Supplementary Memorandum of Economic and Financial Policies

JAKARTA (JP): The following is the full text of the Supplementary Memorandum of Economic and Financial Policies, attached to the letter of intent signed by Coordinating Minister for Economy, Finance and Industry Ginandjar Kartasasmita. The document was released on Sunday.

1. Further progress has been made over the past month in implementing the Government of Indonesia's economic program, and there have been encouraging development on a number of fronts. Progress has been most marked toward the restoration of macroeconomic stability, assisted by continued adherence to a firm monetary policy. The rupiah has generally strengthened toward a more realistic range, food prices have declined while the overall price level has stabilized, and there have been gains in the stock market. However, there continues to be considerable volatility in exchange rate. In addition, output recovery is still not at hand, although production appears to be bottoming out.

2. Against this background, the priority at this juncture is to hasten the recovery as much as possible, while extending the recent gains in macroeconomic stability. We have further developed the frameworks for banking and corporate restructuring, and intent to provide an adequate fiscal stimulus in the period immediately ahead that will better support domestic consultation with the International Monetary Fund (IMF), World Bank, and the Asian Development Bank (ADB).

I. Macroeconomic Framework and policies

Output, prices, and Balance of Payment

3. We have reviewed the macroeconomic framework for 1998/1999 and begun discussions toward a framework that would underpin the 1999/2000 budget to be presented in early January. We are encouraged by the prospect that output could finally stabilized during the next one to two quarters and that modest growth could resume in mid 1999. On this basis, we expect the output decline for 1998 to be contained close to the program projection of 15 percent, and that the forthcoming budget could anticipate modest positive growth during 1999/2000. Indeed, some sectors are already showing tentative signs of the turnaround.

4. Inflation has subsided, helped by the strengthening rupiah and improved food availability. The consumer price index declined in October and is now expected to be about unchanged or to show a very modest rise during the fourth quarter of 1998. Thus, average inflation for 1998 could be contained within the program assumption of 80 percent. During 1999, we expect inflation to fall toward 10 percent, close to pre-crisis level.

5. The careful management of BULOG's operation has helped to stabilize the rice situation and improve overall output and price prospects. Retail and wholesale rice prices have declined by about 15 percent in most regions of the country since mid- September, despite reduced public sales. BULOG's rice import needs from now until the main harvest in February-March are smaller than previously projected, because of improved domestic availability, and these have been mostly contracted. Thus, we are confident of maintaining rice price stability in the coming months. At the same time, we are working to support a substantial increase in the 1999 rice crop, through improved availability of seeds, fertilizer, and credit. As part of our continuing effort to increase efficiency in rice distribution, the release price of third quality rice is being gradually brought closer to market levels, which should help reduce the wide trade margin. The appreciation of the rupiah will allow the exchange rate subsidy for import of rice by BULOG to be removed on December 31, 1998, the remaining subsidies on low quality rice will be provided explicitly through the budget.

6. The overall balance of payment for 1998/1999 is expected to show a surplus, rather than balance as indicated in the program. The external current account surplus will probably be above the program target (in the range of 4-5 percent of GDP), on account of weaker than expected import demand, although still substantially smaller in relation to GDP than in other Asian crisis countries. However, the capital account could less favorable than programmed because of slightly lower disbursements of foreign assistance to the public sector. This would be consistent with the expected lower level of public spending (paragraph 10 below)

7. The conduct of monetary and exchange rate policy under the program have begun to deliver important results. Thus, we reaffirm our commitment to keep base money firmly under control so as to stabilize prices and accommodate a further appreciation of the rupiah.

8. With the strengthening of the rupiah, the monetary policy framework allowed significant reductions of short-term money market rates in October and early November, and we see considerable room for further reductions in the weeks ahead. The interest rate structure of commercial banks has continued to come down, and spreads between deposit and lending rate are beginning to normalize. In addition, we continue to make progress with lengthening the maturity structure of monetary instruments.

