## _cr11309

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### Exchange Rate Assessment and Macroeconomic Context
- Real GDP growth: 6.5 percent y/y in the first half of the year.
- Services sector contributed about two thirds of total economic growth.
- Credit growth: 23.6 percent y/y in August.
- Private sector nonperforming loan ratio: below 3 percent.
- Public debt: 27 percent of GDP at end‑2010; expected to decrease to around 25 percent of GDP by end‑2011.
- International reserves: $125 billion at end‑August 2011.
- CPI inflation: 7 percent y/y at end‑2010; eased to 4.8 percent y/y in August.
- Core inflation: 5.2 percent in August.
- BI policy rate: raised by 25 bps to 6.75 percent in February 2011.
- BI lowered the bottom of the interest rate corridor by 50 bps to 5.25 percent in September 2011 while keeping the policy rate unchanged.
- Overnight money market rates fell by around 100 bps since end‑June and are now 145 bps below the BI policy rate.
- REER: after large Q4 2008 depreciation, returned to pre‑crisis high by Q1 2010 and continued appreciating in 2011; CGER staff assessment indicates the REER is close to equilibrium:
  - Macro balance: medium‑term current account deficit norm at -0.7 (percent of GDP); staff projection medium‑term current account deficit about 1 percent of GDP — implying REER slightly overvalued.
  - External sustainability and regression approaches: REER slightly undervalued.
  - Averaging approaches with confidence interval: REER in line with fundamentals.
- Memorandum items:
  - Current account norm: -0.7 (percent of GDP)
  - NFA‑stabilizing current account at 2010 level: -2.5 (percent of GDP)

### Capital Flows, External Sector, and Market Performance
- Surge in gross portfolio inflows averaging 2 percent of GDP per quarter since June 2009.
- Foreign ownership in government rupiah debt: 35 percent.
- Over one‑third of SUNs and SBIs now owned by nonresidents.
- FDI inflows picked up sharply, including to resources, manufacturing, and retail.
- Exports: strong growth in 2010 and H1 2011; noncommodity manufacturing exports grew on average about 30 percent y/y.
- Sovereign ratings: upgraded by Moody’s and Standard and Poor’s to one notch below investment grade; Standard and Poor’s and Fitch have positive outlooks.
- Market indicators by mid‑September:
  - Stocks up over 4 percent year‑to‑date in U.S. dollar terms.
  - Net inflows to equities nearly $1.4 billion by mid‑September.
- Recent turbulence (September–October episode):
  - Jakarta equity index plunged by almost 13 percent on heavy foreign selling.
  - EMBI and CDS spreads rose 110-125 bps from end‑August to October 3.
  - Rupiah depreciated by about 4 percent against the U.S. dollar.
  - Local 10‑year government bond yields rose 119 bps during September 9‑22, then fell back near end‑August levels.

### Financial Sector and Central Bank Operations
- Banking system: large capital buffer, ample liquidity, profitable through 2009 slowdown; capital adequacy ratios slipped 1 percent between March 2010 and May 2011 (mainly due to introduction of operational risk under Basel II) but system remains well capitalized.
- Loan to deposit ratio edged upwards; lending strongest to mining but broad based across investment and consumption.
- Nonperforming loan ratio: below 3 percent.
- BI measures since October 2010 included:
  - Policy rate increase to 6.75 percent (February 2011).
  - Raised reserve requirements on local currency and foreign currency deposits.
  - Extended holding period requirement on SBIs from one month to six months.
  - Lengthened maturity of SBI issues to nine months.
  - Introduced longer maturity nontradable term deposits available only to banks.
- Operational challenges:
  - Persistent excess liquidity and weak money market activity dampening transmission from BI policy changes.
  - Sterilization costs eroding BI’s capital base because assets are mainly low yielding foreign reserves and noninterest bearing government securities.
- Recommended operational reforms:
  - Increase reserve requirements and run a predictable calendar of longer tenor open market operations; reserve requirements should be generally uniform across banks.
  - Phase out nontradable term deposits and expand use of reverse repos; use variable rate auctions on a regular calendar.
  - Improve interbank repo infrastructure and adopt the new global master repurchase agreement.
  - Replace nonmarketable, noninterest bearing government debt held by BI with marketable debt to supply collateral and improve BI’s financial position.

### Medium‑Term Growth Prospects and Scenarios
- Staff growth projections: 6.4 percent in 2011 and 6.3 percent in 2012 (staff); staff projects growth to reach 7 percent over the medium term under implementation of infrastructure and structural reforms.
- Government Master Plan (2011−2025) investment assumptions:
  - Master Plan targets investments of $468 billion over 2011−2025, of which 45 percent will be in infrastructure.
  - One˗fifth of total investment expected from the government.
- Potential growth scenarios (growth accounting, contributions for 2016 as presented):
  - Potential growth: 6.0 7.2 8.2
  - Capital services: 4.4 5.2 5.5
  - Stock of capital: 4.1 4.8 5.2
  - Capacity utilization: 0.3 0.3 0.3
  - Labor services: 1.3 1.4 1.5
  - 1-NAIRU: 0.2 0.2 0.3
  - Labor force participation rate: 0.3 0.3 0.4
  - Average hours worked: 0.0 0.0 0.0
  - Working age population: 0.8 0.8 0.8
  - Total factor productivity: 0.2 0.7 1.1
- Scenario outcomes:
  - Baseline: potential growth gradually rises to 7 percent.
  - Downside: slow progress on infrastructure and reforms leads to growth stagnating at about 6 percent.
  - Upside/intensive reform: potential growth could reach 8 percent.

### Inflation Outlook and Monetary Policy Recommendations
- Staff projection:
  - Core inflation projected to remain at 5 percent in 2011 and could increase further in 2012 if planned reductions in energy subsidies take place.
  - Headline inflation could reach around 6½ percent in 2012, above BI’s target band of 4.5 ±1.0 percent.
  - Output gap estimated closed by 2011:Q3.
- Monetary policy guidance for BI:
  - Contain inflationary expectations and limit second‑round effects from energy price increases.
  - Use combination of policy rate increases, liquidity withdrawal (including reserve requirement increases), and further exchange rate appreciation.
  - Apply complementary macroprudential measures to manage credit growth risks.
  - Guide price expectations by projecting direct effects of energy price increases and stating how much of first‑round effects will be accommodated.
  - Timely increases in real policy rates if demand conditions remain robust.

### Capital Flows, Reserves, and Exchange Rate Stance
- Strong capital flows expected to continue; portfolio inflows projected to slow for rest of 2011 due to six month SBI holding period imposed in May.
- FDI composition (2010−2011:Q1, in percent):
  - Manufacturing 35%
  - Wholesale and retail trade 18%
  - Mining 18%
  - Transportation and communication 16%
  - Others 13%
- Staff supported greater exchange rate flexibility; limit intervention to dampen volatility rather than accumulate reserves.
- Reserves reported as above existing adequacy metrics (reserves and GDP data for Indonesia as of Q1 2011; other data as of end‑2010).
- Authorities’ market backstops: budget resources, cash reserves, and state owned enterprises’ balance sheets; BI announced it could conduct auctions to buy rupiah denominated government bonds to reduce excessive currency volatility.
- Staff advised flexible implementation of market support to avoid implicit insurance that attracts inflows.

### Central Bank Financial Position and Asset‑Liability Management
- Sterilization costs increasing and eroding BI’s capital base.
- Recommendation: strengthen BI’s financial position within a government asset‑liability management program, including exchange of nonmarketable government debt held by BI for marketable securities usable in monetary operations.

