Supplementary Memorandum of Economic and Financial Policies

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.