Is mortgage lending risky for Indonesian banks?

Elvira Tjandrawinata and Neda Tanaga, Analysts

The sub-prime meltdown in the U.S. is having a far-reaching impact. At first, a few large investment firms faced massive redemptions on some of their funds because investors were scared of being left with worthless assets.

The contagion spread to the stock markets even though many banks said that they did not have any exposure to the U.S. sub-prime market.

Stock markets across the globe tumbled as risk appetite diminished -- although most markets have since pared back their losses.

The sub-prime woes also raise questions over the prospects for the U.S. economy. Some analysts are even forecasting a recession. Housing data is weak and consumer confidence is down. This has raised concerns that U.S. consumers might start to cut back on spending, sending the U.S. economy into a tailspin, given the fact that consumer spending is a central pillar of the U.S. economy and accounts for around two-thirds of GDP.

In a bid to restore confidence, Fed chairman Bernanke said rate cuts were possible while President Bush promised to help sub-prime mortgage borrowers avoid foreclosure. These reassurances have had a calming effect.

Shares on the Jakarta Stock Exchange (JSX) also came under strong selling pressure. But after falling more than 20 percent, the market then rallied, with stocks regaining much of their earlier losses. As a result, the Jakarta Composite Index is now only some 200 points lower than its peak of 2,401.14 on 24 July.

The strong recovery in Indonesian stock prices suggests that Indonesia's fundamentals are unlikely to be affected by the sub-prime meltdown. After all, Indonesian banks have no direct exposure to the troubled U.S. sub-prime mortgage loans market. At the same time, less than 15 percent of Indonesia's exports are sent to the U.S.. This is much lower than many other countries in the region. So, in terms of a direct impact on the Indonesian economy, there is little to worry about.

Moreover, Indonesia's economic prospects remain sound. Improving consumer confidence should fuel the economic rebound. In July, Danareksa Research Institute's Consumer Confidence Index (CCI) jumped 5.8 percent to 86.3, its highest level this year.

And although confidence dipped slightly in August due to concerns over higher prices, buying intentions remain very strong. Indeed, the latest consumer survey reveals that the proportion of Indonesian consumers who plan to buy durable goods over the next six months rose to 28.9 percent in August from 28.5 percent in July. Lower interest rates, greater job security and improving national economic conditions are all helping to encourage consumer spending.

Indonesia's improving macroeconomic conditions have had a positive impact on mortgage growth. In March 2001, consumer loans only accounted for 15 percent of the total loans extended. Yet, this had grown to 29.08 percent by June 2007. And mortgages now account for 40.2 percent of all consumer loans. Note also that declining interest rates since the first half of 2002 have helped spur mortgage lending. This is because lower interest rates mean mortgages become more affordable and therefore more attractive to consumers.

Mortgages are actually more resilient than other consumer loans. Mortgage growth has consistently stayed above 25 percent. And going forward, there is plenty of room for further growth since mortgages only account for 2.47 percent of Indonesia's GDP, compared to, say, 26.12 percent for Malaysia.

Against this backdrop, banks are keen to extend mortgage loans to their customers. They are even willing to offer short-term mortgage loans (5 years) with an interest rate of less than 10 percent. The source of funds for these loans is customer savings and deposits. Hence, there is a mismatch between the relatively liquid savings/deposits and the longer-term mortgage loans. So, does this mean that mortgage lending is risky for the banks?

No, not at all. First of all, mortgages have a good risk-reward profile for the lending banks. The loan is structured in such a way that the principal shrinks as time goes by whereas the collateral grows in value provided that property prices increase.

Secondly, even though savings and deposits are far more liquid than mortgage loans, Indonesian banks have a solid customer base and plenty of assets under management. Almost 80 percent of the financial assets in the country are held by Indonesian banks since Indonesian people prefer to "save" than "invest". As a result, the banks have sufficient sources of funds to cover their loans.

Third, with low interest rates and improving macroeconomic conditions, the mortgage loan rate will decline as well. This means that mortgages will become more affordable.

Fourth, Indonesia does not have sub-prime mortgages. Thus, there is no need to worry about a sub-prime mortgage crisis developing in Indonesia. Besides, the Indonesian mortgage non-performing loan (NPL) rate is even lower than bank NPLs in general. For homes and apartments categorized below Type 70 square meters, the NPL stands at 4.4 percent, while for homes and apartments above Type 70, the NPL is 3.7 percent.

Nevertheless, it is crucial for banks to mitigate the risks. How can this be achieved? Well, firstly, a back needs to establish a sound reputation, develop a wide network and build a stable customer base to ensure it is protected from external shocks.

Second, risk management techniques have to be applied to manage risks -- not merely to evaluate historical NPLs, for example. Lastly, the Indonesian financial market needs to be deepened, as with the development of more financial instruments, the assets-liabilities mismatch can be lessened.

To sum up, then, we are sure that the Indonesian mortgage market -- just like the country's macro economy -- is healthy. Moreover, Indonesia will not experience a sub-prime crisis like in the U.S.. Yet, at the same time, it should also be remembered that Indonesia is not immune to adverse global developments. As such, any turmoil on global financial markets is likely to spill over here as well. Looking further ahead, it is important that Indonesian banks adopt the appropriate policies to ensure that a sub-prime crisis does not break out here. In short, vigilance is key.

The writers are analysts at the research department of Danareksa Securities.
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