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May 11, 2011 By Gray Newman | New York As the beginning of 2011 approached, we argued that Latin America was likely to continue to see a powerful terms of trade shock strengthening currencies through the region. What we didn't see then was just how powerfully and rapidly the region's terms of trade would move, nor did we anticipate the pace and extent of US dollar weakening seen in the first four months of the year (see "Latin America in 2011: Risks to Abundance, Risks of Abundance", This Week in Latin America, December 6, 2010). In This Issue Latin AmericaAbundance at Risk?
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Indeed, gains in Latin America's currencies were so strong in April - associated with such a sharp weakening in the US dollar - that those moves may have contributed to an important correction in the first days in May. Concerns over market positioning appeared to have been mixed, with a new debate over whether the global economic cycle is turning. We'll leave to our currency strategists to tease out the near-term movements and decipher market positioning, but we thought that the current bout of volatility provided a useful moment to reiterate our view that we continue to expect a modest strengthening in most cases in the region's currencies during 2011.
Unless you are working with the assumption that we are on the verge of meaningful downturn in the global economy and in commodity prices, we believe that Latin America's currencies should remain well supported. Indeed, taking into account the improvement in terms of trade in the region in the first three months of the year - we've intentionally excluded the sharp gains in the currencies seen in April associated with a sharp US dollar decline - it is not difficult to conclude that the region's currencies could end the year even stronger than we had originally anticipated. Of course, at some point in 2012, as the Fed begins to hike interest rates in the US and the US dollar rallies, we may seem some partial reversal of some of the gains from 2011. But we expect a relatively supportive global environment to limit commodity and currency weakness in 2012.
Forecast Revisions
Accordingly, we are making modest revisions to most of our currency forecasts. In Brazil, for example, our narrative remains unchanged: we expect the authorities to continue to fight the flows to limit currency strength, but we expect them to have only modest success. Accordingly, Arthur Carvalho now sees the Brazilian real strengthening to 1.55 this year and 1.70 next year (versus 1.65 and 1.80 previously). Luis Arcentales is moving the Chilean peso to 475 this year and 500 next (versus 500 and 510 previously), while Daniel Volberg has Colombia's peso at 1,800 this year and next (versus 1,850 and 1,750 previously).
In two countries, we expect no nominal gains: Venezuela and Argentina. In Venezuela, Daniel Volberg argues that pressure remains for the currency to devalue - the parallel exchange rate trades at close to 9.0 per dollar, near double the official exchange rate of 4.3 per dollar. However, with oil prices surging and two devaluations last year, he suspects that policy-makers will be able to postpone the next devaluation until after elections in September 2012. Meanwhile, in the case of Argentina, Daniel expects to see a continuation of the implicit policy of 7-10% nominal depreciation per year to limit the peso's real gains. In one country, Peru, we are holding off on any adjustments until after the June presidential election. (For more details of these changes and the impact on other macro variables, see Latin America: Forecast Update, which follows.)
Finally, in one country the change is more meaningful: in Mexico, Luis Arcentales is now calling for the peso to reach 11.40 by year-end and 11.80 next (versus 12.2 and 12.3 previously). While Luis had laid out a detailed argument for the ‘super peso' at the start of the year and was more bullish than the consensus as the year began, he held back in adjusting the peso stronger, given limited US economic visibility. However, in the past month, US data releases have consistently surprised on the upside, with industrial indicators remaining exceptionally strong and labor markets apparently on the mend, which suggests that our US economists' call for the recovery to morph from productivity-led one into a sustainable one driven by jobs and associated income growth is playing out. That improvement in the US (despite a slower start to the US economy than our US team had initially expected) combined with Mexico benefitting from a surge in its terms of trade, a more balanced growth story and a policy regime that has shown little interest in engaging in the ‘currency war' have prompted Luis to revise our peso and
Indeed, gains in Latin America's currencies were so strong in April - associated with such a sharp weakening in the US dollar - that those moves may have contributed to an important correction in the first days in May. Concerns over market positioning appeared to have been mixed, with a new debate over whether the global economic cycle is turning. We'll leave to our currency strategists to tease out the near-term movements and decipher market positioning, but we thought that the current bout of volatility provided a useful moment to reiterate our view that we continue to expect a modest strengthening in most cases in the region's currencies during 2011.
