Jakarta, Indonesia
July 22, 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, March 16, and May 14, 1999. We have taken additional steps to strengthen the program, as described in the attached Supplementary MEFP.

We met all the performance criteria and the structural benchmark for end-May 1999 and the structural performance criterion and benchmark for end-June 1999. Quantitative performance criteria have been set for end-July and end-September 1999 for the full set of monetary, fiscal and external variables. Structural performance benchmarks have been set through December 1999.

During the remaining period of the arrangement, the authorities of Indonesia will maintain close contact with the Fund and will consult on the adoption of any measures that may be needed in accordance with the Fund's practices on such consultations. We will also provide the Fund with such information as it requests on policy implementation and achievement of program objectives.

Jakarta, Indonesia
July 22, 1999

1. Market sentiment has improved markedly since the last review, helped by the peaceful completion of the June 7 parliamentary elections. No loss of policy momentum is envisaged during the transition to a new government, and bank and corporate restructuring policies have been further strengthened. There remains a strong consensus for the economic program and its continuity is expected to be well safeguarded.

2. The following improved growth and inflation outcomes are now targeted by the program's revised macroeconomic framework:

Growth prospects are benefiting from improving market sentiment, higher agricultural incomes, and recovering consumption demand. March-May export performance has also been encouraging. Growing confidence is being reflected in the return of some capital from abroad and a recent sharp rise in the stock market. Price declines in each of the past four months, and the strengthening rupiah, should entrench single digit inflation during 1999. The external objectives of the program should be well achieved. The flexible exchange rate system is accommodating the appreciation of the currency toward its medium-term equilibrium, and enjoys wide consensus.

3. The macroeconomic policy mix is becoming much more supportive of recovery. In fiscal policy, achieving a deficit of 5.8% of GDP remains the principal focus. We are determined to safeguard the fiscal stimulus, and have taken the following measures to avoid renewed spending shortfalls: (I) rehabilitation programs have been accelerated for regions hit by the recent social disturbances; (ii) allocations for infrastructure maintenance and rehabilitation have been advanced; and (iii) implementation of foreign-assisted projects is being stepped up by increasing provisions for their local costs and streamlining budget authorization procedures.

4. Monetary policy has delivered, over the past year, very positive outcomes in terms of price stability, significantly lower interest rates and positive interest rate spreads. The exchange rate of the rupiah and the stock market prices have strengthened markedly. The one-month SB. rate is now about 16 percent, half its level just two months ago, and we see room to guide interest rates down cautiously further. The quantitative monetary program remains appropriate (updated in Table 1).

5. As foreshadowed in the May 14 MEFP, fiscal reforms to strengthen the revenue base, (Box 1), improve targeting and monitoring of safety net programs, and carefully sequence fiscal decentralization will be phased in over the next year. While reforms are necessary to safeguard fiscal sustainability, their timing needs to be carefully considered to avoid detracting from the fiscal stimulus in the near-term or upsetting market sentiment.

Tax Reform

6. We have launched two government studies to review aspects of the fiscal incentive framework. One study, on the tax free status of the Barelang area (Batam and surrounding islands), will complete its work by August 31. Another study, to be completed by October 31, will develop a possible successor package to the January 1999 decree on tax holidays to be implemented by the start of the 2000/2001 fiscal year. Based on these studies, and in consultation with the IMF, we will be prepared to take appropriate measures to preserve medium-term revenue potential.

7. We are also phasing in improvements to the efficiency of the value-added-tax (VAT). Between end-August 1999 and January 1, 2000, we will prepare and begin to implement a number of measures to eliminate certain inefficient exemptions and zero ratings, while ensuring prompt refunds for excess credits. The government will also undertake a study, with IMF technical assistance, to review the effectiveness of policies for the Integrated Economic Development Zones (COPOUTS), especially the fiscal concessions.

8. Regarding other aspects of tax and administration policy, we will complete streamlining specific customs administration procedures by January 1, 2000, and are preparing specific reforms aimed at better targeting of large income tax payers. The rationalization of the excise tax on cigarettes is planned for April 1, 2000. We are also reviewing the feasibility of removing unnecessary impediments to the ownership of land and buildings, taking into account the experience of other countries.

9. Export and import tariff reform has been carried further in June-July. The export tax on crude palm oil has been reduced to 10% and eliminated on crude palm kernel and crude coconut oil. The maximum export tax on logs, sawn timber, rattan, and minerals will be reduced to 15 percent by end-December 1999. In this connection, the decree to raise the forest resources royalty rate to 10 percent will be issued shortly. The import tariff on motor vehicles was reduced substantially on June 24.

