Jakarta, Indonesia
May 14, 1999

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Camdessus:

Continued progress is being made in implementing the Government of Indonesia's economic program, supported under an extended arrangement from the Fund, and set out in the Memorandum of Economic and Financial Policies (MEFP) of July 29, 1998, and in the Supplementary Memoranda of September 11, October 19, November 13, 1998, and March 16, 1999. We have taken a number of additional steps to strengthen the program, as described in the attached Supplementary MEFP.

We met all the performance criteria for end-March 1999 and have made progress on structural measures. We request modification of the performance criteria for end-May for NDA and NIR to reflect an updated path of official financing disbursements. End-July 1999 quantitative performance criteria have been set for the full set of monetary, fiscal and external variables. Structural performance criteria and benchmarks have been set through August 1999; these include a proposed modification of the date for the completion of the audit of the Reforestation Fund, which has been delayed until August 30, 1999, but the audits of Pertamina, BULOG and PLN are expected to be completed as scheduled by end-June 1999.

Sincerely yours,

Jakarta, Indonesia
May 14, 1999

1. Steady progress continues to be made in implementing the Government of Indonesia's economic stabilization and reform program despite difficult social and political conditions. The main macroeconomic targets for 1998/99 were all met, including those for containing the decline in real GDP, inflation, the external current account surplus, foreign exchange reserves, and the average exchange rate under the program. However, the budget deficit outcome was much smaller than the program because of spending shortfalls, and end-March 1999 indicative targets for liquidity support and base money were slightly exceeded, partly due to delays in implementing the private bank recapitalization program. All other targets and performance criteria for March 31, 1999 were met.

2. Policies remain guided by the macro framework for 1999/2000 set out in the March 16 MEFP. In particular, we are pressing ahead with bank and corporate restructuring policies, which have been further strengthened at this review. Quantitative performance criteria are shown in Table 1 and structural performance criteria and benchmarks are shown in Table 2. The program continues to be developed in consultation with the IMF, World Bank, and the Asian Development Bank.

I. Macroeconomic Framework and Policies

3. Preliminary indicators suggest that the economy has now bottomed out and stabilization is being consolidated. Ahead of expectations, real GDP rose 1.3 percent in the first quarter on the strength of a good rice harvest, improving the near-term growth outlook. We now expect real GDP growth to be in the 0-2 percent range for 1999/2000. Prices declined in both March and April, also helped by improved rice availability. On this basis, we expect the 12-month inflation rate to fall below 10 percent toward the end of 1999/2000. The macroeconomic framework will be comprehensively reviewed by the middle of the fiscal year, together with a full assessment of the implementation of the 1999/2000 budget, as indicated below.

4. The exchange market has also been more stable within an appreciated range around Rp 8,000 per U.S. dollar. Strengthened export financing policies, the second exchange offer with private banks, official financing commitments, and an orderly political transition should all help achieve the program objectives and, thereby, be supportive of further strengthening of the rupiah. The Paris agreement with official creditors reached in September 1998 is being implemented.

5. Base money is back on track following the uncertainties that contributed to higher currency demand in February-April, and after sustained open market operations. We will maintain monetary control in the period ahead, consistent with the agreed 1999/2000 monetary program, which has been slightly adjusted to be fully consistent with the revised path of official disbursements. Currency demand and, thereby, base money, may remain volatile around the agreed path until the forthcoming elections have been completed.

6. Despite recent interest rate reductions, real interest rates remain very high. The case for continuing durable interest rate reductions has been strengthened by March-April inflation data, and such reductions are necessary for monetary policy to become supportive of recovery. This process will be carefully managed without compromising exchange market stability or inflation performance.

7. We are better prepared to deliver a high quality fiscal stimulus in 1999/2000. We have given the highest priority, as explained below, to better targeting and monitoring public expenditure. We intend to undertake a full assessment of the 1999/2000 budget by the middle of the fiscal year, so that the need for any corrective actions can be identified on a timely basis. This assessment will especially focus on the implementation of the expenditure program, updated costs of bank restructuring, and the revised outlook for medium-term fiscal sustainability. Work toward these ends will be initiated at the next review. The likelihood of higher oil revenues, were world oil prices to remain at their present level, would help finance higher than budgeted bank restructuring costs. At the same time, key structural fiscal reforms are being initiated.