### Fiscal Policy, Budget Flexibility, and Revenue Mobilization
- Fiscal stance:
  - Higher oil prices pushed projected subsidy costs to 3.2 percent of GDP in 2011, compared with projected development expenditure of 2.3 percent of GDP.
  - Staff project the 2011 budget deficit will be 1.3 percent of GDP, compared with proposed revised budget target of 2.1 of GDP.
- Limited budget flexibility:
  - Considerable fiscal space exists to provide stimulus, but automatic stabilizers are small and implementation capacity to expand discretionary spending is very limited.
  - Any revenue overperformance in 2011 could be used to reduce overall deficit.
  - For 2012 staff urged improve targeting of subsidies and increase infrastructure spending.
- Energy subsidies:
  - Energy subsidies have risen in line with oil prices and now account for "18 percent of expenditures."
  - Raising administrative fuel prices and moving to flexible pricing would mean only temporary upward pressure on inflation if second‑round effects are limited.
  - Lower subsidies would create fiscal space for infrastructure and social spending.
- Revenue mobilization (Box 4 facts and targets):
  - Tax revenue ratio: "12 percent of GDP."
  - Personal income tax revenues: "as low as 1 percent of GDP."
  - VAT and corporate income tax each raise "about 4 percent of GDP."
  - Overall tax effort: "around 54 percent."
  - Realistic medium‑term target range for potential tax revenue: "13.4−16.4 percent of GDP," implying a "2−5 percentage point improvement."
- Measures to broaden tax base:
  - Limit VAT exemptions.
  - Limit tax holidays and corporate income tax exemptions; target incentives to well‑specified sectors for preset periods.
  - Tax exempt fringe benefits.
- Tax administration priorities: continue reforms to increase compliance and improve auditing.

### Medium‑Term Fiscal Strategy and Recommendations
- Strategy objectives:
  - Balance public debt consolidation with improving effectiveness of fiscal policy to support growth.
  - Address infrastructure shortfalls; improve regulatory framework for infrastructure and PPPs.
  - Improve budget execution and retarget social safety nets.
  - Increase and improve education and health spending.
  - Raise tax revenue ratio via broadening bases, revenue administration reforms, and containing tax incentives.
- Selected fiscal and macro statistics (as presented):
  - Nominal GDP (2010): Rp 6,423 trillion or US$707 billion
  - GDP per capita (2010): US$2974
  - Unemployment rate (Feb. 2011): 6.8 percent
  - Poverty headcount ratio at national poverty line (2010): 13.3 percent of population
  - Central government revenue (2010, percent of GDP): 15.8
  - Central government expenditure (2010, percent of GDP): 16.4
  - Central government balance (2010, percent of GDP): -0.6
  - Primary balance (2010, percent of GDP): 0.8
  - Central government debt (2010, percent of GDP): 27.4

### Public and External Debt Sustainability (APPENDIX I highlights)
- Public sector debt fell to 27 percent in 2010.
- Baseline public sector debt path (selected years, percent of GDP):
  - 2004: 55.8; 2005: (table shows) 55.8 (baseline series continuing) ... 2009: 28.6; 2010: 27.4; 2011: 25.4; 2012: 24.1; 2013: 23.1; 2014: 22.2; 2015: 21.5; 2016: 20.8.
- Stress scenarios:
  - Fiscal contingent liabilities amounting to 10 percent of GDP could raise public sector debt to 30 percent of GDP by 2016.
  - Currency depreciation of 30 percent would raise debt ratio to about 25 percent of GDP.
  - Increase in real interest rates would raise the debt ratio to 23 percent by 2015.
- External debt:
  - External debt rose to 32 percent of GDP during late 2008/early 2009; projected to decline to about 27 percent of GDP by end‑2011 and to 21 percent of GDP by 2016.
  - One‑time 30 percent real exchange rate depreciation would raise the external debt ratio by 11 percentage points in 2012, and 9 percentage points over baseline by 2016.
- Selected external debt series (baseline, percent of GDP): 2007: 46.5; 2008: 35.8; 2009: 30.9; 2010: 30.3; 2011: 32.1; 2012: 28.6; 2016: 20.2 (as presented in Table I.2 and related series).

### IMF Executive Board, Authorities’ Views, and Policy Priorities
- Executive Directors commended cautious policymaking, strong fundamentals, and buffers; recommended preparedness to tighten monetary policy given high credit growth and subsidy reductions.
- Directors suggested instruments: policy rate increases, macroprudential measures, liquidity absorption; advised BI to focus communications on commitment to inflation target.
- Authorities’ outlook (Aida Budiman and Iss Savitri Hafid, October 7, 2011):
  - Authorities forecast GDP for 2011 and 2012 at 6.6% and 6.5% respectively; forecast inflation for 2011 and 2012 at 4.9% and 5% respectively.
  - Noted reserves sufficient to cover more than 7 months of imports.
  - Highlighted FDI flows surpassing net portfolio flows beginning second‑half of 2011.
  - Noted credit rating upgrades to one notch below investment grade by two rating agencies this year and one rating at the end of last year.

### World Bank‑IMF Collaboration (ANNEX II)
- Strong working relationship as of September 1, 2011 with joint programs on budget, taxation, asset liability management, financial sector, statistics, and macroeconomics.
- Joint and respective work programs and requests listed, including:
  - Bank: Indonesia Economic Quarterly, GFMRAP support, Development Policy Loan 8.
  - IMF: 2011 Article IV mission; tax administration TA; 2012 Staff Visit and Article IV mission.

*Source: content unit _cr11309*

### 1.   Exchange   Rate   Assessment  _________________________________________________  7

### 1. Exchange Rate Assessment

### Context and recent macroeconomic developments
- The Indonesian economy remained resilient during the global financial crisis, supported by prudent macroeconomic policies, lower public and private indebtedness, rebuilt international reserves, and contained inflation.
- Political stability and favorable demographic trends present an opportunity for stronger medium‑term performance.
- Infrastructure bottlenecks, limited fiscal resources for public infrastructure and social spending, and shallow capital markets pose challenges to achieving higher sustained and equitable growth.

- Real GDP growth: 6.5 percent y/y in the first half of the year.
- Services sector contributed about two thirds of total economic growth.
- Credit growth: 23.6 percent y/y in August.
- Private sector nonperforming loan ratio: below 3 percent.
- Public debt: 27 percent of GDP at end‑2010; expected to decrease to around 25 percent of GDP by end‑2011.
- International reserves: $125 billion at end‑August 2011.

### Inflation and monetary stance
- CPI inflation: 7 percent y/y at end‑2010 (outside BI’s 4−6 percent target range); eased to 4.8 percent y/y in August.
- Core inflation: 5.2 percent in August.
- BI policy rate: raised by 25 bps to 6.75 percent in February 2011 (previously unchanged since August 2009).
- BI lowered the bottom of the interest rate corridor by 50 bps to 5.25 percent in September 2011 while keeping the policy rate unchanged.
- Overnight money market rates fell by around 100 bps since end‑June and are now 145 bps below the BI policy rate.
- Yields on BI’s open market operations have fallen by around 150 bps.
- Short‑term treasury yields are now well below money market rates.

### Capital flows, exchange rate, and external sector
- The surge in gross portfolio inflows has averaged 2 percent of GDP per quarter since June 2009.
- Over one‑third of SUNs and SBIs are now owned by nonresidents.
- Foreign ownership in government rupiah debt: 35 percent.
- Foreign direct investment inflows have picked up sharply, to resources, manufacturing, and retail sectors.
- Current account: surplus has declined with strengthening domestic demand.
- Exports: strong export growth in 2010 and the first half of 2011; noncommodity manufacturing exports grew on average about 30 percent y/y.
- Indonesia’s world market share has improved steadily during the last two years.
- Sovereign ratings: upgraded by Moody’s and Standard and Poor’s to one notch below investment grade; Standard and Poor’s and Fitch have positive outlooks.

### Exchange rate assessment (Box 1)
- After a large depreciation in Q4 2008, the REER returned to its pre‑crisis high by Q1 2010 and continued appreciating in 2011.
- CGER staff assessment indicates the REER is close to equilibrium:
  - Macro balance approach estimates a medium‑term current account deficit norm at 0.7 percent of GDP, close to the staff’s projection of a medium‑term current account deficit of about 1 percent of GDP, implying the REER is slightly overvalued.
  - External sustainability and regression approaches suggest the REER is slightly undervalued.
  - Averaging approaches and considering the confidence interval: Indonesia’s REER is in line with fundamentals.

- Memorandum items (as presented):
  - Current account norm: -0.7 (percent of GDP)
  - NFA‑stabilizing current account at 2010 level: -2.5 (percent of GDP)

### Financial sector and market performance
- Banking system: large capital buffer, ample liquidity, profitable through 2009 slowdown; capital adequacy ratios slipped 1 percent between March 2010 and May 2011 (mainly due to introduction of operational risk under Basel II) but system remains well capitalized.
- Lending: loan to deposit ratio edged upwards; strongest lending to the mining sector but broad based across investment and consumption.
- Asset quality: nonperforming loan ratio below 3 percent.
- Market indicators: stocks up over 4 percent year‑to‑date in U.S. dollar terms by mid‑September; net inflows to equities nearly $1.4 billion by mid‑September.
- Property: anecdotal strong price increases in high‑end residential segments and industrial land, but aggregate property price indices rising only in line with CPI inflation.
- External debt spreads: narrowed; EMBI spreads and CDS spreads rose in recent risk aversion episodes but remain below 2010 highs.

