Roubini OfSovereignBondage CreditRatingsInIndiaIndonesiaPhilippines 09jul2012

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July 9, 2012
Of Sovereign Bondage: Credit Ratings in India, Indonesia and the Philippines

By Michael Manetta, Adam Wolfe and Ayoti Mittra Three Countries, Three Credit Rating Stories: Indonesia was upgraded to investment grade by two of the three major credit rating agencies earlier this year; we use Indonesia as a benchmark to judge the Philippines prospects for a similar upgrade in the coming 24 months. Meanwhile, Indias investmentgrade status has come under question as its current account and fiscal deficits have deteriorated. Cracking the Ratings Code: Indonesias upgrade followed a major subsidy overhaul and a shift toward inflation-targeting by the central bank. An improvement in the tax base alongside tighter control on government expenditures is a major reason the Philippines is tipped to receive an upgrade soon. Likewise, Indias commitment to fiscal consolidation in 2003 helped to earn it an upgrade to investment-grade, though its abandonment of this commitment in 2008 could lead to a downgrade. Populism and Its Discontents: Subsidy spending remains a problem for all three economies, as it is politically difficult to reign in and crowds out government investment that could otherwise boost national productivity. The Importance of Revenue Sources: All EMs face difficulties in establishing efficient and reliable fiscal revenue streams, but Indias reliance on non-tax revenues is particularly worrying. Debt Sustainability vs. Debt Finance-ability: Indias twin deficits have coincided with mounting government and external liabilities, while policy missteps have made the country more reliant on portfolio flows to cover its current account deficit. Additionally, the banking sectors ability to absorb more debt is increasingly questionable. Indonesia and the Philippines have both managed to maintain balanced or positive current accounts over much of the past decade. Ratings Outlooks o India: Dodging a Downgrade Should Be Easy, But Delhi Needs to Move: An improvement in the external balance and incremental progress on the policy front may allow India to avoid a ratings downgrade in the next 24 months. However, its investment-grade status will remain questionable without a credible commitment to additional fiscal, regulatory and financial sector reforms. o Indonesia: Overcoming 1998, Staying Put Until 2014: Indonesia still faces a number of fiscal challengesincluding subsidy reform and outstanding contingent liability concernsthat are unlikely to be addressed until after the 2014 general elections. o Philippines: Upgrade Ready: The Philippines is likely to be upgraded in the next 24 months, though the economys growth engines are not yet robust, rendering the governments fiscal resilience to macroeconomic shocks somewhat questionable. Appendix: Key Vulnerability Indicators
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Three Countries, Three Credit Rating Stories
In 2007, Standard & Poors awarded India an investment-grade sovereign credit rating, the third major credit Page | 2 rating agency (CRA) to do so since 2004, citing the countrys strong economic prospects and external balancesheet, a deep capital market and weak but improving fiscal position. By contrast, Indonesian and Philippine sovereign debt remained well below the investment-grade threshold, still mired in the shadow of large external debt overhangs, poor fiscal governance and volatile macroeconomic environments. But times they were a-changin, and the five years since have been a boon for Indonesia: Earlier this year, Indonesian sovereign debt was rated investment-grade by two of the three major CRAs, in recognition of the countrys much-improved fiscal and external debt levels, small deficits and stabilized macroeconomic environment. Meanwhile, the Philippines stands poised to break through the investment-grade plane in the next two years, having, like Indonesia, undertaken several key reforms that put the country on a more solid fiscal trajectory. For India, the past five years have been less fortuitous. Since S&Ps upgrade, persistent current account and fiscal deficits have left Indias national balance sheet in disrepair, the result of structural inefficiencies and policy shortcomings that have in tandem prevented Indias economy from realizing its vast growth potential. These macroeconomic and institutional deficits culminated in downgrade watches issued by S&P and Fitch during the week of June 13, foreshadowing Indias loss of investment-grade status just six years after obtaining it. Figure 1: Credit Rating Timeline
We are referring specifically to foreign-currency sovereign debt here and throughout this analysis. Moodys assigned Indias foreign-currency sovereign debt a sovereign rating in 2004, followed by Fitch in 2006 and S&P in 2007. www.roubini.com NEW YORK - 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | americas@roubini.com | asia@roubini.com LONDON 120 Holborn, 5th Floor, London EC1N 2TD | TEL: 44 207 092 8850 | FAX: 44 207 242 4783 | europe@roubini.com NEW DELHI - Suite 210 Chintels House, A-11 Kailash Colony, New Delhi, 110048 | TEL: +91-11-49022000 Ext. 3001 | india@roubini.com
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Source: S&P, Moodys, Fitch, RGE
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Cracking the Ratings Code
Sovereign credit ratings have taken on new importance in the post-global financial crisis world. Rebalancing the Page | 4 global economy requires massive amounts of investment in EMs to boost labor productivity and employment opportunities, raise incomes and ultimately rebalance growth toward domestic demand. There are extensive savings available in global markets to finance such investment, but for many EMs, it comes at a high price. As credit ratings frequently determine a countrys borrowing costs in international capital markets, at least for EMs, reaching a higher sovereign rating has become an integral part of many EM governments long-term development plans. Many institutional investors are restricted by mandate from investing in below-investment-grade securities, rendering investment grade status a highly coveted award. Sovereign credit ratings are ultimately a measure of potential risk, not potential reward. Ratings reflect a countrys ability and willingness to repay its debts. Unsurprisingly then, political stability, policy flexibility and institutional quality are at the top of most CRA lists of criteria for establishing a credit rating. Quantitative measures, such as the quantity of international reserves and the composition of debt, are also important factors. Of course, each CRA emphasizes certain criteria above others, but in the end, a sovereign credit rating reflects the efficacy and efficiency of policy-institutional factors that play a fundamental role in determining the macroeconomic environment. Indeed, the ratings histories of India, Indonesia and the Philippinesthe focus of this analysis illustrate how unusual it is for a healthy macroeconomic environment to emerge without the support of favorable policy-institutional factors. For example, Indonesias recent return to investment grade status seems obvious from a macro-variable perspective: Small fiscal deficits, low and falling public debt-to-GDP, a strong FX reserve balance, strong economic growth, fairly stable inflation and so on. But this macroeconomic environment came about thanks largely to two major policy-institutional changes in the middle of the last decade: A major subsidy reform in 2005, which helped lower total subsidy spending by 33%, and the introduction of an