10. As part of our efforts to safeguard sustainability and entrench fiscal transparency, we are embarking on a review to take stock of any contingent liabilities and off-budget activities. This review, chaired by the Ministry of Finance, will be completed by October 31, after which all remaining off-budget accounts will be audited before the end of the fiscal year. As a first step, a Presidential instruction will be issued by August 7 to consolidate information on all bank accounts of government agencies, with a view to minimizing the number of these accounts and bringing them under centralized control by December 31, 1999. A consolidated domestic debt management unit in the Ministry of Finance will manage internal debt and government guarantees. Authority for tax incentives is being consolidated within the Ministry of Finance. The government is working to reform the public pension schemes and reduce their budgetary burden. More timely and accurate reporting of local government fiscal operations will be developed.

Social Safety Net

11. Steady progress has been made in developing improved guidelines for social safety net administration (including sanctions against abuses) and, thereby, to help deliver the fiscal stimulus. Comprehensive arrangements for information dissemination, reporting, and independent verification have now been finalized for the majority of key social safety net programs in collaboration with the World Bank. Geographical allocations are close to finalization. The government is currently investigating a number of allegations of abuses in the social safety net programs and has begun to publish its findings. Based on this preparation, we are confident of implementing planned social safety net programs in 1999/2000, and disbursements will accelerate in the second fiscal quarter.

Fiscal Decentralization

12. The Regional Governance and Fiscal Balance laws, approved by Parliament in April 1999, will decentralize substantial economic power away from the center. The measures will be implemented cautiously and in a carefully sequenced manner, beginning in 2001/02, to ensure that central transfers to local governments are commensurate with expenditure responsibilities and revenues from their own sources, regional disparities in the quality of public services are reduced, and macroeconomic control is not jeopardized. Preparatory work has started to ensure that all major revenue (including revenue sharing) and expenditure issues are addressed, which is estimated will require a transition of at least two years.

13. The proposed 25 percent floor for revenue transfers will be implemented in line with the above decentralization framework. A plan is being prepared for the effective devolution of expenditures that will govern the size of the resource pool to be transferred, with strong managerial oversight and local accountability. Most existing special-purpose programs will be converted into broad block grants in order to give progressive autonomy to local governments. An effective grants administration of fiscal allocations will be established, a major role of which will be to move towards uniform standards of public services throughout the country.

14. The Ministry of Finance is taking the lead in implementing the fiscal and financial aspects of the governance and fiscal balance laws, especially setting and enforcing subnational borrowing limits, and developing a government financial management system. Working groups are being established under the Coordinating Minister for Development Supervision and State Administrative Reforms, with the participation of Bappenas, the Ministries of Finance, Home Affairs, and other ministries, to implement proposed government regulations that will define: (I) central government authority and organization after decentralization; (ii) local government authority and accountability, including local taxation, financial reporting and auditing; (iii) the sharing of specified revenues in the new intergovernmental fiscal arrangement; (iv) the basis for allocation of general and special transfers among regional governments; and (v) limits and conditions for borrowing by local governments. In addition, each line ministry has started a review of its own functions with a view to identifying which ones will be decentralized. We are requesting further technical assistance from the IMF, the World Bank and the Asian Development Bank with regard to implementing fiscal decentralization.

15. The banking reforms specified in the May 14 MEFP are being implemented as envisaged. A principal focus continues to be on loan collection and asset recovery by the state banks and, crucially, IBRA whose portfolio (consisting of the 12 BTO banks, its Asset Management Investments (AMI) for shareholder equity assets, and its Asset Management Credit (AMC) for transferred loans) accounts for three-quarters of the total asset value to be resolved (Box 2). At the same time, progress continues to be made in the operational restructuring of the state and IBRA banks (Box 3).

Loan Collection and Asset Recovery

16. The institutional framework set out in the May 14 MEFP is in place. Most importantly, all state and IBRA banks, and the AMC, have publicized the names of their largest debtors (over Rp 50 billion), initiated restructuring negotiations, established loan recovery units, and set monthly recovery targets through December 1999. All state banks, and IBRA's AMC and AMI, have appointed international banks or advisors to assist their restructuring and loan recovery programs. The major BTO banks are also in the process of engaging international banks to assist with restructuring plans and loan recovery management.

