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Cablegate: Bank Indonesia Considers Switch to Overnight

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

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