Public Information Notice No. 06/91

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation and Fifth Post-Program Monitoring Discussions with Indonesia

August 7, 2006

On July 31, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the 2006 Article IV consultation and the fifth post-program monitoring discussions with Indonesia.¹

Background

Over the last few years, Indonesia has continued to make steady economic progress, despite some major natural disasters. In 2005, growth reached its highest level in nine years while macroeconomic vulnerabilities have been declining. The debt-to-GDP ratio has been halved since 2000, banking sector performance has improved, and corporate vulnerabilities have been reduced. S&P recently upgraded Indonesia's external and local currency debt ratings up one notch to BB- and BB+, respectively. The government's key objective is to accelerate growth to 6-7 percent and reverse the rising trend in unemployment.

In early 2006, economic activity slowed as a result of fuel price and interest rate adjustments implemented in the fall of last year in order to restore financial market confidence. After peaking at 18 percent in October 2005, inflation has moderated as the tight monetary stance has constrained domestic demand growth. High interest rates also triggered significant capital inflows in early 2006 leading to substantial accumulation of international reserves and enabling Indonesia to make early repayments to the Fund. While Indonesia was initially hard hit by the turmoil in emerging markets in May/June, the rupiah and stock prices have recently recovered a part of their losses.

Real GDP is projected to pick up in the second half of the year and reach 5.2 percent in 2006, supported by an expected gradual reduction in interest rates and an acceleration in government spending from the very low levels of 2005; the central government's deficit is budgeted to rise by 1 percentage point to 1.2 percent of GDP. At the same time, inflation is on track to reach the lower bound of Bank Indonesia's 7-9 percent target range. The current account is expected to remain in surplus in 2006, partly as a result of lower oil imports following the fuel price increase.

That said, there are some short-term downside risks to this generally favorable outlook. Further tightening in global financial markets could prevent the planned easing in domestic interest rates and the government needs to substantially accelerate spending in support of domestic demand. Higher international oil prices could also have an unfavorable impact on the budget, growth and inflation.

In the banking sector, performance has been on a steadily improving trend and private banks appear to have weathered the recent slowdown in growth and rise in interest rates quite well. Banks are on average well capitalized. However, nonperforming loans (NPLs) at the two largest state-owned banks rose substantially in 2005 and governance remains weak. To address weaknesses in the financial system, the government released in July a package of financial sector reforms that will help resolve state banks' NPLs, foster improvements in banking supervision, and facilitate the development of the nonbank financial sector.

For the medium term, the government has adopted a comprehensive reform agenda to strengthen public institutions, improve the business climate and boost growth. If implemented, these reforms will remove some of the main obstacles to private investment, and contribute to a more flexible labor market and more efficient public administration, thus contributing to an acceleration in growth.

Executive Board Assessment

Executive Directors expressed their deepest sympathies to the people of Java and Sumatra who have suffered recently from earthquakes and tsunamis.

Directors commended the authorities on Indonesia's considerable achievements since the crisis. They noted that real GDP has returned to pre-crisis levels, public debt is on a declining trend, and creditworthiness has improved. The bold policy actions taken last fall and continued sound macroeconomic management have helped to reestablish policy credibility and resulted in large capital inflows with reserves reaching record highs. While Indonesia did not escape the sell-off in global financial markets in May/June, asset prices have been recovering in recent weeks.

Looking ahead, Directors considered that the key challenge facing the country remains to boost economic growth in order to make further progress in alleviating poverty and reducing unemployment. To this end, they encouraged the authorities to accelerate the implementation of their structural reform agenda that aims to enhance investor confidence and promote private-sector led growth. Directors also noted that continued pursuit of prudent macroeconomic policies will remain essential to further reduce vulnerabilities.

Directors saw some scope for a cautious easing of macroeconomic policies in 2006 to support growth. Accordingly, they noted that, after a slowdown in late 2005 and early 2006, economic activity is expected to regain momentum in the second half of this year, with interest rates likely to decline and government spending likely to accelerate in the coming months. Nevertheless, they drew attention to some downside risks. A tightening in global liquidity conditions and higher international oil prices could prevent the planned easing in domestic interest rates and slow the recovery in domestic demand.

