INDONESIA SEESS ASSISTANCE WITH FINANCIAL SECTOR REFORMS

UNCLAS SECTION 01 OF 04 JAKARTA 002217 SIPDIS SENSITVE SIPDIS DEPT FOR EAP/MTS, EAP/RSP AND EB/IF/OMA TREASURY FOR IA-BAUKOL, OTA-MCDONALD SINGPORE FOR TREASURY-BAKER COMMERCE FOR 4430-BERLINUETTE DEPARTMENT PASS FEDERAL RESERVE SAN FRANCICO FOR TCURRAN DEPARTMENT PASS EXIM BANK E.O. 2598: N/A TAGS: EFIN IQNV ECON APEC PGOV ID SUBJECT: INDONESIA SEESS ASSISTANCE WITH FINANCIAL SECTOR REFORMS REF: JAKARTA 1693 ¶1. (SBU) Summary: Minister of Finane (MOF) Sri Mulyani Indrawati and other MOF offiiials greatly appreciate current technical assistn*ce from the U.S. and welcomed more during a visitbby Treasury Deputy Assistant Secretary for Asia Robert Dohner. Mulyani expressed concern about rei(onal financial integration initiatives, citing eeak cost-benefit analysis and lack of clarity abou the implementation process. Bank Indonesia (BI Senior Deputy Governor Miranda Goeltam told Dohner that BI was cautious about portfolio inflows, u t conducted only limited intervention to reducevvolatility in the foreign exchange market. Economs"ts expressed concern about slow infrastructure eevelopment limiting Indonesia's growth potential. End Summary. MoF's Ambitious Agenda for ReformQ Seeks Additional Assistance -------------- ¶2. (SBU) Treasury Deputy Assisa nt Secretary for Asia Robert Dohner visited Indnnesia July 16-17 to discuss various macroeconomic and financial sector issues, goals for the APEC Fia nce Ministers Meeting, and a Treasury-sponsoredAAPEC Capital Markets Technical Assistance proposl( with various officials at MOF and BI. Dohner aas accompanied by regional Financial Attache Susan Baker. In a meeting with Finance Minister Sri Muy(ani Indrawati on July 16, Dohner outlined Treasury's goals for the APEC Finance Ministers meeting and provided background on Treasury's proposed APEC Capital Markets Technical Assistance program. He noted that some governments have expressed concern about the program's resident advisor model. Based on Indonesia's good experience with Treasury advisors, Dohner requested GOI support for the program, and possibly its co-sponsorship. Minister Mulyani said Indonesia has a lot of problems. She would not hesitate to "shout for help" when she needed it and was not afraid to receive it. ¶3. (SBU) She mentioned several areas where technical assistance would be welcomed, specifically: tax policy (particularly taxes on securities),bond market deepening, evaluating regional financial integration initiatives, and internal institutional development at 
the MoF. Mulyani also mentioned her desire to develop a handbook for standard operating procedures on how to manage policy changes at the MOF (akin to a guide book she'd been given when she joined the IMF.) She wants to make sure that after she's gone, MOF remains the protector of the market and can articulate and defend an appropriate vision of the role of the state in the market. She also inquired about scholarships for MoF staff, and Dohner responded that those were more likely to be included in MCC or USAID programs. ¶4. (SBU) Mulyani was surprisingly upbeat on the role she was playing with respect to the Parliament. She repeatedly emphasized that it was vital to have a good dialogue with Parliament and educate them on issues of economic policy. Mulyani joked that she must be, "the only Finance Minister in the world with a Parliament that doesn't like to spend money." She expected tax issues (income and VAT) to be debated at the next session of parliament. Dohner noted that he had met with a group of Indonesian Commission XI (Budget and Finance) Parliamentarians in Washington DC on tax policy and administration, and they had asked serious questions. ¶5. (SBU) On regional financial sector initiatives, Mulyani noted the GOI has made several commitments in ASEAN-plus-3 (ASEAN plus Japan, China and Korea) for regional financial integration initiatives, but was concerned that "no one understands what we have actually agreed to." She is concerned that some parties were "dictating" to others and is not sure what the GOI is supposed to deliver in October at the next meeting. She said the GOI would need resources to meet commitments, but was unsure how it would work. She wanted to know if research would be joint, who would be setting the agenda and who would benefit. "The capacity of ministers varies from country to country," she noted. In separate meetings, MOF staff also raised concerns about their inability to properly evaluate proposed regional initiatives. Bank Indonesia's Many Goals: Inflation, Exchange Rates, Lending, Bond Markets -------------- --- JAKARTA 00002217 002 OF 004 ¶6. (SBU) Miranda Goeltom, Senior Deputy Governor at BI, noted that Indonesia's inflation targeting is improving. Although BI had been announcing its inflation target at the same time as the government budget since 1999, she said that, since 2005, BI has taken inflation targeting more seriously. Better surveys on inflation expectations made their efforts more effective. ¶7. (SBU) On exchange rate policy, Goeltam noted strong and volatile foreign exchange flows in 2006, and that they had done some intervention "from time to time." She tried to argue that while they had an undisclosed range of "comfortable" rupiah exchange rates, BI was not targeting a specific exchange rate level. She said BI might intervene for a week or two, but not as long as three months. BI wants to intervene both ways. She was "cautious" because most