INDONESIA WEATHERING GLOBAL FINANCIAL CRISIS SO FAR, BUT

UNCLAS SECTION 01 OF 04 JAKARTA 000062 SIPDIS SENSITIVE DEPT FOR E, EAP/MTS, EAP/EP, EEB/IFD/OMA AND EEB/EPPD TREASURY FOR IA/MALACHY NUGENT AND TRINA RAND USAID/ASIA/AA FOR MARGOT ELLIS USAID/EGAT/AA FOR MARK SILVERMAN COMMERCE FOR 4430/KELLY DEPT PASS FEDERAL RESERVE SAN FRANCISCO FOR CURRAN DEPARTMENT PASS EXIM BANK SINGAPORE FOR SUSAN BAKER TOKYO FOR ROBERT KAPROTH 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: INDONESIA WEATHERING GLOBAL FINANCIAL CRISIS SO FAR, BUT GROWING IMPACT ON REAL ECONOMY WILL CHALLENGE IN 2009 REFS: A) 08 State 134459 B) Jakarta 31 C) 08 Jakarta 2300 D) 08 Jakarta 2247 E) 08 Jakarta 2207 F) 08 Jakarta 2092 G) 08 Jakarta 2002 H) 08 Jakarta 1987 ¶1. (U) This message includes an action request. Please see paragraph 12. ¶2. (SBU) Summary. Effective policy responses have enabled Indonesia to weather the current financial crisis. IMF and World Bank officials here are cautiously optimistic about Indonesia's ability to absorb the global downturn and do not expect a balance of payments crisis. To date, the financial crisis has primarily affected Indonesia's wealthy, limiting the potential for social instability. Analysts anticipate second round effects of the financial crisis will challenge Indonesia in 2009, with slowing external and domestic demand resulting in rising job losses. The dramatic decline in prices of commodity exports also threatens investment and employment in the resources sector. Upcoming 2009 elections raise the risk that some fiscal policies may do little to improve Indonesia's long-term economic growth prospects. Indonesia's role in the G-20 response to the global financial crisis provides an opportunity for increased U.S. engagement with Indonesia as a strategic partner. End summary. Effective Policies Stave off Larger Crisis - - - - - - - - - - - - - - - - - - - - - - ¶3. (U) The global financial crisis threw Indonesia's financial markets into turmoil, sending stock, bond and currency markets down precipitously. Indonesia's benchmark equity index had lost 50.6% of its value (yoy) as of December 31, 2008, as investors exited emerging market stocks. While large, this decline was in line with other equity markets in the region; the Malaysian, Thai, and Vietnamese indices fell by 38.9%, 47.6% and 66.0% respectively during the same period. Indonesian government bond yields also soared in 2008, increasing by nearly 800 basis points from mid-September to end-October, before partially recovering in December. Ten-year government bonds traded at a yield of 11.64% as of December 30, 2008, up 160 basis points from one year earlier. The Indonesian Rupiah (IDR) depreciated rapidly in response to global market instability and rising aversion to emerging market assets. The IDR breached 13,000/USD on November 21, before recovering to 11,000/USD in December. The IDR/USD rate remained 14.1% (yoy) below the value recorded in December 2007. Interbank lending among Indonesian banks and dollar financing in Indonesia also slowed significantly in late 2008 as losses and rising risk aversion among large international banks spread to the Indonesian financial sector. ¶4. (SBU) The GOI's relatively strong macroeconomic position prior to the onset of the global financial crisis and rapid response to financial market turmoil helped stave off more significant financial market volatility and supported stabilization and a modest recovery of financial markets at year's end. Indonesia entered the crisis with low debt-to-GDP levels (35% of GDP in 2007, down from 80% in 2000),strong economic growth momentum and domestic demand (GDP growth exceeded 6.0% (yoy) for the past 8 quarters),and a healthy banking sector. Since September 2008, the GOI has injected liquidity into financial markets, adjusted 2009 fiscal spending requirements, and worked to secure standby financing from the World Bank and other bilateral sources. ¶5. (SBU) Bank Indonesia (BI)'s measured monetary policy response to the crisis also reinforced confidence in Indonesia's economic team. In contrast to other countries in the region, BI has only slowly JAKARTA 00000062 002 OF 004 begun lowering rates. It reduced the overnight policy rate by 25 basis points to 9.25% in early December, its first cut in 2008, balancing the need to stimulate growth, fight high inflation and support a weak IDR. On January 7, BI cut the policy rate by an additional 50 basis points, to 8.75%, after the rupiah had firmed by more than 10%. BI significantly decreased its defense of the IDR in late 2008 in an effort to preserve foreign exchange reserves. After official reserve assets fell by more than USD 6.5 billion in October, reserve assets stabilized, increasing to over USD 51.6 billion at end-December, up about USD 1.46 billion from end-November. Few Signs of Social Instability - - - - - - - - - - - - - - - - - ¶6. (SBU) The current financial crisis has primarily affected Indonesia's wealthy, limiting the catalysts for social instability. The concurrent decline in food and energy prices and moderation in overall inflation has eased pressure on middle and low-income families. Overall food prices fell 0.12% between October and November 2008 and the price of rice, which comprises as much as one-third of total household spending in Indonesia, is down almost 7% from its 2008 peak. Sharply lower global oil prices allowed the government to reduce the price of subsidized fuel, lowering transportation costs. As a result, consumer confidence and confidence in the government have risen during the latter half of 2008, despite the onset of the global financial crisis. Consumer confidence retreated slightly in December after reaching an 11-month high in November, indicating that the weakening economy has had a limited impact on