Investment prospects in the Indonesian banking sector*

Financial Services

Investment prospects in the Indonesian banking sector • PricewaterhouseCoopers �

Indonesia is set to be one of the economic powerhouses of the twenty-first century. The country is the fourth most populous in the world (see Figure 1), is rich in oil, coal and minerals (including gold, copper and the world’s largest tin mining industry), and has a rapidly developing industrial sector. By 2050, Indonesia’s economy could be bigger than the UK or Germany.1

Although international organisations have built up a significant presence in the Indonesian banking sector through the sale of banks following the Asian financial crisis of 1997, the recent pace of investment has been tempered by high interest rates and high levels of non-performing loans. Now, Indonesia is moving to the centre of the radar as interest rates decline, bad debts come under control and credit demand begins to accelerate. By 2050, the size of the Indonesian banking sector could rival that of France or Italy, while returns could be considerably higher.2

Organisations require a clear strategy to match their ambitions to the relative pros and cons of organic growth, acquisition, branch or joint-venture options. This paper, produced by PricewaterhouseCoopers,3 outlines the prospects for market growth and assesses the various options for entry and development.

Indonesia’s banking sector has stabilised, ready for rapid future growth. Bad debt ratios are declining, demand is rising and balance sheet quality has improved;

The compound annual growth rate (CAGR) of consumer lending between 2002 and 2006 was 30%. By 2050, projected domestic credit is expected to be some 70 times larger than 2004;4

Acquisition (up to 99% foreign ownership permitted) could prove a relatively quick and effective way to establish a market presence, especially if the strategy is to enter niche segments;

Takeover prices are relatively high (2.5 to 3 times book value) on account of the limited supply of available targets in Indonesia, along with the increasing demand for banks in growth markets regionally. However, further privatisation, government curbs on multiple ownership and changes to capital adequacy requirements will mean that there are more banks available to acquire; and

Over the years, several leading international groups have established greenfield (up to 99% foreign ownership permitted) or branch operations. However, gaining new licences could prove difficult at a time when the government and regulators are keen to reduce the number of banks.

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Introduction Overview

1 ‘The world in 2050’, PricewaterhouseCoopers – March 2006.2, 4 ‘Banking in 2050: How big will the emerging markets get?’, PricewaterhouseCoopers –

April 2007.3 ‘PricewaterhouseCoopers’ refers to the network of member firms of

PricewaterhouseCoopers International Limited, each of which is a separate and independent

Figure � – Key facts

Sources: CIA World Factbook, International Monetary Fund World Economic Outlook Database, April 2007.

Population 235 million (July 2007)

2006 GDP (MER – market exchange rate) US$364 billion

2006 GDP (PPP – price purchasing parity) US$960 billion

2006 GDP per capita (MER) US$1,640

2006 GDP per capita (PPP) US$4,752

� Investment prospects in the Indonesian banking sector • PricewaterhouseCoopers

Having largely recovered from the impact of the Asian financial crisis of 1997, the Indonesian economy is now pushing forward into a period of strong and sustained growth. GDP expanded by 5.5% in 2006 and is expected to increase by an average of 5.8% until the end of the decade (see Figure 2). Inflation has fallen from a high of 18% in late 2005 to around 6% in July 2007.5

The stock market rose by more than 25% over the first two quarters of 2007, before reaching a high in July,6 reflecting the increasing confidence about both domestic and export prospects. Though August saw a significant fall in share prices reflecting the global redistribution of capital and re-pricing of risk. Key growth sectors include mining, chemicals and plantation businesses, which have been buoyed by rapidly increasing demand in China, Japan and other parts of Asia (Japan has overtaken the US as Indonesia’s leading export destination).7

Looking ahead, research carried out by PricewaterhouseCoopers suggests that the combination of sustained high growth and a sizeable and relatively young population8 means that the economy of Indonesia could outstrip both the UK and Germany by 2050 (see Figure 3).

The corollary of this immense economic potential will be transformational long-term growth in demand for banking services. PricewaterhouseCoopers research indicates that by 2050, Indonesia will have developed a banking sector comparable in scale to a major European economy such as France or Italy (see Figure 4). Domestic credit in Indonesia is projected to grow from US$0.1 trillion in 2004 to US$7 trillion in 2050 (at constant 2004 prices).9

*Includes projected real exchange rate appreciation (shown in light red bars)

Germany

*% real GDP growth p.a.

UK

Indonesia

China

0 2 4 6 8

Domestic currency US $ terms*

Figure 3 – Projected average real GDP growth �005-50

Source: ‘Banking in 2050: How big will the emerging markets get?’, PricewaterhouseCoopers, April 2007.

