INDONESIA - ASSESSING IMPLICATIONS OF GLOBAL FINANCIAL

UNCLAS SECTION 01 OF 05 JAKARTA 000091 SENSITIVE SIPDIS DEPARTMENT FOR EAP/MTS, EAP/EP, EEB/IFD/OMA, EEB/EPPD, E, EEB/IFD/ODF, F (FOR JAMES MARTIN) USAID/ASIA/AA FOR MARGOT ELLIS USAID/EGAT/AA FOR MARK SILVERMAN TREASURY FOR M.NUGENT AND T.RAND COMMERCE FOR 4430 BERLINGUETTE/KELLY DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR CURRAN DEPARTMENT PASS EXIM BANK SINGAPORE FOR S. BAKER TOKYO FOR R. KAPROTH USDA/FAS/OA YOST, MILLER, JACKSON USDA/FAS/OCRA CRIKER, HIGGISTON, RADLER USDA/FAS/OGA CHAUDRY, DWYER USTR WEISEL, EHLERS E.O. 12958: N/A TAGS: EAID EFIN ECON ETRD EINV ID SUBJECT: INDONESIA - ASSESSING IMPLICATIONS OF GLOBAL FINANCIAL CRISIS FOR U.S. BILATERAL ASSISTANCE PROGRAMS REFS: (A) 08 State 134905 (B) Jakarta 62 (C) 08 Jakarta 2008 (D) Jakarta 69 ¶1. (SBU) Summary: As the global financial crisis unfolds, Indonesia's experienced economic team is acting quickly to implement a broad policy response aimed at stabilizing local financial markets and to secure standby financing from the World Bank, Asian Development Bank and bilateral donors. Although the financial crisis affected primarily Indonesia's wealthy in 2008, second round effects are expected to grow in 2009 -- an election year -- and affect more Indonesians. Accordingly, the government is increasingly focused on how it can minimize impacts on the real economy, particularly on employment and poverty. It is too soon to assess whether measures such as a recently announced fiscal stimulus package and steps to improve access to trade finance will be effective in off-setting reduced global demand and supporting continued economic growth. ¶2. (SBU) Summary continued. Clearly, a sharp economic downturn has serious implications for our assistance efforts. With nearly half the population of the country living on less than two dollars a day, the social, political and economic ramifications of a downturn cannot be isolated. There are potential new demands for social services and safety nets, and, depending on the nature of the downturn, even emergency assistance. Ongoing progress across the portfolio of our investments from security to basic services to efforts to support Indonesia's new democracy could all suffer if GOI revenues and donor resources fall or are redirected to more urgent consumption requirements. This in turn would delay and possibly threaten the consolidation of Indonesia's transformation. If necessary, we want to be able to adjust our interventions to be more nimble and targeted but this could require considerably more flexibility than is now provided by the F process. To date no major adjustments are required but things could unravel quickly. We will continue contingency planning. If there are additive resources, there are opportunities to use them here as part of a proactive exercise to put in place quick response mechanisms that can deliver highly specialized technical assistance on financial and social problems and perhaps targeted safety net support. End summary. GOI Undertakes Broad Policy Response to Financial Crisis - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ¶3. (U) The Indonesian government met the financial crisis with a prompt, broad policy response, which post has extensively reported. A summary of actions taken prior to end-October was reported via 08 Jakarta 2008. Subsequent government policy responses were reported via: Jakarta 62, Jakarta 31, 08 Jakarta 2247, 2007, 2206, 2140 and ¶2092. Real Economy Impacts Expected to Become More Acute in 1H09 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ¶4. (U) Although domestic consumption is the primary driver of Indonesia's economy, the outlook for economic growth deteriorated when commodity prices plunged and demand for Indonesia's exports fell sharply in late 2008. While the government remains optimistic that its fiscal stimulus package and planned large infrastructure spending will help Indonesia achieve economic growth of 4.5-5.5% in 2009, most market analysts have reduced growth forecasts to 3-4%. This is well below recent annual growth rates of more than 6%. As real economy impacts -- including defaults by wholesale buyers of commodity and non-commodity shipments, production cuts and job losses -- have spread, the Indonesian government began increasing JAKARTA 00000091 002 OF 005 its focus on cushioning the real economy from the impact of the financial crisis, in an effort to avoid widespread job losses and a rise in poverty rates. (Please see Jakarta 62, 08 Jakarta 2247 and 08 Jakarta 2207 for additional information). Trade and Investment Impacts: Lower Global Demand and Financing Constraints Exacerbate End of Commodity Bubble - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ¶5. (U) As reports spread regarding liquidity constraints and the increased difficulty of Indonesian exporters to obtain needed trade finance, the Government of Indonesia announced measures to expand available trade finance and accelerate exporters' receipt of export proceeds. Bank Indonesia issued regulations, effective December 5, which provided for the opening of a window through which commercial banks could sell export receivables (valued at least USD 10,000 or equivalent and denominated in USD, yen, pound sterling, euro, Australian dollars and Swiss francs) to BI, under certain conditions (i.e., irrevocable letter of credit with remaining term of 30-90 days, and already accepted by the overseas accepting bank). ¶6. (U) On January 