Jakarta, Indonesia
September 11, 1998

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington DC 20431

Dear Mr. Camdessus:

The Government of Indonesia's economic program, now being supported under an extended arrangement, was set out in the Memorandum of Economic and Financial Policies (MEFP) attached to the letter sent to you on July 29. This economic program is on track, and remains appropriate to Indonesia's circumstances. However, aspects of the program have been developed further, and these new measures are described in the attached Supplementary Memorandum.

We have established indicative targets for monetary and fiscal variables, and for international reserves for end-October and end-November, in order to guide policy during the fourth quarter, and these are set out in the annex. The review scheduled for November 25 will be based, inter alia, on performance in relation to the October indicative targets for base money, net domestic assets of Bank Indonesia, liquidity support to banks and net international reserves.

Jakarta, Indonesia
September 11, 1998

1.  The Government of Indonesia's economic program, most recently described in the Memorandum of Economic and Financial Policies (MEFP) of July 29, 1998, remains on track. In particular, the rupiah has strengthened considerably since mid-July, reflecting strong policy implementation and growing confidence in the program. Monetary policy has been in line with the program, and the fiscal balance is well within the program limit. Important structural policy measures taken in recent weeks in several areas, especially bank restructuring and corporate debt, have also contributed to increasing market confidence. Although inflation was high in July and August, it is expected to decline substantially in the period ahead, given the strengthening of the rupiah and the measures being taken to improve the food situation. In these circumstances, while major changes to the program are not envisaged at this stage, we have further developed some aspects of the program, as described below. An updated matrix of structural policy commitments is attached to this memorandum. The revised program has been worked out jointly with the IMF, World Bank and Asian Development Bank.¹

2.  To help ensure that inflation is reduced quickly and that the rupiah continues to strengthen, we intend to continue to implement a firm monetary policy, consistent with the monetary targets already established as part of our program. As inflation declines, and provided the rupiah remains in line with the program path, we expect that interest rates will decline gradually, easing the pressure on the corporate and banking sectors. At the same time, we are taking steps to ensure that fiscal policy is as supportive of recovery as programmed. In particular, development expenditures, including those for the social safety net, which have been running below the programmed level, are to be stepped up in line with budget targets.

3.  Increases in food prices, especially for rice, have been a major factor behind the pickup in inflation in July and August. For rice, a disappointing second harvest and some panic hoarding have contributed to the sharp run up in prices in recent weeks. As a result, domestic market prices are currently close to international prices. This has made it even more urgent to shelter the poor from the effect of high rice prices. Therefore, our program for providing rice at very subsidized prices to poor families, which has already been extended to over 2 million households, will be extended further to at least 7.5 million poor families by October. In order to stabilize and reduce market prices paid by the general public, BULOG is increasing substantially the quantity of rice released into the market at below market prices, and will maintain a higher level of releases until the main harvest. Also, for the first time in thirty years, we will allow private traders to import rice. These steps are part of the seven point strategy adopted by the government as an immediate response to the rice situation (see annex). In addition, we will continue to provide physical protection to traders and for warehouses and transportation of supplies. Even with these steps, however, recent developments have proved that maintaining domestic prices substantially below prices in international markets is not feasible.

4.  As an additional step to improve the food situation, we have eliminated the BULOG monopoly on wheat, sugar, and soybeans, and we intend to turn over their importation to the private sector. We have also recently decided to eliminate the subsidies on wheat and sugar and to gradually phase out the subsidy on soybeans. While it would have been desirable to maintain the subsidies for the time being, as had been foreseen in our program, their benefit to consumers was being eroded by the difficulties to prevent illegal exporting and higher markups of traders. The decision of the government to eliminate these subsidies was thus dictated by the reality of market participants' behavior, and was not made as a commitment under the program. For the same reasons, subsidies for the importation of soybean meal, fishmeal, and corn have also been eliminated. For all these commodities, relevant import duties have been removed. In the case of sugar, it is expected that these measures will not lead to upward pressure on the domestic price, which has recently been above international levels. For the other commodities, significant price increases are not expected, reflecting increased competition and efficiency, and also the removal of import duties. The removal of subsidies on these commodities means that existing export bans (except for rice) are no longer relevant, and these will be eliminated by September 21.

5.  In coming weeks, we will be working closely with the World Bank and the Asian Development Bank on additional steps to improve the targeting of remaining subsidies, and consideration will be given to selective increases in administered prices. Subsidies on aviation fuel will be eliminated by October 1, 1998. A mechanism for regular adjustments to administered prices to be introduced for 1999/2000 will also be developed. In addition, also in collaboration with the World Bank, we will develop a plan for the longer-term role and the corresponding restructuring of BULOG.

