Rated Indonesian Entities Will Remain Resilient To Persisting Policy Risks Under The Forthcoming Administration

Primary Credit Analyst: Xavier Jean, Singapore (65) 6239-6346; xavier.jean@standardandpoors.com Secondary Contacts: Andrew M Wong, Singapore (65) 6239-6306; andrew.wong@standardandpoors.com Rajiv Vishwanathan, CFA, Singapore (65) 6239-6302; rajiv.vishwanathan@standardandpoors.com Cheul Soo Cho, CFA, Hong Kong (852) 2533 3559; cheulsoo.cho@standardandpoors.com Agost Benard, Singapore (65) 6239-6347; agost.benard@standardandpoors.com

Table Of Contents
Major Economic Policies Are Likely To Continue The Mining Sector Remains Highly Susceptible The Credit Implications Of Consensus On Infrastructure Spending And Subsidy Rationalization Will Vary By Sector "Value-Added" Economic Policies Could Raise Costs For Agribusiness Companies Higher Costs And Lower Margins Are Likely For The Retail And Textile Sectors And State-Owned Companies If Labor Costs Keep Growing Lasting Restrictions Of Credit Availability Or Down Payment Rules Should Not Materially Affect The Rated Real Estate Or Consumer Durables Sectors Restrictions On Foreign Ownerships In Banking Will Likely Persist, Slow Consolidation

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Table Of Contents (cont.)

Domestic Banks' Exposure To Policy-Sensitive Sectors Is Moderate Policy Risk Will Likely Continue After The Elections Related Criteria And Research

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Rated Indonesian Entities Will Remain Resilient To Persisting Policy Risks Under The Forthcoming Administration
Indonesia's corporate and banking sectors have witnessed a flurry of new laws and regulations in the decade of President Susilo Bambang Yudhoyono's administration. Standard & Poor's Ratings Services believes that regulatory and policy risks will persist under the new administration as well. A new government will take over in Indonesia following the April 2014 parliamentary and the July 2014 presidential elections. We expect most of the Indonesian companies that we rate to withstand the lingering policy risk during the next 24 months. Our ratings on about half of the 27 Indonesian corporations we rate fall in the 'B' category or lower. The ratings and outlooks already reflect the higher degree of sensitivity these entities have to changing operating conditions because of smaller scale, narrower diversity, or lower profitability. In contrast, the companies that we rate in the 'BB' category or higher generally have stronger market positions, higher profitability, or lower leverage. This gives them greater ability to absorb heightened policy risk or more onerous regulations. All the four domestic banks that we rate are in the 'BB' rating category, and fall into this group: PT Bank Mandiri (Persero); PT Bank Negara Indonesia (Persero) Tbk.; PT Bank Danamon Indonesia Tbk.; and PT Bank Rakyat Indonesia (Persero) Tbk. Overview Policy and regulatory risks will remain high in Indonesia, regardless of the new administration, in our view. Our expectation of a broad continuity in the key economic policies of value-addition and infrastructure spending will likely influence the financial performance of companies in the mining, agribusiness, and infrastructure sectors. We believe that the credit profiles of rated Indonesian companies and banks will be able to withstand these risks. We do not expect any significant rating impact of the change in administration, given that our ratings already factor in the risks.

Further legislation in the mining and agribusiness sectors is set to materialize under the new administration, in our opinion. This is given the government's policy push toward "value-added" products. We also expect policy decisions on infrastructure and subsidies to influence the financial performance of the power generation and energy-intensive sectors. Microeconomic policies, including those regarding labor costs, will define the financial performance of labor-intensive sectors such as textiles and retail. On the whole, we believe these policies will be more onerous because they could raise operating costs or require substantial capital spending, particularly for small, less diversified, and less financially solid companies (see table 1).

