Public Information Notice No. 05/96

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation and Third Post-Program Monitoring with Indonesia

July 27, 2005

On July 18, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the 2005 Article IV consultation and third post-program monitoring discussions with Indonesia.¹

Background

Since the last Article IV consultation, Indonesia has undergone a historical political transition. In 2004, the country held parliamentary elections as well as its first direct presidential election, and a new government took office in October. The elections gave the government a strong mandate to carry forward the economic reforms initiated by its predecessor, aimed at placing Indonesia on a high and sustained growth path in order to reduce unemployment and poverty. To this end, the new government's medium-term economic strategy focuses on a continuation of macroeconomic stability combined with a deepening of structural reforms. Since the new government assumed office, it has continued the conservative budget stance, and taken important first steps toward strengthening the financial sector and enhancing the investment climate. At the same time, the government's Reconstruction and Rehabilitation Agency has started reconstruction in the tsunami-affected regions, with the support of the international community. Monetary policy is aiming to anchor inflation at a low and stable level; in June, Bank Indonesia announced a switch to a one-month interest rate as its intermediate target in a move toward fully-fledged formal inflation targeting.

Economic growth has gained momentum, with real GDP increasing by 5.1 percent in 2004 and 6½ percent in the first quarter of 2005, driven by private investment and consumption. Inflation has edged up, reaching 7.4 percent (y/y) in June this year reflecting partly the increase in domestic fuel prices in March, but also the vigorous domestic demand and a depreciation of the exchange rate. Following a reduction in the fiscal deficit to about 1½ percent of GDP in 2004, the fiscal accounts registered a surplus in the first half of 2005, largely reflecting underspending compared with allocations. The external current account surplus has been on a downward trend in relation to GDP, as demand for imports of capital goods and raw materials has picked up alongside the overall economy, while the oil import bill has risen.

Against this generally favorable background, financial markets have come under some pressure in early 2005. The exchange rate has been on a depreciating trend and has recently been trading at three-year lows against the U.S. dollar. Responding to these pressures, Bank Indonesia has intervened in the foreign exchange market, increased interest rates, and taken measures to limit the scope for short-term capital flows.

In order to strengthen the financial sector, Bank Indonesia has made encouraging strides in risk-based supervision and upgrading of banking regulations toward international standards, and has introduced new asset classification rules. Moreover, recent management changes at top state-owned banks are expected to help improve governance. The authorities have also started scaling back the blanket guarantee on bank deposits introduced during the crisis, replacing it with a limited deposit insurance scheme. Furthermore, Bank Indonesia in June announced new regulations to guide the strengthening and consolidation of the banking system. At the same time, efforts are being made to bolster the supervision of insurance companies, finance companies, and mutual funds.

The new government is focused on improving the investment climate. The efforts in this regard are centered on simplifying the regulatory framework, preparing a new streamlined investment law, reducing corruption, strengthening the legal system, and increasing infrastructure investment. The authorities have established a Corruption Eradication Commission, and various government agencies are investigating cases of irregularities and corruption, including in state banks and in local government offices. Finally, agreement has been reached in principle between Exxon Mobil and Pertamina with regard to the development of the large Cepu oilfield.

Economic growth is projected to reach 6 percent this year, before increasing further to 6-7 percent annually over the medium term, assuming that the government's economic policies are implemented as planned. Inflation would come down to around 6 percent next year and converge to trading partner country rates over the medium term. Fiscal consolidation is expected to continue, with the government debt ratio declining gradually towards 30 percent of GDP, reducing debt-related vulnerabilities. While the external current account is projected to turn into deficit as domestic demand remains strong, net capital inflows would lead to an increase in international reserves, helping to maintain a comfortable external position.

Executive Board Assessment

Executive Directors welcomed the continuing improvement in the overall performance of the Indonesian economy in recent years, which has been manifested in the considerable progress toward achieving macroeconomic stability, lowering public debt, restoring the health of the banking system, and reducing vulnerabilities. Going forward, Indonesia nevertheless faces key policy challenges in placing the economy on an even stronger footing for economic growth in order to create jobs and reduce widespread poverty. Directors accordingly welcomed the adoption of the medium-term economic strategy, which signals the new government's determination to use its political mandate to place Indonesia on a high and sustainable growth path, by pursuing sound macroeconomic policies, reducing the still-present economic vulnerabilities, and strengthening and completing the institutional and structural reforms required for a lasting improvement in the investment climate.

Directors commended the authorities for their efforts toward reconstruction in Indonesia's tsunami-affected areas. They noted the importance of rapid implementation of reconstruction projects, while also emphasizing the need for donors to follow through on the financing pledges they have made. In this context, Directors welcomed the establishment of the Multi-Donor Trust Fund and the authorities' commitment to transparent allocation and effective use of international aid.