### Policymaker actions and operational measures by Bank Indonesia
- BI measures since October 2010 included:
  - Policy rate increase to 6.75 percent (February 2011).
  - Raised reserve requirements on local currency and foreign currency deposits (no numerical details provided).
  - Extended holding period requirement on SBIs from one month to six months.
  - Lengthened maturity of SBI issues to nine months.
  - Introduced longer maturity nontradable term deposits available only to banks.
- To stimulate money market transactions amid large excess liquidity, BI lowered the bottom of the interest rate corridor by 50 bps to 5.25 percent in September 2011.

### Findings from the 2010 FSAP and other assessments
- FSAP (2010) found the banking sector resilient: large capital buffer, ample liquidity, profitability.
- Stress tests: a limited number of banks vulnerable to extreme liquidity shocks; a few large banks susceptible to concentration risk.
- Key reform priorities identified: strengthen legal and governance framework for supervision, coordinate macro‑microprudential supervision and crisis management, secure BI’s financial independence, and develop capital markets.
- Indonesia in process of addressing AML/CFT framework deficiencies noted by FATF, including passage of AML/CFT Act (October 2010) and Fund Transfer Act (March 2011).

### Outlook and risks
- Staff growth projections: 6.4 percent in 2011 and 6.3 percent in 2012.
- Immediate risks considered manageable given strong reserves and fiscal room (including substantial cash reserves).
- Most likely risk: reversal in portfolio inflows from a sudden drop in foreign investor demand for government debt (e.g., renewed global risk aversion).
  - A sharp rise in bond yields could increase banks’ funding costs, cause market losses, and trigger loan defaults; current bank profitability and capital should help buffer shocks.
  - Lack of a financial safety network remains a major weakness; an individual bank failure could become systemic.
- External outlook: highly uncertain; adverse global shock could affect Indonesia via trade (commodity exports), financial channels (though private sector and banks not dependent on foreign financing), and commodity price channels.
- China’s demand and policy response would be crucial given increased commodity exports to China.
- Market prices: risks remain low but sensitive to global sentiment; correlations with European periphery have been low compared with other G‑20 emerging markets.
- Potential rating upgrade to investment grade could widen the foreign investor base and trigger inflows from investment‑grade‑only funds, pushing local and global bond yields lower.

### Policy recommendations and priorities (as reflected in the Report)
- Maintain exchange rate flexibility as an important tool to manage capital flow volatility.
- BI should signal readiness to respond to rising inflationary pressures to anchor inflation expectations within the target range.
- To reduce sterilization costs and expand BI’s operational toolkit: gradually convert nonmarketable government bonds on BI’s balance sheet to marketable bonds.
- Fiscal reforms to support sustained high growth:
  - Reduce energy subsidies to create fiscal space for infrastructure spending and transfer programs for the poor.
  - Improve public expenditure execution and expand performance‑based budgeting and medium‑term expenditure frameworks across line ministries.

*Source: IMF staff summary from “1. Exchange Rate Assessment” (Indonesia 2011 Article IV Report).*

### 16.      Over the medium term, staff

### _cr11309 - 16.      Over the medium term, staff

### Medium-term growth projection and drivers
- Staff projects growth to reach 7 percent, underpinned by both public and private sector investment, provided that the government’s ambitious infrastructure and structural reform agenda is implemented.
- Current account projected to move to small deficits starting in 2012, due to robust investment demand and a trend decline in the terms of trade.
- Strong capital inflows—both FDI and portfolio investment—are expected to continue as planned structural reforms and infrastructure spending expand private investment opportunities.

### Government Master Plan (2011−2025) and investment assumptions
- Master Plan targets investments of $468 billion over 2011−2025, of which 45 percent will be in infrastructure.
- One˗fifth of the total investment is expected to come from the government.
- First pillar: development of six regional economic corridors through investments in sectors with high growth prospects and clear comparative advantages.
- Second and third pillars: improving connectivity and strengthening human resources and science and technology.
- The Master Plan’s assumptions for GDP growth and private investment are characterized as very ambitious and will require a substantial acceleration in the reform agenda and increased political commitment to implementation.

### Potential growth scenarios (growth accounting, Box 2)
- Historical context:
  - Prior to the Asian crisis (1991−1997), estimated potential growth was 6.5 percent, predominantly input driven (capital accumulation).
  - During 2001−2005, estimated potential growth recovered partly to 4 percent, with productivity gains dominating.
  - Since 2006, potential growth picked up to around 6 percent, driven by growth in labor and capital inputs.
- Baseline and alternative scenarios:
  - Baseline scenario: potential growth rate is estimated to gradually rise to 7 percent, mostly reflecting increases in capital accumulation and efficiency.
  - Downside scenario (slow progress on infrastructure and structural reforms): growth would stagnate to about 6 percent.
  - Upside/intensive reform scenario: potential growth could reach 8 percent over the medium term if substantial enhancements in capital and efficiency occur.
- Contributions (table excerpt for 2016 under three scenarios; listed exactly as presented):
  - Potential growth 6.0 7.2 8.2
  - Capital services 4.4 5.2 5.5
  - Stock of capital 4.1 4.8 5.2
  - Capacity utilization 0.3 0.3 0.3
  - Labor services 1.3 1.4 1.5
  - 1-NAIRU 0.2 0.2 0.3
  - Labor force participation rate 0.3 0.3 0.4
  - Average hours worked 0.0 0.0 0.0
  - Working age population 0.8 0.8 0.8
  - Total factor productivity 0.2 0.7 1.1
- Policy implications to raise potential growth:
  - Address longstanding constraints: weaknesses in infrastructure and the need to raise overall efficiency (TFP).
  - Ample investment is needed so that capital stock growth can contribute to potential growth.
  - Supportive policies for infrastructure development, including more effective fiscal policy through improved budget execution.
  - Structural reforms to increase openness to trade and FDI, deepen financial markets, and reform the regulatory framework to close technology gaps and increase efficiency.

### Inflation outlook and monetary policy stance
- Headline and core inflation projections:
  - Core inflation is projected by staff to remain at 5 percent in 2011 and could increase further in 2012, assuming planned reductions in energy subsidies take place.
  - This would push headline inflation to around 6½ percent in 2012, well above BI’s target band of 4.5 ±1.0 percent.
  - Staff notes the output gap is estimated to have closed by 2011:Q3.
- Monetary policy recommendations to Bank Indonesia (BI):
  - BI will need to contain inflationary expectations and limit second˗round effects from energy price increases.
  - Use all instruments at its disposal to constrain any rise in inflationary pressures and the pace of credit growth:
    - Combination of policy rate increases, liquidity withdrawal (including through additional increases in reserve requirements), and further exchange rate appreciation.
    - Complementary macroprudential measures to manage risks from rising credit growth.
  - BI should guide price expectations around planned energy price increases by providing projections of direct effects on inflation ahead of time and explicitly stating how much of first-round effects it will accommodate in its inflation target.
  - Timely increases in real policy rates are considered necessary if demand conditions remain robust.

### Liquidity, money market functioning, and policy operations (Box 3)
- Issues identified:
  - Persistent excess liquidity and weak money market activity are dampening transmission from BI policy changes to banks’ cost of funds.
  - Structural excess liquidity and impediments to money market development, especially repo and swap markets, need to be addressed.
  - Sterilization costs are eroding BI’s capital base because assets are mainly low yielding foreign reserves and noninterest bearing government securities.
- Recommended operational reforms:
  - Use a combination of increased reserve requirements and a predictable calendar of longer tenor open market operations to provide structural withdrawal of liquidity; reserve requirements should be generally uniform across banks.
  - Phase out nontradable term deposits and expand use of reverse repos; conduct structural operations using variable rate auctions on a regular calendar to create useful benchmarks.
  - Improve incentives for surplus banks to provide liquidity to deficit banks and address segmentation caused by contraction in interbank credit limits.
  - Implement measures to improve the infrastructure for interbank repo markets, including adoption of the new global master repurchase agreement.
  - Replace the nonmarketable, noninterest bearing government debt currently held by BI with marketable debt to supply collateral, improve BI’s financial position, and support development of the local government debt market.
- Operational guidance:
  - BI should be more proactive with monetary operations to withdraw liquidity and bring the overnight interbank rate closer to the policy rate to avoid market confusion about policy intent.