Directors commended Bank Indonesia for its cautious approach in cutting interest rates. They agreed that—while there is scope for further reduction in interest rates in the coming months, given that inflation has been trending down and domestic demand remains relatively subdued—the pace and timing of these cuts would also need to take into account developments in global financial markets. Directors also praised Bank Indonesia for its efforts to improve clarity and consistency in conveying its monetary policy intentions, which have helped to strengthen the credibility of its inflation-targeting framework among market participants.

As regards the exchange rate, Directors noted that, despite some real appreciation recently, the rupiah seems broadly in line with fundamentals. While agreeing that Bank Indonesia had appropriately taken advantage of the rupiah appreciation earlier in the year to enhance reserve coverage, Directors emphasized that intervention should continue to be limited, in a symmetric way, only to smooth fluctuations in the exchange market and thus reduce volatility.

Directors noted that there is scope for fiscal policy to support activity in 2006, while firmly pursuing fiscal prudence. They agreed that the overall deficit targets for 2006 and 2007 are appropriate. Directors welcomed the government's efforts to avoid the spending shortfalls that had occurred in 2005 by simplifying procurement and budget execution procedures. The planned expansion of the fuel cash compensation program should also help support domestic demand. Directors suggested that these actions must be accompanied by improvements in expenditure management and monitoring systems to ensure the quality of outlays and prevent corruption, as well as in project implementation skills at the regional and local levels. They also recommended that, as domestic demand strengthens sufficiently, the authorities should consider reintroducing a mechanism for automatic adjustments of energy prices to depoliticize these adjustments and remove the risk of higher subsidies in the future, while taking into account the need to establish an adequate safety net for vulnerable groups.

Directors welcomed the authorities' intentions to address banking sector vulnerabilities and strengthen financial intermediation in the context of the recently announced financial sector reform package. In particular, they stressed the importance of dealing with the problems at the two largest state banks, where NPLs have risen considerably in the past year and governance remains weak. They commended the authorities on their intention to allow state banks to take haircuts on NPLs, which would give the banks the necessary tool to resolve NPLs, and recommended that this problem be addressed promptly.

Directors supported the medium-term privatization of state banks that do not have a public policy objective. In the meantime, governance could be improved by allowing private shareholders to participate in their management. As regards private banks, Directors were encouraged that these banks have weathered relatively well the current slowdown in activity and the rise in interest rates. Nevertheless, they stressed that bank supervisors will need to remain vigilant to any deterioration in credit quality. Directors encouraged the authorities to participate in a Financial Sector Assessment Program (FSAP), as this could help identify areas for further improvement in the financial system.

Directors commended the authorities for putting together an impressive reform package to improve the business climate and boost growth. However, they emphasized that it is essential to implement these measures in a forceful manner, to jump start investment. In particular, early approval of one or two laws currently under consideration would bring immediate benefits for trade and investment and help restore business confidence. In this context, they also stressed the need to modernize the legal framework.

Directors also underscored the importance of speedy implementation of fiscal reforms currently under consideration. Adoption of the tax package now before parliament, along with modernization of the tax department, will help enhance revenue collection while restoring investor confidence. The government's intention to better manage the potential risks stemming from the operations of public enterprise and private-public partnerships was also welcomed by Directors.

While acknowledging the political difficulties, Directors emphasized that the authorities need to press ahead with establishing a balanced framework for labor-business relations. Such a framework should protect the rights of workers but also be more business-friendly. More flexible labor markets would help Indonesia become more competitive vis-à-vis neighboring countries and should encourage employers to hire new labor more freely.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with all member countries, usually every year. Post-Program Monitoring provides for frequent consultations between the Fund and members whose Fund arrangements have expired but who continue to have substantial Fund credit outstanding. Particular focus is placed on policies that have a bearing on external viability. For both purposes, a staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the July 31, 2006 Executive Board discussion based on the staff report.