RI's memorandum of economic and financial policies
RI's memorandum of economic and financial policies
The following is the text of Indonesia's Second Memorandum of
Economic and Financial Policies attached to the letter of intent
signed by Coordinating Minister for Economy, Finance and Industry
Ginandjar Kartasasmita Thursday in Jakarta.
1. The revised economic program set out in the Memorandum of
Economic and Financial Policies signed on April 10, despite a
promising start, has been driven well off track by the social
disturbances and political change that occurred in May. While the
new government is strongly committed to rapid stabilization of
the economy and the far-reaching structural reform described in
the MEPP, significant changes to the macroeconomic framework and
to monetary and fiscal policy -- including to allow for a
strengthened social safety net to cushion the escalating effects
of the crisis on the poor -- are now needed. The most urgent
priority is to repair the distribution system and ensure adequate
supplies of food and other necessities to all parts of the
country. Also, moving quickly to restructure comprehensively the
banking system is of the highest priority. Achieving these
objectives will, until the economy recovers, require considerable
additional financial support from the international community.
This Supplementary Memorandum describes the changes to our
economic program, with the modifications to the social safety net
and banking restructuring highlighted in the attached appendices.
A revised listing of all policy commitments under the program is
shown in the attached matrix.
2. As a result of the social and political upheavals in May, the
economic situation and outlook have worsened considerably, and
the economy faces a very serious crisis. The distribution network
has been badly damaged, economic activity, including exports,
generally disrupted, and business confidence severely shaken. As
a result, the exchange rate has substantially weakened, rather
than appreciating as envisaged in the April program, and
inflation is running higher than projected. Because of shortfalls
in budgetary resources, expenditures have had to be compressed to
unsustainable levels, with adverse consequences for social
services and economic activity. In addition, large-scale
liquidity support has had to be provided to meet runs on a major
private bank, which has since been placed under the control of
the bank restructuring agency (IBRA)
3. Despite those unfavorable developments, Bank Indonesia has
maintained firm control over monetary policy, effectively
reabsorbing most of the liquidity provided to meet the bank run.
Although base money is somewhat above the indicative target in
the program, this mostly represents an increase in currency
demand following the bank run; net domestic assets (NDA) remain
within the April program target. Also, by avoiding intervention
in the foreign exchange market, net international reserves are
still above the target established in the April program. Another
important positive development is that agreement was reached with
the Steering Committee of creditor banks in Frankfurt in early
June on the restructuring of interbank debt, on maintaining trade
credit, and on a scheme for restructuring corporate debt. These
agreements are a crucial element of our overall economic
strategy, and should provide some immediate relief to the foreign
exchange market, and facilitate the revival of trade and economic
activity.
Macro Framework
4. With the disruptions to economic activity and damage to
business confidence in recent weeks, it is now expected that real
GDP will decline by more than 10 percent in 1998. However, we
believe that the decline in activity should bottom out as the
program takes hold and confidence is restored. The exchange rate,
which in a thin market has been very volatile and dominated by
sudden shifts in market confidence is particularly difficult to
forecast. The revised program is based on the conservative
assumption that the exchange rate will stabilize by the last
quarter of 1998 at around Rp 10,000 per dollar, but we expect a
greater strengthening of the exchange rate. Reflecting high
inflation in the first quarter, inflation is likely to amount to
about 80 percent during calendar 1998, but should slow rapidly
during coming months. This revised macroeconomic framework is
subject to unusually large uncertainty, and will be kept under
review.
Fiscal Policy
5. A central feature of the program continues to be the
limitation of the budget deficit to a level that can be offset by
additional foreign financing. The pressures on the budget,
however, have intensified with the deepening of the crisis. The
depreciation of the exchange rate, through its impact on the cost
of subsidies and debt service, the further decline in oil prices
and weakening of output all add substantially to the deficit. In
addition, given the severity of the crisis and its
disproportionate impact on the poor, there is an urgent need to
strengthen the social safety net to alleviate the impact of
higher unemployment and underemployment and the greater incidence
of poverty.
6. The overall budgetary cost of social safety net program is
now estimated at about 7 1/2 percent of GDP. Food, fuel,
electricity, medicine, and other subsidies are estimated, with
present prices, to amount to about 6 percent of GDP in 1998/99,
about 4 percentage points higher than envisaged in April. In
addition, the government is expanding employment generating
programs, targeted to poor and vulnerable regions and households,
supported by the World Bank, the Asian Development Bank, and
bilateral donors. The UN World Food Program is establishing food-
for-work programs, concentrated in drought-affected areas.