Japan

Germany

% of world total

UK

US

Russia

Mexico

Brazil

Turkey

INDONESIA

China

Spain

ITALY

FRANCE

Australia

Canada

India

Korea

0 5 10 15 20 25

2050 share 2004 share

Figure 4 – Projected shifts in shares of global banking assets

Source: ‘Banking in 2050: How big will the emerging markets get?’, PricewaterhouseCoopers, April 2007.

Investment environment

Figure � – Projected growth (GDP)

Source: Economist Intelligence Unit, ‘Country Profile’ Indonesia, 21.05.07.

2006 2007 2008 2009 2010

5.5% (actual)

6.3% 6.0% 5.2% 5.9%

5 Bank Indonesia Inflation Report – July 2007.6 Reuters market report – 19.07.07.7 ‘Country Profile: Indonesia’, Economist Intelligence Unit – 21.05.07.8 The average age of the Indonesian population is 27, compared to 44 in Japan and 33 in

China. Indonesia’s birth rate (20 per 1000) is also more than double that of Japan (8 per 1000). Source: CIA World Factbook.

9 ‘Banking in 2050: How big will the emerging markets get?’, PricewaterhouseCoopers – April 2007.

Investment prospects in the Indonesian banking sector • PricewaterhouseCoopers 3

Regulation and consolidation

The upper end of the Indonesian banking sector is relatively concentrated, with the top 10 banks accounting for more than 60% of total assets and credit.10 However, with 130 commercial banks in all, the sector as a whole is overcrowded. Many of the smaller institutions are poorly capitalised.

The government is therefore seeking to promote consolidation and strengthen capitalisation through a policy framework known as the Indonesian Banking Architecture (API). The API includes new capital tiers for banks that wish to operate internationally, nationally or regionally.

Underpinning the API is the Single Presence Policy (SPP), which would prohibit shareholders from having a controlling stake in more than one bank by the end of 2010.11 Those with multiple stakes will need to either divest, establish a bank holding company or merge their banking interests in Indonesia (plans need to be submitted to Bank Indonesia, the central bank, by the end of 2007).12 The SPP would have the particular benefit of enhancing regulatory oversight by reducing the number of separate entities that need to be supervised, especially the extensive array of multiple stakes held by conglomerates.

The Indonesian government and Bank Indonesia also recognise the importance of improved transparency, governance and risk management in winning the confidence of investors. Recent reforms include tighter controls on lending, greater nonexecutive scrutiny, the requirement to have formal risk committees in place and mandatory good corporate governance standards, along with curbs on the number of related family members that can hold board-level positions.13 Under current plans, 2008 would potentially mark the beginning of the introduction of Basel II in Indonesia. Ultimately, the embedding of robust standards of governance will come down to the culture of the organisation as much as regulatory supervision.

10 ‘Indonesian Banking Statistics’, Bank Indonesia – May 2007.11, 12 Bank Indonesia Regulation Number 8/16/PBI/2006.13 Bank Indonesia Regulation Number 8/4/PBI/2006.

4 Investment prospects in the Indonesian banking sector • PricewaterhouseCoopers

Although still small in relation to the size of the population, the Indonesian banking sector is already generating a strong return on assets (see Figure 5).

The resurgence of the economy is leading to an acceleration in credit demand. The overall CAGR in lending between December 2002 and December 2006 was 21%. The fastest expanding segment was consumer/retail credit (CAGR of 30%, 2002-06), which now makes up nearly 30% of the overall loan market. The value of small- and medium-size enterprise (SME) lending has also more than doubled since 2002 to reach some US$45 billion in 2006.14 A key spur for the growth in the credit sector has been the reduction in Bank Indonesia’s base rate, from 12.75% in late 2005 to 8.25% in July 2007. This has fallen in line with inflation.

Sales and restructuring had reduced the gross non-performing loans ratio of commercial banks to 6.1% by May 2007 (see Figure 5), releasing fresh funds for new lending and improving the quality of the industry’s balance sheets. Bank Indonesia is pressing for further reductions by insisting that institutions that wish to qualify as ‘anchor banks’ will need to cut their non-performing loan ratio to less than 5% by 2008.15

While product choice and distribution options on the consumer side are still relatively limited, development is beginning to gather pace. For example, Bank Mandiri, Indonesia’s largest bank, has built a successful bancassurance platform.

Having been subdued in the aftermath of the 1997 crisis and subsequent global downturn in 2002 and 2003, corporate banking in Indonesia is now coming back to life. Proposed initial public offerings include Adaro Indonesia, one of the world’s largest producers of thermal coal, which if it goes ahead will be the country’s biggest ever flotation.16 Other opportunities opening up as the economy gathers speed range from derivatives to help control the volatility of the Rupiah and interest rates, to the fast-growing demand for SME credit and advisory services.

The demand for Islamic banking is still surprisingly small in what is the world’s largest Muslim country. However, a number of providers are looking to extend the range of Sharia-compliant products.