II. Social Safety Net

8. The government, in consultation with the World Bank, is working on three fronts to strengthen social safety net programs: ensuring appropriate allocations within the social safety net budget; improving the design of social safety net programs, including better targeting of expenditures; and setting up monitoring arrangements, both national and regional, that aim to reduce leakage and ensure that these programs work well.

9. The budget now includes a "core" social safety net, excluding a variety of unrelated and less effective programs, and allocating adequate resources for the key areas of health, education, employment creation, and food security. It consolidates the proliferation of emergency padat karya (employment generating) projects into a single well-defined program. We are coordinating the various "community-fund" programs which provide block grants directly to the village level and ensuring that the scale of programs is better matched to institutional capacity.

10. Significant improvements have also been made to the design of social safety net programs. For example, the community fund programs now include strengthened representation of civil society, greater availability of information about fund allocation, and tighter supervision. A complete redesign of the padat karya programs will raise benefits to the poor by increasing the labor share, better targeting project activities, and stricter control over selection of workers. A special initiative to raise the participation of women will help address the problem of women's unemployment. Expansion of the rice subsidy program will now include more urban residents, including those without identity cards, and will involve NGO and civil society groups. We are also committed to a process of consultation with civil society in designing social safety net programs for the next fiscal year.

11. Special measures are being taken to ensure that social safety net programs are monitored carefully and budgetary resources safeguarded. The government will improve its own monitoring system, work closely with a "control team" established with prominent members of civil society, and provide timely and accurate information to the public so that local communities are empowered to monitor safety net programs. For each of six important safety net programs, a five point action plan for safeguarding resources has been agreed with the World Bank, which will include (I) regular reporting of key performance indicators; (ii) independent verification of monitoring reports; (iii) information dissemination to beneficiaries and all citizens; (iv) establishment of a complaints resolution mechanism to resolve problems swiftly and fairly; and (v) greater use of civil society groups as independent monitors at each stage of program delivery.

III. Structural Fiscal Reforms

12. Fiscal reform across a broad spectrum is necessary to safeguard medium-term public debt sustainability and effectively deliver public services. A considerable agenda has been developed, based on recent IMF technical assistance recommendations, and will be adopted by the midterm fiscal review. The Ministry of Finance will also be reorganized to secure more efficient fiscal management, closer cooperation with Bank Indonesia, and fiscal decentralization.

13. We have embarked on a comprehensive inter-departmental review of the tax incentive regime, as committed in the last MEFP. However, another two months will be needed for the report to be completed. On the basis of the review, we intend to prepare a sustainable package of incentives (accelerated depreciation, extended period of loss carry forward and reduced dividend tax), based on the prevailing income tax law, for new investment in well defined priority sectors or activities; this package will, in due course, replace the decree issued in January 1999 for new investments in 22 industrial sectors. In addition, and based on Batam's experience as a free trade area, we are considering extending free trade and port status to the entire Barelang area (comprising 42 islands) under Law No. 3 of 1970. However, we need to be assured that this measure will not undermine revenue potential through leakages. Therefore, in consultation with the IMF and World Bank, a feasibility study (which is a prerequisite for submitting a proposal to Parliament) will be undertaken and completed within two months.

14. We intend to adopt specific measures to streamline the VAT at the time of the midyear fiscal review. The VAT refund system will be reformed to reduce the scope for tax evasion. We will also narrow the list of exemptions and zero-rated commodities that detract from its efficiency. We are also reviewing the excise tax on cigarettes in order to enhance efficiency, including through possible further modifications of the new regime to allow market determination of the prices of all cigarettes and to unify the excise tax on all cigarettes.

15. Other aspects of the tax and customs administration are being streamlined and strengthened during 1999/2000. A tax audit program is being developed based on the classification of taxpayers according to size. Customs valuation fraud is being combated through targeted physical inspections and the establishment of special valuation units and other steps. Improved customs post-release controls are being introduced progressively.

