INDONESIA'S CAPITAL MARKETS WEATHERING TURMOIL

UNCLAS SECTION 01 OF 02 JAKARTA 003138 SIPDIS SIPDIS DEPT FOR EAP/MTS AND EB/IFD/OMA TREASURY FOR IA-SSEARLS AND JWEEKS SINGAPORE FOR SBAKER TOKYO FOR MGREWE COMMERCE FOR 4430/BERLINGUETTE DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR TCURRAN DEPARTMENT PASS EXIM BANK E.O. 12598: N/A TAGS: EFIN EINV ECON PGOV ID SUBJECT: INDONESIA'S CAPITAL MARKETS WEATHERING TURMOIL ¶1. Summary. Dr. M. Chatib Basri, a well-respected macroeconomist, stated that Indonesia has weathered recent turmoil in global financial markets and is unlikely to face another significant financial crisis in the near term at a seminar on November 6. Bank Indonesia (BI) Senior Deputy Governor Miranda S. Goeltom underscored the need to deepen capital markets. Ministry of Finance (MOF) Fiscal Policy Agency Head Anggito Abimanyu noted that the Government of Indonesia (GOI) continues to strive to improve market monitoring and establish liquid, transparent, and orderly capital markets. The MOF remains concerned about potential spillover from the subprime mortgage crisis in the United States and high oil prices. Despite recent financial market turbulence, foreign investors have remained invested in Indonesian assets. Macroeconomic Outlook Strong, But Unemployment Persists -------------- ¶2. On November 6, the United States-Indonesia Society (USINDO) hosted a seminar on "Capital Market Development: What Does the Future Hold?" Prominent Indonesian policymakers and economists addressed and attended the forum. Dr. M. Chatib Basri, an advisor to the government, respected macro-economist and University of Indonesia faculty member, observed that Indonesia has weathered recent turmoil in global financial markets and is unlikely to face another significant financial crisis in the near term. Both the stock market and yield curve have returned to the levels witnessed prior to the onset of global credit market problems. The Indonesian banking sector remains strong, foreign exchange reserves are high and the country has low levels of short-term foreign currency debt. He also emphasized Indonesia's strong macroeconomic outlook. Basri believes that investment rates bottomed out in 2006 and will continue improve in the coming 12 months, albeit at a less than optimal pace. Supporting this view are strong capital goods imports, increased electricity use and an increase in value-added tax (VAT) revenues. ¶3. Dr. Basri noted that government statistics often underestimate the level of economic activity in Indonesia. Most small businesses prefer to avoid government officials in an effort to escape official graft and bureaucratic red tape. Basri also asserted that while domestic and international demand for Indonesian products is high, the economy suffers from significant supply side constraints, particularly in labor-intensive industries. As a result, manufacturing and other labor-intensive industries have not responded to lower interest rates and the open unemployment rate remains high. In order to remove these supply side constraints, the government needs to reform labor laws and to improve the investment climate. He also noted that investment climate reforms are necessary -- but not sufficient -- conditions to attract investment. Indonesian companies must also position themselves to become part of the supply network for global products, similar to India and Malaysia. Challenges Ahead for Bank Indonesia -------------- ¶4. BI Senior Deputy Governor Miranda S. Goeltom outlined the current challenges faced by monetary policy makers in Indonesia and underscored the need to deepen capital markets. Despite Indonesia's positive economic outlook, Miranda believes Indonesian policymakers, particularly central bankers, must move cautiously in light of the large amount of uncertainty surrounding global capital markets. The amount of losses and full market impact associated with the U.S. subprime mortgage debacle is still unknown. Miranda expressed concern that a downturn in the United States could have both primary and secondary effects on Indonesia, through direct trade and trade with other US trading partners such as China and India. Miranda also expressed concern about the effect of high oil prices on Indonesian inflation rates. Because Indonesia produces and imports oil, the impact of higher oil prices on the Indonesian economy remains difficult to forecast. ¶5. In Miranda's view, Indonesia needs to develop capital markets to smooth out potential volatility and channel funds more efficiently to the real sector. Indonesian domestic capital markets have the lowest level of market capitalization in the region with the JAKARTA 00003138 002 OF 002 exception of the Philippines. With relatively underdeveloped capital markets, Indonesia is more vulnerable to changes in market sentiment. In addition, without deep capital markets, Indonesia continues to rely on banks to finance most economic activity. Yet Indonesian banks have focused the bulk of their lending in the capital-intensive natural resource sector, creating few jobs in the process. She urged government policy makers to accelerate legal reforms and introduce incentives to initial public offerings and corporate bond issuance that would help spur growth in debt and equity instruments. She also commended the Ministry of Finance's (MOF) efforts to create a more complete yield curve in Indonesia through Treasury bill auctions. MOF Focused on Capital Market Deepening -------------- ¶6. MOF Fiscal Policy Agency Head Anggito Abimanyu, in a presentation entitled "Debt Financing and Deepening Capital Markets," described the GOI's efforts to improve market monitoring and establish liquid, transparent, and orderly capital markets. The MOF now uses Bloomberg-based system to monitor Indonesian financial market developments on a real time basis. The MOF can plot the impact of capital market developments on Indonesia's budget, including the effect on revenue, subsidies and the budget deficit. The system also assess overall economic conditions in Indonesia, issuing a warning sign to indicate whether the operating environment is normal (green),cautious (yellow),or poor (red). ¶7. On the fiscal policy side, Anggito highlighted the MOF's work to develop the T-bill market, which has allowed the GOI to expand its budget deficit and tap domestic financing sources, reducing the external component of the national debt. Anggito also noted that the government securities market is increasingly diverse, with a range of long-term and short-term instruments. The MOF has fully embraced a market-based, disciplined debt management strategy, communicating regularly with the market participants. Looking forward, the GOI also hopes to issue sharia bonds next year in an effort to take advantage of demand for GOI debt in the Middle East. The MOF is also preparing to reduce taxes for initial public offerings in an effort to boost equity market development. ¶8. Anggito noted that the MOF is closely monitoring the current instability in capital markets, and remains concerned about potential spillover from the subprime mortgage crisis in the United States and high oil prices. While recent global market instability has increased volatility of foreign capital markets, foreigner portfolio investors have not retreated significantly from Indonesian markets. HUME