inflation-targeting monetary policy regime by Bank Indonesia, also in 2005, which not only stabilized inflation rates but also reduced interest and 2 exchange rate volatility. The Philippines underwent a similar institutional overhaul in the 2000s, beginning with its own introduction of inflation targeting in 2002, in line with the general shift to inflation-targeting regimes across EMs in the late 1990s and early 2000s. Fiscal consolidation began in earnest in 2005-06 with tax reform under Gloria Macapagal-Arroyo government, which increased the VAT to 12% from 10%. As a result, the countrys fiscal revenue-to-GDP improved markedly, narrowing the fiscal deficit from 5% in 2002 to just 0.2% in 2007, while the central governments outstanding debt fell from 63% of GDP in 2004 to 44% in the same period. The efforts of fiscal consolidation have continued with the Aquino administrations plan to amend the sin tax (a tax on products such as tobacco and alcohol) this year, which is expected to boost revenues equivalent to 0.5% of GDP in 2012 and 1% in 2013. Indias policy and institutional trajectory was on a similar path until about 2008. Its CRA upgrades in 2004-07 were primarily due to the implementation of the Fiscal Responsibility and Budget Management Act (FRMB) in August 2003, which required a minimum 0.5 percentage point annual reduction of the revenue deficit and a 0.3 percentage point fiscal deficit reduction to bring the fiscal deficit down to 3% of GDP by FY2008. FRMB also banned the Reserve Bank of India (RBI) from purchasing government paper in the primary market after FY2006. Although the terminal date was pushed back by one year in the FY2006 budget, to better the prospects of the ruling Congress Party-led coalition in the 2009 elections, India actually managed to stick to the targets set by the original bill as stronger-than-expected economic growth boosted revenues. Still, as opposed to Indonesia and the Philippines, the RBI has never formally adopted inflation targeting, preferring (or being politically required) to
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Indeed, even with the great global upheaval of 2008-09, exchange and inflation rate volatility was lower in 2005-09 than in 2000-04, a trend that has continued through the present. www.roubini.com NEW YORK - 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | americas@roubini.com | asia@roubini.com LONDON 120 Holborn, 5th Floor, London EC1N 2TD | TEL: 44 207 092 8850 | FAX: 44 207 242 4783 | europe@roubini.com NEW DELHI - Suite 210 Chintels House, A-11 Kailash Colony, New Delhi, 110048 | TEL: +91-11-49022000 Ext. 3001 | india@roubini.com
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accept a broader development mandate, and since 2008 the regulatory trajectory in India has reversed, with the FRBM targets softened and pushed back until at least FY2015. Figure 2: Primary and Fiscal Deficits to GDP Through 2011 (%)
6 4 2 0 -2 -4 -6 -8 1995 1998 India 2001 2004 2007 2010 2 0 -2 -4 -6 -8 -10 -12 1995 1998 India 2001 2004 2007 2010
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Indonesia
Philippines
Indonesia
Philippines
Source: Bank Indonesia, IMF, RGE Figure 3: Outstanding General Government Debt to GDP (%)
90 80 70 60 50 40 30 20 2001 2003 India 2005 Indonesia 2007 Philippines 2009 2011
Source: IMF
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Figure 4: Gross Debt-to-GDP Across Emerging Asia at end-2011 (%)
70 60 50 40 30 20 10 0 India Malaysia Thailand Philippines Vietnam China Indonesia
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Source: IMF Figure 5: Inflation Trends in India, Indonesia and the Philippines (%, y/y)
14 12 10 8 6 4 2 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Philippines
Indonesia
India (WPI)
Source: Haver, RGE
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Figure 6: GDP Per Capita in the Region (USD, 2011)
10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0
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GDP Per Capita
Source: Moodys Statistical Handbook Populism and Its Discontents To be sure, even a seemingly healthy macroeconomic environment can mask policy-driven distortions that credit ratings should capture. In contrast to Moodys and Fitch, S&P left Indonesia one notch below investment grade in April 2012 in light of the governments failure to secure additional subsidy reform for the third year in a row. S&P rightly pointed out how sensitive Indonesias fiscal position is to movements in the global price of oil, and even periods of relatively low oil prices have left Indonesias subsidy expenditure above nearly all of its peers on a 3 relative basiscertainly above that of India and the Philippines. Figure 7: Indonesia Outspends Its Peers on Subsidies (% of GDP)
6% 5% 4% 3% 2% 1% 0% 2004 2005 India 2006 2007 Indonesia 2008 Philippines 2009 2010 Malaysia 2011
Source: Bank Indonesia, India Ministry of Finance, Philippine National Statistics Office, Bank Negara Malaysia, IMF
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Malaysia is the only other country in the region that spends nearly as much on subsidies as Indonesia. Malaysia spent 3.6% of GDP on subsidies in 2011, compared to 2.5% in India and 4% in Indonesia. That said, India ranks higher than Indonesia on RGEs Oil Sensitivity Index (ROSI). www.roubini.com NEW YORK - 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | americas@roubini.com | asia@roubini.com LONDON 120 Holborn, 5th Floor, London EC1N 2TD | TEL: 44 207 092 8850 | FAX: 44 207 242 4783 | europe@roubini.com NEW DELHI - Suite 210 Chintels House, A-11 Kailash Colony, New Delhi, 110048 | TEL: +91-11-49022000 Ext. 3001 | india@roubini.com
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The difficulty the Indonesian government has had pushing through additional subsidy reform reflects a challenge that nearly every sovereign faces: How to reform populist policies that create economic distortions and drain Page | 8 much-needed public funds. For emerging markets, this is a particularly pressing issue given the cost of financing fiscal deficits and large-scale infrastructure projects necessary to boost potential growth. Indonesias government 4 has spent almost twice as much on subsidies as public investment every year since 2003. India now finds itself in a similar position, with subsidies outstripping investment in each of the past four fiscal years. In India, subsidies only account for about 15% of Indias total central government expenditure, compared to almost 25% for Indonesia, yet Indias fiscal and primary balances are in considerably worse shape. Interest payments present a considerable fiscal cost, amounting to 3.2% of GDP in 2011, or 22% of total central government expenditure. Even after stripping this out, the sheer size of outstanding debt to GDP forces India to face large debt principle repayments, amounting to 1.2% of GDP in 2011, which is captured in the primary balance. But much of this can be, and is, refinanced, as state ownership of most of the financial sector provides a captive market. Defense spending is another major expense for the Indian government, equivalent to about 3.2% of GDP in 2011, compared to just 1.2% for Indonesia and 0.8% for the Philippines. But given the regional geopolitics of South Asia, elevated defense spending isnt so surprising, or reckless. However, as neither of Indias national partiesthe Congress Party and the Bharatiya Janata Party (BJP)appear able to form a government without coalition partners pooled from Indias regional parties, whose primary negotiating position seems to be extracting rents from the central budget to bring home to their states, it will prove politically difficult to