Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-7237-IND REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED POLICY REFORM SUPPORT LOAN IN THE AMOUNT OF US$1 BILLION TO THE REPUBLIC OF INDONESIA April 28, 1998 Poverty Reduction and Economic Management Unit East Asia and Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (As of April 27, 1998) Currency Unit Rupiah 1 Rupiah = US$0.00013 US$1 = 7987 Rupiah FISCAL YEAR: April 1 to March 31 ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank BI - Bank Indonesia BULOG - National Logistic Affairs Agency IBRD - International Bank for Reconstruction and Development IBRA - Indonesian Bank Restructuring Agency IFC - International Finance Corporation IMF - International Monetary Fund GOI - Government of Indonesia MIGA - Multilateral Investment Guarantee Agency MOF - Ministry of Finance PRSL - Policy Reform Support Loan SAL - Structural Adjustment Loan SCL - Single Currency Loan TOR - Terms of Reference UN, - United Nations UNDP - United Nations Development Program UNICEF - United Nations Children's Fund VAT - Value Added Tax WB - World Bank Vice Presidenit: Mr. Jean-Michel Severino, EAPVP Country Director: Mr. Dennis de Tray, EACIF Acting Sector Manager: Mr. Pieter Bottelier, EASPR Task Team Leader: Mr. Lloyd McKay, EACIF FOR OFFICIAL USE ONLY REPUBLIC OF INDONESIA - POLICYREFORMSUPPORTLLOAN TABLE OF CONTENTS Page No. LOAN AND PROGIRAM SUMMARY iii I. INTRODUCTION 1 II. FROM GRO'WTH TO CRISIS .1 III. THE GOVERNMENT'S RESPONSE TO THE CRISIS.. 4 A. FISCAL AND MONETARY POLICY. 5 B. FINABlCIAL SECTOR REFORM ~~~....................... ... ........ .. ....... .. ... ....................... B. FINANciAL SECTOR REFORM.6 C. CORPORATE DEBT RESTRUCTURING 8 D. STRUCTURAL POLICY REFORMS 9 E. PROTECTING THE POOR ....................... .12 F. INSTITUTIONAL ARRANGEMENTS FOR IMPLEMENTATION AND MONITORING . 14 IV. MACROECONOMIC OUTLOOK ..14 A. PROSPECTS 14 B. EXTElRNAL FINANCING NEEDS 15 V. THE WORLD BANK'S RESPONSE TO THE CRISIS ..16 A. THE WORLD BANK'S PROGRAM OBJECTIVES .16 B. MODALITIES OF BANK SUPPORT FOR A RESTRUCTURED ASSISTANCE STRATEGY 18 C. COORDINATION WITH INTERNATIONAL FINANCIAL INSTITUTIONS AND DONORS 19 VI. THE PROPOSED LOAN 20 A. OBJECTIVES .20 B. LoAN ADMINISTRATION .22 C. BENEFITS AND RISKS .23 VII. RECOMMENDATION .25 ANNEXES: ANNEX 1: Summary of Policy Reforms ... 26 ANNEX 2: Key Macroeconomic Indicators .......................................... 32 Balance of Payments ............................................ 33 Indonesia At a Glance.34 Indonesia t a Glance.............................................. 34....................... ANNEX 3: Status of Bank Group Operations ................................ 36 ANNEX 4: Statement of Development Policy ................................................ 41 The task team includes Magda Adriani, Florence Cazenave, Bridie Champion, Jim Douglas, Jorge Garcia-Garcia, Scott Guggenheim, David Hawes, Peter Heywood, Stephen Howes, Lloyd Kenward, Samuel Lieberman, Vikram Nehru, John Newman, Karin Nordlander, Jacqueline Pomeroy, Yogana Prasta, Richard Roulier, Fadia Saadah, Haneen Sayed, Gurushli Swamy, and Tom Walton. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. REPUBLIC OF INDONESIA POLICY REFORM SUPPORT LOAN LOAN AND PROGRAM SUMMARY Borrower Republic of Indonesia Amount US$ 1 billion Terms Standard amortization terms, grace period and interest rate for fixed-rate US dollar Single Currency Loans with an expected disbursement period of 0-3 years. Description The proposed loan would provide balance of payments assistance to the Republic of Indonesia to support policy reforms designed to overcome the present economic crisis and restore rapid growth, while protecting the poor. The policy reformn program supported by this proposed loan has been jointly developed by the Government, the ADB, the IMF and the World Bank. It embraces: * actions to increase public sector efficiency and transparency, * financial sector reform and principals for a framework for restructuring corporate debt, * structural policy reforms to increase private sector efficiency, improve governance and protect the environment, and * action to protect the poor and to continue priority investments in basic education and health. Benefits * Restoration of confidence and growth by ensuring a sound macroeconomic fiamework, improving governance, increasing efficiency and transparency in both the private and public sectors, and establishing a sounder, more competitive and better supervised banking system. * Protection of the poor from the worst effects of the drought and financial crisis. * Increased environmental sustainability. * A smoother transition of consumption and investment levels, thereby increasing the acceptability of tough reform and supporting an early recovery. Risks The Government's reform program and this supporting operation are subject to considerable risks and uncertainties. There are four main sources of risks: * UJncertainty associated with the early days of a new Cabinet and with political succession. * The possibility of social unrest due to rising unemployment, increasing prices (especially for food and fuel), and falling real incomes. * The fragility of the financial sector and the associated possibility of excessive pressure to expand government expenditure. * Limitations in administrative capacity, coupled with opposition from vested interests. - liii- REPUBLIC OF INDONESIA - POLICYREFORMSUPPORTLOAN The severity of these risks has been mitigated by front-loading the reform program and by designing this loan as a two-tranche operation. In each key area of the program the Government has already implemented important reforms. The risk of social unrest is being lessened by phasing price increases, sustaining basic health and education programs, and expanding programs to shield the poor from the worst effects of the crisis. Pressure on the Government budget is being managed by restricting food subsidies to only rice and soybeans from October 1998, reducing fuel subsidies, limiting the fiscal costs of the bank and corporate debt restructuring programs, and raising additional revenue through privatization. The risks associated with limited administrative capacity have been eased by the provision of extensive technical assistance, especially to support financial sector reforms. Despite the measures that have been put in place to mitigate the risks, they remain considerable. Restoring confidence and credibility in Government actions will take time; the economy will likely be depressed for several years, which will put further strain on the already - fragile political and social situation; and, the ongoing corporate debt restructuring poses risks to the program that the Government can not fully control. Nevertheless, this program presents the only available opportunity to stabilize Indonesia's economy and provide protection to the poorest members of society. Poverty N.A. Category Estimated Two tranches, the first of $600 million to be released on effectiveness and a second disbursements of $400 million expected to be released in July or August 1998. - iv - REPUBLiC OF INDONESIA - POLICYREFORMSUPPORT LOAN Report and Recommendation of the President of the International Bank for Reconstruction and Development to the Executive Directors on a Proposed Policy Reform Support Loan In the Amount of US$1 billion to the Republic of Indonesia I. INTRODUCTION 1. I submit for your approval the following report and recommendation on a proposed Policy Reform Support Loan to the Republic of Indonesia in support of the Government's economic policy reform program. This reform program is designed to rebuild confidence in Indonesia's economy and to restore sustainable, equitable growth. To achieve these objectives, the policy reforms backed by this loan will: improve private sector productivity, make public sector management more transparent and efficient, regain depositor's confidence in banks, resolve problems of illiquid and undercapitalized banks, protect the environment, and shield poor and vulnerable groups. 2. The Bank's initial contribution to a broad program of international support for Indonesia's reform effort consisted of a Banking Reform Assistance Project (Loan 4255-IND) approved by the Board on December 4, 1997. Other operations currently proposed by the Bank include a loan to improve agricultural productivity thereby enhancing food security, a second structural adjustment loan, and two investment loans that will provide iicome earning opportunities to the poor in urban and rural areas. A CAS progress report outlining the Bank's revised Country Assistance Strategy is being prepared for discussion at the Board in July 1998. II. FROM GROWTH TO CRISIS 3. Up until the recent crisis, Indonesia's development achievements over the last thirty years had been remarkable. Real economic growth averaged 7 percent per annum, increasing per capita income from less than half of India's, Nigeria's, or Bangladesh's in the mid- 1960s to between 3 and 5 times those countries' by end 1996. With per capita income surpassing $1000 in 1996, Indonesia joined the ranks of lower-middle income countries. This remarkable growth picture was accompanied by equally remarkable gains in poverty reduction. The incidence of poverty fell from 70 percent in 1965, to 29 percent in 1980 and 11 percent in 1996. Literacy increased from 52 percent in 1965 to 87 percent in 1996. 4. In 1996, high growth continued (7.8 percent), inflation remained under control (6.6 percent), the fiscal accounts were in surplus (nearly 1 percent of GDP), and interest rates were falling. Foreign confidence was strong, allowing the current account deficit, at 3.5 percent of GDP, to be financed from inflows of foreign direct investment and private capital. Official reserves were comfortably high (about 5 months of imports), and public external debt was on the decline (due to a combination of prepayments, low disbursements and third-currency movements). Even during the first half of 1997, the picture remained positive: inflation continued to fall (reaching 5.1 percent for the year ending June 1997), and real domestic demand remained strong. 5. These exemplary macroeconomic achievements masked persistent underlying structural weaknesses in the economy (see Indonesia: Sustaining High Growth with Equity, May 30, 1997). These weaknesses were of three types: a financial sector characterized by too many weak banks, a real sector with too many "hidden costs" that undermined efficiency and competitiveness; and a business culture in which connections rather than cost benefit analysis determined too many investments. -1-~~~~~~~ REPUBLIC OF INDONESIA - POLICY REFORMSUPPORT LOAN 6. These structural weaknesses were exacerbated by two features of the mid-1990s: a slowdown in the country's decade-old deregulation efforts; and, a rapid build-up in private foreign debt. The unfinished deregulation agenda left in place a weak financial sector and a complex web of domestic distortions that slowed growth and hurt the poor, especially those living in the outer islands. On the debt front, while public external debt has been relatively constant during the 1990s, private external debt increased dramatically from $35 billion ($10 billion short term) at the end of 1994 to $68 billion ($16 billion short term) by December, 1997. Moreover, much of this private debt was unhedged. 7. At the same time, Indonesia (along with other developing countries) was being held to progressively higher international standards, as common local business practices came under greater external scrutiny. All this was reflected in persistent perceptions that Indonesia was a high-cost place to do business, where the regulatory system tended to favor the well-connected over the efficient. 8. Contagion from the collapse of the Thai baht in July 1997 drove Indonesia's corporate sector to try to hedge substantial short-term external debt. These actions plus concerns about the sustainability of the current account deficit and weaknesses in the banking system led to a sharp depreciation of the Rupiah. External creditors, uncertain about the underlying health of the economy or its corporate sector, refused to roll over short-term debt. Many corporations have become technically bankrupt. Fueled also by uncertainty surrounding the end of the sixth Soeharto cabinet, the economy suffered a precipitous and collective loss of confidence that, by mid December was driving large amounts of private domestic capital overseas. In January 1998, the Rupiah temporarily fell below 20 percent of its July 1997 value. The banking sector, already weakened by a high proportion of bad debts before the crisis, was crippled by a sharp deterioration in its loan portfolio as the financial positions of corporate clients deteriorated almost overnight. Inflation rose to high levels (see Figure 1), millions of workers have now been laid off, imports have fallen and growth is plummeting. 9. On top of these financial sector and foreign exchange woes, Indonesia is suffering from one of the worst droughts this century. The eastern islands have been hit particularly hard with the rainy season beginning more than two months late in Java. Food, especially rice production, will fall for the second year in a row, creating a need for large food imports which is straining scarce foreign exchange resources even further. BULOG, the Government logistics agency, has already imported 2.5 million tons of rice since November 1997 and plans are under way to import a further 2.85 million tons of rice between April 1998 and March 1999. Food prices have risen sharply in recent months, and high import costs will continue this inflationary pressure (see Figure 1). High prices and shortages in food and medical supplies are adding to the adverse social effects of the currency crisis. 10. The combination of physical and financial shocks, and political uncertainty that hit Indonesia in the second half of 1997, produced a loss of domestic and international confidence in the Indonesian economy of unprecedented proportions. The value of the Rupiah, the chief barometer of confidence in the economy, fell nearly 80 percent from its peak in 1997 to its trough in January 1998. With inflation at the end of 1997 running at 10 percent on an annual basis, the Rupiah's real depreciation is one of the largest on record in the post war era. -2 - REPUBLIC OF INDONESiA - POLICY REFORMSUPPORTLOAN FIGURE 1: RECENT ECONOMIC DEVELOPMENT Rupiah depreciates Foreign exchange market becomes highly volatile (Daily Rupiah per USS spot rate) (3-month swap rate premium, in percent per year) 2,000 2,000 45 3,000 3,000 40 46000 4,000 35 0.000 5,000 0,000 6,0 30 7,000 7,000 25 8,000 8,000 20 0,000 9,000 1000 10,000 I I1,000 11,000 10 12,00 12,000 13,000 13,000 ___O___ .. .,,,,,, 14,000 14,000 RuplahIUS$ L i Stock market crashes Inflation picks up rapidly (Jakarta Stock Exchange Index) (12 month Percentage change in Consumer & Food Price index) a00 60 G0 w°oo a so !~~~~~~~~~~~~~~~~5 so 300~~~~~~~~~~~~~0 00F 700 40 40 6000 30 30 500 20 -20 400 0-1 3001 01 Interest rates rise and become highly variable Depositors lose confidence in private national banks (Overnight interbank call rate) (Ratio of deposits in private national banks to deposits in total commercial banks) 90%1 65 80% 13 70% 51 00% 50%/ 5 40% 5 30% 20% 10% 53 0% 5 , | t s = , U c - O O b = n ;~~~~~~~~~~~~~~~~~~I z a < -3- REPUBLIC OF INDONESIA - POLICY REFORm SUPPORT LOAN III. THE GOVERNMENT'S RESPONSE TO THE CRISIS 11. When the crisis first hit the region in July, 1997, the Government responded with a conventional program designed to address the initial weakness in the exchange rate. Thailand elected to float the Baht on July 2, the Philippines the peso on July 11. That same day, Indonesia widened the exchange rate band to accommodate growing pressure on the Rupiah. When this move was met with continued depreciation pressure, the Government chose on Friday, August 14 to float the Rupiah. The following Monday interest rates were raised dramatically to stabilize the Rupiah and stem the outflow of capital, and cutbacks announced in infrastructure projects to preserve the fiscal surplus. Despite these measures the Rupiah continued to fall. By early October the Rupiah had depreciated by 25 percent and appeared on a continued downward course. In early October the Government invited the IMF to negotiate a stand-by arrangement, which was approved by the Fund's Board on November 5. This agreement emphasized financial sector reforms, although it also contained some important structure reforms. 12. By the first week in December, it was clear that the first IMF package was not working. Exactly why will undoubtedly remain a much-debated issue but several factors were clear contributors. To avoid large-scale collapse of the corporate sector, Bank Indonesia eased up on interest rates, increasing pressure on the Rupiab. In addition, some of the package's key measures put great pressure on the banking sector and monetary management. Key among these measures was the closing of 16 private banks, which caused a flight of depositors to safety and may have contributed to a growing loss of confidence in Indonesian's financial system. There were also indications that some well-connected parties affected by the reforms were not going to take their losses quietly. These challenges to the reforms, along with a set of apparently mixed signals from different cabinet ministers, led international and domestic observers to question the Government's, especially the President's, commitment to the reforns. 13. In response to a rapid deterioration in the Rupiah and a massive build-up of emergency credits to the banking sector, the IMF and the Government renewed talks on January 12. These discussions led to a reform package announced on January 15 that was heavily weighted toward a series of far-reaching structural reforms, but weaker on two other fronts: banking sector reform and resolution of the corporate sector's foreign debt overhang problem. Within a week the January 15 package had been augmented by an enhanced banking sector reform program, the announcement of the start of a process to resolve the corporate debt issue and the implementation of all elements of the package due by end-January. 14. Market reaction to the January 15 package was swift and negative, giving the Government almost no time to demonstrate its commit to implementation. Within hours of the signing of the second Letter of Intent, the Rupiah was in near free fall. On January 20 the Rupiah crashed to 17,000 to the U.S. dollar, about 15 percent of its value seven months earlier. 15. The program was dealt a further, almost fatal blow in early February when the Government announced that it was considering introducing a currency board system as a means of stabilizing the Rupiah. Despite widespread international concern that Indonesia's financial and credibility crisis would make such a measure extremely risky, the debate over the currency board continued for nearly three and a half weeks, until virtually the final days of the Sixth Cabinet. On March 1, the Sixth Cabinet was dissolved. The Seventh Cabinet was announced March 14 and installed on March 16. 16. Beginning the week of March 16, the new Government held extensive discussions with the IMF, ADB and World Bank to develop a more comprehensive and credible response to the crisis. These discussions led to the five-part program this loan will support. The main elements of this strategy are: (a) fiscal and monetary policy action to maintain macroeconomic stability and to increase the efficiency and transparency of public sector activities; -4- REPUBLIC OF INDONESIA - POLICY REFORM SUPPORT LOAN (b) financial sector reform to get credit flowing again and to rebuild the financial sector; (c) corporate debt restructuring to preserve productive assets and ease pressure on the exchange rate; (d) structural reform to increase efficiency, improve governance and transparency, and protect the environment; and, (e) actions to shield poor and vulnerable groups. 17. Together, these actions address the financial crisis's main causes: weaknesses in the financial sector, the heavy burden of private external debt, and loss of confidence in public sector decision making. The Government has supported plans for reform in these five key areas with a high-level committee responsible for implernentation and with institutional arrangements for monitoring the social impact of the crisis. A. FISCAL AND MONETARY POLICY 18. Restoring stability is a critical challenge facing the Indonesian Government today. To achieve this, the Government will maintain tight monetary policies, keep the budget deficit to within acceptable limits, and finance it almost entirely by foreign borrowing. The sharp depreciation of the Rupiah and the slowdown in economic growth is imposing severe constraints on discretionary government expenditures. Growth in government revenues has slowed while the cost of debt servicing has ballooned, subsidies have climbed sharply, and the potential cost of bank restructuring is very large. 19. In view of the acknowledged urgency of actions to consolidate public finances and to refocus public resources on priority areas, some important actions were taken in the context of the FY1998/99 budget. In particular: a. Budgetary and extra-budgetary support and credit privileges to the state-owned aircraft manufacturer (IPTN) have been discontinued; b. The program for bringing non-tax revenue onto the budget is being accelerated from five to three years, and Rteforestation and Investment Funds have already been incorporated in the Government budget for FY 1998/99; c. 12 major infrastructure projects that had been reinstated earlier were canceled and others deferred; d. Excise taxes on alcohol and tobacco have been increased by 80 and 100 percent respectively; e. VAT exemptions will be reduced; and f. A 5 percent local sales tax on gasoline has been introduced. 20. Nevertheless, the deteriorating situation has compelled the Government to make further adjustments to the budget. Since there is little scope in the current environment to raise additional tax revenues, the Government is focusing on measures that cut low-priority expenditures, transfer additional profits from state enterprises to the Government, and raise revenues from state enterprise divestiture. The proposed revised budget strikes a balance between preventing undue deterioration in the fiscal accounts and avoiding excessive fiscal contraction. A budget deficit of about 3.8 percent of GDP in FY1998/99 has been agreed upon with the IMF. 21. To identify low-priority expenditures in the development budget, the Government, in collaboration with the World Bank, has already initiated a Public Expenditure Review. This review will be completed by June 30, 1998 and covers public enterprises and strategic industries, such as IPTN as well as central govemment expenditures. It will lead to a program to improve the allocation of public expenditure, cut low-priority expenditures, and restructure inefficient state-owned enterprises. - 5 - REPUBLIC OF INDONESIA - POLICYREFORMSUPPORTLOAN 22. The Government is accelerating its privatization program with the intention of bolstering public finances as well as improve efficiency. Additional shares of some of the six listed state enterprises will be sold in the coming fiscal year. In addition, by March 1999, seven additional public enterprises will be privatized and five more will be prepared for privatization. Over the longer term, the Government is committed to selling controlling stakes to the private sector of enterprises that operate in a competitive market environment. Non-viable enterprises will be closed. Enterprises that continue to be owned and managed by the state will have their performance monitored according to criteria spelt out in action plans that are to be prepared for each enterprise by end-September 1998. 23. The Government is ensuring that price increases on essential goods will be restrained by budgeting subsidies to mitigate the worst consequences of the crisis on the poor. At the same time, care will be taken to contain the budgetary costs of these subsidies by increasing prices. For example, the price of sugar, wheat flour, corn, soybean meal, and fishmeal will be increased in phases until the entire subsidy is eliminated. In the case of soybean, a product largely consumed by the poor, the subsidy will only be eliminated after the exchange rate has stabilized at a reasonable level. The government will also increase fuel and electricity prices gradually over the fiscal year, and ensure that the price increase for kerosene is smaller because it is consumed mainly by low income households. 