INDONESIA'S ECONOMY - RIGHT DIRECTION, WRONG SPEED

UNCLAS SECTION 01 OF 05 JAKARTA 011767

SIPDIS

SIPDIS
SENSITIVE

DEPT FOR EAP/MTS AND EB/IFD/OMA
TREASURY FOR IA-SETH SEARLS
COMMERCE FOR 4430/GOLIKE
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR FINEMAN
DEPARTMENT PASS EXIM BANK

E.O. 12598: N/A
TAGS: EFIN EINV ECON PGOV KCOR ID
SUBJECT: INDONESIA'S ECONOMY - RIGHT DIRECTION, WRONG SPEED
- VISIT OF TREASURY OFFICIALS BAUKOL AND SEARLS

Ref: A) Jakarta 5704 (Labor); B) Jakarta 10539 (Newmont);

C) Jakarta 11110 (Mudflow); D) Jakarta 9864 (Biofuels);
E) Jakarta 9336 (Infrastructure); F) Jakarta 1833 (Banking
Sector)


1. Summary. Private sector and Government of Indonesia
(GOI) interlocutors expressed optimism about the financial
sector's growth and progress, but concern about the real
sector, during the September 13-15 visit of Department of
Treasury officials Andrew Baukol and Seth Searls. Most
agreed Indonesia's economy needs more growth and investment
and that GOI spending is slow in part due to inefficient
local spending and fears by project managers that they may
face corruption charges. The investment climate remains
very challenging for western firms, so Indonesia will
probably be a market mainly for Asian investors for a long
time. In this environment, capital markets, rather than
long-term investment, are receiving the bulk of overseas
investor interest. Infrastructure development is still
lagging, but the Asian Development Bank (ADB) is helping the
GOI develop a few credible infrastructure projects for
tender in time for a November 1-3 infrastructure conference
in Jakarta. The rest of the banking sector is growing and
relatively healthy. A new GOI regulation on the
restructuring of non-performing loans (NPLs) may help Bank
Mandiri and BNI, the two largest state-owned banks, clean up
their balance books. Bank Indonesia (BI) Senior Deputy
Governor Miranda Goeltum said she worries that recent strong
capital market inflows are a sign that expectations are a
bit too high, but others in the private sector view this
dynamism as a positive sign. End Summary.

Macroeconomy - Good but Could Be Better
--------------


2. (SBU) During three days of meetings with GOI officials
and private sector contacts September 13-15, visiting
Department of Treasury officials Andrew Baukol and Seth
Searls heard that Indonesia's macro-economy is stable but
needs stronger growth. A prominent expat consultant noted
that his most recent presentation on Indonesia's economy and
investment climate is called, "Right Direction, Wrong
Speed." Investment bankers we spoke with agreed that
Indonesia has a good economic team and reasonable growth,
but needs more and that longer-term foreign direct
investment (FDI) is not coming in fast enough. A ratings
agency representative sounded a similar theme, telling us
that he would like to see Indonesia have more exports,
investment and a more stable currency. Senior Bank
Indonesia (BI) Deputy Governor Miranda Goeltum also agreed
with this conclusion, stating that Indonesia has made great
progress compared with the past, but that it is still
lagging behind in the region. One positive aspect is that
inflationary pressures have been more subdued than in
previous episodes when the GOI raised administered prices.
Consumers reacted calmly, and the October 2005 fuel price
hikes did not cause excessive increases in the prices of
other staples or lead to the stockpiling of goods. Thus BI
was abe to bring inflation expectations down in six monts.
Goeltum said she expects inflation will fall t 6.5% on a
year-on-year basis by the end of the ear.

Anti-Corruption Efforts Slow GOI Spending
--------------


3. (BU) Several contacts told us that GOI spending is low
because project leaders responsible for impleenting
projects at the sub-national level are afaid to do their
jobs for fear of corruption accuations. One Indonesian

economist and advisor tothe GOI told us that many project
managers have esigned, and those remaining are not spending
themoney. One private sector contact suggested that he
incentives need to be changed, perhaps by offring a
transparent bonus" for good project implemntation. Other
observers note that provincial gvernments simply lack a
clear mandate as well as apacity to budget and monitor
spending. Severaldonors, including USAID and the World

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Bank, are helping Indonesia with local government capacity
building.

Investment Climate - FDI Needed
--------------


4. (SBU) One prominent expat consultant noted that Indonesia
still has a "socialist ethos" which is suspicious of foreign
direct investment (FDI). In a climate which requires
significant incentives to compete regionally, this system
remains an impediment to Indonesia's competitiveness. The
international business chambers and the Indonesian Chamber
of Commerce and Industry (KADIN) are quite frustrated that
President Susilo Bambang Yudhoyono (SBY) has not been able
to deliver on promises to improve the investment climate.
The consultant noted that given all the investment climate
challenges here, Indonesia will probably remain a
destination for mainly Asian investors for a long time.
Inflexible labor regulations are stifling investment, and
planned GOI changes to the labor law have been held up for
some time. Our consultant contact opined that, "If labor
reform doesn't happen soon, it won't happen." The window is
closing for progress since the elections in 2009 will play
an increasingly complicating role. The investment law has
been in Parliament since late March and may pass by early

2007.