17. As of end-June, 784 debtors (accounting for over half of all debtors with loan values above Rp. 50 billion), have signed letters of commitment providing for: (I) full disclosure; (ii) cooperation with due diligence audits; (iii) a time frame for concluding restructuring; and (iv) willingness to accept a strategic investor or management changes. On the basis of these letters of commitment, and other preparatory work, all debtors with loan values exceeding Rp 50 billion are being classified under four categories (A-D), depending on their willingness to cooperate and financial viability. This exercise will be completed by July 31 for all state banks, and by August 31 for BTO banks and the AMC, thus establishing a core data base for monitoring future progress by the interagency debt restructuring committee (paragraph 19). Noncooperating debtors (C-D categories) will be publicized by August 31 for all state banks, BTO banks, and the AMC; they will be subject to penalties, including prompt filings for bankruptcy and foreclosure, within one month of publication.

18. The strategy aims at giving priority to the largest borrowers on a uniform and transparent basis to maximize the returns to government. All state and BTO banks have adopted a phased approach, starting intensively with their 20 largest borrowers (the 200 largest in the case of the AMC), and moving sequentially to the next largest group of borrowers every 2-3 months. In this way, it is expected that restructuring negotiations will be underway with at least the 80 largest borrowers of each bank, and about 380 obligors of the AMC, by end December, 1999, with the target of completing at least 70% (by book value) of these negotiations by March 31, 2000.

19. Loan recovery performance will be monitored by the new interagency debt restructuring committee, chaired by a former State Auditor and comprising representatives of the Ministry of Finance, IBRA, the Jakarta Initiative, and the State Audit Office, in close cooperation with Bank Indonesia. The committee will ensure that debt recovery and restructurings follow the guidelines established by the government, and are coordinated among the state institutions. The guidelines include providing for the establishment of creditor committees and the appointment of lead creditors, as well as the involvement of the Jakarta Initiative Task Force (JIFF), whenever private (especially foreign) creditors are significantly involved.

20. IBRA's AMI and AMC have established recovery schedules with respect to their shareholder equity holdings, loans, and other assets, aimed at collecting (net of expenses) at least Rp.17 trillion by March 2000. These proceeds will be transferred on a quarterly basis to the government account at Bank Indonesia.

21. To meet these targets, IBRA's AMI will complete discussions with all former owners of the 1998 BTO and BBO banks related to their prudential violations by July 31, enabling the transfers of shareholder assets to holding companies to be completed by August 31, 1999. Several holding companies are now being formed, and it is envisaged that at least 6 of the 8 shareholder agreements will be fully operational by end-August, with a full set of directors and commissioners, as well as full title to all relevant assets. Cases of non-cooperation will be referred to the Attorney General for prosecution by August 31. A similar process has been launched by IBRA with respect to the eight banks taken over in 1999 (BTO), and the 38 banks closed in 1999 (BBO) with any necessary shareholder asset transfers to be completed by end-1999. BI is following the same approach with respect to the sixteen banks closed in November 1997, to be completed also by end-1999. Further, the AMC has scheduled monthly auctions through December 1999.

22. Loan collection efforts will be given full transparency. All state and BTO banks and IBRA have been asked to release quarterly reports on loan recovery performance beginning in September 1999. IBRA will also publish quarterly income statements and balance sheets from September 1999.

Bank Mandiri

23. The process of integrating four state banks into Bank Mandiri is at an advanced stage, and follows closely the strategy contained in the May 14 MEFP. In particular, an international bank has been brought into the management of loan recovery; and a performance contract has been signed with its top management.

24. Bank Mandiri has established the following key restructuring targets:

• Compared with the 26,500 employees of the four component banks, Bank Mandiri's staff requirement has been assessed at 14,500. Of those made redundant, about 6,000 staff will be covered by the voluntary severance scheme, by July 31, with the remainder being placed in temporary contracts and phased into the severance scheme by December 2001. The top management of Bank Mandiri has already been changed.
• In parallel, almost one third of the total number of branches (210) will be closed over the next two years, with half of these closures achieved by end 1999, and many branches significantly downsized.

25. Bank Mandiri has prepared a paper proposing an accelerated program for its capitalization. The Ministry of Finance has asked a group of independent international experts to review Bank Mandiri's progress in operational restructuring and assess its request for accelerated capitalization. The report of the international experts is expected by July 26. It is expected that a final decision on the amount and timing of Bank Mandiri's capitalization will be taken by September 15, in the context of the next bi-monthly review.

