* Export tax hurts farmer income, threatens long-termsupply

By Fitri Wulandari and Sarah McFarlane

JAKARTA/LONDON, Sept 3 (Reuters) - Indonesia's hefty tax oncocoa bean exports may push firms to expand domesticprocessing, but also risks reducing the country's bean outputif farmers are put off rejuvenating ageing trees.

While any impact on production would take years, loweroutput from the world's third biggest cocoa producer would helpbolster the global market.

Major global cocoa players say the tax does change theeconomics of grinding in Indonesia, although the sector stillfaces hurdles such as poor quality beans and erratic powersupply that have kept it operating at below half of capacity.

"The export tax is a subsidy for the local grinder industrypaid by the cocoa farmers," said Noel Janetski, presidentdirector of PT Mars Symbioscience Indonesia, a unit of foodmanufacturer Mars.

"Farmers are businessmen. If there is not enough money forfarmers, they will do something else."

FARMERS TAKE THE PAIN

Farmers are already seeing their income cut as middlemenlower farm-gate prices to compensate for the 10 percent tax onexports imposed in April.

Middlemen in Sulawesi island, which supplies 75 percent ofIndonesia's output, currently buy cocoa beans from farmers at adiscount of $550 a tonne under New York's ICE cocoa futures,double from around $250 a tonne before the tax took effect.

"If farmers incomes fall, they won't care for the crop,which would lead production to fall," said Halim Razak, anexpert at the Indonesia Cocoa Association, adding that it willtake 3-4 years for the tax to have an effect on production.

Exports from the main producing region of Sulawesicollapsed 22 percent from a year earlier in April, the firstmonth of the new tax, as traders hoarded supplies on hopes thetax would be cut later.

Exports have since recovered and are up 21 percent so farthis year versus 2009, while output is up 10 percent this year.

"I still have merchants coming here to buy my cocoa beansbut prices keep falling since February," said Muhammad Tang,who owns 3 hectares of cocoa plantations about 500 kilometresfrom Makassar in South Sulawesi, a key port for cocoa exports.

"I heard in the news about the extra tax for cocoashipments. Maybe that's why prices keep falling?"

LOCAL GRINDING

Grinders are already betting on buying cheaper beanslocally to turn into higher-value products, as they eye risinghousehold spending driving Southeast Asia's top economy and theregion.

State retail firm PT Sarinah, which runs the country'soldest department store, told Reuters it plans to set up agrinder by 2013, while the second largest grinder PT BumiTangerang Mesindotama will double capacity to 80,000 tonnes bymid-2011.

"More investors will race to set up their business here asit will be more efficient and competitive to be close to theraw material source," said Piter Jasman, chief commissioner ofPT Bumitangerang Mesindotama.

Indonesia is Asia's second-largest grinder after Malaysia.

Olam International is eyeing investments in the country,while Indonesia's government says fellow top four cocoa beanbuyer ADM plans to invest $500 million in cocoa processing,though ADM said there was no such deal yet. The world's biggestchocolate maker Barry Callebaut said it is observingdevelopments.

"With the change in tax structure in Indonesia it's lookingmore favourable for processing initiatives in Indonesia to takeshape," said Gerry Manley, head of cocoa at Olam, one of thetop four buyers of cocoa beans globally.

NO SMOOTH GRIND

Despite the tax, firms may wait to see a clearer picture ofglobal demand for 2011 before finalising investment plans.

"To make investments in additional grinding capacity youhave to make the assumption that we're not going to have adouble dip recession," said Gary Mead, analyst at VM Group.

Indonesia's grinders are seen processing 150,000 tonnes ofcocoa beans this year, up 15.4 percent from last year, butstill below capacity of 345,000 tonnes per year, governmentdata shows.

This is much faster than an expected 4 percent globalexpansion, according to International Cocoa Organizationfigures.

There are still challenges for would-be cocoa grinders inIndonesia, a country where foreign direct investors are oftenput off by rampant graft, red tape and inadequateinfrastructure such as erratic power supplies.

The export tax also does not provide certainty forlong-term investment as the government can cancel it at anytime.

Lack of fermentation of local beans by farmers, essentialto improve the flavour in cocoa powder, is another reasonIndonesia's cocoa grinders run below capacity.

The predominance of smallholders -- who own 93 percent ofIndonesia's 1.5 million hectares of cocoa plantations -- makeit difficult to ferment beans and ensure quality control.

"The Malaysian, the U.S and European factories are bigger,more efficient and they have established markets for the betterquality products they produce," Janetski from Mars said.

"The export duty might attract some people to do processinghere, including Malaysians, but ... is an artificially createdcompetitive advantage and investment is normally driven byfundamental reasons." ($1=8965 Rupiah) (Additional Reporting by Yayat Supriatna and Yusuf Achmad;Editing by Neil Chatterjee and Michael Urquhart)