Indonesia—Letter of Intent

April 9, 2002

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, DC 20431

Dear Mr. Köhler:

Steady progress is being made in implementing the Government of Indonesia's economic program supported by the extended arrangement from the Fund and set out in the Memorandum of Economic and Financial Policies (MEFP) of December 13, 2001. This letter builds upon and updates the economic program described in the MEFP of December 13, 2001.

All end-December and end-January quantitative performance criteria were met (Table 1). The indicative target for base money at end-January was met, after a small overrun at end-December was registered. We propose to leave unchanged the quantitative performance criteria and indicative targets for the remainder of 2002 that were presented in the MEFP of December 13, 2001, but we request a waiver of applicability for the end-March 2002 quantitative performance criteria and a waiver of nonobservance for the end-March 2002 structural performance criterion related to the BLBI arrangement. We propose that the latter structural performance criterion be postponed to end-June 2002 to enable an international team of experts to finalize its recommendations on this issue. Given that Parliamentary approval of the Sovereign Debt Securities Law has been delayed, we also propose to rephase the structural benchmark related to the treasury bill auction to end-July 2002 to enable all the necessary preparatory work to be completed. To strengthen the program, additional structural performance benchmarks are proposed for IBRA cash recoveries, the resolution strategy for bank BII, and for finalizing the determination of compliance with IBRA's shareholder settlement agreements, as discussed below (Table 2).

The government remains firmly committed to restoring medium-term fiscal sustainability. The budget deficit for 2001 was contained within the target of 3.7 percent of GDP, and implementation of the 2002 budget is proceeding satisfactorily. With a view to achieving the targeted reduction in budget subsidy expenditures, energy prices were raised in January by an average of 22 percent, and an automatic mechanism for adjusting domestic fuel prices in future was introduced. Also, the initiatives to strengthen tax administration are proceeding according to schedule, and the majority of the tax policy changes announced in the budget are in place. Nevertheless, achievement of the budget deficit target for 2002 remains a challenge, and the budget situation is being monitored closely. The government stands ready to take prompt corrective actions as needed, in close consultation with Parliament, to keep the budget on track.

In the area of monetary policy, we will continue to gear policies towards achieving single digit inflation by the end of 2002. The rise in headline inflation in early 2002 reflects the planned hikes in fuel and other administered prices, as well as the impact of the recent floods on the supply of basic commodities. While we expect these pressures to subside over the course of the year, BI will tailor its monetary stance to ensure that these developments do not lead to a more generalized increase in inflation.

Important progress has been made with the divestiture of the government's holdings in the banking system. The sale of bank BCA to a strong strategic partner was concluded. IBRA also launched the sale of bank Niaga on February 11, 2002, and the swap of its fixed for variable rate bonds has been completed. We are also implementing the strategy to resolve bank BII. In that regard, we will ensure that the bank is adequately capitalized to meet Bank Indonesia prudential standards and to assure its sustainable performance. Under the strategy, we plan to reduce fully the equity position of the original shareholders and we will install an independent management team to protect the government's interest.

In the key area of asset recoveries, IBRA has formalized its strategy for 2002 and published its quarterly cash recovery targets (Table 3). Roughly two-thirds of recoveries are set to come from the sale of restructured and unrestructured loans, and we will use a variety of mechanisms, including new joint venture and securitization schemes, to achieve the desired result. In addition, we will launch a program to sell retail and currently outsourced commercial loans by mid-year.

As part of the asset recovery effort, on March 7 the government decided on a strategy to resolve the long-standing problem of shareholder settlement agreements with former bank owners that have fallen into dispute and /or default. As a first step, a determination will be made within 30 days regarding which former bank owners are in compliance with the terms of their agreements. Those found not to be in compliance will then be given three months to fulfill their obligations under their existing agreements. The government has committed to take strong actions against those former owners who fail to come into compliance with their obligations by the end of this period. These actions include bankruptcy, asset seizures, debtor imprisonment, and criminal charges for corruption. These actions will be enforced through a coordinated effort among the relevant government agencies, including the FSPC, IBRA, the Attorney General's office, the police and the legislature and judiciary. To ensure full transparency and accountability, all determinations of compliance, legal actions, and release and discharge will be made available to the public.

We have also made progress in the other areas of the structural reform agenda. In the area of privatization, we have finalized and published our program for 2002, and are confident we will achieve our targets under the program's budget financing plan. With regard to decentralization, there has been steady improvement in the coverage of the reporting of regional finances and we are confident that the GOI will be able to produce a full year outcome for the 2001 local government finances by end-June 2002. In the area of developing the small and medium size enterprise sector, the SME task force, formed by the GOI in 2001, will develop a policy, in collaboration with the World Bank, AsDB, and bilateral assistance, that is consistent with our budget and efforts to strengthen the financial sector. We expect to be in a position to finalize our policy by the time of the next review.

As part of its ongoing efforts to improve accountability, BI plans in future to publish its complete audited financial statements, starting with the 2001 accounts. BI has also decided to establish an audit committee to strengthen oversight of the external and internal audit mechanisms. In line with the IMF's recently established general policy on safeguards, BI's foreign reserves practices for the half-year ended June 2002 will be audited by an internationally recognized audit firm with the involvement of BI's constitutionally appointed external auditor.

On this basis, the government requests completion of the fifth review under the extended arrangement. During the remaining period of the arrangement, we will continue to consult with the Fund on future economic policies and in order to assess progress under the program and reach understandings on any additional measures that may be needed to achieve its objectives. The next review of the program will be completed by June 2002.

Sincerely yours,