restrain the growth of subsidies and government salaries. Indeed, India continues to raise the minimum support price (MSP) for agriculture products each year, crowding out funds that could otherwise be invested in much-needed fixed capital, which would ensure these products actually made it to the market before spoiling. Meanwhile, Indonesia and Philippines have the somewhat unusual problem of often underspending their allotted budgets: Indeed, the Indonesian government undershot its expenditure target in nine of the past 10 years, by an average of 4%. While such conservatism certainly improves the fiscal balance, the spending shortfall usually comes at the expense of public investment projects. Bureaucratic inefficiencies are often blamed, though as we highlighted above, the desire for investment-grade status also influences the degree to which fiscal authorities are willing to force spending out the door. This is tricky, because while rating agencies obviously see low deficits as a factor in favor of an upgrade, they also consider whether a country has sacrificed other key economic priorities, such as infrastructure investment, to achieve that deficit reduction. Fiscal prudence, whether intentional or not, lowers borrowing costs down the line, which seems to be the strategy that both Indonesia and the Philippines have opted to pursue.
The Philippines stopped itemizing capital outlays in their annual budgets in 2003, so we have no accurate estimate of public investment spending. www.roubini.com NEW YORK - 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | americas@roubini.com | asia@roubini.com LONDON 120 Holborn, 5th Floor, London EC1N 2TD | TEL: 44 207 092 8850 | FAX: 44 207 242 4783 | europe@roubini.com NEW DELHI - Suite 210 Chintels House, A-11 Kailash Colony, New Delhi, 110048 | TEL: +91-11-49022000 Ext. 3001 | india@roubini.com
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Figure 8: Public Capital Expenditure Often Falls Short of Budgeted Levels (IDR billion)
100 90 80 70 60 50 40 30 20 10 0 2001 2002 2003 2004 2005 Actual 2006 2007 2008 2009 2010
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Budgeted
Source: Bank Indonesia The Importance of Revenue Sources Revenue sources are another crucial aspect of public finance that ratings must take into account, as dependable income streams are often difficult to establish in EMs for both political and institutional/logistical reasons. This is particularly problematic in India, where tax revenue is just under 50% of total revenue, compared to almost 75% in Indonesia and 85% in the Philippines. In general, taxes are considered a more stable source of income for governments than nontax revenues linked to natural resources or asset sales. Taxes are usually levied as a percentage of nominal variables, such as income or consumption, and thus rise as the general price level and real output/consumption rise. Revenue from natural resources or asset sales, by contrast, will rise only with inflation in that particular sector, and the amount of resources/assets available to generate revenue is typically fixed. Figure 9: Indias Tax Revenue-to-Expenditure Shortfall Is Among the Largest in Asia; Indonesias Is Among the Smallest (% of GDP in 2010)
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14
-1 Thailand South Korea Malaysia Singapore Expenditure Philippines Indonesia India
Tax Revenue
Expenditure-Tax Gap
Source: World Bank
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However, establishing a broad tax base can be difficult. Tanzi and Zee (2000) of the IMF highlight three of the most formidable challenges to tax base development: The size of the informal economy, limited tax collection capacity Page | 10 and poor data quality. There is no question that these three factors pervade India, Indonesia and the Philippines to similar degrees. All three countries have large informal sectors and are plagued by inefficient (and often corrupt) tax-collecting bureaucracies. The big three CRAs have identified a low tax-to-GDP ratio as an area of needed improvement in Indonesia, despite having the smallest tax revenue-to-expenditure gap among the three. The Philippines has likewise had its own problems with pushing through unwelcome tax reforms, a reason continually cited by CRAs for not upgrading Philippines sovereign rating. But Indias situation warrants the most concern, in our view, given the enormous dependence of the state on capital receipts, or asset sales, to generate revenue. In 2011, capital receipts accounted for a whopping 37% of central government income, more than income taxes brought in. Figure 10: India Has the Smallest Tax Base Relative to Total Revenue Among the Three (2011)
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% India Income and Sales Taxes Indonesia Excise and Customs Taxes Philippines Nontax Revenue 30% 19% 59% 59% 52% 14% 24% 17% 27%
Source: India Ministry of Finance, Bank Indonesia, Haver, RGE Note: For India, nontax revenue includes capital receipts (asset sales); for Indonesia, nontax revenue includes government revenue generated from natural resources; for all three, nontax revenue includes transfers from state owned enterprises. Debt Sustainability vs. Debt Finance-ability None of the countries in this survey appear seriously at risk of an explosive debt-to-GDP ratio in the medium term, but servicing debt may still be problematic, particularly in Indias case. Indias relatively large fiscal and current account deficits have coincided with a buildup of government and external liabilities over the past several years. Unstable external conditions, like eurozone (EZ) bank deleveraging, could make it more difficult to refinance these obligations as they come due. Moreover, strong intersectoral linkages between the government and the financial sector have the capacity to amplify financial shocks, potentially creating nasty feedback loops. Indeed, the central banks most recent Financial Stability Report showed a considerable worsening in banking sector conditions in Q1 2012, with nonperforming loans (NPLs) nearly doubling since FY2007, while another 3-4% of loans that should have been recognized as NPLs were instead restructured and rolled over as unsecured loans in 2008. As weve seen in Spain and Ireland, solvency
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concerns about the banking sector could quickly mutate into financing questions about the sovereign. Indias particular variety of financial repression forces banks to hold government paper with a relatively low return, while Page | 11 the governments contingent liabilities necessarily include the state-owned banks, which weakens its balance sheet. Public-sector banks control about 75% of the market in India, and the largest bank, the State Bank of India (SBI), has about a 17% market share. The central government has been required to regularly top up the state banks capital base; INR146 billion was budgeted in FY2013 for this purpose. In return, Indias commercial banks are required to invest 25% of deposits in government securities, helping to contain the sovereigns domestic financing costs. Clearly, the banking system poses a significant contingent liability risk to the sovereign. Additionally, Indias current account deficit has widened since 2008 and the financing quality of the deficit has deteriorated. Whereas FDI fully covered Indias current account deficit until 2009, it now covers only about 58%, leaving India more reliant on short-term portfolio flows to meet foreign exchange needs. The current account deficit is being driven by strong public-sector consumption and low real interest rates that sparked a decline in savings, in excess of the decline in investment. As is clear, this situation has arisen largely because of policy-institutional choices. As we have outlined elsewhere, Indias persistent current account deficit is tied closely to the governments persistent fiscal deficits, which have been possible to sustain thanks to financial repressive policies and regular punts on fiscal consolidation programs. The deterioration in financing quality of the countrys external deficits is in turn a function of poor governance that has undermined Indias immense growth potential. The end product is a highly inverted national balance sheet in which the governments liabilities can be expected to increase dramatically during any economic downturn, similar to what Southeast Asia experienced in the late 1990s. Moreover, while the Philippines and Indonesia can rely on the US$240 billion Chiang Mai Initiative to provide FX swap lines in an emergency, the RBI only currently maintains a US$2 billion swap agreement with the South-Asian Association for Regional Co-operation members, of which it is the largest FX holder. Figure 11: Current Account Deficits (% of GDP)