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Rated Indonesian Entities Will Remain Resilient To Persisting Policy Risks Under The Forthcoming Administration

Table 1

Possible Policy Considerations And Their Risks To Sector Performance

Sector Mining Electricity/Power Textiles Heavy industry Agribusiness Food retailing Non-food retailing Real estate Likely policy considerations Ban on unprocessed mineral exports; Renegotiation of legacy mining contracts; Royalty regimes for new mining licenses. Reduction in electricity subsidies; Increases in tariffs. Labor policies. Reduction in electricity subsidies; Increases in tariffs. Increases on exports of domestic processed and unprocessed products. Labor policies. Labor policies. Changes in deposit levels; Restrictions on lending and on loan-to-value. Significance Medium to high Medium to high Medium to high Medium Medium Medium Medium to low Medium to low Effect on financial performance Likely negative Marginally positive Marginally negative Marginally negative Marginally negative Marginally negative Mostly neutral Mostly neutral

Major Economic Policies Are Likely To Continue

Regardless of the election results, we believe the new administration will maintain the major economic policy initiatives of the previous government, given the broad political consensus on their relevance. Over the past decade, the two consecutive Yudhoyono administrations passed a number of wide-ranging laws and regulations that carried consequences for virtually every Indonesian corporate sector. These policies had two key underlying themes: Increasing the number of value-added products coming from Indonesia through the development of mining and agricultural commodity processing; this was accomplished through the implementation of a number of import and export restrictions and new tariffs or taxation across primary economic sectors. Renewing the focus on subsidy rationalization and infrastructure spending (see table 2). Our base-case scenario is that the next administration will continue the very gradual subsidy rationalization, taking more affirmative action only when the subsidy bill threatens to balloon to unsustainable levels.
Table 2

Major Regulations Passed Or Announcements Made During The Past Two Administrations
Economic policies Value-added domestic processing Major regulations or announcements Established mining law and domestic processing requirements for unprocessed minerals in 2009; Set export tariffs on unprocessed cocoa beans based on the reference price in 2010; Banned imports of selected horticultural and agricultural products in 2010 and 2013; Enacted the 2014 trade law; Banned the export of certain unprocessed mineral ores in 2014. Reduced the fuel subsidy in 2005 (average of more than 100% increase in fuel prices); Further reduced the fuel subsidy in 2013 (average of more than 40% increase in fuel prices); Established recurring increases in electricity tariffs (up 15% in 2013). Introduced a public service obligation margin in 2008; Established the Infrastructure Guarantee Agency in 2009; Established the Master Plan for Acceleration and Expansion of Indonesia Economic Development in 2011; Established the land acquisition law in 2011. Set requirements for foreign mining company ownership of mineral deposits and divestitures in the 2009 mining law; Established ownership rules in the banking sector (foreign ownership limited to 40%). Tightened mortgage down payment regulations on the purchase of automobiles and motorcycles in 2012; Required additional deposits for second-home buyers; Introduced restrictions on the disbursement of mortgages for real estate developers in 2013. Enacted policies on minimum wages.

Subsidies

Infrastructure

Ownership Financing

Labor- and wage-related policies

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Rated Indonesian Entities Will Remain Resilient To Persisting Policy Risks Under The Forthcoming Administration

The Mining Sector Remains Highly Susceptible

Indonesia's mining sector is at the center of the government's economic policies aimed at adding value to Indonesia's products, as the generally strict application of the mining law passed in 2009 demonstrated. Mining licenses (IUPs) have replaced former mining contracts since 2009, and the government enacted regulations on mining areas and mining services activities, culminating in a ban on unprocessed mineral ores since January 2014. We believe the mining sector will remain a focus for the next administration. We expect the policy focus of the new government to be on: (1) continuing the ban on exporting unprocessed mineral ores; (2) renegotiating mining contracts entered into before the implementation of the 2009 mining law; and (3) clarifying royalty rates for IUPs, especially for coal companies.

