Public Information Notice No. 04/51

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Indonesia

May 9, 2004

On May 3, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Indonesia.¹

Background

Since the last Article IV consultation, Indonesia has made significant progress in strengthening macroeconomic policies and implementing key areas of the structural reform agenda, notably with regard to rehabilitating the banking sector. Indonesia's economic performance has improved correspondingly, and following an impressive fiscal consolidation and disinflation effort, and a significant reduction in external vulnerability, the authorities have laid a strong macroeconomic foundation for Indonesia's economic development.

Nevertheless, Indonesia's economic performance has continued to lag behind other countries in the region, with GDP growth, investment, and exports, continuing to perform less favorably when compared to the experience of other Asian economies. Remaining structural weaknesses, particularly with regard to the development of institutions needed for a stable and efficient market-based economy, have impeded the pace of Indonesia's economic recovery.

The economy performed relatively well in 2003, showing commendable resilience to a number of shocks, including the regional impact of Severe Acute Respiratory Syndrome (SARS) early in the year, the Marriott bombing in August and the lingering after-effects of the Bali bombing in late 2002. Growth edged up to 4.1 percent, supported by strong private consumption. Inflation continued to fall, reaching 5.1 percent in March 2004, and sustained current account surpluses and improved capital flows have led to a significant increase in external reserves and a corresponding reduction in external vulnerability. Although the fiscal deficit exceeded the budget target by a small margin, public debt ratios continued to decline.

The ongoing improvement in the economy was underpinned by steady policy implementation. Performance in the last year of the extended arrangement was relatively good, with all four reviews completed on schedule and significant advances made in bank divestment and fiscal reforms. The government's economic strategy for the post-program period, set out in its White Paper, has provided continuity in the reform process, with a number of notable advances achieved so far in 2004. The sale of Lippo Bank has been concluded, a further minority stake in bank Mandiri has been divested, Indonesian Bank Restructuring Agency (IBRA) has successfully completed its operations, and long-delayed amendments to the BI law have been adopted.

Indonesia's economic performance is projected to continue to strengthen in 2004, provided that sound policy implementation is sustained during the remainder of the year. Growth is projected to pick up to 4.8 percent, sustained by robust consumption. Inflation should remain subdued at around 5 percent. Although the trade surplus is expected to narrow, as imports recover, the current account surplus is expected to remain in substantial surplus. This, together with some improvement in the capital account, would enable Indonesia to absorb the absence of exceptional financing from the Fund and Paris Club creditors, while maintaining a comfortable external reserve position.

The medium-term outlook is sensitive to progress made to improve the investment climate. If strong progress is made, the government's medium-term objectives of raising GDP growth to 5-6 percent could be realized. Such an outturn would be predicated on a rise in investment and a pick-up in exports. Achievement of this outlook depends on progress on addressing institutional weaknesses, particularly with regard to strengthening the legal system, reducing regulatory uncertainty, and improving public sector institutions.

Indonesia's first Stand-By Arrangement was approved on November 5, 1997, with a total of SDR 3.7 billion being drawn (out of a total SDR 8.3 billion). The Stand-By was replaced by an extended arrangement on August 25, 1998, under which about SDR 3.8 billion was drawn (out of an augmented total of SDR 5.4 billion). A new Extended Arrangement in the amount of SDR 3.6 billion was approved on February 4, 2000, and was extended by a year in January 2002. The arrangement concluded on December 31, 2003, with all available purchases drawn. Indonesia's obligations to the Fund now amount to the equivalent of about US$10 billion.

Executive Board Assessment

Executive Directors commended the Indonesian authorities for their good record of policy implementation in recent years, which has successfully restored macroeconomic stability and reduced external vulnerability. Real GDP has surpassed its pre-crisis levels, inflation has declined, the exchange rate has stabilized, gross reserves have risen to comfortable levels, and the public debt has fallen significantly as a share of GDP. These developments have contributed to a strengthening in market sentiment, as underscored by the recent successful sovereign bond issue, marking Indonesia's return to the international capital markets.

Directors noted that despite these achievements, the authorities face the significant challenge of putting Indonesia on a higher sustainable medium-term growth path while maintaining market confidence going forward. Directors observed in this connection that Indonesia's economic performance has lagged behind that of its regional partners, and that the economy is yet to fully share in Asia's recovery. GDP growth continues to be below potential, and investment and exports remain weak. Directors considered that strong efforts to enhance the investment climate will be crucial for achieving higher rates of growth and poverty reduction. In this regard, they welcomed the authorities' focus on improving the business environment, as well as on maintaining macroeconomic stability and continuing the restructuring of the financial system.

