Country Risk Management CEMS MIM Fall 2013(Term 1) High Speed Rail Project In Indonesia Country Evaluation Note Background I am the Corporate Risk Manager at a large European Engineering & Construction firm (say Siemens), which is planning to submit its bid for the 35 KM elevated high speed rail project in Indonesia connecting the Jakarta Airport to the Central Business District in the heart of the city. This will be the company’s first investment in the region. It is facing stagnant order book position from its home market in Western Europe.
This Country Evaluation Report will go as an additional input to the company oard when the final decision to make the FDI in Indonesia is made. The bid amount is approximately in the range of 600-700 million USD. The project is supposed to be a PPP on a DBOT basis. Executive Summary Indonesia is the fourth most populous nation in the world and with a GDP growth rate of 6. 1% in 2012 it was the fastest growing economy in the ASEAN. FDI has grown by 30% YOY and the government plans to solicit investment worth 140 billion USD from the private sector for development of countrys infrastructure sector.
This would suggest that Indonesia is the country to invest and the rail corridor project the ideal ehicle of entry. But one must not forget the 1997 Asian Financial crisis and what it did to the Indonesian rupiah. Public Institutions are still weak and corruption is not completely absent. Indonesia is ranked 100th out of 183 in Transparency International’s Corruption Perception Index. In 2011, World Bank had ranked the country 128th as far as “Ease of doing Business” is concerned. Moreover, S&P ranks Indonesia BB- at below investment grade.
All these might suggest that one should be apprehensive when engaging with Indonesia. In the subsequent sections we will look t both the risks and opportunities associated with undertaking the proposed FDI in Indonesia in order to make an informed decision. In my opinion, at this point, the primary country risk parameter that we should be concerned with is Political in nature. General elections are due in early 2014, and there is a sense that decision making might come to a halt. Although the government is making large scale suggests that there is a chance that the project might not go on ground before mid-2014.
Also the current president Yudhoyono has served his two terms and there will be a change of guard; considering how fragmented the political landscape is, here is a possibility of a prolonged period of political uncertainty in Indonesia. It is still fine if the project start is delayed, but what is a greater concern for the company is the project getting off the ground and then there are bottlenecks on account of impeding elections. We would have invested a lot of capital which would remain stuck without any return. So in this particular domain of political uncertainty, there are three possible scenarios: 1.
The upcoming elections have no impact on the project. 2. Decision making stalls till the time elections are held and then it continues as per previous regime. 3. The new government takes a more protective stance, creating bottlenecks for the implementation of the project in general and against foreign firms in particular. The third scenario is what the company needs to guard against. Basically the risk that we foresee is that the payback period will be increased by 18 months, and this should be accounted for when the project is stress tested for potential impact to our cash flows and profitability.
Second major risk that comes along with investment in Indonesia is the weakness of public institutions and systems. Although a lot of progress has been made post the 1997 crisis, it is fair to ee there are other emerging markets in Asia and elsewhere who have stronger systems in place. Corruption Eradication Commission was put in place but the seeds of graft had been sown so deep, that it has not been able to wipe out the mess. Just a month back, the chief Justice of the Constitutional Court was arrested for allegations of accepting bribe to fix the results of a local election.
Corruption is endemic in some government circles like civil services and as our company abides by practices as listed under the I-JK Anti-Bribery Act and Foreign Corrupt Practices Act (FCPA) for all ue diligence, we are not sure if practices prevalent there will pass those standards. Even if we think it will be fine from an internal corporate governance standpoint, one does not want to be on the wrong side of the laws in the western world. Another associated risk, which is of extreme importance from the perspective of this project, is enforcement of contract.
It is long term project, with a concession period of 20 years, and one should expect that over such a long duration, the clauses of the contract are enforced both in letter and spirit. Indonesia is ranked a lowly 144th long with Malawi in this domain. We have knowledge of two urban infrastructure projects in Jakarta stuck due to contract disputes over cost overruns. Also, the Indonesian civil law makes for certain clauses to be applied to all commercial contracts unless specifically excluded. This can also be a source of litigation, which is known to be extremely time consuming and unpredictable.
This aspect is especially important for our proposed project, as it is a long term concession agreement, and things like toll increase(if required in the case of insufficient traffic) or viability gap unding etc. are usually negotiated or agreed with the government agency, during the contract design phase. At this point in time, there is more than a reasonable doubt that the Indonesian government might raise obstacles when those clauses actually kick-in. Although the investment will be made in an SPV which is supposed to becoming a hurdle.
In view of the forthcoming elections, the government will not be to too keen to take stern action against agitating people, if any. A Japanese investment of 4 billion USD in the power sector is stuck because of this, and as per ontract terms, it is the liability of the executing company to deal with this. The contract will undergo rebidding if the Japanese company is not able to sort this issue out before a pre-defined date. It might not seem fair to put the entire onus on the company bringing in the FDI, but that is part of doing business in Indonesia and must be borne in mind.