Unless you are working with the assumption that we are on the verge of meaningful downturn in the global economy and in commodity prices, we believe that Latin America's currencies should remain well supported. Indeed, taking into account the improvement in terms of trade in the region in the first three months of the year - we've intentionally excluded the sharp gains in the currencies seen in April associated with a sharp US dollar decline - it is not difficult to conclude that the region's currencies could end the year even stronger than we had originally anticipated. Of course, at some point in 2012, as the Fed begins to hike interest rates in the US and the US dollar rallies, we may seem some partial reversal of some of the gains from 2011. But we expect a relatively supportive global environment to limit commodity and currency weakness in 2012.
Forecast Revisions
Accordingly, we are making modest revisions to most of our currency forecasts. In Brazil, for example, our narrative remains unchanged: we expect the authorities to continue to fight the flows to limit currency strength, but we expect them to have only modest success. Accordingly, Arthur Carvalho now sees the Brazilian real strengthening to 1.55 this year and 1.70 next year (versus 1.65 and 1.80 previously). Luis Arcentales is moving the Chilean peso to 475 this year and 500 next (versus 500 and 510 previously), while Daniel Volberg has Colombia's peso at 1,800 this year and next (versus 1,850 and 1,750 previously).
In two countries, we expect no nominal gains: Venezuela and Argentina. In Venezuela, Daniel Volberg argues that pressure remains for the currency to devalue - the parallel exchange rate trades at close to 9.0 per dollar, near double the official exchange rate of 4.3 per dollar. However, with oil prices surging and two devaluations last year, he suspects that policy-makers will be able to postpone the next devaluation until after elections in September 2012. Meanwhile, in the case of Argentina, Daniel expects to see a continuation of the implicit policy of 7-10% nominal depreciation per year to limit the peso's real gains. In one country, Peru, we are holding off on any adjustments until after the June presidential election. (For more details of these changes and the impact on other macro variables, see Latin America: Forecast Update, which follows.)
Finally, in one country the change is more meaningful: in Mexico, Luis Arcentales is now calling for the peso to reach 11.40 by year-end and 11.80 next (versus 12.2 and 12.3 previously). While Luis had laid out a detailed argument for the ‘super peso' at the start of the year and was more bullish than the consensus as the year began, he held back in adjusting the peso stronger, given limited US economic visibility. However, in the past month, US data releases have consistently surprised on the upside, with industrial indicators remaining exceptionally strong and labor markets apparently on the mend, which suggests that our US economists' call for the recovery to morph from productivity-led one into a sustainable one driven by jobs and associated income growth is playing out. That improvement in the US (despite a slower start to the US economy than our US team had initially expected) combined with Mexico benefitting from a surge in its terms of trade, a more balanced growth story and a policy regime that has shown little interest in engaging in the ‘currency war' have prompted Luis to revise our peso and growth call.
Risks to Abundance
It doesn't take more than a few days of turmoil at the beginning of the month to start hearing concerns that perhaps the globe is slowing more than expected. We still believe that the globe is in an unsteady equilibrium and are concerned that the events in the US, Euroland, the Middle East and China all represent important risks to our upbeat assessment of Latin America's prospects in 2011 and 2012. Our working assumption (and our global team's base case) is that the globe remains relatively benign. Even with the revisions downward in US growth by our US team to 2.8% currently for 2011, US growth is still above trend, as is our global growth forecast of 4.2% for 2011.
If global conditions worsen, we think we've already seen how the region would respond: even when faced with the severe shock of 2008, the region saw a downturn in activity but did not experience a financial crisis. Although there are some signs of greater vulnerability today than at the beginning of 2008 - Brazil and Peru, for example, are now running current account deficits versus surpluses at the beginning of 2008 - there are also signs of greater strength. International reserves in every country in the region except Venezuela are larger today than at the beginning of 2008 (at least in dollar terms, although not always as a percentage of GDP). And even in Brazil, which has the region's largest current account imbalance, it is running at only -2.4% of GDP - hardly the kind of over-leverage that we have seen in the region in the past.