26. As an interim measure, the Ministry of Finance has agreed to the partial issuance of bonds to Bank Mandiri by July 31, at the time of the legal integration of the four component banks. Thus, government bonds equivalent to Rp. 80 trillion will be placed in Bank Mandiri's balance sheet on July 31, representing slightly more than half of the bonds requested by Bank Mandiri management. The remainder of Bank Mandiri's capitalization bonds will be provided in two steps, at September 30 and December 31, 1999, linked to its compliance with its performance contract, especially loan recovery and profitability targets.

Restructuring of Other State Banks and BTO Banks

27. We have also advanced the restructuring of BNI, BRI, and BTN aimed at preparing BNI for majority divestment in about 3 years, and developing BRI and BTN into specialized institutions focused on micro finance and mortgage lending, respectively. International banks or advisors have been engaged to help manage loan recovery and prepare new business plans by August 15, enabling performance contracts to be signed with bank managements by August 31. On this basis, recapitalization by government bonds will take place on September 30, 1999, December 31, 1999, and March 31, 2000, tied to the achievement of benchmarks related to loan recovery, as well as branch and staff rationalization, in line with the recommendations of the consultants. These benchmarks will be set by August 31. If rights issues are initiated for these banks, government bonds will be held in escrow until these dates.

28. We are accelerating the privatization process for the four 1998 BTO banks (BCA, Danamon, PDFCI, and Tiara) that were recapitalized in early June. Toward this end, we expect to engage international firms as privatization advisors by August 15. We expect that BCA will be the first to be put on sale, during the last quarter of 1999, after merging into it one of the banks (RSI) taken over by IBRA in March 1999. Regarding Danamon, we have announced that PDFCI and Tiara, together with six of the eight banks that were taken over by IBRA in March 1999, will be merged with it, prior to its sale offer planned for early 2000.¹Toward this end, Danamon will prepare a business plan by August 31, setting out the process of integrating the eight banks, improving efficiency, and demonstrating viability. The solvency of these banks will be maintained during the privatization process by performance-based management and regulatory contracts that will be signed by August 31. The remaining bank (Niaga) taken over by IBRA in March 1999 will be resolved separately. None of the 1999 BTO banks will be individually recapitalized, and the fit and proper test will be applied to any role played by the former owners.

Private Bank Recapitalization and Restructuring

29. The recapitalization process for the eight eligible banks has been completed. Private owners have made additional capital contributions toward covering the revised estimates of capital need, and the government has completed its own injection of capital. In aggregate, these contributions have now restored the eight banks to a CAR of 4%. MOUs have been agreed, as envisaged, leaving the private owners in day-to-day control, and with the first right to buy back the government's share by June 2002.

30. Bank Indonesia is on track to complete the comprehensive evaluation of the 74 A-category banks by July 31. By that date, it is envisaged that all owners, managers, and directors of these banks who failed the fit and proper test will be removed, and former controlling shareholders who failed the test will fully divest their holdings. By July 31, BI will also complete its review and discussion of individual banks' financial soundness and business plans. Corrective programs to deal with unviable business plans will be established, where necessary, with individual banks by September 30. Through this process, and regular supervision, BI will ensure that private banks remain solvent.

Legal, Regulatory, and Supervisory Framework

31. We have taken the following steps to strengthen the oversight role and functioning of IBRA's Independent Review Committee (IRC): (I) a Presidential decree has been issued formally establishing this Committee; (ii) a new chairman has been appointed; and (iii) a permanent secretariat will be established on site at IBRA, by end-August, followed by regular meetings of the committee. To ensure transparency, and communicate the Committee's findings to the public, the IRC will issue a communique after each quarterly review meeting.

32. BI is taking a number of steps to improve supervision and increase the transparency of its operations and accountability to the public, including through IMF technical assistance.

• Regarding supervision, and in order to maintain the integrity of the newly recapitalized banking sector, we are progressively introducing aggressive measures toward a comprehensive bank supervisory process which fully incorporates the Basle Committee's Core Principles by end-2001. We have completed an assessment of the nine units at the core of BI's supervision function. Based on this review, and with the assistance of the IMF, we will complete preparation of, and adopt, a master strategy for strengthening BI's regulatory, supervisory, and examination activities by September 1999. This strategy will: (I) assign clear responsibility for the supervision and regulatory functions within the Board of Governors; (ii) establish uniform supervision standards for all public and private banks; and (iii) require formulation of an annual risk-based supervisory program for each bank. All technical assistance projects on banking supervision will be undertaken within the framework of this master strategy.
• Under the new central bank law, BI will henceforth be regularly audited by the Supreme Audit, and the first audit under the new law will be completed by November 1, 1999.

