IMF concludes Article IV consultation with Indonesia

IMF concludes Article IV consultation with Indonesia

On Sept. 14, 2000, the International Monetary Fund's Executive
Board concluded the Article IV consultation with Indonesia. The
following is the complete report.

WASHINGTON: Since the last Article IV Consultation, Indonesia
has undergone a major political transition to democratic
government. The reform program of the new government has been
strongly supported by the international community. Indeed, the
new government moved quickly to adopt a three-year IMF-supported
economic program, and secured necessary financing assurances
through a successful Consultative Group meeting and a Paris Club
rescheduling.

The new coalition government inherited deep political, social,
and economic problems and, during its first year of office, the
authorities have had to deal with an upsurge of sectarian
violence, threats of secession from various provinces, and a
series of political disputes. All of these have affected the
implementation of the economic program.

Nonetheless, significant progress has been achieved in
macroeconomic stabilization. Preliminary data indicate that real
gross domestic product (GDP) has risen by about 4 percent (year-
on-year) during the first half of 2000. The recovery continues to
depend principally on growth of private consumption, though
rising non-oil export volumes have also helped in recent months.
Gross fixed investment appears to have bottomed out, but with
real GDP still some 10 percent below its pre-crisis level, there
has been minimal new investment from private sources.
Inflationary pressures have remained relatively subdued-
reflecting the large output gap as well as prudent fiscal and
monetary policies. Gross reserves of Bank Indonesia have also
been substantially replenished over the last two years to some
$28 billion.

Some progress is also being made in the core structural areas,
particularly in bank and corporate debt restructuring, although
there have been delays. The government is making efforts to move
more forcefully in imposing sanctions on recalcitrant debtors,
recapitalizing and restructuring the banking sector, and pushing
forward the process of asset recovery and debt restructuring.
However, uneven program implementation and increasing political
uncertainty have made this progress slow and uneven, contributing
to the recent deterioration in market sentiment.

These areas, together with the achievement by Indonesia's
banking system of international prudential standards, remain the
core outstanding tasks for sustaining the recovery.

The authorities' macroeconomic framework for 2000 entails
achieving a real growth rate of 3-4 percent, keeping average
annual inflation at 3-4 percent, and a further build-up in
foreign exchange reserves. The approved budget deficit of 4.8
percent of GDP should help to promote recovery, while ensuring
adequate protection for the poor. The room to lower interest
rates should return once confidence improves and risk premia
begin to fall. Looking beyond the current year, achievement of 4-
5 percent growth and maintaining inflation below 5 percent in
2001 are well within each. However, there are many risks in the
near-term, and achievement of these objectives is predicated on
swift reduction of political uncertainties and intensified
program implementation.

Indonesia's stand-by arrangement (SBA) was approved on Nov. 5,
1997, with a total of SDR 3.7 billion being drawn (out of a total
of SDR 8.3 billion). The SBA was replaced by an extended
arrangement on Aug. 25, 1998, under which about SDR 3.8 billion
was drawn (out of an augmented total of SDR 5.4 billion). A new
extended arrangement in the amount of SDR 3.6 billion was
approved on Feb. 4, 2000 and, thus far, about SDR 0.8 billion
has been drawn. Indonesia's obligations to the Fund now amount to
the equivalent of about $10 billion.

Executive Board Assessment

Executive Directors noted that, three years into its economic
reform program, and with strong international support, Indonesia
has achieved significant progress in macroeconomic stabilization.
The economy is growing again, inflation is low, gross reserves
have been considerably restored, and the poverty rate is
declining. Nevertheless, Directors saw many vulnerabilities that
give considerable uncertainty to the medium-term outlook. In
particular, the renewed volatility and weakness in financial
markets in the year 2000 pose a risk to the recovery. Market
confidence is fragile, and private capital flows have yet to
recover. Moreover, asset recovery and corporate debt
restructuring have not yet reached a decisive stage.

Directors stressed that, to consolidate the recovery and
improve the medium-term outlook, the authorities should address
these weaknesses rapidly and give strong political leadership to
the economic program. They considered that careful and consistent
management of macroeconomic policy is a prerequisite for the
return of confidence and growth. Equally, they stressed the need
for further banking sector reform, rapid progress in asset
resolution, acceleration of corporate debt restructuring, and
adherence to good governance, which will be critical to
delivering a sound medium-term outlook. Directors were encouraged
by the commitment of the new economic team to take ownership of
the program and intensify its implementation with greater
consistency.

