Cover Story: Rising bad loans turn up the heat on Indonesian banks

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ASSET quality and proftability pressures are on the rise in Indonesia’s banking sector, taking a toll on Malaysia’s top two banking groups — CIMB Group Holdings Bhd and Malayan Banking Bhd (Maybank) — which have operations in Asean’s biggest economy.

Last month, both their Indonesian banking subsidiaries turned in weaker-than-expected numbers for the third quarter ended Sept 30, largely because of higher loan loss provisions. Analysts are saying their fourth-quarter performance could be just as bad, if not worse, with the heavy provisioning expected to continue.

CIMB Group’s 96.9%-owned PT Bank CIMB Niaga Tbk, the fifth largest lender in the republic by assets, reported a third quarter net profit of IDR343 billion — a sharp 68.2% decline from the same quarter a year ago and a 59.9% drop from the previous quarter.

As for Maybank’s 78.9%-owned PT Bank Internasional Indonesia Tbk (BII), the ninth largest lender, its third-quarter net profit at IDR3.7 billion was a dramatic 99.1% plunge from that in the same quarter a year ago and a 97.5% drop from that in the previous quarter.

But they are not alone in turning in dismal performances. Except for Indonesia’s Big Four state-owned banks, namely PT Bank Mandiri Tbk, PT Bank Rakyat Indonesia Tbk, PT Bank Negara Indonesia Tbk and PT Bank Tabungan Negara Tbk, other mid and small-sized lenders also saw their third-quarter earnings take a hit for similar reasons — higher provisions and lower margins.

Will things improve from next year or are both CIMB Group and Maybank headed for a long and bumpy ride in Indonesia?

Investors are understandably nervous at these developments as both CIMB Group and Maybank have, in recent years, derived a substantial portion of their earnings from Indonesia.

What’s clear, however, is that the tougher challenges in that country will have a greater impact on CIMB Group than Maybank as the former tends to derive about 30% of its bottom line from Indonesia. For Maybank, it’s only about 7%.

To make things worse, both banking groups have been seeing sharply lower investment banking income amid weaker capital markets in the region. And in the case of CIMB Group, it is in the midst of a proposed merger with smaller Malaysian rivals RHB Capital Bhd and Malaysia Building Society Bhd (MBSB), which throws up other complexities and uncertainties for investors.

What went wrong

Indonesian banks have enjoyed strong profits in the last few years as the gap between the interest they charge on loans and what they pay out to depositors is relatively wide. Despite increasingly coming under pressure, net interest margins (NIM) in Indonesia are still the highest among Asean countries — averaging around 4% to 5% now compared with 5.9% in 2009.

This, and the sector’s high growth potential in the populous nation, were reasons banks around the region, including CIMB Group and Maybank, flocked to Indonesia in recent years.

But a combination of factors that have come into play since last year — slower economic growth, high inflation, a rising interest rate environment, a weaker rupiah and lower commodity prices — have weighed on the sector.

“Things took a turn for the worse this year. In the run-up to the presidential election (in July), a lot of corporates were not willing to spend amid all the uncertainties ... so investments were put on hold and loan growth tapered off. Also, the export-oriented companies were hit by a decline in commodity prices,” says a senior banking analyst who tracks the sector.

“Then, there were fuel price increases last week (of more than 30%), following June 2013’s 44% increase under the government’s fuel subsidy rationalisation programme, which hurt consumer sentiment and also led to an increase in the benchmark interest rate. Additionally, the larger state-owned banks started a price war on the deposit rate side, so competition for deposits got stiffer and funding costs rose. All these factors ruined the banking party in Indoneisa.”

Joko Widodo, sworn in as Indonesia’s new president on Oct 20, raised fuel prices last week in his first major economic policy decision since taking on the role, to help fund his reform agenda.

Last year alone, Indonesia’s central bank raised the benchmark interest rate by 175 basis points to contain inflation. The IDR2,000 per litre fuel hike last Tuesday also prompted the central bank to lift the rate for the first time this year, by another 25 basis points, to 7.75%.

Outlook

A combination of these factors could push banks’ non-performing loans (NPLs) even higher next year, putting further pressure on profits.

Economists expect the inflation rate in Indonesia to rise to 7.5% at the end of the year, from 4.83% in October, as a result of the fuel price adjustment, before peaking at around 8.5% in the middle of next year. More interest rate hikes are expected next year.

“Usually, after two or three quarters after inflation peaks, NPLs should start to come off,” says Rahmi Marina, an Indonesia-based banking analyst at Maybank Kim Eng Research. She has a “neutral” call on the sector.

As it stands, the outlook for the sector’s 119 commercial banks remains murky.

The industry’s gross NPL ratio — which measures banks’ NPLs against total loans — deteriorated to 2.31% in August from 1.8% as at end-2013, according to latest data from the Financial Services Authority. Although still relatively low and well below the 5% threshold that is considered “safe” — it was around 4% in August 2008 and even higher at 8% in December 2005 — the level is expected to continue to trend upwards by year-end.

“We expect NPL levels to remain elevated going into 2015,” Maybank chief financial officer Rafique Merican tells The Edge.

In mid-September, Bank Indonesia deputy governor Halim Alamsyah revealed that the central bank had been monitoring the high level of NPLs in four sectors — construction (4.43% as at July), trade (3.06%), mining (3.09%) and social services (2.96%) — and would study whether this was a temporary phenomenon.

Indonesian banking analyst Rocky Indrawan of RHB Research says the country is undergoing its third NPL “upcycle” since the 1997/98 Asian financial crisis, the last ones having been in 2006 and 2009, driven by a combination of a slowdown in the economy, elevated inflation and higher interest rates following increases in the price of fuel.