Budgetary allocations for health are being increased with
emphasis on spending directed to the vulnerable groups, including
village health centers and immunization programs. To minimize the
decline in school enrollment, the government is expanding the
block grant program, strengthening the school lunch program and
instituting a scholarship program for poor students. Further
details of social safety net programs are shown in Annex I.
7. Without offsetting measures, the budget deficit could
increase to an unmanageable level in 1998/99. the viable options
for reducing the deficit are few, given the weakness of the
economy. Significant revenue measures are not feasible in short
term, although over the medium term we intend to overhaul the
revenue system, and we intend to request IMF technical assistance
to this end. Further increases in the administered prices of
staple foods and fuels would exacerbate the impact of the crisis
on the poor, and will have to be delayed until the economy has
begun to improve. It remains our objective, however, to phase out
subsidies as output and household incomes recover, and a system
for adjusting administered prices on a regular basis will be
developed by the end of this fiscal year. So the savings are
envisaged from improvements in efficiency in the management of
state-run operations, including through the renegotiation of
existing contracts, and from resources previously utilized
outside the budget. Most of the needed savings, however, will
have to come from cuts in infrastructure projects. We have
reviewed investment spending in the budget carefully, and in
close collaboration with the Asian Development Bank and World
Bank have cut or delayed projects amounting to about 2.5
percentage points of GDP.
8. These cuts reduce the protected budget deficit to 8.5 percent
of GDP in 1998/99, a level that we believe can be offset by
additional foreign financing. A deficit of this magnitude, while
justified by the severity of the present crisis, is not
sustainable. We envisage that the overall deficit in the
1999/2000 budget will be substantially smaller in relation to
GDP, partly as a result of measures to raise revenue and reduce
subsidies.
Monetary Policy and Banking System
9. Tight monetary policy continues to be essential if the
exchange rate is to stabilize and inflation decline. Given the
recent weakness of the rupiah and the danger of an inflationary
spiral, we intend to hold base money and NDA broadly constant
during the third quarter. As in the April program, allowance has
been made in the monetary program for the repayment of arrears on
interbank debt and trade credit under the agreement with foreign
banks, which will imply a fall in net international reserves
(NIR) of about $1 billion and a corresponding increase in NDA in
late June. Once the economy has stabilized, some modest increase
in NDA and base money will probably be needed to accommodate a
recovery in economic activity. Because of the considerable
uncertainty about the demand for rupiah, however monetary policy
will be kept under continuous review, and adjusted as necessary,
including in light of developments in the exchange rate and
inflation.
10. To strengthen monetary management, BI intends to switch from
the current system in which interest rates on central bank paper
(SBIs) are set administratively to an auction system for these
instruments. This changeover will begin with auctions of one
month paper in July, and later expand to a full range of
maturities. It is expected that auctions of SBIs will have become
the primary means for conducting open market operations by end-
September. In addition to strengthening monetary control, this
will enable a fully market-determined term structure of interest
rates to emerge. Given the need to hold NDA and base money
constant, interest rates are likely to remain high in the pear
terms, but should decline as markets stabilize. In order to
provide BI with the autonomy for conducting monetary policy, the
preparation of legislation on central bank independence is being
accelerated and will be submitted to parliament by end September.
11. The condition of banks has deteriorated further in recent
months, and implementing a comprehensive solution for the banking
system is being given the highest priority. This is an essential
precondition for the recovery of the corporate sector. The
objective is to resolve the financial difficulties of the weak
banks and establish a sound functioning banking system quickly. A
key element of the revised strategy involves measures to
strengthen relatively sound banks partly through the infusion of
new capital. The approach to the weak banks will involve moving
swiftly to recapitalize, merge or effectively close them, while
maintaining the commitment to guarantee all depositors and
creditors. Decisions regarding individual banks will be based on
uniform and transparent criteria, drawing as appropriate from the
results of portfolio reviews by international accounting firms. A
presidential decree will be issued providing appropriate legal
powers to IBRA, including its Asset Management Unit by mid July
1998. Also, a high level Financial Sector Advisory Committee is
being established to advise on the coordination of all the
accessory actions for bank restructuring. the strategy for the
banking system is described in more detail in Annex II.
