VZCZCXRO3360
RR RUEHCHI RUEHDT RUEHHM
DE RUEHJA #1128/01 1130651
ZNR UUUUU ZZH
R 230651Z APR 07
FM AMEMBASSY JAKARTA
TO RUEHC/SECSTATE WASHDC 4434
RUEATRS/DEPT OF TREASURY WASHDC
INFO RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHKO/AMEMBASSY TOKYO 0484
RUEHBJ/AMEMBASSY BEIJING 4060
RUEHBY/AMEMBASSY CANBERRA 0684
RUEHUL/AMEMBASSY SEOUL 4058
RUEAIIA/CIA WASHDC

UNCLAS SECTION 01 OF 04 JAKARTA 001128 
 
SIPDIS 
 
SIPDIS 
SENSITIVE 
 
DEPT FOR EAP/MTS AND EB/IFD/OMA 
TREASURY FOR IA-SETH SEARLS 
SINGAPORE FOR SUSAN BAKER 
COMMERCE FOR 4430 - BERLINGUETTE 
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR FINEMAN 
DEPARTMENT PASS EXIM BANK 
 
E.O. 12598: N/A 
TAGS: EFIN EINV ECON PGOV ID
SUBJECT: BANK INDONESIA CONSIDERS SWITCH TO OVERNIGHT 
INTEREST RATE AS BENCHMARK 
 
REF: A) JAKARTA 486 
 
¶1. (SBU) Summary:  Bank Indonesia (BI) seems likely to 
move to targeting the overnight interest rate rather than 
its one-month Bank Indonesia Certificate (SBI) rate as 
its policy rate for targeting inflation.  This duration 
shift will have the benefit of addressing anomalies (some 
self-induced) in the short-term yield curve which 
currently has a 500 basis points (bps) gap between the 
overnight and one-month interest rate.  At the same time, 
the Ministry of Finance (MoF) plans to begin issuing 
short-term T-bills, which may eventually become the 
primary instrument for BI?s open market operations.  The 
switch from SBIs to T-bills has the benefit of putting 
excess funds in the financial system to work in the 
Government budget rather than simply sitting on deposit 
at BI, potentially reducing pressure on BI to encourage 
banks to increase lending.  Under current plans, however, 
BI would be financing the government directly since it 
and the MOF have struck a deal to allow BI to purchase up 
to 50% of T-bill auctions in order to build up an initial 
stock of T-bills with which to conduct monetary policy. 
End Summary. 
 
Inflation Targeting Impacts on Yield Curve 
------------------------------------------ 
 
¶2. (SBU) According to Bank Indonesia contacts, when BI 
implemented its inflation targeting policy in 2005, it 
decided to use the one-month SBI rate as its policy 
interest rate.  At the time, BI only issued SBIs in one 
and three-month durations and had no shorter-term 
instruments.  Despite technical advice to the contrary, 
BI chose to use the one-month rate as its benchmark 
rather than launch new one-week or 14-day SBIs partly due 
to familiarity of market participants with the one-month 
instrument and partly due to concerns about high 
volatility in the overnight interbank rate. 
 
¶3. (SBI) Meanwhile, BI has maintained its overnight 
facility (known by its Indonesian acronym FASBI) at about 
500 basis points below the one-month SBI rate since late 
¶2005. The FASBI rate has set the floor for the overnight 
inter-bank market.  Market participants argued that this 
arrangement created an incentive for a ?domestic carry 
trade? whereby banks borrowed on the short-term interbank 
market to buy one-month SBIs due to the wide spread 
between the two rates.  The ease of making money in risk- 
free SBIs under this strategy did not help increase 
incentives of banks to lend more to the real economy. 
 
¶4. (SBU) However, the buildup of large holdings of SBIs 
in many banks proved politically uncomfortable for BI, 
since it faces political pressure from many quarters to 
encourage Indonesia?s commercial banks to increase 
lending, according to both market participants and BI 
officials. When auctions for one-month SBIs began to face 
large demands from the highly liquid bank sector, BI 
officials in charge of implementing monetary policy began 
to ration issuances.  Allocations for auction 
participants were running around 10-25% of indicated 
interest, leading to an escalation of indications and 
even more restrictive rationing, according to a Citigroup 
analyst.  In the March 21 SBI auction, however, BI 
changed course and decided to accept 62.4% of indicated 
interest, sending banks scrambling to find funds to pay 
for their allocations.  This sent the overnight interbank 
rates up to 20% from their previous level of around 
4.25%. 
 
