IMF Executive Board Concludes Fourth Post-Program Monitoring Discussion with IndonesiaPublic Information Notice (PIN) No. 06/18
February 22, 2006
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report for the Article IV consultation with Indonesia may be made available at a later stage if the authorities consent.
On February 6, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Fourth Post-Program Monitoring Discussions with Indonesia.1
The Indonesian authorities took strong policy actions in the fall to calm financial markets and reestablish policy credibility. After the rupiah hit a four-year low in late-August, Bank Indonesia (BI) tightened monetary policy aggressively—one-month policy rates were increased by a cumulative 425 basis points to 12¾ percent by December (their current level). In addition, the government raised domestic fuel prices sharply in October. Following these steps, financial markets stabilized quickly, with the rupiah appreciating significantly. Equity markets have recently reached record levels and bond yields have declined.
However, macroeconomic indicators and near-term prospects have weakened somewhat. Growth momentum has been moderating since the beginning of 2005 with staff estimates showing that seasonally adjusted growth (annualized quarter-on-quarter) slowed to the 4½ percent range in the first three quarters of the year. The slowing reflects several factors, amongst others, interest rates edging up since early 2005 and the under-execution of government spending. Headline and core inflation increased in 2005, ending the year at 17.1 percent and 9.5 percent, respectively, up from 6.4 percent and 6 percent, respectively, in 2004.
Looking ahead, the unavoidable near-term fallout of the fuel price increase and high interest rates on purchasing power and production costs are likely to limit growth in the first half of 2006. Government plans to expedite budget execution in early 2006 and the recent recovery in market sentiment should help to partially offset the weakening, and activity is expected to gradually strengthen over the course of 2006 as inflation and interest rates come down.
The 2005 overall fiscal deficit is estimated to have declined to 0.6 percent of GDP from 1.4 percent in 2004. The introduction of new budget procedures for disbursing funds to executing agencies, slow project implementation, and the late adoption of the revised 2005 budget resulted in significant delays in spending. Part of the unspent amounts (0.3 percent of GDP) are being carried over and will be spent as part of the 2006 budget.
After a year of high profits in 2004, which helped improve banks' capital positions, banking sector performance weakened in 2005, in part reflecting higher interest rates. Non-performing loans (NPLs) at state banks rose three-fold to 15 percent at end-September. Although most of the increase was related to tighter NPL classification rules, there are signs that the underlying loan portfolio also deteriorated. Nevertheless, stress tests suggest that the overall banking sector remains resilient to moderate credit, interest and depreciation risks. On the financial sector safety net, the deposit insurance agency has been set up and the initial phase of withdrawal of the full deposit guarantee (interbank funds are no longer covered) has been completed.
As regards the external sector, the current account surplus has narrowed, largely reflecting the surge in oil imports (before the October fuel price increase) and weaker export volumes. Capital inflows, which declined sharply during the summer, have resumed as investor sentiment has improved. Gross international reserves stand at about US$35 billion at end-December (about 150 percent of short-term debt).
The government has made some encouraging initial progress in combating corruption. However, progress has been slower than expected in other areas, including resolving investor disputes and improving labor market flexibility and the legal environment. The new economic team intends to give high priority to reforms on tax and labor issues, and is formulating a time-bound schedule for all sectors with clear lines of responsibility to ensure that progress is made.
Executive Board Assessment
Executive Directors commended the authorities on the bold policy measures taken to address the causes of financial market volatility during the summer. They noted that, while these measures have resulted in unavoidable adverse effects on the near-term outlook, with a slowdown in economic activity and high inflation and interest rates, medium-term prospects had strengthened. The outlook should remain favorable, provided the authorities continue to implement policies consistent with macroeconomic stability and accelerate structural reforms.
Directors agreed that the priority for monetary policy is to ensure that inflation comes down. In this context, most Directors considered Bank Indonesia's commitment to maintain a tightening bias until inflation shows clear signs of abating as appropriate. They also agreed with staff that Bank Indonesia should stand ready to raise interest rates further in coming months if inflation does not show signs of declining. That said, once inflation pressures subside, interest rates could be reduced. Directors also emphasized that a clear communication of the authorities' policy stance to the public will be critical in enhancing the effectiveness of monetary policy and promoting policy credibility. Directors observed that the flexible exchange rate regime has served Indonesia well, supporting the inflation-targeting framework, and helping to cushion exogenous shocks.
Directors commended the authorities for their continued emphasis on limiting the budget deficit, which has helped to reduce the public debt burden further. In view of this and given the current slowdown in economic activity and the pressing infrastructure and social needs, the somewhat higher deficit for 2006 is warranted. A number of Directors were of the view that if the slowdown in economic activity proves to be sharper-than-projected, the authorities could allow for a mild fiscal stimulus through automatic stabilizers and permit the budget deficit to be a little higher, subject to the availability of financing and the strength of market confidence. Most Directors welcomed the adjustment of domestic fuel prices as a positive step to fiscal sustainability, and supported the authorities' intention to eliminate them over time. At the same time, they stressed the importance of well-targeted and effective safety nets to protect the poor.
Directors emphasized the need to address banking sector vulnerabilities, especially at state banks, given the downside risks due to high interest rates and a slowing economy. In this context, they underscored the need for further strengthening the oversight of state banks' management and credit practices. While supporting the formation of an asset management company to restructure the non-performing loans of a state-owned bank, Directors noted that consideration should be given to amending legislation that prevents state banks from taking hair cuts on these loans. Such an approach would remove an important obstacle to the restructuring of non-performing loans and help in their speedier resolution. Directors also urged the authorities to complete the remaining steps on the financial sector safety net to improve banking system resilience. Some Directors noted that strategic privatization of state banks over the medium-term should be considered.
Directors underscored the critical importance of structural reforms to help boost investor confidence. This will not only provide an important stimulus in the current economic environment but also ensure sustained growth over the medium term. In this context, they welcomed the authorities' emphasis on tax and labor market reforms, as well as on improving infrastructure and enhancing legal certainty. In particular, with respect to tax reforms, Directors emphasized the importance of ensuring a proper balance between taxpayer rights and the powers of tax collectors. Directors also welcomed the government's plans to formulate a time-bound schedule for implementing reforms, as this would allow for a transparent monitoring of the progress achieved.
In sum, Directors agreed that despite the current weakening in economic activity, prospects for the medium-term remain strong, as long as the authorities continue to implement policies consistent with macroeconomic stability and push ahead with the structural reforms needed to attract investment and generate growth and employment.