8 6 4 2 0 -2 -4 -6 -8 1990 1993 1996 India 1999 Indonesia 2002 2005 Philippines 2008 2011
Source: IMF On the contrary, Indonesia and the Philippines have both managed to maintain balanced or positive current accounts over much of the past decade, reflecting not only the relatively prudent fiscal policies of each
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government, but also the severe external dislocation that took place following the Asian financial crisis. Indonesia in particular suffered a massive external devaluation in 1998 that never reversed and was accompanied a painful Page | 12 recession and several (small) external defaults. Yet this external adjustment vastly improved the countrys external balance thereafter. Meanwhile, the Philippines has been enjoying a current account surplus and healthy FX reserves sustained by robust remittance inflows from overseas Filipino workers (OFW) that form 10% of GDP. Figure 12: Moodys External Vulnerability Indicator Reveals India Overtaking Indonesia in 2012
100 90 80 70 60 50 40 30 20 10 0 2002 2004 India 2006 Indonesia 2008 Philippines 2010 2012
Source: Moodys Note: Moodys external vulnerability indicator measures short-term external debt, currently maturing long-term external debt and nonresident deposits as a ratio of official foreign exchange reserves. Figure 13: Indias Elevated Total Debt Stock Narrows Policy Space to Offset Shocks (% of GDP)
160 140 120 100 80 60 40 20 0 2006 2007 2008 2009 2010 2011 2006 2007 2008 2009 2010 2011 2006 2007 2008 2009 2010 2011 India Government debt Philippines Non-bank private sector debt
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Indonesia Banking sector debt
Source: BIS, IMF, World Bank, Country Insights
Country Insights is a wholly owned subsidiary of Roubini Global Economics. Country Insights takes a systematic approach to country analysis using our proprietary model: Quantitative Country Analytics. In combination with RGEs macroeconomic and strategy research, users can easily identify country risks, financial distress and critical correlations that would otherwise be missed. www.roubini.com NEW YORK - 95 Morton Street, 6th Floor, New York, NY 10014 | TEL: 212 645 0010 | FAX: 212 645 0023 | americas@roubini.com | asia@roubini.com LONDON 120 Holborn, 5th Floor, London EC1N 2TD | TEL: 44 207 092 8850 | FAX: 44 207 242 4783 | europe@roubini.com NEW DELHI - Suite 210 Chintels House, A-11 Kailash Colony, New Delhi, 110048 | TEL: +91-11-49022000 Ext. 3001 | india@roubini.com
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Going forward, our views on India, Indonesia and the Philippines largely correspond with their current ratings trajectories of the CRAs. India remains stuck in a policy-institutional crisis that continues to worsen and has so far Page | 13 shown little sign of impending resolution. Indonesia faces its own policy challenges, such as subsidy reform and contingent liability exposure via the state-owned banks, but we believe its institutional setup is more flexible and resilient than Indias, putting the country in a better position to handle external shocks and capitalize on the positive momentum of the past several years in terms of credit worthiness. Likewise, the Philippines has undertaken fiscal reforms to broaden the tax base and improve the fiscal balances, yet much remains to be achieved. Still, given strong macroeconomic fundamentals, we see Philippines on the right track to receive a rating upgrade in the next 18-24 months, while India will lose its investment-grade status if it cannot shift policy making in a more productive direction. Ratings Outlook: India, Indonesia and the Philippines India: Dodging a Downgrade Should Be Easy, But Delhi Needs to Move We can look back at Indias 1991 balance-of-payments crisis to gain some perspective on the countrys current vulnerabilities. That crisis was sparked by persistent fiscal and current account deficits similar to todays, which led to a sharp decline in investor confidence. India posted its largest current account deficit ever in Q1 2012 at US$21.7 billion, leaving a 4.4%-of-GDP deficit for the 2011-12 fiscal year. Meanwhile, the fiscal deficit for FY201112 came in at 5.7% of GDP, nearing the post-FY1991 record. The combined twin deficits nearly touched that of FY1990-91, and motivated the CRAs shift to negative sentiment. However, Indias FX reserve position is much stronger now than in the 1990s, which will certainly help to delay a crisis from setting in, though it will not be enough to prevent a crisis without a preemptive policy response. Just like in 1991, India easily has the macroeconomic potential to escape this trap; the only real question is whether the government will act in time to prevent a serious balance of payments crisis. Figure 14: Current Account and General Government Fiscal Deficit to GDP (%)
4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 -12.0 FY1988 FY1991 FY1994 FY1997 FY2000 FY2003 FY2006 FY2009 FY2012 Current Account Fiscal Balance
Source: RBI, Haver, RGE calculations
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Figure 15: Indias FX Reserve Position is Much Stronger Now Than in the 1990s
40000 30000 20000 10000 0 -10000 -20000 -30000 199091:Q1 320000 270000 220000 170000 120000 70000 20000 -30000 199293:Q1 199495:Q1 199697:Q1 199899:Q1 FDI E&O 200001:Q1 200203:Q1 FPI Overall Balance 200405:Q1 200607:Q1 200809:Q1 Loans Reserves 201011:Q1
14
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Current Account Others