consumers. A small number of labor demonstrations occurred following a government attempt to cap regional minimum wage contract increases to the forecast rate of economic growth. The government subsequently modified its position, linking wage increases to the inflation rate. To date there have been no signs of rising social tension toward the Chinese-Indonesian minority or the government. More Severe Impact on Real Economy Expected in Early 2009 - - - - - - - ¶7. (SBU) Analysts anticipate that the second round effects of the global financial crisis will create significant economic challenges for Indonesia in 2009, slowing growth and raising unemployment. The World Bank recently lowered its 2009 growth forecast to 4.4%, and cautioned that it may fall further due to continued uncertainty about the global economy. Most market analysts are more bearish about Indonesia's 2009 growth prospects and have reduced GDP growth projections to 3-4%, as global demand for Indonesian products continues to slump. In addition to weak external demand, the prices of Indonesia's commodity exports have plunged, threatening investment and employment in the resources sector, particularly in areas outside Java. Some observers warn that Indonesia could lose more than one million jobs in the formal sector before the end of ¶2009. ¶8. (SBU) The banking sector may also come under new pressure in 2009, with rising non-performing loans and higher funding costs limiting the potential for investment growth. Indonesian authorities are handling fall-out from two banking failures which occurred since the onset of the financial crisis: the takeover of BI-owned Bank Indover by Netherlands banking authorities in October and the first takeover by Indonesian authorities of a large commercial bank (Bank Century) since the 1997/98 financial crisis in November. Small banks in Indonesia have already faced rapidly rising funding costs, as deposits shift from smaller to larger JAKARTA 00000062 003 OF 004 banks. Although small bank failures are unlikely to cause an immediate systemic banking collapse, a series of small bank failures could test depositor confidence in the banking system as a whole. Despite the outlook for significantly slower growth, IMF and World Bank officials here are cautiously optimistic in Indonesia's ability to absorb the global economic downturn and very few analysts envision massive capital flight or a balance of payments crisis in Indonesia in 2009. 2009 Election May Prompt Short-term Policy Focus - - - - - - - - - - - - - - - - - - - - - - - - - ¶9. (SBU) On January 4, President Yudhoyono announced plans to introduce a larger fiscal stimulus package aimed at supporting domestic demand and stemming job losses as the growth outlook deteriorates. The IDR 50.5 trillion (USD 4.6 billion) stimulus package includes IDR 12.5 trillion included in the 2009 budget and about IDR 38 trillion in unspent 2008 budget funds. This stimulus is in addition to $9.2 billion in new infrastructure projects and a $1.6 billion commuter train project in Jakarta financed by a Japanese government loan. The actual impact of the stimulus package is questionable: the Indonesian government may not have the capacity to spend the money quickly enough to have an impact. Yudhoyono also announced that the government plans to raise funds in international bond markets to finance additional spending 2009. His priorities for 2009 are job creation, inflation control and corruption eradication. ¶10. (SBU) The proximity of the 2009 elections and the GOI's inability to spend money quickly raises the risk that the government will pursue policies with maximum short-term benefit rather than measures to promote sustainable job-creating growth. The government has already increased import restrictions and begun rigorously enforcing non-tariff barriers in an effort to preserve foreign currency and protect domestic business. The government's fiscal stimulus package includes incentives for the corporate sector (tax breaks and access to trade finance). The government has not yet released details on the recently announced IDR 38 trillion stimulus. Pressure to support domestic firms in the name of economic nationalism has been on the rise, as revealed by the government's support for the ailing Bakrie Group. The government has extended a direct cash transfer program for poor households through February 2009 and cut subsidized fuel prices to blunt the impact of slower growth on low-income households. While popular and effective in alleviating short-term poverty, these programs do little to promote long-term economic growth. Lack of institutional capacity in the government could undermine policies with longer-term impact, such as the government's plan to expand the education budget or to double infrastructure spending. New Global Role Provides Opportunity To Strengthen Partnership - - - - - - - - - - - - - ¶11. (SBU) Indonesia's role in the G-20 response to the global financial crisis provides an opportunity for increased U.S. engagement with Indonesia as a strategic partner. As co-chair (with France) of the G-20 working group tasked with reforming the World Bank and Regional Development Banks, Indonesia is in a position to play a constructive role in strengthening the international financial system. However, Indonesia has limited experience in leading a G-20 working group and could benefit from consultations with U.S. officials. By engaging Indonesia on this and other global financial sector issues, the U.S. can shift the focus of its engagement with Indonesia from donor-recipient to strategic partner. JAKARTA 00000062 004 OF 004 ¶12. (SBU) ACTION REQUEST: Post recommends that a senior Treasury official meet with the Indonesian team working on the G-20 proposal prior to the G-20 summit in April 2009. HEFFERN