24. To stabilize the Rupiah and to curb inflation, the Government is committed to pursuing tight monetary policy. Interest rates on Bank Indonesia's primary monetary instruments (SBIs) were raised significantly on March 23, 1998. Commercial bank deposit rates also rose in response to the increase in SBI rates. In view of the deposit guarantee that is in place, however, the authorities have limited the increase in the deposit rates of weak banks to the average deposit rate of a group of strong banks. In the future, Bank Indonesia will adjust its interest rate policy in accordance with developments in prices and in the foreign exchange market. B. FINANCIAL SECTOR REFORM 25. As part of its efforts to stabilize the economy and restore credit flows to the corporate sector, the Government is taking immediate steps to address pressing problems and fundamental weaknesses in the banking system. In the short term, the Government's goals are to help restore depositors' confidence in banks and to identify and resolve the problems of seriously illiquid and/or undercapitalized banks. In the longer-term, the goal is to establish a banking system that is sound, competitive and properly supervised, and to broaden and deepen the financial system through further development of non-bank financial institutions and the capital markets. 26. For many years, Indonesia's strong economic growth provided little incentive to tackle fundamental weaknesses in the financial system. The system lacked (a) criteria to assure that credit applications were analyzed based on the borrower's financial performance, (b) capabilities to assure that loans were classified based on risk or loan collectability, (c) effective rules to assure bank statements reflected financial reality and thus provide an "early warning" signal of deterioration, and (d) the legal infrastructure to allow contract enforcement when borrowers failed to perform as agreed. It was common for enterprises without foreign currency earnings to borrow in foreign currency, to reduce the cost of borrowings. Loan approvals were often based on relationships with bank owners rather than creditworthiness. These practices led to an unsustainable level of problem loans. Even before the current crisis, numerous banks were insolvent or seriously undercapitalized. As a result, when the currency began to depreciate in July 1997, banks were poorly positioned to absorb any further deterioration in their portfolios. Bank liquidity was eroded as borrowers with unhedged foreign currency positions rapidly found themselves unable to service their debts and depositors withdrew large amounts from private national banks as confidence evaporated. -6 - REPUBLIC OF INDONESIA - POLICYREFORMSUPPORTLOAN 27. Under the current program, the Government's objective is to address the immediate priorities of stabilizing the banking system, restoring depositors' confidence in banks, and ensuring continued essential banking services in the economy. To this end, the Government has established a comprehensive guarantee program covering all depositors and creditors and an Indonesian Bank Restructuring Agency (IBRA). In addition, the program includes measures that lay the foundations for achieving a competitive banking system in the medium-term. These include: strengthening bank supervision; improving the timely disclosure and dissemination of key financial information to support better informed financial markets; and strengthening the legal framework and legal institutions to facilitate bankruptcy, enforce contracts, and encourage corporate mergers, acquisitions, and restructuring. Rebuilding Confidenrice through a Guarantee Program 28. In an effort to boost confidence in banks, the Government announced a guarantee that covers all depositors and creditors of locally incorporated banks. The guarantee covers Rupiah and foreign currency claims, with payment of foreign currency claims to be made in Rupiah at the market exchange rate. It also covers all foreign currency obligations associated with imports of essential commodities, but excludes shareholdings, subordinated debt, depositor and creditor claims of controlling shareholders, members of the Board of Directors and their families, and deposits held by delinquent debtors. The guarantee will remain in place for at least two years and will only be terminated after six months' advance notice. The guarantee agreement signed with all locally-incorporated banks requires that all participating banks will be subject to enhanced supervisory oversight. The Government is working to ensure that a well-designed and financed deposit insurance scheme is in place by the time the guarantee scheme is removed. Strengthening bank supervision 29. Strengthening Bank Indonesia's supervisory capabilities will be critical to building a safer, sounder financial sector and to avoid a repeat crisis. Over the next two years, internationally recognized experts will provide active support in banking supervision, to transfer best practices and international experience. Loan classification and provisioning rules and the role of collateral, have been tightened, and are now based on risk rather than solely on delinquency. Minimum capital requirements for banks have been set at Rp.250 billion. Reporting requirements for foreign exchange and credit risk will be tightened with the help of outside specialists. Key banking data will be published on a regular basis to better inform markets and exert greater discipline over managers. Establishing the Indlonesian Bank Restructuring Agency (IBRA) 30. On January 27, 1998, the Government announced the establishment of the Indonesian Bank Restructuring Agency (IBRA) and gave it responsibility for restructuring unsound banks, including decisions on recapitalization, mergers, takeovers, or liquidation. On February 14, 54 banks (including 39 private banks, 4 state banks and 11 regional development banks) were transferred from the regulatory oversight of Bank Indonesia and placed under the supervision of IBRA. By the end of June 1998, the Government will appoint an independent review committee, with high-profile foreign participation, and assisted by an international audit firm, to regularly review IBRA preparations and ensure its sound and transparent functioning. 31. On April 4, IBRA took action on 14 of the banks under its supervision, freezing the operations of seven small to medium-sized banks (comprising some 1 percent of the assets of the commercial banking system), and placed seven others under IBRA management with immediate effect. The seven banks whose operations were frozen had used central bank liquidity support in excess of 500 percent of their total equity and at least equal to 75 percent of their total assets. Depositors' accounts at these banks, fully - 7 - REPUBLIC OF INDONESIA - POLICY REFORM SUPPORT LOAN benefit from the government guarantee, and were transferred automatically to the nearest branch of Bank Negara Indonesia, the largest bank in the country. The seven banks whose managements have been taken over by IBRA include some of the largest private banks and account for approximately 20 percent of the assets of the commercial banking system. These banks continue to operate but under IBRA management because they have used liquidity support of more than Rp.2 trillion each (comprising 75 percent of total Bank Indonesia lending to the banking system) and in excess of 500 percent of their total equity. As a next step, IBRA plans to restrict the foreign exchange transactions, increase surveillance and closely monitor the liquidity position of other banks under its supervision. 32. All banks under IBRA's umbrella are preparing rehabilitation plans and IBRA will engage internationally recognized auditors to carry out diagnostic reviews. By the end of June 1998, portfolio reviews will be completed for banks whose assets total at least 80 percent of the total combined assets of these 54 banks. Findings of diagnostic reviews and rehabilitation plans will be made public. Following a review of these plans, IBRA will either agree with each proposal and monitor its implementation, or will proceed with restructuring the bank. Bad assets will be transferred to an Asset Management Company in the course of bank restructuring, and legal action will be taken if fraud or malpractice are discovered. The Asset Management Company will specialize in debt collection with the objective of minimizing IBRA's fiscal costs. IBRA will be funded by government bonds issued specifically for this purpose. 33. IBRA, in coordination with Bank Indonesia will also be responsible for overseeing merger plans of state banks. To begin the process, Bapindo and Bank Bumi Daya are to be merged, and their bad assets are to be transferred to IBRA's Asset Management Company. In preparation for further restructuring, internationally recognized auditors are to do portfolio and system reviews for all state banks. The reviews will establish adequate loan loss provisions and provide critical information for the segregation of good and bad assets. Strategic partners will be sought for all state banks. Until their privatization, Government will set annual financial and operational objectives for state banks and monitor performance against targets. Improving the Legal and Institutional Framework for Banking 34. To strengthen the legal and institutional infrastructure for banking, the Government is undertaking a thorough review of all banking laws and regulations and will then make changes to the legal and regulatory framework as necessary. Likely areas for reform include information disclosure, taking and realizing collateral security interests, and laws and regulations on financial instruments and insurance. Action plans to improve the legal framework will be initiated by end-September 1998 with the help of the World Bank. 35. Similarly, to increase transparency and the quality of information in banking, the Government now requires all corporations (including banks) to publish audited financial statements annually. Bank Indonesia is to review the adequacy of data provided by banks and improve the dissemination of information on individual banks. 36. The Government will level the playing field for foreign investors in banking by lifting the restriction limiting foreign banks to one branch in each of nine major cities; changing the definition of foreign banks' capital; and lifting limits to foreigners' holdings. These actions will be completed by end- 1998. Legal changes to eliminate restrictions on foreign investment in listed banks will be enacted by end-June 1998. C. CORPORATE DEBT RESTRUCTURING 37. The restructuring of private sector debt is also critical to restoring the health of the private sector and relieving pressure on the foreign exchange markets. A "steering committee" of lenders and a "contact committee" of borrowers have been formed to facilitate discussion and communication between -8 - REPUBLIC OF INDONESIA - POLICYREFORM SUPPORTILOAN the two groups. Major lenders to Indonesia comprising banks from Japan, Singapore, the United States, Germany, Korea, Hong Kong and the United Kingdom are represented on the Steering Committee. The contact committee represents private sector corporates that have large external debts. A number of proposals have been considered by these committees and by government officials. 38. As outlined in the Statement of Development Policy (see Annex IV), a scheme is under consideration with features broadly similar to that of the FICORCA scheme adopted by the Mexican authorities in 1983, which proved to be a powerful tool to encourage debtors and creditors to negotiate and reach agreement on the rescheduling of private debt. The scheme's basic principles are that the final scheme must limit the potential fiscal cost, ensure that lenders alone bear the commercial risk, and allow debtors and lenders to renegotiate debts on a bilateral basis. 39. Sound laws and regulations of general application are necessary for the orderly restructuring of corporate debt. The specialized services required in connection with restructuring firms and corporate debt are available in Indonesia and regionally, but they cannot operate effectively without effective laws and regulations. The Government is meeting this need in the following ways: * Immediate modification and strengthening of the Bankruptcy Law. The existing law is being modified to establish transparent rules for the evaluation and confirmation of reorganization plans for failing firns and their conversion to liquidation procedures. Amendments to the existing bankruptcy law will be enacted in late April and go into effect 120 days later. * Establishment of special-purpose legal institutions. The government is considering establishing special commercial tribunals/courts and simpler procedures to facilitate bankruptcy proceedings. Taking such steps could create incentives for Indonesian corporates to maintain payments to creditors and enhance the confidence of creditors. * Provision of special support for small debtors. Smaller debtors often have neither the skills nor the funds to contract specialized professionals. Government support could consist of information dissemination, seminars, workshops, and limited technical assistance. * Strengthening corporate disclosure and governance mechanisms. The pace of adopting new disclosure standards is being accelerated. For firms undergoing reorganization and undertaking debt restructuring, new disclosure standards will be a prerequisite for forbearance from creditors. Such an approach will enhance the willingness of creditors and financial markets to accept debt- forgiveness and rollover arrangements. D. STRUCTURAL POLICY REFORMS 40. The structural policy reforms being implemented by the Government improve efficiency, protect the environment, and enhance transparency and governance. They strike at the heart of the governance issue by making the policy environment more market-oriented. Thus they will help rebuild investor confidence and lay a foundation for efficient economic recovery and sustained growth. Reforming Trade and Investment Policies 41. Import policy. The medium-term tariff reduction program has been extended to embrace chemicals, metal products and agricultural goods. This leaves motor vehicles and alcohol as the only exceptions to a maximum tariff of 10 percent by 2003. Moreover, import tariffs of 15 percent or more (except those applying to motor vehicles and alcohol) were reduced by 5 percentage points in February 1998, in keeping with this tariff reduction program. The maximum tariff on food items was reduced to 5 percent (effective Feb. 1, 1998). Local content regulations on dairy products and all import restrictions -9- REPUBLIC OF INDONESIA - POLICY REFOR SUPPORT LOAN on ships have been abolished (effective Feb. 1, 1998). All other remaining quantitative import restrictions, other than those justified by health, safety, environmental and security concerns, will be completely phased out by the end of 2000. All special provisions for the national car project have been discontinued for new imports, and the local content program that provides producers with customs concessions based on higher local content will be phased out by 2000. This relaxation of import restrictions will continue the Indonesian pattern of increasing productivity through import competition and of strengthening export competitiveness by reducing costs. 42. General importers are now free to import wheat and wheat flour, garlic, sugar and soybeans, thus removing BULOG's monopoly over these items. Moreover, all restrictions on domestic marketing of these items has also been lifted and subsidies are being extended to all market participants. Farmers have been released from the formal and informal requirements to plant sugar cane. This will rationalize sugar production, allowing inefficient mills to close and giving farmers freedom to switch from growing sugar cane to producing higher valued rice. The only item that BULOG still has an import and marketing monopoly over is rice. Ensuring adequate supplies of rice at affordable prices has become BULOG's priority for the coming months and will be very important in view of the ongoing drought. 43. Export policy. To avoid the risk of over-exploitation of natural resources, a set of resource royalties are being introduced for environmentally sensitive items. The resource royalties on forest products will be linked to world prices, vary according to independently estimated extraction costs and be independent of who buys the logs. This makes revenue sharing from forest use much more like that applying to the oil and gas sector. Export taxes on leather, cork, ores and waste aluminum products, were abolished on February 1, 1998. Export taxes on logs and sawn timber, rattan, and minerals are being reduced to a maximum of 30 percent ad valorem and will be fuirther reduced to a maximum of 20 percent by end-1998, 15 percent by end-i999, and 10 percent by end-2000. These reductions of export impediments together with resource royalties will promote more environmentally sustainable use of resources, help sustain rapid export growth, and force domestic users of these resources to be more efficient. 44. To balance the need to maintain domestic supplies of palm oil at affordable prices with the need to facilitate exports of this important foreign exchange earner (over $1 billion per annum), all quantitative export restrictions are being replaced by an export tax on crude and processed palm oil, olein and stearin ranging from 30 to 40 percent ad valorem. The export taxes will be reviewed regularly, initially to maintain relatively stable domestic prices and then to reduce the tax rate in stages to reach 10 percent by the end of 1999. 45. Investment and pricing policy. The freeze on foreign investment in oil palm plantations has been removed. Hence, there is now no discrimination between foreign and domestic investors in this sector; they both face the same restrictions arising from environmental and land use guidelines. Restrictions on foreign investment in wholesale and retail trade have been lifted. This paves the way for increased foreign investment, technology transfer, and closer linkages between domestic wholesaling operations and export marketing. In November 1997, the administrative controls on cement pricing were removed, thus increasing competition in the industry. These investment and pricing policy changes will compress distribution margins through competition, thereby helping consumers, small-scale enterprises and exporters. 46. Domestic marketing and trade reforms. A number of measures are being taken to deregulate domestic trade and marketing. The plywood cartel has been dissolved so producers can now sell to whomever they choose and they can ship with any carrier of their choice. Similarly, traders are now free to purchase and distribute all brands of cement in all provinces and to export without acquiring permits - 10 - REPUBLIC OFINDONESIA - POLICYREFORMSUPPORTLOAN other than a general exporter's license. Domestic trade in agricultural products is also being deregulated: (i) since February 1, 11998, traders have been free to buy and sell all commodities (including cloves, cashew nuts, oranges and vanilla) at unrestricted prices and to transport them across district and provincial boundaries; (ii) by July 1, 1998, the Clove Support and Marketing Board will be eliminated; and, (iii) by September 30, 1998, the system of quotas limiting the inter-provincial sale of livestock will be abolished. Moreover, provincial governments have been prohibited from restricting trade within or between provinces (effective February 1, 1998). To support export expansion, the Government is enforcing the prohibition on retribusi (local tax) on export goods and to strengthen domestic competition and avoid market fragmentation, the Government will abolish taxes on trade within or between provinces by April 1, 1999. All these measures will better integrate the domestic market and provide the poor in the outer islands with freedom to pursue the highest possible market return for their goods and labor. 47. Strengthening competition laws. These structural reforms targeted at specific monopolies and cartels are being backed up with reform of legislation and regulations relating to corporate restructuring and competition policy. The key objective of these changes is to achieve and maintain an improvement in economic efficiency and consumer benefits through competition. This reform will make anti- competitive conduct illegal. The changes will facilitate the merger and acquisition of failing firms by other firms so long as such a merger does not result in a substantial lessening of competition. These provisions will help expedite corporate restructuring and provide safeguards against anti-competitive and predatory practices. Considerable work, including the drafting of some legal and regulatory reforms relating to corporate restructuring, has already been completed with bilateral assistance. An action plan for implementation reforms in this area will be completed by June 1998. Protecting the Environment 48. To strengthen overall environmental management, the Government introduced a new law in 1997 (UW 23/97). Work is now focusing on the necessary implementing regulations. Regulations pertaining to at least four of the highest priority areas (air quality, water quality, hazardous waste management, and environmental assessment) will all be issued by June 30, 1998. The remaining regulations (about 15 in all) will be issued by June 30, 1999. 49. To improve urban air quality, the President has already ordered the phasing out of lead as an additive in gasoline. Regulations and decrees setting December 31, 1999 as the deadline for achieving the phase-out for Bali and Java, and December 31, 2001 for the other provinces, will be issued by April 30, 1998. The Government will supplement the shift to unleaded gasoline with phased improvements in the quality of diesel fuel, and measures to increase the use of other clean fuels for motor vehicles such as compressed natural gas and liquefied petroleum gas. The Government is also developing a policy and strategy to reduce and control pollution caused by domestic wastewater, with particular attention to urban areas, for inclusion in Repelita VII. 50. In addition to the beneficial effects stemming from the revised system of forestry rent taxation, the Government intends, by June 30, 1998, to improve forest resource management by lengthening substantially the period of new logging concessions, enacting regulations to allow for the sale of concessions and to define a transparent process for concession award, and removing the current requirement that a company must possess a wood processing facility in order to qualify for a concession. By the end of 1998, the Government will develop an independent system for monitoring the use of forest resources. This system will encourage participation by local communities. No new licenses and permits for-converting forest land into other uses will be issued until this new system is in place. - 11 - REPUBLIC OF INDONESIA - POLICYREFORMSUPPORTLOAN Improving Governance and Transparency 51. Governance is being improved in three key ways: (a) structural reforms that increase competition; (b) changes that make public sector decisions more transparent; and (c) actions that increase the transparency and credibility of information, particularly in the financial sector. 52. Increased competition. Most of the structural reforms described above, in addition to improving the efficiency of the economy by increasing competition, will also reduce rent-seeking opportunities. Most notably: eliminating the clove monopoly and dismantling the marketing cartel for plywood removes huge rents that have been going to strong vested interests; in the forestry sector, since the prohibitively high export taxes on logs and sawn timber have enabled the plywood cartel to appropriate a large share of the forestry resource rent, the move to a more modest export tax and the introduction of resource royalties will enable the Government to get a larger share of this rent; and, the removal of restrictions on interprovincial trade will integrate the domestic market and reduce opportunities for corruption, such as in the cement sector. Finally, actions to reform legislation and regulations relating to competition, corporate restructuring and bankruptcy also increase transparency and improve governance. 