Reform programs to spur recovery later in the year

The following is the full text of the Supplementary Memorandum of Economic and Financial Policies. The memorandum was the outcome of a three-week negotiation between the government and the International Monetary Fund.

1. The overall economic stabilization and reform strategy of the Government of Indonesia remains as described in the Memorandum of Economic and Financial Policies signed on Jan. 15, 1998. This supplementary memorandum updates the earlier document to allow for recent changes in the macroeconomics situation and outlook, and also describes areas where our strategy needs to be modified, extended or strengthened. The main changes are highlighted in seven attached appendices.

2. The economic situation has deteriorated since the beginning of 1998. The depreciation of the rupiah in recent months combined with a severe drought has resulted in a large increase in prices, with the consumer price index rising by 6.9 percent in January and 12.7 percent in February before slowing to 5.5 percent in March. Because of the drought, food prices have risen particularly sharply during the first quarter of the year. The financial position of the domestic banking system has dramatically deteriorated, as the crisis in the economy has deepened. Bank Indonesia granted very large scale liquidity support, creating additional pressure on the exchange rate and international reserves. At the same time, foreign banks have cut trade and other credit lines to Indonesian banks, and enterprises are having difficulty in obtaining the imported inputs needed for production. The rupiah strengthened briefly in February, but then weakened again, fluctuating during the first half of March in the region of Rp 10,000 per U.S. dollar. In the second half of March the rupiah strengthened again to Rp 8,500 per U.S. dollar. After declining by $5 billion during the first two months of 1998, gross foreign exchange reserves stabilized in March at about $16 billion.

3. Our strategy is to (i) stabilize the rupiah at a level more in line with the underlying strengths of the Indonesian economy, including through a tightening of monetary policy, (ii) strengthen and accelerate our strategy for restructuring the banking system; (iii) strengthen the implementation of the structural reforms that will create the foundations for a more efficient and competitive economy; (iv) provide a framework for comprehensively addressing the debt problems of private corporations; and (v) restore trade financing to a normal basis, thereby allowing domestic production and especially the export sector to recover. The government expects that its bold policy program will be reinforced by financial support from the international community, including trade financing and the provision of food and medical aid.

4. With the deterioration in the economic situation, inflation will be higher and the economy weaker in 1998 than we had earlier hoped. While it is difficult to be precise in current circumstances about the macroeconomic outlook, the revised program envisages that the exchange rate would strengthen rapidly during the first quarter of 1998/99. We expect that the exchange rate will eventually stabilize below Rp 6.000 per U.S. dollar. On that basis, inflation would decelerate quickly, but would probably still amount to over 45 percent during 1998 as a whole. Given the disruption to production that has already taken place, a decline in real GDP in 1998 of 5 percent is probably now unavoidable. We expect the economy to start to recover in the second half of 1998 and the decline in real GDP is predicted to be 4 percent for the fiscal year. With the depreciation of the rupiah and the weakening of the economy, the external current account is expected to show a shift from a deficit of about 1 percent of GDP in 1997/98 to a surplus of about 3 percent of GDP in 1998/99. With the projected increase in official external concessional assistance, the cessation of private capital outflows as the program takes hold, as well as the restructuring of corporate debt, the overall balance of payments position is expected to be manageable.

5. Monetary policy is being tightened in order to bring the exchange rate to a more appropriate level and to reduce inflation. The monetary program target has been shifted to net domestic assets (NDA) of Bank Indonesia instead of base money as agreed in October 1997. This change is being made because it is essential to curb the expansion of central bank credit, which has grown rapidly in recent months. This will require that liquidity support to banks be brought firmly under control. Limits on NDA and net international reserves will be performance criteria. Because of uncertainties over monetary relationships, the performance criteria for NDA and NIR will for the time being established only one month in advance, within the context of a rolling three month indicative framework. It is envisaged that both NDA and NIR would be broadly constant during April-June 1998. This is consistent with the outlook for the balance of payments. Bank Indonesia will publish key monetary data on a weekly basis.

6. Within the month, should the exchange rate deviate from its programmed path, NDA and interest rates will be adjusted as necessary. Consistent with the implications of the performance criteria for NDA and NIR, base money is projected to be approximately constant during April to June. This reflects modest growth in rupiah broad money combined with a decline in the currency-deposit ratio resulting from improved confidence in the banking system. We will establish indicative limits for base money and liquidity credit to banks. The central bank will appoint high level foreign advisors to assist in the conduct of monetary policy.