Risks of Abundance
Indeed, we would argue that a slowing in growth or a bout of currency weakening would be healthy for the region and reduce the risk we most worry about - the risk of abundance. It's not that the risks to abundance don't worry us: the US economy, the debt turmoil in Euroland and the path of Chinese policy and growth matter a great deal. If the globe turns away from the relatively benign path that we are working with, we expect to see Latin America's growth trajectory suffer as well. But we focus a bit less on those risks because we believe that they are being constantly monitored and handicapped by investors. We worry more about the risks of abundance precisely because it is easy to misinterpret the current abundance as a positive development. After all, it's not hard to be bullish on multi-decade high terms of trade, strong currencies and robust consumer purchasing power.
But the risk of abundance is already creating tensions in the region. Nowhere is that more apparent than in Brazil, where abundance has contributed to a multi-decade strong exchange rate. The strong real in turn is driving a wedge between sluggish domestic production and robust consumer demand (the Growth Mismatch) and prompting policy-makers to fight the flows.
Not only have we seen a series of taxes and controls announced in recent months, including hikes to the IOF taxes on portfolio flows and funding abroad, but we have also seen a renewed interest in industrial policy. While some Brazil watchers argue that policy-makers should simply allow Brazil's manufacturing base to shrink and focus instead on commodities where Brazil has the greatest comparative advantage, we do not expect that advice to receive any support from local authorities. After all, the industrial sector represents nearly 23% of GDP and roughly one-quarter of formal employment. Indeed, we have heard repeatedly from the administration that Brazilian exports to Asia are "excessively concentrated" in a handful of commodities and need to be diversified, and that greater focus needs to be given to "value-added" job creation rather than focusing solely on extracting commodities. A bout of currency weakening, far from being a negative development, might help to reduce some of those tensions.
Alas, we suspect that beyond any currency movements in the coming months, Brazil is likely to face a stronger currency for longer. Usually we see the following sequence in the region: mounting currency strength leads to a consumer boom, stronger growth and more inflows supporting the boom until the level of financing and the size of the imbalance (the current account deficit) reaches 5% or 6% or larger of GDP. At that point, some event (sometimes home-grown, sometimes from abroad) eventually leads to a substantial correction in the currency, GDP growth and the balance of payments. The challenge for Brazil is that, even with our latest projections, the current account is still shy of 4% of GDP in 2012, and by 2013 or 2014 when we can imagine the external accounts becoming a constraint, Brazil is likely to begin to enjoy the pre-salt-related oil export boom helping to sustain a strong currency for even longer. That, in turn, should keep the risk of abundance present.
Bottom Line
The jitters in early May should serve as a reminder that the region remains closely linked to the global business cycle. But as long as the globe remains relatively benign, the region should continue to enjoy strong currencies and good growth. Indeed, while we were optimistic as the year began, we suspect that growth and currency strength in the region in 2011 may be even greater. What worries us the most is not the prospect of a growth scare - that could actually help to ease some of the tensions forming in the region from the abundance of inflows. What continues to worry us most is the risk of abundance - that policy-makers spend too much time fighting the flows with short-term measures rather than focusing on reforms needed to boost the region's long-term productivity path.
Forecast Update May 11, 2011 By Luis Arcentales and Daniel Volberg | New York, Arthur Carvalho | Sao Paolo
Brazil: Losing the Currency War?
The Brazilian government has been active in what it's calling a "currency war". Despite the recent appreciation - BRL broke through 1.65 in late March - there is little indication that the central bank intervention and further actions are off the table. What is motivating the authorities to continue to intervene and announce new controls and taxes? The fact that the Brazilian real is at a multi-decade high in real effective trade weighed terms and appears to be partially responsible for the weakness seen in Brazil's industrial sector. Although, some may argue that the authorities have admitted defeated by allowing BRL to break through 1.65 in late March, reserve accumulation relative to the inflow has kept its pace, as have the interventions in the derivatives markets. The IOF measures and reserve requirements implemented in the recent months have reduced the returns on arbitrage in the derivatives market, reducing some of the pressure.
