INDONESIAN CURRENCY, MARKETS DROP ON MARKET TURMOIL

UNCLAS SECTION 01 OF 02 JAKARTA 001755

SIPDIS
SENSITIVE

DEPT FOR EAP/MTS AND EB/IFD/OMA
TREASURY FOR IA/MALACHY NUGENT
COMMERCE FOR 4430/KELLY
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR CURRAN
DEPARTMENT PASS EXIM BANK
SINGAPORE FOR SBAKER
TOKYO FOR MGREWE
USDA/FAS/OA YOST, MILLER, JACKSON
USDA/FAS/OCRA CRIKER, HIGGISTON, RADLER
USDA/FAS/OGA CHAUDRY, DWYER
DEPT PASS USTR WEISEL, EHLERS

E.O. 12598: N/A
TAGS: EFIN EINV ECON EAGR ID
SUBJECT: INDONESIAN CURRENCY, MARKETS DROP ON MARKET TURMOIL

REF: Jakarta 1694


1. (SBU) Summary. Indonesian financial markets dropped sharply on
U.S. financial market uncertainty and falling commodity prices. The
Indonesian stock index declined 4.7% on September 15, the sharpest
drop in the region. The Rupiah (IDR) has also fallen, moving close
to the psychologically important level of IDR/USD 9500 this week.
The Government of Indonesia (GOI) announced several measures to
address liquidity shortages and calm markets on September 15 and 16.
Ongoing uncertainty in global markets and pressure on Indonesia's
balance of payments threaten to undermine hard won macroeconomic
stability and curb growth. End Summary.

Financial Markets Fall on Uncertainty
--------------


2. (SBU) Indonesia's financial markets are under heavy pressure due
to growing global investor risk aversion created by US financial
market turmoil and the decline in global commodity prices. The
Jakarta Stock Index (JSX),which is comprised largely of
commodity-based companies and financial institutions, declined 4.7%
on September 15, the worst decline in the region. The JSX was down
an additional 7.0% in early trading on September 16, before
recovering those losses toward the end of the day. The index has
lost roughly 25% of its value in the month of September. Government
bonds have also come under pressure, with the yield on the 5-year
government bond increasing 100 basis points from September 5 to
September 15. In addition, several recent government bond auctions
have failed due to insufficient interest.


3. (SBU) Downward pressure on the IDR, which began earlier this
month in conjunction with Indonesia's deteriorating trade balance
(reftel),accelerated this week in response to financial turmoil in
the US. The IDR has traded close to IDR/USD 9500 for the past three
trading days, up from 9150 in late August. Bank Indonesia (BI) has
intervened heavily in the foreign exchange market in recent days to
keep the IDR from exceeding the psychologically important rate of
IDR/USD 9500, according to market analysts. Commercial banks have
also faced liquidity issues in recent weeks, hiking deposit rates to
attract additional funds.

Indonesian Officials Appeal for Calm
--------------


4. (SBU) On September 15, Indonesian officials warned against
excessive reaction to market volatility, stressing that Indonesian
economic fundamentals remain sound. Officials also outlined a
series of actions to improve liquidity. Finance Minister Sri
Mulyani Indrawati announced that the government would trim issuance
of government bonds by IDR 15 trillion ($1.6 billion) to ease
pressure on markets. She noted that lower oil prices had reduced
Indonesia's subsidy bill lowering the projected 2008 budget deficit
from 2.1% to 1.7% of GDP. The Finance Minister also stated that the
GOI would increase the pace of government expenditures, which have
significantly lagged tax collection this year.


5. (SBU) BI also announced several initiatives to calm markets and
increase liquidity in the banking sector. On September 16, BI
increased the rate it pays commercial banks for deposits held
overnight by the central bank by 100 basis points to 8.25% and cut
the rate it charges commercial banks for overnight borrowing from
the central bank, by 200 basis points to 10.25%. BI adjusted the
rates in an effort to reduce the overnight interbank lending rate,
which had risen to close to 13% in recent weeks. BI also announced
plans to revise several repo market regulations to make it easier
for banks to obtain liquidity from BI. BI maintained its overnight
policy rate at 9.25% and plans to use open market operations to
provide additional liquidity to markets. BI summoned management
from the twenty largest banks to appeal to them to stop engaging in
"deposit rate wars" which had taken some deposit rates up to

JAKARTA 00001755 002 OF 002


13.25-14%, according to press reports.

Macroeconomic Vulnerabilities Increase
--------------


6. (SBU) Global financial market turmoil and lower commodity prices
threaten to undermine macroeconomic stability in Indonesia. Most
analysts dismiss the risk of a 1997 style economic crisis given the
comparative health of Indonesia's banking system and size of foreign
currency reserves, which stood at $58 billion as of August 31. In
addition, foreign ownership of state bonds has not declined sharply
in recent weeks, remaining a roughly 20% of total outstanding
government bonds. However, pressure on the currency may increase in
the coming months if the balance of payments position deteriorates.
Market analysts expect Indonesia's trade balance to worsen this
quarter due to flagging demand from the US, Japan and Europe and the
deterioration of Indonesia's terms of trade. In addition, foreign
and domestic portfolio investors may seek a safe-haven in cheaper US
stocks and bonds, which carry significantly less country risk,
raising the risk of increased capital outflows. [Note: Indonesia's
open capital account allows for rapid conversion from IDR to USD
assets. End note.]


7. (SBU) The outlook for economic growth this year also continues to
weaken, as policy rate hikes appear inevitable. If pressure on the
currency increases significantly, the cost of foreign exchange
intervention may begin to drain BI's foreign exchange reserves.
Some analysts also worry that by setting a clear target for the IDR,
BI may actually be increasing pressure on the currency by
discouraging currency traders from buying Rupiah. Significant
depreciation of the currency could fan inflationary pressures and
reduce the benefit of lower world food prices. Some market analysts
and the IMF are already calling for additional rate hikes to ensure
price stability. While more aggressive monetary tightening will
help control inflation, higher interest rates will slow domestic
demand as global demand also stagnates, clouding economic growth
prospects for the second half of 2008.

HUME