Indonesia: East Java Banks' Conservatism Causing

UNCLAS SECTION 01 OF 05 JAKARTA 006120

SIPDIS

FROM AMCONSUL SURABAYA 1303

DEPT FOR EAP/MTS AND EB/IFD/OMA
TREASURY FOR IA-JEWELL
COMMERCE FOR 4430-GOLIKE
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: EFIN EINV ECON PGOV ID
SUBJECT: Indonesia: East Java Banks' Conservatism Causing
Credit Contraction

Ref: A. Jakarta 1833 - Banking Sector Update


B. Jakarta 3244 - Sharia Banking


1. (SBU) SUMMARY: East Java accounts for 15 percent of
Indonesia's GDP, 20 percent of total population and is an
important industrial and manufacturing center in Indonesia.
Credit contraction, increasing non-performing loans (NPLs)
and declining inflation, implying demand reductions, are
slowing the local economy and causing concern for East Java
Banking officials. Credit contraction is counter to the
Bank Indonesia's national credit expansion objectives for
2006 in support of its 5.0 to 5.7 percent national growth
goals. Bank of Indonesia Surabaya (BIS) officials are
pressuring local bankers to ease credit and grow loan
portfolios faster. Risk-adverse East Java headquartered
banks are committed to maintaining credit discipline even
though loanable funds are expanding due to increasing
deposits. Rural credit banks are reeling from the slowing
economy and increased competition. Higher interest rates
have also slowed growth in East Java sharia banking. BIS
seems to exert little influence on local bank lending
behavior and practices. East Java bankers believe that the
recent 25 basis point reduction in Bank Indonesia base rate
will have little or no impact on stimulating the economy.
If East Java bank behavior is indicative of the rest of
Indonesian banks; Bank Indonesia will need to look at other
tools, like further base interest rate reductions, to
stimulate growth. END SUMMARY.

East Java Credit Crunch
--------------


2. (SBU) In an April 21 meeting with ConGen Surabaya
Econoff Williams, Bank Indonesia - Surabaya Branch Office
(BIS) officials initially asserted that as of February
2006, credit in East Java was growing at 23 percent per
annum and loan growth was on track to meet 2006
expectations. After reanalyzing their own closely held
monthly statistics, they discovered that total credit held
by all banks in East Java had actually contracted by 2.5
percent over the first two months of 2006 (15 percent
annualized). Officials were also worried that banks
headquartered in East Java had reduced loan portfolios by
3.6 percent (21.6 percent annualized) over the same period.
(Note: Total credit grew in East Java by over 27 percent
during 2005. End Note.) Credit contraction is counter to
the Bank Indonesia's (BI) national stated objective of 20
percent credit expansion for 2006 in support of its 5.0 to
5.7 percent national growth projections. BIS officials
stated earlier this year that they had made "suggestions"
to local banks that 20 percent credit growth was the magic
number, and they had expected that level of loan growth or
greater from the East Java banks. BIS officials said they
would be having "additional discussions" with East Java
banks regarding local loan growth performance, implying
they will pressure local banks to ease credit.

NPLs on the Rise
--------------


3. (SBU) BIS also noted that NPLs for all banks in East
Java increased by 16.4 percent (from 5.5 to 6.4 percent)
during the first two months of 2006. NPLs for East Java
headquartered banks grew by 25 percent (from a very low 1.0
percent to 1.25 percent) at the end of February. According
to Bambang Pramasudi, Deputy Head of Bank Supervision at
BIS, East Java bankers are complaining of a worsening
economy. Durable goods sales continue to decline due to
higher interest rates and lower disposable incomes
following fuel price increases in October 2005. Pramasudi
was surprised that the East Java economy is not responding
to positive macroeconomic indicators. "Interest rates are
stable, inflation is low, the rupiah is strong and the
stock market is up. But business in East Java is still

JAKARTA 00006120 002 OF 005


slowing and even some good customers are paying slowly now.
The slowdown seems to be impacting all levels of the
economy here", Pramasudi commented. (Note: Two ConGen
contacts recently reported closing furniture factories
making export goods in East Java, laying off hundreds of
employees, due to unavailability of local raw materials and
the recent strengthening of the rupiah wiping out profit
margins.) Following national trends, inflation in East
Java declined from an annualized rate of 18.72 percent in
January 2006 to 4.32 percent annualized in March 2006,
reflecting reported decreases in regional demand. While
the credit contraction itself is enough to cause concern,
BIS officials' lack of awareness of provincial economic
trends is worrisome at a time when the private sector is
pessimistic about local economic performance.