16. The new local government and fiscal decentralization legislations were approved by Parliament in late April, providing the regions with greater autonomy and wide ranging authority in all matters except defense, foreign policy, judicial, fiscal and monetary policies, and religious affairs. Within an agreed national framework, we will ensure that the regions' own revenue-raising capabilities and general purpose transfers are commensurate with the devolution of expenditure responsibilities and functions, in order to prevent a loss of macroeconomic control. Consistent with this principle, the following revenue-sharing arrangements have been made. All oil and gas revenue will continue to be assigned to the central government budget; regions which have oil and gas resources will then receive 15 percent of the government's share in after-tax oil revenue and 30 percent of the government's share in after-tax gas revenue collected in their region. Local governments will also receive 80 percent of nontax revenue (fees and charges) from mining, logging and fisheries and 40 percent from the reforestation fund. These arrangements will be implemented in 2000/2001, and will include appropriate equalization mechanisms addressed at reducing regional disparities. Given the systemic importance of this issue, implementation in fiscal decentralization will be made in consultation with the IMF, the World Bank, and the AsDB, and further technical assistance is underway.

IV. Banking reforms

17. We have now carried the private bank recapitalization program to a decisive stage, and are making progress in the other key areas identified in the March MEFP (Box 1).

18. The March MEFP committed the government to intensify loan collection efforts so as to reverse the negative interest spread, contain sharply rising quasi-fiscal losses, and restore a functioning banking system. To drive the collection efforts of all state, BTO banks and IBRA's AMU, an intensified loan recovery strategy has been adopted and will be managed and implemented with the participation of international banks or financial advisors (Box 2). The strategy includes bank-specific targets for loan collection and improvement in asset quality, which will be incorporated into performance-based management contracts at these banks. Progress will be reviewed regularly, initially on a monthly basis, from June 30.

19. To ensure the loan collection targets are reached, while corporate restructuring is accelerated, the following specific steps are being taken: (I) the government has instructed state banks, BTO banks, and IBRA to accelerate their restructuring efforts and maximize expected asset recovery values; (ii) initially, resolution strategies have been targeted at the 20 largest delinquent borrowers of each bank and IBRA's Asset Management Unit (AMU); and (iii) appropriate legal action (including bankruptcy filings) against recalcitrant borrowers will be undertaken. Transparency will be assured by publicly inviting the delinquent borrowing groups to engage in debt negotiations, through regular quarterly progress reports commencing on June 30, and by announcing the noncooperating borrowing groups. The strategy will also underpin IBRA's efforts to achieve its objective of contributing at least Rp 17 trillion to the 1999/2000 budget, including from the assets that are being disposed under the agreements with former bank owners for the repayment of their connected lending. Sales of noncore assets by IBRA have already commenced.

20. The following principal elements are central to IBRA's efforts: (I) it is reaffirmed that IBRA's AMU will be the sole government-supported entity for asset recovery in nonperforming assets transferred from banks; (ii) all loan documentation on these assets will be transferred to IBRA promptly; (iii) IBRA has been delegated full authority to approve all transactions, except those of clear strategic magnitude (above Rp 2 trillion per obligor), which will need the approval of FSAC; (iv) a coordinated resolution strategy will be developed and implemented in all cases where IBRA, BTO banks, and the state banks share common borrowers; (v) insofar as IBRA retains private sector specialists to assist in speeding recovery through debt restructurings or asset sales, this will be done through a transparent tender process; and (vi) it is expected that, by end-June, IBRA's AMU would have completed classifying its major assets by resolution strategy. These steps are being monitored closely through regular meetings of IBRA management and IMF, World Bank and AsDB representatives.

21. While the loan recovery measures indicated above will crucially help improve bank profitability, action on the deposit side has also been taken to reverse negative interest rate spreads. Thus, we have progressively reduced the maximum spread above the JIBOR rate that banks are able to offer depositors, while remaining covered by the government guarantee, from 500 basis points to 200 basis points; the maximum spread will be reduced further to100 basis points by midyear. State and BTO banks' deposit rates are now well within the ceiling. As a result, since early April, deposit rates in some state and BTO banks have fallen by as much as 7 percentage points, helped also by the overall decline in interest rates. These developments helped to alleviate the negative spread problem, but it remains substantial, especially because of poor loan collection.

