Report No. PID6344 Project name Indonesia-Policy Reform Support Loan Region East Asia and Pacific Sector Structural Adjustment Lending Project ID IDLL56230 Borrower The Republic of Indonesia Implementing Agency Coordinating Ministry for the Economy, Finance and Industry Taman Suropati No. 2 Jakarta, Indonesia Telephone: 62 21 3843655; Facsimile: 62 21 334779 Date this PID prepared May 6, 1998 Appraisal date April 3, 1998 Projected Board date May 19, 1998 Country and Sector Background 1. 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. With per capita income surpassing $1000 in 1996, Indonesia joined the ranks of lower-middle income countries. 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. 2. 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. Large private capital inflows became large outflows and the value of the Rupiah 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 postwar era. 3. Indonesia has struggled to overcome this crisis with a series of initiatives, including reform program agreed with the IMF in October and in January. The first of these emphasized financial sector reforms. The second included far-reaching structural reforms. But neither of them managed to restore confidence. These efforts were dealt a further blow in February when the Government announced it was considering introducing a currency board system in an effort to stabilize the Rupiah. Uncertainty regarding the composition of the new Cabinet was removed when it was installed on Mach 16. Since then the new Government has held extensive discussions with the IMF, the ADB, and the World Bank to develop a more comprehensive response to the crisis. This is the reform program the proposed loan is to support. Loan Objectives 4. 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: - actions to increase the efficiency and transparency of public sector operations; - financial sector reform and principals for a framework for restructuring corporate debt; - structural policy reforms to increase productivity, improve governance and ensure environmental sustainability; and - actions to protect the poor and to continue investments in education and health. Loan Description 5. The proposed loan would provide balance of payments assistance to the Republic of Indonesia to support policy reforms covering the four points listed in the preceding paragraph. Examples of the policy reform actions supported under each point are summarized below. 6. Actions to increase public sector efficiency and transparency: complete a review of public sector expenditures; increase petroleum product and power prices; establish guidelines for private participation in provision of infrastructure; and accelerate privatization. 7. Financial sector reform actions: tighten reporting requirements for foreign exchange and credit risk; complete portfolio reviews for banks that account for at least 80 percent of the assets of banks under IBRA supervision; remove restrictions on foreign investment in banks; establish a framework that defines GOI's participation in restructuring private corporate debt; modify and strengthen bankruptcy laws; and achieve private participation in all state banks. 8. Structural policy reforms to increase private sector efficiency, improve governance and protect the environment: remove restrictions on foreign investment in wholesale and retail trade; reduce import tariffs; ensure that all traders are free to compete with BULOG on all goods except rice; introduce a system of resource royalties and reduce export taxes on logs, sawn timber and rattan; dissolve the Clove Support and Marketing Board; abolish taxes on inter-provincial and inter-district trade; adopt an action plan for enacting legislation and regulations relating to competition and corporate restructuring; issue all implementing regulations needed for the new Environmental Law; allow transferability by sale of forest concession permits, remove the requirement to have a processing facility in order to hold a concession, develop an effective surveillance system to avoid overfishing, and eliminate the use of lead in gasoline. 9. Actions to strengthen social safety nets and protect the poor: expand community-based, labor-intensive public works; import a further 3 million tons of rice; phase out food subsidies over time; ensure adequate resources for basic education and scholarships for an additional 3.5 million poor primary and junior secondary school students; and ensure adequate resources for primary health services, including communicable disease control and family planning. -2- Financing 10. A total of US$1 billion is proposed for this adjustment loan. The amount is based on an overall external financing plan worked out with the Government and IMF. 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. The proposed loan has two tranches, the first of $600 million and the second of $400 million. Implementation 11. 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 implementation is being led by the Coordinating Minister for Economics, Finance and Industry and a team of senior Government officials. The Central Bureau of Statistics is responsible for monitoring key social indicators, and is finalizing a monitoring plan with inputs from the UNDP, UNICEF, ADB and the World Bank. Risks 12. There are substantial political, social, economic and implementation risks associated with the reform program and hence this operation. These risks have 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 labor intensive public works. Pressure on the Government budget is being lessened by reducing food and 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 are being eased through continued technical assistance from bilateral and multilateral sources and increased private sector involvement. However, these measures reduce rather than remove these risks. Restoring confidence and rapid economic growth will take time and will require perseverance. Environmental Aspects 13. No environmental assessment is required for structural adjustment lending. However, the proposed loan incorporates policy reforms to improve environmental management in Indonesia and measures to minimize adverse environmental impacts. Program Objective Categories 14. The proposed loan contributes to poverty reduction, environmentally sustainable development, financial institutions, natural resources management, economic management, and private sector development. Contact Point: The InfoShop The World Bank 1818 H Street, N.W. Washington, D.C. 20433 - 3 - Telephone No. (202)458 5454 Fax No. (202) 522 1500 Note: This is information on an evolving project. Certain activities and/or components may not be included in the final project. Processed by the InfoShop week ending May 8, 1998. - 4 -