The likelihood that the ban on unprocessed mineral exports will last has increased
We see little prospects for exports of unprocessed mineral ore to resume for at least the next three to six months, given that the parliamentary and presidential elections will take place in April and July 2014, respectively. After that, the likelihood of a lasting ban will grow, in our view, because we believe major political constituents in Indonesia agree with the main objective of the ban, which is to increase the value of Indonesia's products. Parliament has consistently resisted the government's efforts to soften the effects of the ban over the past six months. The new administration is also likely to take some time to decide on the ban's implementation, including if it should provide short-term relief and to whom. The new administration could provide ad hoc exemptions to the ban, in our opinion, for example to companies with firmer plans to build processing infrastructure domestically. But we believe these would probably be accompanied by stringent conditions, such as a legally binding commitment and guarantee deposits. For domestic producers, these projects are likely to be debt-funded, in our opinion, because weak product pricing has strained miners' profitability for the past two years. Taking on debt could negate any improvement in cash flows from an exemption to the ban. In addition, margins of large-scale smelting projects tend to be significantly lower than those of upstream mining activities over an industry cycle, compressing the overall returns on capital invested.

Renegotiating legacy mining contracts will likely be a high priority

We believe the election of a new administration could provide some momentum to the renegotiation of legacy mining contracts. This is given that little progress has been made on this front in the past five years and negotiations with mining companies are stalled. The mining law passed in 2009 mandated a realignment of the terms and conditions of those legacy mining contracts with the new IUP mining framework developed under the 2009 law. We considered the former frameworks fairly robust and predictable, but we view the latter as less predictable in terms of royalty and income tax payments and less favorable in terms of concession sizes, renewal conditions, and dispute mechanisms. A presidential decree in 2012 set up a team in charge of renegotiating the legacy contracts with a key focus on concession sizes, extension of mining licenses, royalty and income taxation, domestic processing and refining (if applicable), and share divestment. We expect the credit impact of a renegotiation of legacy mining contracts to be marginally negative for the sector as a whole:

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Rated Indonesian Entities Will Remain Resilient To Persisting Policy Risks Under The Forthcoming Administration Refinancing of bullet debt could be made more difficult because of the uncertainty of license extensions, or extensions after substantial changes are made in their terms and conditions. We believe this is especially relevant when the maturity of the notes falls within five years of the end of the contract (see table 3). We foresee a high likelihood of increased royalties for contract of work (COW) holders such as PT Freeport Indonesia, PT Newmont Nusa Tenggara, and PT Vale Indonesia Tbk. upon completion of these negotiations. This is because their royalty rates are well below 5%, and the assets would still be highly profitable even at higher royalty rates. We think coal companies face less risk of a hike in royalties because they already pay sizable royalties (about 13.5% of sales minus relevant deductions for certain costs), one of the highest rates globally.
Table 3

Coal Companies With Bonds Or Major Bank Loans Maturing And Contract Expiration Dates
Company PT Bumi Resources Tbk. PT Indika Energy Tbk. PT Adaro Energy Tbk. PT Berau Coal Energy Tbk. PT Bayan Resources Tbk. CCOW/CCA expiration 2019 (Arutmin asset); 2021 (KPC asset) 2023 (Kideco asset) 2022 (Adaro Indonesia asset) 2025 2025 to 2038 for major producing assets Note amounts and maturity dates US$300 million in November 2016; US$700 million in October 2017 US$300 million in May 2018; US$500 million in January 2023 US$800 million in October 2019 US$450 million in July 2015; US$500 million in March 2017 US$750 million club loan*

Source: Company filings. *Amortizes quarterly to April 2017. CCOW--Coal contract of work. CCA--Coal cooperation. agreement.

The royalty system for holders of IUP mining licenses will likely be clarified
The current administration has for the past year been floating the idea of increasing royalties for IUP coal mining license holders to about 13.5%, the same as those for coal contract of work (CCOW) holders, from the current 3% to 7%. A hike of this magnitude would have substantially negative effects on most IUP holders (none of which we rate). This is because they generally have smaller scale, lower operating efficiency, higher cash costs, and produce lower-quality coal with a lower selling price than CCOW holders. Such a royalty increase would make a large majority of IUP holders unprofitable, in our view, in the currently subdued coal environment and given that IUP holders generally hold lower-quality coal assets. We also believe illegal mining could increase and negate some of the intended effects of the royalty, including industry rationalization.
Table 4