22. The operational restructuring of Bank Mandiri is being implemented, in accordance with the strategic objectives outlined in the March MEFP. The voluntary severance plan has already resulted in over 9,000 staff applications, and the centralized treasury unit is in place; the centralized credit unit will be organized by May 28 for performing corporate loans. We have, however, determined that it is more cost effective for non-loss loans (categories 2-4) to remain with Bank Mandiri and its component banks rather than be transferred to IBRA. As a result, Bank Mandiri and its component banks have launched an aggressive loan recovery effort, using all available resources. The loan-recovery targets will be incorporated into a performance contract by May 28 and, as indicated above, will be closely coordinated with IBRA to ensure that a common resolution strategy is followed by all state and IBRA banks. By May 28, we intend to include an international bank in the management of loan recovery.

23. We have delayed taking decisions regarding the restructuring of three state banks (BNI, BRI, BTN), whose restructuring plans were to be prepared by March 31. More time was needed to study the nature of their problems, their potential viability, and additional restructuring options. The recapitalization of these banks will be in step with demonstrable progress in the implementation of approved restructuring plans. BNI will undergo extensive financial and operational restructuring so as to create an efficient, more focused, and profitable bank, which will be ready for majority divestment within three to five years. BRI and BTN will become specialized banking institutions concentrating on microfinance and mortgage lending, possibly through future merger. In consultation with the IMF, the World Bank, and the AsDB, interim measures to strengthen management and reduce losses for each bank will be publicly announced by May 28. Comprehensive business plans will be prepared with the assistance of international advisors by mid-August. Recapitalization will begin thereafter, in line with restructuring.

24. Progress in the restructuring of the four original BTO banks (BCA, Danamon, PDFCI, and Tiara) is being accelerated in close consultation with the IMF, World Bank, and the Asian Development Bank. Acceptable business plans for these banks will be finalized by June 30. For BCA and Danamon, we are developing credible restructuring strategies to address their on-going operational losses, which will enable performance-based management and regulatory contracts to be signed by July 15. These two banks will be prepared to be offered for sale during the second half of 1999/2000. We will recapitalize these banks to 4 percent CAR in line with operational restructuring, or when the banks have a firm prospective buyer; in the meantime, we have transferred only category 5 loans to the AMU. The legal merger of PDFCI into Danamon will be completed by July 31, with the operational merger to be completed by September 30. Bank Tiara is expected shortly to enter into an MOU with an international bank, failing which the bank's operations will be merged into Danamon after midyear.

25. As regards the 7 banks taken over by IBRA in March 1999, resolution strategies will be developed on a case-by-case basis, in close coordination with the IMF, World Bank, and AsDB, for presentation to the FSAC by end-July. As with the 1998 listed BTO banks, the government reaffirms that the former controlling shareholders have no role in or effective rights to these banks. Strict tests will be developed, in consultation with the IMF, World Bank, and AsDB, for any future role to be played by the former owners of all the BTO banks. The former owners would need to pass the fit and proper tests. They would also need to settle their obligations to the government and reach acceptable agreements about their recapitalization of the bank. Former minority shareholders' interests are to be diluted to 1 percent in the event of government recapitalization.

26. Eight of the nine previously qualified B Category banks are on track for their recapitalization to a 4 percent capital adequacy ratio, one of them with the participation of a major international bank. Their owners have already put up their 20 percent share of the previously estimated December 1998 capital requirements and the government will issue bonds to cover its share by May 28. The owners of the ninth bank chose not to inject new capital and the bank has been taken over by IBRA, while negotiations are continuing with new strategic investors. All eligible interbank claims of these banks will be settled by May 28. By June 30, owners are expected to make additional contributions to cover the revised estimates of their banks' capital needs since December 1998. In cases where owners cannot provide their 20 percent share, the government will by that date cover the shortfall by commensurately increasing its own equity share. Safeguards to protect the rights of the government and the private bank owners have been incorporated into the recapitalization agreements which will be signed by May 28.

27. Bank Indonesia has verified the integrity of the capital injections for those banks which were upgraded to A Category. BI has also subjected all 74 A Category banks to a fit and proper test for owners and managers and is taking the appropriate actions against those individuals who violated laws and/or BI regulations. This will involve some changes in ownership, the board of directors, and management by July 31. The process of comprehensive review of their business plans is also underway, as part of the normal supervision function of Bank Indonesia.