Source: RBI, RGE Calculations Economic reforms undertaken in conjunction with an IMF financing in 1991 helped to boost Indias trend growth rate to 7% from below 5% previously. The reform effort during the 1990s simplified Indias tax code, encouraging an increase in the aggregate savings rate, while the opening up of Indias economy made it more resilient to external shocks. Indias total external trade was less than 20% of GDP in 1990, which may have protected it somewhat from the global business cycle, but also made it extremely difficult to earn the FX necessary to fund its current account deficit once investor sentiment shifted. Growth in Indias tradable sector helped solve this problem, with total trade now at about 50% of GDP. By the early 2000s, Indias external balance had improved markedly, which in 2004 prompted Moodys to upgrade India to an investment-grade sovereign credit rating. S&P remained less convinced, citing Indias weak fiscal profile, but in 2007 decided to grant an upgrade. However, the reforms were only half completed, with most focusing on liberalizing the services sector, over which state control was already weaker, while allowing License Raj to continue its reign over the manufacturing sector, where vested interests were better organized. It is no surprise that Indias manufacturing sector has been constrained to about 15% of GDP since, while the services share has increased by about 12 percentage points. Although India likes to hype this as evidence that it has leap-frogged a stage of economic development, what it really means is that those with less education and fewer skills face fewer economic opportunities than they would if it was easier to open a low-end manufacturing operation. This has unnecessarily increased inequality, as highly educated, skilled labor gets to set wages in a competitive market, while a surplus of less-skilled labor is stuck in agriculture or low-value-added services. It has also helped to fuel the governments persistent deficit, as politicians try to paper over their mistakes with subsidy spending on those left behind. With elections looming in 2014, the government has all but abandoned its reform efforts, and the fiscal deficit has grown, crowding out private investment, choking off growth and exacerbating the current account deficit. There will be incremental progress in the current fiscal year, as the start of a new five-year plan usually sees a pickup in public investment, which should help to boost growth. However, the current situation, in which neither of the national parties can muster a majority in the parliament, seems likely to remain after the elections. This will leave
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the Congress Party or the BJP reliant on regional parties who are only interested in extracting rents from the central budget to bring back to their home states, making economic reforms more difficult. Figure 16: India Remains Less Business-Friendly (tax rate as % of profits, USD cost per export container)
80 70 60 50 40 30 20 200 10 0 India 2006 2007 2008 Philippines 2009 2010 Indonesia 2011 2012 2006 0 India 2007 2008 Philippines 2009 2010 Indonesia 2011 2012 800 600 400 1200 1000
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Source: World Bank Doing Business Report Nevertheless, the steps that need to be taken now are much smaller than those in 1991, and even small policy moves in the right direction should lead to lower yields on Indian debt. Multinational corporations still want to invest in India, but a heavy regulatory burden, which lately has become erratic as well, and comparatively high operations costs have kept Indias FDI inflows below potential and forced India to rely on portfolio flows to finance its current account deficit. Pranab Mukherjees decision to step down as finance minister, and Manmohan Singhs decision to take on the portfolio himself in the interim, presents a possible opening for India to show that it will not spend resources pursuing controversial tax claims on foreign investors, which should boost investor sentiment. Additionally, while INR devaluation only brought India pain in 1990, its now-larger export sector should be able to take advantage of its new competitiveness in international markets. The trade balance should be further supported by lower crude prices and the governments pledge to lower gold imports in FY2012-13 after they doubled import duty to 4% in March this year. Nevertheless, liberalization of the manufacturing sector would be necessary for India to achieve its goal of posting China-like GDP growth rates and pulling millions more out of poverty, but the government looks unable and unwilling to pursue this. In the end, the question remains whether India has the political will to undertake these reforms in the face of internal opposition. The division within the governing coalition has resulted in whimsical policy making, as the government has backtracked on several reforms, including the liberalization of FDI in the retail sector, which would have substantially improved Indias financial vulnerabilities and left it on stable credit rating trajectory. However, we believe that some improvement in Indias external balance and incremental progress on the policy front will allow India to avoid a ratings downgrade in the next 24 months, though this cannot be taken for granted. Moreover, India will continue to grow below potential until it picks up the reform mantle once again. Indonesia: Overcoming 1998, Staying Put Until 2014 Much of Indonesias credit rating troubles over the past 15 years are the result of a severe debt hangover following the Asian financial crisis that erupted in 1997. Interestingly, private rather than public-sector debt was the root of the problem; through the first half of the 1990s, a broad range of Indonesian firmsmany of which lacked much, if
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any, FX revenue via exportsborrowed heavily from foreign creditors, accumulating substantial external debt denominated in USD. When the financial crisis that began in Thailand spread to Indonesia, leading to a break in the Page | 16 fixed USD/IDR exchange rate, the currency mismatch among these firms assets and liabilities led to panicked USDbuying in the FX market, putting further pressure on the rupiah and creating a vicious cycle of depreciation, more rupiah selling and thus a larger external debt burden in local currency terms. The rupiah lost more than 350% of its value versus USD in 1998 alone, pushing private external debt to almost 80% of GDP; public external debt also approached 80% of GDP, but the vast majority of the latter constituted official development assistance. Short-term external debt was also particularly problematic, and the central banks efforts to slow the rupiahs slide drained reserves to just 46% of total short-term external debt by the end of 1997. Despite the concentration of external debt in the private sector, Indonesias sovereign credit rating suffered massively as a result of these depreciations: Standard & Poors relegated the countrys foreign-currency sovereign credit rating to selective default three separate times between 1999 and 2002. When it emerged from its last default, in September 2002, external debt-to-GDP had fallen to a more manageable 63% (from more than 100% in 1998), while total government debt had fallen to 60% (from more than 80% in 1998). The rupiahs steep devaluation following the onset of the crisis also helped push the current account back into surplus via an improved trade balance, which, coupled with IMF loan packages, bolstered official FX reserves to more than 200% of remaining short-term external debt by end-2002. External debt rescheduling also helped reduce the countrys outstanding external debt stock, and it was the conclusion of these negotiations that pulled the country out of selective default by the end of that year (the IMF loans were extinguished in 2005). Ratings upgrades came in rapid succession in 2003 as reserves continued to grow. The reduction in both external debt-to-GDP as well as public debt-to-GDP helped bolster investor confidence as well, though one sticking point in particular weighed on the countrys credit rating outlook: A lack of reform on fuel subsidies. This was partially remedied in 2005 when the Yudhoyono government canceled subsidies on diesel oil used by industry and fuel oil (while keeping gasoline, diesel and kerosene subsidies), lowering total fuel subsidy spending by more than 33% the following year and earning Indonesia ratings upgrades from all the major CRAs. Figure 17: Standard Deviations of Key Nominal Macroeconomic Variables for Indonesia Before and After Introduction of Inflation Targeting in 2005
2000-04 2005-09 2010-12

