Estimating NPLs in the finance industry amid inflation pressure

Thu, 05/08/2008 11:03 AM

Inflation has risen rapidly recently. Adding to the inflationary pressure, it seems more likely now that the government will increase fuel prices due to the soaring price of crude oil on international markets.

Soaring inflation is a worry since it will reduce the people's purchasing power, which may subsequently lead to lower consumer spending. Thus, given the aggressive expansion of Indonesia's financing sector over the last few years, fears are mounting that the country may experience a credit crisis.

Adding to the concerns is the likelihood that the Indonesian central bank will have to pursue a tighter monetary policy by raising interest rates to rein in inflation. Against this backdrop, it is feared that economic conditions may weaken.

When the government raised fuel prices in 2005, people's purchasing power took a significant hit. This subsequently led to lower booking sales by finance companies.

Even though the amount of non-performing loans (NPLs) tended to be stable at that time, finance companies had to implement more conservative policies that limited their growth in order to maintain profitability.

But as interest rates started to decline in the middle of 2006, the finance industry recovered on the back of improving purchasing power and greater demand. According to Bank Indonesia data, the outstanding financing of finance companies reached Rp 107.7 trillion at the end of 2007, up 26.17 percent on average each year from Rp 67.6 trillion at the beginning of 2006.

The growth in the finance sector has attracted a great number of players. This has brought about stiffer competition in the industry. As a result, finance companies have tended to be more flexible in their requirements -- such as requiring minimal down payments and being less prudent and selective in accepting potential customers.

Recent data on non-performing loans for some finance companies suggest the overall amount of NPLs is tending to increase. This is reflected in the higher proportion of past-due receivables compared to total receivables.

The proportion of past-due receivables to total receivables is expected to have increased by 1 to 2 percent in the first quarter of 2008 from around 13 percent at the end of 2007.

However, the figure will vary for each finance company depending on the business model adopted. These business models have different characteristics and take into account the size of the company, the product mix and the market segmentation.

Finance companies that have a larger amount of earning assets tend to suffer from higher NPLs compared to finance companies with a smaller amount of earning assets. This is most likely related to the ability of a finance company to control a large amount of assets.

In smaller companies, stricter procedures and more intensive collections are more easily applied. Smaller companies are also better able to manage their human resources due to the smaller number of employees. In contrast, it is more difficult for large companies to find well-trained and capable employees as quickly as they are needed when those companies are growing briskly.

The ability to obtain an optimum product mix also affects the performance of the earning assets. Finance companies that have more flexibility in changing their product mix tend to have lower NPLs.

As an example, when strong demand for used cars started to emerge, the finance companies that were able to pick up on this trend managed to maintain -- and in some cases even reduce -- their NPLs.

Going forward, the demand for used cars is expected to grow further. Also, it has been indicated that finance companies that have a higher proportion of automobile financing in their product mix are more likely to have lower NPLs, while, in contrast, finance companies that have a higher proportion of motorcycle financing may face more NPL problems.

This reflects the different characteristics of automobile and motorcycle customers: while automobile customers tend to have higher and more stable incomes, motorcycle customers, in contrast, are likely to have lower and less stable incomes.

Market segmentation also affects the performance of finance companies. Finance companies that target commercial customers tend to have lower NPLs. This is because the purchasing power of retail customers is more sensitive to higher rates of inflation.

Commercial customers, however, usually generate sufficient margins to cover increases in costs. This stems from the fact that most of the time they are able to pass on the higher costs to their customers.

At the same time, commercial customers also usually have a credit history that allows finance companies to analyze the creditworthiness of the potential customer. Since retail customers are more affected by rising inflation, they may have difficulties in making timely payments.

Moreover, collection is usually easier from commercial customers than retail customers. While commercial customers usually have a fixed address, retail customers in contrast have much greater mobility, thereby making it more difficult for finance companies to locate them and collect payments.

Thus, it is important for finance firms to implement a clear business model that is hard for competitors to replicate.

This shall determine the earning assets performance of the finance companies (including the NPL ratio). Even though the overall amount of NPLs of some finance companies has not increased significantly -- which means it is not a serious issue -- the companies should nonetheless pay more attention to their business models as well as implementing stricter procedures amid the current economic uncertainty.

The government also plays an important role in monitoring NPLs. To monitor the activities of finance companies, the government should require them to submit timely reports to the relevant authorities. This should improve transparency.

Currently, this regulation only applies to finance companies that are affiliated with banks. In this case, these finance companies are required to adopt "mirroring" reporting with the parent bank and to submit a report on a monthly basis to the central bank. Using this data, the central bank can monitor the activities of the bank, finance companies, as well as customers (i.e. the end users).

The system will provide information regarding the credit history of borrowers. This information can then be used to assess the creditworthiness of potential customers and to determine the legal lending limit.

In conclusion, even though the overall amount of NPLs in the finance industry is likely to have risen slightly recently, the growth is still at an acceptable level. However, looking forward, we believe that close monitoring of the level of NPLs is very important given the uncertain prospects for the economy.

As such, finance companies should review their business models carefully and adopt the one that has the best fit in consideration of their resources and the current economic conditions.

In addition, we also believe that it is vital for the government to push finance companies to report to the relevant authorities on a timely basis in order to support monitoring of the finance industry.

Erisa Habsjah Debt Analyst - PT Danareksa Sekuritas

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