¶5. (SBU) The rationing of one-month SBIs also led to 
higher than necessary one-month interest rates, and 
created a temporary ?hump? in the Indonesian yield curve 
whereby one-month rates were higher than three-month 
rates.  The higher one-month rate has short-lived but 
real effects on the economy because lending in Indonesia 
 
JAKARTA 00001128  002 OF 004 
 
 
usually prices off a spread to one-month SBI rates. 
 
----------------------------------------- 
Table 1: SBI Rates (%) 
----------------------------------------- 
              1-month SBI     3-month SBI 
----------------------------------------- 
April 2006       12.75          12.64 
May 2006         12.50 
June 2006        12.50 
July 2006        12.25          12.15 
August 2006      11.75 
September 2006   11.25 
October 2006     10.75          11.36 
November 2006    10.25 
December 2006     9.75 
January 2007      9.50           9.50 
February 2007     9.25 
March 2007        9.00 
April 2007        9.00           8.10 
 
Source: Bank Indonesia 
 
------------------------------------------- 
Table 2: Benchmark Government Securities 
------------------------------------------- 
Term to Maturity   Seri   Yield    Coupon 
------------------------------------------- 
5 years           FR0023    9.16    11.00 
7 years           FR0026    9.45    11.00 
10 years          FR0028    9.82    10.00 
15 years          FR0043   10.36    10.25 
20 years          FR0042   10.46    10.25 
 
Source: Surabaya Stock Exchange 
 
Impact on Overnight Rates 
------------------------- 
 
¶6. (SBU) As a result of episodes like this, market 
participants and BI acknowledge that the effective one- 
month interest rate is not the one-month SBI, but rather 
a weighted average of the allocation bankers receive in 
the SBI and the rest of the funds they are forced to put 
into the overnight market.  Market participants argued 
that it would improve transparency for BI to move to 
actually targeting the overnight rate (rather than 
rationing one-month issuances). 
 
¶7. (SBU) Many market participants believe that the switch 
to overnight targeting would cause overnight rates to 
rise by more than the one-month rate would fall.  Fixed 
income analysts believed that the overnight rate should 
reflect a real rate of around 0%, and so would likely 
rise by at least 300 bps to around 6.5 to 7.0% based on 
inflation expectations of 6.0 to 6.5%.  One-month SBI 
rates would probably fall by less than this, they argued. 
These analysts were not concerned about BI creating 
confusion in the market by raising overnight rates. 
(Note: BI?s official prediction is for interest rates to 
fall over the course of 2007 as the inflation impacts of 
the October 2005 oil price increase continue to 
dissipate.)  However, both market participants and BI 
officials noted that BI will need to properly communicate 
the policy shift to the market to avoid adverse impacts 
on the real economy or damage to BI?s policy credibility. 
 
¶8. (SBU) Concerns over the implication of the shift have 
led BI officials to warn U.S. Treasury officials in 
Washington and in Jakarta that they are ?still studying? 
the switch from one-month to overnight rate targeting. 
One BI official noted that the market participants may be 
a little more ?forward leaning? than the BI team right 
now, and may have misinterpreted their consultations with 
the market on the topic.  While BI officials now are 
generally persuaded by research showing that shorter term 
 
JAKARTA 00001128  003 OF 004 
 
 
policy rates are more effective tools for inflation 
targeting, they remain concerned about possible 
misperceptions in the market of raising rates and want to 
make sure that the bank implements the transition at an 
appropriate time when the overnight market is less 
volatile. 
 
First T-Bill Auction Postponed 
------------------------------ 
 
¶9. (SBU) The Ministry of Finance was planning to launch 
its new T-bill products with auctions for 9-month T-bills 
beginning April 4, but postponed the launch until April 
24 or later.  The MOF plans to auction the T-bills 
through its new primary dealer network of 18 banks and 
securities companies (ref A).  The new primary dealers 
participated in their first government bond auction on 
March 20 without any glitches.  According to officials, 
as the T-bill market develops, BI will begin to replace 
SBIs with T-bills as its instrument of choice for open 
market operations. 
 
