Investment Grade for Indonesia?

On Thursday, May 21, one of the big three rating agencies in the world, Standard & Poor's (S&P), released a change of credit rating for Indonesia, from previously BB+ with a stable outlook, to BB+ with a positive outlook. Thus in fact the rating remains the same, only it outlook has changed to be better. Yet still, the investors respond to this news positively, where the Jakarta Composite Index (JCI) closed up for the day despite had been down for a moment in the morning. And on that Thursday, too, the foreign investors recorded a net buy for the first time in the last few weeks (but they recorded another net sell on Friday). The question might be, what is credit rating? And how it affects the economy in Indonesia, especially JCI itself?

Based on the latest ratings released by Moody's and Fitch (two largest rating agencies in the world, in addition to S&P), Indonesia currently has the status of investment grade, or in other words considered by the global investors as a country that is eligible for investment, although it should be noted here that the ratings are the lowest in the investment grade classifications, namely Baa3 and BBB-. This means that if later Moody's and Fitch downgraded Indonesia’s ratings for one rank only, then Indonesia will no longer have investment grade status. However, there are currently no signs that the two rating agencies will downgrade Indonesia.

While the S&P, they're still not assign the status of investment grade for Indonesia. Nevertheless, the rating BB+ given by S&P is the highest rating in the classifications of non-investment grade. Or in other words, Indonesia only needs to obtain one rank of upgrade of rating, to be considered as a country with the status of investment grade by S&P. And on last Thursday, by changing the outlook of its rating from stable to positive, then the S&P provided an indication that in some future time, probably not later than a year from now (with an assumption that there aren’t extraordinary events related to the economy of Indonesia), they will also assign the status of investment grade for Indonesia.

And when that happens (remember that S&P has not actually raised Indonesia's rating), the foreign investors may allocate more cash to buy assets in here, whether it be financial assets through bond and equity markets, or through direct investments by establishing factories, offices, etc. Because when a fund manager of a global asset management company is planning to invest in countries around the world, he would first choose a country that gained full status of investment grade (from the three rating agencies earlier). So in this case, since there is one agency that has not given investment grade status for Indonesia, then Indonesia is still considered as a second choice for foreign investors to invest here, especially when compared with Singapore, for example, which its ratings are even higher than the United States.

Back again to the matter of the increase of outlook given by S&P. The question is, with the economic conditions of the country that is, frankly, not very good lately, then why the S&P gave an indication that they may raise Indonesia's rating? Well, before answering that question, then we need to learn what a credit rating is and how it works.

So basically, when an investor asks for an opinion from an investment adviser regarding what is the best stock (or any other investment instruments) to buy, then the adviser would ask back: 'What risk of losses can you bear?' Because if the question, 'How large the potential of profit you want to earn?', then the investor’s answer would definitely, ‘As large as possible!’ But when risk of losses was the question, then the answers from the investor will be different. Some investors may be willing to take a high-risk investment if it also offering a high potential gain, but some other investors may prefer to take a conservative approach by choosing an investment with the lowest risks.

Because in investing, risk of losses and potential of profits are like two inseparable sides of a coin. On its development, professional investors always focus on efforts to reduce the risk of losses to as low as possible, then only after that they could talk about the potential of profits. Just like Warren Buffett's famous quote: 'Rule #1, never lose money. Rule #2, do not forget rule #1'. This means that, instead of pursuing a maximum profit, Warren prefers to suppress the risk of his investments to a minimum level. Just like a football match: If your team could keep their own net to be not conceded, then if they can score one goal only against the opponent, they will still win the match, right?

So the positions of Moody's, Fitch, and S&P are just like that investment adviser earlier. They will not invest in stocks or any other assets, but only make investment recommendations for investors around the world in the form of ratings, where the rating is not based on how high the potential profits offered by an assigned investment instrument (usually bonds), but based on how low the risk of losses that may be suffered by the investors, if they choose the instrument.

