July 18, 2005
1. On behalf of the Indonesian authorities, we would like to thank the staff for a well-written and excellent set of reports. The selected issues paper is particularly useful since it has provided in-depth analysis and policy recommendations on key areas of the government’s growth strategy. The authorities are appreciative of the extensive technical assistance and policy advice received from the Fund which has contributed to the favorable economic performance and the success of structural reforms in recent years.
2. The Indonesian authorities would like to take this opportunity to thank the members of the Board for their longstanding support and constructive comments expressed during the last Post Program Monitoring discussions held in February this year. They particularly took note of the suggestion to reduce the fuel subsidies and to channel the savings to development spending. The government has increased domestic fuel prices by an average of 30 percent, effective March 1, 2005 and used the budget savings to support expenditure on education, health, and rural development.
3. The authorities are pleased to note in the staff report that the mission team fully supports the Medium Term National Development Plan (RPJMN) for the period 2004-2009, launched by the new administration as part of the government’s efforts to maintain sustainable growth. One of the main objectives of the RPJMN is to reduce the incidence of poverty from 16.6 percent to 8.2 percent and the unemployment rate from 9.7 percent to 5.1 percent over the period 2004-2009. The authorities are well aware that macroeconomic stability and rigorous structural reforms are required for sustained growth. Improving the investment climate and export competitiveness are also essential.
Recent Macroeconomic Development
4. Growth in the Indonesian economy increased over the last three years, reaching 5.1 percent in 2004. The underlying components of growth also showed a more sustainable trend, marked by the increasing role of private investment and exports. Investments rebounded to 15.7 percent after three years of sluggish growth, exports increased by 8.5 percent while consumption growth remained robust at 4.6 percent.
5. Inflation rose to 6.4 percent but was still within the authorities’ target range while the exchange rate has remained stable in 2004. Indonesia’s current account balance remained in surplus, albeit lower than last year, due primarily to substantial increases in imports of capital goods and raw materials on the back of a pick-up in domestic production. Exports reached a historic high of $72.2 billion last year, boosted by strong sales of palm oil, electronics, clothing, coal, and tin but high world oil prices only had a slight impact on the trade balance since Indonesia also imports oil for domestic consumption. Foreign exchange reserves were $ 36.3 billion at end-2004, equivalent to a safe level of 4.8 months of imports or 195 percent of short-term external debt. The forex reserves declined to about $33.9 billion by end-June 2005, attributable mainly to debt service payments and the authorities’ intervention to smoothen exchange rate volatility.
6. The fiscal position improved amidst increasing world oil prices which caused fuel subsidies to increase since the government had not adjusted domestic fuel prices in 2004. The banking sector performed favorably with loans increasing in line with the rebound in business activity. More importantly, bank financing to the micro, small and medium enterprises (MSME) increased. Overall, the loan to deposit ratio (LDR) rose to 50.0 percent at end-2004 and 51.3 percent in April 2005 but it is still well below the level before the Asian crisis.
7. The prospects for the Indonesian economy are promising, driven by buoyant investment and exports. The economy is projected to grow at 6 percent in 2005, which is a conservative projection, given that the y-o-y GDP growth in the first quarter of 2005 was already 6.4 percent. Growth is projected to increase by 6-6.5 percent in 2006 and 6 to 7 percent over the medium term. The growth performance in the first quarter of 2005 indicated that investment, including FDI, and export growth were relatively high in 2005, underpinned by improving business sentiments. The Jakarta Stock Exchange also reached a new high with the index reaching 1080 at the end of the first quarter this year and stabilized towards end June.
Monetary And Exchange Rate Policy
8. For 2005, upward pressure on inflation stemmed from the increase in domestic fuel prices and the depreciation of the rupiah. In the first quarter of 2005, inflation rose to 8.81 percent (y-o-y) compared with 5.11 percent over the same period last year and declined in the following months. The rupiah depreciated by 5.3 percent in the first semester 2005 as demand for foreign exchange increased to service debt payments and imports, particularly the imports of oil by PERTAMINA for domestic consumption. Bank Indonesia (BI) shifted the monetary policy stance from an accommodative to a tightening bias beginning Q3, 2004. Further monetary tightening ensued with several increases in the SBI rates from 7.43 percent in February to 8.25 percent as at end June to contain the second-round effects of the increase in domestic gasoline prices. Under the new monetary policy framework, the interest rate (the BI rate) has been set by BI at 8.5 percent early this month for third quarter-2005.
9. To support the effectiveness of monetary policy operations, a new monetary instrument, Fine Tuning Operations (FTO), was introduced by BI in April 2005. Under the FTO arrangement, BI can take the initiative to absorb liquidity with maturity up to 14 days. BI also tightened prudential regulations to reduce volatility in the foreign exchange market by temporarily adjusting the existing bank regulation on the Net Open Position from 30 percent to 20 percent, effective April 26, 2005. Foreign exchange intervention was also carried out cautiously by the central bank and was limited only to smoothing short-term exchange rate volatility. The government is considering changing the mechanism of transferring the oil subsidy to PERTAMINA from rupiah into foreign exchange in order to reduce the demand for foreign exchange in the market.
