Between 2014 and the first half of 2018, system loan growth hovered around 8-10 percent annually — not even half the average pace of 23 percent in 2010-2013. But we think this is about to change for the better.

Indonesia’s banking system differs from those in more developed countries in the sense that business loans make up 72 percent of overall system lending, with the remaining 28 percent coming from consumer loans. 

This fits with Indonesia’s status as an emerging economy, as more funding is required for business purposes than consumption. A similar loan mix can be found around the region in India, Thailand, and the Philippines.

The end of the global commodity supercycle in 2014 indirectly weighed on the economy, causing gross domestic product (GDP) growth to slow from between 6 and 6.5 percent to 5 percent. 

This kicked off a streak of moderate GDP growth at 4.8 to 5.1 percent in the following years.

The slowdown led to overcapacity in many industries. Smaller businesses had to scale back on capacity by closing factories and shops, reducing work hours, and even trimming headcounts. 

Bigger businesses may have been able to avoid closures and headcount reductions by absorbing the costs of idle capacity. Regardless, businesses of all sizes had one thing in common: they did not require loans. 

Our compilation of the balance sheets of all listed companies (except the financiers) shows that their combined capital expenditure growth was halved from 14 percent in 2013 to 7 percent in 2017. 

This suppressed business loan demand, causing system loan growth to slow from 21.6 percent in 2013 to between 8 and 10 percent in the past few years.

Is this 8 to 10 percent pace the new norm? That seems unlikely, judging by the dynamic of loan growth multiplier (a.k.a. loan growth elasticity, i.e. loan growth/nominal GDP growth). In 2010-2013, Indonesia’s loan growth multiplier stood out at an average of 1.9 times, but it dropped to an average of 1.1 times between 2014 and the first half of 2018. 

We believe this was driven by businesses scaling back capacity, but we do not think the change is permanent. We expect the new norm for Indonesia to be somewhere around 1.5 times, considering the nature of an emerging market with a relatively still attractive economic growth in the global context. 

We expect the loan growth multiplier to normalize and rise in the near term, driven by a few factors. 

First, after five years of consolidation, businesses should no longer have excess capacity. 

Second, GDP growth looks set to accelerate. Morgan Stanley economists expect GDP growth to improve to 5.3 percent in 2019 from 5.2 percent in 2018 and 5.1 percent in 2017.

Net interest margins still face headwinds from the tighter monetary stance globally and domestically.

Third, public confidence is improving on the back of the more stable social and political environment. 

We expect all three factors to encourage businesses to commit to investment decisions, leading to renewed loan demand.

Green shoots are appearing in system loan data, particularly working capital loan growth, which accelerated from 8.5 percent year-on-year in December 2017 to 13.7 percent year-on-year in November 2018. 

Similarly, investment loan growth accelerated from 4.8 percent year-on-year to 9.8 percent year-on-year in the same period. 

We expect more demand to come as businesses see a need for more capacity following reductions over the last five years. We forecast that system loan growth will accelerate to 13.8 percent in 2019 from 12 percent in 2018, assuming nominal GDP growth of 10.2 percent and a loan growth multiplier of 1.35 times. 

Another bit of good news is that the private sector has become more active on loan demand, judging by the loan book dynamic of major private banks such as Bank Central Asia. 

The return of private-sector loan demand should fire up the second engine in the system, adding thrust to the first engine, i.e. demand from the government and state-owned enterprises, which had been supporting system demand during the downcycle.

Despite the encouraging dynamics for loan growth, however, net interest margins still face headwinds from the tighter monetary stance globally and domestically in the second half of 2018. 

This could drive heightened competition for funding, given the already high system loan/deposit ratio of 93 percent. Overall, we expect the combined NIM to decline by around 10 basis points.

Nevertheless, we expect a net positive impact. We forecast that earnings growth for the major banks we cover will accelerate to 18 percent in 2019 from 10 percent in 2018, while return on equity will improve to 15.9 percent from 15.1 percent in 2018.

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The writer is Morgan Stanley’s head of Indonesia research.