53. Transparency in public sector management. The ongoing public expenditure review will highlight inefficient public investments and areas where public resources are being wasted. The establishment of a more transparent project selection and tendering system for public investments, begun with the issuing of Keppres 7 of 1998, will make it difficult to allocate projects on the basis of connections. To further strengthen the transparency of public decision making, the Government will issue implementation guidelines for Keppres 7, including, inter alia, guidelines to clarify the scope of this Keppres, establish principles to govern cooperation arrangements, establish criteria and institutional arrangements for project screening and selection, make requirements for transparent bidding explicit, strengthen tariff setting and adjustment provisions, refine dispute resolution mechanisms and support arrangements for "non-commercial" projects, and establish sector-specific procedures. Increased transparency in privatization procedures will lend credibility to the process and reduce opportunities for impropriety. Bringing off-budget revenues and expenditures onto the budget, as has already been done with the Reforestation and Investment Funds will lend greater transparency to budgetary processes and resource use. The removal of public funding for the airplane company will limit public finance losses to this project. The removal of special provisions for the National Car removes the associated implicit subsidy. 54. Credibility and transparency of information. Lack of credible information has hampered efforts to rebuild market confidence, particularly in the financial sector. Requiring all corporations to publish audited financial accounts annually will help rebuild confidence. In the specific case of banks, this also involves publishing more comprehensive data on their operations within two years. All state banks and those private banks falling under IBRA supervision will be subject to independent external audits, at international standards. Furthermore, Bank Indonesia is reviewing the adequacy of data provided in condensed biannual balance sheets from banks. E. PROTECTING THE POOR 55. Indonesia is rightly proud of its achievements in poverty reduction over the past 30 years, and is striving to protect these gains during the current economic crisis. The combination of drought and the economic crisis is reducing incomes, increasing food prices, and increasing unemployment and under- employment. This will lower the living standards of many, and increase the number of poor, because the incomes of many non-poor are clustered near the poverty line. - 12- REPUBLIC OF INDONESIA - POLICYREFORMSUPPORTLOANv 56. Many aspects of the reform package, e.g., export tax cuts, reductions in tariffs, and the deregulation of domestic markets, will have pro-poor effects by enabling farmers, informal sector workers and small scale enterprises to benefit from more attractive market prices. The relaxation of import and marketing monopolies, together with less costly domestic transport and increased competition in wholesaling and retailing, will result in more efficient food markets. Removing import barriers on ships will reduce the cost of inter-island shipping, thus helping the poor in the outer islands. Reducing tariffs on food items and removing non-tariff barriers on dairy product imports will help contain food price increases. Removing domestic marketing restrictions (taxes on inter-provincial trade, quotas on inter-provincial trade in livestock, regulations restricting the freedom of traders to buy, sell and transport cashew nuts, oranges, vanilla and cloves at unrestricted prices) will increase returns to producers in outer islands and lower consumer prices in Java, thus helping the poor. This is particularly important for the eastern islands, where poverty is the deepest. 57. The pro-poor benefits of these reforms may not occur instantaneously. Therefore, to help ensure adequate and affordable food supplies for the poor and vulnerable groups, the Government has correctly initiated a three-part strategy: (a) expanded labor-intensive public works programs to provide purchasing power to the poor, (b) actions to ensure the continued availability of key goods with only modest price increases, and (c) initiatives to maintain access to quality basic education and health. 58. Providing purchasing power through public works. The Government has expanded labor- intensive public works projects by reallocating funds in the 1997/98 budget and by allocating Rp 1.7 trillion ($850 million equivalent) in the 1998/99 budget. These funds are for urban and rural job creation schemes (Padat Karya, various infrastructure investrnents) and for the best of the country's micro-credit programs. The Government plans to work closely with non-government, community-based groups to extend the coverage of these infrastructure and micro-credit programs. This expansion of labor-intensive public works is being done with financial support from the World Bank. ADB and bilateral agencies. 59. Ensuring the continued availability of key goods with only modest price increases. Rice production declined about 4 percent in 1997 and is expected to decrease further in 1998. This decrease in production and the depreciation of the Rupiah have combined to increase rice prices by almost 50 percent during the last 12 months. The Government, through BULOG, is protecting the most vulnerable groups of the population by guaranteeing the supply of lower quality rice with only modest price increases. BULOG has already ordered 2.5 million tons of rice imports and plans to import a further 2.85 million tons before April 1999. To smooth price changes for the poor and vulnerable groups, BULOG will sell this lower quality rice in the market at a subsidized price. For people living in isolated areas that have been particularly hard hit by drought, the Government is continuing to provide grant food assistance, with the help of non-government organizations. 60. Petroleum fuel prices have not been increased since January 1993, so the Rupiah's depreciation has now resulted in a very large subsidy to local consumers. The VAT-inclusive prices of automotive diesel fuel and kerosene are around US 5 cents and 3.7 cents per liter, respectively, when the exchange rate is Rp 7500 per US dollar. The Rupiah's depreciation has also increased the subsidy on electricity by reducing PLN's power tariff from an already insufficient US 6.7 cents per KWh in mid-1997 to only around US 2.5 cents per KWh at the above exchange rate. The Government plans to phase out subsidies on petroleum products and electricity over the next three years, but in a manner that softens the impact on the poor and vulnerable. In particular, the initial price increases for kerosene and diesel prices -- the fuels whose prices most affect lower income groups -- will be lower than for gasoline. 61. Maintaining service delivery in basic education and health. Income reductions, food shortages and price increases are likely to adversely affect education and health outcomes. School enrollments may fall, and health vulnerability to communicable disease may increase. To combat these possibilities, the - 13 - REPUBLIC OF INDONESIA - POLICY REFORM SUPPORT LOAN Government is committed to allocating sufficient resources to sustain delivery of basic education and health services, each of adequate quality, to the poor, and to safeguarding health through communicable disease control efforts. To ensure continued high enrollment rates for children through the first nine years of school, the Government is to provide scholarship funds for an additional 3 million needy primary school students and 0.5 million needy high school students. Additional resources are being allocated to finance essential drugs, including the vaccines and drugs needed for communicable diseases control. The prices of these drugs have risen sharply due to their high import content, and inventories have been depleted. Additional funding will be provided for materials required for drug and vaccine quality control and for hospital and health center laboratory work; equipment and crucial consumables needed to sustain hospital emergency room services. To design a sustainable medium term health strategy by the end of 1998, the Government (with assistance from the World Bank) will (a) assess the sustainability of health service delivery systems; (b) evaluate competitiveness of pharmaceutical/vaccine production; and (c) develop a strategy to extend pre-paid health finance mechanisms. F. INSTITUTIONAL ARRANGEMENTS FOR IMPLEMENTATION AND MONITORING 62. Overall responsibility for Indonesia's reform program rests with the Economic Resilience Council, which is chaired by the President and comprised of senior advisors, key economic Ministers and private sector representatives. Day-to-day work on implementation is being led by the Coordinating Minister for Economics, Finance and Industry and a team of senior Government officials. One of the strengths of this program is that the majority of structural reforms have already been implemented, and key actions have also been taken in financial sector and public sector reform. 63. The Government has made the Central Bureau of Statistics responsible for monitoring key social indicators. The Bureau will work with the Ministries of Social Welfare, Education and Culture, Health, and Manpower, and the National Family Planning Board on this monitoring program. The final action plan for this is being prepared with inputs from the UNDP, UNICEF, ADB and the World Bank. Existing information collection mechanisms will be used wherever possible to avoid duplication, but where necessary, additional brief surveys and participatory techniques will be used. The intention is to focus on a limited number of key variables (including availability and quality of essential drugs and vaccines, educational enrollment, immunization rates, nutritional status of children under 5 years old, and prices of essential commodities) and to make the information public every three months. This information will be used to revise policies where necessary to ensure their effectiveness. IV. MACROECONOMIC OUTLOOK A. PROSPECTS 64. Indonesia's short-term macroeconomic prospects are bleak. The sharp depreciation of the Rupiah has rendered a large number of corporations technically bankrupt. The precarious state of the country's banks has harmed export performance, as foreign banks have refused to accept letters of credits drawn on Indonesian banks. The exchange rate has whipsawed, sometimes by over ten percent in a day, disrupting commerce and creating severe difficulties for trade and financial transactions. Domestic demand is shrinking as corporates struggle to survive, declining real wages, rising unemployment, and widespread drought, take their toll on investment and consumption expenditures. 65. Uncertainty surrounding Indonesia's present predicament and its future prospects make projections of macroeconomic variables particularly hazardous. Consequently the projections presented here are subject to a wider-than-usual degree of uncertainty. Much will obviously depend on the continued commitment of the Government to the wide range of structural and financial sector reforms that are needed to rebuild confidence and the financial sector. In addition, the faster corporate debtors - 14- REPUBLIC OF INDONESIA - POLICYREFORMSUPPORTLOAN and external creditors work out an agreement, the quicker will be the recovery. If these uncertainties can be resolved, Indonesia's prospects will become noticeably brighter, as the economy still has a solid base of human capital and physical infrastructure, an abundance of natural resources, and close links with the global economy. 66. In the current fiscal year it is likely that GDP will fall by about 4 percent and inflation (year on year) is likely to exceed 40 percent for calendar year 1998. Adjustments to administered prices for petroleum, electricity, and food to reflect the change in the exchange rate will contribute to this inflation in the middle half of 1998. The contraction of domestic demand and the depreciation in the real exchange rate will depress import demand and encourage export-oriented firms and industries. But continued problems in banking are likely to hamper the availability of export finance and dampen rapid improvements in export performance. Nevertheless, the current account is expected to swing into a surplus, of about $4 billion for 1998/99 (see Annex II). Shrinking GDP will mean that per capita income will decline, though investment will absorb most of the compression. Unemployment is expected to rise in the cities as firms lay off workers and drought-affected farmers come to the cities in search of jobs. Disaffection among the poor and unemployed could increase social tensions. 67. After running fiscal surpluses for several years, the Government has programmed a fiscal deficit of nearly 4 percent of GDP in FY1998/99. The relaxation of the Government's fiscal stance is warranted by four considerations. First, a decline in revenues is inevitable because of drought, rising inflation and economic recession. Second, the expenditure side of the budget will be under considerable strain from bank restructuring and subsidies for food, petroleum and electricity. Third, the Government is appropriately committed to making every effort to protect expenditures on priority investments in health and education, and to expand labor-intensive public works programs to help the poor. Fourth, the depreciation of the currency has sharply increased the Government's interest payments on foreign debt. 68. As the Government continues to implement structural and financial sector reforms, and assuming a satisfactory workout of corporate debt, investment, consumption and incomes will begin to rise again in 1999/2000. But the economy's prospects will be subdued for several years. Growth is expected to recover to 6 percent per annum in the early years of the next century, but only if there is adequate international financial support and domestic economic reform (see Annex II). B. EXTERNAL FINANCING NEEDS 69. The excess demand for foreign exchange resulting from the turn-around in private capital flows needs to be offset by a combination of three factors: (a) a temporary decline of international reserves held by Bank Indonesia, (b) an increase in the trade surplus, and (c) large transitional official capital inflows. Though Indonesia had relatively large foreign exchange reserves, they were not sufficient to finance all private sector external debt obligations due in 1998. Similarly, a trade surplus is needed, but it cannot carry the full burden of this adjustment without a very large compression of imports, investment and consumption. 70. A large amount of transitional official borrowing is needed to help Indonesia through this crisis. Without it, consumption and investment would be compressed even further and economic recovery would be delayed. A realization of this by Indonesia and the international community lies behind the package of international support spearheaded by the IMF in early November 1997. This proposed operation is part of the Bank's contribution to this coordinated effort. Even with extensive external support from multilateral financial institutions and bilateral donors, the current account balance is still projected to swing from the $7.8 billion deficit of 1996/97 to a surplus of about $4 billion in 1998/99. - 15- REPUBLIC OF INDONESiA - POLICYREFORMSUPPORT LOAN Table 1. Sources and Uses of External Financing (US$ Billion) 1996-97 1997-98 1998-99 1999-00 2000-01 Actual Estimated -------Projected---- Uses of Financing 5.6 19.7 11.1 5.5 5.6 Current account deficit (-ve = surplus) 7.8 2.3 -4.0 -1.6 0.6 Principal repayments (public) 8.0 6.5 6.2 6.4 6.0 Net Private capital outflow (-ve = inflows) -10.2 10.9 8.9 0.7 -1.0 Sources of Financing 5.6 19.7 11.1 5.5 5.6 Foreign direct investment (net) 2.0 0.5 0.4 1.0 1.2 Public MLT loans 7.5 9.5 14.7 7.5 7.5 IBRD 0.9 0.9 3.0 1.1 1.1 o.w. Policy Reform Support Loan 0.0 0.0 1.0 Other Multilateral (including ADB and IMF) 0.8 3.8 7.5 2.4 1.8 Bilateral 2.3 2.6 3.7 2.5 2.1 Other 3.6 2.2 0.4 1.4 2.6 Reduction in official reserves (- ve = increase) -3.9 9.6 -4.0 -3.0 -3.2 Debt service ratio (%) 37.0 40.6 36.0 30.2 25.7 Source: Bank Indonesia and World Bank staff estimates. V. THE WORLD BANK'S RESPONSE TO THE CRISIS 71. Since the early days of the crisis in Indonesia, during the fall of 1997, the World Bank has been continually adjusting its Country Assistance Strategy to respond to the rapidly changing economic and social situation in Indonesia. With the onset of the crisis, it became clear that the Country Assistance Strategy (discussed at the Board on July 10, 1997) needed to be fundamentally restructured to help meet critical immediate needs and to pave the way for a return to sustainable, equitable growth as quickly as possible. A CAS Progress Report is currently under preparation for discussion in July 1998. 72. The adjustment in the Bank's assistance strategy has three aspects. First, our restructured program of assistance to Indonesia will help meet critical immediate needs and build a platform for a return to sustainable growth. Second, we have modified significantly the nature and type of the Bank's lending, technical assistance, and non-lending services to respond to the new priorities of our revised assistance strategy. And finally, the Bank has intensified its coordination with the IMF and the ADB, as well as with bilateral donors, to ensure that there is a consensus in the diagnosis and development of remedies and that each institution is playing a distinct, but mutually supportive, role in helping the Government implement reforms. A. THE WORLD BANK'S PROGRAM OBJECTIVES 73. The World Bank's restructured program of assistance has been designed to address the immediate priorities of helping to brake the economy's free fall and to mitigate the effects of the economic crisis and the drought on the poor, and the medium term priorities of supporting policy and institutional changes to get productive assets back to work and to reduce the chance of a repeat crisis. - 16- REPUBLIC OF INDONESIA - POLICY REFORmSUPPORT LOAN 74. To respond to the immediate crisis, the Bank is structuring a program on three pillars--protecting the poor, restoring domestic confidence through structural reform and improved governance, and restarting the domestic financial system. (a) Helping the Poor. Our program has as its immediate focus ensuring that low income and poor households have adequate food security and access to critical basic needs such as medicine, hospital supplies and contraceptives. Shortages of food and other basic needs can result from four factors: a lack of purchasing power, poor distribution, sudden large price increases and shortage of aggregate supply. Our assistance strategy is: * to help finance labor-intensive public works in poor urban and rural areas through using portfolio savings; * to identify critical needs and to isolate bottlenecks in the distribution of food and key social services by launching sector work and improved monitoring; * to help ensure sufficient aggregate supply to keep price rises to socially acceptable levels by organizing donor assistance; * to enhance the government's framework for labor intensive local public works and poverty reduction through preparing poverty-oriented investment operations in rural and urban areas. (b) Restoring domestic confidence, increasing transparency and improving governance. This is a critical dimension of the Bank's strategy in Indonesia and the area where the Bank has taken the lead in helping to design reforms. The well-known perception of an economy dominated by special interests and monopolies precipitated a widespread loss of domestic and foreign confidence and was a major factor in the economic crisis. The vigorous implementation of the structural reforms in the Government's reform program remain an essential cornerstone to restoring domestic confidence and stabilizing the economy. Implementation of the reform program in this area is being supported by this proposed Policy Reform Support Loan, extensive technical assistance in the design of reforms and a monitoring facility being developed and managed in conjunction with Bappenas (the national development planning agency). (c) Restarting the domestic financial sector. Actions in this area are critical to stabilize the economy and restore credit flows to the corporate sector. The Bank's efforts in this area are closely coordinated with the IMF and the ADB. Responsibilities have been divided so as to use the comparative advantages of each institution: the IMF is focusing its attention on strengthening Bank Indonesia; the ADB has taken responsibility for strengthening so-called "good banks," that is, banks that are not under the Indonesian Bank Restructuring Agency (IBRA) supervision or control, as well as working on other aspects of Indonesia's financial system; and the World Bank is supporting IBRA's work with banks under IBRA control or banks whose operations have been suspended. The Bank assistance strategy in this area includes: * assisting the newly-created Indonesian Bank Restructuring Agency, initially through a US$20 million Banking Reform Assistance Project loan, * helping the Government achieve the three key immediate objectives of stabilizing the banking system, restoring depositors confidence in banks and ensuring continued essential banking services in the economy through this proposed US$1 billion Policy Reform Support Loan, and * helping the Government establish a framework that defines the Govemment's role in restructuring private corporate debt and within which private, bilateral creditor and debtor discussions can take place. - 17- REPUBLIC OF INDONESIA - POLICY REFORMSUPPORTLOAN 75. The program's medium term objective is to restore growth and continue a successful battle against poverty. The crisis mentality that has engulfed the Government in recent months risks ignoring the country's longer term development needs. Indonesia's economy will return to health. When it does, its pace of recovery and development will depend on how well it rebuilds a foundation for growth. To achieve this, there a number of important medium-term priorities and the Bank will have an important role to play in helping the Government achieve the following objectives: * rebuilding the financial system, * rebuilding and improving Indonesia's agricultural sector and water management, * developing a program to maintain physical and human capital in times of severe restrictions on Government expenditures, and * working with the government to build public and private institutions to carry Indonesia into the next century. 76. IFC and MIGA. The IFC and MIGA are also adjusting their programs as appropriate. The IFC is continuing a close working relationship with the Government and the corporate sector. In keeping with the Government's wish that creditors adopt a flexible approach to the private sector, the Corporation is concentrating on helping its clients and other business firms that need financial restructuring and/or additional working capital. This includes initiatives to provide additional equity and loan finance to clients in the financial sector, identifying a small number of banks that are fundamentally sound but require capital infusion, and supporting mergers where that leads to a sounder and more robust banking sector. MIGA's current portfolio in Indonesia includes five contracts of guarantee for a total exposure of US$ 80.4 million. These contracts represent four projects, including three in the infrastructure sector (two power projects and one telecommunications project), and one in the manufacturing sector. As a result of the current crisis in Asia, MIGA has received an increasing number of inquiries for coverage in the infrastructure and financial sectors. B. MODALITIES OF BANK SUPPORT FOR A RESTRUCTURED ASSISTANCE STRATEGY 77. In terms of the instruments of the Bank's assistance program--lending, non-lending services and technical assistance--we are adjusting our program in three principal ways: * reconfiguring existing projects to ensure that resources are made available quickly for public works programs to help the poor restore lost income; * adjustment lending and non-lending assistance to support policy reforms and to provide balance of payments support; and * a revised pipeline of investment lending that gives increased prominence to labor intensive public works as a means of containing poverty. 