Consultative Group Meeting for Indonesia
Remarks by Mr. Daniel Citrin
Senior Advisor, Asia & Pacific Department
International Monetary Fund

January 21, 2003

1. Ladies and Gentlemen, thank you very much for the opportunity to address you once again on the occasion of the annual CGI meeting. Since the last occasion more than a year ago, there have been a number of domestic and external events that have had significant impacts on Indonesia's economic and financial circumstances. The following stand out of course: the weakening in global growth in the aftermath of September 11^th, and more recently, the tragic events here in Bali in October. Such events would have profound effects on any country, let alone one in the midst of recovery from crisis. It is at such a time that strong support from the international community for Indonesia is all the more important.

2. In my remarks today, I will address the following topics. First, I will take stock of developments over the last year, assessing them in relation to the key policy priorities that were identified in the Government's economic program for 2002 supported by the IMF. Second, I will provide you with our assessment of Indonesia's short-term economic prospects in light of the current global environment and in the wake of the Bali attacks. Finally, I will address what we see as the main priorities for 2003.

3. Before doing so, however, let me briefly report on the status of Indonesia's EFF program, which is now on its fourth and final year. The seventh review of the program was completed last December, following satisfactory progress in policy implementation scheduled for that review, and we have now initiated discussions for the eighth review, which will set out the government's economic program for 2003 in detail. We will continue these discussions following the conclusion of this meeting, with a view to completing the review by the end of the first quarter of this year.

Achievements During 2002

4. In reviewing Indonesia's performance during 2002, it would be useful to remind ourselves of the challenges facing the government when it formulated its 2002 economic program in late 2001. Market sentiment had deteriorated as a result of the September 11^th attacks, global growth was weakening, and there was a perception that the pace of structural reform implementation in Indonesia would slow.

5. In light of the challenging economic environment, the following main policy priorities were identified for achieving macroeconomic stability and promoting growth:

• Making decisive progress towards fiscal sustainability and a reduction of Indonesia's large public debt burden;

• Implementing a monetary policy aimed at bringing inflation back to single digits;

• Making headway in restructuring and privatizing assets held by the public sector;

• Strengthening efforts to reduce vulnerabilities in the banking system and restore a functioning credit mechanism; and

• Accelerating efforts to improve the investment climate through governance and legal reforms.

6. How has performance in the past year measured up? On the macroeconomic front, performance has been positive. Major progress was made towards restoring a healthy and sustainable budget position. The budget deficit is estimated to have fallen to under 2 percent of GDP, below the program target of 2.5 percent of GDP, and down from 3.6 percent of GDP in 2001. As a result of this success, and helped by the appreciation of the rupiah, 2002 also witnessed a large reduction in Indonesia's public debt burden. The public debt-to-GDP ratio fell from nearly 90 percent at the end of 2001 to almost 70 percent by the end of last year. Further in this area, the Government in November restructured a significant portion of its debt held by state banks, lengthening and smoothing the maturity of its debt repayment profile in coming years.

7. On the monetary policy front, Bank Indonesia was successful in containing the price pressures that emerged in 2001, and although the government's goal of reducing inflation to single digits by year-end was not quite reached, single-digit inflation is likely to be achieved early this year. Lower inflation and a stronger rupiah have enabled BI to lower interest rates —from nearly 18 percent in December 2001 to under 13 percent at present—thus providing support for the economi recovery.

8. Let me now turn to the implementation of reforms in the three other priority areas, where performance was more mixed. Even there, however, there was good progress on a number of fronts. Let me highlight a few:

• IBRA asset sales accelerated significantly during 2002, raising Rp 46 trillion and exceeding IBRA's ambitious recovery target for the year. IBRA has now disposed of over half of the original portfolio of NPLs taken over from weak and closed banks. These asset sales play a major role both in restoring corporate finances and in financing the deficit and paying down public debt.