9. We will continue to be guided by the agreed quantitative monetary program for 1998/1999. Net domestic asset of the Bank Indonesia (BI), net international reserves, base money, and liquidity support were all within the indicative targets for end- October. The program allows base money to grow by up to about 6 percent during the last quarter of 1998 and about 4.5 percent during the first quarter of 1999, providing scope for strengthening confidence to be related in reserve increases and the monetary aggregates. Of course, monetary policy will remain flexible and be tightened if renewed dangers arise to exchange rate stability, or eased if circumstances warrant.

Fiscal Policy, Development Spending, and Social Safety Net

10. Fiscal developments have been carefully reviewed, focusing on the adequacy of the fiscal stimulus, the social safety net, the institutional framework for development spending and the privatization program. Based on the measure outline in MEFP of October 19, we expect development expenditure (which was only 21 percent of the annual budget in the first half year), to rise sharply during the second half of this fiscal year, providing key stimulus to domestic demand and strengthening the social safety net. Nevertheless, because of the delayed start in development spending, total expenditure will likely fall below the revised 1998/1999 budget projection under the program. In addition, the budget outcome will benefit somewhat from the recent strengthening of the rupiah. Both factor will help offset emerging shortfall in privatization proceeds, while also containing the budget deficit to about 6 percent of GDP for 1998/1999 as a whole, below the program target of 8.5 percent of GDP.

11. Our concern for accelerating development expenditure is tempered by the importance of ensuring that budgetary resources reach the intended beneficiaries. In this context, we are seeking the collaboration of provincial government, civil society, and non governmental organizations at all levels, and are stepping up internal government oversight mechanisms, to help identify leakages, and ensure accountability. In addition to better monitoring, we will adjust the regional and program composition of social safety net expenditures in light of information on the regional impact of the crisis and the success rate of different anti-poverty programs. On November 3, a Presidential decree was issued to form a high-level ministerial task force, as well as a monitoring team led by distinguished member of civil society to supervise and coordinate implementation of these programs. They are expected to make specific proposals by end-December.

12. We are also working closely with the World Bank to ensure that subsidies and social safety net programs are better targeted to the poorest groups. The targeted subsidized rice scheme reached six million families by end-October and will be substantially expanded in the coming months. We intend to increase monthly allocations under the scheme from 10 kilogram to 20 kilograms per family, effective December 1. As a step toward reducing the untargeted subsidies in the energy area, we will raise aviation fuel prices to international levels on January 1, 1999.

13. We have commenced preparation for the 1999/2000 central government budget. At this stage, it is our intention to ensure that fiscal stimulus is maintained through the next fiscal year. High priority will be attached to social safety net spending, while untargeted subsidies are phased down. We plan to frontload expenditures into the first semester of 1999/2000, so as to give maximum support to domestic demand in the period immediately ahead. The 1999/2000 budget will include the interest costs of the bonds that will be issued to cover the costs of bank restructuring. These costs will be higher than the budgeted restructuring costs of this year and will be estimated in detail in early December, in consultation with the IMF.

II. Privatization and State Enterprise Audits

14. The privatization program for the current fiscal year is broadly proceeding as envisaged in the MEFP of October 19, although some further slippages into the next fiscal year are still possible. As before, we are focusing on selling, by end- March 1999, majority interest in Jakarta container port, as well as minority interest in Jakarta airport, the largest palm oil plantation in Indonesia, and the international telecommunications enterprise. To support the sale of the international telecommunications concern, we intend to introduce into parliament by end-December a new telecommunications law covering all aspect of regulation and competition. Care will be taken to ensure that contract design and bidding procedures follow international best practice and that complete transparency is maintained throughout the privatization process. We are committed to divest at least two state enterprises by end February 1999.

15. The masterplan for the restructuring and privatization of all state enterprises over the medium term, has been adopted and publicly released. The masterplan also provides for the review of the regulatory framework in the key privatized sectors. Except for a specified short list, the program calls for all of the present 150 state enterprises to be divested over the next decade. Details of companies to be privatized during 1999-2001 are included in the plan, focusing on hotels, trading, construction, mining and civil engineering firms, and fertilizer producers. In the meantime, enterprise efficiency will be improved through greater management autonomy, enhanced competition, hard budget constraints, and the phased elimination of preferential access to bank credit (by end-March 2000). Companies to be restructured during this period for later privatization include the state electricity corporation and the national airline.