78. Reconfiguring existing projects. We have begun a "crash" program of community-based, labor- intensive small public works by restructuring existing urban loans and using the savings (estimated to be over US$100 million) to finance employment programs. Adjustments are also being made to the rest of our portfolio to free additional resources from exchange rate savings for use in poverty alleviation programs. A full review of the portfolio is underway, which will inevitably lead to cancellation of some loans and project components. 79. Adjustment Lending and Associated Non-Lending Assistance. The lending program has been redesigned to provide Indonesia with quick disbursing support during calendar year 1998. Our lending program now includes this proposed US$1 billion Policy Reform Support Loan and two to three - 18- REPUBLIC OF INDONESIA - POLICYREFORMSUPPORTLOAN additional fast disbursing operations early next fiscal year which would total another US$1 billion. This proposed Policy Reform Support Loan, which is a key element of the Bank's response to the crisis, is designed to contribute to the short-term objective of protecting the poor and stopping the economy's near free-fall by supporting social programs and by helping to rebuild confidence and restart the financial sector. It also contributes to the medium term objective of restoring growth and reducing poverty by helping to rebuild the financial sector, establishing a more market-friendly policy environment, improving public sector efficiency and protecting investment in human capital. The remaining adjustment operations would focus on improving agriculture efficiency and sustainability and continued support of the Government's structural and financial policy reform programs. Needless to say, future adjustment lending will depend on satisfactory implementation of the reform program. 80. Revised investment lending pipeline. The Bank is preparing two poverty alleviation investment projects for consideration by the Board - one in May and the other early next fiscal year. One of these, the recently-negotiated Kecamatan Development Project (KDP), consists of cash grants and technical assistance to poor villages so they can build productive infrastructure. The second operation, focused on urban areas, will adapt the KDP model to peri-urban areas to offset income loss from the recession in construction. C. COORDINATION WITH INTERNATIONAL FINANCIAL INSTITUTIONS AND DONORS 81. The World Bank has been part of a collaborative effort along with the IMF and the ADB to help the Government design an overall program of stabilization and structural reform in response to the crisis and the drought. The Bank's relationship with the IMF and the ADB has been excellent in recent months. The three institutions are working to their comparative advantages, and to Indonesia's benefit. 82. This proposed Loan is an integral part of the package of financial support assembled by the IMF for Indonesia during October 1997 and revised in January and March 1998. Bank staff have worked closely with the Government and IMF in strengthening all aspects of the reform program and will continue to be heavily involved in implementation and supervision. The Bank's primary involvement has been in the design of structural reforms, bank restructuring, and programs to protect the poor. Initiatives being supported under this proposed Loan strengthen and deepen reforms already agreed with the IMF. The ADB is also preparing a Structural Adjustment Loan and Bank staff are in close contact with ADB staff to ensure a strong, mutually-agreed support program and to avoid needless duplication. Japan is currently exploring options for disbursing their support in parallel with structural adjustment support from the Bank. Bank staff have been working with Japanese officials on how best to integrate support, with the result being parallel operations rather than formal cofinancing. 83. The World Bank has also intensified its aid coordination efforts, in particular to ensure a smooth flow of essential imports, especially rice and other food essentials. The Bank has been asked by the Government to help it coordinate donor contributions to social safety net issues, ADB to coordinate efforts to sustain small and medium scale enterprises, and the UNDP to coordinate technical assistance efforts. We have convened a special session of donors supporting Indonesia to coordinate multilateral and bilateral finance of essential imports, and to discuss ways of increasing the supply of trade financing. Additional meetings are planned for donor representatives in Jakarta over the coming weeks and months. The regular Consultative Group meeting for Indonesia will take place toward the end of July. - 19- REPUBLIC OF INDONESIA - POLICYREFORMSUPPORT LOAN VI. THE PROPOSED LOAN A. OBJECTIVES 84. The overriding objective of this loan is to support Indonesia's efforts to rebuild confidence and restore rapid poverty-reducing growth as quickly as possible, while shielding the poor. This objective is pursued by supporting policy reforms and other actions to: * increase the efficiency and transparency of public sector operations, * rebuild an efficient, competitive and properly supervised banking sector, * improve governance, increase productivity and ensure environmental sustainability, and * shield poor and vulnerable groups. 85. This loan is a critical component in an overall package of external assistance provided by the IMF, the World Bank, the ADB, and bilateral donors to Indonesia. Without strong external financial support for Indonesia's efforts, there is a risk that the policy reform program under implementation could be undermined by continued uncertainty, large private capital outflows, and collapse of the corporate sector and the banking system. 86. Management and monitoring of the program. The Government's institutional arrangements for implementing and monitoring the program are described in paragraphs 62 and 63. The international financial institutions will not only be supporting the Government in this effort with technical assistance, but will also continue independent monitoring of reforms. The World Bank's monitoring of economic developments and policy reforms has been intensified since the crisis began and this will continue as part of the supervision of this operation. World Bank staff will continue to contribute to regular IMF reviews of the program and will review the overall program in preparation for release of the second tranche which is expected in July or August. In addition, a concurrent World Bank analysis of poverty in Indonesia is examining the likely effects of this crisis on the poor, and ongoing supervision of investment operations (e.g. health, education and power) will provide additional monitoring of policy actions. 87. Letter of development policy. The Government's Statement of Development Policy, dated April 8, 1998 is attached as Annex IV. 88. Policy actions supported by this loan. The program of policy action supported by this loan covers the four points listed in paragraph 84 and is summarized in Annex I. These actions directly address the key domestic causes of the economic crisis. Financial sector reforms and corporate debt restructuring, coupled with sound fiscal and monetary management, will overcome weaknesses in the financial sector and reduce risks arising from the build up of private debt. Increased transparency and improved governance through public sector and structural reforms will help rebuild confidence and restore efficient growth. 89. The first tranche of this loan is in support of actions already taken by the Government of Indonesia. These actions are listed in column 3 of Annex I. They include: * Measures to increase the efficiency of public sector activities and confront pressures for an unsustainably large fiscal deficit -- many public investments deferred or canceled, Reforestation Fund and the Investment Fund incorporated into the state budget, budgetary support for IPTN (the airplane manufacturer) discontinued, and Keppres 7/1998 issued to make procedures for project evaluation and bidding more transparent and competitive. -20 - REPUBLIC OF INDONESIA - POLICY REFORMSUPPORTLOAN * Reforms to rebuild an effective and competitive financial sector -- 16 banks were closed in November 1997, the Indonesian Bank Rehabilitation Agency (IBRA) has been created to restructure unhealthy banks, IBRA froze the operations of seven banks and placed seven other banks under its management in April 1998, portfolio reviews of all banks are being conducted by internationally-recognized firms, two state banks are being merged and loan classification and provisioning regulations have been revised. * Actions to increase private sector efficiency, and improve governance -- tariff reduction for about 2000 items; special privileges granted to the national car program discontinued; import monopolies in wheat, wheat flour, sugar, garlic and soybean has been terminated; non-tariff barriers on imports of new and used ships eliminated; local content requirements for dairy products abolished; the export cartel for plywood dismantled; export taxes on leather, cork, ores and waste aluminum products abolished, restrictions on trade within and between provinces eliminated (including the monopoly in clove marketing); cement marketing and pricing decontrolled; and restrictions on foreign investment in oil palm plantations and in wholesale and retail trade removed. * Programs to shield the poor -- price subsidies for key food items, and labor intensive public works expanded to provide purchasing power to the poor. 90. In spite of this front loading of reforms, it will take time to rebuild confidence. Success will depend heavily on maintaining this effort over time. In recognition of this, the conditions of second tranche release focus on sustaining and deepening implementation. They are: (a) Continue to maintain a sound macroeconomic policy framework, consistent with the objectives of the policy reform program as indicated by Annex I. (b) Maintain discipline in public expenditure management, increase public sector efficiency and make public sector management more transparent by: * Completing a review, under terms of reference acceptable to the Bank, of public sector expenditures and investments, including public enterprises and strategic industries, and adopt an action plan for implementing agreed recommendations. * Increasing the weighted average price for regulated petroleum products (BBM fuels) and the weighted average electricity tariff, both by at least 50 percent from their March 1998 level. * Ensuring implementation guidelines, acceptable to the Bank, providing for private participation in the provision of infrastructure. Such guidelines are to include: (i) principles that will govern cooperation arrangements; (ii) criteria and institutional arrangements for project screening, selection and review; (iii) transparent bidding requirements; (vi) tariff setting and adjustment provisions; (v) dispute resolution mechanisms; and (vi) sector specific procedures. * Identifying at least seven public enterprises to be privatized by March 31, 1999, and identifying at least five more public enterprises that will, by March 31, 1999, be prepared for privatization, and adopting a plan for the sale of additional Government controlled shares in companies listed on the Jakarta stock exchange, as of March 31, 1998. - 21 - REPUBLIC OF INDONESIA - POLICY REFORM SUPPORT LOAN (c) Rebuild an efficient financial sector, contain further bank losses, and protect productive assets of corporations by: * Completing portfolio reviews, under terms of reference acceptable to the Bank, for banks whose assets total at least 80 percent of the total combined assets of the 54 banks that were under the supervision of IBRA as of February 28, 1999. * Establishing an independent review committee, with terms of reference and membership acceptable to the Bank, to verify the sound and transparent functioning of IBRA. * Establishing a framework, acceptable to the Bank, that defines the Government's participation in restructuring private corporate debt. (d) Improve governance and transparency, increase competition and make the policy environment more market-friendly by: * Introducing a system of resource use royalties for forestry, reducing export taxes on logs, sawn timber, and rattan to a maximum of 30 percent ad valorem and adopting and announcing a program for reducing this to a maximum of 20 percent by Dec. 31, 1998, 15 percent by Dec. 31, 1999 and 10 percent by Dec. 31, 2000, removing the requirement to have a processing facility in order to hold a forestry concession, and allowing forest concessions to be transferred by sale. Resource royalty rates will be directly linked to international prices for the raw material, inversely related to the cost of efficient extraction, and independent of end use. * Adopting an action plan, acceptable to the Bank, for enacting legislation and regulations relating to competition and corporate restructuring. * Replacing all existing quantitative export controls on crude and processed palm oil, olein and stearin with an export tax not exceeding 40 percent ad valorem, and implementing a system of regular reviews with an objective of reducing this in stages to reach 10 percent by Dec.31, 1999. * Dissolving the BPPC (Clove Support and Marketing Board) and maintaining the right of traders to buy and sell cloves at unrestricted prices and to transport cloves across district and provincial boundaries. * Ensuring that all traders, including foreign direct investors, continue to be free to compete with BULOG by importing, wholesaling and/or retailing any commodity other than rice, and ensure that private traders and BULOG have access to foreign exchange at the same rate when importing goods other than rice. B. LOAN ADMINISTRATION 91. Borrower and loan amount. The Republic of Indonesia is the borrower. At the request of the Government, a total of US$1 billion is proposed for this adjustment loan. This amount is based on an overall external financing plan worked out with the Government and IMF in November 1997. It will be a fixed rate single currency loan (SCL) in US dollars, with standard amortization terms, grace period and interest rate for fixed-rate US dollar SCLs with an expected disbursement period of 0-3 years. - 22 - REPUBLIC OF INDONESIA - POLICY REFORM SUPPORT LOAN 92. Disbursement and procurement. The proposed loan has two tranches, a first of $600 million and a second of $400 million. Funds will not be disbursed against expenditures normally excluded from adjustment loans, i.e., imports of alcoholic beverages, tobacco and tobacco processing machinery, radioactive material, pearls and precious stones, nuclear reactors, gold and jewelry of gold, silver platinum, and military equipment, luxurious and environmentally hazardous goods. The Government will open and maintain a deposit account with Bank Indonesia for the disbursement of these funds. Upon effectiveness, the Government will submit a simplified withdrawal application to the Bank, against which the Bank will disburse the loan proceeds for the first tranche into the deposit account. Disbursements will not be linked to specific purchases and supporting evidence for disbursements is therefore not required. If after deposit is made in the deposit account, the proceeds of the loan or any part thereof are used for ineligible purposes as defined in the Loan Agreement, the Bank will require the Borrower to either (a) return the amount to the deposit account for use for eligible purposes, or (b) refund the amount directly to the Bank, in which case the Bank will cancel an equivalent undisbursed amount of the loan. 93. Accounts and audit. Bank Indonesia will maintain the accounts for this loan in accordance with sound accounting practices. The accounts under the program will be audited within four months of a request by the Bank. 94. Environmental assessment requirements. In accordance with the Bank's Operational Directive on Environmental Assessment (OD4.00, Annex A), the proposed operation has been placed in "Category C" and will not require an environmental assessment. C. BENEFITS AND RISKS 95. There are four key benefits from this operation. First, the policy reforms will restore stability and confidence in the economy by ensuring a sound macroeconomic framework, improving governance, increasing the transparency and efficiency of public sector activities, restoring stability in the banking system, and increasing the competitiveness of the private sector. Second, actions being taken help protect the poor from the worst effects of the crisis. Third, the reforms strengthen the environmental sustainability of Indonesia's development. Fourth, as part of a broad program of external financial support, the resources provided under this loan will help Indonesia avoid an excessive transitional decline in consumption, and help continue investments (including investments in human resources) that are critical to rapid recovery. 96. The Government's reform program and this supporting operation are subject to considerable risks and uncertainties. Without a strong and sustained reform effort, Indonesia could slip into a severe crisis entailing major losses of output and employment, and hyperinflation. The past few months of delays and reversals of some key elements of the two earlier reform programs have eroded the Government's credibility and will make it even more difficult to re-establish the confidence in economic management necessary to stabilize the economy. There are four major risks that could undermine the effectiveness of this operation: (i) The first is the political juncture at which Indonesia finds itself. Anxieties about the President's age (76 years) and health over the past year, coupled with concerns about the lack of effort to prepare a successor and ensure a smooth transition, have exacerbated foreign investors' concerns about the future of the economy. In addition, the newly appointed Cabinet contains several of the President's close friends and prominent business leaders who have benefited from past policy distortions. This heightens anxieties about possible conflicts of interest and the willingness of the Cabinet to implement policy changes that would potentially hurt their private financial interests. - 23 - REPUBLIC OF INDONFSIA - POLICY REFOR SUPPORT LOAN (ii) The second risk is the social tension and the rising (albeit still small) threat of societal breakdown resulting from a combination of slower growth, rising unemployment, rising prices (especially of food, fuel, and electricity), and declining real incomes. Adding to this tinderbox of tensions, the drought is encouraging rural migrants to compete with the unemployed for jobs in cities. These tensions have occasionally erupted into local violence, some of which has taken an ugly turn against the Chinese ethnic minority. This violence, if allowed to spread, could threaten the coalition of political, ethnic, regional, and economic interests that has maintained conditions conducive of rapid development and sharp reductions in poverty. Violence would also scare foreign investors and domestic entrepreneurs away, and add to capital flight. (iii) The third risk is the fragility of the banking system and the possibility that pressure for rising government expenditures could undermine commitment to conservative fiscal management. Upward pressure on public expenditures could come from (a) a desire to buy social peace through food and energy subsidies, (b) higher-than-expected fiscal costs of nurturing banks back to health, (c) pressures for the Government to absorb the exchange rate risks associated with corporate debt restructuring, and (d) a desire to continue funding selected projects. Giving in to these pressures would mean greater budget deficits and the possibility of accelerating inflation. In addition, there is always the possibility that government revenue estimates may turn out to be optimistic. (iv) Limitations in administrative capacity, coupled with inevitable opposition from vested interests, may result in delayed implementation of some reforms. The need for such a wide array of reforms has stretched the Government's administrative capacity to the limit. The relative inexperience of the new Cabinet and the complexity of the problems its members face also exacerbate this risk. 97. The design of the reform program, the structure of this loan, and the mechanisms that have been established for monitoring program implementation are the principal means by which these risks are mitigated. The loan supports a "front-loaded" reform program where many of the difficult decisions have already been taken. In virtually every sphere of reforms -- bank restructuring, budget management, structural reforms, even corporate debt restructuring -- the Government has already implemented important, and in many cases irrevocable, reforms. While the business connections of some Cabinet appointees raise concems about conflicts of interest, their proven managerial skills and no-nonsense styles have created a new momentum and help ensure a commitment to the program at the highest level. Close supervision by the IMF of the monetary and budgetary program and by the World Bank and ADB of the banking sector, public expenditure, and structural programs will ensure that the program is monitored in detail and warning signs of slippage are raised immediately to the highest levels. 98. To soften the impact of the exchange rate depreciation on the prices of essential commodities and thereby lessen the risk of social unrest, the budgetary program agreed with the IMF includes measures to ensure continued supplies of basic foodstuffs (rice, soybeans and cooking oil) at reasonable prices, the phasing of price increases for power and petroleum products, and special public works programs in both rural and urban areas. World Bank financing of labor-intensive public works will help in this regard. The Bank will also monitor these measures and bring any shortcomings to the government's attention. 99. Pressure on the government budget is being managed in several ways. First, the reform program calls for bringing all off-budget revenues on to the budget thus increasing both transparency and revenues. Second, subsidies are being contained by restricting them to a few commodities, especially rice and soybeans that are key food items for the poor. Third, the bank reform program includes safeguards to contain the costs of reforms. Fourth, the Government will use all possible avenues to raise additional - 24 - REPUBLIC OF INDONESIA - POLICYREFORMSUPPORT LOAN revenues, including through privatization. Finally, the IMF will work with the Govemment in ensuring that aggregate govemment expenditures and the budget deficit will be kept within reasonable limits and remain consistent with the broad objective of restoring stability to the economy. 100. The risk of inadequate administrative capacity is being mitigated through technical assistance provided by bilateral and multilateral institutions. Much of this is ongoing and will continue over the next several years. Active technical support of World Bank, ADB and IMF staff and consultants has been instrumental in moving financial sector and structural reforms forward and getting changes implemented. Similarly, World Bank and IMF staff, have provided significant inputs into shaping the budget and designing appropriate subsidy schemes. Bilateral programs are assisting with judicial reforms. The Asian Development Bank and the IMF are assisting Bank Indonesia authorities with strengthening the payments system and improving the capacity of bank examiners and supervisors. 