7. To help reduce monetary growth and restore confidence in the rupiah, interest rates in Bank Indonesia certificates (SBIs) have been substantially increased, and Bank Indonesia has publicly indicated its intention to adjust interest rates as necessary to reduce inflation rapidly and strengthen the exchange rate. Steps have also been taken to remove impediments to the pass through of higher money market interest rates to deposit and lending rates. In addition, new liquidity support facilities have been introduced to make access to this support more restrictive and costly. These changes are summarized in Appendix I. Reflecting these measures, bank deposit interest rates increased sharply.

8. Bank restructuring is being accelerated and the Indonesian Bank Restructuring Agency (IBRA) strengthened. This is crucial for stopping the flow of liquidity support to banks and regaining monetary control. The most urgent priority is to effectively take over seven large banks that account for the bulk of the liquidity support that has been provided to the banking system. The action plan for addressing the banking sector problems is described in Appendix II. Implementation of this plan is a prior action. In addition, a number of steps are being taken to strengthen IBRA and ensure that it has the resources and independence to complete the restructuring of the banking system effectively and to maintain the highest standards of governance. These measures are also described in Appendix II. Given the overall objective of restoring quickly a credible and viable banking system, Bank Indonesia is also intensifying its efforts to rehabilitate and strengthen relatively healthier banks, including raising their capital adequacy levels to international standards. The implementation guidelines for the government guarantee program on commercial bank obligations were issued on March 6, which should help to further strengthen confidence in the banking system. Coordination of work between BI and IBRA in strengthening the banking system will be enhanced by maintaining a full and well structured flow of information and data.

9. The total cost of bank restructuring, including the cost of recapitalizing banks to an 8 percent capital asset ratio and of repaying Bank Indonesia for the liquidity support provided to banks taken over by IBRA, is tentatively estimated to be of the order of 15 percent of GDP, on the basis of end-January balance sheet data and the macroeconomic assumptions underlying the revised program. Part of this cost will eventually be recovered as recapitalized banks are sold by IBRA. The costs to the government of bank restructuring will be recorded transparently in the budget. It is envisaged that the repayment to Bank Indonesia for the liquidity support will be implemented in the first instance through the transfer of Rp 80 trillion (roughly the stock of credit outstanding to the 54 banks taken over by IBRA) of indexed bonds to IBRA from the Ministry of Finance which will likely on-sell them to Bank Indonesia. Additional bonds of perhaps Rp 75 trillion with market-related nominal interest rates will be issued during the course of the year for restoring the financial viability of banks taken over by IBRA. Including allowance for the cost of running IBRA and managing the assets that it takes over, the budgetary cost of bank restructuring in 1998/99 is estimated at about 1 1/2 percent of GDP. The budgetary burden in subsequent years may be higher as amortization payments begin, even after allowing for significant cost recovery, and lower nominal interest rates.

10. The budgetary position in 1998/99 will come under severe pressure as a result of the decline in economic activity, the need for temporary subsidies to protect low income groups from the impact of the depreciation of the exchange rate on the prices of staple foods and other essential items, the large cost of restructuring the banking system, and the decline in international oil prices. Without offsetting measures, these factors could increase the deficit to at least 6 percent of GDP. However, the government intends to limit the deficit to about 3 1/2 percent of GDP, almost all of which can be covered by foreign financing.

11. To achieve the program's budgetary objective the government has taken the following steps: (i) subsidies remain limited to a few items that have a large weight in the consumption baskets of low income groups, and the subsidies are being contained by large price increases for several food items, petroleum products and electricity (Appendix III). In the present environment, there is little or no scope to raise revenues by increasing taxes. Subsidies will be substantially scaled down by October 1. (ii) low priority development expenditures have been reduced; and (iii) profit transfers from state enterprises, including from Pertamina, will be increased as a result of efforts to scale back state enterprise investment and accelerate management reforms. The remainder of the budgetary gap will be covered by divestiture proceeds. During the program period, we intend to conduct a revenue review in conjunction with the Fund that would aim to strengthen overall revenue performance and improve tax administration. The first stage of this review will be undertaken by end-September 1998.

12. A detailed state enterprise reform and divestiture plan (Appendix IV) is being developed with the intention of improving the efficiency of the enterprise sector as well as helping to strengthen the public finances. Transparent procedures are being developed for the sale of state assets. Over the longer-term, at a minimum, all enterprises that operate in competitive markets will be privatized, with the government retaining only selected public utilities and strategic companies. For 1998/99, divestiture receipts have been estimated conservatively because of the uncertain market conditions.