Market environment

Figure 5 – Banking sector overview (May �007)

Source: Bank Indonesia ‘Indonesian Banking Statistics’, May 2007.

Assets US$188 billion

Deposits US$142 billion

Loans US$90 billion

Number of banks 130

Number of offices 9,110

Gross non-performing loans 6.1%

Capital Adequacy Ratio 22%

Return on assets 2.98%

Figure 6 – Top �0 banks by assets (as at 3� March �007)*

Source: Bank Indonesia ‘Indonesian Banking Statistics’, May 2007.

US$ billion

Rank Name Assets Credit

1 Bank Mandiri** 27 11

2 Bank Central Asia 20 6

3 Bank Negara Indonesia** 19 7

4 Bank Rakyat Indonesia** 17 10

5 Bank Danamon 9 4

6 Bank Internasional Indonesia 6 2

7 Bank Niaga 5 4

8 Citibank NA 4 2

9 Bank Permata 4 2

10 Panin Bank 4 2

* Rounded to nearest billion** State-owned banks

14 Calculated from Bank Indonesia ‘Indonesian Banking Statistics’ – May 2007.15 ‘Indonesian Banking Booklet’, Bank Indonesia – March 2007.

16 Financial Times – 02.07.07.

Investment prospects in the Indonesian banking sector • PricewaterhouseCoopers 5

Ownership and investment

Many of Indonesia’s leading banks, including Bank Mandiri, are state-owned (see Figure 6), though the government appears keen to renew privatisation. This includes the sale of a 30% stake in Bank Negara Indonesia in August 2007, which raised approximately US$875 million in the government’s largest banking divestment to date.17

Foreign investors hold significant stakes in a number of the top 10 banks. Much of this investment stems from the sale of stakes in nationalised banks between 2002 and 2005 (see Figure 7).

International groups that have banking subsidiaries in Indonesia include Rabobank, DBS Bank, Commonwealth Bank of Australia and the Australia and New Zealand Banking Group. A number of international groups, including HSBC, Citibank, ABN Amro and Standard Chartered have also established branch operations.

Renewed interest from regional and global groups is now evident as the economy and credit markets continue to grow. For example, a survey of 230 financial executives from across

Asia, which was carried out by PricewaterhouseCoopers in April 2007, found that 20% expect to carry out M&A activities in Indonesia over the next five years. Among respondents from Indonesia itself, 56% expect to undergo significant M&A, 50% anticipate a sizeable divestment and 75% will seek a foreign strategic investor or partner in a major new venture over the next five years.18

International groups that have extended their presence recently include Rabobank, which took control of Bank Haga and Bank Hagakita as part of its aim to become the ‘bank of reference’ for SME business in Indonesia.19 Prospective entrants include private equity and other financial buyers. In May 2007, for example, US private equity company TPG (formerly Texas Pacific Group), agreed to acquire a majority stake in Bank Tabungan Pensiunan Nasional, a niche bank that mainly serves retired people.20

Figure 7 – Significant foreign investment in banking sector (�00�-�005)

Source: PricewaterhouseCoopers/Bloomberg Research.

Year Stake sold Acquirer

Bank Central Asia 2002 51% Farallon Capital

Bank Niaga 2002 51% Commerce Asset Ventures Sdn Bhd

Bank Danamon 2003 51% Temasek/Deutsche

Bank Internasional Indonesia 2003 51% Temasek/Kookmin

Bank Lippo 2004 52% Swiss Bank Consortium

Bank NISP 2004/05 71% OCBC

Bank Buana 2004/05 61% UOB

Bank Permata 2004 51% Standard Chartered/Astra

Bank Lippo 2005 83% Khazanah Nasional Bhd

17 Jakarta Post – 01.08.07. 18 ‘Financial services M&A: Going for growth in Asia’, PricewaterhouseCoopers – June 2007.19 Rabobank media release – 10.01.07.20 Financial Times – 17.07.07.

6 Investment prospects in the Indonesian banking sector • PricewaterhouseCoopers

Companies looking to control a banking operation in Indonesia have three main options: establishing a new bank, opening a branch of a foreign bank or acquiring an existing institution. Investors need to weigh up a number of regulatory and operational factors before choosing which route to take.

Option 1

Establishing a new bankGreenfield entry (up to 99% foreign ownership permitted) naturally provides the flexibility of starting afresh and eliminates the risk of liabilities from past activities. However, companies must provide more than US$330 million in paid-up capital, which could be a sizeable disincentive. Establishing a new business also tends to be more time-consuming than acquisition. In particular, companies need to allow at least a year to complete operational preparations, including feasibility studies, licence applications (120 days at least), recruitment, IT and marketing development. Even then, gaining approval for a new start-up may be difficult at a time when Bank Indonesia is looking to reduce the number of banks. In this respect, it is notable that no new banking licences have been issued since 1999.

