Indonesia—Letter of Intent

Jakarta, December 10, 2003

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

1. This letter marks the final review under Indonesia's Extended Arrangement with the Fund, which concludes at end-2003. Over the four-year period of the arrangement, macroeconomic stability has been restored, the banking system has been recapitalized, and most banks taken over during the crisis have been divested. In addition, balance of payments vulnerability has been reduced sharply with a fall in external debt and a rebuilding of foreign reserves. While important challenges remain, the key objectives under the program have largely been met, and we believe the external financing situation next year can be managed without further exceptional balance of payments support from the international community. Our Economic Policy Package announced in September reaffirms our efforts to foster economic growth by maintaining macroeconomic stability and further advancing structural reforms.

2. Turning to progress under our economic program for 2003, a good record of policy implementation has been achieved, and we are on track to meet our broad macroeconomic objectives. In particular, GDP growth of 4 percent in 2003 is expected, and inflation should finish the year at around 6 percent. With the global recovery gaining strength, GDP growth should pick up next year to close to 5 percent, and we expect inflation to remain moderate at 6 to 7 percent.

3. All end-September quantitative performance criteria were met; the indicative target on base money was exceeded by a small margin, but the target for end-December is expected to be achieved (Table 1). With regard to the September structural benchmarks set for this review (Table 2): (i) the IPO for BRI has been successfully completed; (ii) we have decided on the resolution strategy for assets that may remain unsold at the end of IBRA's mandate (see below); and (iii) while IBRA cash collections through September were somewhat lower than expected owing to a slight delay in certain sales programs, our cash collections are on track to meet the full-year target.

4. Achieving a sustainable fiscal position remains a key priority. The deficit outturn for the first three-quarters of the year was well within programmed levels. To achieve the 2003 program budget deficit ceiling of 1.9 percent of GDP, we are monitoring revenue developments closely and are exercising restraint over non-priority spending. Parliament has approved the 2004 budget, targeting a deficit of 1.2 percent of GDP. The budget strives to increase non-oil revenues through continued efforts to strengthen tax and customs administration, while preserving priority development and other social spending. With no further external debt rescheduling from Paris Club creditors, the financing of the budget will shift toward domestic sources.

5. The stability of the rupiah and decline in inflation over the past year have enabled Bank Indonesia (BI) to achieve a significant reduction in interest rates. The scope for further reductions in interest rates in the period ahead is now limited. Looking ahead, BI will continue to implement a cautious monetary policy stance. In this context, while we are preparing the groundwork for a gradual shift to a formal inflation targeting framework, monetary policy in 2004 will continue to be guided by a base money path consistent with our inflation objective.

6. Discussions with Parliament on amendments to the BI Law continue. We are working to reach agreement with Parliament on amendments to establish a lender of last resort facility administered by BI, a new financial supervisory agency in due course, and a supervisory body aimed at enhancing institutional credibility while preserving policy independence.

7. With regard to IBRA, as noted above we continue to make good progress toward asset sales. We are finalizing, ahead of schedule, the sale of a 51 percent stake in bank BII, and plan to sell another 20 percent to retail investors by the end of the year. The majority divestment of bank Lippo was recently postponed, due to unacceptably low bids, but was relaunched in December, with completion expected by February. The divestment of a majority stake in Permata, the remaining IBRA bank, will be launched in early 2004, subject to resolving outstanding legal issues. We are working on a plan to resolve outstanding obligations of IBRA's largest debtor, the Texmaco group. The plan would ensure that there will be no further public financial assistance to the conglomerate. It is based on the existing Master Restructuring Agreement signed between IBRA and the group in 2001, and aims to dispose of the group's exchangeable bonds held by IBRA in two bundles, with the textiles and engineering divisions offered separately so as to maximize investor interest.

8. IBRA's existing mandate expires in February 2004. We have decided to transfer the remaining assets to several self-liquidating holding companies for future disposal. These holding companies will be managed by the Ministry of State-Owned Enterprises. Until such time as the new deposit insurance agency is established, IBRA's deposit guarantee responsibilities will be transferred to the Ministry of Finance. Its bank resolution functions related to individual banks will be managed by Bank Indonesia and in systemic cases by the government in coordination with Bank Indonesia according to the prevailing banking and central bank laws.

9. As part of our efforts to restore the soundness of the banking sector, we are strengthening the oversight and accountability of the state banks. At bank Mandiri's shareholders meeting last September, we appointed additional independent commissioners, and we are also monitoring closely the bank's performance under its business plan. Also, a business plan for the bank is being drawn up for 2004, which we will review shortly. As has been well publicized, recent irregularities at BNI have surfaced, revealing serious control weaknesses in the bank's operations. We are taking prompt steps to address these weaknesses through changes in the bank's management, and the adoption of a time-bound action plan to strengthen the bank's internal controls.

10. We are also making progress to improve public sector governance, an important element of our structural reform agenda. The selection of commissioners of the Anti-Corruption Commission (ACC) is underway, and resources have been allocated in the budget for its operations. The appointment of the commissioners is expected to be completed by the end of December. These steps will enable the ACC to commence operations in early 2004. We remain committed to working with Parliament to ensure the expedited passage of amendments to the Bankruptcy and Foundations Laws, and the Judicial Commission Bill.

11. In view of the progress in policy implementation, we request completion of the eleventh review under the Extended Arrangement. The challenge in the period ahead will be to maintain investor confidence through the maintenance of sound policies. For this purpose, we are committed to the timely implementation of our Economic Policy Package, which aims to maintain macroeconomic stability, strengthen the financial sector, and generate higher investment, exports, and employment. As we implement our economic policies, we intend to maintain a close policy dialogue with the Fund and the international community.