RI's macroeconomic situation remains difficult

RI's macroeconomic situation remains difficult

The following is the International Monetary Fund's Public
Information Notice (PIN) No. 99/33 issued on April 13 reviewing
the situation in Indonesia.

WASHINGTON: On March 25, 1999 , the Executive Board concluded
the 1999 Article IV consultation with Indonesia.

Background

Prior to mid-1997, Indonesia had experienced 25 years of
sustained economic progress, during which income per capita had
trebled and the number of people in poverty had fallen sharply.
However, structural weaknesses had intensified over the years,
leaving the economy vulnerable when hit by the regional financial
crisis. In particular, the corporate sector had borrowed very
heavily abroad, usually without hedging foreign currency
exposure; the banking system had been poorly supervised, with
widespread violations of legal lending limits; and microeconomic
policies had been compromised by poor governance.

Sustained pressure on the rupiah in the wake of the flotation
of the Thai baht in July 1997 imposed severe stress on the
economy. In November, the authorities reached agreement with the
Fund on an economic adjustment program that was supported by a
large official external financing package.

Key elements of the program included monetary policy
tightening, strengthening of the banking system, and a set of
structural reform measures to enhance efficiency and transparency
in the corporate sector.

However, uneven program implementation and increasing
political uncertainty in the ensuing months led to intensified
capital outflows and a precipitous decline in the value of the
rupiah. The political disturbances in May 1998, which culminated
in the resignation of President Soeharto, were accompanied by
further economic disruption and further sharp depreciation of the
rupiah.

In late-June 1998, the new Indonesian government reached
agreement with the Fund on a new stabilization package intended
to restore macroeconomic stability, rebuild the distribution
system, strengthen the social safety net, and address the
deteriorating condition of the financial system.

Monetary policy focussed on reducing inflation and
facilitating an appreciation of the overly depreciated exchange
rate. The fiscal stance was eased to permit greater social
expenditure and help stimulate economic activity. The program
achieved important results in terms of restoring macroeconomic
stability, although output during the 1998/99 fiscal year was
down 16 percent on the previous year's level, with the decline in
investment especially marked, and the inflation rate was about 66
percent.

Real wages fell sharply and surveys indicated that the share
of the population below the poverty line rose.

The authorities' macroeconomic framework for 1999/2000
envisages that the economy should soon bottom out, that real GDP
for the year would be broadly unchanged, and the external
position should strengthen, with foreign reserves expected to
increase to around $29 billion (five months of imports of goods
and services). Prudent monetary policy should lay the basis for
average inflation of some 15-20 percent for the year. The budget
deficit is projected at nearly 6 percent of GDP to help promote
recovery, with increased provisions for targeted social safety
net outlays; the bulk of this deficit will, as in 1998/99, be
financed through external borrowing from multilateral and
bilateral donors.

IMF financial support to Indonesia at the beginning of the
Asian crisis took the form of a three-year Stand-by Arrangement,
approved by the Executive Board in November 1997, in an amount of
SDR 7.3 billion. In July 1998, this amount was increased by SDR 1
billion. In August 1998, the Executive Board agreed to convert
the undrawn amount of SDR 4.7 billion into an Extended
Arrangement, which gave Indonesia more favorable repayment
conditions. On March 25, 1999, the Executive Board approved an
increase in the amount to be made available by a further SDR 0.7
billion.

Total purchases by Indonesia now amount to SDR 6.8 billion
(about US$9.3 billion), with a further SDR 2.2 billion (about
US$3 billion) available between now and November 2000.

Executive Board Assessment

Executive Directors expressed satisfaction with the continued
progress in implementing the program, while noting that recent
political and security developments underscored the fragility of
the current situation. Directors welcomed the announcement on
March 13, 1999, of a major program of private bank
recapitalization and closures, and the agreement reached with the
Fund staff on strengthening macroeconomic and structural
policies.

However, recent export performance has been disappointing,
there has been renewed volatility of the rupiah within a more
depreciated range, inflation rose in December through February,
and progress in corporate restructuring has been limited. These
developments are all a reminder of the considerable risks that
could lie ahead. Moreover, Directors noted that the recent
incidents of social unrest and the uncertainties related to the
upcoming elections had also affected confidence.

Directors supported the proposed tightening of the monetary
stance, which should help to consolidate the program's
stabilization gains. They endorsed the efforts of the authorities
in recent days to bring base money down substantially through
vigorous open market operations, thereby offsetting the upsurge
in liquidity that had occurred prior to the finalization of the
bank restructuring package. Directors agreed that monetary policy
should remain cautious in 1999/2000, and that the monetary stance
should not be eased prematurely-before there were clear signs of
improving confidence and lower inflation. However, concern was
expressed about the inadequate availability of credit to the
export sector.

Directors were also concerned about the continuing negative
spreads between the borrowing and lending rates of banks, which
further underscored the urgent need for bank restructuring.

Directors expressed concern that fiscal stimulus had been slow
to develop over the past year. This was due principally to delays
in finalizing spending programs and improving their execution, as
well as slower than anticipated disbursements of external
financing. They considered that the size of the 1999/2000 budget
deficit was appropriate to impart a larger stimulus to the
economy than was achieved in 1998/99. Directors noted that the
budget is projected to be fully financed without recourse to
domestic bank financing, but cautioned that the budgetary
framework needed to retain the flexibility to respond both to
evolving circumstances-including the possibility of shortfalls in
external financing-and the need to maintain long-term
sustainability.