101. Despite the measures that have been put in place to mitigate risks, they remain considerable. Restoring confidence and credibility in economic management will take time and there is little, if any, room for slippage in implementation, as has occurred in the past few months. Even under the best circumstances, the economy could be severely depressed for several years, which will continue to put pressure on Indonesia's already fragile political and social fabric. Finally, uncertainties about the resolution of Indonesia's private corporate debt and the resumption of normal trade credits pose considerable risks to the program that the Government can not fully control. Nevertheless, this program presents the only available opportunity to stabilize Indonesia's economy and provide protection to the poorest members of society. Thus, the risks of not supporting this program are also considerable. The financial support of the Bank for the Government's program of stabilization and structural reforms will contribute positively to market sentiments, add to Indonesia's ability to finance essential imports, and strengthen the Government's fiscal position. VII. RECOMMENDATION 102. I am satisfied that this proposed loan complies with the Articles of Agreement of the Intemational Bank for Reconstruction and Development and recommend that the Executive Directors approve it. James D. Wolfensohn President by Sven Sandstrom Washington, D.C. April 28, 1998 - 25 - ANNEX I SUMMARY OF POLICY REFORMS Objective: To quickly restore sustained rapid growth while shielding the poor and protecting the environment Overarching Instrument and sub- Actions Already Taken OtherActionsfor 199.8" Actonsfor 1#99944 a Re' objective objective A. Increase Increase transparency of Bring Reforestation and Investment Funds Complete, under terms of reference acceptable Bring remaining off-budget efficiency and public administration and into the Government Budget. to the Bank, a review ofpublic sector government revenues and transparency of budget. expenditures and investments, including public expenditures on budget within 3 public sector enterprises and strategic industries, and adopt years. operations. an action planfor implementing accepted recommendations. Discontinue any budgetary and extra Increase the weighted average price of budgetary support and credit privileges regulatedpetroleum products (BBMfuels) and granted to IPTN projects. the weighted average electricity tariff by at least 50 percentfrom their March 31, 1998 level. Establish a clear Keppres 7 of 1998 issued to establish clear Issue implementation guidelines, acceptable to framework for and transparent cross-sectoral procedures for the Bank, providingforprivate participation in competitive bidding on competitive tendering on the private provision the provision of infrastructure. The guidelines public projects. of infrastructure. are to include: (i) the principles that will govern cooperation arrangements, (ii) criteria and institutional arrangementfor project screening, selection, and review; (iii) transparent bidding requirements; (iv) tariff setting and adjustment provision, (v) dispute resolution mechanism; and (vi) sector specific procedures. Broaden and hasten Establish a clear framework for the management privatization. and privatization of the Govemment assets, including (i) a criteria for determining whether enterprises should be closed, restructured, or privatized and (ii) a transparent sales processes that maximizes the return to the Govemment and treats all bidders equally. Action plans for every public sector enterprise will be completed by end-September 1998. 1/ Actions in bold italics are second tranche release conditions. Establish clear profit and performance targets for Close non-viable enterprises. government enterprises and make these targets Establish performance contracts for public. the ones remaining in the public sector. Identify at least 7 public enterprises that shall By March 31, 1999, privatize be privatized by March 31, 1999, identify at seven additional public enterprises least an additional 5 public enterprises that and prepare a further five for will, by March 31, 1999, be preparedfor privatization. In all cases, the privatization, and clarify plans forfurther sales government will allow the private ofpublic holdings in enterprises listed on the sector to have majority stock exchange, as of March 31, 1998. shareholdings. B. Establish a Establish a Guarantee program for all depositors and sound financial comprehensive guarantee creditors of locally incorporated banks sector with a program to instill announced Jan 27, 1998. This guarantee will competitive and depositor and creditor be in place for at least 2 years and will not be * properly confidence. terminated without 6 months advance notice. supervised Guarantee made retro-active to cover large banking system. depositors of 16 private banks closed in Nov. 1997. Improve governance and Have international experts assist in bank Continue to use technical supervision of banks examinations and provide best practice and assistance to improve supervision international supervisory experience. capabilities. Establish base loan classifications based on Tighten reporting requirement for foreign risk rather than delinquency exchange and credit risk. Establish an Indonesian Close 16 banks in November 1997. Complete portfolio reviews, under terms of Dissolve IBRA when it has Bank Restructuring reference acceptable to the Bank, for banks fulfilled its current purpose. Agency (IBRA) to (i) Announce IBRA creation on January 27 whose assets total at least 80 percent of the total restructure or liquidate 1998. Operational in March 1998. combined assets of the 54 banks under the Manage asset resolution to restructure or liquidae combined assets of he 54 banks under themaximize recoveries on the bad banks that threaten 39 private banks voluntarily place themselves supervision of IBRA as of Feb. 28, 1998. loan portfolios and contain fiscal systemic stability and (ii) under IBRA's supervision and are asked to costs f bank restructurin create an asset resolution prepare rehabilitation plans to be validated by Establish an independent review committee, o ares g. entity to maximize bad diagnostic reviews, with terms of reference and membership loans recoveries. acceptable to the Bank, to verify the sound and transparentfunctioning of IBRA. Over i ffinstr tsament and s.- A;O i 9 ; 9 Objective jeie-/ Operations of 7 private banks frozen on Monitor rehabilitation plans and restructure banks April 4, 1998. On same date, 7 other whose rehabilitation plans is non-viable. banks placed under IBRA management. Bapindo and Bank Bumi Daya to be merged; their Achieve private participation in all Intention to merge 4 state banks good and bad assets to be separated; and bad assets state banks. announced on 31 Dec. 1997, with to form basis for an Asset Management Company ultimate goal of privatization. to manage, restructure and sell bad assets. Establish regulatory and/or performance contracts on state bank management. Strengthen the policy Remove legal impediments on private ownership and institutional of the state banks. infrastructure for banking. Remove restrictions on foreign investment in, and ownership of, banks. Require banks to regularly publish Review adequacy of financial date published by comprehensive financial data. banks. Strengthen bankruptcy Establish aframework, acceptable to the Bank, and debt restructuring that defines the Government's participation in provisions. restructuring private corporate debt. Modify and strengthen bankruptcy laws to provide adequate protection to debtors and creditors, and to adopt transparent rules for evaluating reorganization plans and for liquidation procedures. C. Increase To reduce costs and Include chemicals, metal products and Remove local content regulations for productivity/ increase efficiency by agricultural goods in the program for motor vehicles by 2000. efficiency of increasing import further tariff reductions' . private sector competition Import tariffs on all goods except Reduce import tariffs that are 15 motor vehicle & alcohol to be reduced percent or above by 5 percentage points to 10 percent by the year 2003. (excludes motor vehicles and alcohol), and reduce tariffs on all food items to 5 percent. 'This phased program now reduces the maximum import tariff to 10 percent by 2003 for all goods except motor vehicles and alcohol. Reduce tariffs on non-food agricultural products by 5 percentage points. Discontinue special tax, customs duty and credit privileges granted to new imports under the National Car Project. Allow general importers to import wheat, Ensure that all traders, includingforeign direct wheat flour, soybeans, garlic and sugar. investors, continue to befree to compete with BULOG by importing, wholesaling and/or retailing any commodity other than rice, and ensure that private traders and BULOG have access toforeign exchange at the same rate when importing goods other than rice. Abolish local content regulations on dairy products and all ships. Remove export Abolish export taxes on leather, cork, ores and Introduce a system of resource royalties, reduce Abolish all quotas and other impediments to improve waste aluminum products. export taxes of logs, sawn timber, and rattan to restrictions on exports by the end export competitiveness a maximum of 30 percent ad-valorem, and of 2000, except for health and adopt and announce a program to reduce this security reasons. to 20 percent by Dec. 31, 15 percent by Dec. 31, 1999, and 10 percent by Dec. 31, 2000. Resource royalties on forestry use will be linked to world market value, vary with cost, and be independent of end use. Replace quantitative export controls on crude and processed palm oil, olein and stearin with an export tax of 40 percent ad-valorem or less, and hold regular reviews with an objective of reducing this in stages to reach 10 percent by Dec. 31, 1999. Relax investment Remove the restrictions on foreign investment Issue a shortened list of activities closed to restrictions to encourage in oil palm and in wholesale and retail trade. foreign investors by June 30, 1998. investment erarching Instrument and sub-. AcionosAIready en Other&Acdtos or 99: Aliffn 9 d : ' J'' ... .. :'.' :,: '1,,, 'cs,,,,', . : " '.:.' ", :' : , , ,, ,, ,, S :",'.,',:'':.:':..:.".':.'.....'.'..".:: :',,::", Deregulate domestic Dissolve all restrictive marketing trade to reduce costs and arrangements, including those for cement, increase efficiency. paper and plywood. Deregulate domestic prices of cement. Give traders freedom to buy, sell and transfer Dissolve the Clove Support and Marketing all commodities across district and provincial Board(BPPC), and naintain the rights of boundaries, including cloves, cashew nuts, traders to buy and sell cloves at unrestricted oranges and vanilla. prices and to transport cloves across district andprovincial boundaries. Prohibit provincial governments from Implement a program for abolishing restricting trade within or between provinces. Abolish the system of quotas that limit the taxes on inter-provincial and inter- sale of livestock by September 30, 1998. district trade by April 1, 1999. Prohibit provincial or district governments from charging export taxes (retribusi). Permit domestic wheat millers to sell or distribute wheat flour to any agent. .i Allow traders to market sugar domestically. Release farmers from the formal and informal requirements for the forced planting of sugar cane. Establish rules to Background preparation with bilateral support Adopt an action planfor enacting legislation maintain competition. over past two years. and regulations relating to conpetition and corporate restructuring. D. Strengthen Maintain purchasing Increase budget resources for labor intensive Expand community-based labor-intensive safety nets and power in the poorest local community public works. public works in rural and urban areas. protect the poor areas. Ensure supply of food. BULOG ordered 2.5 million tons of rice and Import a further 2.85 million tons of rice. Phase out subsidies for all agricultural subsidizing sales. commodities except rice. Ensure the poor's access Ensure adequate resources for basic Continue adequate resources for basic to quality social services, education, and scholarships for an education, along with scholarship including communicable additional 3.5 million poor primary and program for the poor as needed disease control. junior secondary school students. Ensure adequate resources for primary Continue adequate support for primary health services, including communicable health services, communicable disease disease control and family planning control and family planning services. services. E. Ensure Strengthen overall New Environmertal Law (UU23/97) issued. Establish implementation rules needed for Issue remaining regulations for t.he environmental environmental four priority items under the new New Environmental Law. sustainability management. environmental law-air quality, water quality, hazardous waste management environmental assessment. Protect forest cover and Ensure that the reforestation fund is transparent Allow the transferability by sale of strengthen forest and used only for reforestation and closely concession permits, remove the management. related activities. requirement to have a processingfacility in order to hold aforestry concession. By June 30, 1998 lengthen concession periods and reduce land conversion targets to environmentally sustainable level. Ensure sustainable Restrict new imported and large domestic Develop and implement an effective fisheries management. boats to the EEZ until a new monitoring monitoring contro' and surveillance and control system is in place. system by the end of 1999 to avoid overfishing. Improve air quality. Prepare plans for reducing lead in gasoline Reduce the use of lead as an additive in and formalize with regulations and decrees. gasoline. F. Monitoring Establish monitoring Issue quarterly reports on social outcomes Maintain monitoring of social sector and system to assess covering at least the following items (i) the outcomes. Administration outcomes and refine availability and quality of essential drugs, policies. vaccines and contraceptives, (ii) nutritional status of children under five years old, (iii) price changes for essential commodities, and (iv) educational enrollment for grades one through nine. GOI working groups, with assistance from the Bank, to (a) assess sustainability of Government health service delivery; (b) evaluate competitiveness of pharmaceutical/vaccine production; and (c) develop a strategy to extend pre-paid health finance mechanisms. Establish administrative Economic resilience committee appointed with President Soeharto as Chairman. mechanism to achieve Implementation led by Coordinating Minister for Economic, Finance and Industry. effective implementation. ANNEX 2 INDONESIA: KEY ECONOMIC INDICATORS FY96/97 FY97/98 FY98/99 FY99/00 FYOO/01 Actual Estimated --------Projected------ NATIONAL ACCOUNTS Growth rates: Real GDP 7.8 2.0 -4.0 3.0 4.0 Consumption 8.1 2.3 1.0 2.5 2.8 Investment (GDFI) 10.2 -9.9 -30.3 16.6 15.2 Real GDP per capita 5.1 0.5 -5.4 1.5 2.6 Consumption per capita 5.4 0.7 -0.4 1.1 1.4 Share of GDP: Investment 31.9 29.1 21.9 24.2 26.3 Domestic Private Savings 21.6 21.7 20.9 20.4 20.6 Government Deficit(-)/GDP 0.9 -0.2 -3.8 -0.8 0.2 BALANCE OF PAYMENTS Export volume growth rate (Merch. FOB) 6.2 9.5 5.0 6.8 8.2 Import volume growth rate (Merch CIF) 10.4 -4.4 -9.2 17.2 13.9 Exports (Merch FOB) (US$billion) 52.1 54.3 56.9 62.9 70.4 Imports (Merch CIF) (US$billion) 50.9 47.3 44.2 52.7 61.9 Non-oil merch. export growth rate in US$ 5.8 11.6 9.1 12.4 12.8 Current Account Balance (US$billion) -7.8 -2.3 4.0 1.6 -0.6 Current Account Balance/GDP -3.5 -1.5 2.6 0.8 -0.3 Gross Reserves (months imports GNFS) 5.7 3.9 5.2 5.0 4.8 EXTERNAL DEBT Total DOD (US$Billion) 129" 1342' 134 130 128 M< DOD (US$Billion) 971/ 1172/ 118 114 112 External Government Debt (US$Billion) 65" 702/ 72 73 73 Total Debt/GDP 57 86 86 71 60 Debt Service (M<, US$Billion) 19.9 22.9 21.6 19.9 20.1 Amortization (US$Billion) 14.8 17.5 16.1 14.6 13.7 Interest Burden (M< US$Billion) 5.1 5.3 5.5 5.3 5.1 Total Debt Service/Exports(GNFS) 37 41 36 30 26 EXPOSURE INDICATORS DOD/XGS (%) 214 218 207 181 159 Concessional/DOD (%) 4.0 3.8 4.2 4.3 4.3 IBRD exposure indicators IBRD DS/public DS (%) 19.3 17.5 19.0 18.8 16.1 Preffered creditor DS/public DS (°O) 36.1 26.3 30.3 32.4 39.0 IBRD DS/XGS (%) 3.7 2.8 3.1 2.9 2.7 IBRD DOD (US$Billion) 11.1 10.0 11.9 11.9 11.8 Share of IBRD portfolio (%) 10.2 9.0 10.6 10.4 10.3 IDA DOD (US$m) 736 715 694 672 648 1/ end-Dec, 2/ end-January. Source: Government of Indonesia and World Bank staff estimates Note: Balance of payment and debt numbers do not build in any private debt write-off. DOD- debt outstanding and disbursed, DS-debt service, GNFS-goods and non-factor services, M<- medium and long term, XGS - exports of goods and services. - 32 - BALANCE OF PAYMENTS (US$ BILLION) FY96/97 FY97/98 FY98/99 FY99/00 FYOO/01 Actual Estimated --------Projected----- Merchandise Exports (FOB) 52.1 54.3 56.9 62.9 70.4 Oil & Gas Exports 12.8 10.5 9.0 9.1 9.7 Non Oil & Gas Exports 39.3 43.8 47.8 53.7 60.6 Nonfactor Services 6.0 5.8 5.6 5.8 6.1 Exports of GNFS 58.1 60.1 62.5 68.7 76.5 Merchandise Imports (FOB) -41.5 -42.6 -39.9 -47.5 -55.8 Merchandise Imports (CIF) -50.9 -47.3 -44.2 -52.7 -61.9 Nonfactor Services -6.1 -5.7 -5.5 -6.3 -7.4 Imports of GNFS -57.0 -53.0 -49.8 -59.0 -69.3 Resource Balance 1.1 7.1 12.7 9.7 7.2 Net Factor Income and Transfers -8.9 -9.4 -8.7 -8.1 -7.8 Current Account Balance -7.8 -2.3 4.0 1.6 -0.6 Capital Account Balance 11.7 -7.3 0.0 1.4 3.8 Net Disbursment of Public M< debt -0.5 3.0 8.5 1.1 1.5 Amortization 6.3 6.5 6.2 6.4 6.0 Foreign Direct Investment 2.0 0.5 0.4 1.0 1.2 Net Other Capital (- = outflow) 10.2 -10.9 -8.9 -0.7 1.0 Change in Official Resources (- = increase) -3.9 9.6 -4.0 -3.0 -3.2 Memo Items: Current Account Balance/GDP -3.5 -1.5 2.6 0.8 -0.3 Export real growth rate (Merch FOB) 6.2 9.5 5.0 6.8 8.2 Non-oil merch. export growth rate in US$ 5.8 11.6 9.1 12.4 12.8 Import real growth rate (Merch CIF) 10.4 -4.4 -9.2 17.2 13.9 Total debt service/Exports (GNFS) 37.0 40.6 36.0 30.2 25.7 Total DOD (US$ billion) 129 134 134 130 128 " Estimates, 2/ Projections. Source: Government of Indonesia and World Bank staff estimates. DOD-debt outstanding and disbursed, GNFS-goods and non-factor services. - 33 - INDONESIA AT A GLANCE Lower POVERTY and SOCIAL East Middle- Indonesia Asia income Development diamond' Population mid-1996 (millions) 197.1 1,726 1,125 Life expectancy GNP per capita 1996 (US$) 1,090 890 1,750 GNP 1996 (billions US$) 213.7 1,542 1,967 1 Average annual growth, 1990-96 Population (%) 1.7 1.3 1.4 A Labor force (%) 2.5 1.3 1.8 GNP | Gross More recent estimate (latest year per I primar available since 1989) capita enrollmen Poverty: headcount index (% of population) 11 Urban population (% of total population) 36 31 56 Life expectancy at birth (years) 64 68 67 Infant mortality (per 1,000 live births) 51 40 41 Access to safe meter Child malnutrition (% of children under 5) 11 Access to safe water (% of population) 62 49 78 Illiteracy (% of population age 15+) 16 17 .Indonesia Gross primary enrollment (% of school-age -Lovier-mide-incomegroup population) 115 117 104 Male 117 120 105 Female 113 116 101 KEY ECONOMIC RATIOS and LONG- 1975 1985 1995 1996 TERM TRENDS Economic ratlos' GDP (billions US$) 32.1 87.2 201.2 225.8 Openness of economy Gross domestic investmentlGDP 23.7 26.1 31.1 31.8 Exports of goods and services/GDP 24.0 23.0 26.4 26.2 Gross domestic savings/GDP 26.6 28.6 32.3 33.2 Gross national savings/GDP .. .. 24.7 25.6 Current account balance/GDP .. . -3.5 -3.5 Savings Investfnen Interest payments/GDP 1.0 2.3 2.5 2.3 Total debt/GDP 35.8 42.1 61.7 56.5 Total debt service/exports .. .. 29.8 37.0 Present value of debt/GDP .. .. .. .. Indebtedness Present value of debt/exports .. 1975-85 1986-96 199 1996 1997-05 (average annual growth) hdonesia GDP 7.0 7.9 8.2 7.6 6.6 -Lower-middle-incomegroup GNP per capita 4.3 6.1 5.8 6.0 5.1 Exports of goods and services -1.0 8.9 8.6 6.3 7.6 STRUCTURE of the ECONOMY 1975 1985 1995 1996 Growth rates ot output and investment t%) (% of GDP) 201 Agriculture 30.2 23.2 17.2 16.315 Industry 33.5 35.9 41.5 42.7 1 Manufacturing 9.8 16.0 24.2 25.2 _ , . . . Services 36.3 40.9 41.4 41.0 91 92 93 94 95 96 Private consumption 64.3 59.6 59.9 59.2 GDI OGDP General government consumption 9.0 11.8 7.9 7.7 Imports of goods and services 21.0 20.5 25.2 24.9 (average annual growth) 1975-85 1986-96 1995 1996 Growth rates of exports nd imports Agriculture 4.2 3.4 4.2 1.9 25 Industry 7.0 9.9 10.4 10.5 20 Manufacturing 14.5 11.2 10.8 11.0 15 / Services 9.0 8.0 7.7 6.9 10. Private consumption 10.0 7.2 9.6 7.4 0 ,l General government consumption 10.5 4.4 1.3 3.8 91 92 93 94 9s ss Gross domestic investment 12.1 10.8 13.5 11.8 Imports of goods and services 8.8 9.4 15.8 9.6 Exports SImports Gross national product 6.5 7.9 7.5 7.5 Note: 1996 data are preliminary estimates. * The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete. - 34 - PRICES and GOVERNMENT FINANCE 1975 1985 1995 1996 Inflation (W Domestic prices (% change) D) Consumer prices 19.1 4.7 5.1 6.6 8 Implicit GDP deflator 11.2 4.3 9.4 8.7 6 4 Government finance 2 (% of GDP) o l l l l l Current revenue .. 19.2 15.5 15.3 91 92 93 94 95 96 Current budget balance .. 6.0 6.4 6.2 Overall surplus/deficit .. -3.2 -0.2 0.9 - DPdef. cI TRADE (millions US$) 1975 1985 1995 1996 Export and Import levels (mill. US$) Total exports (fob) .. 18,823 47,454 50,188 e0,000 Fuel .. 12,804 10,465 11,722 T Rubber .. 714 1,986 1,894 40,000 Manufactures .. 2,287 30,853 32,653 40,000 Total imports (cif) .. 14,056 40,286 44,240 30,000 Food .. 812 3,397 3,852 20,000 Fuel and energy .. 2,870 3,841 4,693 10,000 Capital goods .. 5,394 18,957 20.783 0 S U R E Export price index (1987= 100) .. 121 137 131 90 91 92 93 94 95 96 Import price index (1987= 100) .. 85 127 127 *Exports *IrIports Terms of trade (1987=100) .. 143 108 103 1 BALANCE of PAYMENTS 1975 1985 1995 1996 (millions US$) Exports of goods and services . .. 52,683 58,060 Current account balance to GDP ratio (%) Imports of goods and services .. .. 51,589 56,961 Resource balance .. .. 1,349 1,099 Net income .. .. -7,832 -8,548 Net current transfers .. .. -284 400 1 Current account balance, before official capital transfers .. .. -6,987 -7,849 -2 Financing items (net) .. .. 9,418 11,747 Changes in net reserves .. .. -2,651 -3,898 -3 - Memo: -4 Reserves including gold (mil. US$) 592 13,184 26,139 27,519 Conversion rate (local/US$) 415.0 1,110.6 2,248.6 2,342.3 EXTERNAL DEBT and RESOURCE FLOWS 1975 1J85 1995 1996 (millions US$) Composition of total debt, 1996 Total debt outstanding and disbursed 11.498 36,715 124,398 129,033 (mill. US$) A IBRD 57 3,590 12,503 11,139 11139 B IDA 318 844 756 736 G 736 D 32230 _ _ 5375 Total debt service 1,060 5,823 16,416 21,462 IBRD 2 384 1,875 2,249 IDA 2 12 26 26 E 28911 Composition of net resource flows Official grants . .. 249 190 Official creditors 515 980 1,115 -805 -. Private creditors 1,749 154 2,314 6,971 F Foreign direct investment . .. 4,348 7,986 50642 Portfolio equity .. .. 