Corporate debt and bankruptcy legislation
12. The financial restructuring of the corporate sector is
crucial for economic recovery, and an essential counterpart to
banking system restructuring -- a sound corporate sector is
necessary for a sound banking sector. The scheme agreed in
Frankfurt provides a framework through the Indonesia Debt
Restructuring Agency (INDRA) for the voluntary restructuring of
the debt of corporations to foreign banks on terms that are
consistent with Indonesia's overall external payments capacity,
and that would give cash flow relief to domestic corporations. It
is envisaged that domestic as well as foreign creditors will
participate in debt workouts for individual companies, with all
creditors sharing in the burden of providing the necessary
relief. In some cases debt writedowns will be needed. IBRA,
especially its asset management unit, will be the major
participant in many workouts.
13. An effective bankruptcy system is an essential part of the
corporate debt restructuring strategy, without which debtors may
be reluctant to negotiate with their creditors. A government
regulation in lieu of law was issued in April 1998 to modernize
the bankruptcy system and provide for the fair and expeditious
resolution of commercial disputes. It will take effect on August
20, 120 days after the date of enactment of the regulation. The
new system will enable receivers and administrators to be drawn
from qualified professionals in the private sector. A commercial
court will be established (within the domain of the District
Court) to handle matters under the bankruptcy regulation.
Procedural rules are designed to ensure certainty and
transparency in the proceedings, especially to prevent
unjustifiable delays in the adjudication of bankruptcy.
Substantive rules are being introduced to provide better
protection to the assets of the estate. A committee was set up in
June to oversee the selection of judges from the District Court
and the Supreme Court for the bankruptcy jurisdiction, the
provision of a separate organizational structure for the
Commercial Court, including its own personnel, facilities and
equipment; the establishment of a training program in bankruptcy
and related issues for the judges that will be selected for the
Commercial Court, and the establishment of a system for the
selection, training and licensing of suitably qualified receivers
and administrators. The government has submitted the bankruptcy
regulation to Parliament for ratification.
Food security
14. The government is placing considerable emphasis on ensuring
that there are adequate supplies of essential commodities,
especially rice, and that these are available easily through the
distribution system at affordable prices. Toward this end, BULOG
has increased its import target for rice in 1998/99 from 2.85
million tons to 3.1 million tons. Special measures are being
introduced to ensure that domestic markets have adequate supplies
of cooking oil at reasonable prices. As noted earlier, food
subsidies have been increased substantially this year, as part of
a broader effort to ensure food security for the poor. To improve
purchasing power in rural and urban areas, the government plans
to set up public works projects throughout the country to boost
incomes of the poor, the unemployed and the underemployed. To
supplement these efforts, food-for work programs are being
implemented in drought-stricken areas of the country.
15. A critical aspect of the government's efforts to improve food
security is to rehabilitate and strengthen the distribution
system following the disruptions and damage cause by the recent
social disturbances. While private trading appears to be
returning to normal in many parts of the country, the government
feels that additional temporary measures are required to further
improve the distribution system. The Ministry of Industry and
Trade has established a special monitoring unit to identify
potential shortages of foodstuffs or distribution bottlenecks so
that the government can take early corrective action. In key
parts of the country, the government has been extending special
security arrangements for the transport of essential commodities.
Where retailing has been disrupted severely, the government is
trying to reactivate the retail network through the
rehabilitation and construction of traditional markets. In some
especially poor and remote regions of the country, where
transport costs have risen sharply due to a shortage of spare
parts, the government is considering providing facilities for the
direct distribution of food by government agencies. The Ministry
of Home Affairs has instructed regional government and local
authorities to mobilize support for the private retail and
wholesale sector, including streamlining licensing procedures to
facilitate interprovincial trade.
Structure Policies
16. The government remains committed to implementing all of the
structural reforms agreed earlier, in collaboration with the
World Bank. The resource rent tax on logs and sawn timber has
been introduced and procedures are being established for regular
of the rate to reflect changes in world prices. The ban on palm
oil exports has been effectively lifted. Environmental guidelines
have been issued to clarify the procedures for foreign and
domestic investment in palm oil plantations. The clove marketing
board has been dissolved and cigarette manufacturers are now free
to purchase supplies from any source. Efforts are continuing to
create means by which private sector enterprises can compete
effectively with BULOG in the importation and marketing of wheat,
soybean and sugar, although it is proving more difficult to
complete arrangements that had been expected. Finally
international standard audits will be undertaken of the financial
accounts of Pertamina (the state petroleum corporation), PLN (the
state electrical corporation), BULOG, and the Reforestation Fund.