6.  The Government is fully committed to moving ahead with privatization and a master plan for privatization is nearing completion, including provision for the sale of majority stakes in state enterprises over the medium term. The privatization program for this year, however, has been proceeding more slowly than originally hoped, because of the weakening of the domestic economy, and an adverse shift in investor attitudes toward emerging markets generally. Procedural difficulties, including with respect to regulatory and legal changes required in some cases, and concerns about selling assets when prices are very depressed have also been factors. While in these circumstances our privatization efforts in the near term will need to be more selective than originally envisaged, we have been working closely with the World Bank, and preparations in a number of suitable cases are well advanced. These include cement, some areas of telecommunications, mining, plantations, and infrastructure. On the basis of current plans, achievement of the program target for privatization receipts for 1998/99 is still possible. However, given the exceptionally unfavorable environment and inevitable uncertainties related to privatization, especially as regards timing, a shortfall from the program revenue target is now likely. This should not jeopardize the achievement of the overall target for the fiscal deficit, given the savings on subsidies now in prospect.

7.  On August 21, the Government announced a major bank restructuring package that covered banks accounting for almost half of banking system assets. As immediate steps to implement this plan, we intend by September 21, 1998 to complete negotiations with the former owners of large intervened banks for the repayment of Bank Indonesia liquidity support. We also intend by September 30, 1998 to (i) prepare a final plan for the restructuring of Bank Danamon; (ii) finalize the strategy for recapitalizing and privatizing two other banks, PDFCI and Tiara; and (iii) finalize the plan for recapitalizing and rehabilitating Bank Central Asia. In addition, the legal requirements for the merger of four state banks are to be completed and an initial action plan for the operational merger of those banks drawn up by end-September. Full details of the plan for the recapitalization of stronger banks, announced on August 21, will be developed by end-September. We intend to proceed quickly with the issuance of government bonds needed to finance bank restructuring operations. The five members of the Independent Review Committee of IBRA will be appointed by end-September 1998, and a first meeting will be held by end-October 1998. The government recently submitted to Parliament a set of amendments to the banking law that would enhance IBRA's legal powers, allowing the speedy transfer of assets to its asset management unit; reform bank secrecy laws; and eliminate the legal restrictions on foreign ownership of listed banks. We hope that these amendments can be passed into law by October 20.

8.  As outlined in the MEFP dated July 29, the government is establishing a framework designed to promote the voluntary restructuring of corporate debt, which is essential for a broad-based recovery of output. This framework, called "The Jakarta Initiative", was announced on September 9, 1998. The initiative, which is intended to complement the newly amended bankruptcy law and the INDRA scheme, establishes principles to guide and streamline out-of-court corporate restructuring. These principles cover, importantly, the provision of interim financing during workouts, which is essential for preserving viable corporations, and the provision of adequate information by debtor corporations, which is necessary for creditors to be able to evaluate viability and business plans. A Task Force, including representatives of relevant ministries and agencies, is being established by the Private Debt Team to oversee the Initiative, and will be staffed and funded over the next two weeks so as to ensure that the Jakarta initiative is operational by end-September 1998. To provide advice on the implementation of the initiative, an advisory group, consisting of representatives of domestic and foreign creditors, and domestic corporations will also be established, and will meet regularly. The Task Force will receive initial technical assistance from the World Bank and the Asian Development Bank, and the government is exploring with the World Bank a more comprehensive funding program. Attention will be given to supporting the restructuring efforts of small and medium sized enterprises. Following initial discussions with debtors and creditors, it is envisaged that the first restructuring negotiations will take place shortly after the Jakarta Initiative becomes operational. Other steps being taken by September 30, 1998 to promote corporate restructuring include: (i) issuance of regulations that remove the impediments and disincentives to debt-equity conversions; and (ii) issuance of a decree to remove tax disincentives to the merger and restructuring of companies, and that also facilitates debt forgiveness and debt-equity swaps by limiting the current taxation of any related income. By end-October, the Task Force will have established a forum for "one-stop" facilitation of regulatory filings made in connection with corporate restructuring.

9.  Regarding bankruptcy reform, the Special Commercial Court opened as scheduled on August 20 and has received and registered a number of bankruptcy petitions. As required by law, the court hearings for the adjudication of bankruptcy are scheduled to take place within 30 days of the date of registration. Supported by technical assistance provided by the Fund and other contributors, procedures are being introduced to ensure that court proceedings are efficient, transparent and predictable. To further enhance the capacity of the Special Commercial Court, special court fees--the modalities of which are being worked out--are being introduced that will generate resources on a transparent basis for the operation of the court system.

10.  To guide financial policies during the fourth quarter of 1998, we have established indicative targets for end-October and end-November for base money, the net domestic assets of Bank Indonesia, the net international reserves of Bank Indonesia, liquidity support to banks, and the overall government balance, as shown in the attached table. As the program is on track, these are all in line with the respective indicative targets and performance criteria for end-September 1998 and the indicative targets for end-December 1998 established earlier, and set out in the MEFP of July 29, 1998.

ANNEX

2.  This rice will be released into the market at less than the market price.

3.  BULOG will increase direct deliveries of medium quality rice to retailers and cooperatives.

4.  To put further downward pressure on prices, VAT on rice (and also other essential commodities) will be suspended.

5.  The program for delivering rice at prices well below market prices to poor families will be expanded as quickly as possible, with the help of provincial governors.

6.  BULOG will actively seek new import contracts for rice to ensure that stocks remain adequate.

7.  Private traders will be freely allowed to import rice.