Option 2

Opening a branch of a foreign bankIf the bank is one of the global top 200, by assets, it can open a branch in Indonesia. This route does away with the need to find a local partner and comes with no risk from past activities. However, the paid-up capital requirement (US$330 million) is the same as greenfield entry. The nature, extent and time needed to complete the operational and regulatory preparations are also similar. Although current regulations permit this approach, the fact that Bank Indonesia has issued no new branch licences since 2003 would suggest that gaining its approval may be difficult.

Option 3

Acquiring an existing institutionAcquisition (up to 99% foreign ownership permitted) offers an established customer base, existing operational systems and distribution channels. While target identification through to due diligence, negotiation and sale can take four to six months, this is still considerably less than the greenfield route. Bank Indonesia is also far more likely to grant approval.

On the flip side, buyers run the risk of taking on unwanted liabilities from the past. Moreover, acquisition prices have been running at 2.5 to 3 times net book value, reflecting the increasing demand for banks across this fast-growth region and, within Indonesia itself, the shortage of available supply in a country where most leading institutions are either state, family or foreign-owned and therefore rarely for sale. Now, however, both privatisation and the impact of the Single Presence Policy are adding to the supply of potential targets. The relatively fast turnaround of private equity investment could also mean that recently acquired entities could soon be back on the market. Developments in price and availability may encourage more acquisitions as an alternative to greenfield start-ups.

Entry strategies

Investment prospects in the Indonesian banking sector • PricewaterhouseCoopers 7

The Indonesian banking sector is set to be transformed over the next few years as the number of banks decreases, foreign investment continues to increase and institutions respond to the impact of the API, Basel II and other pressing regulatory developments. The result is likely to be a more competitive market, marked by heightened pressure to improve efficiency, drive down payroll and other costs, and generate greater product and service differentiation.

Those spearheading investment and development are likely to include financial buyers, capable of turning around under-performing institutions ready for selling on to more long-term acquirers. The longer term investors are likely to include the key regional and, increasingly, global players attracted to the huge potential of what is set to become one of the world’s biggest banking markets.

The way forward

� Investment prospects in the Indonesian banking sector • PricewaterhouseCoopers

If you would like to discuss any of the issues raised in this paper, please speak to your usual contact at PricewaterhouseCoopers, or one of those listed below:

Contacts

Nick Page Partner (Editor) PricewaterhouseCoopers (UK) 1 Embankment Place, London WC2N 6RH United Kingdom Tel: + 44 (0) 207 213 1442 Fax: + 44 (0) 207 804 4907 nick.r.page@uk.pwc.com

Stuart Scoular Financial Services Leader PricewaterhouseCoopers (Indonesia) Jl. H.R. Rasuna Said Kav. X-7 No. 6 Jakarta 12940, Indonesia Tel: +62 21 5289 1213 Fax: +62 21 5290 5555 stuart.a.scoular@id.pwc.com

Cliff Rees Financial Services Advisory Leader PricewaterhouseCoopers (Indonesia) Jl. H.R. Rasuna Said Kav. X-7 No. 6 Jakarta 12940, Indonesia Tel: +62 21 5289 0550 Fax: +62 21 5290 5555 cliff.rees@id.pwc.com

Sahala Situmorang Director PricewaterhouseCoopers (Indonesia) Jl. H.R. Rasuna Said Kav. X-7 No. 6 Jakarta 12940, Indonesia Tel: +62 21 5289 0969 Fax: +62 21 5290 5555 sahala.situmorang@id.pwc.com

Nick Page is a member of the PricewaterhouseCoopers Financial Services Transaction Services team, based in London. Stuart Scoular (Financial Services Leader), Cliff Rees (Financial Services Advisory Leader) and Sahala Situmorang (Director) are members of PricewaterhouseCoopers Indonesian Financial Services team, based in Jakarta. PricewaterhouseCoopers Indonesian Financial Services team has been associated with more than 60% of the banking mergers and acquisitions in the market over the last three years. Activities range from involvement in financial due diligence (including tax), to more comprehensive deal-related valuation, structuring and accounting advice, vendor/target identification, sell-side due diligence and post-deal integration services.

Subjects covered in the Financial Services M&A flyer series

Entering the Indian financial services market

Banking in 2050: How big will emerging markets get?

Entering the Gulf financial services market

Entering the financial services market in Taiwan

Entering the Chinese investment management industry

Russian financial services M&A

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Recent financial services M&A related publications

Financial Services M&A: Going for growth in Asia (2007)

Financial Services M&A: Going for growth in Europe (2007)

Going for growth: The outlook for mergers and acquisitions in the financial services sector in Asia (2006)

Financial services M&A: Review and outlook for mergers and acquisitions in the European financial services market (2006)

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