### Capital flows, reserves, and exchange rate management
- Capital flows:
  - Strong capital flows are projected to continue.
  - Portfolio inflows projected to slow for the rest of 2011 due to the six month holding period for SBIs imposed in May restricting rollover by foreign investors.
  - Foreign investors have shifted to T-bills and shorter maturity government bonds; available amounts are smaller and trading thin.
  - FDI inflows are projected to increase further and are expected to become a larger and perhaps less volatile source of capital account support than portfolio inflows.
- FDI composition (2010−2011:Q1, in percent):
  - Manufacturing 35%
  - Wholesale and retail trade 18%
  - Mining 18%
  - Transportation and communication 16%
  - Others 13%
- Reserves and exchange rate stance:
  - With reserves at comfortable levels, staff supported BI’s stance to allow greater exchange rate flexibility and to limit intervention to dampening volatility rather than emphasis on reserve accumulation.
  - Staff and authorities concurred that portfolio inflows could reverse if the Euro Area crisis intensifies; international reserve buffers and government cash reserves built in the last year could help alleviate pressure if a sharp reversal occurred.
  - Reserves are reported as being above existing adequacy metrics (reserves and GDP data for Indonesia are as of Q1 2011; other data as of end-2010).
- Capital flow measures and market backstops:
  - Existing measures shifted composition of inflows away from BI’s sterilization instruments.
  - Additional capital flow measures are not recommended given the need to develop and deepen capital markets.
  - Authorities have backstops for bond market stabilization funded by budget resources, cash reserves, and state owned enterprises’ balance sheets; BI announced it could conduct auctions to buy rupiah denominated government bonds to reduce excessive currency volatility.
  - Staff advised a flexible approach in implementing market support mechanisms to avoid implicit insurance that could attract more inflows.

### Central bank financial position and asset-liability management
- Sterilization costs are an increasing drain on BI’s financial resources and have led to erosion of BI’s capital base.
- Recommendation: strengthen the central bank’s financial position within a broader government asset-liability management program, including exchange of the nonmarketable government debt held by BI for marketable securities that can be used for monetary operations and to develop money and government debt markets.
- BI and Ministry of Finance agreed on the importance of addressing sterilization costs and discussed modalities for implementing the asset liability management agenda, including replacing the nonconvertible government debt held by BI.

### Fiscal policy stance and implications for infrastructure spending
- Fiscal stance has been a source of macroeconomic strength, but postponement of subsidy reforms limits fiscal flexibility to increase infrastructure and social spending.
- Higher oil prices pushed projected subsidy costs to 3.2 percent of GDP in 2011, compared with projected development expenditure of 2.3 percent of GDP.
- Staff project the 2011 budget deficit will be 1.3 percent of GDP, compared with the proposed revised budget target of 2.1 of GDP, largely based on a historical pattern of underspending.
- Execution of spending in the first six months of 2011 remained low despite recent reform measures to improve budget implementation.

*Italic: IMF staff summary of content unit _cr11309 - 16.      Over the medium term, staff*

### 29.      The limited flexibility of the budget

### 29. The limited flexibility of the budget

### Fiscal flexibility and countercyclical policy
- Limited budget flexibility constrains the use of fiscal policy for countercyclical purposes, placing a greater burden on monetary policy.
- There is "considerable fiscal space" to provide stimulus if needed, but:
  - Automatic stabilizers are small.
  - Implementation capacity to expand discretionary spending in a timely manner is very limited.
- If economic developments remain robust, any overperformance in revenue collections in 2011 could be used to reduce the overall deficit.
- For 2012, staff urged:
  - Improve targeting of subsidies.
  - Increase infrastructure spending.

### Energy subsidies and macroeconomic implications
- Staff noted prior achievements in reducing energy subsidies and expanding cash transfer programs to vulnerable groups (implemented in 2005 and 2008).
- Energy subsidies have risen in line with oil prices and now account for "18 percent of expenditures."
- Risks to the budget going forward include:
  - Fast increasing domestic fuel demand.
  - Volatile oil prices.
  - Uncertainties in oil and gas production.
- Policy options and effects:
  - Raising administrative fuel prices and moving to a flexible pricing policy would mean only temporary upward pressure on inflation if other policies limit second-round effects.
  - Lower subsidies would provide fiscal space for increasing infrastructure and social spending to support higher economic growth.
- Authorities’ stance:
  - Widespread agreement that fuel prices must be raised, but the decision remains political.
  - Plans exist to restrict fuel subsidies to private vehicles on Java, but significant implementation hurdles remain.
  - Authorities see scope to increase nontax revenues by raising dividend and royalty income.
  - Authorities agreed that increasing revenues will be crucial for fiscal reform.

### Revenue mobilization (Box 4)
- Current tax revenue facts:
  - Tax revenue ratio is "12 percent of GDP" (current low level).
  - Personal income tax revenues are "as low as 1 percent of GDP."
  - Value-added tax and corporate income tax each raise "about 4 percent of GDP."
- Tax effort and targets:
  - Overall tax effort—ratio of actual tax revenue to estimated tax capacity—is "around 54 percent."
  - A realistic target range for potential tax revenue in the medium term is "13.4−16.4 percent of GDP," implying a "2−5 percentage point improvement" from current levels.
  - Achieving this target requires both broadening tax bases and increasing tax compliance.
- Measures recommended to broaden the tax base over time:
  - Limit VAT exemptions: reduce number of exempt goods and services to expand the tax base and raise VAT revenues.
  - Limit tax holidays and corporate income tax exemptions: remove inefficiencies such as investment tax allowances, accelerated depreciation, and special tax rates; target any remaining incentives to a few well-specified sectors with clear criteria and a well-defined preset period.
  - Tax fringe benefits: tax exempt fringe benefits to raise substantial additional revenues.
- Tax administration priorities:
  - Continue reforms focused on increasing tax compliance and improving auditing.
  - Further efforts needed to increase compliance of those already in the tax net despite growth in the number of personal income taxpayers.
- Note: For a more detailed discussion, see referenced Chapter III of the accompanying selected issues papers (as cited in the source).

### Financial policies and institutional recommendations relevant to fiscal stance
- Staff appraisal links fiscal constraints to broader macro policy:
  - Rising domestic demand pressures and lags in monetary policy transmission imply BI should be prepared to tighten policy to achieve the lower inflation target for 2012.
  - Macroprudential measures suggested to address accelerating credit growth include: raising risk weights on rapidly growing credit sectors (e.g., consumer credit), countercyclical capital, and forward-looking provisioning requirements.
- Fiscal guidance in the appraisal:
  - Any revenue collections in excess of the 2011 budget estimates should be saved to reduce fiscal stimulus.
  - If the economic outlook deteriorates, there is fiscal space to provide stimulus, but timely implementation is constrained by capacity.
  - The overall fiscal stance in 2012 should emphasize infrastructure spending.
  - Government should implement its commitment to reduce, and better target, subsidies this year.
  - The burgeoning cost of current subsidy schemes limits fiscal flexibility and the ability to fund priority expenditures, and contributes to uncertainty regarding inflation and other macroeconomic outcomes.

### Key projections and macro context (staff appraisal)
- GDP growth projection: "around 6−6½ percent y/y in both 2011 and 2012."
- Drivers: increases in both foreign and domestic investment, including anticipated increase in government infrastructure spending; offsetting lower contribution from net exports as import demand rises.
- Inflation and balance of payments:
  - Accelerating credit growth and anticipated reduction in energy subsidies should push core inflation modestly higher in 2011 and into 2012.
  - Although the current account could move into deficit next year, the overall balance of payments will remain in surplus as capital inflows continue.
- Risks highlighted:
  - Further deterioration in advanced economies (Europe, United States) could reduce global demand and commodity prices and trigger capital outflows.
  - Continued exchange rate flexibility and the buildup in reserves over the past eighteen months help buffer deterioration in international financial conditions.