Credit Impact--Rated Companies

Export ban on unprocessed minerals --On Jan. 14, 2014, we lowered our rating on PT ANTAM (Persero) Tbk. to 'B-' with a developing outlook because we project ANTAM will have substantially diminished cash flows, reduced cash flow adequacy and interest coverage ratios, and a declining liquidity buffer in 2014 because of the ban. We also believe the company's business risk profile has weakened because of ANTAM's greater reliance on high-cost operations and reduced product diversity. --Our ratings and outlooks on Freeport-McMoRan Copper & Gold Inc. and Newmont Mining Corp. are not affected so far. These are the major shareholders in PT Freeport Indonesia and PT Newmont Nusa Tenggara, respectively, which produce and export unprocessed ore. Freeport and Newmont have broad asset diversity outside Indonesia. Lower dividends from PT Freeport Indonesia in the event of a lasting ban on unprocessed mineral ores could slow down debt reduction at Freeport, and this is reflected in the negative rating outlook on the company. --Our ratings on coal miners Bumi Resources and Berau Coal Energy are also not affected. Both companies are still allowed to export coal, and the ban does not immediately affect them. Tenor of legacy mining contracts --Our rating on Bumi is not affected in the short term despite US$1 billion in senior notes maturing shortly before the expiration of its two CCOWs. The ratings already reflect the prospect of a distressed exchange over the next three months. --Our rating on Berau, which still has more than a decade until the expiration of its mining contract, is also not immediately affected.

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Table 4

Credit Impact--Rated Companies (cont.)

Prospects for higher royalties --There is a moderate financial impact but no immediate rating effect so far on Freeport, Newmont, and Brazil-based miner Vale S.A. These companies are well-diversified or have strong profitability buffers and low debt that can enable them to absorb higher royalties. Our base case does not factor in higher royalty rates for coal companies operating under CCOWs.

The Credit Implications Of Consensus On Infrastructure Spending And Subsidy Rationalization Will Vary By Sector
Infrastructure is another common economic theme in Indonesia as most parties see renewed spending as a catalyst for more rapid economic growth. As a result, we believe any new administration will maintain the strong momentum on infrastructure spending. We expect a further, albeit possibly gradual, rationalization of fuel and electricity subsidies to significantly help finance infrastructure spending. That will likely enable large state-owned companies to increasingly fund their investments internally. The past two administrations rationalized fuel subsidies in 2005 and 2013 and introduced better stability and predictability of revenues in the power sector by implementing the public service obligation margin. Credit implications of sustained focus on infrastructure and prospective rationalization of subsidies will be differentiated, in our opinion (see table 5).
Table 5

Credit Impact--Power, Refining, Building Material And Construction, And Energy Segments
Credit impact for the power generation sector: generally positive --The sector should benefit from higher prices and a more timely ability to pass through volatile fuel costs to end customers. --We raised the stand-alone credit profile on electricity producer PT Perusahaan Listrik Negara (Persero) (PLN) to 'bb-' from 'b+' on April 4, 2014, because we forecast higher cash flows from increased tariffs and greater generation capacity. This is despite still-heavy spending on the second tranche of its fast-track program. --We also expect PLN's working capital management to improve as the company becomes less reliant on the timing of subsidy payments from the government. --We expect gas-based power producers to raise prices as a result of price hikes from upstream gas producers. Credit impact for the refining sector: generally positive --Profitability and cash flow at PT Pertamina (Persero), the only domestic refiner, should benefit from a gradual normalization of the selling price of refined products. --Reduced reliance on timely receipts of government subsidies should enhance Pertamina's liquidity and the quality of its cash flow. --Nevertheless, that will be insufficient to stabilize cash flow adequacy ratios because of increased capital spending. Credit impact for the building material and construction sectors: moderately positive --These sectors should experience sustained demand and volume growth for the next three to five years. --We believe a renewed commitment by any incoming administration to increase infrastructure spending will boost cement sales for infrastructure projects from a paltry 21% in 2013, according to the Indonesia Cement Association. --Increased infrastructure spending should, in turn, help absorb substantial volume capacity growth coming into the cement market over the next three years. Credit impact for the energy-sensitive sectors: moderately negative --Electricity can account for 10% to 20% of operating costs for energy-intensive industries.

