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.