corporation.

Pakistan: Meezan Bank

Meezan Bank, the first and largest Islamic bank in Pakistan, consolidated its hold on this award over the last 12 months. Firstly, it makes a compelling case based on scale: in January it announced its 222^nd branch across 63 cities in Pakistan. Irfan Siddiqui, president and CEO, has always talked of providing quality Shariah-compliant banking “to every citizen of Pakistan at their doorstep”, and that vision moves closer by the day; some achievement, since when he started saying it eight years ago, it was the smallest bank in the country. It also has the best (local) rating among Islamic banks in the country, at AA.

Secondly, its results are consistently strong. In February it announced its full-year results for 2010, with 61% growth in net profit for the year to Rs1.65 billion. Earnings per share were comfortably up, deposits grew 31% to Rs131 billion, and investments increased 139% to Rs 55 billion. Shareholders received 15% bonus shares in an effort to boost paid-up capital to Rs8 billion (the State Bank of Pakistan had earlier declared a Rs7 billion minimum, a requirement Meezan has now met a full year earlier than scheduled).

Other developments during the year included setting up a new car financing partnership with Indus Motor Company, and the launch of a new Mudarabah-based business account called Meezan Business Plus. It is also an increasingly successful asset manager.

There is huge opportunity in being the biggest Islamic bank in Pakistan. The country has one of the biggest domestic Muslim populations in the world, interest in Islam is clearly increasing – with more and more people wanting to invest their money in keeping with their faith – and individual wealth is climbing too. As more and more people shift from conventional to Islamic banking products, Meezan is ideally placed to benefit.

Indonesia: Bank Syariah Mandiri

The market for Islamic finance in Indonesia, while little developed, is becoming extremely competitive, with five new commercial Islamic banks licensed over the last 18 months in addition to the entrenched players. Of those who have been here longer, two compete in terms of assets, brand and overall standing: the Shariah versions of Bank Mandiri and Bank Muamalat.

A case can be made for both, but we have opted for Mandiri, which is starting to bring the strength of the conventional parent into its Islamic operations too. It is the national leader in assets – in the third quarter of 2010, it had Rp28.05 trillion in assets, up from Rp22.04 trillion at the end of 2009. Profits are still modest, at Rp291 billion in 2009 (the most recent full-year figure yet disclosed), but that’s still a fourfold increase since 2006 and the trajectory is encouraging. It had already beaten that figure in the first nine months of 2010, earning Rp320 billion.

Mandiri has had time on its side: it has had a designated Shariah team ever since the merger that created the overall Bank Mandiri back in 1999, and Bank Syariah Mandiri was formed the same year. It claims some 513 offices operating in 33 Indonesian provinces – one would imagine this involves some overlap with the broader network, but it’s not simply a statement of the overall Mandiri branch count, which is over 900. As a free-standing Islamic entity it has, for example, 220 ATMs in its own right, and claims a staff headcount of some 7,000 in September 2010, although again it seems likely there must be some overlap with the parent in that number.

BSM was upgraded by Fitch in early January to AA(idn); Fitch also upgraded its subordinated Islamic bond from 2007. These upgrades were chiefly predicated on the support from Bank Madiri itself, which put in Rp200 billion over 2008 and 2009 and is believed to be adding an additional Rp400 billion this year in order to bolster the Shariah bank’s capital adequacy ratio to 12%.

Like Islamic finance more broadly in Indonesia, BSM hasn’t done a whole lot so far but shows potential. Fitch, in its upgrade, noted robust financing growth, higher financing yields, a satisfactory deposit mix, and a falling (but still high) non-performing financing ratio (4.2%). It also has a healthy 117.5% provision cover. In the year ahead the bank is expected to expand its micro and SME portfolio in order to lower the concentration risk it faces through corporate financing.

Bahrain: Al Baraka Banking Group

At a time when one of Bahrain’s biggest and oldest Islamic banks, Bahrain Islamic, was announcing a BD39.7 million (US$105 million) loss for 2010, its rival Al Baraka was announcing a $193 million net profit, up 15% year on year. While other banks in the increasingly troubled kingdom have shrunk, Al Baraka’s total assets went up 21% to $16 billion. While others have stopped lending and investment, finance and investments at Al Baraka rose 21% to $11.4 billion.

Customers are getting the message too. Deposits and investment accounts were up 23% to $13.6 billion at the end of 2010, a clear sign of confidence.

Al Baraka chairman Shaikh Saleh Abdullah Kamel attributes the relative strength of Al Baraka to “a model that reflects the true values of Islamic banking and far-sighted business strategies,” which may or may not be a suggestion that not everyone has stuck to those true values and is now suffering accordingly. But it certainly hasn’t come at the cost of expansion: Al Baraka is arguably Bahrain’s most outwardly ambitious Islamic group, and now has 370 branches across 13 countries. In 2010 it opened a new commercial bank in Syria, and launched a new head office for its Turkish business. In October, it completed a merger with Emirates Global Islamic Bank Pakistan and so was able to turn its existing Pakistan branches into a local commercial bank, creating an entity with US$710 million of assets and 89 branches across the country. Next up: Libya – although it’s possible that might now be on hold for a while. Nevertheless, it expects the total number of branches worldwide to hit 500 within the next three years.

Back home, it remains a powerful and comprehensive bank with a full range of operations on the retail and commercial side. It has revamped HR, technical and operational infrastructure, and is working on joint financing of new projects with the Islamic Development Bank.

At the time of writing, with the Saudi army crossing the causeway to Manama, it was not clear just how events were going to pan out in Bahrain. “Not now,” said one person in Bahrain when asked for their opinion on the best Islamic bank. “There are gunshots in the back garden.” Bahrain has built itself on being a hub of stability and reason, and a loss of that status would have an immense impact on businesses there. But, set up in Bahrain in 1984, Al Baraka continues to look one of the strongest names in the country and the region.