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Table 5

Credit Impact--Power, Refining, Building Material And Construction, And Energy Segments (cont.)
--Higher energy or fuel costs will weigh upon the margins of energy- and fuel-intensive industries without integrated power facilities, such as cement, pulp and paper, steel and aluminum, and metal smelting.

"Value-Added" Economic Policies Could Raise Costs For Agribusiness Companies

We believe the forthcoming administration will maintain existing policies to target value addition to Indonesia's agribusiness activities. During the past decade, the government implemented export tariffs on cocoa beans in 2010; revised export taxes for crude palm oil in 2007, 2008, and 2012; banned the export of certain unprocessed wood products in 2011 and the import of a number of horticultural products in 2013; and implemented regulations on, and then relaxed, imports of live cattle in 2013. The palm oil, rubber, pulp, and coffee sectors are those that offer the widest scope for legislation on "value-addition", in our view. The crude palm oil (CPO) sector, in particular, seems to be an obvious target for any forthcoming administration keen to develop the domestic downstream oleochemicals or specialty oils segments. This is because CPO is a large export contributor--about US$11.9 billion for the nine months ended Sept. 30, 2013, according to Bank Indonesia-and the proportion of unrefined exports remains significant (about 40% of production). The progressive export tax on CPO exports implemented in May 2012 led to substantial growth in refining capacity, according to the Indonesian Palm Oil Association. That might encourage the new administration to raise export taxes further. Indonesia also exported about 78% of its production of natural rubber in 2012, according to the Rubber Association of Indonesia, and about 80% of its pulp and paper production. So those two sectors could also face a drive to develop downstream industries, with similar implications for their operating performance and credit profiles.
Table 6

Credit Impact--Rated Companies

Credit Effect For Rated Companies: mostly neutral --Higher export taxes will likely impede the profitability of palm oil producers lacking refinery capacity, reduce their free cash flows as greater capital spending might become more optimal, and could temporarily put small domestic producers at a disadvantage in the global markets. --Our ratings and outlooks on Malaysia-based Sime Darby Bhd. and IOI Corp. Bhd. are not affected. About 40% of Sime Darby's CPO production and 7% of IOI's plantation size come from Indonesia. We believe both companies can absorb moderately higher export taxes at their current ratings, given their strong operating efficiency, high profitability, large scale, and Sime Darby's diversity outside of the palm oil sector. --Our rating and outlook on poultry feed and beef producer PT Japfa Comfeed Indonesia Tbk. are not affected because we expect the company's more regulation-sensitive beef operations to account for less than 10% of its EBITDA over the next 24 months.

Higher Costs And Lower Margins Are Likely For The Retail And Textile Sectors And State-Owned Companies If Labor Costs Keep Growing
We expect Indonesia's minimum wage to continue rising by at least 10% annually on average for the next three years, regardless of the new administration, in line with the pace of the previous five years. Consensus for enacting further increases is widespread. In addition, regional governments have the power to establish minimum wages, so salary increases larger than that have been common across Indonesia.

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Rated Indonesian Entities Will Remain Resilient To Persisting Policy Risks Under The Forthcoming Administration