Directors commended the authorities for their continued emphasis on fiscal consolidation, which should help further reduce the level of public debt. They welcomed the government's commitment to achieving its 2004 budget deficit target despite the challenges and spending pressures of an election year. Directors noted that over the medium term it will be important to reduce reliance on declining oil revenue by enhancing non-oil tax revenues through broadening the tax base and strengthening tax administration. A priority will also be to strengthen the governance framework in the institutions responsible for tax policy and administration. Directors saw scope for savings in the wage bill and noted the need to improve the efficiency of spending by phasing out poorly targeted subsidies—including for petroleum products—and to ensure that any revisions to the decentralization framework do not weaken the central government's fiscal position. Directors recommended a continued strengthening of debt management and a cautious approach to foreign currency bond issues, and they welcomed the use of a collective action clause in the recent foreign currency bond issue.

Directors welcomed the authorities' progress in reducing inflation. Together with the stability of the rupiah, this has provided room for significant reductions in policy interest rates over the past year. Looking ahead, Directors urged Bank Indonesia to maintain a cautious monetary stance, particularly in light of the potential for shifts in market sentiment and the prospect of higher interest rates abroad. They supported the authorities' intention to move over time to an inflation targeting framework, as well as their continued commitment to a floating exchange rate regime.

Directors emphasized that continued financial sector reform will be key to returning Indonesia to a higher growth path. They commended the authorities on the successful closure of IBRA, and emphasized that the successor public sector asset management company should press ahead with the disposal of remaining assets. Directors were encouraged by the progress made in putting in place a financial safety net, including the establishment of procedures on bank resolution and lender of last resort support. They called for early passage of the deposit insurance legislation to enable a phased removal of the blanket guarantee on bank liabilities, and emphasized the importance of improving the accountability of the central bank by establishing the planned supervisory body for Bank Indonesia. The authorities were commended for the steps taken to strengthen the Anti Money Laundering (AML)/Combating the Financing Terrorism (CFT) framework, and were encouraged to move ahead with the implementation of further planned reforms.

Directors noted that state banks continue to be the main source of fragility in the financial system. They urged the authorities to maintain close oversight of state banks to strengthen their financial position and ensure that their lending practices are in line with sound banking standards. Also, they stressed that exerting moral suasion on banks to increase lending and lower interest rate spreads, could entail risks for the health of the banking system. Directors encouraged the development of a strategic plan aimed at reducing the risks posed by the state banks by increasing private sector participation and improving their efficiency and governance.

Directors were encouraged that further structural reforms to strengthen the investment climate and bolster export performance are a central theme of the government's White Paper. They welcomed the authorities' recognition that priorities include addressing weaknesses in the area of tax administration, and recommended that emphasis be placed on avoiding arbitrary tax assessments, illegal fees, burdensome customs procedures, and inefficiencies in the refund system for VAT and income taxes. Directors suggested that the authorities use the pending tax legislation to address these issues.

Directors urged the authorities to strengthen their efforts to establish a clear and competitive framework for labor relations, the absence of which remains a major impediment to investment. Specific steps in this direction should include finalizing the implementing regulations associated with the manpower and industrial disputes legislation, in a manner that protects workers' rights while maintaining labor flexibility. They urged that minimum wage increases be contained to preserve competitiveness and reduce unemployment.

Directors underscored the need for progress in strengthening key institutions, particularly in the legal and judicial areas, to enhance certainty with regard to property rights and contract enforcement. In this regard, Directors urged the authorities to secure approval of the relevant amendments to the bankruptcy law, and to support the ongoing efforts to strengthen the administrative capacity of the judiciary and enhance its accountability and the public's confidence, including through establishing the planned Judicial Commission. It will also be essential to push ahead with efforts to combat corruption and promote good governance by taking the steps necessary to make the Anti-Corruption Commission fully operational, and by expediting the establishment of the Anti-Corruption Court.

Directors welcomed the overall openness of Indonesia's trade regime and the authorities' commitment to further multilateral trade liberalization under the Doha round. They also welcomed the government's intention to allow temporary restrictive trade measures imposed in recent years to expire as scheduled, and urged the authorities to refrain from imposing any new restrictive measures.

Directors welcomed the use of post-program monitoring to maintain a close policy dialogue between the Indonesian authorities and the Fund, which should aim to help support Indonesia's reform efforts to promote foreign direct investment, economic growth, and poverty alleviation. Some Directors looked forward to early completion of the Poverty Reduction Strategy Paper (PRSP).