17. The privatization program is proceeding on schedule. Despite
the depressed state of the economy, taking into account the
interest that has been expressed by foreign investors, we are
confident that the projected receipts from privatization of $1.5
billion for the 1998/99 budget can be realized. The planned sales
of shares in the domestic and international telecommunication
corporations will provide substantial part of this total. The
Minister of State Enterprises has issued a statement confirming
that sales of shares in all enterprises would be conducted
through transparent competitive processes consistent with
international best practices. International investment bankers
have been selected to advise on the sale of each of the twelve
enterprises that were identifies for privatization in April. In
parallel, international experts are being engaged to advise on
sector structure and regulatory oversight enterprises. This
approach will ensure a high quality technical foundation for
reforming state enterprises. The World Bank and the Asian
Development Bank will finance these technical assistance services
in key policy and strategic areas. This will include the
preparation of a master plan on the reform of state enterprises,
compromising programs of corporate restructuring and
privatization for individual companies by September 30, 1998.
Monitoring
18. High priority is being given to effective monitoring of
the economic program. The Monetary Monitoring Committee--
compromising representatives of Bank Indonesia, the IMF, the U.S.
Treasury, and the Bundesbank-- has been meeting frequently since
April. External debt monitoring is being undertaken on a daily
basis by Bank Indonesia, with IMF assistance. A committee to
monitor structural reforms has been established under the
chairmanship of the Ministers of Planning with representatives
from other government agencies, the World bank, the Asian
Development Bank, and the IMF. Additionally we intend to ask the
IMF to provide a high- level expert to the Minister of Finance to
establish budgetary monitoring mechanism including to ensure
expenditure releases are consistent with agreed priorities.
External Issues
19. The large decline in trade credit in recent months is a major
concern, particularly as it jeopardizes exports. Part of the
problem has been the unwillingness of foreign banks to confirm a
letter of credit, but this is being addressed through the
assistance recently provided by JEXIM expert cover from a number
of credit agencies. and the Frankfurt trade facility agreement
with foreign banks. A major remaining problem is the reluctance
of domestic banks to open letters of credit except on a cash
basis, or to provide pre-shipment credit because of the weak
state of the corporate sector. As a temporary solution, Bank
Indonesia will establish during July a pre- shipment export
guarantee program to facilitate import and pre-shipment export
financing for exporters holding export letters of credit. The
guarantee will be provided for a fee on a loan by loan basis and
will be partial, so that risk is shared with the domestic bank.
The program would be temporary and initially be limited to about
0.5 billion, the risk associated with the guarantee would be
borne by the government rather than Bank Indonesia. We believe
this approach is warranted by the severity of the current crisis.
20. The external financing needs of our economic program are
large. Despite the recent weakening in the exchange rate, the
external current account surplus is likely to be significantly
smaller this year than envisaged earlier, as export markets have
been lost as a result of concerns on the part of foreign buyers
about disruptions to supplies. In addition, recent political
disturbances have caused further capital outflows, and weakened
the prospects for a resumption of capital inflows in the near
term. The deterioration in the regional economic situation is
also adversely affecting the balance of payments. Although the
agreements reached in Frankfurt regarding the private sector
obligations to banks are expected to ease external pressures ,
the capital account will be substantially deficit. Despite the
considerable support that is being provided by bilateral and
multilateral sources additional balance of payments support in
1998/99 if $4-6 billion from these sources is needed to close the
financing gap. At this critical moment we are seeking the further
support of the international community to ensures the success of
our economic program.
Annex I: Social Safety Net
* As a result of the economic downturn, open unemployment is
rising rapidly, there is increasing and widespread
underemployment and upward pressure on the prices of imported
foodstuffs and medicines is mounting. The incidence of poverty
may rise substantially. The recent drought has aggravated food
shortages in some regions. Students are dropping out of school as
a result of the crisis.
* The government will ensure that sufficient quantities of
essential foodstuffs are made available through the State
Logistics Agency (BULOG) to the market, and for the time being
will seek through subsidies, to stabilize the domestic prices of
rice, soybeans, sugar, wheat, flour, corn, soybean, meat, and
fishmeat, which account for a large part of the expenditure of
poor households. In addition, the government will temporarily
freeze the prices of kerosene, gasoline, diesel, electricity and
essential medicines.
* The government will substantially expand its program designed
to provide immediate employment for the poor. These programs some
of which are financed by the World Bank and the Asian Development
Bank, will be complemented by a food- for-work program, financed
by the UN World Food Program. Food distribution and job creation
programs financed by bilateral grants and concessional loans,
will also be introduced.