16. We are taking steps to fulfill our commitment to release detailed financial information on BULOG, Pertamina, the state electricity corporation (PLN), and the reforestation fund. In the case of PLN, international standard audits have already been completed for each of the past three financial years and are being made available to the IMF, World Bank and ADB. For the other three institutions, we believe that it would be more useful to audit the accounts for the 1998/99 financial year (which ends in March) rather than completing the audits by end-December. Auditors in each case will be appointed by end-November and the tasks will be completed not later than end-June 1999. For Pertamina, we are providing IMF and World Bank staff a recent performance audit completed by international consultants. We also intend to extend the audit process to other key public entities with substantial market or debt exposure.

III. Banking Sector Reforms

17. The focus of our reform strategy remains as described in the MEFP of October 19. Immediate priority is to proceed, with maximum efficiency, in the following areas (i) press ahead with recapitalizing viable private banks; (ii) achieve final resolution of the 14 banks taken over or frozen in April and August, as well as of the other banks under the control of the Indonesian Bank Restructuring Agency (IBRA); (iii) finalize agreements with former bank owners for the repayment of obligations owed to the government; (iv) advance the merger of four state banks into the newly established Bank Mandiri; and (v) issue key laws and prudential regulations.

18. Toward implementing the recapitalization program for private banks, all banks will soon have been classified according to their capital adequacy ratio which is a key determinant for participation in the program. The next stages in the program are as follows:

* First, business plans will need to be submitted by banks in order for a judgment to be made on their viability, and must include an agreed plan for the settlement of related party lending by the owners. Already, 69 privately owned banks, for which independent reviews or BI examinations have been completed, have been invited to submit business plans for this purpose. This process will be extended to the remaining private and regional banks, and two state banks (BNI and BRI), as well as to the banks taken over by IBRA, provided they meet all the conditions.

* Second, the business plans will be evaluated and approved by review committees, that will include representatives from BI, the Ministry of Finance, IBRA and independent observers (from the World Bank, ADB, and IMF) on the basis of agreed criteria.

* Third, banks with approved plans and which meet the other prescribed conditions will be recapitalized, after existing shareholder equity has been written down commensurately with adequate provisioning for non performing loans and other assets. The government's contribution to the recapitalization (up to 80 percent) will be in the form of long-term bonds, including both market-linked and indexed bonds. Alternative resolution strategies will be implemented by January 31, 1999 for banks unwilling or unable to participate in recapitalization or for banks with rejected business plans, including mergers or closure by Bank Indonesia.

19. The above framework for the bank recapitalization program will be put in place very quickly. The committees will be established by mid-November, the criteria finalized shortly thereafter; and bond issues initiated by end-December. It is expected that, by end-January 1999, a first group of eligible banks will be recapitalized to at least 4 percent capital adequacy ratio.

20. Rapid progress is also being made toward resolving the banks taken over by IBRA:

* The liquidation process for the 10 banks frozen in April and August is at an advanced stage; (i) their asset transfer to IBRA's Asset Management Unit (AMU) will be completed, as scheduled, by end-November; (ii) the AMU is to undertake a complete inventory of these assets and, by end-year, develop plans for managing and realizing their maximum value; and (iii) the revocation of their licenses will be done by end-December 1998.

* Regarding the four banks taken over by IBRA, but still operating (BCA, Danamon, PDFCI, and Tiara), decisions on resolving their status have been delayed pending completion of negotiations by IBRA with the former owners on the repayment and settlement of connected lending. The outstanding issues are nearing resolution, helped by the enactment of the amendments to the Banking Law, and the agreements with owners on repayment terms (see below).