This tug of war between government willingness to reduce arbitrage opportunities and a strong terms of trade should keep the BRL pressured for the foreseeable future. Indeed, we continue to suspect that the authorities will have only partial success in limiting currency strength and expect by end-2011 for BRL to trade closer to R$1.55 per US dollar. We have long-held that the real would strengthen: during last year we held a forecast of 1.65 and reiterated that forecast at the start of the year when many Brazil observers argued for currency weakness towards 1.85 in 2011. Our forecast adjustment to 1.55 represents a reaffirmation of our view that the currency is likely to remain under pressure to strengthen even from current levels. Of course, one caveat is in order: with BRL becoming increasingly dependent on commodity prices, any important correction in commodity prices would likely to trigger a correction in our BRL forecasts.
Chile: As Good as it Gets?
Boosted by record-high terms of trade, strong growth prospects and expectations for further central bank tightening, the Chilean peso has strengthened, temporarily in May beyond the level (465 to the US dollar) that triggered intervention at the beginning of 2011. In a context of dollar weakness, the recent acceleration in the pace of tightening by the central bank - in response to an increase in inflation expectations and rising inflation risks - has added further fuel to the rally, in our view.
Accordingly, we are adjusting slightly our outlook for the peso in 2011 to 475 (500 previously); for 2012, we still expect peso weakness - consistent with our G10's call for broad dollar strength - with the currency reaching 500. The terms of trade reached a historical high in early 2011 and have rolled over, giving back a significant part of the gains observed since late 2010; this reflects some pullback in copper prices and, above all, the surge in crude quotes. Though the terms of trade remain at historically elevated levels, the recent deterioration suggests that they are unlikely to be a source of incremental currency strength going forward. High oil prices, moreover, are likely to gradually feed into a worsening in growth expectations - though we have upgraded our 2011 GDP growth to 5.9% from 5.6% previously, our call is still slightly below consensus of 6.2%. Consumer confidence has collapsed back to post-earthquake levels due to rising inflation, which is likely to reach 4.1% by year-end (3.7% previously). Moreover, businesses are facing much higher costs and government actions have only partially cushioned the energy blow, as has been the case with gasoline quotes, for example. Though we see only a very low risk of capital controls, we cannot rule out an intensification of the intervention policy currently in place.
Colombia: Fundamentals versus Policy-Makers
We are adjusting our 2011 peso forecast to 1,800 from 1,850 and our 2012 forecast to 1,800 from 1,750. The change to the outlook for this year is largely driven by the surprising strength of the external environment this year. We had previously adjusted the 2011 forecast from 1,720 to 1,850 based on a moderating trade surplus, tighter fiscal accounts and effective policy action, but now realize that the fiscal accounts may not have been as strong or policy action effective.
Several factors are at play in driving a stronger peso, in our view. First, and most important, the continued rise in commodity prices, particularly oil, has lifted the terms of trade to near a record peak. Second, the economy remains healthy, with balanced growth. Third, the continued economic expansion has prompted the central bank to hike rates in order to start normalizing the stance of monetary policy. Finally, the potential upside from a pending reform agenda and/or another upgrade to investment grade could be additional drivers of peso strength. The risk to this call stems largely from stronger policy action, in particular intervention and/or capital controls. We are also adjusting the trade and international reserves forecasts in line with the stronger terms of trade and more active policy action.
Argentina: More of the Same
We are maintaining our forecast for a modest (7.5%) depreciation in 2011 to end the year at 4.30 and are changing the forecast for 2012 to 4.70 from 4.00. This outlook is consistent with an implicit policy in recent years of weakening the nominal exchange rate by 7-10% per year to partially compensate for loss of competitiveness from real exchange rate appreciation via inflation. Our previous forecast of 4.00 in 2012 had assumed a significant change in policy regime: that possibility cannot be ruled out, but it is no longer a part of our current forecast base case. The outlook for 2012 has low visibility, given the importance that the elections in October could have for the economic policy regime.