inflows were portfolio inflows. Goeltam noted that if China kept allowing currency to be undervalued, Indonesia would be affected, especially in commodities and manufacturing. However, they refrain from telling others what to do. All Indonesia can do is note how they are being affected. "China subsidizes almost everything," she noted. She said small movements by China were better than none. ¶8. (SBU) She said that one of BI's goals is more independence from the government. She thought BAPEPAM-LK, the capital markets regulator, needed to be more independent as well, so that it would hire better people and not be hampered by budget constraints at MoF. On bond market development, she noted the need to improve coordination capacity, and that the Asian Bond Fund was one way that BI had tried to "deepen the market." She emphasized that BI wanted a more active and liquid repo market so that it wouldn't have to use its own paper to absorb liquidity. She noted the incomplete government yield curve and lack of tax clarity as impediments to bond market deepening. ¶9. (SBU) On banking, Dohner asked if Goeltam was concerned that BI's recent weakening of standards on bank lending to spur investment would lead to problems. Goeltam tried to make the case that the policy change was not "forbearance" (especially for big borrowers or bad projects) and BI was not responding to political pressure. She asserted that bank lending in Indonesia has become generally more prudent and cautious. To encourage lending, bank loans below Rp 5 billion (about $550,000) are allowed to observe only one (timely repayment) of the three pillars for asset quality classification (cashflow capacity, prospects, timely repayment) generally used in international standards. She noted the need for more financial services for small-and-medium enterprises (SMEs) and micro-enterprises. She also noted that risk avoidance in the face of the anti-corruption movement had slowed down investment and led to large SBI holdings by local governments. Economists Outline Structural Problems Slowing Growth -------------- ¶10. (SBU) International financial institution economists (Asian Development Bank, World Bank and International Monetary Fund) and the Australian Embassy regional financial attache described concerns with Indonesia's economic policies. They noted that despite BI's concern about portfolio inflows, the central bank is allowing appreciation of the currency to take some of the pressure off money supply growth and inflation. Overall they expected the GOI to reach its growth target for 2006, but were concerned about 2007 due to several structural issues, including: -- Infrastructure: The GOI needs to develop a model project and provide clarity on issues with projects deemed "non-compliant," address land acquisition issues, and spend fiscal resources on infrastructure rather than waiting for private sector involvement. -- Lack of employment and poverty alleviation. Since 2001 the minimum wage has gone up 40-50%. Indonesia still needs to "catch up" from the 1997-98 financial crisis, but the 2003 labor law which revised severance pay rules raised costs significantly. This has meant less labor intensive growth, and employment growth has been in the service sector which is less pro-poor. Labor productivity has JAKARTA 00002217 003 OF 004 gone up some, but employment growth has been slow. -- Taxes: Tax reform is progressing but there are still several challenges such as the need for better tax administration; taxes on rice imports; and the institutionalization of tax policy and implementation including at the local level. Withholding taxes on securities has also complicated the development of a repo market. Tax treatment of securities, in general, is creating distortions and impeding capital market development. -- Decentralization: Regional governments are under-spending more due to process issues than policy. The World Bank economist argued that the GOI made a smart move in telling regional governments that they would lose some funding if they did not start spending their allocations. In some cases, regional and central governments are crowding each other out. The World Bank is doing some training for regional governments on developing projects. More Capital Markets Technical Assistance Requests -------------- ¶11. (SBU) At the Capital Markets Supervisor Agency BAPEPAM-LK, Chairman Fuad Rahmany welcomed the possibility of more Treasury Office of Technical Assistance (OTA) advisors in BAPEPAM. He seeks help evaluating various regional integration programs (giving the specific example of the proposal for a regional clearing and settlement institution) and whether they were beneficial (or not) for Indonesia. Rachmany also requires assistance developing bond markets, mutual fund regulation, market surveillance capacity, a bond pricing agency, and appropriate tax treatment on securities. ¶12. (SBU) Rachmany was keen to get resolution on tax treatment of several issues (repo markets, T-bills, securitizations, including ABS) to avoid double taxation different tax treatment between products. He thought that the new tax bill would take a year to finish, and they needed to resolve this sooner. In the meantime, he feared all the good listings would move to Singapore. Rachmany seemed to want to focus more on domestic developments, specifically focused on implementing the International Organization of Securities Commissions (IOSCO) Objectives and Principles for Securities Regulation. His