10. In consequence, inflation declined in the following months since March and stabilized in June. The volatility of the rupiah exchange rate was subsequently reduced. Inflation is estimated to reach 7.5 percent for 2005 and return to a declining path in 2006. BI is monitoring monetary developments very closely and stands ready to further tighten monetary policy to ensure that inflation is contained.
11. Bank Indonesia has further strengthened the monetary policy framework by formally shifting to interest rate targeting, as part of the steps to full inflation targeting (IT), effective July of this year. IT has implications on the conduct of monetary policy, including the use of the interest rate—-called the BI-rate-—as the operational target, a forward looking decision making process, a more transparent communications strategy, and strengthened policy coordination with the government. It is expected that the new framework will enhance the credibility of monetary policy and facilitate the achievement of the 3 percent inflation target over the medium term.
12. As the staff report underscores, the flexible exchange rate system has served the economy well. The authorities are committed to maintaining the system since it will help to protect the economy against shocks.
13. The Indonesian authorities are fully committed to strengthening fiscal consolidation and debt reduction while recognizing the need for public investment in key infrastructure and social projects over the medium term. The overall budget deficit has declined from 3.2 percent of GDP in 2001 to 1.4 percent of GDP in 2004, with the external debt to GDP ratio falling from 81 percent to 53 percent over the same period. In light of domestic and external developments, particularly high world oil prices, the revised 2005 Budget was approved by the Parliament in June. The authorities are committed to containing the overall deficit at 0.8 percent of GDP for 2005. The deficit will be financed by domestic sources, primarily through the issuance of government bonds, proceeds from privatization and asset recovery. The debt to GDP ratio is expected to decline further from 53 percent in 2004 to 48 percent in 2005 and fall below 35 percent by 2009.
14. The government is mindful of the need for measures to meet its deficit target of 0.8 percent in 2005. Tax administration reforms—including intensification and strict enforcement of tax and customs compliance—are already underway and are now being accelerated in order to increase tax revenues. The measures are expected to increase tax collections in 2005, including 0.2 percent of GDP from non oil & gas income tax and 0.1 percent each from property tax, and excise tax. As noted by staff, the authorities are finalizing a package of tax reforms aimed at improving non-oil tax revenues while providing incentives for private investment. On the expenditure side, the tsunami disaster and increasing world oil prices have resulted in public expenditure increasing substantially by Rp.67.5 trillion from the initial budget of 2005, of which Rp.57.5 trillion is for fuel subsidies. On a net basis, high world oil prices have only a slight positive impact on the budget since the fuel subsidies increase as well. Oil production is expected to increase in the near term since the final deal on a new oil field with estimated capacity of 170,000 barrels/day has been agreed by the government in June.
Banking Sector Policy
15. The Indonesian banking sector has been on a steady recovery path since the Asian crisis. Banks have gradually resumed their financial intermediary role with improving capital bases. Banks are well-capitalized with capital asset ratios (CARs) far above 8 percent while profitability has remained strong, reflecting strong loan growth and increased efficiency. Gross NPLs declined from 18.8 percent in 2000 to 5.6 percent by April 2005. Banks are also adequately capitalized, reflecting their improved capacity to mitigate market risk.
16. Bank Indonesia is making progress in efforts to strengthen supervisory oversight of the banking system. In 2004, BI launched the Indonesian Banking Architecture (API), a blueprint that maps the direction of the banking sector in the next 10 to 15 years. All banks are required to meet a set of minimum performance criteria by 2010, including minimum CAR of 10 percent and a capital base of at least Rp. 100 billion. On June 30, BI unveiled plans to accelerate bank consolidation and set eligibility criteria for key banks (called the anchor banks) to acquire smaller banks. Under the new policies, an anchor bank must meet, at least in the preceding three years, the following conditions: CAR of above 12 percent; tier-one capital of a minimum 6 percent; loan-to- deposit ratio (LDR) of above 50 percent; minimum annual credit growth of 22 percent; nonperforming loans of below 5 percent; and return on assets (ROA) of a minimum 1.5 percent. The authorities emphasize that qualifying banks should ensure sound credit expansion.
17. Progress has also been achieved at the supervisory and regulatory level, paving the way for more risk-based supervision. At the regulatory level, additional prudential regulations have been introduced. These include:
- incorporation of market risk in the calculation of CAR for banks with larger trading portfolios;
- new asset quality valuation rules that contain more stringent classification and provision requirements for earning and non-earning assets; and
- Higher statutory reserve requirements for banks with larger deposit bases.
Further reforms include the introduction of a financial safety net scheme while a gradual phasing out of the blanket guarantee scheme will be fully implemented by March 2007. The credit bureau commenced operations in April 2005, requiring all commercial banks and credit card operators to update information on all borrowers on a regular basis.
18. Steady progress has also been made in the implementation of the anti-money laundering regime since Indonesia’s removal from the list of Non-Cooperative Countries and Territories (NCCTs) by the Financial Action Task Force (FATF) in February 2005. With the President signing the bill on the Mutual Legal Assistance Law, the legal framework for anti-money laundering will be improved. The bill has been submitted to the Parliament for approval.