5. (SBU) BI officials told us another constraint on
investment is poor infrastructure: companies do not have any
certainty that what they need to be successful will be
available or reliable, including roads, water, electricity,
human capital, and property rights. Dr. M. Chatib Basri,
Director of the Institute of Economic and Social Research
concurred, noting that while many analysts have focused on
inflexible hiring and firing practices, logistics represent
14% of production costs while labor is only 7%. Factors
that raise costs include inefficient roads, "irregular"
trucking and customs fees, and congested ports. On the
positive side, tax reforms are beginning to produce results.
In special tax offices set up for medium-sized companies,
VAT collection is up 80% as a result of new information
technology systems. Customs reform, however, remains
sluggish.


6. (SBU) Several international business contacts noted the
dramatic contrast between the Environment Ministry's harsh
handling of the international mining company Newmont in the
Buyat Base case and the lenient treatment afforded the
Indonesian firm Lapindo in the Sidoarjo mudflow disaster.
The Environment Ministry initially condemned the company,
but backed off a few days later, a fact likely due to
Lapindo's connection with Coordinating Minister for Peoples'
Welfare Aburizal Bakrie. The Environment Minister has even
made public comments downplaying the environmental and
health effects of the mud and its noxious, sulfurous gases,
and no one involved has yet been charged with any crime.
One expat consultant remarked, "I'm surprised the
international media has not publicized this story. It's a
huge environmental disaster."

Infrastructure - Credible Projects by November?
-------------- --


7. (SBU) Several contacts noted Indonesia has had difficulty
in reviving its real sector. BI officials told us that many
of the large Indonesian companies that could be players in
infrastructure development have a corrupt history and are
therefore unappealing to potential foreign partners. In
order to move forward, Indonesia needs to establish a good
model for public-private partnerships. ADB officials, who
have been advising the GOI on infrastructure issues, said
the ADB and GOI are selecting a short list of 6-8 projects,
and hoped to have 2-3 ready for a credible tender by the
November 1-3 Infrastructure Conference November 1-3 (Ref E).
Another ADB official said that, "If Indonesia can showcase
even one, non-corrupt, bankable, credibly implemented
infrastructure tender and project, it will make a huge

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positive impact." ADB officials also said that the debate
about corruption in Jakarta's monorail project is "exactly
what is supposed to happen. Expectations are higher for
greater transparency now."

Biofuels - Right Goals, Wrong Concept?
--------------


8. (SBU) Dr. M. Chatib Basri, Director of the Institute of
Economic and Social Research and informal economic advisor
to SBY, gave us some insight into the thinking behind SBY's
biofuel initiative (reftel D). Basri said that the
President specifically had Roosevelt's "New Deal" in mind
and asked Basri to find him a good book about it. The
President has been growing impatient with the lack of
progress on reducing unemployment. He has in mind three
initiatives to generate new jobs, especially to achieve
results before the 2009 election.

- a "cash for work" program for the unemployed;
- better facilitation of overseas worker remittances;
- a biofuel initiative to generate 3.5 million jobs.


9. (SBU) However, Basri said he was concerned about
underlying economics of SBY's biofuel initiative since Crude
Palm Oil (CPO) production requires a huge amount of land and
too much lead time to get results quickly. Land issues in
Indonesia are always very difficult because a patchwork of
different property rights and land use practices, laws and
regulations prevail in different areas. The plantation
sector is "hot" right now, Basri noted, and prices of some
good land have already inflated to US $6,000 per hectare.
Political parties are already interfering. An international
investment bank also noted that CPO, the primary ingredient
in the biodiesel, costs Rp 3,500 (US $0.40) per kilogram to
purchase and Rp 1,500 (US $0.17) to process into biofuel.
By comparison, subsidized diesel fuel sells for Rp
4,300/liter (US$ 0.45).


10. (SBU) Basri added that with state-owned energy company
Pertamina serving as the sole buyer, it is not clear how the
program can be profitable. As a job creation program, the
biofuel initiative will probably not be either effective or
sustainable. Basri said he is recommending that a cash-for-
work program would bring better results. He suggests that a
rural infrastructure development program - already part of
the GOI's priorities - would achieve both goals of creating
jobs and improving rural economies.