We expect the immediate credit effect of such increases to be marginally negative for companies in labor-intensive, competitive, and low-margin sectors, which have a limited ability to pass through higher costs beyond inflation to customers. Those companies include food retailers and textile manufacturers, for which we see little margin improvement for at least the next 12 months. For example, labor expenses accounted for only about 6% to 8% of operating costs at PT Matahari Putra Prima Tbk. (MPPA), PT Hero Supermarket Tbk., and PT Sumber Alfaria Trijaya Tbk. But we estimate that each 5% increase in wages above inflation could shave off 5% to 10% from their EBITDA margins because of these companies' thin profitability. Persisting labor cost inflation will also have varying effects on the profitability and margins of state-owned entities. PT Krakatau Steel (Persero) Tbk., PT Garuda Indonesia (Persero) Tbk., ANTAM, and to a lesser extent miners PT TIMAH (Persero) Tbk. and PT Bukit Asam (Persero) Tbk., will likely feel the pinch because of their fairly sizable workforces and pension obligations and thin profitability. On the other hand, labor costs are much lower for the large state-owned companies PLN, Pertamina, and PT Perusahaan Gas Negara (Persero) Tbk. (PGN). Highway operator PT Jasa Marga (Persero) Tbk.'s high profitability provides some buffer against potential further hikes in labor costs.
Table 7

Credit Impact--Rated Companies

Credit impact for rated companies: mostly neutral --Growing labor costs would not immediately affect our 'B+' ratings on retailers MPPA or PT Multipolar Tbk. We already factor persisting thin operating margins in our "weak" business risk profile assessments for both companies. --We also expect no immediate rating impact on integrated textile and garment producer PT Sri Rejeki Isman Tbk. because of our forecast of a fairly strong EBITDA margin of 14%-16% in the next two years, which should provide sufficient buffer to rising labor costs. --There is also no rating effect on the state-owned companies ANTAM, PLN, Pertamina, and PGN. Reduced cash flows from the mineral export ban is the major credit risk for ANTAM, and the profitability of the three other companies is sufficiently strong to absorb further moderate cost increases.

Lasting Restrictions Of Credit Availability Or Down Payment Rules Should Not Materially Affect The Rated Real Estate Or Consumer Durables Sectors
We do not expect further material tightening of real estate regulations in the next 12 months. We believe the forthcoming administration and the central bank will first assess how the measures implemented in 2013 have affected credit growth and property prices before they take further action. Market sentiment also seems less upbeat than at this time last year, which reduces the need for an imminent round of additional measures. That said, we believe the new administration will not hesitate to take firmer measures if credit growth remains robust and property prices continue to grow steadily. Such actions could include further tightening of loan-to-value regulations; increasing down payments, mortgage controls, and restrictions on real estate purchases; or enacting higher stamp duties for real estate developers. The prospects of similar rules for durable consumer products, including cars and motorcycles, could trigger a slowdown in production growth in the manufacturing sector, but we believe this would be temporary. Volume growth dropped for a few months in 2012 when Bank Indonesia raised the minimum down payments on automobiles and motorcycles purchased on credit, but growth subsequently resumed.

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Rated Indonesian Entities Will Remain Resilient To Persisting Policy Risks Under The Forthcoming Administration

Table 8

Credit Impact--Real Estate Developers And Consumer Durables

Credit impact for rated real estate developers: neutral --There is no immediate rating effect on the five real estate developers that we rate (PT Lippo Karawaci Tbk., PT Alam Sutera Realty Tbk., PT Metropolis Propertindo Utama, PT Modernland Realty Tbk. and PT Kawasan Industri Jababeka Tbk.). --Our base-case scenario already accounts for a slowdown in average revenue growth for the five rated developers because of lower volumes sold as the market adjusts to the recently implemented tightening measures, normalization after the high growth since 2010, and slower price growth. --All five developers maintain sufficient cash flow adequacy and liquidity buffers under our current base-case projections and downgrade rating triggers to absorb further moderate tightening of regulations and the potential repercussions on sales and liquidity. Credit impact for rated consumer durables manufacturing: neutral --There is no immediate rating effect on tire producers or conglomerates. --We have factored into our base-case projections reduced demand volume growth for domestic tires for Gajah Tunggal and car sales at Astra International. --Both companies have good buffers under our downgrade triggers and sufficient liquidity to withstand extended demand growth slowdowns.