28. We have established an Independent Review Committee (IRC) as external reviewer of IBRA and have strengthened its role. The responsibility for decisions of a strategic nature will continue to be exercised by FSAC without, in any way, interfering with the independence of IBRA's operations. We also intend to issue shortly a policy regarding the management of conflicts of interest in those situations where IBRA is both an owner and a creditor of the same entity.

29. As regards the regulatory framework, Parliament has approved the Central Bank Law and this will be signed into Law by the President during May. BI will develop and begin implementing a comprehensive and timebound strategy by end-June to enhance its supervisory and examination activities. This will feature an efficient organizational structure, comprehensive policies and procedures to guide staff, enforcement of prudential regulations, an offsite surveillance program to facilitate early identification of deteriorating conditions in the banking sector, an onsite supervision function to target each banking institution annually, and a comprehensive training program for supervisors.

30. The President has also signed the implementing government regulations to the banking law amendments that cover, inter alia, foreign investments into the banking system. Specifically, foreign investors will now be able to acquire control of any banking institution in Indonesia. We will put in place during May the implementing regulations and the necessary legal authority is in place to issue the recapitalization bonds. We are initiating another comprehensive review of the banking law and related regulations, in consultation with the IMF, the World Bank, and the AsDB. This review will be completed by September 30.

V. Corporate Restructuring and legal reform

31. Key bankruptcy and judicial reform measures in the program are being implemented on schedule (Boxes 3 and 4). In late April, Parliament passed legislation providing for an independent permanent commission to combat collusion, corruption, and nepotism (KKN) in the public sector, including a subcommission for the judiciary. This legislation will be signed into law by the President by May 28. It will become effective in six months and the interim period will be used to develop the institutional infrastructure for the subcommission. The regulations and Presidential decrees necessary to implement the law will be issued by June 30. We will ensure that, by the effective date of the law, highly regarded and independent persons would have been appointed to the judicial subcommission, and the subcommission provided with adequate authorization, resources, and facilities to carry out its job effectively.

32. A recent Supreme Court decision was favorably received by the market and should help alter perceptions about implementation of the bankruptcy law. The Commercial Court Steering Committee will shortly propose detailed procedures for the assignment of ad hoc judges to actual cases before the Commercial Court, and operational issues related to pre-packaged bankruptcies are being addressed. Improving judicial salaries is part of the strategy, and the government will implement the salary proposal of the Commercial Court Steering Committee in June. The government, in consultation with the IMF and World Bank, is undertaking a review of the Bankruptcy Law. This should be completed shortly after mid-1999.

33. As regards other corporate restructuring-related legal reforms, a consolidated Directorate General Circular on tax treatment of company restructuring, and a Ministry of Finance decree providing more favorable tax treatment of transfers of land and buildings, will be issued by May 28. Laws on arbitration and on secured transactions have been submitted to Parliament. In coordination with the World Bank, implementation of the one stop facilitation process for restructuring filings is underway. In that context, high level meetings of the member ministries and agencies have taken place to formulate an operational strategy and agreed rules and procedures for approval of regulatory filings have been established; these incorporate deadlines for the approval of filings, including on a lapse of time basis. Specifically, all applications for restructuring will be addressed by the relevant ministers and agencies within 30 days.

34. The scope for extending the Jakarta Initiative to give added momentum to debt restructuring is under way. Taking into consideration experience in other Asian countries, we will continue to explore, in close consultation with the World Bank, additional measures that would accelerate the pace of corporate restructuring under the Jakarta Initiative. As explained above, we have instructed IBRA and the state banks to accelerate restructurings under the Jakarta Initiative where appropriate, and to follow clear deadlines and procedures in targeting restructuring or bankruptcy filings for their largest debtors. The World Bank has approved a $31.5 million technical assistance loan to support our corporate restructuring program, and AsDB assistance for small- and medium-size enterprises will be finalized shortly. Steps have been taken to enable the Jakarta Initiative Task Force to utilize its funding in an effective manner, enhancing its staff and professional facilitators to allow for accelerated restructuring. We anticipate that at least 20 facilitators will be retained by June 30.

