INDONESIA SEESS ASSISTANCE WITH FINANCIAL SECTOR REFORMS

UNCLAS SECTION 01 OF 04 JAKARTA 002217

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SENSITVE

SIPDIS

DEPT FOR EAP/MTS, EAP/RSP AND EB/IF/OMA
TREASURY FOR IA-BAUKOL, OTA-MCDONALD
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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