Overweight Banking

A return to fundamentals

External risks on the rise
The global economy that had slowly taken a turn for the better last year suffered another contraction this year as the US and Europe battled worsening economic conditions on their shores. By October the IDX Index has shaved 30% off its peak to sink to 3,218. While the full impact of the highly uncertain macro environment is yet to be seen, we believe our growth forecast of 6.2% for Indonesia’s economy in FY12 is still intact. That said, we remain cautiously positive on the banking sector with its world‐beating net interest margin (6%) and rapid loan growth (18%).

Bold policies by central bank
Bank Indonesia recently surprised the market with a 75bp cut in benchmark rate to 6%, effectively sending a bearish signal on domestic economic growth in 2012. The central bank has been striving to fulfil its objectives of improving the banks’ intermediary functions, promoting prudent banking and supporting efficiency by steering the banks along a declining NIM trajectory. Several other new policies have been lined up but the one that will likely attract the most attention is its plan to restrict ownership in private banks to a level much lower than the current 99%.

Big winners in 3Q11 but no near‐term catalyst
The banks have all reported their third‐quarter results and it was clear that recent economic developments and changes in banking policies favoured the big players. However, we see no immediate catalyst for all but a couple of the banks. Hence, short‐term share price sentiment will likely be driven more by external factors.

Overweight on sector; Bank Mandiri and BRI as our top picks
We are Overweight on the banking sector because of the sound fundamental measures. In the absence of a rapid rebound in valuation, we prefer banks that have a solid track record in weathering global turmoil. With FY11 results scheduled for release next March, better‐than‐expected earnings should also be a positive catalyst. Our top picks in the sector are


Bank Mandiri (BMRI.IJ) and Bank Rakyat Indonesia (BBRI.IJ).
External risks on the rise again
The Eurozone sovereign debt debacle will no doubt encumber the Indonesia’s economy for some time to come. Demand for exports will slide and access to funding will likely tighten. For now, its direct impact is believed to be less than meaningful. But the significance will increase once the effect of the crisis is transmitted through economic slowdowns in Japan, China and the US, Indonesia’s important trading partners.
Central bank in crisis‐fighting mode again?
With the inflation rate on a firmly decelerating path since the middle of this year until last month when it reached 4.15%, Bank Indonesia (BI) has softened its anti‐inflation stance. In the past couple of months, it surprised the market with a total of 75bp cuts in the benchmark rate to 6.0%. The lower rate augurs well for the banks as it will enable them to keep borrowing costs low while whetting the appetite for loans. In our view, the main beneficiaries will be the banks that have high consumer lending (time lag in repricing) and low CASA portion (leads to lower CoF).

On the flip side, the bold moves by the central bank signaled that domestic economic growth next year would be restrained by the ongoing tensions in the Eurozone financial markets and such stimulus was needed to shield the economy. This was confirmed when BI slashed its 2012 economic growth forecast by 40bp to 6.3%. The cut underscores Indonesia’s worries over the
fallout from the Eurozone debt crisis and anemic US growth, even as its economy remains largely domestic‐demand driven and its trade shifts away from the West towards neighboring countries and the emerging markets.

The main risk to the recent sharp reduction in benchmark rate is that the Rupiah could depreciate even faster. While this could drive import prices up and reignite inflation, BI’s immediate concerns appear to be the shoring up of economic growth rather than easing price pressures. Another risk is asset quality deterioration as a result of swift lending growth in times of crisis.

Another rate cut next year
Our economist Luz Lorenzo forecasts another 25bp rate cut next year before the central bank tightens monetary policies the following year.

Key banking policies in recent times
We highlight several policies that have helped steer Indonesia’s banking sector in the past couple of years. Some were implemented as part of BI’s efforts to support the banks’ intermediary functions. These include a change in the structure of reserve requirements, a cap on Rupiah‐denominated time‐deposit rate (BI rate + 50bp, only applicable to Indonesia’s 14 biggest banks), a minimum capital adequacy ratio of 8%, a maximum NPL ratio of 5% and the single presence policy (valid since last year except for stateowned banks).

The central bank also plans to restore pricing discipline by setting a formula to determine the bank’s prime lending rate. This is in addition to its requirement since 2Q11 for banks to publish their lending rates in the mass media. The proposed prime lending rate will consist of three components: (1) overhead cost, (2) profit margin, and (3) risk premium. We believe the clear breakdown is intended to encompass the diversity of banks’ businesses and preempt any sudden reversal in NIM or profitability. Additionally, BI will introduce a lower limit on majority ownership in private banks from the current 99%. The regulation, which is said to be applicable
retroactively, is expected to be issued later this month. While current investors would need some time to adjust to the new parameters, we believe the upcoming policy could provide an entry point for new investors. More details on the new banking regulations and monetary policies for the next two years are expected to be announced early 2012.


A return to fundamentals
In line with the changes to Indonesia’s macroeconomic assumptions, we adjust the valuation forecasts for banks under our coverage. Our earnings revisions point to lower net profit growth of 14% in FY12F, compared with the previous expectation for 20%.
No bank is crisis‐proof, but this time around we believe the banking sector would be better prepared, armed with the lessons learned from the financial crisis in 1997 and 2008. The sector has sufficient capital to serve as a buffer against any downside surprise in the economy, as well as sudden deterioration in asset quality. In our case, we prefer banks that are better equipped to withstand a downturn. We remain cautiously positive on the banking sector. Our top picks are Bank Mandiri and Bank Rakyat Indonesia.

Source: KIMENG dated 12 December 2011