Public Information Notice No. 05/38

Public Information Notice: IMF Executive Board Concludes Second Post-Program Monitoring Discussion with Indonesia

March 22, 2005

On February 14, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the second Post-Program Monitoring Discussion with Indonesia.¹

Background

Last year saw landmark accomplishments, but also a major tragedy in Indonesia. The parliamentary and the first direct presidential elections were conducted peacefully, with President Yudhoyono's new government taking office on October 20, completing a historical transition. Moreover, macroeconomic and financial market developments were on the whole favorable. Toward the end of the year, the tsunami disaster resulted in untold loss of lives and human suffering, as well as severe damage to property in the province of Aceh.

The economy performed well in 2004, helped by sound macroeconomic policies. Real GDP growth is estimated at 5 percent, with private consumption the main driver behind the recovery, although private investment and exports showed signs of recovery. Inflation ended the year at 6½ percent. Buoyant tourism and non-oil exports, coupled with high oil and gas prices helped keep the current account in surplus. International reserves remained adequate at $36 billion or 159 percent of short-term debt.

Macroeconomic policies contributed importantly to these favorable developments. The fiscal deficit was reduced from 2¼ percent of GDP in 2003 to 1½ percent of GDP in 2004² and public debt declined from 59 percent of GDP in 2003 to an estimated 53 percent of GDP in 2004. Bank Indonesia's conduct of monetary policy helped contain financial market pressure during the spring months and kept inflation in check.

Important progress was made on financial sector reforms in 2004. Bank Permata, the last of the IBRA banks, was returned to private ownership, and the government divested part of its remaining shares in Bank Danamon and Bank Niaga. Although overall banking sector performance improved, aided by the decline in interest rates, asset quality, especially at state banks, remained weak. The deposit insurance law was passed and a schedule to gradually phase out the blanket guarantee system, starting in April 2005, has been announced. Less progress has been made in improving the private investment environment, where weak implementation and enforcement of legislation, poor governance, and labor market rigidities remain key concerns.

Financial markets have been strong, reacting favorably to the presidential elections and the new government's announced economic policy intentions. The stock market was up by 45 percent last year and the exchange rate has recovered from its lows in early June. The financial market strength has continued in the aftermath of the tsunami disaster, reflecting markets' assessment that the disaster will have limited impact on the overall economy, that reconstruction costs will be largely covered by donor flows, and that the new government is committed to sound economic policies. Indeed, the government recently announced its four-pronged medium-term strategy, focused on (i) ensuring security, (ii) improving governance, (iii) generating growth and employment, and (iv) enhancing infrastructure.

To manage and coordinate immediate relief to the tsunami-affected areas, the Indonesian government set up a Joint Disaster Management Center with the United Nations at the office of the Vice-President on January 11. The Ministry of Planning, with the assistance of the World Bank, the Asian Development Bank (AsDB) and the Fund, has completed a preliminary assessment of the damage and the associated replacement costs, which indicates that the total replacement costs could be in the $4-5 billion range. At the Consultative Group meeting for Indonesia on January 19-20, donors pledged nearly $4 billion to finance reconstruction spending in 2005-2009. In addition, several private donors, as well as domestic and international non-governmental organizations (NGOs), are providing substantial financial support and help in immediate relief operations.

Indonesia's economic performance is expected to improve in 2005 with GDP growth projected at some 5½ percent, underpinned by continued strong growth in consumption combined with a recovery in investment. While the economy of Aceh has been severely hit by the tsunami, the province's contribution to national GDP is only about 2 percent, and the negative supply side effects will be offset by reconstruction spending so that the net impact on growth will be minimal. Moreover, inflation is expected to generally remain in the 6 percent range, notwithstanding in the pick-up registered in January. Fiscal consolidation is set to continue with the government aiming at budget deficit of around 1 percent of GDP in 2005, which would allow further reduction in the debt-to-GDP ratio. Over the medium term, Indonesia's economy could grow in the 6-7 percent range, provided that the government follows through with its economic agenda.