From a Business Environment risk perspective, it should be known that the Indonesian Government has a negative list of industries, which are restricted to foreign investors. Although in case of this project, 100% FDI is permissible, the list s reviewed every 3 years and there might be a case where the company might be asked to give up certain stake if the Indonesian government so decides to make a retrospective change to the list. In the mining industry, the government has been moving to ask foreign companies to give up part of their stake in favour of local miners.
DBS Singapore’s bid for the countrys sixth largest lender Danamon was blocked when regulators put up restrictive ownership rules. This issue of Economic Nationalism is something that should be given a serious thought before making this PPP investment. The project will be guaranteed by the recently set up Government agency Indonesian Infrastructure Guarantee Fund (IIGF). While having a sovereign backstop is beneficial from a risk sharing, insurance and fund raising point of view, the issue of sovereign financial risk becomes more acute.
As mentioned in the introduction, Indonesia is still not ranked investment-grade by all the rating agencies, which should be a matter of concern for us. Some of the fiscal indicators are not exactly comforting. The budget deficit is expected to rise to 2% of GDP, significantly higher than the assumed 1. % as targeted by the President in August. While we are not directly concerned with the Sovereign Bond Rating and the Indonesian government fiscal situation, as we are not lending money to them, but it is something that we have to watch as it can impact us in the following ways: 1.
Our local borrowing in Indonesia will be linked to the Government Bond Yields which are influenced by the Rating, Inflation and fiscal situation. The Benchmark 10 Year Government Bond Yield has climbed by more than 300 bps this year alone. 2. If the company’s corporate finance division decides to use internal accruals and borrowing n Euros to invest in this proposed PPP, then the potential devaluation of the Indonesian rupiah as a result of adverse fiscal situation will have a negative impact on the project financials.
This problem is magnified since all our revenues are going to be in local currency in the form of toll receipts. The resulting currency exposure is something that needs to managed, especially with the hindsight of what happened with Indonesia in 1997. 3. Also, a worsening fiscal situation will affect the Insurance premiums that we pay to offset some of the investment risks, especially since the roject will have a Government Agency backstop.
If we look at the market opportunity for this kind of project, then we see that foreign tourist arrivals in Indonesia are expected to grow 25% during 2012-14 period to touch 10 million by next year, and a substantial portion of them are through the Jakarta International Airport. According to one estimate Indonesia’s GDP per capita is expected to grow from 3300 USD in life. So the market opportunity is definitely there for this Airport Metro link, both from domestic and foreign travellers. It will cut down travel time to the city centre from the urrent 90 minutes to less than 20 minutes.
So based on the risks and opportunities identified with investing in this PPP in Indonesia and also taking into account where we stand as a company with respect to orders from our more mature markets in Europe and the US, we make the following recommendation: In our opinion we should go ahead with this project but with a long term view. WE should not expect to make profits in the short term. The execution stage could be tough but things should work out as we spend time on ground and start to understand their way or working in greater detail. Therefore, we have the following recommendations to mitigate some of the risks listed above: 1.
Domestic Partner: Even though as per the regulations, it is possible to set up a 100% owned company for implementing this project, I recommend having a 51%-49% JV with a reputed Indonesian construction group. This will allow us to tackle the local on ground issues with the government and civil services in an efficient manner. 2. Arbitration and Litigation: Include International Arbitration for settlement of disputes. A good choice is the Singapore International Arbitration Centre, where the final arbitral award is binding is utomatically ratified by Indonesian Courts.
This is very important as litigation in Indonesia can be very time consuming, and subject to transparency issues. 3. Insurance: Over and above the common insurance protection that our company generally takes for such infrastructure projects, one should definitely take one for losses due to delay caused by political uncertainty, which is a big risk over the short to medium term here. 4. Contract Design: It is imperative that clause related to provision for toll increase and extension of concession duration are put in place and learly defined, to ensure that we are hedged against risks in delay of project execution.
I would conclude by saying that, opportunities do exist to make money and benefit by investing in this project, but we should not look for quick results, it might be a long drawn process, but if we have appropriate checks and balances in place, this will be a success and it will also open up opportunities for further engagement with the country. END of SUMMARY References: 1. The Jakarta Post – “FDI growth set to fall below 20%” : http:// www. theJakartapost. com/news/2013/11 /08/fdi-growth-set-fall-below-20-next- ear. html 2. Indonesia-Investments : http://www. ndonesia-investments. com/ 3. Indonesia Private Equity : http://indoprivateequity. com/2012/02/16/1iberalization-and- fdi-in-indonesia/ 4. BKMP – Indonesia Investment Coordinating Board : http:// www4. bkpm. go. id/ 5. FDI Intelligence : http://www. fdiintelligence. com/Locations/Asia- Pacific/lndonesia/can-lndonesia-keep-pace-with-its-own-growth 6. COFACE Indonesia Country Report : http://www. coface. com/Economic-Studies-and-Country-Risks/ Indonesia 7. Indonesia : Risk Assessment by global EDGE : http://globaledge. msu. edu/ countries/indonesia/risk
