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UNCLAS SECTION 01 OF 05 JAKARTA 006120 
 
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SENSITIVE 
SIPDIS 
 
E.O. 12958:  N/A 
TAGS: EFIN EINV ECON PGOV ID
SUBJECT: Indonesia: East Java Banks' Conservatism Causing 
Credit Contraction 
 
Ref:  A. Jakarta 1833 - Banking Sector Update 
 
 ¶B. Jakarta 3244 - Sharia Banking 
 
¶1. (SBU) SUMMARY: East Java accounts for 15 percent of 
Indonesia's GDP, 20 percent of total population and is an 
important industrial and manufacturing center in Indonesia. 
Credit contraction, increasing non-performing loans (NPLs) 
and declining inflation, implying demand reductions, are 
slowing the local economy and causing concern for East Java 
Banking officials.  Credit contraction is counter to the 
Bank Indonesia's national credit expansion objectives for 
2006 in support of its 5.0 to 5.7 percent national growth 
goals.  Bank of Indonesia Surabaya (BIS) officials are 
pressuring local bankers to ease credit and grow loan 
portfolios faster.  Risk-adverse East Java headquartered 
banks are committed to maintaining credit discipline even 
though loanable funds are expanding due to increasing 
deposits.  Rural credit banks are reeling from the slowing 
economy and increased competition.  Higher interest rates 
have also slowed growth in East Java sharia banking.  BIS 
seems to exert little influence on local bank lending 
behavior and practices.  East Java bankers believe that the 
recent 25 basis point reduction in Bank Indonesia base rate 
will have little or no impact on stimulating the economy. 
If East Java bank behavior is indicative of the rest of 
Indonesian banks; Bank Indonesia will need to look at other 
tools, like further base interest rate reductions, to 
stimulate growth. END SUMMARY. 
 
East Java Credit Crunch 
----------------------- 
 
¶2. (SBU) In an April 21 meeting with ConGen Surabaya 
Econoff Williams, Bank Indonesia - Surabaya Branch Office 
(BIS) officials initially asserted that as of February 
2006, credit in East Java was growing at 23 percent per 
annum and loan growth was on track to meet 2006 
expectations.  After reanalyzing their own closely held 
monthly statistics, they discovered that total credit held 
by all banks in East Java had actually contracted by 2.5 
percent over the first two months of 2006 (15 percent 
annualized).  Officials were also worried that banks 
headquartered in East Java had reduced loan portfolios by 
3.6 percent (21.6 percent annualized) over the same period. 
(Note: Total credit grew in East Java by over 27 percent 
during 2005.  End Note.)  Credit contraction is counter to 
the Bank Indonesia's (BI) national stated objective of 20 
percent credit expansion for 2006 in support of its 5.0 to 
5.7 percent national growth projections.  BIS officials 
stated earlier this year that they had made "suggestions" 
to local banks that 20 percent credit growth was the magic 
number, and they had expected that level of loan growth or 
greater from the East Java banks.  BIS officials said they 
would be having "additional discussions" with East Java 
banks regarding local loan growth performance, implying 
they will pressure local banks to ease credit. 
 
NPLs on the Rise 
---------------- 
 
¶3. (SBU) BIS also noted that NPLs for all banks in East 
Java increased by 16.4 percent (from 5.5 to 6.4 percent) 
during the first two months of 2006.  NPLs for East Java 
headquartered banks grew by 25 percent (from a very low 1.0 
percent to 1.25 percent) at the end of February.  According 
to Bambang Pramasudi, Deputy Head of Bank Supervision at 
BIS, East Java bankers are complaining of a worsening 
economy.  Durable goods sales continue to decline due to 
higher interest rates and lower disposable incomes 
following fuel price increases in October 2005.  Pramasudi 
was surprised that the East Java economy is not responding 
to positive macroeconomic indicators. "Interest rates are 
stable, inflation is low, the rupiah is strong and the 
stock market is up.  But business in East Java is still 
 
JAKARTA 00006120  002 OF 005 
 
 
slowing and even some good customers are paying slowly now. 
The slowdown seems to be impacting all levels of the 
economy here", Pramasudi commented.  (Note: Two ConGen 
contacts recently reported closing furniture factories 
making export goods in East Java, laying off hundreds of 
employees, due to unavailability of local raw materials and 
the recent strengthening of the rupiah wiping out profit 
margins.)  Following national trends, inflation in East 
Java declined from an annualized rate of 18.72 percent in 
January 2006 to 4.32 percent annualized in March 2006, 
reflecting reported decreases in regional demand.  While 
the credit contraction itself is enough to cause concern, 
BIS officials' lack of awareness of provincial economic 
trends is worrisome at a time when the private sector is 
pessimistic about local economic performance. 
 