19. The authorities recognize the importance of intensifying structural reforms in order to encourage private investment and sustain growth. Structural reforms are ongoing in a wide range of areas as elaborated in paragraph 24 of the staff report. Particular attention has been given to eradicating corruption, enhancing labor market flexibility and improving infrastructure through public-private partnerships (PPPs). Efficiency, transparency, and accountability in public expenditure management are also being improved with the support of the World Bank Program Loan.
20. One of the first measures adopted by the new Government has been the requirement that all cabinet ministers sign a contract committing themselves to maintaining high standards of integrity. All ministers also have to submit their personal asset declarations with the KPK (Commission for the Eradication of Corruption) for verification. New procedures have already been put in place to suspend government officials if they are under investigation for alleged corruption. Steady progress has been made in recent months by the Supreme Audit Agency, the KPK (which became operational in 2004), and the Attorney General in addressing governance problems through strict enforcement procedures in various institutions. The corruption charges brought against top officials of government agencies and a state related enterprise have sent an important signal to the public about the strong commitment of the new government to the eradication of corruption.
21. The selected issues paper (Chapter VII) has provided insights into Indonesia’s labor market rigidities. The authorities recognize and fully agree with staff that labor market inflexibility is one of the main causes of rising unemployment in recent years. A number of measures are being undertaken in support of the government’s medium-term program to halve the unemployment rate by 2009. In this context, the establishment of tripartite councils, which bring together employers, labor unions and the government, acknowledges the importance of labor productivity when considering minimum wage increases. The new government is also strongly committed to reprioritizing public spending by redirecting poorly targeted subsidies to health and education. This is essential for improving education levels and labor force skills. In addition, the government has finalized the bill on the Social Security system which would provide the basis for scaling back statutory severance payments.
22. In an effort to support PPPs, the government has launched the Infrastructure Road Map 2004-2009 outlining the regulatory framework of PPPs. Within the infrastructure development framework, four important government regulations (PPs) have been issued on electricity (PP 3/2005), toll road (PP 15/2005), water piping system (PP 16/2005), and most recently the regulation on land acquisitions for public use (PP 36/2005). The main components of the new regulations include clarifying and emphasizing the government’s role only as a regulator; strengthening the legal framework for market determined price setting based on cost recovery; establishment of governing bodies; and clear and transparent procedures for land acquisition for public use. The authorities have indeed taken into account the Fund’s advice during the last Board meeting, particularly on ensuring that the PPPs strategy does not create unfunded liabilities.
23. The government has offered 20 projects through an open tender system during April-June, including 8 toll roads, 1 power generator, 1 railway, and 3 airports, among others. Eighteen consortiums were shortlisted in the first prequalification selection. It is expected that some projects will materialize this year and will facilitate employment creation.
24. Structural reforms are also underway to address the complex issues of efficiency, transparency, and accountability in public financial management (PFM). Significant accomplishments have been achieved over the last two years through reforms supported by the World Bank loan and technical assistance provided by the Fund. Political consensus has been gained on a new legal framework leading to updated laws on State Finances, State Treasury, State Planning and State Audit in 2003-2004. These laws now provide an adequate architecture to modernize public resource management and oversight. The roles and responsibilities of BAPPENAS (The National Planning Agency) and the Ministry of Finance have also been clarified.
25. A new budget preparation process has been introduced, beginning 2005, to enhance budget transparency and good governance. Planning and budgeting have been integrated by linking ministerial work plans with budgets. The government presented to Parliament a more transparent 2005 fiscal budget with identifiable sectoral allocations. Furthermore, budget execution is being rapidly modernized and efforts are being devoted to streamlining the disbursement process. A new law on procurement is also being drafted while accounting and reporting systems for public resource management are being improved and implemented in phases. The government has presented to Parliament, for the first time, a consolidated Government Balance Sheet for 2004, marking a significant achievement in accountability.
26. The Government’s strong commitment to improving governance is also being adopted in the program of rehabilitation and reconstruction of Aceh and Nias. A Master Plan for Rehabilitation and Reconstruction of Aceh and Nias was issued setting out the main principles to address the social, economic, institutional and financial needs of both regions while a special government unit, the Rehabilitation and Reconstruction Agency (BRR), was set-up to implement the rehabilitation process. In response to the government’s commitment to good governance, several donor partners have, together with the government and civil society, established a Multi-Donor Trust Fund (MDTF). All activities of MDTF will be consistent with and guided by the government’s master plan under the BRR’s oversight. The authorities are thankful to donors for their financial support in the reconstruction and rehabilitation of Aceh and Nias.
27. The authorities’ efforts to strengthen multilateral and regional trade arrangements are underway. Indonesia has also made a commitment, together with the ASEAN + 3 countries, to reduce import tariffs in stages as part of its commitment to pursue an open trade policy.
28. As noted by the staff, Indonesia’s economic data are considered adequate for surveillance purposes. Nonetheless, the authorities have taken steps to further improve data quality and to follow up on recent ROSC recommendations.
29. The Indonesian authorities remain committed to transparency and consent to the publication of all staff reports.