This means that, when a country obtained a rating of investment grade status, then it is considered as a safe country for investment (safe only, and does not mean that the country has the potential for high investment returns). The higher the rating, the more secure the country. If the Government of Singapore issuing a bond, for example, then the bond is considered to have a very, very low risk to be default. Meanwhile, if the Government of Indonesian issue a bond, then the bond has a higher risk to be default, than the bond of Singapore.

And if we talk about the potential of profits/investment returns that can be obtained by investors, then although its rating is lower, but Indonesia may offer a higher investment returns compared to Singapore. A simple example: In the past five years, the JCI has risen 90.0% in total, but not including dividends. While the Straits Times of Singapore? Rose only 25.3% during the same time period. However, once again, both Moody's, Fitch, and S&P did not pay attention to the potential of profits, but only focus on risk factors.

Then how the rating agencies measure the level of risk of investing in a country?

Basically, the risks of investing in a country are divided into two types, namely political risk and economic risk. Countries with stable political conditions will be considered safer for investment compared to any other states which in a civil war, for example. And a country with a developed economy will also be considered safer compared to developing countries. For political issues, Indonesia is relatively stable since Joko Widodo became President replacing Susilo Bambang Yudhoyono. As for the economy, our economic growth had been 4.7% only, the lowest in the last five years and this is certainly a bad signal, particularly when inflation rate and the exchange rate of Rupiah also showed unsatisfactory figures.

However, various government policies related to the economy such as the repeal of fuel subsidies, probably seen by S&P as a good step which, in the long term, will be able to reduce the risks of certain problems of the country’s economy. During this time, every time oil prices soared, the burden of state for fuel subsidies also increased, so that the state does not have enough fiscal space for any other spending that is much more useful, such as to develop the infrastructure. When the subsidy is now totally abolished, the state now has more money for other purposes, including to repay foreign debts (including its interests) when the debt matures later.

So in this case, or at least in the view of S&P, the risk of debt default that may be happened to Indonesia, whether it's debt of corporations or the Government of Indonesia itself, could be lower in the future, if the elimination of fuel subsidies etc were actually able to produce a positive effect on the state budget, and of course the overall economy.

But once again, the S&P only raised the outlook only, but not the rating itself. In the view of S&P, Indonesia is still a country that isn’t safe enough for investment (the risk is not reduced, not now). If the government policies really have a positive impact on the national economy in, let say, 1 – 2 years from now, then after 1 or 2 years, the S&P might raise the rating.

Okay, but let us be a little optimistic: If the S&P eventually provide investment grade status for Indonesia, then what would the impact on JCI? Well, of course there is no direct impact. The JCI indeed rose on Thursday, and the foreigners recorded a net buy. But a day later, the JCI went down (and the foreigners recorded a net sell again). Also, in the long term, as it was already mentioned above, the increase in the Straits Times in the last five years are even lower than the JCI, although the ratings of Singapore are much higher than Indonesia.

But clearly, when the S&P eventually provide investment grade status for Indonesia, then the bargaining position of Indonesian companies will improved. Let say, if Indonesian companies currently have to offer interest 10 – 12% per annum when they issue Eurobonds (the interest is high, and that’s because the risk of the bonds are considered high), then in the future, the interest can be lowered to 7 – 9% only. Due to lower interest rates, the company’s financial burden becomes lighter, so that the net profit could be greater. If these conditions occur in many companies at the same periode, then the fundamentals of the national economy would be better. Foreign investment funds will flow to the country, whether in the form of direct investment or through stock and bond markets, and it will improve financial liquidity, increasing the volume of transactions, and could ultimately help the economy to grow.

But still, bear in mind that at this point, the above conditions has not happened yet. So let's face it: Our economy is not in a very good shape. Will it improve later? Well, may be yes, may be no. But why bother? Just do your job, pick the right stock, then sit tight and see.