9, the Ministry of Trade announced issuance of a new regulation (01/M-DAG/PER/1/2009),effective March 5, 2009, which requires (1) the use of Letters of Credit (L/C) for exports of various primary commodities, including crude palm oil, cocoa, coffee, rubber, tin and other specified mining products, and (2) the deposit of these export proceeds in on-shore banks. Trade Minister Pangestu characterized the measure as an effort to protect exporters from non-payment and as a way to ensure Indonesia's access to needed foreign exchange. ¶7. (U) Press reports and anecdotal evidence suggest that a number of foreign and domestic investors have chosen to delay, cancel or scale down planned investment in Indonesia as commodity prices have plunged and the outlook for global demand for products such as textiles, garments and footwear remains uncertain. ¶8. (U) There have also been press reports citing the National Commission for Placement and Protection of Indonesian Migrant Workers announcing that some 250,000 Indonesian migrant workers have returned home from Malaysia, South Korea, Hong Kong and various Middle Eastern countries as a result of the financial crisis and growing global economic downturn. With an estimated 5.8 million Indonesians working abroad in recent years, providing at least IDR 60 trillion (over USD 6 billion) in remittances, a significant return of migrant workers from abroad would boost unemployment and place additional strains on the domestic economy. A return of internal migrant workers into Java from other islands, notably Kalimantan and Sumatra, reportedly is also occurring as a plunge in commodity prices has forced some plantations to scale down production. Financial Sector Impacts - - - - - - - - - - - - - ¶9. (U) BI advises that while Indonesian banks remain relatively well capitalized, the level of non-performing loans will increase in ¶2009. Banking regulation and supervision has improved markedly since the 1997/98 crisis. The IMF has provided a resident banking advisor to assist in this effort. Recent bank failures such as that of BI-owned Bank Indover in the Netherlands in October and Bank Century in Indonesia in November have raised questions about whether BI has sufficient resources to carry out effective supervision beyond Indonesia's largest banks. In recent years, BI has relaxed JAKARTA 00000091 003 OF 005 some prudential regulations in an effort to encourage bank lending. Credit growth subsequently rose by more than 30% in 2008. Government Revenue Growth Expected to Moderate in 2009, But GOI Committed To Preserving Pro-Poor Spending - - - - - - - - - - - - - - - - - - - - - - - - - ¶10. (U) Indonesia enjoyed high revenue growth for most of 2008, with tax revenues up 40% in 2008, as the government took extensive efforts to increase the number of tax registrations and taxpayers. The effects of the global economic slowdown became visible in the fourth quarter of 2008, with lower imports resulting in lower VAT and luxury tax revenues. Over-performance of revenue targets allowed the GOI to trim the 2008 budget deficit to 0.1% of GDP (from a planned deficit of 2.1% of GDP). In late-2008, the Indonesian government revised the 2009 state budget, recognizing that government revenues, including tax and non-tax revenues, were likely to decline as a result of the economic slowdown and sharply lower commodity prices. The government adjusted downward state revenues and grants from IDR 1,022.5 trillion to IDR 985 trillion and trimmed the planned budget deficit to 1.0% of GDP (down from the original planned budget deficit of 1.9%). On January 13, the government provided a broad outline of proposed budget revisions it will present to the legislature, based on changed macroeconomic assumptions (see septel). Finance Minister Sri Mulyani Indrawati said that the proposed revisions, which would increase the budget deficit to 2.5% of GDP (IDR 132 trillion),reflect a significant decline in expected state revenues and the need for counter-cyclical fiscal stimulus. Other Ministry of Finance officials said the government plans to maintain a net bond issuance target of IDR 54.7 trillion. ¶11. (U) The Indonesian government announced a halt of bond issuance in October, when rising risk aversion increased yields on Indonesian bonds by 800 basis points. Credit market conditions have since improved, with yields on Indonesian government bonds falling from a high of 20.9% in late-October to 11.9% in early January (on benchmark ten-year bond). These improved conditions should support the government's 2009 bond issuance. The government resumed rupiah-denominated bond issuance on January 13, when it raised IDR 5.95 trillion (USD 531.7 million),nearly double its target, from the auction of Treasury bills maturing in 2010 and fixed rate bonds maturing in 2012 and 2014. The Finance Ministry has also announced plans to issue a retail sukuk (Islamic bond) in early February and a Japanese-yen denominated Shibosai bond by no later than mid-2009. Indonesia also plans to move forward with the issuance of a global USD sukuk bond, originally scheduled for late 2008, but has not yet announced a date. ¶12. (U) Despite some constraints on government revenues, the Indonesian government has taken specific measures focused on Indonesia's most vulnerable, including extending through February 2009 direct cash transfer payments for poor households and plans to increase funding for programs such as the National Community Empowerment Program, which provides