* On November 6, final agreement was reached with the former owners of four banks (BCA, Danamon, BDNI and Surya) and the part- owner of BUN on the terms of repayment of obligations owed to the government (repayment over four years, with a 27 percent cash component in the first year, with interest on the outstanding balances). Now that these terms have been clarified, the government is committed to applying them consistently and transparently in negotiations with the owners of a further six similarly indebted banks. Discussions have resumed between IBRA and the former owners of these banks, and final agreements are expected, in at least four cases, by end-November, and all cases, by end-December 1998.

21. The merger of the four previously separate state banks into the newly formed Bank Mandiri (comprising 30 percent of the deposit base of the banking system) is proceeding satisfactorily, with assistance from a major international bank under a management and operational restructuring contract. Already, highly respected officials have been appointed to head the Board of Commissioners and the Board of Directors of the bank. A preliminary corporate plan has been developed which focuses initially on centralizing control of credit risk management and trading operations. A consolidated balance sheet will be prepared by December 31, 1998 providing the basis for the transfer of non- performing assets to the AMU.

22. Meanwhile, we are moving ahead with strengthening the regulatory and prudential framework for the banking system. A draft central bank law providing for independence of Bank Indonesia will be introduced into Parliament by end-December 1998. The banking law has been recently amended by Parliament and has entered into force, following its signature by the President; it permits major improvement in the areas of bank licensing and ownership, openness to foreign direct investment, bank secrecy, and empowerment of IBRA. New prudential regulations governing loan classification, loan loss provisioning and the treatment of debt restructuring operations will be issued by mid-November and regulations related to liquidity management and foreign currency exposure by end-November. A further three regulations on connected lending, the capital adequacy ratio, and the semi- annual publication of financial statements will be issued by December 15. We will shortly issue implementing regulations for the full functioning of IBRA and, at the next program review, we will assess the adequacy of provisions relating to debt equity conversions and liability provisions in the banking law.

IV. Corporate Restructuring and Bankruptcy Reform

23. Efforts to implement the Jakarta Initiative announced on September 9, 1998, have intensified. The Jakarta Initiative Task Force is becoming fully operational, and its staffing and facilities should be greatly enhanced by end-December, with the help of a planned World Bank Corporate Restructuring Technical Assistance Loan. A conference on the Jakarta Initiative, co- sponsored by the World Bank, was held in early November, and has helped to increase public understanding of the Initiative and the role of the Task Force, with many participants endorsing the underlying framework.

24. Meanwhile, the necessary legal and regulatory changes to overcome obstacles for corporate restructuring are being completed. A government regulation providing for tax neutrality for mergers and other reorganizations and removing certain other identified tax disincentives for restructuring was signed on October 30. A regulation under the company law to remove obstacles to debt-to-equity conversion is in the final stages of preparation and will be signed by end-November. A review of the legal changes needed to create an effective and predictable system for security rights is being undertaken and a public registry system is planned to be initiated by end-December, with ADB assistance. The one-stop regulatory facilitation process for filings related restructuring arrangements will be put in place by mid-December.

25. In light of the Jakarta Initiative, effective bankruptcy law reform and implementation has taken on additional significance. Now that the commercial court, which exercises jurisdiction in bankruptcy matters, is operational, attention is being focused on the establishment of a transparent court fee system, the mechanism for the appointment of ad hoc judges to assist the court as provided for in the bankruptcy law, and the effective enforcement of court orders. Measures in the first two of these are expected to be in place by end-December. Additional training courses for judges of the commercial court are being organized.

V. Foreign Exchange Monitoring System

26. Since the last review, further progress has been made in the development of a foreign exchange monitoring system. Bank Indonesia is preparing a regulation requiring banks to report daily their sales and purchases in the exchange market, in a prescribed format. This system should enable BI to monitor foreign exchange flows on a more timely basis than is possible with existing data collection systems. BI is undertaking a thorough review of its current balance of payments data collection system, with IMF technical assistance, before the new system is put into place. As before, we remain committed to a free foreign exchange system, without surrender or repatriation requirements or capital controls.