Directors agreed that a supportive fiscal stance remains
appropriate for 2000, but considered that fiscal consolidation
should begin in 2001-in view of the high level of government
debt. In light of the improved outlook for growth, they welcomed
the authorities' intention to use additional oil revenues to help
advance fiscal consolidation. In particular, they cautioned
against additional public sector pay increases unless these were
accompanied by significant civil service reform.

Directors commended the authorities for the early passage of
five tax laws that are aimed at improving the efficiency of the
tax system and enhancing the revenue base.

Directors observed that fiscal decentralization poses a
difficult challenge. They see considerable risks to fiscal
sustainability as well as to the delivery of essential public
services. Directors stressed that reducing the macroeconomic
risks will require a pragmatic and phased approach to fiscal
decentralization, especially given the delays in setting up the
necessary implementing institutions. They cautioned that all
borrowing by sub-national governments should be subject to strict
limits, and that a contingency should be built into the 2001
budget.

Executive Directors welcomed the Indonesian authorities'
continued commitment to a floating exchange rate and an open
capital account. They stressed the importance of strengthening
public confidence in the currency. Regarding monetary policy,
Directors agreed that as market sentiment improves and risk
premia are reduced, there should be some room for real interest
rates, which are still high, to decline. This would, however,
require consistent and forceful implementation of key reforms,
particularly in the areas of bank and corporate debt
restructuring.

On structural reforms, Directors noted that considerable
progress had finally been made in recapitalizing the state banks,
and in restoring the banking system to solvency, albeit at
substantial cost in terms of the increase in public sector
indebtedness. However, the restructuring process remains far from
complete. They noted with concern that profitability is low, the
state banks have high operating costs and low earnings potential,
and the large state banks continue to suffer from illiquidity.
They thus underlined the need for vigilance on the part of the
supervisory agencies, to ensure continued financial and
operational restructuring, especially of the state banks, and
with the help of international expertise. The government should
also divest the large shareholding that it acquired in the
banking system during the crisis, while strengthening the
supervisory and governance framework to international standards.

Directors expressed disappointment at the slow progress in
asset recovery and corporate debt restructuring. They welcomed
the authorities' renewed efforts in these areas and their
commitment to accelerate the pace of asset sales and debt
restructuring by the Indonesian Bank Restructuring Agency (IBRA)
and the Jakarta Initiative Task Force (JITF). These efforts will
be essential to stimulate new investment and capital inflows and
facilitate a reduction in Indonesia's public debt burden and,
thereby, should help to enhance medium-term growth prospects.
Directors noted, however, that strong political leadership is
needed to change the incentive structure faced by recalcitrant
debtors.

In this regard, Directors welcomed the establishment of the
new IBRA governing board that aims to balance independence with
accountability.

They also welcomed the supporting legal reforms to enhance
governance in the court system-which will be crucial to the
acceleration of corporate debt restructuring and asset
resolution-such as the appointment of ad hoc judges from the
private sector to cases before the Commercial Court, and the
establishment of a Joint Investigating Team to address governance
issues with respect to the court system.

Directors emphasized the importance of progress in fiscal
transparency, including oversight of private foundations,
integration of all off-budget funds, and improvements in treasury
management, which should help to anchor the outlook for medium-
term recovery and the achievement of fiscal sustainability. They
also agreed that improving public sector governance and
privatization of state enterprises will help to create a more
favorable climate for increased foreign investment and sustained
economic growth.

Directors welcomed Indonesia's recent compliance with the SDDS
and noted that data provision is adequate for basic macroeconomic
surveillance. They noted, however, that a number of data
shortcomings remain, and stressed that priority should be given
to improving the statistical base to allow for better monitoring
of economic reforms and performance. In particular, fiscal and
debt data are weak, and bank and corporate sector data needs
strengthening for the better monitoring of restructuring.

Directors welcomed the authorities' commitment to address
these deficiencies.

Public Information Notices (PINs) are issued, (i) at the
request of a member country, following the conclusion of the
Article IV consultation for countries seeking to make known the
views of the IMF to the public.

This action is intended to strengthen IMF surveillance over
the economic policies of member countries by increasing the
transparency of the IMF's assessment of these policies; and (ii)
following policy discussions in the Executive Board at the
decision of the Board.