In addition we are changing our GDP forecasts for 2011 to 6.2% (from 5%) and for 2012 to 5.8% (from 5%). We suspect that demand will once again drive the economy in Argentina this year. In the context of a very strong, positive terms of trade shock - as soft commodity prices have soared - organized labor looks increasingly assured of obtaining wage hikes of near 30-35%, generating a significant boost to real income at least until 4Q11. That boost in income - even if temporary until price increases catch up - should boost private consumption and GDP growth. And the boost in the terms of trade means better external accounts - we are also adjusting our trade, current account and international reserves forecasts.
Peru: Wait and See
Our forecasts for Peru remain unchanged at this point due to the binary nature of the economic outlook. We expect a thorough review once there is clarity on the outcome of the highly contested June 5 presidential election.
Supercharging the Peso May 11, 2011 By Luis Arcentales | New York
The talk of the ‘super peso' has been intensifying among Mexico watchers, as the currency briefly traded below the 11.5 to the US dollar early in the month. Recent market gyrations notwithstanding, chatter of the ‘super peso' has been making the rounds for a few months, following the exchange rate's breaching of the elusive 12.0 level in mid-January for the first time since the Great Recession sparked a sharp devaluation in the peso (see "Return of the Super Peso?" This Week in Latin America, January 31, 2011). At the time, we highlighted that the case for near-term peso strength seemed well justified, for reasons ranging from an improving growth outlook to firmer terms of trade, a supportive balance-of-payments backdrop and the fact that Mexican authorities had avoided the type of aggressive action to limit currency strength adopted elsewhere in Latin America (see "MXN: After the Move", FX Pulse, February 3, 2011).
The case for the ‘super peso' remains as compelling as ever, and the currency is likely to stay stronger for longer, in our view. Though the supportive drivers we identified earlier in the year remain in place, in some cases we did not foresee the magnitude of their improvement and the extent of the associated rally in the peso against a backdrop of persistent dollar weakness (see "G10: FX Forecast Update", FX Pulse, April 28, 2011). With the relevant external backdrop for Mexico likely to remain supportive ahead - in a context of a more balanced growth dynamic and a benign intervention regime - we see scope for the peso to stay strong and even gain some modest ground ahead. Accordingly, we now see the peso ending the year at 11.4 to the dollar (12.2 previously), followed by some normalization during 2012 to 11.8 on the back of the start of interest rate hikes by the Federal Reserve and US dollar strength.
Rebalancing Act
The outlook for economic activity has improved materially, both in terms of actual magnitude as well as its composition, supporting the case for a stronger currency. For most of this cycle, Mexico's strong growth performance has been characterized by strong exports coupled with sluggish domestic demand (see "Mexico: The Two-Tier Economy", This Week in Latin America, May 11, 2010). However, Mexico's growth dynamic has been gradually becoming better balanced - with domestic demand taking an increasingly important role as a growth driver - with positive implications for the sustainability of the ongoing recovery and the currency, in our view. Indeed, in 4Q10 when the economy expanded by 4.6% from a year earlier, domestic demand contributed essentially all the growth while net exports were a modest drag for the first time in two years. The renewed relative momentum in domestic demand reflects in part an incipient recovery in investment spending. And the good news is that the recovery in investment appears to have legs: with capacity utilization above its long-term averages in a context of rising domestic business confidence and a supportive external backdrop, including an improvement in Mexico's terms of trade, we suspect that the uptick in investment observed in late 2010 represents only the first stage of what is likely to be a more substantial turnaround over the course of 2011 (see "Mexico: Capex Un-Squeezed", This Week in Latin America, March 28, 2011).
Consumption, meanwhile, is likely to keep benefiting from rising employment and, importantly, the ongoing improvement in the quality of job creation (see "Mexico: Are the Good Jobs Finally Returning?" This Week in Latin America, February 28, 2011). We suspect that this improvement in labor market conditions has been an important factor behind the ongoing pick-up in credit demand - bank loans to consumers expanded at a real 14% annualized pace in 1Q. Inflation, moreover, has remained well behaved as low services costs have offset pressure from rising processed food quotes, thus limiting the damage to confidence from higher prices for important staples like tortillas and bread.