Background on East Java Banking 
------------------------------- 
 
¶4. (SBU) East Java is considered an economic engine for 
Indonesia with almost 20 percent of the total population 
and a high concentration of Indonesia's heavy industry. 
According to a recent Bank Indonesia internal report, all 
East Java banks hold 11 percent of all bank loans and 13 
percent of total assets in Indonesian banks.  In addition 
to the Jakarta-based national banks with branches in East 
Java, there are approximately 370 banks of varying sizes 
headquartered in East Java.  BIS is responsible for 
regulating all banks headquartered in East Java, as well as 
those in Bali, West Nusa Tenggara and East Nusa Tenggara 
provinces. 
 
Surabaya Commercial Banks A Tight Bunch 
--------------------------------------- 
 
¶5. (SBU) Nine of the approximately 370 East Java-based 
banks are, or will be, large enough with capitalization 
over USD 9 million to be considered core commercial banks 
(CCBs) under the Indonesian Banking Architecture law (API) 
i.e. with capitalization over IDR 80 billion (USD 9 
million).  The remainder are small, privately owned, rural 
credit banks (BPRs) with capitalization under IDR 10 
billion (USD 1.15 million).  Under the API, banks with 
capitalization between IDR 10 billion and 80 billion (USD 
1.15 - 9 million) are targeted to be closed or merged with 
larger banks by the end of 2007.  Five of the nine Surabaya 
based CCBs are currently capitalized under the IDR 80 
billion minimum.  All five banks have submitted plans to 
increase their capital above the minimum requirement before 
the year end 2007 deadline. 
 
¶6. (SBU) Local ethnic Chinese Indonesian business families 
own all nine of Surabaya's CCBs.  By far the largest of 
East Java based CCBs is Bank Maspion, controlled by Alim 
Markus, President and Managing Director of the Maspion 
Group, Indonesia's largest domestic houseware manufacturer. 
Bank Maspion has total assets of approximately IDR 1.75 
trillion (USD 200 million), NPLs under 2 percent and 
services primarily small and medium sized businesses.  "We 
have been taking a wait and see attitude on the economy, 
and business conditions have been weak," Herman Halim, 
President of Bank Maspion and the East Java chapter of the 
Private Banking Association (Perbanas) said.  "However, 
unlike the first quarter, we are seeing increased business 
activity in April.  There is a sign of light," he added. 
Halim still does not foresee significant increases in 
credit this year, adding, "We are having a hard time 
finding good customers and plan to maintain our strict 
underwriting standards."  Halim feels pressure for credit 
growth from BIS but commented ruefully, "I would feel a lot 
more pressure from my bosses if the bank's performance 
drops." 
 
¶7. (SBU) According to Abdul Mongid, head of research at the 
 
JAKARTA 00006120  003 OF 005 
 
 
Pembanas Institute in Surabaya (which trains many of the 
tellers and junior bankers entering East Java Banks), the 
owners of the nine Surabaya based CCBs are close friends 
and rarely compete directly with one another for customers. 
"Their account officers move up and down value chains to 
find new business.  They do business with their existing 
customers' suppliers and customers.  They do not work with 
walk-in customers not referred by existing customers," 
stated Mongid.  Mongid thought that the owners of the 
undercapitalized banks would all inject equity into their 
banks to avoid a forced merger, because owning a bank is a 
status symbol in the business community. 
 
¶8. (SBU) East Java bank owners mention liquidity management 
and the ability to move money around as reasons for bank 
ownership.  A director of the Surabaya-based Wings Group, 
the largest domestic manufacturer of soap products and 
owner of Bank Ekonomi (a Jakarta-based bank), disagreed 
with Mongid that status was a primary motivation for bank 
owners.  He explained, "We keep our bank as a liquidity 
management vehicle.  We deposit our profits in the bank, 
which can then be lent or invested domestically or 
internationally.  We are not concerned that the bank be 
terribly profitable, only that is does not lose money."  He 
explained the importance to ethnic Chinese East Javanese of 
maintaining liquidity andd fleibility with their investable 
fund s as a hedge aainst local instability.  Andry Wijaya, 
Director f Bank ANK, (a Surabaya-based bank currently 
undr the minimum capital requirement) noted that, "Wefeel 
no pressure to grow and we will wire funds in whatever 
amount BIS requires to stay independent before the 
deadline."  Surabaya banks remain very liquid, ending 2005 
with a very conservative 52.8 percent loan-to-deposit (LDR) 
ratio, which further reduced to 46.2 percent at the end of 
March 2006.  The high interest rates are attracting 
deposits into local banks faster than they can make prudent 
loans, according to Widjaya. 
 