Executive Board Assessment

Executive Directors expressed deep sympathy for the losses suffered by Indonesia in the wake of the earthquake and tsunamis at the end of last year, and commended the authorities on moving expeditiously to put together a plan for disaster management and for medium-term reconstruction and rehabilitation. Directors welcomed the generous international financial assistance for the tsunami relief and reconstruction efforts, and looked forward to its prompt delivery. Directors also welcomed the commitment of the authorities, at the highest level, to economic reforms, including prudent macroeconomic policy and accelerated structural reforms to improve the investment climate, while addressing the urgent need for reconstruction of Aceh. Ultimately, it will be the fundamental economic reforms that will help Indonesia realize its economic potential and address its unemployment and poverty problems.

Directors welcomed the favorable performance of the Indonesian economy last year, against a backdrop of parliamentary and presidential elections. Over the last few years, Indonesia has made considerable progress toward achieving macroeconomic stability, lowering public debt, restoring a healthy banking system, and reducing vulnerabilities. Maintaining stability, while broadening reforms to attract private investment, will be key for placing Indonesia on a high and sustained growth path. In this context, Directors noted that the government's medium-term strategy is appropriate and, if fully implemented as envisaged, will help Indonesia achieve its objectives. They emphasized that the election has given the new government a strong mandate to tackle the needed economic reforms.

Directors commended the authorities for their continued emphasis on fiscal consolidation, which will help to further reduce the public debt burden and vulnerabilities. They congratulated Indonesia on its success in reducing the budget deficit last year, despite it being an election year, and welcomed the new government's commitment to continued fiscal prudence. In this context, they noted that externally-financed reconstruction spending may raise the deficit somewhat in 2005, from its previous target, but were pleased to learn that the government is still committed to an underlying budget deficit of 1 percent of GDP. Directors welcomed the authorities' efforts to coordinate the relief and reconstruction efforts efficiently, and to ensure the transparent allocation and effective use of international aid.

Directors urged the authorities to continue their efforts to improve tax administration so as to raise non-oil revenues. This will help avoid undue reliance on oil revenues and strengthen the budget position. In this regard, Directors expressed concern about the government's plan to provide a tax amnesty, and urged caution in ensuring that this does not result in revenue losses, as often seen in other countries. Directors welcomed the government's intention to reorient public expenditures toward more productive and growth-oriented spending. In particular, they saw merit in the authorities' plans to phase out the fuel subsidy and to channel the savings to development spending, including infrastructure, health and education. A strengthening of budget management will underpin the efforts to establish a better budget structure. Directors also agreed that private sector participation in much needed infrastructure investment could complement government efforts, but noted that it will be important to ensure that this does not create unfunded liabilities, in particular through the establishment of a transparent institutional framework and appropriate risk management. Directors also encouraged the authorities to consider developing a comprehensive debt management strategy, including with a view to reducing vulnerabilities to exchange rate risk.

Directors commended Bank Indonesia (BI) for its conduct of monetary policy, which had helped to contain financial market pressure during the spring of last year and to keep inflation in check. Looking ahead, Directors welcomed the BI's readiness to act to avoid any re-emergence of inflation. They also supported the authorities' intention to move to formal inflation targeting, and encouraged the authorities to continue to work on the necessary preparatory steps.

Directors emphasized the need for continued efforts to ensure a banking system that is sound and supportive of economic growth. To this end, Directors urged the authorities to address weak asset quality and governance, especially at state banks, and to further strengthen bank supervision. In this regard, several Directors also stressed the importance of the government refraining from directed lending. Directors congratulated Indonesia on the passage of the deposit insurance law and urged the authorities to gradually phase out the blanket guarantee system per the adopted timetable.

Directors welcomed the new government's commitment to improve the investment climate and underscored the need to take early and decisive action to help bolster investor confidence. In this context, early action to resolve investor disputes will be important, as will strengthened implementation of legislation, improved governance, enhanced labor market flexibility, and a better regulatory environment facilitating private sector investment, including in infrastructure development.

In conclusion, Directors endorsed the new government's overall economic policy approach, which deserves the support of the international community. Directors wished the new government success in its endeavors and were pleased that the authorities are maintaining a close policy dialogue with the Fund. They stressed that the Fund stands ready to support Indonesia, both in the reconstruction efforts and in the implementation of its overall economic strategy.