Policy Packages - Getting Results?
--------------


11. (SBU) We asked our contacts what they thought about the
new financial sector reform package. An international
economist noted that part of the reason for these packages
is to impose a "new form of coordination" on the ministries.
Coordinating Minister Boediono, for example, has 16 line
ministries under him from Finance to Fisheries headed by
Ministers from several different political parties. The
packages, with responsible ministries and deadlines clearly
stated, create some measure of discipline. Currently, it is
difficult to get ministries to do what they are not already
planning to do themselves, the economist commented.


12. (SBU) The new package also addresses the non-bank
financial sector. Some of Indonesia's small domestic
insurers are in poor financial condition and the insurance
sector has not been closely regulated in the past. However,
on August 31, the Financial Institution and Capital Markets
Supervisory Board (BAPEPAM-LK) BAPEPAM-LK issued a decree on
insolvent insurance companies. The decree outlines the
government's strategy for managing insolvent insurance and
reinsurance companies. Our Coordinating Ministry contact
said the Directorate of Insurance under MOF is already
looking at the books of many small insurance companies.
They will not become efficient on their own, our contact
noted, "we must force them to grow up." Insolvent companies

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will have to restructure or close.

Banking Sector - Healthy Except
Those Big State-Owned Banks
--------------


13. (SBU) Private bankers told us that last year's fuel
price hikes and subsequent inflation are still hurting the
buying power of consumers. Consumers were hit three times,
one banker noted, with fuel prices going up, prices for
staples rising in response, and interest rates increasing as
well for consumer loans. Car and motorcycle sales are
beginning to creep up again, he noted, but mortgages remain
soft. The overall non-performing loan ratio is about 8% but
without state-owned banks Mandiri and BNI it would only be
4.8% (Ref F). A private commercial banker told us that it
is relatively easy for private banks to restructure bad
loans, but state-owned banks have strict rules and limited
options. Under current regulations, state-owned banks must
obtain approval from the Minister of Finance before taking a
haircut on loans up to US $1 million. For loans up to US
$10 million, banks must get the approval of both the
Minister of Finance and the President, and for loans above
this amount Parliament must approve as well. By relaxing
these rules a new Presidential Instruction under the
financial sector package should help the state-owned banks
clean up their books.


14. (SBU) Private commercial bankers at large domestic banks
told us that their business is expanding. Representatives
from two large private banks, Bank Central Asia (BCA) and
Bank Danamon, said they continue to expand their business
and the number of branches. BCA has 773 branches: it added
29 new ones in 2005 and will add another 27 by the end of

2006. Bank Danamon said that a recent banking services
demographics study showed that the 60,000 wealthiest
households in Indonesia keep most of their assets overseas.
Most banks focus on the next wealthiest sector of the market
consisting of about 6 million households: they try to sell
them car loans, credit cards, mortgages, etc. and this
segment has become very competitive. However, the largest
(by population) sector of the market consists of 50 million
households largely categorized as "self-employed mass
market." Bank BRI, a state-owned bank and one of the
largest micro-lenders in the world, services about 30% of
this market. Danamon has also been setting up small
marketplace branches to offer four simple loan products and
four simple savings products to this sector and has been
very successful. It opened its first small "marketplace"
branch in July 2004 and now has over 800.


15. (U) BI officials told us that its new credit bureau is
working fairly well. Due to a lack of unique identifier
however, three parameters were required to search a
borrower: name, address and date of birth. BI has been
discussing a unique taxpayer identification number with the
GOI.

Capital Markets Growing
--------------


16. (SBU) Capital markets are receiving the bulk of overseas
investor interest in Indonesia. The Ministry of Finance
noted that foreign ownership of rupiah-denominated bonds has
more than doubled from 6% of total in September 2005 to 14%
in August 2006. The main owners of domestic bonds, however,
remain domestic banks at 55%. Indonesia is still designing
a primary dealers market for GOI bonds. It is not yet clear
if or when the GOI would offer Treasury bills with shorter
maturities since "these could present another challenge for
debt management," MOF officials told us.


17. (SBU) The Jakarta Stock Exchange (JSX) has also received
a great deal of investment from overseas and domestic
buyers. However, the JSX is still relatively thin, with
only 336 listed companies valued at about US $88 billion.
As a result, large portfolio flows from overseas can create

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big swings. The Jakarta Composite Index (JCI) has risen
from 750 in mid-2004 (before President SBY was elected) to
over 1,400 in August 2006. Senior BI Deputy Governor
Miranda Goeltum said she worries that these historic highs
could mean a bubble. "The markets may be expecting more
than we can fulfill," she noted. So much foreign exchange
is coming into the capital markets that BI has to sterilize
some of the inflows to smooth out the appreciation of the
currency. "If the rupiah gets too strong, exporters can't
compete," she said. Others in the private sector were
encouraged by the dynamism in the capital markets, "We will
have a very interesting couple of years ahead of us in
Indonesia," one analyst told us.

HEFFERN