Restrictions On Foreign Ownerships In Banking Will Likely Persist, Slow Consolidation

We believe restrictions on foreign ownership in Indonesia's banking sector will remain in place under the new administration. There seems to be broad consensus across the political spectrum on limited foreign participation in the domestic banking market even though the banking regulator has been pushing for fewer, but stronger, banks that could compete with regional and international banks. Foreign ownership is currently capped at 40%. The stake can be increased if acquirers demonstrate sufficient financial strength and good corporate governance during an 18-month review period and Bank Indonesia has retained the right to authorize a majority stake. But it is unclear, in our view, how the central bank would exercise this discretion. The ambiguity of foreign ownership rules will likely delay a structural improvement in Indonesia's banking system, in our opinion. Protectionism reduces the urgency and need for consolidation in a system in which the sheer number of small financial institutions creates inefficiency and strains supervisory resources. Small banks often have rudimentary risk management and weak corporate governance, and we expect these conditions to persist as long as ownership protectionism remains in place. Incentives to merge in the absence of external threats from foreign entrants will also remain limited, in our view, because buoyant economic growth has supported these banks' operations.
Table 9

Credit Impact--Banks
Credit impact for rated banks: neutral --There is no immediate rating effect on the four banks we rate: PT Bank Mandiri (Persero), PT Bank Negara Indonesia (Persero) Tbk., PT Bank Danamon Indonesia Tbk., and PT Bank Rakyat Indonesia (Persero) Tbk. --Our 'BB' category ratings and stable outlooks reflect our expectations that Indonesia's banking industry and country risk will remain high for the next 12 to 18 months.

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Rated Indonesian Entities Will Remain Resilient To Persisting Policy Risks Under The Forthcoming Administration

Domestic Banks' Exposure To Policy-Sensitive Sectors Is Moderate

We do not expect enduring policy risks for the corporate sector to lead to a material deterioration in the asset quality of the four domestic banks we rate. A lasting mineral ban, higher prospective taxation, or wage inflation would impede the creditworthiness of small companies in the mining and labor intensive sectors such as textile. But we estimate loans to those sectors that are more sensitive to policy risks, such as mining, agribusiness, textiles, food retailing, and energy-intensive sectors, at less than 10% of the Indonesian banking system loans (see chart).
Chart

Along with the lingering effects from the "tapering" by the U.S. Federal Reserve, our base-case scenario includes a moderate increase in credit costs of Indonesian banks to 1.2% of loans in 2014. We also expect gross nonperforming loans to increase to about 2.5% in 2014, from about 2% in 2013. Nevertheless, we are of the view that Indonesia's banks will be able to withstand the potential pressure without risking negative rating implications. Indonesian banks have sufficient earnings buffers to offset a potential rise in credit costs, in our opinion, and we believe our ratings on these banks--all in the 'BB' category--largely reflect the risks.

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Rated Indonesian Entities Will Remain Resilient To Persisting Policy Risks Under The Forthcoming Administration

Policy Risk Will Likely Continue After The Elections

We will have greater insight on the shape the legislature will take only over the next few weeks. But we believe policy risk will subside beyond this electoral cycle, given the lag between legislation and implementation of any laws that the new administration may enact. For that reason, we see no prospect of a change in our overall assessment of Indonesia's country risk. We believe weaknesses in the effectiveness, stability, and predictability of the sovereign's policymaking and political institutions will continue to weigh down country risk and be an important consideration in our assessment of Indonesian entities.

Related Criteria And Research

Related Research
Research Update: PT ANTAM (Persero) Tbk. Downgraded To 'B-' On Risk Of Continuing Export Ban, Reducing Cash Flows; Outlook Developing, March 21, 2014 Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings, March 5, 2014 Indonesia Banking Outlook 2014: A Weakening Rupiah And Increasing Interest Rates Could Expose Credit Vulnerabilities, Feb. 11, 2014 Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013 Sector Review: Asia-Pacific Credit Trends 2014: Still Robust Domestic Growth and Steady Financial Profiles Underpin Our Mostly Stable Outlook On Indonesia's Corporate Sector, Oct. 30, 2013 Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

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