¶10. (SBU) T-Bills are typically issued at a discount and 
mature at par, requiring the GOI to sort out tax and 
accounting treatment, i.e. whether the ?capital 
appreciation? or ?interest? will be subject to taxation. 
The GOI first announced in January it would issue T-bills 
on April 3, July 10 and December 4, 2007.  At first 
analysts believed the T-Bill auctions for all of 2007 
would not exceed Rp 3 trillion ($330 million).  For a 
variety of reasons including market development and 
budgetary demand, however, the MOF has decided to 
increase the size and frequency of the auctions.  The 
goal is now to eventually offer regularly scheduled 
monthly T-Bill auctions, a goal a MOF debt advisor 
believes is realistic and achievable.  The MOF now 
targets its first T-Bill auction for April 24. 
 
¶11. (SBU) Both market participants and officials believe 
the eventual switch to T-bills will be economically and 
politically beneficial as banks will have to put excess 
liquidity in an instrument funding the government, rather 
than parking it at BI in the form of SBIs.  In this way, 
the GOI can channel banks? excess funds back into the 
real economy through its fiscal policy.  A smaller amount 
of outstanding SBIs also would make the central bank less 
of a target of Parliamentary and senior GOI officials, 
including Vice President Kalla, who have criticized BI 
for ?letting? banks invest in risk-free SBIs rather than 
lending to real economy.  This criticism partially 
explains BI?s efforts to urge local and foreign banks to 
substantially accelerate their lending growth. 
 
Direct Central Bank Financing of the GOI Budget? 
--------------------------------------------- --- 
 
¶12. (SBU) One controversial part of the switch from SBIs 
to T-bills is an agreement between BI and MoF that BI 
will be able to purchase up to 50% of each auction on a 
?non-competitive basis.?  Under this arrangement, the 
private sector participants will set the interest rate in 
the auctions first.  Then BI will be able to purchase 
bills worth up to a maximum of 50% of the total auction 
amount issued at that same market-determined rate.  One 
problem is that the BI Law (Law 23/1999) stipulates 
clearly that BI may only buy bonds in the secondary 
market.  It is unclear what kind of compromise 
arrangement will be made to get around this requirement. 
There is also the possibility that BI could print money 
to buy government debt and lead to irresponsible economic 
policy if abused in the future.  However, the fact that 
BI maintains the prerogative to buy or not to buy T-bills 
may help mitigate this risk. 
 
¶13. (SBU) One BI official suggested this deal was a 
temporary measure to ensure that BI could more quickly 
 
JAKARTA 00001128  004 OF 004 
 
 
build a sufficient stock of the new T-bill to conduct 
monetary interventions such as open market operations and 
repo facilities.  However, the same official argued that 
it would be inappropriate to put a specific expiration 
date on the deal as BI?s needs for monetary instruments 
will in part be a function of the outcomes of those 
auctions and other macro-economic events and trends. 
BI?s outstanding stock of SBIs stood at Rp 235 trillion 
($25.8 billion) in January 2007, and weekly SBI issuances 
are currently approximately eight times larger than the 
originally planned 2007 T-Bill auction target of Rp 3 
trillion ($330 million).  It will thus take many months 
or even years for T-Bills to replace SBIs as Indonesia?s 
prime monetary policy instrument unless the MOF 
dramatically increases the size of T-Bill auctions. 
 
Comment 
------- 
 
¶14. (SBU) The success of the MOF?s government bond market 
development program is encouraging and the shift to T- 
bills from SBIs is a step in the right direction for 
better transparency and the development of a government 
yield curve.  It may also help to reduce political 
pressure on monetary and bank supervision policies. 
However, BI purchases of government paper could set a 
dangerous precedent for undue influence of the government 
on the central bank, especially in light of the 
reluctance among senior BI officials to resist political 
pressure to encourage faster bank lending.  Improving 
communication strategies at BI also will be important to 
limit any adverse impact on the real economy from the 
shift from one-month to overnight rate targeting. 
 
¶15. (U) Treasury Regional Attache in Singapore Susan 
Baker drafted this message. 
 
HEFFERN