UPDATE 1-Fitch sees Indonesia's FX reserves growing, worries about banks

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JAKARTA Jan 17 (Reuters) - Fitch Ratings expects Indonesia's foreign currency reserves to sustain their growth, but the ratings agency voiced concerns about the shallow debt market and the banking system, which could threaten investor confidence.

The agency, which last month upgraded Indonesia to investment grade, also said on Tuesday that it expects a slowing momentum in governance improvements ahead of 2014 presidential elections in southeast Asia's biggest economy.

"We do expect some stalling in the overall momentum but we don't see a sustained deterioration in governance in Indonesia," Philip McNicholas, a director of sovereign ratings at Fitch in Asia-Pacific said at a briefing in Jakarta.

Fitch's move to return Indonesia to investment grade status shone a spotlight on both the G20 member's economic successes and its failure to implement faster reforms such as deepening local markets, improving infrastructure and curbing corruption.

Bank Indonesia has more than doubled foreign reserves in the past three years to around $110 billion, giving it a cushion to deal with capital outflows, though reserves have fallen in recent months as the central bank defends a weakening currency.

"The currency flexibility we see is a net positive for Indonesia, even if there can be some short-term discomfort," added McNicholas.

Indonesia's President Susilo Bambang Yudhoyono pledged last month to guard reforms, following Fitch's upgrade of Southeast Asia's top economy to BBB minus with a stable outlook that put it on a par with BRIC member India.

"Fitch... recognizes that there are governance deficiencies in Indonesia but which are insufficient to disturb economic growth or price stability; and thereby it does not pose a huge or imminent risk for the... rating/outlook," said Aninda Mitra, head of economic research for southease Asia at ANZ in Singapore.

"But, even then, it does pose a downside risk to their overall rating rationale of BBB-/STA," he added.

A major negative risk would be a severe shock to external and domestic investor confidence, with a need to improve a shallow debt market that has high foreign ownership, McNicholas said.

McNicholas told Reuters that Fitch had some concerns about the country's banking system because of sharp increases in asset prices and credit growth of over 20 percent, though he said this was not a constraint on its rating at this stage. Fitch sees the economy growing 6 percent this year and 6.5 percent in 2013.

Loan growth in the country is running at around 25 percent, with the central bank having slashed rates to a record low 6 percent last November to support growth in the face of a global slowdown.

Despite solid 2011 economic growth of 6.5 percent and falling debt levels, global risk aversion has led to investor sell-offs that have taken its rupiah currency down 1.5 percent this year making it emerging Asia's worst performer.

Bank Indonesia Governor Darmin Nasution said on Monday the central bank would remain the currency market, after having appeared to defend the currency in recent months at around its current level of 9,200 per U.S. dollar.

Economists said a more flexible policy on the rupiah and government reform of wasteful fuel subsidies would mean less pressure on the central bank's foreign currency reserves. (Reporting by Matt Bigg and Aditya Suharmoko; Writing by Neil Chatterjee; Editing by Ramya Venugopal)