“The system is currently digesting similar adjustments. Although we cannot compare the upcycles of 2006 and 2009 with the current one, we note that asset quality only improved after 20 and 10 consecutive months respectively of elevated NPL ratios.

“The possibility of further fuel price and interest rate hikes suggests that there may be sustained stress on NPLs. (But) NPL ratios should stay below historical peaks due to tightening and prudential measures along with banks’ reduced risk appetite,” he says in a Sept 10 report on the banking sector.

As it is, the industry is seeing slower loan growth. Expectations are that lending will slow to 15% this year from 22% last year. And intense competition for deposits has driven up funding costs, particularly for the small to mid-sized lenders, squeezing margins.

On the positive side, however, the central bank imposed a cap on deposit rates last month, so there could be some improvement in the banks’ funding costs. “This could be the only bright spot for these banks. Asset quality, however, could remain an issue for a while,” AllianceDBS Research’s banking analyst Lim Sue Lin says.

Earnings hit

CIMB Niaga’s gross NPL ratio inched up to 3.4% as at end-September — higher than the industry average — from 2.3% a year ago, arising from a large corporate account relating to the mining sector. The lender’s provisions in the third quarter rose 157.8% from the second quarter to IDR941 billion.

Its nine-month net profit, at IDR2.296 trillion, was down 28.5% year on year and accounted for a mere 53.9% of analysts’ full-year profit estimate for the lender.

Hence, it came as no surprise when parent company CIMB Group reported disappointing earnings last week. Its net profit for the third quarter ended Sept 30 fell 16.1% y-o-y and 6.3% q-o-q to RM890.27 million, hurt mainly by the high provisions at CIMB Niaga as well as the weaker capital markets.

For the first nine months, net profit was 17% lower at RM2.91 billion, making up just 67% of analysts’ profit estimate for the group for the full year. Excluding one-off items in the previous nine months, the fall in the group’s net profit was smaller, at 7.4%.

If CIMB Niaga were removed from the equation, the rest of the group would actually have grown 6%.

CIMB Niaga accounted for 22% of CIMB Group’s nine-month pre-tax profit compared with 31% in the same period last year. As always, it was the Malaysian operations that contributed the most to the group’s bottom line, at 69% so far this year, followed by its other big markets of Indonesia, Singapore (6%) and Thailand (5%).

The group said its 13.5% to 14% return on equity target for this year would not be met, given the challenging outlook for Indonesia.

CIMB Group chairman Datuk Seri Nazir Razak, who is also president commisioner of CIMB Niaga, acknowledges that the going will be tough in Indonesia.

“The operating environment in Indonesia is indeed very challenging at the moment, but one has to accept this kind of potential volatility when investing in most less-developed markets. When we first invested in Indonesia in 2002, the markets punished us and a few years ago, the markets gave us a big premium for our large Indonesian exposure.

“The tide has turned again, driven by the decline in the rupiah, the end of the commodity boom and tougher operating conditions, especially for banks outside the top four that have a huge funding advantage because the rupiah wholesale market lacks depth,” he tells The Edge.

But Nazir says Indonesia remains a fundamentally attractive long-term story and that the country is an essential component of CIMB’s Asean banking franchise.

“We will just ride out this period of higher credit charges and tight rupiah liquidity. How long it will last will depend on the resolve of the new government’s leadership to tackle the twin deficits and regain the confidence of the business sector. If the Jokowi administration handles the short-term challenges and then quickly moves on to the infrastructure bottlenecks, the markets would turn bullish on Indonesia quite fast. No one is banking on a recovery in commodity prices, so I think the key for Indonesia will be infrastructure and FDI (foreign direct investment).”

As for BII, its nine-month earnings, at IDR339.7 billion, were down 69.1% from a year ago as provisions increased 151% to IDR1.46 trillion. Its asset quality deteriorated with gross NPL ratio sliding to 2.55% as at end-September from 1.55% a year ago.

BII’s weak performance is likely to weigh on Maybank’s third-quarter results, analysts say. Maybank is expected to release its results this week.

AllianceDBS Research’s Lim estimates BII’s nine-month contribution to the Maybank group to be “negligible”. “It has indeed been a tough year for foreign banks operating in Indonesia this year,” she observes in an Oct 30 report.

Maybank’s Rafique says asset quality will continue to be a key concern for BII going into 2015 as a result of the higher projected interest rates and inflation. But the group hopes to see an improvement at BII “towards the second half of 2015”.

The group’s biggest challenge in Indonesia at the moment is the squeeze on margins. “The banking industry continues to face pressure on margins as it is increasingly challenging to source for low-cost funds, especially with expectation of rising interest rates and higher inflation due to the increase in fuel prices,” says Rafique.

“However, the government’s plan to reduce the fuel subsidy may have a positive impact on loan growth, particularly in working capital and investment, as the government is expected to shift its focus to utilising fiscal expenditure from the fuel subsidy to infrastructure development and investment.”

BII has carried out a series of strategic initiatives to improve its performance, he says. Meanwhile, despite the uncertainties in Indonesia, analysts are mostly calling a “buy” on Maybank, mainly for its dividend appeal. Bloomberg data shows that of at least 25 analysts tracking the stock, 20 have a “buy” call on it and a 12-month target price of RM11.03. The stock, which has gained just 1.7% so far this year, closed at RM9.56 last Thursday.

As for CIMB, of at least 21 analysts, nine have a “hold” call on it and six each a “buy” and “sell” call. The stock has fallen sharply since the group released its third-quarter results last Tuesday, closing at an over four-year low of RM5.90 on Thursday. It has declined about 20% so far this year.

This article first appeared in The Edge Malaysia Weekly, on November 24 - 30, 2014.