Background on East Java Banking
--------------


4. (SBU) East Java is considered an economic engine for
Indonesia with almost 20 percent of the total population
and a high concentration of Indonesia's heavy industry.
According to a recent Bank Indonesia internal report, all
East Java banks hold 11 percent of all bank loans and 13
percent of total assets in Indonesian banks. In addition
to the Jakarta-based national banks with branches in East
Java, there are approximately 370 banks of varying sizes
headquartered in East Java. BIS is responsible for
regulating all banks headquartered in East Java, as well as
those in Bali, West Nusa Tenggara and East Nusa Tenggara
provinces.

Surabaya Commercial Banks A Tight Bunch
--------------


5. (SBU) Nine of the approximately 370 East Java-based
banks are, or will be, large enough with capitalization
over USD 9 million to be considered core commercial banks
(CCBs) under the Indonesian Banking Architecture law (API)
i.e. with capitalization over IDR 80 billion (USD 9
million). The remainder are small, privately owned, rural
credit banks (BPRs) with capitalization under IDR 10
billion (USD 1.15 million). Under the API, banks with
capitalization between IDR 10 billion and 80 billion (USD
1.15 - 9 million) are targeted to be closed or merged with
larger banks by the end of 2007. Five of the nine Surabaya
based CCBs are currently capitalized under the IDR 80
billion minimum. All five banks have submitted plans to
increase their capital above the minimum requirement before
the year end 2007 deadline.


6. (SBU) Local ethnic Chinese Indonesian business families
own all nine of Surabaya's CCBs. By far the largest of
East Java based CCBs is Bank Maspion, controlled by Alim
Markus, President and Managing Director of the Maspion
Group, Indonesia's largest domestic houseware manufacturer.
Bank Maspion has total assets of approximately IDR 1.75
trillion (USD 200 million),NPLs under 2 percent and
services primarily small and medium sized businesses. "We
have been taking a wait and see attitude on the economy,
and business conditions have been weak," Herman Halim,
President of Bank Maspion and the East Java chapter of the
Private Banking Association (Perbanas) said. "However,
unlike the first quarter, we are seeing increased business
activity in April. There is a sign of light," he added.
Halim still does not foresee significant increases in
credit this year, adding, "We are having a hard time
finding good customers and plan to maintain our strict
underwriting standards." Halim feels pressure for credit
growth from BIS but commented ruefully, "I would feel a lot
more pressure from my bosses if the bank's performance
drops."


7. (SBU) According to Abdul Mongid, head of research at the

JAKARTA 00006120 003 OF 005


Pembanas Institute in Surabaya (which trains many of the
tellers and junior bankers entering East Java Banks),the
owners of the nine Surabaya based CCBs are close friends
and rarely compete directly with one another for customers.
"Their account officers move up and down value chains to
find new business. They do business with their existing
customers' suppliers and customers. They do not work with
walk-in customers not referred by existing customers,"
stated Mongid. Mongid thought that the owners of the
undercapitalized banks would all inject equity into their
banks to avoid a forced merger, because owning a bank is a
status symbol in the business community.