• The Government has also made progress toward enhancing recoveries under the settlement agreements with former bank shareholders, reaching understandings with a number of shareholders on an accelerated repayment schedule in exchange for a reduction of interest and penalties. It is now important for the government to take a firm stand against uncooperative shareholders who remain delinquent in meeting their obligations. Seeking economic justice in this area matters not only for the public purse, but also sends an important signal that the rule of law is taken seriously by this Government.

• There has also been progress on the bank restructuring and divestment agenda. Perhaps most noteworthy here were the successful sale of the government's majority stakes in two banks and the launching of the sale of a third. I believe these successes were key milestones that significantly buoyed investor sentiment towards Indonesia. In addition, as part of the Government's program to strengthen the banking system, the mandatory capital adequacy ratio was increased to 8 percent last year, while the financial solvency of a number of banks was restored through an injection of some additional public funds and a merger.

• Even in the area of privatization, which had lagged earlier in the program, the Government recently sold as you all know a major stake in its international telecommunications company—Indosat. As a result, the Government exceeded its 2002 privatization target of Rp 6.5 trillion, collecting Rp 7.7 trillion.

9. Notwithstanding all of this progress, the investment climate remains weak. Although financial market conditions improved considerably, several high-profile legal cases focused observers' attention on the slow pace of reform in the legal and judicial sphere. The recent establishment of the Anti-Corruption Commission is welcome, but much will depend on its implementation and operation. Decentralization, which on the whole has proceeded relatively well, has also raised problems for both existing businesses and prospective investors, in the form of new and conflicting regulations and taxes. Investors have also expressed increasing concern about the framework for labor regulations and the trend of increasing minimum wages. And recently, the terrorist attack in Bali has heightened concerns related to internal security. All this means that the Government must do all it can to improve the investment climate and build growth prospects in the period ahead.

Indonesia's Current Economic Prospects

10. Indonesia's economic prospects for 2003 in particular will depend on a number of factors. Late last year, particular attention was focused on the impact of the Bali attacks. Together with the Indonesian authorities, we have reviewed the latest indicators and updated the outlook. I should highlight that there is still much uncertainty regarding the likely response of tourism. The main features of our current assessment is as follows:

• Financial markets showed surprising resilience to the Bali attack, coming under modest pressure in the immediate aftermath but stabilizing quickly thereafter. After an initial weakening, the rupiah strengthened back below Rp 9,000 per dollar, and by year-end the stock market had rebounded to above its pre-Bali level. Interest rates were held steady in the weeks following the attack and have since been reduced modestly. To a large extent, these positive trends reflect a generally favorable assessment of the Government's efforts on the security front as well as progress late last year on the economic reform agenda.

• That said, the economic outlook no doubt is less favorable than before the Bali attack. With a significant drop in tourism likely, we expect a direct impact on growth of around one half of a percentage point. This comes on top of the effects of a slowing global economy since the previous forecast. All told, we are of the view that growth in 2003 will be about 1 percentage point weaker than previously foreseen, or down to 3½-4 percent.

Priorities for 2003

11. Let me now turn to the key policy priorities for this coming year. While much has been achieved, the reform agenda remains unfinished. Growth, while positive, remains disappointing relative to the 6 percent pace needed to make significant inroads to reducing poverty and unemployment. The overriding objectives for the 2003 program therefore are to: (i) consolidate recent gains in macroeconomic stability; (ii) strengthen public debt sustainability over the medium term; (iii) continue to make progress in restoring a sound banking sector capable of performing its critical financial intermediation function; and (iv) enhance the investment climate through a range of reforms.

12. The government has already made a good start toward meeting these challenges:

• The approved 2003 budget, which targets a deficit of 1.8 percent of GDP, represents an appropriate balance between keeping the budget on a firm path of lower deficits while maintaining adequate support to the economy in the face of a weaker growth picture. In this connection, let me touch briefly on the Government's reduction of fuel subsidies, which has been on the minds of all of us in recent days. At their peak in 2000, these subsidies cost the Government around 6 percent of GDP. With so much of the nation's resources spent on subsidies that were in any case not well targeted on the poor, less was left to spend on high-priority areas like health, education, and infrastructure. Reducing subsidies is of critical importance, not only to reducing the burden of public debt, but also to allow the Government to reallocate spending to where it matters most. At the same time, the Government has taken complementary actions to compensate the most vulnerable groups in society for the associated price increases, as detailed in the World Bank report for this meeting.