*Source: IMF staff discussion in "The limited flexibility of the budget" (Indonesia 2011 Article IV Report).*

### 51.      The medium term fiscal strategy

### The medium term fiscal strategy

### Key findings on fiscal strategy and constraints
- The medium term fiscal strategy should balance the authorities’ wish for further public debt consolidation with improving the effectiveness of fiscal policy to support growth.
- A lack of infrastructure remains one of the biggest constraints to boosting Indonesia’s growth potential.
- Significant improvements to the regulatory framework are needed to support infrastructure spending and PPP projects.
- Weak budget implementation is an obstacle to higher public investment.
- Social safety nets should be better targeted towards vulnerable groups.
- Increased, and more effective, education and health spending will be needed to promote improvements in human capital and generate more equitable growth.
- Continued efforts are needed to raise the tax revenue ratio from its current low level to provide greater fiscal space.
- Improving tax efficiency will require broadening tax bases through increasing tax compliance with revenue administration reforms and containing the use of tax incentives.

### Policy recommendations
- Strengthen regulatory framework to accelerate infrastructure spending and public–private partnership (PPP) implementation.
- Improve budget execution to remove obstacles to higher public investment.
- Retarget and strengthen social safety nets to focus on vulnerable groups.
- Increase and enhance the effectiveness of education and health spending to build human capital and promote equitable growth.
- Raise the tax revenue ratio by:
  - Broadening tax bases.
  - Increasing tax compliance through revenue administration reforms.
  - Containing the use of tax incentives to preserve revenue.

### Operational guidance / process
- It is proposed that the next Article IV consultation with Indonesia take place on the standard 12˗month cycle.

### Selected related fiscal and macroeconomic statistics (as presented)
- Nominal GDP (2010): Rp 6,423 trillion or US$707 billion
- GDP per capita (2010): US$2974
- Unemployment rate (Feb. 2011): 6.8 percent
- Poverty headcount ratio at national poverty line (2010): 13.3 percent of population
- Central government revenue (2010, percent of GDP): 15.8
- Central government expenditure (2010, percent of GDP): 16.4
- Central government balance (2010, percent of GDP): -0.6
- Primary balance (2010, percent of GDP): 0.8
- Central government debt (2010, percent of GDP): 27.4

*Source: _cr11309 - 51.      The medium term fiscal strategy*

### APPENDIX I: INDONESIA—PUBLIC AND EXTERNAL

### APPENDIX I: INDONESIA—PUBLIC AND EXTERNAL DEBT SUSTAINABILITY

### Public Debt: recent developments and baseline projections
- Public sector debt fell to a record low level of 27 percent in 2010.
- Drivers of decline: primary fiscal surpluses averaging 1.6 percent of GDP per year in the last decade; modest fiscal stimulus in 2009; lower interest rates; high real GDP growth; and reduced foreign currency debt share (mostly to multilateral institutions) to less than half of total debt.
- Baseline projection:
  - Public sector debt likely to fall to about 25 percent of GDP in 2011, reflecting rupiah appreciation, falling interest rates, and robust economic growth.
  - Medium-term projection: public debt declines to 21 percent of GDP by 2016 under gradual fiscal adjustment (subsidy reduction and tax administration reforms) and continued strong growth.
  - Strategy implies a primary balance near zero while accommodating extra resources for development spending.

### Public Debt: stress tests and sensitivity analysis
- Fiscal contingent liabilities amounting to 10 percent of GDP could raise public sector debt to 30 percent of GDP by 2016.
- Currency depreciation of 30 percent would raise the debt ratio to about 25 percent of GDP.
- An increase in real interest rates would raise the debt ratio to 23 percent by 2015.
- Other macroeconomic shocks have a more limited impact; overall, public debt is characterized as sustainable and robust to macroeconomic and oil price shocks.
- Table I.1 highlights (selected series, in percent of GDP unless otherwise indicated):
  - Baseline: public sector debt time path (selected years): 55.8 (2004); 46.3 (2005); 40.4 (2006); 36.9 (2007); 33.2 (2008); 28.6 (2009); 27.4 (2010); 25.4 (2011); 24.1 (2012); 23.1 (2013); 22.2 (2014); 21.5 (2015); 20.8 (2016).
  - Foreign-currency denominated share (percent of GDP): 28.7 (2004); 24.0 (2005); 18.2 (2006); 16.5 (2007); 17.1 (2008); 13.3 (2009); 12.1 (2010); 10.9 (2011); 10.3 (2012); 9.6 (2013); 9.0 (2014); 8.5 (2015); 7.9 (2016).
  - Change in public sector debt: -4.7 (2005); -9.5 (2006); -5.9 (2007); -3.6 (2008); -3.6 (2009); -4.6 (2010); -1.2 (2011); -2.0 (2012); -1.3 (2013); -0.9 (2014); -1.0 (2015); -0.6 (2016).
  - Primary deficit (percent of GDP): -2.1 (2005); -3.1 (2006); -2.6 (2007); -1.0 (2008); -1.8 (2009); 0.1 (2010); -0.2 (2011); 0.6 (2012); 0.1 (2013); 0.1 (2014); 0.1 (2015); 0.2 (2016); 0.1 (2016, repeated).
  - Public sector debt-to-revenue ratio: 289.1 (2005); 239.1 (2006); 198.7 (2007); 191.0 (2008); 156.2 (2009); 173.6 (2010); 160.9 (2011); 144.1 (2012); 137.4 (2013); 130.8 (2014); 125.4 (2015); 120.2 (2016); 114.2 (2016).
  - Gross financing need (percent of GDP): 2.6 (2005); 0.8 (2006); 2.2 (2007); 3.5 (2008); 2.1 (2009); 3.7 (2010); 3.2 (2011); 3.3 (2012); 2.9 (2013); 2.9 (2014); 2.6 (2015); 2.6 (2016); 2.4 (2016, repeated).

### Public Debt: key macroeconomic and fiscal assumptions (baseline)
- Real GDP growth (in percent): 5.0 (2005); 5.7 (2006); 5.5 (2007); 6.3 (2008); 6.1 (2009); 4.5 (2010); 6.1 (2011); 6.5 (2012); 6.5 (2013); 6.7 (2014); 7.0 (2015); 7.0 (2016); 7.0 (2016).
- Average nominal interest rate on public debt (in percent): 5.1 (2005); 5.3 (2006); 6.1 (2007); 5.9 (2008); 6.1 (2009); 5.7 (2010); 5.5 (2011); 5.8 (2012); 6.3 (2013); 6.4 (2014); 6.6 (2015); 7.0 (2016); 7.3 (2016).
- Average real interest rate (nominal rate minus change in GDP deflator, in percent): -3.4 (2005); -9.1 (2006); -7.9 (2007); -5.4 (2008); -12.1 (2009); -2.7 (2010); -2.5 (2011); -0.5 (2012); -0.7 (2013); 0.8 (2014); 1.2 (2015); 2. (2016); 12.4 (2016 — value formatting as in source).
- Inflation rate (GDP deflator, in percent): 8.6 (2005); 14.3 (2006); 14.1 (2007); 11.3 (2008); 18.2 (2009); 8.4 (2010); 8.0 (2011); 6.2 (2012); 7.0 (2013); 5.6 (2014); 5.4 (2015); 4.9 (2016); 4.9 (2016).
- Growth of real primary spending (deflated by GDP deflator, in percent): 11.9 (2005); 0.2 (2006); 14.8 (2007); 9.7 (2008); 12.8 (2009); -11.1 (2010); 8.0 (2011); 14.7 (2012); 3.0 (2013); 8.2 (2014); 6.9 (2015); 9.0 (2016); 8.2 (2016).
- Nominal appreciation (increase in U.S. dollar value of local currency, in percent): -9.3 (2005); -5.5 (2006); 9.3 (2007); -4.3 (2008); -13.8 (2009); 16.1 (2010); 4.6 (2011); (subsequent entries elided in source).