East Java's Largest Bank Taking Things Slow 
------------------------------------------- 
 
¶9. (SBU) The head of Bank Jatim has his own thoughts on 
credit growth and does not feel compelled to bend to the 
wishes of Bank of Indonesia - Surabaya (BIS).  Bank Jatim 
(short for Java Timur or East Java), headquartered in 
Surabaya, is the largest East Java-based bank.  The East 
Java Provincial Government and each of the province's 39 
city and regency governments own Bank Jatim in partnership. 
The Bank's primary mission is economic development in East 
Java.  All funds distributed by the central government to 
East Java government entities flow through Bank Jatim, and 
all provincial, regency and city employee salary payments 
are made to Bank Jatim accounts.  According to Bank Jatim 
Managing Director Agus Sulaksono, the bank makes a variety 
of types of loans but specializes in construction lending 
to contractors building government projects such as roads 
or schools.  They also carry a large portfolio of small and 
medium enterprise (SME) loans, generally structured and 
revolving lines of credit secured by real estate, with 
loan-to-value ratios generally under 70 percent.  Bank 
Jatim is also a primary small agriculture lender in the 
province and a large purchaser of development loan 
syndications from other provincial development banks.  The 
bank charges interest rates of 12 to 18 percent per annum 
on its business loans, significantly less than competing 
private institutions.  Bank Jatim is notoriously 
conservative with its underwriting, reserving its 
inexpensive, government-subsidized loan funds for only the 
safest lending opportunities.  This is reflected in its 
1.25 percent NPL ratio, well below the national average of 
8.9 percent at year-end 2005. 
 
¶10. (SBU) As Sulaksono noted about his bank's reputation 
for risk aversion, "Why should I take any risk?  I must now 
 
JAKARTA 00006120  004 OF 005 
 
 
personally guarantee all of the deposits in this bank to 
the Indonesian Deposit Insurance Company (LPS) and I retire 
in two years.  We play it straight here, unlike some other 
banks.  So I do not have large foreign bank accounts to 
fall back on like some of my counterparts (at other 
government-owned banks).  I can not afford to risk my 
retirement by making imprudent loans."  From his analysis 
of credit card receipts from business banking customers and 
increasing NPLs, Sulaksono sees the East Java economy 
slowing.  He projects Bank Jatim NPLs will increase to 3 to 
4 percent this year.  He feels 5 to 10 percent loan growth 
at Bank Jatim in 2006 would be aggressive by the bank's 
standards, and seemed comfortable dismissing BIS efforts to 
push for higher loan growth.  Sulaksono noted that the 
goals set for Bank Jatim by its local government owners for 
safety and profitability were his primary decision-making 
factor, not BIS policies. 
 
Small Banks Facing Increased Competition 
---------------------------------------- 
 
¶11. (SBU) There are roughly 360 small, privately owned 
rural credit banks (BPRs) in East Java, most located 
outside of Surabaya in small cities and villages.  BIS 
regulates all BPRs in East Java.  BPRs hold 2.7 percent of 
East Java bank loans and, according to 2005 BIS statistics, 
provided approximately 25 percent of all micro credit loans 
in the province, making BPRs an important source of seed 
capital for new business development. BPRs focus on micro- 
business lending as well as micro-agricultural lending, 
using a collateralized fixed rate term loan product. 
Interest rates range from 36 to 42 percent per annum. 
Pompong Setiadi, head of the East Java BPR Association said 
the big competitive advantage BPRs have over Bank Rakyat 
Indonesia (BRI), a large national bank with extensive 
branching, or Bank Jatim in East Java is underwriting 
flexibility and the ability to respond quickly to loan 
requests.  BPRs can grow with their customers more 
effectively than BRI but tend to avoid management-intensive 
loan products like revolving lines of credit because they 
lack trained commercial lenders. BPRs are forced to charge 
higher interest rates to borrowers due to high overhead 
costs, averaging 7 to 12 percent of total assets per annum, 
and generally higher credit losses.  The higher rate 
structure and high leverage (110 percent average LDR) of 
BPRs make them particularly susceptible to new, better 
capitalized and managed competitors, such as Bank Danamon 
Simpan Pinjam (Bank Danamon).  Bank Danamon is expanding 
rapidly in East Java opening hundreds of marketplace based 
micro-branches in the province, directly competing with 
BPRs (Ref A).  Bank Danamon offers lower interest rates, 
better service and a greater ability to use non-traditional 
collateral to secure its micro loans. 
 