• IBRA has already put in place its program for disposing its remaining assets in 2003, and it will need to continue to work forcefully in this area.

• In the area of bank divestment, the Government has already announced its intention to divest majority stakes in the remaining IBRA banks this year. Completing these sales would represent a major achievement, as it would entail the return to majority private ownership of all private banks taken over during the crisis. With regards to state-owned banks, the Government is also preparing to moving ahead with their divestment and restructuring.

• Efforts are already in train on the privatization front as well, with the divestment process having been launched for stakes in several public enterprises. These efforts not only raise important budget financing but also allow state-owned enterprises to benefit from the efficiency gains that are likely to accrue from private ownership.

13. In addition to these efforts, we are confident that a prudent monetary policy aimed at reducing inflation further will be maintained, and that additional steps to enhance bank stability through continued improvements in supervisory capacity and the regulatory framework will be taken.

14. In order to lay a firm foundation for Indonesia's economic recovery, however, it will also be essential to begin to tackle more decisively the problems related to the investment climate. Historically, Indonesia's considerable economic strengths have made it an attractive destination for foreign investment: a large domestic market and labor force, abundant natural resources, a solid infrastructure, and a strategic location among some of the world's major trade routes. However, foreign direct investment flows into Indonesia remain at less than half their pre-crisis peak. Investment by Indonesians also remains weak, with the result that through September of 2002, gross fixed capital formation was still running about 35 percent below its pace in 1997.

15. What then is most needed to restore market confidence and support investment in Indonesia? Legal and judicial sector reform must be a critical element of any strategy to produce sustained improvement in the investment climate. Ensuring the effective operation of the newly-created Anti-Corruption Commission, passage of amendments to the bankruptcy law, and continued efforts to strengthen the commercial court are specific priorities. A sensible labor market policy that strikes a balance between protecting workers' rights and preserving a flexible labor market is also important in light of recent concerns that have been expressed. Continued care will need to be taken to ensure that decentralization does not lead to an unduly complex and unstable regulatory framework that discourages investors. Customs and tax administration, which are often reported to have deteriorated in terms of transparency, predictability, and fairness, are also frequently cited as disincentives for investment. These are some key areas where the Government will need to make a serious commitment to addressing problems if it is to have a significant impact on the overall investment climate.

Concluding Remarks

16. To conclude, thanks to the significant achievements that have been made this past year, the Government has begun to lay a solid foundation for Indonesia's economic recovery from the crisis. While the Bali attacks pose a significant concern for the outlook, Indonesia stands a good chance of weathering the incident with only a modest impact. However, without further progress on critical reforms as outlined above, there is a risk that growth over the medium term will not reach the pace needed to generate enough jobs and reduce poverty in a meaningful way.

17. We have provided our assessment of what is needed over the next year for Indonesia to cross the bridge towards a sustainable recovery. Implementation of such an agenda will require broad-based commitment from the Government and its partners in Parliament and elsewhere. As we have seen in the last few weeks, the pre-election environment in 2003 poses greater challenges for the Government as it seeks to implement its reform program. The economic team will need to work even harder to convince the public of the merits of its program. With such a show of commitment, we believe that the Government's economic program for 2003 would deserve the continued strong support of the international community.

18. Finally, the Government is now considering its strategy for 2004 and beyond, following the expiration of the current Fund arrangement. We certainly share in the wish that Indonesia can complete its recovery from the 1997-98 crisis as soon as possible, thereby no longer needing to seek recourse to exceptional financial support from the international community. But this will require that Indonesia redouble its effort in the implementation of the reform agenda. In the meantime, together with the Indonesian authorities, we will assess the outlook as it evolves, and in due course consider all options.