### External Debt: recent developments and baseline projections
- External debt rose temporarily from 30 percent to 32 percent of GDP during the sharp nominal depreciation of late 2008 and early 2009.
- Rapid recovery in exchange rate and strong growth are reversing the increase; external debt projected to decline to about 27 percent of GDP by end-2011.
- Baseline projection: external debt reaches 21 percent of GDP by 2016.
- Factors offsetting weakening current account:
  - Sustained high real GDP growth in the range of 6.5−7.0 percent per year.
  - Increasing nondebt creating (i.e., FDI) flows.
  - Some further real appreciation.
- Medium-term noninterest current account balance projected at −0.5 percent of GDP, remaining above the debt stabilizing level of −3.4 percent of GDP.

### External Debt: stress tests and sensitivity analysis
- External sustainability is robust under standardized shock scenarios.
- A one-time 30 percent real exchange rate depreciation would raise the external debt ratio by 11 percentage points in 2012, and 9 percentage points over the baseline by 2016.
- Table I.2 highlights (selected series, in percent of GDP unless otherwise indicated):
  - Baseline: external debt time path (selected years): 46.5 (2005); 35.8 (2006); 30.9 (2007); 30.3 (2008); 32.1 (2009); 28.6 (2010); 25.9 (2011); 24.6 (2012); 23.4 (2013); 22.3 (2014); 21.3 (2015); 20.2 (2016).
  - Change in external debt: -6.9 (2005); -10.6 (2006); -4.9 (2007); -0.6 (2008); 1.8 (2009); -3.5 (2010); -2.7 (2011); -1.3 (2012); -1.1 (2013); -1.1 (2014); -1.1 (2015); -1.1 (2016).
  - Current account deficit, excluding interest payments (percent of GDP): -1.8 (2005); -4.3 (2006); -3.5 (2007); -0.9 (2008); -3.3 (2009); -1.4 (2010); -0.7 (2011); 0.0 (2012); 0.3 (2013); 0.5 (2014); 0.8 (2015); 0.8 (2016).
  - Net nondebt creating capital inflows (negative, percent of GDP): -1.6 (2005); -1.0 (2006); -1.5 (2007); -0.7 (2008); -0.5 (2009); -1.6 (2010); -1.6 (2011); -1.4 (2012); -1.4 (2013); -1.4 (2014); -1.5 (2015); -1.3 (2016).
  - Gross external financing need (in billions of U.S. dollars): 26.7 (2005); 32.8 (2006); 33.6 (2007); 59.1 (2008); 44.2 (2009); 68.0 (2010); 82.0 (2011); 96.5 (2012); 103.8 (2013); 110.3 (2014); 119.1 (2015); 127.8 (2016).
  - Gross external financing need (percent of GDP): 9.3 (2005); 9.0 (2006); 7.8 (2007); 11.6 (2008); 8.2 (2009); 9.6 (2010); 9.8 (2011); 10.3 (2012); 10.1 (2013); 9.7 (2014); 9.5 (2015); 9.2 (2016).

### External Debt: key macroeconomic assumptions (baseline)
- Real GDP growth (in percent): 5.7 (2005); 5.5 (2006); 6.3 (2007); 6.0 (2008); 4.6 (2009); 6.1 (2010); 6.4 (2011); 6.3 (2012); 6.7 (2013); 7.0 (2014); 7.0 (2015); 7.0 (2016).
- GDP deflator in U.S. dollars (change in percent): 5.2 (2005); 20.8 (2006); 11.6 (2007); 11.6 (2008); 0.7 (2009); 23.7 (2010); 11.0 (2011); 5.6 (2012); 3.3 (2013); 3.0 (2014); 3.0 (2015); 3.0 (2016).
- Nominal external interest rate (in percent): 3.5 (2005); 3.7 (2006); 3.4 (2007); 3.4 (2008); 2.7 (2009); 2.3 (2010); 1.9 (2011); 1.8 (2012); 1.7 (2013); 1.8 (2014); 1.8 (2015); 2.5 (2016).
- Growth of exports (U.S. dollar terms, in percent): 20.7 (2005); 15.1 (2006); 13.4 (2007); 18.7 (2008); -14.0 (2009); 31.2 (2010); 23.5 (2011); 2.6 (2012); 6.0 (2013); 5.5 (2014); 5.0 (2015); 6.1 (2016).
- Growth of imports (U.S. dollar terms, in percent): 28.0 (2005); 4.1 (2006); 15.0 (2007); 32.3 (2008); -24.7 (2009); 40.8 (2010); 26.7 (2011); 5.0 (2012); 7.1 (2013); 6.4 (2014); 6.6 (2015); 7.2 (2016).
- Current account balance, excluding interest payments (percent of GDP): 1.8 (2005); 4.3 (2006); 3.5 (2007); 0.9 (2008); 3.3 (2009); 1.4 (2010); 0.7 (2011); 0.0 (2012); -0.3 (2013); -0.5 (2014); -0.8 (2015); -0.8 (2016).

*Source: IMF staff estimates and country data as presented in APPENDIX I: INDONESIA—PUBLIC AND EXTERNAL DEBT SUSTAINABILITY.*

### ANNEX II: WORLD BANK-IMF COLLABORATION

### ANNEX II: WORLD BANK-IMF COLLABORATION

### Background
- As of September 1, 2011, the working relationship between the IMF and the World Bank in Indonesia is acknowledged by both sides to be very strong with joint working programs in many areas and close coordination through frequent meetings between resident offices and with headquarters missions, including the Article IV consultation.

### Key Areas with Joint Programs
- Budget
  - The reform agenda for budget and treasury remains a high priority for both institutions.
  - The strategic framework for joint work is built into joint Bank/Fund budget missions.
  - Bank support is being provided through the GFMRAP program (recently restructured), trust funds and DPLs, with elements in support of:
    - (a) efficient treasury operations including accounting reforms, improved in˗year budget disbursement, and regulatory reform;
    - (b) improved linkages between planning and budget preparation through the implementation of a medium term expenditure framework, and the enhancement of budget flexibility at the service delivery level;
    - (c) improved capacity for budget oversight through organizational reform.
  - The Fund team takes the lead in the development of the budget reform strategy, treasury single account, and cash planning. Moving forward this assignment of responsibilities is expected to continue.

- Taxation
  - Taxation is a priority for the Fund and the Bank with improving tax revenues an important issue for both macroeconomic security and the investment climate.
  - The Fund has a longstanding program of support for the tax department in Indonesia, recently focused on tax policy and donor coordination.
  - The Bank involvement is now also quite large. Support for tax administration reform will largely be executed through the Program for Indonesian Tax Administration Reform program which is now being prepared.
  - Participants generally anticipate that the current division of labor will continue.

- Asset Liability Management
  - The Bank and Fund have been leading an effort to improve asset liability management, including at the Treasury and Debt Management Office of the Ministry of Finance and Bank Indonesia.
  - The Bank and Fund team will continue to work together as needed.

- Financial Sector
  - The Bank has focused on broad monitoring of the financial sector with emphasis on issues important for the investment climate (as part of the Development Policy Loan series).
  - The Bank has engaged more actively on nonbank financial sector policy and access to finance.
  - The Fund has concentrated on the banking system with emphasis on bank regulation and supervision.
  - A joint Bank/Fund FSAP was completed last year and may lead to changed priorities and work programs going forward.

- Statistics
  - The Bank has a major program with the statistics agency launched in 2010, designed to focus on improvements in key statistical series through an institution wide approach including significant IT and personnel/institutional reforms.
  - There is a need for quick wins while longer-term reform plays out.
  - The Fund indicated it is prepared to continue to assist in government finance statistics.

- Macroeconomics
  - The Fund continues to take the lead in macroeconomic areas, via the Article IV and other missions, staff reports and policy notes on fiscal, monetary, and exchange rate policies, the credibility and effectiveness of monetary policy, macrofinancial linkages, and global spillovers.
  - The Bank has begun to play a larger role on macroeconomic monitoring and capacity building and has been assisting the Ministry of Finance, Fiscal Policy Office, to improve macroeconomic monitoring and forecasting capacity.
  - The Bank team has worked on longer term macro/fiscal capacity and forecasting with the planning agency.
  - Both parties expect to continue these threads of work and to hold regular meeting(s) to explore ways to improve synergies, including keeping each other informed and making requests of each other.
  - Issues being addressed include:
    - For the Fund: the impact of structurally high inflation rates and associated higher volatility on real interest rates;
    - For the Bank: the link between macro/fiscal policy and real economic outcomes, potential growth, employment, and longstanding problems in the implementation and effectiveness of government spending.