4,873 3,099 A-IBRD E-Bilateral B-IDA F-Private World Bank program C-IMF G-Short-term Commitments 311 1,068 1,312 1,194 D-Other Multilateral Disbursements 164 777 1,045 905 Principal repayments 0 133 975 1,429 Net flows 164 644 69 -523 Interest payments 3 262 926 846 Net transfers 160 382 -857 -1,370 Development Economics Note: Govemment finance and trade fiscal year (April to March) -35 - ANNEX 3 STATUS OF BANK GROUP OPERATIONS IN INDONESIA IBRD LOANS AND IDA CREDITS IN THE OPERATIONS PORTFOLIO Difference Between expected and actual Loan or Fiscal Original Amount in US$ Millions disbursements a/ Project ID Credit No. Year Borrower Purpose IBRD IDA Cancellation Undisbursed Orig Frm Revised 5 Number of Closed Loans/credits: 162/48 Active Loans ID-PE-3960 IBRD3209 1990 GOI Gas Utilization 86.00 0.00 0.00 18.06 18.1 13.3 ID-PE-3977 IBRD3246 1991 GOI Third Jabotabek Urban Development 61.00 0.00 0.00 12.16 12.2 0.0 ID-PE-3922 IBRD3340 1991 GOI Sulawesi Irian Jaya Urban Development 100.00 0.00 0.00 2.17 2.2 0.0 ID-PE-3928 IBRD3402 1992 GOI Agricultural Financing 106.10 0.00 0.00 38.91 38.9 0.0 ID-PE-3966 IBRD3431 1992 GOI Third Non-Formal Education 69.50 0.00 0.27 4.46 4.7 0.0 ID-PE-3940 IBRD3448 1992 GOI Primary Education Quality Improvement 37.00 0.00 0.00 11.75 11.5 0.0 ID-PE-4012 IBRD3454 1992 GOI BAPEDAL Development 12.00 0.00 0.00 0.30 0.3 0.0 ID-PE-3860 IBRD3464 1994 GOI Treecrops Smallholder 87.60 0.00 0.00 24.00 16.9 0.0 ID-PE-3997 IBRD3482 1992 GOI Fourth Telecommunications 375.00 0.00 0.00 133.53 103.5 0.0 ID-PE-3969 IBRD3496 1992 GOI Primary School Teacher Development 36.60 0.00 0.00 7.02 7.0 0.0 ID-PE-3916 IBRD3501 1992 GOI Suralaya Thermal Power 423.60 0.00 100.00 72.50 139.4 47.1 ID-PE-3914 IBRD3550 1993 GOI Third Community Health & Nutrition 93.50 0.00 0.00 27.66 8.6 0.0 ID-PE-4006 IBRD3579 1993 GOI E. Indonesia Kabupaten Roads 155.00 0.00 0.00 16.65 16.6 0.0 ID-PE-4009 IBRD3586 1993 GOI Integrated Pest Management 32.00 0.00 0.00 11.41 9.9 0.0 ID-PE-3999 IBRD3588 1993 GOI Groundwater Development 54.00 0.00 18.94 10.76 12.1 -0.3 ID-PE-4018 IBRD3589 1993 GOI Flores Earthquake Reconstruction 42.10 0.00 0.00 1.52 1.6 0.0 ID-PE-4007 IBRD3602 1993 GOI Cirata Hydroelectric Phase II 104.00 0.00 0.00 58.79 53.3 0.0 ID-PE-3990 IBRD3629 1993 GOI Water Supply & Sanitation for Low Income 80.00 0.00 0.00 40.70 32.7 13.9 ID-PE-3985 IBRD3658 1994 GOI National Watershed Mgmt and Conservation 56.50 0.00 0.00 43.41 17.4 0.0 ID-PE-3945 IBRD3712 1994 GOI Second Highway Sector Investment 350.00 0.00 0.00 181.42 128.9 0.0 ID-PE-3952 IBRD3721 1994 GOI Skills Development 27.70 0.00 4.91 8.49 13.4 6.0 ID-PE-3998 IBRD3726 1994 GOI Surabaya Urban Development 175.00 0.00 0.00 106.90 57.3 -0.1 ID-PE-4020 IBRD3732 1994 GOI Fifth Kabupaten Roads 101.50 0.00 0.00 19.94 5.9 0.0 ID-PE4010 IBRD3742 1994 GOI Dam Safety 55.00 0.00 0.00 35.55 20.0 0.0 ID-PE-3890 IBRD3749 1994 GOI Semarang-Surakarta Urban Development 174.00 0.00 3.67 94.45 44.9 0.0 ID-PE-4017 IBRD3754 1994 GOI University Research for Graduation Study 58.90 0.00 0.00 31.53 10.4 0.0 ID-PE-3937 IBRD3755 1994 GOI Integrated Swamps 65.00 0.00 0.00 35.27 10.5 0.0 Difference Between expected and actual Loan or Fiscal Original Amount in US$ Millions disbursements a/ Project ID Credit No. Year Borrower Purpose IBRD IDA Cancellation Undisbursed Orig Frm Revised s ID-PE-3910 IBRD3761 1994 GOI Sumatera & Kalimantan Power 260.50 0.00 0.00 206.80 110.1 0.0 ID-PE-3954 IBRD3762 1994 GOI Java Irrigation Improvements and Wtr Resource 165.70 0.00 0.00 99.09 38.2 0.0 Mgmt. ID-PE-3984 !BRD3792 1995 GOI Land Administration 80.00 0.00 0.00 51.51 14.2 0.0 PE-4019 iBRD3801 1995 GOI Second Accountancy Development 25.00 0.00 0.00 17.33 13.4 0.0 ID-PE-3988 IBRD3825 1995 GOI Second Professional Resource Development 69.00 0.00 0.00 36.81 6.3 0.0 ID-PE-3979 IBRD3845 1995 GOI Second Rural Electrification 398.00 0.00 0.00 214.12 162.8 0.0 ID-PE-3951 IBRD3854 1995 GOI Kalimantan Urban Development 136.00 0.00 0.00 68.35 40.8 0.0 ID-PE-3972 IBRD3886 1995 GOI Second Agriculture Research Management 63.00 0.00 0.00 53.57 22.8 0.0 ID-PE-3968 IBRD3887 1995 GOI Book & Reading Development 132.50 0.00 0.00 113.51 3.5 0.0 ID-PE-34891 IBRD3888 1995 GOI Village Infrastructure 72.50 0.00 0.00 3.78 0.0 0.0 ID-PE-4001 IBRD3904 1995 GOI Telecommunications Sector Modernization 325.00 0.00 0.00 300.31 105.3 0.0 ID-PE-3965 IBRD3905 1995 GOI Fourth Health 88.00 0.00 0.00 76.43 10.4 0.0 ID-PE-39754 1BRD3913 1995 GO( Second Technical Assistance for Infrastructure 28.00 0.00 0.00 24.69 13.5 0.0 ID-PE-3978 IBRD3972 1996 GOI Industrial Technology Development 47.00 0.00 0.00 38.83 22.8 0.0 ID-PE-4021 IBRD3978 1996 GOI Second Power Transmission and Distribution 373.00 0.00 0.00 359.99 155.6 8.0 ID-PE-4003 IBRD3979 1996 GOI Second Teacher Training 60.40 0.00 0.00 52.09 20.3 0.0 ID-PE-39643 IBRD3981 1996 GOI STD/AIDS 24.80 0.00 0.00 22.99 13.5 0.0 ID-PE-4008 IBRD3984 1996 GOI Nusa Tenggara Agriculture Development 27.00 0.00 0.00 24.16 3.7 0.0 ID-PE-4011 IBRD4007 1996 GOI Sulawesi Agriculture Area Development 26.80 0.00 0.00 22.95 1.0 0.0 ID-PE-4014 IBRD4008 1996 GOI Kerinci Seblat ICDP 19.10 0.00 0.00 18.44 3.5 0.0 ID-PE-39312 IBRD4017 1996 GOI Second E. Java Urban Development 142.70 0.00 0.00 129.46 65.2 0.0 ID-PE 41896 IBRD4030 1996 GOI Human Resource Capacity Building 20.00 0.00 0.00 19.22 5.2 0.0 ID-PE-37097 iBRD4042 1996 GOI E. Java Junior Secondary Education 99.00 0.00 0.00 95.81 9.5 0.0 ID-PE-4004 IBRD4043 1996 GOI Higher Education Support 65.00 0.00 0.00 51.27 -2.0 0.0 ID-PE-4016 IBRD4054 1996 GOI Strategic Urban Roads 86.90 0.00 0.00 76.83 16.8 0.0 ID-PE-3987 IBRD4062 1997 GOI C. Indonesia Secondary Education 104.00 0.00 0.00 100.10 13.4 0.0 ID-PE-41894 IBRD4095 1987 GOI Sumatra Secondary Education 98.00 0.00 0.00 93.02 2.5 0.0 ID-PE-4052i IBRD4100 1997 GOI Second Village Infrastructure 140.10 0.00 0.00 104.39 15.5 0.0 ID-PE-36053 IBRD4105 1997 GOI Second Sulawesi Urban Development 155.00 0.00 0.00 147.00 29.4 0.0 ID-PE-4026 IBRD4106 1997 GOI Railway Efficiency 105.00 0.00 0.00 105.00 10.0 0.0 ID-PE-42540 IBRD4125 1997 GOI Iodine Deficiency Control 28.50 0.00 0.00 26.99 0.9 0.0 Difference Between expected and actual Loan or Fiscal Original Amount in US$ Millions disbursements a/ Project ID Credit No. Year Borrower Purpose IBRD IDA Cancellation Undisbursed Orig Frm Revised s ID-PE-35544 IBRD4132 1997 GOI Solar Homes Systems 20.00 0.00 0.00 20.00 2.0 0.0 ID-PE-36047 IBRD4155 1997 GOI Bali Urban Infrastructure 110.00 0.00 0.00 106.80 -3.2 0.0 ID-PE-40195 IBRD4193 1997 GOI Undergraduate Education 71.20 0.00 0.00 68.70 2.5 0.0 ID-PE-49051 IBRD4194 1997 GOI BEPEKA Audit Modernization 16.40 0.00 0.00 15.40 1.3 0.0 ID-PE-42882 IBRD4198 1997 GOI Renewable Energy Small Power 66.40 0.00 0.00 66.40 0.0 0.0 ID-PE-36956 IBRD4207 1998 GOI Safe Motherhood 42.50 0.00 0.00 41.15 -1.4 0.0 ID-PE-48715 IBRD4244 1998 GOI Information Infrastructure Development 34.50 0.00 0.00 34.50 2.0 0.0 ID-PE-55755 IBRD4255 1998 GOI Banking Reform Assistance 20.00 0.00 0.00 20.00 0.0 0.0 ID-PE-40061 IBRD4290 1998 GOI Bengkulu Regional Development 20.50 0.00 0.00 20.50 0.0 0.0 ID-PE-36048 IBRD4305 1998 GOI Coral Reef Management Rehabilitation 6.90 0.00 0.00 6.90 0.0 0.0 ID-PE-37095 IBRD4306 1998 GOI Maluku Regional Development 16.30 0.00 0.00 16.30 0.0 0.0 ID-PE-3993 IBRD4307 1998 GOI N. Sumatra Regional Roads 234.00 0.00 0.00 234.00 0.0 0.0 ID-PE-39644 IBRD4308 1998 GOI W. Java Basic Education 103.50 0.00 0.00 103.50 0.0 0.0 Total 7,246.3 0.0 127.8 4,558.3 1,743.5 87.9 Active Closed 00 Loans/Credits Loans/Credits Total Total Disbursed (IBRD and IDA): 2,560.2 16,138.9 18,699.1 of which has been 0.0 7,641.7 7,641.7 repaid: Total now held by IBRD and IDA: 7,118.5 8,542.4 15,661.0 Amount sold: 0.0 88.1 88.1 Of which repaid: 0.0 88.1 88.1 Total Undisbursed: 4,558.3 45.2 4,603.6 a/ Intended disbursements to date minus actual disbursements to date as projected at appraisal. b/ Rating of 1-4: see OD 13.05. Annex D2. Preparation of Implementation Summary (Form 590). Following the FY94 Annual Review of Portfolio performance (ARPP), a letter based system will be used (HS = highly Satisfactory, S = satisfactory, U = unsatisfactory, Note: Disbursement data is updated at the end of the first week of the month. INDONESIA STATEMENT OF IFC'S COMMITTED AND DISBURSED PORTFOLIO AS OF 31-JAN-98 (In US Dollar Millions) Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1971 Unitex 0.00 .35 0.00 0.00 0.00 .35 0.00 0.00 1980/87 Semen Andalas 7.04 10.02 0.00 7.99 7.04 10.02 0.00 7.99 1982/84/93 Saseka Finance 0.00 .38 0.00 0.00 0.00 .38 0.00 0.00 1988 Manulife 0.00 .32 0.00 0.00 0.00 .32 0.00 0.00 1989 PT Agro Muko 2.52 2.20 0.00 2.73 2.52 2.20 0.00 2.73 1989/91/94 PT Astra 0.00 12.16 0.00 0.00 0.00 12.16 0.00 0.00 1990/91/93/95 PT Indo-Rama 32.07 8.72 0.00 51.48 32.07 8.72 0.00 51.48 1991 LYON-MLF-lbis 2.01 0.00 0.00 2.01 2.01 0.00 0.00 2.01 1991 PTArgoPantes 11.25 13.00 0.00 15.14 11.25 13.00 0.00 15.14 1991 PT Indaci 0.00 0.00 1.83 0.00 0.00 0.00 1.44 0.00 1991 PT RIMBA 5.99 .60 0.00 2.50 5.99 .60 0.00 2.50 1991 SEAVI Indonesia 0.00 1.50 0.00 0.00 0.00 1.50 0.00 0.00 1992 PT Swadharma 20.22 0.00 0.00 30.56 20.22 0.00 0.00 30.56 1992/94/96 PTKIAKeramik 25.68 9.12 0.00 84.64 17.19 8.99 0.00 57.13 1992/95 PT Viscose 30.53 0.00 0.00 40.13 30.53 0.00 0.00 40.13 1992/95/97 PT Bakrie Kasei 27.85 0.00 0.00 0.00 27.85 0.00 0.00 0.00 1993 PTNusantara 3.60 0.00 0.00 10.70 3.18 0.00 0.00 10.38 1993 PT Samudera 1.64 5.00 0.00 4.74 1.64 5.00 0.00 4.74 1993/96 PT BBL Dharmala 15.11 0.00 0.00 28.18 15.11 0.00 0.00 28.18 1994 KDLC Bali 6.00 1.14 0.00 0.00 6.00 1.14 0.00 0.00 1994 Prudential Asia 0.00 6.75 0.00 0.00 0.00 4.19 0.00 0.00 1994 PAMA (Indonesia) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1994 PT PAMA 0.00 .71 0.00 0.00 0.00 .71 0.00 0.00 1994 PT Saripuri 6.67 0.00 0.00 16.00 6.67 0.00 0.00 16.00 1995 PT ABS Finance 0.00 1.31 0.00 0.00 0.00 1.31 0.00 0.00 1995 PT Bakrie Pipe 17.14 0.00 9.50 0.00 17.14 0.00 9.50 0.00 1995 PT Bunas Finance 7.10 0.00 0.00 3.00 7.10 0.00 0.00 3.00 1995 PT Grahawita 0.00 0.00 5.00 0.00 0.00 0.00 5.00 0.00 1995 PT Hotel Santika 9.00 0.00 0.00 0.00 6.75 0.00 0.00 0.00 1995 PT KIA Serpih 15.00 6.35 0.00 49.50 15.00 6.24 0.00 49.50 1995 PT Panin Finance 5.14 1.93 0.00 6.00 5.14 1.93 0.00 6.00 1996 PT Dharmala 20.00 0.00 0.00 15.00 20.00 0.00 0.00 10.00 1996 PT Pramindo Ikat 25.00 8.18 25.00 300.00 25.00 3.27 25.00 70.00 1997 PT AdeS Alfindo 24.00 3.53 0.00 46.00 10.29 3.53 0.00 19.71 1997 PT Alumindo 15.00 0.00 0.00 20.00 15.00 0.00 0.00 20.00 1997 PT AstraDian 0.00 1.07 0.00 0.00 0.00 1.07 0.00 0.00 1997 PT Astra Graphia 0.00 2.00 0.00 0.00 0.00 2.00 0.00 0.00 1997 PT Bank NISP 10.00 0.00 0.00 0.00 10.00 0.00 0.00 0.00 1997 PT Berlian 22.00 20.00 0.00 68.00 0.00 8.50 0.00 0.00 1997 PTKalimantan 20.00 15.00 0.00 6.00 11.11 15.00 0.00 3.33 1997 PT Karabha 0.00 10.43 0.00 0.00 0.00 10.43 0.00 0.00 1997 PT Sayap 14.00 0.00 0.00 27.99 10.00 0.00 0.00 20.00 1997 PT Wings 11.00 0.00 0.00 27.01 8.68 0.00 0.00 21.32 -39- Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic Total Portfolio: 412.56 141.77 41.33 865.30 350.48 122.56 40.94 491.83 Approvals Pending Commitment Loan Equity Quasi Partic 1997 NISP A LOAN INCR 5.00 0.00 0.00 0.00 1998 P.T. MEGAPLAST 11.50 2.50 0.00 19.50 1996 PANIN FINANCE II 6.00 0.00 0.00 4.00 1996 PANIN II - BLINC 0.00 0.00 0.00 4.00 1996 PT ASIANAGRO 40.00 0.00 0.00 40.00 1995 PT BAKRIE PIPE 0.00 0.00 0.00 13.00 1995 PT INDO-RAMA RI 0.00 2.50 0.00 0.00 1995 PT VISCOSE II 0.00 5.00 0.00 0.00 Total Pending Commitment: 62.50 10.00 0.00 80.50 - 40 - ANNEx 4 COORDINATILNG MluKEMERt OF THE ECONOwy. FPANwL. ANb INDusThvi C.KACMAN -OF ThI KATIOKA L DEVEOPMENT JPLANNIKC ACE!'CY REPUBLIC OF INWDOESA Jakarta. Indconesia Apri3 8, 1998 Mr. James Wolfensohn4 President, WC orld Bank 18181 l St. NW. Washington, DIC Dear Mr. Wolfensolhn, Thi3 -attachci Starenmeni of 3 )evdopmenL Policy outlines the ac-tions Ind4onesia is imiiplementin,g tco address the futidaniecital causcs of rho curreClt economic cnisis I hese actions have been designed to rebuild confidence and restore sustained rapid grCowth as quick ly as possible, while shieldin,g poor and v-ulnerable groups fi-om hars transit]onal difficuLties. Si nerely yours, -) ~ ~ ~ - Ginandj ar Kartasasm ita SACte Co)rTdinating Mini-ster For Economy, Finance. and Industry Cc: Mlinister of Finance A tac hments -41- STATEMENT OF DEVELOPMENT POLICY I. BACKGROUND 1. For the past several decades, prudent macroeconomic policies and continuing structural reforms have kept Indonesia on a path of rapid economic development. Since the 1970s, economic growth has averaged 7 percent per annum, raising GDP per capita toward the level of middle income countries, while dramatically lowering the incidence of poverty. The economic structure has become diversified, as dependency on the oil sector has declined and an export-oriented manufacturing base has emerged, led by a dynamic private sector and fueled by high domestic savings and large inflows of foreign direct investment. Meanwhile, macroeconomic balance has been maintained: the budget has been balanced; inflation has been contained at relatively low levels; current account deficits have been kept moderate; and international reserves have remained at comfortable levels. 2. Despite this strong macroeconomic performance, a number of underlying weaknesses have made the country vulnerable to adverse external shocks. Structural rigidities arising from regulations in domestic trade and import monopolies have impeded economic efficiency and competitiveness. At the same time, the relative stability of the Rupiah during most of the 1990s, together with high rates of return on domestic investment, encouraged and facilitated high levels of overseas borrowing. An increasing portion of this has been private short-term debt that has been unhedged. By the end of 1997, Indonesia's external debt stood at $134 billion (about two-thirds of GDP), of which $16 billion was short term, while its debt service has remained close to 40 percent of exports of goods and non-factor services. Also, the rapid expansion of the financial system since the late 1980s has left a number of banks with significant amounts of nonperforming loans, straining their liquidity and, in a number of cases, undermining their financial viability. 3. In the wake of the recent currency turmoil in the region, the exchange rate has depreciated to alarming levels. From mid-July last year to early January this year, the cumulative depreciation of the Rupiah reached 70 percent, with over half of this decline occurring since the end of November. Since January, the Rupiah has fluctuated between Rp.8,000 and Rp.10,000 per US dollar, down 65-75 percent from its value in July 1997. The fall in the Jakarta stock exchange index reached 50 percent by December, before recovering somewhat to an accumulated decline of about 30 percent by March, 1998. The enormous depreciation of the Rupiah did not seem to stem from macroeconomic imbalances, which remained quite modest. Instead, the large depreciation reflected a severe loss of confidence in the currency, the financial sector, and the overall economy. 4. The plummeting of the Rupiah has led to very large increases in the Rupiah debt service costs of banks and corporations that had borrowed largely without hedging from abroad. Moreover, since the currency depreciation has engendered a substantial rise in domestic interest rates, the burden of paying for, and collecting, domestic currency loans has also increased, further straining the position of corporations and financial institutions, particularly those that were already weak. A major concern for the Government is that the process has become self-reinforcing: growing strains on firms have amplified investor uncertainty and encouraged capital flight, thereby intensifying pressures on the exchange rate and domestic interest rates. 5. From the outset of the currency crisis, the Government has taken strong corrective action. To discourage speculative attacks, the exchange rate band was widened in July and, in August, in the face of continued pressure on the currency, the Rupiah was allowed to float. This policy was backed by a significant tightening of liquidity conditions and an announcement that the budget surplus would be preserved by postponing major infrastructure projects, cutting low priority development programs, and extending the coverage of the luxury sales tax. At the same time, import tariffs on over 150 items (mainly raw materials - 42 - and other intermediate goods) were reduced effective mid-September, while the 49 percent limit on foreign holdings of listed shares was abolished. Further trade liberalization measures, including removing monopoly restrictions on imports of wheat and wheat flour, soybeans and garlic were announced in November last year. These actions, however, were not sufficient to restore confidence in the Rupiah and the economy. 6. In November, 1997, the Government initiated a program of policy reform, aimed at bringing the economy back to a path of rapid growth, by transforming the economy into one which would be more open, transparent, competitive, and efficient. In spite of actions taken at that time, the economic crisis has deepened during December and early January, making it clear that bolder, and faster, reform was needed to overcome the economy's problems. Accordingly, the Government strengthened this program with a wide array of additional reforms in January, 1998. This program was further strengthened during February, March and April with additional fiscal adjustments, financial sector reforms, efforts to restructure corporate debt, and actions to continue the implementation of structural reforms. This letter describes the Government's overall reform program and the administrative and monitoring arrangements that have been initiated to ensure that it is effectively implemented. II. FISCAL AND MONETARY POLICIES 7. Restoring macroeconomic stability is a critical foundation for restoring growth. To achieve this, the Government will maintain tight monetary policy, keep the budget deficit within reasonable limits, and finance the deficit almost entirely by foreign financing. 8. The Government has a long record of sound fiscal policy and is committed to continuing that pattern. With the sharp depreciation of the Rupiah and the slowdown in economic growth, though, the fiscal balance is being strained by the rise in Rupiah cost of debt servicing, losses of tax revenue and costs associates with subsidies and bank restructuring. The budget strikes a balance between preventing undue deterioration of the fiscal position and avoiding an excessive fiscal contraction. After running a fiscal surplus of close to one percent of GDP in FY1996/97 and a balanced budget in FY1997/98, the current crisis calls for a budget deficit of nearly 4 percent of GDP in FY 1998/99. This has been agreed with the IMF. 9. In view of the importance of containing the fiscal deficit by limiting expenditures and focusing them on priority areas, the Government will, by June 1998, complete a public sector expenditure and investment review. This review is being carried out with technical support from the World Bank, and will result in a comprehensive program to improve fiscal efficiency, and restructure state-owned enterprises. Without waiting for this review, though, the following actions have already been taken to consolidate public finances: * all budgetary and extra-budgetary support and credit privileges granted to IPTN (the airplane development company) have been discontinued; * the program for bringing non-tax revenue onto the budget is being accelerated, with Reforestation and Investment Funds already being incorporated in the central government budget; * twelve major infrastructure projects have been canceled, including the Tanjung Jati-C power plant; * excise taxes on alcohol and tobacco have been increased by 80 and 100 percent respectively; * VAT exemptions have been removed and a 5 percent local sales tax introduced on gasoline. 10. To mitigate the worst consequences of the crisis on the poor, price increases for essential goods will be restrained by subsidies. The price of sugar, wheat flour, corn, soybean meal, and fishmeal are being increased to focus the Government's capacity to subsidize food on the most important items for the poor - rice and soybean. But government may continue to subsidize all these items until October 1, 1998. By then, price increases, together with exchange rate movements, are expected to eliminate the subsidy on all food -43 - items except rice and soybeans. The subsidy of soybeans will also be eliminated after the exchange rate is stabilized at a reasonable level. Fuel and power prices are being increased over time to phase out subsidies. During the transition period, fuel subsidies will be concentrated on kerosene and diesel because of the importance of these items to the poor. Fuel and power price adjustments will begin with a weighted average increase of over 50 percent by June 30, 1998. 11. The public expenditure review will also be the basis for an accelerated program of privatization. In the near future, oversight of public enterprises will be moved to the State Minister for Empowerment of State Enterprises. A clear framework will be established for the management and privatization (either through share flotation or negotiated enterprise sales) of government assets, including: (i) criteria for determining whether enterprises should be closed, restructured or fully privatized; and (ii) a transparent sales process that maximizes the return to the Government and treats all bidders equally. Action plans for every public sector corporation will be completed by end-September 1998. 12. The Government is accelerating privatization and taking decisive action to restructure or close poorly performing enterprises. By end-June 1998, 12 enterprises will be identified for early privatization. Seven of these will be privatize during FY1998/99 and the others prepared for privatization. In all of these cases, the Government intends to go beyond the recent pattern of seeking minority shareholders in public enterprises by selling controlling, or even complete, stakes to the private sector. In addition, further tranches of government-controlled shares in public enterprises which are already listed will be offered for sale, so that these enterprises, too, can be fully privatized. 13. As for those enterprises remaining within the public portfolio, clear profit and performance targets will be established, which will be made public and reported upon annually. Nonviable enterprises will be closed. 14. To generate additional revenue, the Government is increasing certain taxes and improving tax administration. These changes include (a) increasing the number of goods subject to the luxury sales tax; and (b) increasing the proportion of the market value of land and buildings assessable for tax to 40 percent for plantations and forestry property. In order to improve tax administration, the Government intends to introduce a single taxpayer registration number. The annual audit coverage of income tax returns is being increased. The VAT audit programs are being improved for large potential taxpayers, and an intense effort is being made to increase the recovery of tax arrears. The efficiency of public expenditure will be increased, through the introduction of a comprehensive and transparent system to report on the accounts of the public sector, especially quasi-fiscal operations. 15. The Government is committed to strengthening the transparency of public-private sector decision making and to securing efficient private participation in the provision of public infrastructure in a manner that achieves an equitable sharing of risks and rewards. To this end, the Government has already issued Keppres 7 of 1998, establishing cross sectoral rules concerning, inter alia, the selection of projects for private participation and the procedures by which bids are to be solicited and evaluated. The Government is now embarking on further refinement and implementation of this Keppres, including the development of consistent sector-specific rules and procedures. This includes (i) clarifying the scope of this Keppres; (ii) establishing principles that will govern cooperation arrangements; (iii) establishing appropriate criteria and institutional arrangements for project screening, selection and review; (iv) making explicit the requirement for transparent award of projects through competitive bidding processes; (v) strengthening the provisions relating to tariff setting and adjustment/remuneration of private parties; and (vi) refining and enhancing the provisions relating to dispute resolution mechanisms, and support arrangements for "non-commercial" projects. All project proposals will now be subject to this evaluation and competitive tendering. - 44 - 16. The energy sector is particularly important because of its size, and because of effects on the environment and using industries. As indicated in the policy statement issued by the Minister of Mining and Energy on August 21, 1997, the Government is committed to expanding domestic use of natural gas by stimulating the participation of foreign and domestic investors in exploration, production, transmission and distribution. The Government is committed to enabling private ownership of gas transportation and distribution assets, permit gas producers to negotiate contracts directly with large consumers, and establish the basis for transparent regulation, where needed. To achieve this, a new draft law amending UU8/1971 (the current Authority granted to Pertamina) will be submitted to Parliament by December 31, 1998. Fuel subsidies will be phased out, with price increase to begin by July 1998, and an automatic (quarterly) adjustment mechanism that aligns prices with world/regional market levels will be established to avoid any future subsidies build up. The Government is also exploring options for a national per liter fuel tax (in addition to the 5 percent local tax) that is applied at different rates to different products. This tax would enable the pump price of unleaded fuels to be kept lower than that for leaded fuel, and would allow recovery of a proportion of road use costs (especially from trucks). 