13. The government remains fully committed to the structural reforms set out in the January Memorandum of Economic Policies. However, implementation has lagged in some areas and difficulties with implementation encountered in others, notably the elimination of certain restrictive marketing arrangements and the operations of BULOG. The situation in these areas and the steps that the government is taking to rectify any problems that have arisen are set out in Appendix V. In particular, the government will, by April 22, 1998, eliminate all restrictions on foreign investment in wholesale trade and establish a level playing field in the import and distribution of essential food items between BULOG and private sector participants. Clove marketing has been opened to private sector competition, with the government ensuring that small holders are not disadvantaged; foreign and domestic applications for investment in oil palm plantations are being treated identically throughout the country; and the plywood joint marketing body has been dismantled. Provincial and local export taxes have been abolished. Transparent and competitive bidding for the private provision of infrastructure is being strengthened or improved.

14. The Executive committee of the Resilience Council will be in charge of constant monitoring of the structural reforms. The Executive Committee will be assisted in this task by the Asian Development Bank, the World Bank and the Fund, and will employ independent auditors as necessary to ensure effective progress in this area. The auditors' reports will be made available to the three institutions.

15. The government has already taken steps as part of its economic restructuring program to improve competitive conditions in a number of specific markets. In order to enhance the overall efficiency of markets, the government will write and implement a law on competition policy to establish guidelines for fair business practices and to avoid anti-competitive behavior. Competition policy will benefit consumers by making quality goods available at the lowest possible prices; small scale enterprises will benefit from improved access to the widest range of goods and trade facilities. As a first step, the government will implement by September 1998 the necessary regulations establishing guidelines and clear procedures and mechanisms for mergers, acquisitions, and exit which facilitate efficient corporate restructuring while safeguarding against anti- competitive or predatory behavior. The broader draft law will be completed by December 1998.

16. The government will further strengthen and support the development of small and medium scale enterprises and cooperatives through various measures. In particular, the government will ensure an adequate flow of credit to these enterprises and cooperatives during the period of general credit restraint. In the first instance, this will be done by improving the targeting and implementation of existing schemes with assistance from the Asian Development Bank and World Bank. If necessary, additional budgetary resources will be made available to these schemes. Over the medium-term, the government will strengthen the overall institutional framework for enhancing efficiency of the small and medium enterprises and cooperatives. The government will develop a specific plan of action, with assistance from the Asian Development Bank and the World Bank. Such a plan will include measures to (1) strengthen the capabilities of financial institutions involved in lending to small and medium scale enterprises and cooperatives, especially with regard to credit appraisal and project supervision; (2) manage the risks and reduce the transaction costs associated with such lending; (3) enhance access to trade financing and insurance facilities; (4) develop technical skills and improve access to appropriate technologies; and (5) improve provision of suitable infrastructure and reduce administrative control.

17. Steps are being taken to strengthen the initiative for addressing the external debt problems of private corporations, where progress so far has been slow. Efforts to collect data from corporations on their external obligations are being accelerated and reinforced. In addition, the government-appointed private external debt team is working on the development of a framework for greater, though still limited, government involvement in corporate debt restructuring, in order to help move the process forward. This process should be well underway by mid-April. These steps are described in Appendix VI. To strengthen the incentives for corporations to participate in the corporate debt restructuring scheme, and to improve the business environment more generally, we are overhauling the bankruptcy system and are establishing a special commercial court to provide for fair, transparent and expeditious resolution of commercial disputes (the activities of the court will initially be limited to bankruptcy proceedings) (Appendix VII). We also intend to request that foreign banks roll over interbank credits to domestic banks and restore trade financing.

18. To help restart the normal provision of trade finance, which has been severely disrupted, Bank Indonesia is putting in place a facility to guarantee letters of credit opened by participating foreign banks for the import of raw materials. Beginning March 13, 1998, Bank Indonesia deposited $100 million with each of seven foreign banks as backing for these banks' confirmation of letters of credit issued by six state-owned banks. Up to three more foreign banks are considering participating, which would bring Bank Indonesia's commitment to $1 billion.

19. Adequate financial support from the international community will be essential for the success of the stabilization strategy. We have been assured that assistance will be provided by the Asian Development Bank and the World Bank once the program review is completed. The provision of other assistance including food aid and a restoration of trade credit exposure by foreign commercial banks to domestic banks will need to be coordinated. Additional bilateral financial support has been pledged.

20. It is imperative that the adjustment program does not result in a worsening of the economic and social conditions of the poor. Our policies stated previously on providing a social safety net will be continued and strengthened. The government also is broadening subsidized credit schemes for small and medium-size enterprises where most of the non-agricultural labor force is employed. In addition, community-based work programs are being expanded, in cooperation with the Asian Development Bank and the World Bank and to sustain the purchasing power of the poor in both rural and urban areas, especially those households suffering unemployment.