short-term employment on community road-building and other small community infrastructure projects. Other government measures, such as recent cuts in subsidized fuel prices, while popular, primarily benefit middle-income and wealthy Indonesians. In response to slowing economic growth, the government of Indonesia has also announced plans for a significant stimulus package. Although the amount of the package appears a moving target, most officials have spoken of a IDR 50.5 trillion (USD 4.6 billion) stimulus package, consisting of IDR 12.5 trillion included in the 2009 budget and about IDR 38 JAKARTA 00000091 004 OF 005 trillion in unspent 2008 budget funds. This stimulus is in addition to an estimated $9.2 billion in new infrastructure projects, intended to boost domestic demand, competitiveness and employment. GOI Acts Quickly to Secure Alternative Financing - - - - - - - - - - - - - - - - - - - - - - - ¶13. (SBU) Indonesian officials moved quickly to secure alternative external financing to cover the 2009 budget deficit when bond market conditions deteriorated. This was essential for reassuring currency and credit markets. At the government's request, the World Bank has led efforts to secure stand-by financing. Bilateral donors Australia and Japan have been primary partners in this effort. France also reportedly agreed to provide budget support through climate change-related assistance. President Yudhoyono and other officials continue to reject publicly any consideration of seeking access to IMF financing, including its new Short-term Lending Facility, due to ongoing ill will from the Asian financial crisis period. ¶14. (SBU) Post is carefully monitoring the impact of the global financial crisis on ongoing and other development activities. Thus far, the GOI appears to be managing the crisis well and deleterious impacts on development activities have been minimal. Mission is not aware of significant problems and/or weaknesses due to the financial crisis identified by other donors regarding development activities or of specific additional proposed new assistance beyond the World Bank-led effort described above. U.S. Assistance Focused on Helping Indonesia Succeed - - - - - - - - - - - - - - - - - - - - - - - - - - - ¶15. (SBU) U.S. assistance to Indonesia targets an array of critical challenges faced by the country. Most of the assistance is centered on ensuring that the remarkable ongoing transformation here continues in the right direction at a steady pace. Clearly, an economic downturn complicates that prospect. Investments in security, education, health, the environment, economic growth and democratic governance all have benefitted from Indonesia's recent robust economic growth but the experience here after the financial crisis of 1997 is still in people's mind. ¶16. (SBU) And the lessons of that crisis underline some of the ways in which a large economic shock can quickly impact both society and assistance investments. Indonesia is not at such point now, but experience also suggests that things could change quickly, underlining the need for continued contingency planning. ¶17. (SBU) Some examples of how such a downturn could affect ongoing activities are suggested by some USAID investments in the economic sector. Many of those activities seek to stimulate improvements in the climate for business, to enhance Indonesia's competitiveness and to stimulate strong growth in jobs. One byproduct of the current global financial crisis which has already impacted this portfolio is seen in work with the Ministry of Trade, previously a champion of reform in the GOI. Pressures of the current crisis and the atmosphere in the run up to the national elections have led to increasingly protectionist attitudes and actions (see Ref D and septel reporting on these measures). Similarly, on the jobs front, the downturn has encouraged regions benefitting from Indonesia's decentralization efforts to impose trade constricting actions internally. ¶18. (SBU) Aside from continuing to monitor the situation, the JAKARTA 00000091 005 OF 005 mission is working on a new approach to future investments which will better embed these concerns. Mission will likely give higher priority to strengthening institutional capacity to identify and remove key constraints to trade and investment, increasing productivity of high-value agricultural sub-sectors, and enhancing growth of safe and sound non-bank financial institutions (NBFIs). Similar kinds of ramifications are being assessed across the rest of the current and planned portfolio. One possible critical constraint from the USG side is that when and if a crisis hits and does so suddenly, current programming policies under the F process are rigid, exceptionally cumbersome and time consuming. ¶19. (SBU) With these caveats in mind, the mission does not consider that the impacts of the financial crisis will significantly affect the intended results of ongoing bilateral assistance programs in the near term. The mission does not believe the financial crisis poses significant new risks for the success of ongoing programs. ¶20. (SBU) Resources: While additive resources to address these issues are not needed currently, the situation could change quickly and we need to be prepared. We expect to continue monitoring, but a source of flexible funds, either from reprogramming or new money, would be vital to enable us to be responsive to urgent requests for technical assistance and to bolster existing social safety nets. HEFFERN