BANK INDONESIA TO CONTINUE CAUTIOUS LOWERING

UNCLAS SECTION 01 OF 03 JAKARTA 007718

SIPDIS

SENSITIVE
SIPDIS

DEPT FOR EAP/MTS AND EB/IFD/OMA
TREASURY FOR IA-BAUKOL
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO

E.O. 12598: N/A
TAGS: EFIN EINV ECON PGOV PREL ID
SUBJECT: BANK INDONESIA TO CONTINUE CAUTIOUS LOWERING

REF: A) JAKARTA 7013, Early IMF Repayment;
B) JAKARTA 7340 Economic Highlights May


1. (SBU) Summary. Bank Indonesia (BI) Deputy Governor
Hartadi Sarwono told us on June 13 that BI remains confident
consumer price inflation will fall to less than seven
percent on a year-on-year (YoY) basis by the end of 2006,
leaving BI room to continue a "cautious lowering" of
interest rates over the next six months. He said BI has run
a series of foreign reserve simulations, and is comfortable
with its current reserve level of about USD 44 billion,
although the risk of renewed, rapid portfolio outflows
remains a concern. Despite the expected downward trend in
interest rates, Sarwono expressed concern about the
prospects for GDP growth in 2006--the Ministry of Finance,
BI, the International Monetary Fund (IMF) and others have
revised 2006 GDP growth estimates for Indonesia downward to
below 6 percent due to lower government spending and
investment. Like in other emerging economies, capital
markets have been volatile in Indonesia in recent weeks, but
Sarwono and the majority of our economic contacts believe
the country is in a solid macroeconomic position to weather
the current storm. End Summary.


2. (SBU) We met BI Deputy Governor Dr. Hartadi Sarwono on
June 13 to explore BI's thinking about the likely course of
Indonesia's monetary policy over the remainder of 2006.
Sarwono is a former Director for Economic Research and
Monetary Policy at BI and perhaps the top macroeconomist on
the BI board. Our contacts consistently place him among the
interest rates "hawks" on the BI board along with Senior
Deputy Governor Miranda Goeltom and Deputy Governor Bun
Bunan E. J. Hutapea. In contrast, BI watchers cite Deputy
Governors Maman H. Somantri and Aslim Tajuddin as the
leading proponents of a more accommodating monetary policy,
with frequent support from BI Governor Burhanuddin Abdullah.
BI sets monetary policy at monthly meetings of its Board of
Governors.

Interest Rate Lowering will Continue
--------------


3. (SBU) Sarwono made it clear that that BI believes
inflationary pressures are falling, and predicted that YoY
consumer price inflation would fall below eight percent by
October 2006 and to less than seven percent by year-end. He
said BI wants to keep real interest rates at about three
percent, which would give the bank scope to reduce its
benchmark BI rate to 11 percent by year's end. With rates
currently at 12.5 percent, Sarwono said he believes the most
likely interest rate scenario would be continued, cautious
lowering through the end of 2006, 25 basis points at a time.
However, Sarwono admitted this scenario depends on the
course of the U.S. federal funds rate. BI seeks to keep the
difference between the U.S. federal funds rate and the BI
rate at about six percent, so if the federal funds rates
rises much beyond current levels, it will leave less
maneuvering room for BI.


4. (SBU) While noting that BI does not directly target the
Rp/USD exchange rate, Sarwono said Indonesia enjoys a
comfortable stock of foreign exchange reserves (USD 44.2
billion as of May 31) that should permit it to accommodate
continued capital outflows without undue pressure on the
rupiah. BI has performed a series of simulations of reserve
scenarios, including one that sets short-term capital
outflows at twice the total year-to-date inflows. As a
result of the scenarios, Sarwono said BI is confident
Indonesia has sufficient reserves to cover 4-5 months of
imports and short term debt repayments. Nonetheless, he
acknowledged BI is concerned about renewed, rapid outflows
of portfolio capital if rates drop too quickly. He said the
stock of foreign-held BI certificates (SBIs) had dropped
sharply after the mid-May emerging market sell-off from Rp
22 trillion (USD 2.4 billion) to Rp 10 trillion (USD 1.1
billion). However, the broader government bond market and
stock market had fared much better during the recent
emerging market sell-off, Sarwono claimed, with a small, net
outflow from the former and two-way movement and profit

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sharing in the latter.