VI. State Enterprises and Structural Issues

35. Privatization receipts for 1999/2000 already amount to about $800 million, following the sale of 51 percent interest in the Jakarta port, 49 percent interest in the Surabaya port, a 10 percent share in the domestic telecommunication company, and an additional 5 percent share in a food processing corporation. The sales of shares in the international telecommunication company has been delayed to July 1999 pending passage of the new telecommunication law. We are revising the bid structures on a large palm plantation and gold/nickel companies to improve their valuation and expect to complete their privatization by September 1999. Additional companies to be privatized this year include the Bali airport concession company, container port concession companies outside Java, a fertilizer plant, a steel company, additional plantations, and several other small enterprises. The overall profitability of the state-owned enterprise sector increased substantially in 1998/99 as a result of efforts to cut costs, strengthen efficiency, and promote restructuring, which should facilitate privatization. There is no legal limit to foreign ownership in state-owned companies unless strategic or national security interests are involved.

36. We are making progress with the restructuring program for the state electricity corporation (PLN) that is designed to strengthen its financial viability and prepare for its privatization over the medium term. The strategy provides for PLN's reorganization within the context of a rapid transition to a competitive retail electricity market on Java-Bali, as well as for fundamental changes in the role of the government including tariff and subsidy policies, an expanded role for the private sector, and legal and regulatory changes to facilitate these reforms. The AsDB has provided a program loan in support of the power sector restructuring policy. The World Bank and AsDB are also financing technical assistance to support the implementation of the reform program.

37. The government is overseeing PLN's restructuring effort. A working group of senior government and PLN officials is defining the framework of principles within which PLN conducts the renegotiations of contracts with independent power producers (IPPs) and to ensure that fair, well-structured, and transparent procedures are followed. However, all negotiations with the IPPs are being conducted by PLN on a commercial basis, without direct government involvement.

38. The special audits of BULOG, Pertamina, and PLN are expected to be completed on schedule by end-June 1999. The audit of the Reforestation Fund has been delayed, because more time was needed to appoint international auditors, and will be completed by end-August. Efforts are underway to ensure that all enterprises scheduled for privatization in the Master Plan are audited to international standards.

39. The people's economy initiative is intended to reorient the economic, financial, and government structure in order to broaden participation by weaker economic groups and regions. In particular, the objective is designed to promote small and medium-sized enterprises and cooperatives in a manner that will promote economic efficiency and growth, while respecting ownership rights. On the implementation of these new initiatives, the government is determined to avoid any loss of macroeconomic control and to remain consistent with the fiscal framework, and will consult with the IMF, the World Bank, and the AsDB.

40. Under the Competition Law, the Independent Supervisory Committee will be established, and will report directly to the President. It has been given extensive powers to investigate and penalize monopoly practices, in accordance with the law. The law will be implemented to preserve the public interest and increase efficiency by prohibiting anti-competitive business practices. This includes price fixing cartels and agreements between companies to reduce competition by dividing product ranges and marketing territories. The World Bank is presently providing technical assistance in drafting the implementing regulations for the law.

VII. Other Issues

41. The foreign exchange transactions law was approved by Parliament in late April. It formally entrenches Indonesia's free and open foreign exchange system, after nearly three decades during which this had only the force of a government regulation. The law also gives Bank Indonesia the authority to obtain information about foreign exchange transactions. This is aimed at strengthening the monitoring of capital flows in and out of the country, without imposing limits on the amount of transfers or other controls. IMF technical assistance is being provided to draft the implementing regulation and the monitoring system, which are expected to be in place by June 1999.

42. In consultation with JEXIM and the World Bank, the government is in the process of establishing an Export Bank to improve the availability of credit for exporters, including small and medium exporters of manufactures. The Export Bank will provide trade finance and working capital loans to exporters, as well as pre- and post-shipment export credit guarantees to commercial banks extending loans to exporters. The legal foundations for this new financial institution and its financing arrangements will be finalized shortly. Initially, the Export Bank will be created by decree but the government intends to later enact a special establishment law to secure its operational independence and financial autonomy.