33. We have embarked on a second phase of comprehensive review of the banking law and related regulations, in consultation with the IMF, to be completed by December 31, 1999.

34. We are also taking specific measures to develop a bond market, which will increase financing options for the central government, as well as expand the range of instruments for monetary control.

35. The caseload of restructurings of the Jakarta Initiative Task Force (JIFF) has steadily increased. As of July 7, 234 companies with a combined debt of $24 billion were being assisted by the JIFF. Twenty-two agreements in principle, with a debt of $ 3 billion, have been reached. Restructurings are also underway without the assistance of the JIFF. Nevertheless, we are deepening implementation of the corporate restructuring strategy to accelerate the number and amount of restructurings (Box 4).

36. First, regarding the Jakarta Initiative: (I) the Ministry of Finance has released $ 2 ½ million to the JIFF ensuring that, by July 31, all JIFF's operational expenditures will be met and arrears cleared; (ii) The JIFF is now sufficiently staffed and funds committed by the World Bank are available to finance its activities; (iii) 20 new facilitators will be retained by the JIFF by July 31; and (iv) accelerated approvals of restructuring filings under the one-stop facilitation process have already begun to take place, within clear deadlines, including on a lapse-of-time basis.

37. To improve implementation of the bankruptcy law: (I) guidelines for the assignment and remuneration of ad hoc judges as members of the panel in cases before the commercial court will be put in place by August 31; (ii) salaries of the judiciary have been raised, and will be effective July 31; (iii) an inter-agency steering committee will be established by August 31, to carry out all preparatory work necessary to the effective functioning of the commission for investigating state officials' wealth (and, in particular, the judicial subcommission) as soon as the relevant legislation passed in May (Law 28/1999) becomes effective in November; and (iv) the necessary decrees and regulations to implement this law will be issued by October 31. In addition, a broad anti-corruption law is currently under discussion in Parliament, and is likely to be passed within the next month.

38. Restructuring will also be encouraged by the measures we are taking to improve corporate governance. A high-level committee on corporate governance policy and implementation will be formed by July 31 with members from the private and public sector. The strategy will include measures to rationalize the regulatory framework, emphasize transparency of business practices, increase the accountability of corporate insiders to shareholders and regulators, and increase the effectiveness of enforcement by regulatory agencies. These measures are also crucial to strengthening market discipline, reducing the scope for corruption, and preparing for private sector-led growth.

39. Considerable progress has been made in recent months in implementing the programmed privatization effort for 1999/2000. Next on the agenda is the privatization of a large palm plantation and gold/nickel companies, followed by regional airport and container concession companies, and fertilizer, steel, and additional plantation companies. We have reaffirmed the reliance in all cases on competitive and transparent bidding procedures. The program already contains the commitment to conduct independent audits to international standards on all enterprises scheduled for privatization. The Ministry of State Enterprises is committed to (I) privatizing the majority of state enterprises in line with the privatization master plan; (ii) improving the efficiency and governance of those that will temporarily remain in state hands in preparation for privatization; and (iii) preserving budgetary control. The authorities will examine, with help from the World Bank and the Asian Development Bank, the most effective ways of achieving these aims.

40. The special audits of three public entities (BULOG, Pertamina, PLN) were completed in June 1999. Their reports are currently being reviewed by the government and the findings will be published by August 31, 1999. The Reforestation Fund audit will be completed in August 1999; after its review by the government, the findings will be published by October 31, 1999. In each case, corrective actions will be taken as necessary. A second round of special audits for enterprises with strategic significance and public exposure has been drawn up. The list includes the principal national airline, the toll road operators, the port corporations, and the domestic telecommunication company (and its joint operations), among others. This second round of audits will be completed by December 31, 1999 by international consultants, and the results will again be published.

41. A major concern is the precarious financial position of the state electricity corporation (PLN) and the implications of recent arbitration decisions against the enterprise. The potential scope for higher electricity prices for industrial users and large household users is under examination, as these tariffs are still below PLN's average production cost and lower than other countries in the region. Rates for small household users are not expected to be revised in the near term, thus achieving better targeting of electricity subsidies. PLN is pressing ahead with the renegotiation of their contracts for electricity purchases from independent power producers (IPP's), which are being conducted on a commercial basis without direct government involvement. Discussions have already begun with the first group of IPP's.

42. As part of our strengthened environment policy, specifically regarding forest management, we will implement a broad-based consultation process, seeking assistance from the World Bank, the AsDB, and other stakeholders prior to implementing major forest policy reform.