staff supports undertaking a Report on the Observance of Standards and Codes (ROSC) in the area of securities regulation (perhaps in conjunction with a Financial Sector Assessment Program) as a way to prioritize the myriad of reforms he was interested in undertaking. ¶13. (SBU) Similarly, the Director General for Debt Management, Rahmat Waluyanto is a very enthusiastic supporter of Treasury's resident advisor, saying he is making a "great contribution" to their bond market. After the successful launch of the primary dealer network in March, Waluyanto said they are moving on to developing the T-bill market. This should improve the money market and support the corporate bond market by providing more benchmarks. Waluyanto also thought they needed to work on sharia-based debt markets, reduce external debt exposure (while keeping some presence in the international markets),and develop repo markets (requiring MoF, BAPEPAM-LK and BI to work together). He also noted the need for a concrete agenda on developing financial derivatives. ¶14. (SBU) Walyanto noted that in 2003, only 0.5% of their domestic debt was owned by foreigners, now it is 18%, mainly concentrated in medium and long-term bonds. He wanted to push the development of more diverse set of domestic institutional investors and was not happy that most government debt was held by banks. He thinks BAPEPAM needs to work more on pension and insurance reform so that these institutions would have better asset-liability matching, which would help the bond market develop. He noted that a better domestic investor base could help mitigate concerns about the high foreign portfolio capital flows and potential for abrupt reversals. Regarding regional initiatives, Waluyanto reiterated concerns about the Asia Bond Market Initiative and the need to define more clearly what the priorities are. He admitted that the Minister had been asking for more analysis on this issue. Waluyanto felt that Indonesia had to deepen its own debt markets first, before engaging regionally. JAKARTA 00002217 004 OF 004 MOF Generally Supports APEC Proposals -------------- ¶15. (SBU) At a meeting with Herwidayatmo, Senior Officer for the Office of the Secretary General and Head of APEC Team, Dohner emphasized that at the APEC Finance Ministers meeting on August 2-3, the USG would likely push for a strong statement on open trade, open investment, exchange rate flexibility, and preventing abuse of the financial system. Herwid noted that Indonesia tries to play a moderating role in the APEC discussions and values the consensus building process. Dohner spent most of the meeting with Herwid describing Treasury's APEC Capital Markets Technical Assistance proposal. He emphasized that the program was voluntary, and the services provided by the resident advisors would be confidential. He also showed appreciation for not duplicating regional efforts on capital market development, and emphasized the "bottom up" nature of the program. He noted that at the Spring World Bank/IMF meetings when Finance Minister Mulyani met with Treasury Deputy Secretary Robert Kimmit, she requested more assistance. ¶16. (SBU) Herwid agreed that everyone was extremely pleased with Treasury's current resident advisor working on government bond market development. Herwid inquired about internships with US regulators, noting their positive experiences working with the Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulatory Authority (APRA). Dohner noted that we could not provide it through this program, but would try through other channels. Herwid said that he would need some more time, but would not "mind to be a co-sponsor." Foreign Bankers' Association -------------- ¶17. (SBU) At a roundtable discussion with the Foreign Bankers' Association, Citi Indonesia's Country Director noted that there is still no word on the scope of the BI regulation limiting banks' ability to send back office task for processing offshore. However, Citi had "tested" BI's views by asking for approval of a service agreement in Manila. BI turned it down. He noted that BI may have the wrong idea that offshoring hurts Indonesian employment. Citi employs 4.6 Indonesians outside of Indonesia for every one expatriate worker it has inside of Indonesia. ¶18. (SBU) Citi also mentioned that foreign banks can apply to BI for an exemption to the five-year audit firm rotation requirement (reftel),and that visa applications for expat managers were being approved without problems. DAS Dohner noted in his comments that the U.S. was increasing assistance on public debt management in ASEAN, as well as improving tax administration. The USG also continues to press for openness to foreign investment abroad and reaffirmed its own open investment policy at home in President Bush's policy statement on May 9. Comment: Mulyani's Great Expectations -------------- ¶19. (SBU) Indonesia's technical assistance needs are great if the MoF staff is to meet Minister Mulyani's high expectations and achieve her ambitious policy goals. However, despite all the financial and fiscal reforms, the economy will remain hamstrung by remaining structural problems and an always challenging monetary policy situation -- areas outside the MOF's control. Her relentless commitment to institution building in the context of Indonesia's developing democracy is all the more impressive and worthy of support. End Comment. ¶20. (SBU) Regional Financial Attache Susan Baker contributed to and cleared on this report. HUME