Jakarta – A political stalemate and lack of legal certainty are hampering efforts to reform and restructure Indonesia's banks, Moody's Investors Service warned Monday.

The global ratings agency said the banks' financial strength ratings have seen a modest recovery due to recapitalisation, intensive restructuring, upgrading programmes and tighter regulation.

But it said in its annual report on the country's banking system that the ratings "remain hostage to a largely unfavorable operating environment, low economic capital and potentially volatile earnings."

The New York-based agency said the outlook for the ratings is stable. But it said that at an average of a "very modest" E+, in the short- to medium-term they continue to be determined "largely by political considerations."

It cited a wide range of conflicting political and social agendas which has led to policy stalemate that is stifling progress in reform and restructuring. The lack of legal certainty also hampered operations and undermined creditor protection.

Moody's said that political stalemate had also adversely affected investor sentiment, resulting in a weaker rupiah which threatens the viability of a number of debt restructuring exercises that have already been completed, with negative implications for bank asset quality.

"Possibly, one of the most important catalysts for change in Indonesia's banking system may be increased foreign ownership in Indonesian banks. The forthcoming sale of a majority stake in Bank Central Asia will serve as a litmus test as to the feasibility of such a development," it said.

Indonesia is in the process of selling its majority stake in the country's largest retail bank, Bank Central Asia. British-based Standard Chartered is among the leading bidders but the sale has attracted opposition from politicians and bank employees.

"Longer term, if political and social stability prevail, Indonesia's banking market offers the potential of attractive margins, which could help banks attract fresh capital and rebuild their financial strength relatively swiftly," said vice-president Patrick Winsbury, the report's author.

Moody's said the outlook for Indonesian bank deposit ratings is largely stable at the sovereign ceiling of Caa1 because of the government guarantee which is expected to remain in force until July 2003.