Source: Haver, RGE
USDIDR 10% 7% 3%
CPI 12% 12% 3%
M2 12% 22% 11%
Since 2005, there have been no major changes to structural fiscal policy, despite a number of false starts, yet Indonesia managed to continue climbing the ratings ladder one rung at a time, due to an improved external balance, continued reduction in both public and external debt, and admirable monetary management by the central bank. The latter was greatly facilitated by the introduction of an inflation-targeting regime in 2005, which not only stabilized inflation rates but also reduced interest- and exchange-rate volatility. Indeed, even with the great upheaval of 2008-09, exchange- and inflation-rate volatility was lower in 2005-09 than in 2000-04, a trend that has continued since.
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Indonesias relatively impressive economic performance through the worst of the global financial crisis, the stabilization of key macroeconomic variables, a growing stockpile of foreign reserves and persistently small fiscal Page | 17 deficits all contributed to the countrys return to investment-grade ratings for Fitch and Moodys this year. Moreover, even as gross public and external debt continue to rise in absolute terms, they have fallen sharply as a share of GDP, to just 22% and 25% respectively, a far cry from the 80-100% levels of 1998-99. Figure 18: Indonesias Official Foreign Reserves to Short-Term External Debt
300%
250%
200%
150%
100%
50%
0% 1996 1999 2002 2005 2008 2011
Source: BIS, Haver, RGE Still, S&P has resisted giving Indonesia its final investment upgrade due to the continued lack of subsidy reform, citing risks to the fiscal balance stemming from Indonesias expensive subsidy program. This years reform attempt fell apart in the eleventh hour as the Golkar party, an important member of the governing coalition, abandoned the cause in order to bolster its position with the public, who were vociferously opposed to subsidy reform. We can expect this kind of political jockeying to continue from now until the 2014 election, limiting the upside risk to Indonesias credit rating. However, beyond 2014, the political environment should improve. Subsidy reform is incredibly difficult to pass under coalition governments, but behind closed doors, many of Indonesias major political parties, including Golkar, support the idea. Once the new political order has been established after the elections, we expect further subsidy reform to become reality, paving the way for Indonesia to maintain and expand upon its recent credit rating success. The Philippines: Upgrade Ready The Philippines has been working hard toward securing an investment-grade rating, and we believe it is 18-24 months away from reaching that status. Rating agencies have become more cautious in granting upgrades since the global financial crisis, predominantly affecting emerging market economies. Still, the Philippines has come a long way since 2005 and its efforts are certainly not going unnoticed. The country has received several rating upgrades from all three CRAs in less than two years. On July 4, S&P upgraded the Philippines long-term foreign currency debt to BB+, one notch below investment grade, while on May 29 Moodys upgraded their outlook from stable to positive, indicating that a credit rating upgrade may be in order in the next six to 12 months.
ASIA/PACIFIC
Figure 19: 5y CDS Shows Philippines in Line with Countries with Superior Credit Rating
800 700 600 500 400 300 200 100 0
18
Page | 18
Philippines
Thailand
Indonesia
Poland
Italy
Spain
Source: Bloomberg Currently the Philippines has a rating of Ba2 from Moodys and the anticipated upgrade will put Philippines sovereign rating one notch below investment grade. Fitch upgraded Philippines to BB+ in June 2011, citing countrys strong external position, macroeconomic stability and efforts by the government to reduce the fiscal deficit. And for the most part, markets are indeed treating Philippines like an investment-grade economy, with the cost of issuance comparable to those with a superior rating. Essentially, rating agencies are lagging behind market expectations, which begs the question, do ratings really matter? Yes, ratings do matter, because an upgrade to investment grade will open up the Philippines markets to a wider universe of international investors, including large pension and endowment funds. The big plus would be inclusion in benchmark indexes such as the Barclays Capital Aggregate Bond Index, since it would increase the demand for the sovereign debt from many institutional investors who use the same.
ASIA/PACIFIC
Figure 20: Interest Payments Consumed One-Third of Total Payments in the Mid-2000s
35% 30% 25% 20% 15% 10% 5% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011
19
Page | 19
Interest Payments % of total expenditure
Source: Haver, RGE Years of corruption, political uncertainty and poor fiscal management had impacted the Philippines rating. In the early-to-mid-2000s, the Philippines was constantly under review and even downgraded due to large government and external debt that made the country particularly vulnerable to external shocks, undermining the governments efforts at fiscal consolidation. High debt levels in 2004-05 (70% of GDP) meant that interest payments were taking up one-third of total expenditure, leaving very little for public investment. During that time, Philippines depended greatly on external borrowing to meet its budgetary needs. As a result, the countrys fiscal performance had a direct impact on its foreign debt position. Further, following the 1997 Asian Crisis, the Philippines was unable to attract sufficient foreign equity investments, unlike its regional peers, and hence continued to rely on foreign debt to fund the public sector and the balance of payments. The Philippines has made significant progress since the mid-2000s on addressing impediments to a sovereign upgrade. Under President Benigno Aquino, the current government has made headway in tackling corruption and improving transparency. Having run on a promise to clean up corruption, Aquino, with the Senate, delivered the conviction of the Chief Justice of the Supreme Court for failing to disclose USD deposits in his asset disclosures statements, as well as the detention of former President Gloria Arroyo, who is being tried for vote-rigging. Moreover, the recent amendments to the Anti-Money Laundering Act (AMLA) to improve transparency and corruption will lend further credibility to the Aquino administrations efforts at tackling graft. The government will have to continue pushing toward improving transparency, which will increase governmental efficiency and win investor confidence. The Philippines has been running a current account surplus for six years, and gross international reserves stand at USD75 billion currently, a level that can support 11.4 months of imports and is equivalent to 10.8 times its short-term debt based on original maturity. The peso has also remained strong in spite of risk aversion, to become the best performer in the region this year.