17. To stabilize the Rupiah and to curb inflation, the Govermnent will pursue tight monetary policy. To this end, interest rates on Bank Indonesia's primary monetary instruments (SBIs) were raised significantly on March 23, 1998. Bank deposit rates also rose in response to this increase in SBI rates. In view of the deposit guarantee that is in place, however, the authorities have limited the increase of the deposit rate of weak banks to the average of deposit rate of a group of strong banks. In the future, Bank Indonesia will adjust its interest rate policy in accordance with developments in prices and in the foreign exchange market. Bank Indonesia has introduced a new facility for providing liquidity support for financially troubled banks with interest rate incentives designed to discourage banks to seek BI support, but not so high as to force banks into insolvency. III. FINANCIAL SECTOR REFORMS 18. For many years, Indonesia's strong economic growth provided little incentive to tackle fundamental weaknesses in the financial system. The system lacked, inter alia: (a) underwriting criteria to assure that loans were analyzed based on adequate knowledge of the borrower's financial position and performance; (b) examination capabilities to assure that loans were classified based on risk or loan collectability; (c) accounting and provisioning rules to assure bank statements reflected financial reality or provided an "early warning" signal of deterioration; and (d) the legal infrastructure to allow contract enforcement, collateral perfection or conversion of collateral to cash when borrowers failed to perform as agreed. Loan approvals were often based on relationships with bank owners rather than creditworthiness or capacity to carry exchange rate risk. These and other unsafe and unsound lending practices led to an unsustainable level of problem loans. Even before the crisis, numerous banks were insolvent or seriously undercapitalized. As a result, when the currency began to depreciate in July 1997, banks were poorly positioned to absorb any further deterioration in their portfolios. Bank liquidity was eroded as borrowers with unhedged foreign currency loans rapidly found themselves unable to service their debts and as the confidence of depositors evaporated, leading to large deposit withdrawals from private national banks. 19. The Government's program of banking reforms has been designed with this background in mind. It has both short- and longer-term objectives. In the immediate term, the goals are to help restore depositors' confidence and to identify and resolve the problems of those banks which are the most seriously illiquid and/or undercapitalized. In the longer-term, the goal is to establish a competitive system which is safe, sound, competitive and properly supervised. To these ends, the Government has: established a comprehensive guarantee program to instill depositor and creditor confidence; linked the guarantee directly to improved governance in and supervision of the banks; and established an Indonesian Bank Restructuring - 45 - Agency (IBRA) to supervise the restructuring, including possible mergers of those banks, and to establish and manage an asset resolution effort to maximize recoveries on the existing stock of bad loans. Finally, the Government will strengthen the policy and institutional and legal infrastructure for banking to support this comprehensive program. (a) Establishment of a Guarantee Program 20. The Government's key short-term objective is to restore depositor confidence, and to increase the resilience of the banking system. To this end, the Government has announced a guarantee that covers all depositors and creditors of locally incorporated banks, including private national banks and state-owned banks. The guarantee covers Rupiah and foreign currency claims processed made the guarantee, with payment of foreign currency claims to be made in Rupiah at the market exchange rate, covers all foreign currency obligations associated with imports of essential commodities, and excludes shareholdings, members of the Board of Directors and their family members, subordinated debt and depositor and creditor claim of controlling shareholders, and deposits offset by bad loan. The guarantee, which will remain in place for at least two years and. will be terminated only after six months of advance notice, includes a fee (based on the value of the liabilities of the covered banks) to help defray the possible costs of the guarantee. The guarantee agreement signed with all locally-incorporated banks requires that all banks party to this guarantee will be subject to operational limits and enhanced supervisory oversight. In addition, the guarantee was made retroactive to cover large depositors of the 16 private banks that were closed in early November, 1997. (b) Strengthening Bank Indonesia Supervisory and Regulatory Capabilities 21. A critical element of the program will be the strengthening of the supervisory capabilities of Bank Indonesia. Over the next two years, internationally recognized experts will provide active support in on- and off-site supervisions, in order to transfer best practices and international experience on bank examination techniques. Loan classification and provisioning rules and the role of collateral have been tightened. More specifically, loan classifications and provisioning rules are now being based on risk assessment rather than solely on delinquency. Reporting requirement for foreign exchange and credit risk will be strengthened with the help of outside specialists. (c) Establishment of the Indonesian Bank Restructuring Agency (IBRA) and Privatization of the State Banks 22. On January 27, 1998, the Government announced the establishment of the Indonesian Bank Restructuring Agency (IBRA) that will operate under the auspices of the Ministry of Finance and will decide on the best course for restructuring unsound banks, including recapitalization, mergers, takeovers, or liquidation. In February, 54 banks (comprising 39 private banks, 4 state banks and 11 regional development banks) were transferred from the regulatory oversight of Bank Indonesia and placed under the auspices of IBRA. By the end of June 1998, the Government will appoint an independent review committee, with high- profile foreign participation, and assisted by an international audit firm, to regularly review IBRA preparations and ensure its sound and transparent functioning. 23. On April 4, IBRA took significant action to protect the banking system and contain the flow of liquidity support from Bank Indonesia to the banks under IBRA supervision. The operations of seven small to medium-sized banks (comprising some 1 percent of the assets of the commercial banking system) were frozen immediately. The operations of these banks were frozen because they had used central bank liquidity support in excess of 500 percent of their total equity and at least equal to 75 percent of their total assets. - 46 - Depositors' accounts at these banks, fully benefit from the government guarantee, and were automatically transferred overnight to the nearest branch of Bank BNI, the largest bank in the country. 24. On the same day, IBRA also placed seven banks under IBRA management with immediate effect. These seven banks (whose assets account for approximately 20 percent of the assets of the commercial banking system) include some of the largest private banks (e.g., BDNI, Danamon) and one state bank. These banks were placed under I]BRA management because they have used liquidity support of more than Rp.2 trillion (comprising 75 percent of total Bank Indonesia lending to the banking system) and in excess of 500 percent of their total equity. These banks will continue their business as usual, but their majority shareholders represented as Commissioners and Directors have signed powers of attorney conferring authority to IBRA to operate the banks. As a next step, IBRA plans to restrict the foreign exchange transactions, increase surveillance and closely monitor the liquidity position of other banks under its supervision. 25. Banks under IBRA.'s umbrella will prepare rehabilitation plans and IBRA will have diagnostic reviews conducted by internationally recognized auditors. By the end of June 1998, portfolio reviews will be completed for banks whose assets total at least 80 percent of the total combined assets of these 54 banks. Findings of diagnostic reviews and rehabilitation plans will be made public. Staff from Bank Indonesia have been placed under temporary secondment with IBRA and have been put in strategic positions in each bank that IBRA supervises. Depending on the review of the rehabilitation plans, IBRA will either monitor the rehabilitation process of the bank according to the plan or will proceed with its restructuring. Under its wing, IBRA will develop a specialized asset management capability to manage and collect the assets acquired in the course of bank restructuring. IBRA will initially be funded by government bonds issued specifically for this purpose, but will hopefully become more self-financing as recoveries increase. IBRA will take over and suspend shareholder rights of banks that fail to meet criteria based on liquidity and solvency ratios. Legal action will be taken against the current shareholders if fraud or malpractice are revealed. 26. IBRA, in coordination with Bank Indonesia and the Directorate General of State Enterprises of the Ministry of Finance will also be responsible for overseeing the announced merger plans of state banks. The Government will seek to increase the strength and efficiency of state banks and to privatize them. To begin the process, Bapindo and Bank Bumi Daya are to be merged, and their good assets separated from their bad assets; the bad assets are to form the basis for IBRA's Asset Management Company, which will specialize in debt collection with the objective of minimizing IBRA's fiscal costs. 27. In preparation for the next steps, the state banks are being subjected to portfolio and system reviews from internationally recognized auditors. The reviews will establish loss provision according to international best practice, and will provide critical information for the segregation of good and bad assets. Strategic partners will be sought for the remaining state banks, to assist in attracting other private sector participation and eventual privatization to the fullest extent permitted under the law. Portfolio reviews will be conducted each subsequent year to assess the evolution of the portfolio quality and will be complemented by financial reviews, the scope of which will be gradually increased to prepare for a full audit to be conducted by internationally recognized auditors, before privatization. 28. The state banks that were not placed under IBRA will also be subject to portfolio reviews, as well as limited financial reviews. The scope of the financial reviews will be increased with time so that a full financial audit can be performed before privatization. Reviews and audits will be conducted by internationally recognized auditors. - 47 - 29. Until their privatization, the Governnent will set the financial and, operational objectives of state banks and monitor their implementation. The Government as majority shareholder in the state banks is responsible for ensuring that the state banks perform according to agreed benchmarks. To this end, the State Minister for Empowerment of State Enterprises will prepare perfornance contracts, including suitable incentives for superior performance, in consultation with the management of state banks. The agreed contract will be the basis against which the above State Minister will judge future performance and determine rewards and/or penalties. State banks that do not meet Bank Indonesia minimum prudential standards will be required to perform in accordance with a regulatory contract drawn up by Bank Indonesia. These contracts will be drawn up annually and separately for each legal state bank entity. (d) Improving the Legal and Supervisory Framework for Banking 30. A critical step in strengthening the policy and institutional infrastructure for banking will be improvements to the legal and regulatory environment for banking. After a thorough review of all banking laws and regulations, the Government will rectify any identified deficiencies and shortcomings. Likely areas of focus would include bankruptcy, banking disclosure, taking and realizing collateral security interests, company law implementation including shareholder rights and governance, and laws and regulations on financial instruments and insurance. Action plans to improve the legal framework will be initiated by end- September 1998 with the assistance of the World Bank. 31. Similarly, in order to increase transparency, quality of information and disclosure in banking, the Government will immnediately require all corporations (including banks) to publish audited financial statements annually. Bank Indonesia will also review the adequacy of data provided in banks' condensed biannual balance sheets with a view to improving the dissemination of information on the financial condition of individual banks. The Government will also require banks to regularly publish comprehensive data on their operations, after a transition period that is expected to be less than 2 years. Banks wishing to publish such data prior to the end of the transition period will be encouraged to do so. 32. Finally, the Government will level the playing field for foreign investors in banking. As part of its WTO negotiations for liberalizing trade in financial services, the Government has decided to: lift restrictions on branching (foreign banks are currently allowed to open only one branch in each of the eight major cities of Indonesia); and bring limits to foreigners' holdings of listed banks in line with government policies for non-fimancial corporations by amending the relevant laws to eliminate restrictions on foreign investment in banks by end-June, 1998 (foreigners can not currently buy more than 49 percent of a listed bank). IV. CoRPORATE DEBT RESTRUCTURING 33. The restructuring of private sector debt is critical to restoring the health of the private sector and relieving pressure on the foreign exchange markets. On January 27, 1998, the Govermnent announced an initiative to facilitate the restructuring of corporate debt. The Government supported a temporary pause in foreign currency debt service (of interest and principal) that started immediately to allow borrowers and lenders time to negotiate a new schedule of principle and interest payments. A "steering committee" of lenders and a "contact committee" of borrowers were formed to facilitate discussion and communication between the two groups. Major lenders to Indonesia comprise banks from Japan, Singapore, the United States, Germany and the United Kingdom. The contact committee represents some 800 of the largest external private sector corporate debtors. A number of proposals concerning the Government's financial involvement in corporate debt workouts were considered by the steering and contact committees, as well as by governnent representatives. The Government has adopted the principles that the final scheme will -48 - minimize the potential loss to the budget, ensure that lenders alone bear the commercial risk, and allow debtors and lenders to renegotiate debts on a bilateral basis. 34. The Government is considering a scheme with features broadly similar to that of the FICORCA scheme adopted by the Mexican authorities in 1983 and which proved to be a powerful tool to encourage debtors and creditors to negotiate and reach agreement on the rescheduling of private debt. Under the scheme, the government wvould sell dollars through a trust (with the central bank as trustee) to private sector debtors who reach agreement with their creditors to restructure their debt on terms that include a minimum grace period for the repayment of principal and a minimum maturity. The dollars would be sold at a price based on current market exchange rates and the trust would provide local currency financing for the purchase. The local currency financing would be repayable in constant monthly installments in real terms (escalating nominal amounts), with the possibility of capitalization of a portion of the interest in the early years. Thus, cash flow requirements for the borrower would be significantly more favorable than under standard market terms. The trust would be obligated to deliver dollars to the debtor (or directly to the creditors if instructed to do so by assignment on behalf of the debtor) as required to meet the repayment terms of the restructured debt as long as, and only as long as, the debtor is not in default of its obligations to service to local currency financing provided by the trust. Thus, the trust and the government would not take any private sector credit risk. The trust would invest the proceeds received by it from the sale of dollars in local currency instruments, such as SBIs. If domestic interest rates remain positive in real terms, the trust (and therefore the government) bears no foreign exchange risk to the extent that the local currency retains its value in real terms. 35. Sound laws and regulations of general application are required to permit the orderly restructuring of corporate debt and operations. For example, the law needs to contain clear guidelines for ranking of creditors. The specialized accounting, valuation, liquidation and legal services required in connection with restructuring, foreign and domestic firms, are available in Indonesia and regionally. The capital market is sophisticated. The expertise is available to design restructuring packages and raise additional financing for the restructured firms. For these reasons direct government involvement in day to day management of the restructuring process could be kept at a minimum. 36. While private markets in Indonesia should be able to manage the process and specific transactional details of restructuring, there are areas where government action or involvement is necessary to facilitate this. These include: * Immediate modification and strengthening of the Bankruptcy Law. The existing law is being modified to provide adequate protection to debtors and creditors during the bankruptcy process. It will include adoption of transparent rules for the evaluation and confirmation of reorganization plans for failing firms and their conversion to liquidation procedures. A final version of the law is expected to be presented to Parliament for approval by end-April, 1998. * Establishment of special-purpose legal institutions. The government is considering the advisability of establishing special commercial tribunals/courts and simpler procedures to facilitate bankruptcy proceedings. These decisions will be talken in concert with the modifications to the bankruptcy law itself. Taking such steps will create strong incentives for Indonesian corporates to maintain payments to creditors. At the same time, it will enhance the confidence of creditors that they have legal recourse if all else fails. * Provision of special suipport for small debtors. Of the 800-900 Indonesian firms with external debts greater than US$1 million, only about 150-200 owe in excess of $50 million. These corporates have the expertise, or access to the expertise, for debt and operations restructuring. Smaller debtors, however, have -49 - neither the skills nor the funds to contract specialized professionals. Government support will consist of information dissemination, seminars, workshops, and limited technical assistance as required. The ADB has expressed an interest in funding such a component. * Strengthening corporate disclosure and governance mechanisms. The pace of adopting new disclosure standards will be accelerated. In the case of firmns undergoing reorganization and undertaking debt restructuring, compliance with these new disclosure standards will be made mandatory as a quid pro quo for forbearance from creditors. Such an approach will enhance the willingness of creditors and financial markets to accept debt-forgiveness and rollover arrangements. V. STRUCTURAL POLICY REFORMS 37. The program of structural policy reform includes: * trade and investment policy changes to increase private sector productivity; * actions to increase the efficiency and transparency of public sector activities; and * policy changes to promote the environmental sustainability of development. (a) Trade and Investment Policy Changes to Increase Productivity 38. Import policy. The Government has already made considerable progress with implementing this policy reform program to open up the economy and to increase competition. BULOG's import monopoly over wheat and wheat flour, soybeans, sugar and garlic has been eliminated. Moreover, to ensure that final consumers obtained maximum benefits from this reform, all restrictions on domestic marketing of these items have been lifted, and subsidies are being extended to all market participants by mid-April. Farmers have already been released from the formal and informal requirements to plant sugar cane. This will rationalize sugar production, allowing inefficient mills to close and giving farmers freedom to switch from growing sugar cane to producing higher valued rice. The only item that BULOG still has an import and marketing monopoly over is rice. Ensuring adequate supplies of rice at affordable prices has become BULOG's priority for the coming months and will be very important in view of the ongoing drought. 39. Second, the medium-term tariff reduction program has been extended to cover chemicals, metal products and agricultural goods, thus leaving motor vehicles and alcohol as the only exceptions from the program to reduce the maximum tariff to 10 percent by 2003. Import tariffs of 15 percent or more were reduced by 5 percentage points in February 1998. To ensure that food price increases are as modest as possible, the Government has reduced tariffs on all food items to a maximum of 5 percent, and has abolished local content regulations on dairy products. At the same time, tariff rates on non-food agricultural products will be reduced by 5 percentage points, and will gradually be reduced to a maximum of 10 percent by 2003. 40. To ensure competition and low prices for inter-island shipping and to encourage efficiency in local ship-building, import restrictions on all new and used ships have been abolished. Excessive exploitation of fishery resources is being avoided by concurrently strengthening the management of fishing. All other remaining quantitative import restrictions, other than those which may be justified for health, safety, environment and security reasons, and other non-tariff barriers that protect domestic production, will be completely phased out by the end of 2000. All special tax, customs and credit provisions for the national car project have been discontinued, and the local content program that provides producers with higher local content with customs concessions will be phased out by the end of 2000. - 50 - 41. Export policy. Punitive export taxes are being phased out to help export growth and to increase efficiency in resource use. Accordingly, export taxes on leather, cork, ores and waste aluminum products, have already been abolished. For other products, however, export taxes cannot simply be eliminated, since they serve as an important means of discouraging over-exploitation of Indonesia's natural environment and ensuring that the Government receives appropriate returns for the use of these resources. In such cases, therefore, export taxes will be replaced by resource royalties, which would protect the environment, while eliminating the bias against production for export, rather than for domestic use. As a first step, by April 22, 1998, export taxes on logs, sawn timber, rattan, and minerals will be reduced to a maximum of 30 percent ad valorem, and appropriate resource royalties imposed. The maximum export tax will be reduced to 20 percent by end-1998, 15 percent by end-1999, and 10 percent by end-2000. Quantitative restriction on the export of palm oil, olein and stearin will be replaced by an export tax not exceeding 40 percent ad valorem by April 22, 1998, and this rate will be reviewed regularly, with a view to reducing it to 10 percent by end-Dec., 1999. 