8. (SBU) East Java bank owners mention liquidity management
and the ability to move money around as reasons for bank
ownership. A director of the Surabaya-based Wings Group,
the largest domestic manufacturer of soap products and
owner of Bank Ekonomi (a Jakarta-based bank),disagreed
with Mongid that status was a primary motivation for bank
owners. He explained, "We keep our bank as a liquidity
management vehicle. We deposit our profits in the bank,
which can then be lent or invested domestically or
internationally. We are not concerned that the bank be
terribly profitable, only that is does not lose money." He
explained the importance to ethnic Chinese East Javanese of
maintaining liquidity andd fleibility with their investable
fund s as a hedge aainst local instability. Andry Wijaya,
Director f Bank ANK, (a Surabaya-based bank currently
undr the minimum capital requirement) noted that, "Wefeel
no pressure to grow and we will wire funds in whatever
amount BIS requires to stay independent before the
deadline." Surabaya banks remain very liquid, ending 2005
with a very conservative 52.8 percent loan-to-deposit (LDR)
ratio, which further reduced to 46.2 percent at the end of
March 2006. The high interest rates are attracting
deposits into local banks faster than they can make prudent
loans, according to Widjaya.

East Java's Largest Bank Taking Things Slow
--------------


9. (SBU) The head of Bank Jatim has his own thoughts on
credit growth and does not feel compelled to bend to the
wishes of Bank of Indonesia - Surabaya (BIS). Bank Jatim
(short for Java Timur or East Java),headquartered in
Surabaya, is the largest East Java-based bank. The East
Java Provincial Government and each of the province's 39
city and regency governments own Bank Jatim in partnership.
The Bank's primary mission is economic development in East
Java. All funds distributed by the central government to
East Java government entities flow through Bank Jatim, and
all provincial, regency and city employee salary payments
are made to Bank Jatim accounts. According to Bank Jatim
Managing Director Agus Sulaksono, the bank makes a variety
of types of loans but specializes in construction lending
to contractors building government projects such as roads
or schools. They also carry a large portfolio of small and
medium enterprise (SME) loans, generally structured and
revolving lines of credit secured by real estate, with
loan-to-value ratios generally under 70 percent. Bank
Jatim is also a primary small agriculture lender in the
province and a large purchaser of development loan
syndications from other provincial development banks. The
bank charges interest rates of 12 to 18 percent per annum
on its business loans, significantly less than competing
private institutions. Bank Jatim is notoriously
conservative with its underwriting, reserving its
inexpensive, government-subsidized loan funds for only the
safest lending opportunities. This is reflected in its
1.25 percent NPL ratio, well below the national average of
8.9 percent at year-end 2005.


10. (SBU) As Sulaksono noted about his bank's reputation
for risk aversion, "Why should I take any risk? I must now

JAKARTA 00006120 004 OF 005


personally guarantee all of the deposits in this bank to
the Indonesian Deposit Insurance Company (LPS) and I retire
in two years. We play it straight here, unlike some other
banks. So I do not have large foreign bank accounts to
fall back on like some of my counterparts (at other
government-owned banks). I can not afford to risk my
retirement by making imprudent loans." From his analysis
of credit card receipts from business banking customers and
increasing NPLs, Sulaksono sees the East Java economy
slowing. He projects Bank Jatim NPLs will increase to 3 to
4 percent this year. He feels 5 to 10 percent loan growth
at Bank Jatim in 2006 would be aggressive by the bank's
standards, and seemed comfortable dismissing BIS efforts to
push for higher loan growth. Sulaksono noted that the
goals set for Bank Jatim by its local government owners for
safety and profitability were his primary decision-making
factor, not BIS policies.

Small Banks Facing Increased Competition
--------------


11. (SBU) There are roughly 360 small, privately owned
rural credit banks (BPRs) in East Java, most located
outside of Surabaya in small cities and villages. BIS
regulates all BPRs in East Java. BPRs hold 2.7 percent of
East Java bank loans and, according to 2005 BIS statistics,
provided approximately 25 percent of all micro credit loans
in the province, making BPRs an important source of seed
capital for new business development. BPRs focus on micro-
business lending as well as micro-agricultural lending,
using a collateralized fixed rate term loan product.
Interest rates range from 36 to 42 percent per annum.
Pompong Setiadi, head of the East Java BPR Association said
the big competitive advantage BPRs have over Bank Rakyat
Indonesia (BRI),a large national bank with extensive
branching, or Bank Jatim in East Java is underwriting
flexibility and the ability to respond quickly to loan
requests. BPRs can grow with their customers more
effectively than BRI but tend to avoid management-intensive
loan products like revolving lines of credit because they
lack trained commercial lenders. BPRs are forced to charge
higher interest rates to borrowers due to high overhead
costs, averaging 7 to 12 percent of total assets per annum,
and generally higher credit losses. The higher rate
structure and high leverage (110 percent average LDR) of
BPRs make them particularly susceptible to new, better
capitalized and managed competitors, such as Bank Danamon
Simpan Pinjam (Bank Danamon). Bank Danamon is expanding
rapidly in East Java opening hundreds of marketplace based
micro-branches in the province, directly competing with
BPRs (Ref A). Bank Danamon offers lower interest rates,
better service and a greater ability to use non-traditional
collateral to secure its micro loans.

