VZCZCXRO3084
RR RUEHCHI RUEHDT RUEHHM
DE RUEHJA #7718/01 1700958
ZNR UUUUU ZZH
R 190958Z JUN 06
FM AMEMBASSY JAKARTA
TO RUEHC/SECSTATE WASHDC 6027
RUEATRS/DEPT OF TREASURY WASHINGTON DC
INFO RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUEHKO/AMEMBASSY TOKYO 9865
RUEHBJ/AMEMBASSY BEIJING 3489
RUEHBY/AMEMBASSY CANBERRA 9632
RUEHUL/AMEMBASSY SEOUL 3678
RUEHBR/AMEMBASSY BRASILIA 0177
RUEHBU/AMEMBASSY BUENOS AIRES 0030
RUEAIIA/CIA WASHDC

UNCLAS SECTION 01 OF 03 JAKARTA 007718 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EAP/MTS AND EB/IFD/OMA 
TREASURY FOR IA-BAUKOL 
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO 
 
E.O. 12598: N/A 
TAGS: EFIN EINV ECON PGOV PREL ID
SUBJECT: BANK INDONESIA TO CONTINUE CAUTIOUS LOWERING 
 
REF: A) JAKARTA 7013, Early IMF Repayment; 
     B) JAKARTA 7340 Economic Highlights May 
 
¶1. (SBU) Summary. Bank Indonesia (BI) Deputy Governor 
Hartadi Sarwono told us on June 13 that BI remains confident 
consumer price inflation will fall to less than seven 
percent on a year-on-year (YoY) basis by the end of 2006, 
leaving BI room to continue a "cautious lowering" of 
interest rates over the next six months.  He said BI has run 
a series of foreign reserve simulations, and is comfortable 
with its current reserve level of about USD 44 billion, 
although the risk of renewed, rapid portfolio outflows 
remains a concern.  Despite the expected downward trend in 
interest rates, Sarwono expressed concern about the 
prospects for GDP growth in 2006--the Ministry of Finance, 
BI, the International Monetary Fund (IMF) and others have 
revised 2006 GDP growth estimates for Indonesia downward to 
below 6 percent due to lower government spending and 
investment.  Like in other emerging economies, capital 
markets have been volatile in Indonesia in recent weeks, but 
Sarwono and the majority of our economic contacts believe 
the country is in a solid macroeconomic position to weather 
the current storm.  End Summary. 
 
¶2. (SBU) We met BI Deputy Governor Dr. Hartadi Sarwono on 
June 13 to explore BI's thinking about the likely course of 
Indonesia's monetary policy over the remainder of 2006. 
Sarwono is a former Director for Economic Research and 
Monetary Policy at BI and perhaps the top macroeconomist on 
the BI board.  Our contacts consistently place him among the 
interest rates "hawks" on the BI board along with Senior 
Deputy Governor Miranda Goeltom and Deputy Governor Bun 
Bunan E. J. Hutapea.  In contrast, BI watchers cite Deputy 
Governors Maman H. Somantri and Aslim Tajuddin as the 
leading proponents of a more accommodating monetary policy, 
with frequent support from BI Governor Burhanuddin Abdullah. 
BI sets monetary policy at monthly meetings of its Board of 
Governors. 
 
Interest Rate Lowering will Continue 
------------------------------------ 
 
¶3. (SBU) Sarwono made it clear that that BI believes 
inflationary pressures are falling, and predicted that YoY 
consumer price inflation would fall below eight percent by 
October 2006 and to less than seven percent by year-end.  He 
said BI wants to keep real interest rates at about three 
percent, which would give the bank scope to reduce its 
benchmark BI rate to 11 percent by year's end.  With rates 
currently at 12.5 percent, Sarwono said he believes the most 
likely interest rate scenario would be continued, cautious 
lowering through the end of 2006, 25 basis points at a time. 
However, Sarwono admitted this scenario depends on the 
course of the U.S. federal funds rate.  BI seeks to keep the 
difference between the U.S. federal funds rate and the BI 
rate at about six percent, so if the federal funds rates 
rises much beyond current levels, it will leave less 
maneuvering room for BI. 
 
¶4. (SBU) While noting that BI does not directly target the 
Rp/USD exchange rate, Sarwono said Indonesia enjoys a 
comfortable stock of foreign exchange reserves (USD 44.2 
billion as of May 31) that should permit it to accommodate 
continued capital outflows without undue pressure on the 
rupiah.  BI has performed a series of simulations of reserve 
scenarios, including one that sets short-term capital 
outflows at twice the total year-to-date inflows.  As a 
result of the scenarios, Sarwono said BI is confident 
Indonesia has sufficient reserves to cover 4-5 months of 
imports and short term debt repayments.  Nonetheless, he 
acknowledged BI is concerned about renewed, rapid outflows 
of portfolio capital if rates drop too quickly.  He said the 
stock of foreign-held BI certificates (SBIs) had dropped 
sharply after the mid-May emerging market sell-off from Rp 
22 trillion (USD 2.4 billion) to Rp 10 trillion (USD 1.1 
billion).  However, the broader government bond market and 
stock market had fared much better during the recent 
emerging market sell-off, Sarwono claimed, with a small, net 
outflow from the former and two-way movement and profit 
 
JAKARTA 00007718  002 OF 003 
 
 
sharing in the latter. 
 