### Indonesia: JMAP Implementation
- A. Mutual Information on Relevant Work Programs
  - Bank work program:
    - Indonesia Economic Quarterly — Launched in March and June 2011; next issues due September and December 2011.
    - World Bank follow up work related to WB/IMF Financial System Assessment Program missions (October 2009 and February/March 2010) — Ongoing.
    - Development Policy Loan 8 — Winter 2011.
  - IMF work program:
    - 2011 Article IV mission — July 2011; Board discussion expected in September 2011.
    - Tax administration technical assistance — July 2011; Ongoing.
    - 2012 Staff Visit — January 2012.
    - 2012 Article IV mission — July 2012.

- B. Request for Work Program Inputs
  - Fund request to Bank:
    - Assessment of economic developments and structural policies — Ongoing.
    - Information sharing — Ongoing.
  - Bank request to Fund:
    - Assessment of macroeconomic developments and policies — Ongoing.
    - Information sharing — Ongoing.
    - Government Financial Statistics training — June 2011.

- C. Agreement on Joint Point Products and Missions
  - Joint work program:
    - Asset liability management — December 2010.

*Source: ANNEX II: WORLD BANK-IMF COLLABORATION (As of September 1, 2011).*

### 1.      Similar to other emerging markets, Indonesian financial markets have recently been

### _cr11309 - 1.      Similar to other emerging markets, Indonesian financial markets have recently been

### Financial market developments during recent global turmoil
- Jakarta equity index plunged by almost 13 percent on heavy foreign selling.
- Indonesia’s EMBI and CDS spreads rose 110-125  bps from end-August to October 3.
- The rupiah depreciated by about 4 percent against the U.S. dollar.
- Local 10-year government bond yields rose 119 bps during September 9-22, then fell back to near end-August levels in the last week of the episode.
- Offshore NDF markets remained stressed despite central bank intervention supporting the spot rupiah rate.
- Foreign investors reduced holdings of rupiah-denominated assets; equity prices fell in recent weeks but remained among the better performers in the region.
- Bond markets recovered after a sharp sell-off in mid-September, supported by government and Bank Indonesia (BI) purchases.
- There was little sign of rupiah liquidity problems in the banking system; BI overnight deposit facility volume and excess reserves signaled available liquidity.

### Inflation, trade, and external sector developments
- Headline inflation eased to 4.6 percent y/y in September from 4.8 percent in August, reflecting a larger-than-expected fall in food prices after Ramadan and base effects.
- Core inflation slowed to 4.9 percent y/y from 5.2 percent y/y in August.
- Trade surplus widened to US$3.8 billion in August, from US$1.2 billion in July.
- Exports (f.o.b.) grew 37.1 percent y/y in August.
- Import growth (c.i.f.) slowed to 23.7 percent y/y in August.
- International reserves increased to $125 billion by end August 2011 (noting elsewhere in the document reserves shown as 96.2 in 2010 and 126.4 for 2011 in the table).

### Policy actions and regulations
- Bank Indonesia (BI) intervened to stabilize the exchange rate and both BI and the government purchased government securities to support the bond market.
- On October 3, 2011, BI issued a regulation requiring that export proceeds and external borrowing in the form of non revolving loan agreements and debt securities be received by domestic banks.
  - The regulation contains no minimum period for which these funds need to be kept at a domestic bank, allowing firms to transfer them offshore immediately afterwards.
  - The regulation will not take effect until January 2012, and there will be a one-year transition period.
- Since October 2010, BI raised its policy rate by 25 basis points to 6.75 percent in February 2011 (after holding it at 6.5 percent since August 2009).
- Reserve requirements on both local currency and foreign currency deposits were raised.
- BI shifted composition of inflows away from central bank bills (SBI) by extending holding requirements, lengthening maturities of issues, and introducing longer maturity nontradable term deposits available only to banks.

### IMF Executive Board assessment and policy recommendations
- Executive Directors commended cautious policymaking underpinning strong macroeconomic performance and manageable risks from global deterioration given strong fundamentals and policy buffers.
- Directors recommended preparedness to tighten monetary policy in view of high credit growth and planned reduction in energy subsidies; the timing should consider global developments and impact on capital flows.
- Suggested instruments to tighten monetary conditions:
  - Policy rate increases.
  - Macro-prudential measures.
  - Liquidity absorption.
- Advised BI to focus communications on commitment to the inflation target.
- To improve monetary policy effectiveness, Directors suggested adjusting BI’s operational framework to link interbank rates to the policy rate more effectively and promote money market development.
- Recommended strengthening BI’s financial resources by increasing the share of marketable securities in its balance sheet and replenishing its capital base.
- Noted progress on FSAP recommendations and encouraged adoption of the Financial System Safety Net (FSSN) law to improve crisis management and resolution.
- Commended commitment to strong public finances and urged phasing out poorly targeted subsidies to create room in the 2012 budget for infrastructure and priority expenditures.
- Called for improvements in budget execution, public financial management, and tax reforms.
- Recommended renewed structural reforms to improve regulation, strengthen governance, and bolster the business climate.

### Selected economic indicators and key statistics (2007–12, as presented)
- Nominal GDP (2010): Rp 6,423 trillion or US$707 billion
- Main exports (percent of total, 2010): mineral fuels (36), manufactured goods (23), machinery and transport equipment (13)
- GDP per capita (2010): US$2974
- Unemployment rate (Feb. 2011): 6.8 percent
- Poverty headcount ratio at national poverty line (2010): 13.3 percent of population

- Real GDP (percent change): 2007: 6.3; 2008: 6.0; 2009: 4.6; 2010: 6.1; 2011 Proj.: 6.4; 2012 Proj.: 6.3
- Domestic demand: 2007: 4.1; 2008: 7.6; 2009: 5.2; 2010: 5.7; 2011 Proj.: 6.4; 2012 Proj.: 6.7
- Gross fixed investment: 2007: 9.3; 2008: 11.9; 2009: 3.3; 2010: 8.5; 2011 Proj.: 9.4; 2012 Proj.: 10.5
- Gross investment (percent of GDP): 2007: 24.9; 2008: 27.8; 2009: 31.0; 2010: 32.5; 2011 Proj.: 32.9; 2012 Proj.: 34.4
- Gross national saving (percent of GDP): 2007: 27.3; 2008: 27.8; 2009: 33.5; 2010: 33.3; 2011 Proj.: 33.1; 2012 Proj.: 34.0
- Current account balance (in billions of U.S. dollars): 2007: 10.5; 2008: 0.1; 2009: 13.6; 2010: 5.6; 2011 Proj.: 1.5; 2012 Proj.: -4.0
- Consumer prices (end period): 2007: 5.4; 2008: 11.1; 2009: 2.8; 2010: 7.0; 2011 Proj.: 5.0; 2012 Proj.: 6.4
- Consumer prices (period average): 2007: 6.0; 2008: 9.8; 2009: 4.8; 2010: 5.1; 2011 Proj.: 5.7; 2012 Proj.: 6.5
- Central government revenue (percent of GDP): 2007: 17.9; 2008: 19.8; 2009: 15.1; 2010: 15.8; 2011 Proj.: 16.4; 2012 Proj.: 15.9
- Central government expenditure (percent of GDP): 2007: 19.1; 2008: 19.9; 2009: 16.7; 2010: 16.4; 2011 Proj.: 17.7; 2012 Proj.: 17.2
- Central government balance (percent of GDP): 2007: -1.2; 2008: -0.1; 2009: -1.6; 2010: -0.6; 2011 Proj.: -1.3; 2012 Proj.: -1.3
- Central government debt (percent of GDP): 2007: 36.9; 2008: 33.2; 2009: 28.6; 2010: 27.4; 2011 Proj.: 25.2; 2012 Proj.: 23.9
- Private sector credit (12-month percent change; end of period): 2007: 25.1; 2008: 30.9; 2009: 8.2; 2010: 22.2
- Non-oil exports (f.o.b) (billions of U.S. dollars): 2007: 93.1; 2008: 107.9; 2009: 99.0; 2010: 129.4; 2011 Proj.: 159.1; 2012 Proj.: 163.5
- Non-oil imports (f.o.b) (billions of U.S. dollars): 2007: -66.1; 2008: -92.8; 2009: -73.5; 2010: -102.0; 2011 Proj.: -128.4; 2012 Proj.: -135.3
- Foreign direct investment (billions of U.S. dollars): 2007: 2.3; 2008: 3.4; 2009: 1.9; 2010: 10.6; 2011 Proj.: 11.6; 2012 Proj.: 11.2
- Gross reserves (in billions of U.S. dollars, end period): 2007: 56.9; 2008: 51.6; 2009: 66.1; 2010: 96.2; 2011 Proj.: 126.4; 2012 Proj.: 147.2
- Gross reserves (in months of imports): 2007: 4.7; 2008: 5.7; 2009: 5.2; 2010: 5.9; 2011 Proj.: 7.4; 2012 Proj.: 8.1
- Total external debt (in billions of U.S. dollars): 2007: 133.6; 2008: 155.0; 2009: 172.8; 2010: 202.4; 2011 Proj.: 216.1; 2012 Proj.: 230.0
- Total external debt (percent of GDP): 2007: 30.9; 2008: 30.3; 2009: 32.1; 2010: 28.6; 2011 Proj.: 25.9; 2012 Proj.: 24.6
- Indonesian oil price (US$/bbl): 2007: 70.7; 2008: 96.6; 2009: 61.4; 2010: 78.6; 2011 Proj.: 103.7; 2012 Proj.: 100.5
- Nominal GDP (in trillions of rupiah): 2007: 3,951; 2008: 4,949; 2009: 5,604; 2010: 6,423; 2011 Proj.: 7,223; 2012 Proj.: 8,175
- Nominal GDP (in billions of U.S. dollars): 2007: 432; 2008: 511; 2009: 538; 2010: 707; 2011 Proj.: 834; 2012 Proj.: 936