ASIA/PACIFIC
Figure 21: Peso Continues to Remain the Strongest Performer in the Region Against USD (Jan 2012=100)
110.00
20
Page | 20
105.00
100.00
95.00
90.00
85.00 Jan-12
Feb-12 PHP
Mar-12 THB IDR
Apr-12 INR
May-12 MYR
Jun-12
Source: Bloomberg, RGE Meanwhile, despite the ongoing global financial turmoil threatening the EZ and the U.S., the Philippines has managed to avoid a liquidity squeeze. In terms of financial soundness, capital adequacy ratios for universal and commercial banks remain at 16.3%, well above the BSP's minimum ratio of 10% and the Basel Accords standard ratio of 8%. There remains a good availability of peso credit, thanks to the banking sector having a very low loanto-deposit ratio. Figure 22: Gross Fixed Capital as Percent of GDP
33% 31% 29% 27% 25% 23% 21% 19% 17% 15%
Indonesia
Philippines
Source: Haver, RGE Despite great progress, there is still a lot that remains to be done. Insufficient infrastructure, bureaucracy, delay in implementing public-private partnerships (PPP) are all reasons why the Philippines continues to lag behind Indonesia in attracting FDI. For all the hype, the Aquino administration has tendered only one PPP project in the past two years and bidding for the light-rail system upgrade contract scheduled for May was postponed, pushing
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21
back the shovel-ready date. The Philippines has the room to ramp up its investment, especially as it is competing with the likes of Indonesia to secure an investment-grade rating in the near future. Even now, Philippines Page | 21 investment-to-GDP is a meager 19%, compared to Indonesias 32%, when they started at the same level in 2003. For all the discussion on improved revenue collection, Philippines tax-to-GDP ratio continues to be unimpressive at 12%. This is one of the reasons the country has failed to invest in basic infrastructure and other services. Figure 23: Real Growth Comparison (%)
12 10 8 6 4 2 0 2002 2003 2004 2005 Indonesia 2006 2007 India 2008 Philippines 2009 2010 2011
Source: Haver While the Philippines debt-to-GDP ratio has improved, it is still significantly above Indonesias 25%. On the macro side, though the Philippines is enjoying a period of low inflationcurrently under 3%its growth continues to trail Indonesias robust expansion. While Indonesia grew at a promising 6.5% in 2011, the Philippines grew 3.9% as exports dwindled in the face of the EZ crisis. Over 2005-11, Indonesias growth averaged nearly 6%, compared to the Philippines 4.7%. The reason for the Philippines poor performance is largely an overdependence on exports, particularly the electronics sector, whose fate is tied to the swings of the global economy. Thus, there is an urgent need for the country to diversify its exports to improve growth, upgrade its infrastructure to attract FDI and ultimately boost domestic demand to reduce dependence on export-oriented growth. This will also allow the country to retain talent, which currently seeks employment overseas. The Philippines over-reliance on remittances to fuel domestic consumption also merits some attention. Currently, remittances account for 10% of GDP and are vital to sustain consumption, which accounts for 75% of GDP. This over-reliance stems from structural issues pertaining to lack of employment opportunities; improving the ease of doing business and investing in human capital are necessary to prevent the ongoing brain drain.
The above content is offered for the exclusive use of RGE's clients. No forwarding, reprinting, republication or any other redistribution of this content is permissible without expressed consent of Roubini Global Economics, LLC. All rights reserved. If you have received access to this content in error, RGE reserves the right to enforce its copyright and pursue other redress. RGE is not a certified investment advisory service and aims to create an intellectual framework for informed financial decisions by its clients. This content is for informational purposes only and does not constitute, and may not be relied on as, investment advice or a recommendation of any investment or trading strategy. This information is intended for sophisticated professional investors who will exercise their own judgment and will independently evaluate factors bearing on the suitability of any investment or trading strategy. Information and views, including any changes or updates, may be made available first to certain RGE clients and others at RGE's discretion. Roubini Global Economics, LLC is not an investment adviser. For questions about reprints or permission to excerpt or redistribute RGE content, or for a PDF version, clients should contact their RGE account representative.
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APPENDIX: Key Vulnerability Indicators
End-2011 Nominal GDP (USD bn) Nominal GDP Per Capita (USD) India 1676 1389 Indonesia 846 3509 Philippines 213 2223 Stock Variables Gross Public Debt/GDP (Moody's) Gross Public Debt/GDP (IMF) Gross External Debt/GDP Short-term External Debt/Total External Debt Short-term External Debt/GDP Short-term External Debt/Official FX Reserves 1 M2/Official FX Reserves 2 "Dollarization" Vulnerability Indicator Net Foreign Direct Investment/GDP
3
22
Malaysia 279 9700
Thailand 346 5394
Brazil 2493 12789
Russia 1850 12993
China 7298 5414
Page | 22
41.5 68.1 19.0 18.8 3.6 23.1 5.4 4.8 0.2
24.3 25.0 26.5 16.9 4.5 35.6 3.0 32.2 1.2
50.9 40.5 34.7 15.8 5.5 15.5 1.6 28.2 0.6 Flow Variables
53.5 52.6 30.2 40.4 12.2 25.4 2.9 -1.5
29.0 41.7 30.7 45.9 14.1 27.8 2.4 2.5 -0.3
54.2 66.2 18.1 9.9 1.8 13.0 4.7 0 3.1
9.6 9.6 29.5 13.3 3.9 16.5 1.7 35.3 -0.8
30.7 25.8 9.6 72.1 6.9 15.9 4.1 2.4
Fiscal Deficit/GDP
-9.0 -8.7 372.3 21.7 -3.9
-1.1 0.1 151.1 7.8 0.2
-2.0 0.8 364.3 20.5 0.2
-4.8 -2.9 246 9.6 11.5
-1.5 0.6 160.8 8.0 3.4
-3.5 3.2 150.2 18.6 -2.1
1.6 1.9 25 0.9 5.3
-1.3 -0.3 135.8 4.2 2.8
Primary Deficit/GDP Public Debt/Public Revenues General gov't int payment (% of gov't revenue) Current Account Balance/GDP
Other Relevant Factors Liquidity Ratio relative to BIS banks Exchange Rate Regime Financial Openness
5
416.9 Floating -1.15
297.8 Floating 1.13
59.0 Floating -1.15
95.6 Floating -1.15
52.8 Floating -1.15
127.4 Floating 0.15
53.2 Managed 0.42
135.6 Crawling Peg -1.15
Source: Moodys, IMF, RGE 1) Measures vulnerability to foreign capital flight ("external drain") 2) Measures extent to which domestic banking system liabilities are backed by reserves and thus vulnerability to domestic capital flight ("internal drain") 3) Total Foreign Currency Deposits in the Domestic Banking System/(Official Foreign Exchange Reserves + Foreign Assets of Domestic Banks) 4) India's Fiscal Deficit/GDP includes Central and State government 5) Liabilities to BIS Banks Falling Due Within One Year/Total Assets Held in BIS Banks