Further fiscal consolidation over the medium tem is a key priority in the authorities' strategy to help further reduce the government debt burden and lay the basis for sustained economic growth. Directors accordingly welcomed the revised 2005 budget, which aims to further reduce the fiscal deficit. Achievement of this target will require careful budget management. Achievement of the budgetary targets in 2006 will require careful consideration of the revenue implications of the tax policy package under way. In this context, Directors advised caution in expanding tax exemptions, and several saw scope for reducing current tax exemptions. Directors also stressed the importance of further steps to mobilize non-oil revenues. Directors noted that unexpected further rises in international oil prices will call for continued budget vigilance. They commended the steps taken by the authorities toward reducing domestic fuel subsidies, and the allocation of these savings to spending for vulnerable population groups. Several Directors recommended further progress toward market-based prices and away from fuel subsidies, in view of their still significant strain on the budget, along with continuing efforts to minimize the impact on vulnerable groups.

Directors noted the importance of continuing fiscal structural reforms in order to enhance the quality and sustainability of fiscal adjustment. In this context, they welcomed the authorities' intention to improve tax administration and emphasized the need to strengthen governance and modernize customs administration. Directors cautioned against introducing a tax amnesty, which could undermine revenue performance. On the spending side, Directors noted that the planned reorientation of spending toward capital and social expenditure should bring tangible results in terms of creating jobs and improving productive capacity. Key for reducing debt-related vulnerabilities will be careful management of government liabilities, including the adoption of a debt management strategy and a consolidated debt management unit; a framework for limiting contingent liabilities; and the inclusion of the many extra-budgetary funds into the budget. Directors applauded the authorities' intention to strengthen fiscal soundness at the regional level, and emphasized the importance of maintaining fiscal control as the decentralization framework is implemented. In particular, Directors encouraged the authorities to ensure the coherence of regulations at different levels of government, and to make sub-national borrowing contingent upon the establishment of appropriate safeguards and regular fiscal reporting.

Directors commended Bank Indonesia for its focus on anchoring inflation at a low level, and the steps taken to tighten monetary policy to ensure that inflation is contained. While recognizing the authorities' concern that significantly higher interest rates might affect economic growth, a number of Directors suggested that further tightening may still be desirable in view of the recent pressures on inflation and the exchange rate. Directors welcomed the recent announcement to use the interest rate as the intermediate target for monetary policy as part of the move toward formal inflation targeting. Convincing use of the new interest rate policy will help maintain stability and enhance confidence. More generally, Directors recognized the importance of a credible and transparent monetary policy for effective inflation targeting, and welcomed the steps being taken to put in place the operational and institutional pre-requisites for this monetary policy regime. Indonesia's flexible exchange rate system has helped protect the economy against shocks and will help the functioning of the new monetary framework. Directors recommended that Bank Indonesia limit interventions in the foreign exchange market to those needed to counter short-term volatility.

Directors noted the banking system's improved performance in asset quality and profitability, as well as the progress made in banking supervision. At the same time, they stressed that it will be important to move forward with further improvements in prudential regulations and strengthened risk management, especially against the background of higher interest rates that may put pressure on margins going forward. In this context, Directors welcomed the ongoing work toward introducing risk-based supervision and improving governance Directors also supported the authorities' objective of further bank consolidation, as well as their intention to allow the process to be market based and ensure that the merged banks are sound. Several Directors noted that the privatization of state banks over time would enhance the efficiency and soundness of the banking sector. With respect to the financial sector safety net, Directors welcomed the progress so far, and noted the importance of establishing the deposit insurance fund and putting in place the remaining elements of the financial sector safety net without delay. This will help maintain confidence in the banking system as the blanket guarantee is phased out. Several Directors encouraged the authorities to undertake a Financial Sector Assessment Program, which should help the authorities improve their understanding of financial sector vulnerabilities and address them. Directors welcomed the progress in enhancing the anti-money laundering regime in Indonesia, which has led to its removal from the list of Non-Cooperative Countries and Territories maintained by the Financial Action Task Force (FATF), and encouraged the authorities to continue careful monitoring.

Directors underlined the importance of steps to improve the investment climate, especially against the background of the recent declines in some of Indonesia's export market shares and the relative attractiveness of other investment destinations. Accordingly, they welcomed the authorities' commitment to improve the investment climate. They commended in particular the recent steps taken to address corruption, to attract investment in the oil and gas sector, and to put in place a new investment law. It is acknowledged that dealing with deep-seated structural impediments to investment will take time. Directors nevertheless noted the importance of taking further decisive steps to improve the functioning of the legal system, simplify the regulatory framework, strengthen infrastructure, improve labor market flexibility, and bolster tax administration. Actions in all these areas will be helpful for enhancing productivity, improving external competitiveness, and boosting foreign direct investment flows. Directors welcomed the authorities' commitment to maintaining Indonesia's open trade regime, while some Directors suggested that the country phase out its import restrictions on sugar and rice.