42. The Government will also eliminate all other types of export restrictions, such as quotas, by the end of 2000. The only exceptions, will be either for health and security reasons, or time-bound, temporary, measures introduced in the event of occasional domestic shortages. 43. Investment and pricing policy. Another pressing need in the current circumstances is to encourage foreign investment. Accordingly, the Government has decided that in June 1998 it will issue a revised and shortened negative list of activities closed to foreign investors. As part of this process, the Government has removed restrictions on foreign investment in palm oil plantations and in retail and wholesale trade. These changes will not only compress distribution margins and thereby contain price increases; increased freedom for foreign investment in wholesale trade will help small scale exporters. In November 1997, the administrative retail pricing of cement was eliminated, thus increasing competition in the industry. 44. Domestic marketing and trade reforms. Domestic trade is being deregulated to promote domestic competition and expand the scope of the private sector. As a first, bold step, all of the existing formal and informal restrictive marketing arrangement, including those for cement, paper, and plywood, have been dissolved. Henceforth, no firm will be forced to sell its products through a joint marketing organization, nor be required to pay fees or commissions to it. Neither will any organization be allowed to assign exclusive marketing areas, or to dictate production volumes or market shares to individual enterprises. In the case of cement, restrictions have also been eliminated, so that traders are now free to purchase and distribute all brands of cement in all provinces and export without acquiring permits other than a general exporters' license. 45. Similarly, trade in agricultural products is also being deregulated. Traders have been granted freedom to buy, sell, and transfer all commodities across district and provincial boundaries, including cloves, cashew nuts, oranges, and vanilla. In particular, traders are now able to buy and sell cloves at unrestricted prices to all agents, effective immediately. The Clove Support and Marketing Board will be eliminated by July 1 1998, and the system of quotas limiting the sale of livestock will be abolished by September 30 1998. Furthermore, provincial governments have been prohibited from restricting interprovincial or intraprovincial trade. 46. To support export expansion the Government is now enforcing the prohibition of retribusi (local taxes) at all levels on export goods. To strengthen competition and market integration, the Government will abolish taxes on interprovincial and inter-district trade by April 1, 1999. Any loss of local government revenue will be addressed through a combination of local fuel taxes and transfers from the central government. This deregulation of domestic trade and marketing will integrate the domestic market and - 51 - provide the poor in outer islands with freedom to pursue the highest possible market return for their goods and labor. 47. Strengthening competition laws. Government is committed to back these structural reforms targeted at specific monopolies and cartels with reform of legislation and regulations relating to corporate restructuring and competition policy. The key objective of these changes is to achieve and maintain an improvement in economic efficiency and consumer benefits. This reform will make anti-competitive conduct illegal, including monopolist and monopsonist behavior. The changes will facilitate the merger and acquisition of failing firms by other firms so long as such a merger does not result in a substantial lessening of competition. These provisions will help expedite corporate restructuring through mergers and acquisition and yet provide safeguards against anti-competitive and predatory practices. Considerable work has already been completed with bilateral assistance. Work has begun on draft legal and regulatory reforms to facilitate corporate restructuring (mergers, acquisitions etc.) and to strengthen and preserve competition. An action plan for completing this preparatory work and implementing planned changes will be completed by June 1998. (b) Policy Changes to Promote the Environmental Sustainability of Development 48. To strengthen overall environmental management, the Government will issue the implementing regulations for Indonesia's new environment law, Law No. 23 of 1997 Concerning Environmental Management (UU23/97). As this involves up to 19 regulations and decrees, they will be issued in stages. At least four of the highest-priority regulations (air quality, water quality, hazardous waste management and AMDAL (environmental assessment)) will be issued by June 30, 1998. Issuance of the remaining regulations will be completed by June 30, 1999. 49. To improve urban air quality, the President has already announced the phasing out of lead as an additive in gasoline. The Government will formalize this by April 30, 1998 in a Presidential decree that sets December 31, 1999 as the deadline for achieving phaseout of leaded gasoline sales in Java and Bali, and December 31, 2001 as the deadline for achieving phaseout of leaded gasoline sale nationwide. To encourage use of unleaded gasoline, the Government will ensure, with effect from April 30, 1998, that its pump price is less than that for leaded gasoline with a similar octane number. The Government will also amend the specifications for diesel and gasoline fuels so as to reduce other harmful emissions, will develop and implement a fuel pricing plan, and take other necessary actions to promote the greatly expanded use in motor vehicles of other clean fuels such as compressed natural gas (CNG) and liquefied petroleum gas (LPG). By October 1, 1998, the Government will prepare a comprehensive and carefully costed action plan for implementing its urban air quality improvement plan, issue its revised fuel specifications, and take appropriate steps to reduce impediments that discourage conversion of vehicles to use CNG and LPG. 50. A resource royalty will be introduced for forestry products when export taxes are reduced (i.e., by April 22, 1998) to prevent over-exploitation of natural forest resources and capture a high portion of resource rent as public revenues. The total forestry resource rent tax may include both current log royalty and reforestation levy charges. It will be based on a formula which will relate unit revenues directly to f.o.b. values of logs, and independently estimated efficient cost of their extraction and delivery. Allowances will be incorporated for species, quality and location differentials, on the basis of classifications in existing government regulations governing revenues from logs. This will make the system of fees charged for the use of forestry resources much more like that applying to revenue sharing from oil and gas production. These resource royalties will depend on best estimates of f.o.b. values and operational costs, and be the same for all buyers. The cost and price data, and the resulting royalties figures will be re-estimated at intervals no greater - 52 - than six months. Moreover, the Government will develop and implement a reliable system for monitoring the collection of these fees. 51. To further improve forest resource management, the Government will, by June 30, 1998: lengthen substantially the period of new logging concessions, enact regulations to allow for the sale of concession rights, enact regulations defining a transparent process for concession award, and remove the current requirement that a company must possess a wood processing facility in order to qualify for a concession. Finally, by the end of 1998, the Government, in consultation with other levels of government and other stakeholders, develop an improved methodology for allocating forest land for logging, plantation forestry, or conversion for agriculture, mining, or other uses based on suitability and carrying capacity; complete an updated map showing the correct outer forest boundary; reform the concession system so that forest land is properly valued; develop an effective and independent system for monitoring, controlling and reporting on the management of operations on all forest land, with specific time bound targets for implementation, and with provisions to encourage participation by local communities, and protection of indigenous forest dwellers. The Government will not issue any new licenses and permits for forest land conversion until the system just described is implemented. 52. The Government will develop a policy and strategy to reduce and control pollution caused by domestic wastewater, with particular attention to urban areas, for inclusion in Repelita VII. The strategy will include among other things provision of incentives, resources and capacity for local government to manage domestic wastewater. To avoid overfishing of coastal fish stocks and to control illegal fishing in Indonesian waters, the Government will, by December 1999, develop and implement an effective monitoring, control and surveillance (MCS) system for fishing activities. The Government has just completed negotiating a coral reef rehabilitation and management project (including fishery surveillance) with the World Bank, and will seek additional support ais needed from the World Bank, Asia Development Bank and bilateral agencies, to ensure sustainable management of fishery resources. Until the MCS is in place, the Government is restricting the operation of newly imported fishing boats and new locally manufactured ones above 60 tons to the Exclusive Economic Zone (EEZ). This policy, together with the liberalization of boat imports, will increase the competitiveness of Indonesian fishing fleets in the EEZ which is currently dominated by foreign vessels. VI. INITIATIVES TO SHIELD THE POOR AND SUSTAIN HUMAN INVESTMENTS 53. Indonesia's advances during the last 30 years in poverty reduction and human development have drawn praise, and the Government is determined to use its policy instruments, including the structural reform package, to protect and to continue to build on these achievements. Many aspects of the reform package, e.g., export tax cuts, reductions in tariffs, and the deregulation of domestic markets, will have pro-poor effects by enabling farmers, informal sector workers, and small scale businesses to benefit from exchange rate depreciation and more attractive market prices. The relaxation of import and marketing monopolies together with increased competition in wholesaling and retailing will result in more efficient food markets. However, the Government is aware that such results may not occur instantaneously and that the current economic crisis will reduce the purchasing power of many Indonesians. The economic crisis is already increasing unemployment and threatens to increase the number of poor. Reductions in income for some are inevitable. The Government, has taken, or is initiating a range of measures to contain these possible adverse direct and indirect effects. In this context, the Government plans to use much of the resources provided under the Bank's proposed Policy Reform Support Loan to import food and medical supplies to cushion adverse effects of the crisis and drought on the poor. 54. Providing purchasing power through public works. Late in 1997 the Government increased support for labor-intensive public works projects by allocating an additional Rp. 33 billion in the 1997/98 budget. - 53 - This has been continued with Rp. 1.7 trillion in the 1998/99 budget in anticipation of rising needs associated with the drought and the economic crisis. The Government will continue to allocate additional funds for various urban and rural job creation schemes (Padat Karya, various infrastructure investments) and for the best of the country's different micro-credit programs, to provide minimal purchasing power to the poor. The Government is working closely with Local Community Organizations (LCOs) to extend the coverage of infrastructure and micro credit programs, and will organize a series of national and provincial workshops to develop understanding and to improve the working relationships. 55. The Central Govermnent is helping to build the capacity of local community based organizations to implement public works and rural development schemes. The INPRES scheme is already being used to decentralize decision making for these employment creating schemes. Each year, an increasing share of INPRES funds are going to community managed projects. The ceiling amount of funds for projects in any one village has been increased more than four-fold in the 1998/99 budget and the Government is committed to reviewing and consolidating INPRES amounts to move as much as possible to community and sub-district levels. To ensure that these employment creation projects are established quickly, decision making has been decentralized to the district and sub-district level. The Government is reviewing Kabupaten procurement procedures to expand the scope for local participation in these development projects. This expansion of public works programs to provide minimum income for the very poor is being done with financial support from the World Bank and bilateral agencies. Existing rural development projects are also being restructured to free up funds for community-based works through the Pembangunan Prasarana Pendukung Desa Tertinggal (P3DT) system (village infrastructure projects). For people living in isolated areas that have been particularly hard hit by drought, the Government have and will continue to provide grant food assistance. The Government will work closely with community-based organizations and development LSMs (non- government organization) to achieve this. 56. Ensuring the continued availability of key goods with only modest price increases. Rice production declined about 4 percent in 1997 and is projected to decrease by another 2 percent in 1998. This decrease in production and the depreciation of the Rupiah have combined to increase rice prices by about 30 percent during the last 12 months. The Government, through BULOG, has tried to protect the most vulnerable groups of the population by guaranteeing the supply of rice at reasonable prices. In addition to domestic procurement, BULOG has already ordered 2.5 million tons of rice, of which 1.6 million arrived before the end of March, 1998. BULOG plans to import an additional 2.85 million tons of rice between April 1, 1998 and March 31, 1999. To smooth price changes, BULOG will sell this rice in the market at a lower price than its international cost. Because BULOG is focusing on imports of lower priced rice, the subsidy involved in this approach is expected to be concentrated on the most vulnerable groups of the population. Special efforts are also being made to enhance domestic food production. 57. Pertamina is required to supply petroleum fuels to the domestic market at prices set by the Government, with any consequent financial losses being financed from the state budget. Prices were last increased in January 1993, and in FY1996/97 the subsidy totaled over Rupiah 1.4 trillion. The Rupiah's sharp depreciation has meant that this subsidy increased dramatically in FY1997/98. All products are now being sold at prices well below their international market levels; thus for example, at Rupiah 7,500 to the US$, the VAT-inclusive prices of automotive diesel fuel and kerosene are around 5 cents and 3.7 cents US$ equivalent per liter, respectively. The Rupiah's depreciation has also impacted the electricity sector, with PLN's tariff having been reduced from an already insufficient US 6.7 cents equivalent per KWh in mid-1997 to only around US 2.5 cents equivalent per KWh at the above exchange rate. The Government has committed to phasing out subsidies on oil fuels and electricity by the end of 2000 in a manner that will soften the impact on the poor and vulnerable. In particular, the initial increases for kerosene and diesel oil-the fuels whose prices most affect the lower income groups-will be lower than for gasoline and other products. - 54 - 58. Maintaining service delivery in basic education and health. The direct consequences of the economic crisis and the drought are likely to bring adverse education and health effects in their wake. For instance, primary and junior secondary enrollment will fall if parents find they cannot afford various costs associated with school attendance. Meanwhile, income reductions, price increases and food shortages may result in greater malnutrition and vulnerability to communicable disease and other health problems linked to micronutrient deficiencies. Income cuts and price increases may make contraceptives less accessible and could result in fertility increases, especially among low income groups. The Government is committed to allocating sufficient resources to sustain delivery of basic education and health services, each of adequate quality, to the poor, and to safeguarding health through communicable disease control efforts. In these sectors, resources will be used not only to preserve present levels of coverage by health and education facilities and staff, but to ensure that the quality of services provided remains adequate. To this end, the Government is committed to allocating substantially increased resources to finance essential drugs provided through the country's network of rural and urban health centers and public hospitals together with the vaccines and drugs needed for commuXnicable diseases control. Due to their high import content, the prices of essential drugs have risen sharply and inventories and stocks have been depleted. Increased allocations will also include resources required to finance a long planned inclusion of hepatitis-B in the group of childhood diseases covered by publicly provided immunization services. In response to price increases, funding will also be directed to reagents and materials required for drug and vaccine quality control and for hospital and health center laboratory work; equipment and crucial consumables needed to sustain hospital emergency room services; and the purchase of oral pills and other contraceptives 59. In order to design a sustainable medium term health strategy, the Government, with assistance from the World Bank, will (a) assess the sustainability of Government health service delivery; (b) evaluate the competitiveness of pharmaceutical/vaccine production; and (c) develop a strategy to extend pre-paid health finance mechanisms. All three parts will be done by about the end of 1998. 60. The Government is also committed to maintaining high rates of participation in education and improving learning achievement, especially in basic education (grade 1-9), in both public and private schools. One key initiative concerns the continued enrollment of children from poor households. About 4.5 million primary school students (15 percent of enrollment) and 800,000 junior high school students (10 percent of enrollment) need financial assistance to remain in school. Existing allocations and programs are not sufficient to cover even half this need. The Government is determined to provide the funds required to cover the 3 million needy primary students and 0.5 million needy junior high school students not currently covered. To achieve this, the Government will provide expanded funding for scholarships for needy primary and junior secondary school students. 61. The Government also reaffirms its intention to proceed with other major initiatives directed at strengthening basic education enrollment and quality. These include improving the management of schools, upgrading teaching quality and strengthening management of teacher recruitment and allocation. These measures will also inclucle operationalizing the decision to make the local government responsible for the coverage and quality of basic education. VII. ADMINISTRATION AND MONITORING 62. President Soeharto himself is heading up the implementation team for this policy reform program. He has appointed and chairs a Council composed of senior advisor Prof. Dr. Widjojo Nitisastro (Deputy Chairman), Antony Salim (Secretary General), the Coordinating Minister for Economics, Finance and Industry, Minister of Finance, Governor of Bank Indonesia, Minister of Industry and Trade, Minister of the -55 - State Secretariat, Minister of Foreign Affairs, Minister for Empowerment of Public Enterprises, Mr. Subowo, and Mr. Radius Prawiro. 63. Day-to-day work on implementation is being led by the Coordinating Minister for Economic, Finance and Industry and a team of experts. In response to the serious nature of this economic crisis, the majority of structural reforms included in this program have already been implemented. Financial sector reform and restructuring of private corporate debt is underway. The Government is determined to fully implement this program and to monitor both progress with reform and social development. To this end, the Government welcomes independent monitoring of the program provided by the World Bank and by the other international financial institutions and bilateral. 64. The Government is committed to monitor transitional effects of the economic crises (currency and drought related) in order to be in a position to regularly modify programs so that they achieve the best possible results. To do this, the Government will regularly compile up-to-date information on changes in key indicators of household welfare and the availability of basic services during the coming months, and will make it public in a timely manner. The Central Bureau of Statistics is being given responsibility for this monitoring effort and will collaborate with the Ministries of Social Welfare, Education and Culture, Health, and Manpower, other Ministries as appropriate, and the National Family Planning Board. They will seek assistance from the World Bank, ADB and bilateral donors, as needed, to undertake this important task. 65. The Government will regularly collect information on the realization of public expenditures for health and education, the effects of policy changes outlined in this letter, and on social and economic developments more generally. This monitoring will cover at least the following information: * actual spending on drugs, vaccines, and contraceptives, as well as primary and junior secondary school scholarships targeted at the poor; * availability and quality of essential drugs (including contraceptives) and vaccines; * educational enrollment, especially in grades 1 through 9; * inmmunization rates; * nutritional status of children under 5 years old; * income and/or consumption; * employment and wages; * prices of essential commodities; and * food production. 66. This monitoring effort will draw on existing data resources as much as possible. Only when there is no currently available data source will additional surveys be initiated. Monitoring may also involve participatory techniques to assess the nature of social changes in more depth and the implementation of community-based public works programs and food subsidies. The Government will seek World Bank assistance while designing questions and survey instruments for this purpose, including the frequency of reports. Information will be made publicly available quarterly and within 3 months of the collection date. The first report will be no later than June 1998. - 56 -