In light of strong incoming data and our expectations that these favorable trends in consumption and investment will continue during 2011, we have adjusted our GDP growth forecast to 4.7% from 4.4% previously. The change, along with the currency strength, is largely a reflection of a stronger start to the year than even we thought.
Mexico's better-balanced growth dynamic has been accompanied by steady upward revisions to 2011 GDP growth, with Mexico watchers upping their outlook for 2011 growth by a significant 0.9pp. The most recent April survey by Banco de Mexico showed yet another upgrade to 2011 growth expectations to 4.37%, continuing an interrupted string of upside adjustments since last December, coinciding with the approval the approval of the tax and fiscal stimulus deals in the US. Going forward, we see limited scope for further upward revisions to GDP growth, echoing the trend in US growth revisions, which peaked in February and have declined modestly since (see, for example, US Forecast Update: Slower Growth in 2011, May 6, 2011). Still, Mexico is on track to post a second consecutive year of above-trend growth, whose composition is set to be qualitatively better than the 5.5% rebound experienced last year.
No Longer Squeezed from Abroad
Mexico's external accounts have also been supportive of currency strength. Even as the economy resumed its rapid recovery last year, the current account deficit narrowed materially to just -0.5% of GDP in 2010 compared to -0.7% during 2009. And so far the external accounts do not seem to have experienced any deterioration. After all, the trade balance - trade is the current account's largest swing factor - posted a US$1.8 billion surplus in 1Q, nearly five times the magnitude of the surplus in 1Q10. Oil has clearly played a role - the balance of petroleum products reached US$3.4 billion in 1Q from US$2.6 billion a year earlier - but that is only part of the story: the solid pick-up in imports so far in 2011 - echoing the domestic demand recovery - has been matched by a surge in industrial exports, which rose to new historically high levels. Though we have long expected a gradual deterioration in the current account deficit over 2011, we have been surprised by the extent of the favorable trends in external accounts of late. Accordingly, we are adjusting our forecasts, with the current account deficit still likely to double during 2011 to 1.1% of GDP (1.4% previously), as a pick-up in domestic demand leads to a widening in the trade deficit (-US$12.0 billion from -US$18.5 billion previously).
Though net FDI has been far from stellar so far this cycle - just US$5.0 billion in 2010 - net portfolio inflows jumped sharply last year, thanks in great part to inflows related to Mexico's inclusion in the World Government Bond Index (WGBI). After increasing by over US$23 billion last year, daily figures from the central bank indicate that the pace of foreign inflows into local debt has remained quite strong so far in 2011, accumulating inflows of US$14 billion through late April, some 40% higher than the inflows in the same period in 2010.
With oil on the rise, Mexico's terms of trade have moved sharply higher in recent months, representing another factor supportive of a stronger exchange rate. Unlike most of the region which has been enjoying a exceptional, positive income shock from rising terms of trade - which in countries like Brazil, Colombia and Peru are at or near record highs - Mexico has been dealt a far less favorable hand by the globe (see "Mexico: Squeezed from Abroad", This Week in Latin America, November 8, 2010). The lack of support from rising terms of trade, in our view, has been partly responsible for the relatively sluggish turnaround in Mexico's domestic demand as well as the fact that, unlike other currencies in the region, the Mexican peso is still weaker than its pre-crisis peak on a real effective basis, which we estimate is near 11.2 to the dollar today. But this picture has quickly shifted thanks to the surge in the terms of trade since late 2010, which should play a role supporting the currency as well as helping the hand-off from external strength into more robust domestic demand growth, which we expect to continue during 2011. While further gains in the terms of trade may be welcome news for the peso on a short-term basis, the nature of the shock also matters: if the increase comes from another upleg in crude prices, then the negative impact on the US economy is likely to eventually feed into a deterioration in Mexico's growth outlook and potentially a weaker currency.
With intervention likely to remain a key focus for investors, the peso should continue to benefit as Mexican authorities have remained on the sidelines of the ‘currency war' by avoiding the type of aggressive actions to limit currency strength seen in other parts of the region. Though further intervention does not seem imminent, the authorities are unlikely to remain on the sidelines in the face of a more substantial bout of sustained currency appreciation past our 11.4 year-end forecast. Importantly, the authorities have continued to stress the detrimental consequences and limited effectiveness of capital controls, suggesting that additional measures may be benign in nature such as, at least initially, increasing the size of the central bank's monthly auction.