* The government will increase budgetary allocations for the
existing social programs targeted to the children of poor
households. To minimize the decline in school enrollment, the
government will initiate, with World Bank and Asian Development
Bank financial assistance, a block grant program for primary and
junior high schools to replace existing school fees. A
scholarship program designed to offset private costs of attending
school for junior high school students has also been introduced.
In addition, the government will expand the school lunch program.
These programs are aimed at reaching households in the poorest
regions.
* To strengthen the implementation of social safety nets, the
government will form a panel of experts from government and civil
societies to assist the government in monitoring social safety
net programs and provide advice on implementation. The government
will create an administrative unit to work in conjunction with
the panel and will allocate sufficient resources to ensure the
adequate functioning of the unit.
Annex II: Banking System Restructuring
* The strategy for achieving a comprehensive solution to the
banking sector is being strengthened in collaboration with the
Asian Development Bank, World Bank and IMF. The weak banks will
be addressed through a combination of mergers recapitalizations,
and freezings. If banks are frozen, deposits are to be
immediately transferred to a designated recipient bank. The bad
loans of the banks will be transferred to an Asset Management
Unit (AMU) to be established within IBRA. In all cases,
depositors and creditors will be fully protected in line with the
guarantee. Measures are also envisaged that will strengthen
relatively sound banks.
* Presidential decrees will be issued that will provide
appropriate legal powers to IBRA and its AMU by mid-July.
Supervisory functions will be returned to BI to leave IBRA free
to concentrate on bank restructuring. These provisions are to be
included in banking law amendments to be submitted to Parliament
shortly, In addition to ensure priority attention to bank
restructuring, a Financial Sector Advisory Committee is being
established , compromising the Coordinating Minister for
Economy, Finance and Industry, the Finance Minister, the
Development Planning Minister, the Minister for Industry and
trade, the Governor of Bank Indonesia and the head of IBRA. The
Committee will coordinate actions to eliminate impediments to
sound banking system developments. An Independent Review
Committee for IBRA is being established compromising two eminent
Indonesians (already nominated) and three foreign members (to be
nominated soon)
* Decisions regarding individual banks will be based on uniform
and transparent criteria, drawing on portfolio reviews by
international accounting firms, and on uniform and transparent
criteria. Such reviews have been completed for the 6 private
banks that were effectively taken over by IBRA in April,
portfolio reviews for an additional 32 IBRA banks, and 15 non-
IBRA banks are scheduled to be completed by end-July. Portfolio
reviews for all other banks will be completed by end-October
1998. In addition IBRA will announce soon the modalities of the
merger of two state banks, Bank Bumi Daya and BAPINDO.
* To strengthen relatively sound banks, schemes will be announced
by end-July in which (i) banks that achieve a specified increase
in capital will be able to sell their bad loans to the AMU at
fair prices, thus improving their risk weighted capital adequacy;
and (ii) the government will provide for the two capital,
generally in the form of subordinated loans, to banks whose
capital has been increased by their owners, Such schemes will be
developed drawing on portfolio, systems, and financial reviews to
be undertaken by internationally recognized audit firms.
* Discussions are also under way with foreign banks regarding
investments in the banking sector; all restrictions on foreign
ownership of banks will be lifted as part of the prospective
amendments to the banking law. As an interim measure, teams of
foreign bankers will also be used to strengthen the management of
banks under IBRA's control.
* All banks are to achieve minimum capital adequacy ratios of 4
percent of risk weighed by end-1993, rising to 8 percent by end-
1999 and 10 percent by end-2000. Banks that do not meet these
targets will be subject to sanctions imposed by Bank Indonesia.
The minimum capital requirement of Rp 250 billion is being
reduced for existing banks to allow them to focus on achieving
specified capital adequacy ratios in their restructuring.
* The cost of bank restructuring is expected to be higher than
estimated in April reflecting the further deterioration in the
banking system. Financing of the cost will be through the
issuance of government bonds, many of which are to be index-
linked, provided to Bank Indonesia to clear the liquidity support
outstanding to IBRA banks. The remainder, most of which would pay
market interest rates on a monthly basis, will be used to
compensate banks for the transfer of deposits, recapitalize
insolvent banks that are to remain open, and provide additional
capital to these banks where the owners are themselves adding
equity. The estimated budgetary cost in 1998/99, primarily
interest on these bonds and IBRA's operational costs, is
estimated at Rp 15 trillion (1.6 percent of GDP).