We are downgrading Indonesian banks to Underweight (from Neutral). This is not a valuation call, nor do we doubt the structural change afoot in Indonesia (reflected in a halving in long bond yields over the last 18 months). This downgrade reflects a view that NIMs and hence ROEs would disappoint given the compression in yield spreads (spread between 10year and 3-mth rates). While this is a necessary development to spur consumer lending, we do not anticipate a smooth switchover from NIMs to volumes. Underlying earnings growth would thus likely disappoint a trend already evident in 2Q. We recommend buying Danamon as a beneficiary of low interest rates.
If we are bullish on the structural change and see the re-rating as justified, why the Underweight?
NIM and hence RoE compression in the near term - the optimism from lower bond yields is simply the fact that lower interest rates would spur lending opportunities in what is amongst the most underpenetrated consumer credit markets in the region. HOWEVER, the drop in bond yields has been accompanied by a compression in yields spreads by some 250bp as well. With the short-end of the yield curve anchored, the curve has significantly flattened. Another way to think about this is that for the borrowing demand to rise as a result of lower interest rates, it has to be driven by a drop in lower lending yields. COMPRESSING yield spreads WILL IMPACT NIMs and hence RoEs. This process is already underway.
As chart 78 above shows, the spread between loan yields and deposit-spreads narrows, NIMs will likely come down. We would argue that this is effectively a transfer of margins from lenders to borrowers, in exchange of a better volume growth opportunity. A common push back to this argument is whether a mix change (both in IEA and loan book) as well as higher leverage (L/D ratios) would offset this spread compression. While we agree with the argument, WE DO NOT SEE THIS SWITCHOVER FROM MARGINS to VOLUMES AS SMOOTH and EXPECT a period where NII will come under pressure. This trade-off, already in evidence, is discussed below.
Where is the Growth in a Growth Sector? – an interesting outcome of the 2Q reporting season was the fact that despite solid volume growth (23%), PPOP growth at 2% was unexciting. Ultimately, a growth sector needs to deliver growth.
Can a Mix change and leverage offset spread?
As noted earlier, a common push back to our call on spread compression is that (1) a higher proportion of consumer lending will uplift aggregate loan yields (2) rising loan growth would increase the leverage – both within the IEA mix as well in terms of aggregate assets (so a rising Loans/IEA ratio and a rising IEA/Assets ratio).
While we broadly agree with this view, we see the transformation from higher margins to higher volumes as not a smooth one. Consider:
• A 50bp compression in NIMs would require a rise in L/D ratio from 74%% to 81% completely offset this impact
• Differential in consumer and corporate lending is 250bp - to offset a drop in loan spreads, the mix of. Consumer lending would need to rise from 31% to 44% to offset a generic drop in loan spreads.
• Differential between bond yields and loan spreads is modest so a switchover from bonds to loans will have it's limitations. To offset a 50bp compression in loandeposit spreads, the proportion of bonds would need to drop to 20% from 31%, tough given that 46% of bonds are classified as HTM
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