Directors welcomed the planned expansion of well-targeted
social spending in 1999/2000. They urged the authorities to
ensure that spending goals on health, education, and employment
generation were fully met, consistent with the overall deficit
target, in order to limit the social impact of the crisis.
Directors noted that this would require timely agreement with
multilateral and bilateral donors on the transparent
administration and monitoring of social safety net programs. On
labor issues, they welcomed Indonesia's adoption of four of the
International Labor Organization's seven core labor standards,
and encouraged it to subscribe to the other three, as well as to
improve compliance with the standards already adopted.

Directors stressed that the large bank restructuring costs
pointed to the urgency of intensifying asset recoveries from
large corporate debtors and reversing the declining budgetary
revenue effort. In this connection, they strongly urged the
removal of the recently granted income tax holidays-for up to
eight years to newly established corporations in 22 industrial
sectors-in accordance with the recommendations of the Fund's
Fiscal Affairs Department of earlier this month, and called for
efforts to strengthen tax and customs administration.

Directors welcomed the commitments that had been made by
Japan, the World Bank, and the Asian Development Bank to fill the
external financing gap in 1999/2000. They supported the further
augmentation of the Fund-supported program, which they believed
had helped to catalyze these resources, while noting that the
relatively low level of disbursements from other multilateral
institutions raised serious issues of burden sharing.

Directors stressed the importance of avoiding delays in the
disbursement of official external financing, especially in the
next few months when private capital inflows are not expected.
They noted that discussions are also ongoing with the London Club
(on public debt) and on a second interbank exchange offer on
private debt. In light of the financing assurances, Directors saw
scope for the exchange rate of the rupiah, which is market
determined, to appreciate significantly if economic and security
conditions stabilize.

Directors stressed that successful bank and corporate
restructuring were crucial to improve governance and sustain
medium-term recovery. However, both were still at an early stage,
and Directors urged that the processes be accelerated. They noted
that the private bank recapitalization program will retain an
important element of private ownership and management in
Indonesia's banking system. Directors emphasized the particular
importance of periodic checks of the soundness of the banking
system, the successful restoration of which also depended
critically upon the restructuring of the state banks and their
early privatization. They stated that state bank recapitalization
should be undertaken only after restructuring was completed, and
emphasized that sound and transparent restructuring of the state
banks was critical to the success of the overall Indonesian
economic stabilization and reform program.

Directors emphasized that the Indonesian Bank Restructuring
Agency (IBRA) is central to banking system reform, especially for
asset recovery. They stressed that the agency must be fully
independent to provide assurances that the public costs of bank
restructuring are being minimized. Directors underlined the
importance of the Asset Management Unit's developing asset
management procedures at an early date, and stressed that it
should remain fully independent and be provided with adequate
resources. Strong political leadership and external monitoring
will be required to assure that this process is successful.

Directors urged the authorities to accelerate corporate debt
restructuring under the Jakarta Initiative and take effective
measures to counter growing debtor resistance. In this regard,
they stated that the bankruptcy law must be applied as envisaged,
in a manner consistent with international practice. Directors
pressed for early implementation of legislation aimed at
improving governance, including in the judiciary, which has
already been sent to Parliament, and strengthening of the
Commercial Court. They said that state banks and IBRA should
aggressively pursue loan collection from their largest borrowers,
and quickly initiate bankruptcy filings against recalcitrant
debtors. Directors expressed disappointment at the delays in
privatization. While recognizing that in part this reflected weak
market conditions, they urged the authorities to accelerate the
privatization process, including by improving the regulatory and
legislative framework.

Directors recognized that the authorities were trying to
reorient the economic, financial, and government structure to
broaden participation by weaker economic groups and regions. They
strongly supported the authorities' commitments in this regard to
respect existing ownership rights, move cautiously to avoid any
loss of macroeconomic control, and consult with international
institutions before implementing new initiatives. Consolidation
of the new competition law and the first phase of fiscal
decentralization would be the task of the successor government,
and Directors observed that this would need to be an early and
essential part of the Fund's dialogue with that government. In
the meantime, they cautioned that, based on experience in other
countries, devolution of revenue should be commensurate with
expenditure responsibilities, and that a loss of overall
macroeconomic control had to be avoided.

Directors concluded that the macroeconomic situation in
Indonesia would remain difficult until the political transition
was further advanced. Firm implementation of the program and the
expected continued strong financial support of the international
community should allow for the restoration of positive real
growth from late this year. They underscored the importance of
ensuring transparency in program implementation, especially with
regard to corporate and bank restructuring, and the need to avoid
political interference in these processes. Directors also stated
that policy continuity after the elections and a clear political
will for reform will be crucial to unleash new confidence in the
adjustment program and to strengthen the country's medium-term
growth prospects and its external position. Overall, Directors
were satisfied that policies and developments continue to evolve
as best as possible in a manner consistent with setting the stage
for economic recovery, against a background of difficult and
unsettled domestic conditions.

Window A: ...the macroeconomic situation in Indonesia would remain
difficult until the political transition was further advanced.

Window B: ...the importance of ensuring transparency in program
implementation, especially with regard to corporate and bank
restructuring, and the need to avoid political interference in
these processes.