Cablegate: Commodity Price Collapse Undermines Growth Amid Ongoing

VZCZCXRO8746
RR RUEHCHI RUEHCN RUEHDT RUEHHM
DE RUEHJA #2002/01 3040635
ZNR UUUUU ZZH
R 300635Z OCT 08
FM AMEMBASSY JAKARTA
TO RUEHC/SECSTATE WASHDC 0471
RUEATRS/DEPT OF TREASURY WASHINGTON DC
INFO RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEHRC/DEPT OF AGRICULTURE WASHINGTON DC
RUEHKO/AMEMBASSY TOKYO 2661
RUEHBJ/AMEMBASSY BEIJING 5546
RUEHBY/AMEMBASSY CANBERRA 3216
RUEHUL/AMEMBASSY SEOUL 5063
RUEHGP/AMEMBASSY SINGAPORE 6351
RUEAIIA/CIA WASHDC

UNCLAS SECTION 01 OF 03 JAKARTA 002002

SIPDIS
SENSITIVE

DEPT FOR EAP/MTS, EAP/EP AND EEB/IFD/OMA
TREASURY FOR IA/MALACHY NUGENT AND TRINA RAND
COMMERCE FOR 4430/KELLY
DEPT PASS FEDERAL RESERVE SAN FRANCISCO FOR CURRAN
DEPARTMENT PASS EXIM BANK
SINGAPORE FOR SBAKER
TOKYO FOR MGREWE
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: COMMODITY PRICE COLLAPSE UNDERMINES GROWTH AMID ONGOING
TURMOIL

1. (SBU) Summary: The global financial crisis, slower global
growth, and falling commodity prices continue to weigh heavily on
Indonesian financial markets. The sharp decline in world prices for
Indonesia primary commodity exports clouds the already diminished
outlook for economic growth over the next twelve months and adds
additional pressure on the Indonesian Rupiah (IDR). The negative
commodity price shock also threatens to weaken the banking system,
given rapid expansion of lending to commodity-based sectors in
recent years. Food prices, which have seriously strained Indonesian
household budgets this year, have not fallen significantly in
Indonesia, limiting the potential positive impact of lower world
prices on Indonesian households. Analysts worry that growing
political pressure to ease monetary policy and lower subsidized fuel
prices will further undermine investor confidence, putting pressure
on the IDR and destabilizing prices. End Summary.

Financial Market Turmoil Continues
----------------------------------
2. (SBU) The global financial crisis, global growth, and falling
commodity prices continue to weigh heavily on Indonesian financial
markets. The Indonesian stock market fell an additional 4.7% on
October 28, bringing the decline in value since its peak in January
2008 to over 60%. The yields on 10-year government bonds continued
to rise rapidly on October 27, jumping over 400 basis points in one
day to 20.9%. The one-month Jakarta interbank lending rates also
continued to move upward, rising to 11.5% this week, up from 9.5% in
July. Market analysts attribute much of the recent volatility to
Indonesia's thin capital markets and open capital account, which
allows investors to move money quickly out of Rupiah-based assets.

3. (SBU) The IDR has also depreciated sharply, crossing the IDR/USD
12,000 mark during trading on October 28. As of October 29, the IDR
has lost almost 18% yoy of its value, despite active intervention by
the central bank. Bank Indonesia's (BI) official reserves fell by
$4.1 billion during the first 15 days of October, suggesting that
BI's over $50 billion in foreign currency reserves may be
insufficient to fight further depreciation. To date, analysts have
attributed the decline to both an increase in across the board
emerging market risk and an increase in Indonesian sovereign risk.
Other currencies in the region have suffered similar or worse
declines, with the Korean won down 35% yoy, the Indian Rupee down
over 20% yoy, and Philippine dollar down almost 11% yoy. The
leading indicator of Indonesian sovereign risk, Indonesia's credit
default spread over US Treasuries, rose to over 1200 basis points in
recent trading, several hundred basis points above the Philippines
and Vietnam. The swift move in the currency prompted the Government
of Indonesia (GOI) to announce several measures to stem the decline
in financial markets increase demand for the IDR, including a plan
for the GOI and BI to purchase government bonds and a requirement
for state-owned enterprises to deposit all foreign exchange in
state-owned banks (septel).

4. (SBU) The risk of capital flight from foreign investors remains
significant, but capital flight from domestic investors poses a much
bigger risk to macroeconomic stability. The face value of foreign
holdings of Indonesian government bonds is roughly $10 billion,
according to the IMF resident representative. However, the market
price of these assets has fallen significantly, reducing the
probability and impact of foreign investors selling their holdings.
Moreover, shorter-term investors such as hedge funds hold less than
$16 billion of the total $54 billion of foreign investment in
Indonesian equities, limiting the potential impact of foreign
capital flight from the stock market, according to Joshua Tanja, a
banking analyst with UBS Jakarta. Tanja notes that a decision by
large domestic investors to move money out of the country poses a
significant risk to the stability of Indonesia's currency and
capital markets. To date, however, UBS Jakarta has not seen signs
of significant movement of domestic wealth.