Small Rural Banks Feeling the Pinch 
----------------------------------- 
 
¶12. (SBU) The quick rise of Bank Danamon and the emergence 
of non-regulated thrifts in East Java is having a direct 
and immediate negative impact on East Java BPRs ability to 
retain good customers and experienced lenders.  Setiadi 
from the BPR Association admitted that the growth of Bank 
Danamon has hurt BPR business prospects.  "Our interest 
margins are shrinking due to the increased competition, the 
loss of experienced lenders is a problem and some of our 
weaker members will not survive", he said.  In January 
2006, BIS announced that no new BPR licenses would be 
issued in East Java; the instruction ran counter to Bank 
Indonesia's strategy of increasing the number of BPRs 
nationally.  BIS privately disclosed that East Java BPRs 
are experiencing significant growth in NPLs, increasing 
over 20 percent to 8.3 percent during the first two months 
of 2006.  According to BIS, dozens of East Java BPRs are 
experiencing NPL ratios over 15 percent and total deposits 
 
JAKARTA 00006120  005 OF 005 
 
 
in East Java BPRs also shrank by over 7 percent during 
2005, reflecting depositor's perception of increasing risk 
at these institutions.  Pramasudi said that BIS is getting 
pressure from Bank Indonesia in Jakarta to reevaluate the 
freeze on BPR licenses and the policy may be reversed soon. 
 
¶13. (SBU) BIS bank examiners are very concerned with the 
deteriorating condition of the BPRs, and complained that 
this issue is currently taking up much of their time. 
Pramasudi claimed that BIS is setting up work out plans for 
their cooperative troubled banks and closing the 
uncooperative ones.  Year to date, five BPRs have closed in 
East Java; Pramasudi declined to speculate on the number of 
additional closures this year or the closures' impact on 
overall banking service in the province. 
 
East Java Sharia Banking 
------------------------ 
 
¶14. (SBU) According to BIS statistics, sharia banking in 
East Java (Ref B) is still in its infancy.  During 2003, 
2004 and the first quarter of 2005, East Java sharia banks 
and SBUs showed strong deposit and loan growth, taking 
market share from conventional banks.  East Java sharia 
deposits grew from less than a 0.3 percent market share at 
the end of 2003 to 0.7 percent at year-end 2004 and 0.9 
percent in March 2005.  The increasing interest rates in 
2005 rates flattened the growth in East Java sharia 
deposits, which ended 2005 at the same 0.9 percent market 
share with a 26 percent jump in new deposits during the 
last few days of the year.  BIS was unable to explain the 
source of the year-end burst of sharia deposit activity. 
LDRs for East Java sharia banks remain very high at an 
average 95 percent.  Most assets are concentrated in 
collateralized fixed payment loans to consumers.  To date, 
sharia banks and sharia banking units in East Java have 
demonstrated a greater ability to attract and retain 
borrowing clients than depositors. 
 
Conclusion 
---------- 
 
¶15. (SBU) Both corporate and banking contacts have 
expressed concern with local economic prospects.  Credit 
contraction signals BIS's inability to force credit growth 
in the province through persuasive means.  East Java 
bankers seem content to stay liquid, observing economic 
trends and resisting pressure to rapidly expand loan 
portfolios.  These conservative East Java bankers seem 
unlikely to be persuaded by further Bank Indonesia pressure 
to ease underwriting standards and grow credit if they feel 
it will risk the integrity of their balance sheets.  The 
recent 25 basis point reduction in Bank Indonesia base rate 
will have little or no impact on stimulating the economy, 
according to local bankers who called for larger rate 
decreases to avoid further economic slowing. If East Java 
bank behavior is indicative of the rest of Indonesian 
banks; Bank Indonesia will need to look at other tools, 
like further base interest rate reductions, to stimulate 
growth. 
 
PASCOE