Bottom Line
The case for the Mexican peso remains as compelling as ever and the currency is likely to stay stronger for longer, supported by a strong and better-balanced growth outlook, significantly higher terms of trade combined with a supportive balance-of-payments backdrop and Mexico's benign intervention policy. While Mexico's cycle remains linked to the US, Mexico has not suffered the same kind of banking or fiscal fallout as the US did in the aftermath of the 2008 downturn: that puts Mexico's domestic drivers - which are already on an improving path - on a much stronger footing for 2011 and 2012.
Indonesia Infrastructure: A US$250bn Opportunity May 11, 2011 By Deyi Tan | Singapore
Conclusions: The bull story for Indonesia is now well known (see Indonesia: Adding Another ‘I' to the B-R-I-C Story, June 12, 2009). We think that infrastructure spend is a key driver of this bullish outlook and an important source of positive surprise. Working from a bottom-up perspective and drawing insights from India's experience, we expect +20% CAGR in infrastructure spend, totaling US$250 billion over the next five years. This implies that infrastructure spend will rise from 3.9% of GDP in 2009 to 5.9% in 2015, helping to push GDP growth to 7.2% by 2015. In our bull case, infrastructure spend could rise to 7% by 2015, lifting potential GDP growth to 8.0%. In the bear case, infrastructure spend stays at 4% and potential GDP growth at 6%.
How we differ: The government is more conservative than us, targeting +14%CAGR in 2009-14, a total of US$203 billion in infrastructure spend, averaging 5% of GDP each year. Our back-of-the-envelope calculations suggest that consensus is likely factoring in only a mild rise in infrastructure spend to around ~4.5% of GDP by 2015. Overall infrastructure spend data is hard to come by. We estimate the headline number from bottom-up sources. We highlight that despite perceived slow reforms, infrastructure spend has actually increased from 3.2% of GDP in 2005 to 3.9% in 2009. In our view, two factors will help to support a faster pace of spend going forward:
1) Reforms gaining critical mass: We believe that Indonesia is now where India was six years ago. India started its infrastructure reforms in 2000 but it wasn't until 2005 that reforms gained critical mass and infrastructure spend began to accelerate. For Indonesia, 2005 marked the inflection point in reforms. Time was needed to implement these reforms and they are now building towards critical mass. Already, 17 important regulatory reforms have been passed. Some sector laws will be effective this year and next, and a new land acquisition law is in the pipeline in 2H11. Such reforms create the right micro environment for infrastructure spend to pick up further.
2) Macro environment extremely supportive: Infrastructure investment takes a long time to break even, and the right micro environment also needs the right macro backdrop. Indonesia's macro environment has become more favourable and much more stable since the 1998 Asian Financial Crisis and relative to six years ago. As a result, cost of capital is on a structural decline, falling by 250bp since January 2009, and Indonesia's emergence as the darling of EM investors has opened wide the access door to funding. Better public finances should also enable the government to undertake a more active role in providing infrastructure funding relative to six years ago.
Infrastructure Stretchmarks...
Simple statistics are telling of the infrastructure bottlenecks in Indonesia. Despite the shorter distance, shipping a container within Indonesia from Jakarta to West Sumatra is 4-5 times more expensive than shipping it from Jakarta to Singapore. High logistic costs and the world's largest archipelago are also to blame for the significantly higher product prices in the outer islands. Cement is 10 times more expensive in Papua than in Jakarta. Road transport accounts for 80-90% of passenger and freight traffic and the number of vehicles per km of road has almost tripled from 2000 to 2009. This would not surprise those with first-hand experience of Jakarta's traffic jams. Four out of the top five international airports, including Soekarno-Hatta, are operating above 100% capacity. The public railway track has hardly seen an expansion since late 1980s and more than two-thirds of the rolling stock is more than 20 years old. Meanwhile, only 64.5% of the population has access to electricity. This ratio drops to as low as 20-30% in outer islands such as Nusa Tenggara and Papua.
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