Concerns About Currency Volatility
--------------


5. (SBU) Sarwono confirmed that concerns about the possible
impact of a second, 25-basis point cut in rates on the
Rp/USD exchange rate led BI's Board of Governors to leave
rates unchanged at its June 6 meeting. He claimed part of
the rupiah's volatility can be traced to the character of
Indonesia's foreign exchange markets, which are very thin
(daily turnover of USD 300 - 350 million) and operate almost
exclusively on a spot basis. The thin spot market leads to
wide swings during the trading day, Sarwono said, which are
reported on Bloomberg and affect market psychology. Sarwono
said BI is working hard to develop swap and forward markets
to take some of the pressure off the spot market. (Note:
Some investors use a Singapore-based "non-deliverables
market" to manage volatility via swaps and options.) A
contact at the IMF office in Jakarta noted that intra-day
currency trading of the rupiah sometimes swings as much as
600 points against the dollar in a single day, making it
hard for businesses to plan.


6. (SBU) Investment bankers we spoke with confirm that most
of the money that wanted to leave Indonesia has already
left. "Yields are still attractive here...some who left are
waiting to come back in and buy bonds, expecting the
interest rate to drop," one noted. Another said, "Indonesia
is politically stable, has a balanced budget, a low deficit,
a trade surplus and a current account surplus. This is
attractive to many investors."

Concerns Mounting about Slow Growth
--------------


7. (SBU) BI's cautious plan for lowering short-term rates
has left Sarwono and other economists concerned about the
prospects of GDP growth in 2006. The Minister of Finance
announced on June 14 a growth estimate of 5.9 percent for
2006, revised downward from the budget assumption of 6.2
percent. For its part, the IMF revised downward its GDP
growth estimate for 2006 to 5.2 percent. Sarwono is
concerned that both central and regional government spending
remains much lower than expected (Ref B) and that
infrastructure investment and spending probably will not get
seriously underway until 2007. Regional governments
(provinces and districts) account for approximately one
third percent of total government spending, and there is
clear evidence of spending backlogs at the local level.
"The regions are sitting on Rp 28 trillion (USD 3 billion)
of SBIs," Sarwono told us, "which they should disburse via
social spending." However, Coordinating Minister for the
Economy Boediono told donors on June 14 that he is confident
government spending would pick up in the second half of

2006. The World Bank was also a bit more optimistic, noting
that the GOI traditionally backloads public spending, now
6.9 percent of GDP, which could rise to 20 percent by the
end of the year.

Capital Markets Volatile
--------------


8. (SBU) Indonesia's foreign exchange, stock, and government
bond markets have remained volatile over the past week.
However, our contacts in the financial markets believe the
volatility is part of a global trend rather than an
Indonesia-specific one. "Money is moving around the world
very quickly," one trader told us. "The amount of money
investing globally has grown dramatically in the last 18
months, but investors view Indonesia as more politically and
macro-economically stable than other emerging markets, so
will sell Indonesia last." Another investment banker
agreed, "there is a mountain of liquidity in every country
looking for high returns, and Indonesia offers attractive
rates."

Comment
--------------

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9. (SBU) Indonesia seems well positioned to weather the
current wave of emerging markets volatility. It has a small
budget deficit, declining inflation, a comfortable reserve
level, and a very highly regarded team of economic
ministers. Our contacts also express optimism about BI's
ability to manage the delicate move to lower interest rates
in a climate of emerging market volatility and declining
risk appetites among many investors. A more difficult
challenge will be finding ways to boost growth given the
very slow progress on government spending and investment
climate reforms. BI Governor Abdullah has already
speculated to the press about accelerating the move to lower
interest rates, and we expect continued pressure on BI to
find a way contribute to higher growth levels.

AMSELEM