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ASIA/PACIFIC

Of Sovereign Bondage: Credit Ratings in India, Indonesia and the Philippines

Source: S&P, Moodys, Fitch, RGE

Source: Haver, RGE

GDP Per Capita

-1 Thailand South Korea Malaysia Singapore Expenditure Philippines Indonesia India

Source: World Bank

Indonesia Banking sector debt

Source: BIS, IMF, World Bank, Country Insights

Source: RBI, Haver, RGE calculations

Current Account Others

2000-04 2005-09 2010-12

CPI 12% 12% 3%

M2 12% 22% 11%

0% 1996 1999 2002 2005 2008 2011

Interest Payments % of total expenditure

Mar-12 THB IDR

Malaysia 279 9700

Thailand 346 5394

Brazil 2493 12789

Russia 1850 12993

China 7298 5414

41.5 68.1 19.0 18.8 3.6 23.1 5.4 4.8 0.2

24.3 25.0 26.5 16.9 4.5 35.6 3.0 32.2 1.2

53.5 52.6 30.2 40.4 12.2 25.4 2.9 -1.5

29.0 41.7 30.7 45.9 14.1 27.8 2.4 2.5 -0.3

54.2 66.2 18.1 9.9 1.8 13.0 4.7 0 3.1

9.6 9.6 29.5 13.3 3.9 16.5 1.7 35.3 -0.8

30.7 25.8 9.6 72.1 6.9 15.9 4.1 2.4

-9.0 -8.7 372.3 21.7 -3.9

-1.1 0.1 151.1 7.8 0.2

-2.0 0.8 364.3 20.5 0.2

-4.8 -2.9 246 9.6 11.5

-1.5 0.6 160.8 8.0 3.4

-3.5 3.2 150.2 18.6 -2.1

1.6 1.9 25 0.9 5.3

-1.3 -0.3 135.8 4.2 2.8

416.9 Floating -1.15

297.8 Floating 1.13

59.0 Floating -1.15

95.6 Floating -1.15

52.8 Floating -1.15

127.4 Floating 0.15

53.2 Managed 0.42

135.6 Crawling Peg -1.15

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