Concerns About Currency Volatility 
---------------------------------- 
 
¶5. (SBU) Sarwono confirmed that concerns about the possible 
impact of a second, 25-basis point cut in rates on the 
Rp/USD exchange rate led BI's Board of Governors to leave 
rates unchanged at its June 6 meeting.  He claimed part of 
the rupiah's volatility can be traced to the character of 
Indonesia's foreign exchange markets, which are very thin 
(daily turnover of USD 300 - 350 million) and operate almost 
exclusively on a spot basis.  The thin spot market leads to 
wide swings during the trading day, Sarwono said, which are 
reported on Bloomberg and affect market psychology.  Sarwono 
said BI is working hard to develop swap and forward markets 
to take some of the pressure off the spot market.  (Note: 
Some investors use a Singapore-based "non-deliverables 
market" to manage volatility via swaps and options.)  A 
contact at the IMF office in Jakarta noted that intra-day 
currency trading of the rupiah sometimes swings as much as 
600 points against the dollar in a single day, making it 
hard for businesses to plan. 
 
¶6. (SBU) Investment bankers we spoke with confirm that most 
of the money that wanted to leave Indonesia has already 
left.  "Yields are still attractive here...some who left are 
waiting to come back in and buy bonds, expecting the 
interest rate to drop," one noted.  Another said, "Indonesia 
is politically stable, has a balanced budget, a low deficit, 
a trade surplus and a current account surplus.  This is 
attractive to many investors." 
 
Concerns Mounting about Slow Growth 
----------------------------------- 
 
¶7. (SBU) BI's cautious plan for lowering short-term rates 
has left Sarwono and other economists concerned about the 
prospects of GDP growth in 2006.  The Minister of Finance 
announced on June 14 a growth estimate of 5.9 percent for 
2006, revised downward from the budget assumption of 6.2 
percent.  For its part, the IMF revised downward its GDP 
growth estimate for 2006 to 5.2 percent.  Sarwono is 
concerned that both central and regional government spending 
remains much lower than expected (Ref B) and that 
infrastructure investment and spending probably will not get 
seriously underway until 2007.  Regional governments 
(provinces and districts) account for approximately one 
third percent of total government spending, and there is 
clear evidence of spending backlogs at the local level. 
"The regions are sitting on Rp 28 trillion (USD 3 billion) 
of SBIs," Sarwono told us, "which they should disburse via 
social spending."  However, Coordinating Minister for the 
Economy Boediono told donors on June 14 that he is confident 
government spending would pick up in the second half of 
¶2006.  The World Bank was also a bit more optimistic, noting 
that the GOI traditionally backloads public spending, now 
6.9 percent of GDP, which could rise to 20 percent by the 
end of the year. 
 
Capital Markets Volatile 
------------------------ 
 
¶8. (SBU) Indonesia's foreign exchange, stock, and government 
bond markets have remained volatile over the past week. 
However, our contacts in the financial markets believe the 
volatility is part of a global trend rather than an 
Indonesia-specific one.  "Money is moving around the world 
very quickly," one trader told us.  "The amount of money 
investing globally has grown dramatically in the last 18 
months, but investors view Indonesia as more politically and 
macro-economically stable than other emerging markets, so 
will sell Indonesia last."  Another investment banker 
agreed, "there is a mountain of liquidity in every country 
looking for high returns, and Indonesia offers attractive 
rates." 
 
Comment 
------- 
 
JAKARTA 00007718  003 OF 003 
 
 
 
¶9. (SBU) Indonesia seems well positioned to weather the 
current wave of emerging markets volatility.  It has a small 
budget deficit, declining inflation, a comfortable reserve 
level, and a very highly regarded team of economic 
ministers.  Our contacts also express optimism about BI's 
ability to manage the delicate move to lower interest rates 
in a climate of emerging market volatility and declining 
risk appetites among many investors.  A more difficult 
challenge will be finding ways to boost growth given the 
very slow progress on government spending and investment 
climate reforms.  BI Governor Abdullah has already 
speculated to the press about accelerating the move to lower 
interest rates, and we expect continued pressure on BI to 
find a way contribute to higher growth levels. 
 
AMSELEM