JAKARTA 00002002 002 OF 003

Commodity Price Reversal Threatens Exports, Growth
--------------------------------------------- -----
5. (SBU) The recent reversal in commodity prices will slow
Indonesia's export growth in coming months and may significantly
slow overall growth in 2009. Rubber, coal and palm oil, which
comprise 30% of Indonesia's exports, have fallen 10%, 17% and 33%,
respectively from July to September 2008, and are expected to
continue to decline. Indonesia recorded a trade deficit in July and
a small surplus in August, compared to larger surpluses during most
of the last two years. In addition to lowering overall economic
growth, the weaker trade balance has put pressure on the currency,
as currency traders worry that a potential trade deficit combined
with capital flight will undermine Indonesia's balance of payments.
Analysts expect demand for Indonesian commodities to continue to
decline in line with the forecast for markedly lower world growth
rates in 2008 and 2009. The GOI reduced the export tax on crude
palm oil to zero in an attempt to offset the impact of declining
prices.

6. (SBU) A number of analysts have also raised concerns about the
level of leverage among commodity-based firms, given the sharp
increase in borrowing over the past two years. The Indonesian
corporate sector has undergone significant deleveraging since the
financial crisis of 1997-98, with debt-to-equity ratios of listed
firms falling from 180 to below 40 over the period 2001-2007.
However, lending to the corporate sector, particularly the mining
sector, expanded rapidly over the past two years. The year-on-year
increase in bank lending rose from less than 10% in the third
quarter of 2006 to 35% by July 2008. Lending to the mining sector
rose 65% yoy as of August 2008. In addition, a Deutsche Bank
representative in the region reported to the Embassy that some large
Indonesian corporations borrowed USD from foreign banks using
various interest-linked structured products to reduce borrowing
costs in recent years. These products have since reversed direction
and now significantly increase borrowing costs, according to the
bankers. It remains unclear if this is a widespread problem or
confined to a few firms.

Banking Sector Asset Quality May Deteriorate
--------------------------------------------
7. (SBU) Banking sector analysts expect Indonesian bank exposure to
the commodity sector to strain asset quality and liquidity, but the
scale of the problem is uncertain. Indonesian plantations and
mining firms that over expanded during the commodities boom may face
significant cash flow shortages in light of the commodity price
reversal and limited access to new credit. According to Raihan
Zamil, the IMF's resident adviser in BI's banking supervision
department, there is very limited information available about the
underwriting standards used for loans to the plantation and mining
sectors during the boom. If the banks based these loans on
assumptions of rising commodities prices, the banks may be facing a
new wave of non-performing loans. Although Indonesia's largest
banks are well capitalized and able to absorb an increase in
nonperforming loans (NPLs), a rise in NPLs levels could further
tighten liquidity conditions in the sector given the rising level of
risk aversion associated with the global financial crisis.

8. (SBU) Indonesian banks are also facing a rapidly rising cost of
funds that may strain earnings and slow loan growth considerably,
further constraining growth in the real sector. Deposit growth
rates have failed to keep pace with loan growth in 2008, and
competition for deposits in the current environment has become
fierce. Although the large banks have agreed to cap retail deposit
rates at 13%, analyst reports indicate that banks are paying rates
as high as 15% for large corporate deposits. The banks also hold a
significant amount of government bonds, which have sharply declined
in value in recent weeks and remain largely illiquid.

JAKARTA 00002002 003 OF 003

9. (SBU) The higher funding costs will squeeze net interest margins
and likely impact access to credit for the corporate and consumer
sectors. A growing number of analysts and business leaders have
commented on the difficulty of securing USD denominated trade
finance from local and foreign banks in Indonesia. Note: The GOI
has recently announced plans to guarantee all local bank trade
finance to ensure banks continue to extend to economically viable
firms, but the details of the plan remain unclear. End note.]
Deutsche Bank representatives suggest corporate debt rollovers are
also becoming increasingly difficult to secure in Indonesia.
Mortgage and motorcycle lending rates at many Indonesian banks have
also increased, in some cases as much as 500 basis points, according
to UBS' Tanja.

Limited Local Food Price Adjustments
------------------------------------
10. (SBU) The sharp decline in commodity prices has failed to
provide significant price benefits to Indonesia's poor. Lower world
rice, wheat and soybean prices should eventually increase purchasing
power among low-income Indonesian households who spend over 50% of
their income on food. However, local food prices have been slow to
adjust to declining world prices, according to local market data
collected by the Foreign Agricultural Service. The local price of
rice is down 3% from its peak in June 2008, but remains near
historical highs. The price of wheat-based instant noodles has
continued to rise steadily. Both local and imported soybean prices
also remain near peak levels. While international prices may ease
further as global demand continues to slow, continued depreciation
of the IDR may offset the effect of lower international food prices
in local markets.

Political Pressure on Economic Team Increases
---------------------------------------------
11. (SBU) Analysts worry that growing political pressure to ease
monetary policy and lower subsidized fuel prices will undermine
investor confidence, further destabilizing the IDR and spurring
inflation. On October 27, Senior Deputy Governor of Bank Indonesia
(BI), Miranda Goeltom, stated BI plans to shift its focus to
addressing risks to economic growth, which now clearly outweigh the
risk of inflation. Local press reports indicate that BI had already
faced considerable political pressure not to raise rates on October
7. A reduction in interest rates in the current environment may
contribute to additional capital outflows and further undermine the
value of the IDR.

12. (SBU) At the same time, the sharp fall in global oil prices has
prompted calls from politicians to lower the price of subsidized
fuel. The GOI increased the subsidized fuel price by almost 29% in
May to ease pressure on the GOI's budget, as world oil prices rose
to over $140 a barrel. A reduction in subsidized fuel prices, which
would increase the GOI's subsidy bill and financing requirements,
would heighten concerns about fiscal sustainability at a time when
Indonesia's sovereign risk is already on the rise.

HUME

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