### Authorities' statement and outlook (summary of statement by Aida Budiman and Iss Savitri Hafid, October 7, 2011)
- Authorities thanked the IMF team and welcomed the appraisal of economic resiliency from prudent macroeconomic and financial measures and structural reforms.
- Outlook: Despite a bleak global outlook, Indonesia continued to show impressive progress and stability with more balanced growth sources as investment gains momentum.
- Authorities forecast GDP for 2011 and 2012 at 6.6% and 6.5% respectively; forecast inflation for 2011 and 2012 at 4.9% and 5% respectively.
- Noted all-time-high reserves sufficient to cover more than 7 months of imports and external debt services of the Government.
- Highlighted improving composition of capital inflows with FDI flows surpassing net portfolio flows beginning second-half of 2011.
- Noted improvements in financial stability (high capital adequacy ratio and markedly lower NPL), rising government bond prices and stock market index, and an appreciating rupiah trend.
- Mentioned credit rating upgrades to one notch below investment grade by two rating agencies this year and one rating at the end of last year.

*IMF staff report and Public Information Notice (PIN) materials as provided in the content unit.*

### 3. The authorities are cognizant of the challenges that lie ahead and broadly agree with

### 3. The authorities are cognizant of the challenges that lie ahead and broadly agree with

### Monetary policy
- Objective: achieve and safeguard price stability.
- Policy responses must be assessed carefully because of:
  - uncertainties in the global economy,
  - massive capital inflows and the possibility of capital reversal,
  - gaps in market development.
- Policy tools:
  - policy rate remains part of the policy tool-kit to maintain macroeconomic and financial stability,
  - other monetary and macro-prudential policies,
  - continued efforts to strengthen monetary policy operation and promote financial deepening.
- Authorities acknowledge the possibility of higher inflation pressures in 20121.
- Two considerations in formulating policy responses to inflation:
  - any adjustment in administered prices should be viewed as a one-time and temporary shock;
  - possibility of a more pronounced global economic slowdown, hence less pressure from commodity and oil price.
- Focus: limit any second-round effects of administered price adjustments to headline inflation; authorities have demonstrated ability to do so during the episode of food price increase in 2010.
- Monitoring and indicators:
  - decomposition of core inflation analyzed to track demand-side pressures;
  - current uptrend in core inflation attributed mainly to gold;
  - core inflation excluding gold is 4.2%;
  - non-food core inflation excluding gold is 4%;
  - core inflation is 5.2%.
  - inflation expectation indicators indicate a declining trend in public expectations for both for 2011 and 2012.
- Complementary measures:
  - ensure sufficient supply of food and its smooth distribution;
  - strengthen communication strategy to anchor public expectations;
  - continued use of the exchange rate as an economic shock absorber (effective so far in containing inflationary pressures and impact of capital flows).

### Credit and growth
- Expansion in credit growth is important to boost economic capacity.
- Contrast with 2009: 2009 credit growth was dominated by consumption loans.
- 2010 and 2011 rapid credit growth witnessed broad-based expansion, including working capital and investment loans.
- Most funds are channeled to productive sectors, supporting economic capacity and addressing infrastructure bottlenecks.

### Fiscal Policy
- Authorities committed to fiscal sustainability and improving public finance management.
- Medium-term fiscal strategy: attain public debt consolidation and improve quality of government expenditure.
- Public debt to GDP declined from 36.9% in 2007 and is targeted to fall to less than 24% at the end of 2011.
- Revenue-side efforts: increase tax revenue ratio through broadening tax base and continuing administration reform agenda.
- Budget structure improvements:
  - gradual phase-out of subsidies,
  - reallocation of spending towards infrastructure and alleviation of poverty and unemployment.
- Authorities seeking TA programs to help design blueprint and implementation strategy for strategic government projects.
- Budget management reforms:
  - implementing multi-year performance-based budgeting (PBB) and a medium-term expenditure framework (MTEF) for 2010-14;
  - Presidential Decree on procurement adopted in 2010 to maintain governance and streamline procurement-related regulations.
- Transitional impacts and corrective actions:
  - new procurement regulation contributed to current low execution of government spending due to transitional period and operational guidelines;
  - corrective actions include introducing an incentive system to ministries and government institutions capable of optimizing their budget by March 2011;
  - Ministry of Finance delegated some authority for budget virement to Treasury regional offices and line ministries.

### Financial Sector Policy
- Ongoing efforts to optimize financial intermediation while maintaining financial stability.
- Indonesia implementing FSAP recommendations and welcomes TA programs to address priority sector concerns.
- Banking sector reforms:
  - Basel II implementation progressing according to timeline;
  - shift to principle-based supervisory approach.
- Capital market development by Bapepam-LK focused on five development areas:
  - increasing accessible and efficient source of fund,
  - improving ease of transaction,
  - promoting a stable, resilient and liquid industry,
  - enhancing fair and transparent regulatory framework guaranteeing legal certainty,
  - promoting a credible, reliable international standard infrastructure.
- Crisis management strengthening:
  - concerted effort to establish a national crisis management protocol while awaiting enactment of the Financial Stability Safety Net Law;
  - harmonizing protocol among related agencies.
- Banking sector oversight improvements:
  - Bank Indonesia revamped system for individual banking;
  - introduced Prompt Corrective Action measure with Risk Based Bank Rating (RBBR) to preemptively determine bank supervisory status and exit policy.
- Government bond market measures:
  - Ministry of Finance and Bank Indonesia coordinating to provide back-stop mechanism as necessary to avoid excessive volatility;
  - initiative important because bond price fluctuation influences market expectations.

### Structural reform
- Government actions to address infrastructure bottlenecks:
  - strengthened provision of government guarantees and direct contribution for infrastructure projects;
  - accelerated and streamlined procurement process.
- Clear annual target-setting for infrastructure development; 2011 targets include projects related to national food security, transportation connectivity, communications, energy security, water resource and flood management.
- Efforts toward achieving investment grade status are in progress.
- Investor engagement:
  - intensified engagement with investors by improving communication channels and data transparency;
  - based on the IIF’s 2011 assessment, the Investors Relations Unit of Indonesia ranked first, together with a few other emerging market countries.
- Expected outcome: increased longer-term financing from abroad, including infrastructure financing, and at better cost.

### Conclusion and outlook
- Indonesia successfully weathered the deep global crisis in 2008 and registered continued notable economic growth.
- Progress attributed to intensive reform and prudent macroeconomic policies, laying a solid foundation for sustainable economic growth.
- Authorities envisage improving the quality of growth to bring more people out of poverty line and deliver equality in social welfare.
- Indonesia resolves to play a greater role in cushioning a potential global economic slowdown, together with other EMDCs.

*Source: content unit _cr11309*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11309.pdf_