Small Rural Banks Feeling the Pinch
--------------


12. (SBU) The quick rise of Bank Danamon and the emergence
of non-regulated thrifts in East Java is having a direct
and immediate negative impact on East Java BPRs ability to
retain good customers and experienced lenders. Setiadi
from the BPR Association admitted that the growth of Bank
Danamon has hurt BPR business prospects. "Our interest
margins are shrinking due to the increased competition, the
loss of experienced lenders is a problem and some of our
weaker members will not survive", he said. In January
2006, BIS announced that no new BPR licenses would be
issued in East Java; the instruction ran counter to Bank
Indonesia's strategy of increasing the number of BPRs
nationally. BIS privately disclosed that East Java BPRs
are experiencing significant growth in NPLs, increasing
over 20 percent to 8.3 percent during the first two months
of 2006. According to BIS, dozens of East Java BPRs are
experiencing NPL ratios over 15 percent and total deposits

JAKARTA 00006120 005 OF 005


in East Java BPRs also shrank by over 7 percent during
2005, reflecting depositor's perception of increasing risk
at these institutions. Pramasudi said that BIS is getting
pressure from Bank Indonesia in Jakarta to reevaluate the
freeze on BPR licenses and the policy may be reversed soon.


13. (SBU) BIS bank examiners are very concerned with the
deteriorating condition of the BPRs, and complained that
this issue is currently taking up much of their time.
Pramasudi claimed that BIS is setting up work out plans for
their cooperative troubled banks and closing the
uncooperative ones. Year to date, five BPRs have closed in
East Java; Pramasudi declined to speculate on the number of
additional closures this year or the closures' impact on
overall banking service in the province.

East Java Sharia Banking
--------------


14. (SBU) According to BIS statistics, sharia banking in
East Java (Ref B) is still in its infancy. During 2003,
2004 and the first quarter of 2005, East Java sharia banks
and SBUs showed strong deposit and loan growth, taking
market share from conventional banks. East Java sharia
deposits grew from less than a 0.3 percent market share at
the end of 2003 to 0.7 percent at year-end 2004 and 0.9
percent in March 2005. The increasing interest rates in
2005 rates flattened the growth in East Java sharia
deposits, which ended 2005 at the same 0.9 percent market
share with a 26 percent jump in new deposits during the
last few days of the year. BIS was unable to explain the
source of the year-end burst of sharia deposit activity.
LDRs for East Java sharia banks remain very high at an
average 95 percent. Most assets are concentrated in
collateralized fixed payment loans to consumers. To date,
sharia banks and sharia banking units in East Java have
demonstrated a greater ability to attract and retain
borrowing clients than depositors.

Conclusion
--------------


15. (SBU) Both corporate and banking contacts have
expressed concern with local economic prospects. Credit
contraction signals BIS's inability to force credit growth
in the province through persuasive means. East Java
bankers seem content to stay liquid, observing economic
trends and resisting pressure to rapidly expand loan
portfolios. These conservative East Java bankers seem
unlikely to be persuaded by further Bank Indonesia pressure
to ease underwriting standards and grow credit if they feel
it will risk the integrity of their balance sheets. The
recent 25 basis point reduction in Bank Indonesia base rate
will have little or no impact on stimulating the economy,
according to local bankers who called for larger rate
decreases to avoid further economic slowing. If East Java
bank behavior is indicative of the rest of Indonesian
banks; Bank Indonesia will need to look at other tools,
like further base interest rate reductions, to stimulate
growth.

PASCOE