RECENT ECONOMIC REPORTS

1. General Policy Framework

More than four years after the Asian financial crisis, Indonesia continues to struggle with the wreckage of its 1998 economic collapse. Its efforts to return to the sustained economic growth it enjoyed before 1997 have been made more difficult by the fact that the country is simultaneously undergoing a painful and, so far, incomplete transition to democracy. Government institutions are weak, political competition is robust and often violent, and powerful forces of the old regime retain sufficient influence to block reforms that threaten their privileges.

In July 2001, the People's Consultative Assembly, the nation's highest legislative body removed President K.H. Abdurrachman Wahid and elected Vice President Megawati Soekarnoputri to the Presidency after almost a year of fierce political infighting. The new government's first task was to reverse a slumping economy and reinvigorate the economic reform process. Even if the new government succeeds in establishing much needed coherence in economic policymaking, daunting challenges remain. The Wahid government left most of the nation's problems unresolved, including: building effective, democratic institutions; establishing the rule of law; restoring private capital inflows; resolving violent regional conflicts; and addressing the chronic economic problems of corruption, a heavy debt burden, and a crippled banking system.

Indonesia is the world's fourth most populous nation and the anchor of Southeast Asia politically and economically. The country has a strategic location, a large labor force earning relatively low wages, and abundant natural resources. The country retains its diversified export base of oil, gas, minerals, and agricultural commodities such as coffee, tea, rubber, timber, palm oil, and shrimp. After a nascent economic recovery in 2000, recent signs point to an economic slowdown coupled with increasing inflationary pressures. Observers expect overall real GDP growth in 2001 to be 3 percent, down from 4.8 percent a year earlier. The slowdown was most prominent in the export sector. Indonesia's exports in the first seven months of 2001 fell 3.4 percent over the same period one year earlier due to slower growth in Indonesia's major export markets. Indonesian exports to the United States will be flat this year at about $10.5 billion while imports from the United States, which fell by more than half between 1997 and 1998, will be about $2.3 billion.

The IMF-supported stabilization and recovery program has provided the framework for Indonesia's economic recovery since November 1997. However, the government has been slow to implement its commitments. The Indonesian Bank Restructuring Agency (IBRA) has recapitalized the banking system, but it has not moved quickly to dispose of assets acquired in the debt-restructuring process or to take on uncooperative debtors. Thus it runs the risk of having to inject more funds into the banking system. The Indonesian government has historically maintained a "balanced" budget: expenditures were covered by the sum of domestic revenues and foreign aid and borrowing, without resort to domestic borrowing. Often the government ended the year with a slight surplus. This remains the government's long-term goal. However, the financial crisis put a heavy burden on government finances. To recapitalize the banking system, the government issued more than Rp 426 trillion (USD 41 billion, at current exchange rates.) almost $ 25 billion of this debt is at variable rates linked to SBI rates. This limits the government's ability to use monetary policy to fight inflation. Interest payments on domestic debt, will reach Rp 55 trillion ($6.4 billion) or 19 percent of total spending in FY-2001. The government's chronic inability to expand domestic tax revenues and delays in sales of government assets held by IBRA means the government's fiscal position will remain precarious. The gap in FY-2002 is targeted at approximately 2.5 percent of GDP.

In parallel with its fiscal policy, the Indonesian government had a reputation for prudent monetary policy that helped keep consumer price inflation in the single digits. However, the massive depreciation of the rupiah that began in mid-1997 and huge liquidity injections into the banking system have fueled inflation. Indonesian monetary authorities tried to dampen pressure on prices and the exchange rate by tightening monetary policy but the money supply has expanded faster than the targets agreed with the IMF. By mid-2001, inflation had reached an annual rate of 13 percent.

2. Exchange Rate Policies

In August 1997, the government eliminated the rupiah intervention band in favor of a floating exchange rate policy.

3. Structural Policies

In October 1997, deteriorating conditions led Indonesia to request support from the International Monetary Fund (IMF). The government signed its first Letter of Intent (LOI) with the IMF on October 31, 1997. The letter called for a three-year economic stabilization and recovery program, supported by loans from the IMF ($10 billion), the World Bank, the Asian Development Bank, and bilateral donors. Apart from financial support, the international community also offered detailed technical assistance to the government. Foreign governments and private organizations also contributed food and other humanitarian assistance.

Indonesia's agreement with the IMF has been revised repeatedly in response to deteriorating macroeconomic conditions and political changes. The result is a complex, multi-faceted program which attempts to address macroeconomic imbalances, financial weaknesses, real sector inefficiencies, and the loss of private sector confidence. Implementation of IMF commitments was erratic and disbursements were suspended for the second time in December 2000 after the two sides failed to reach agreement on the program's third review. Key stumbling blocks were Indonesia's failure to complete a number of crucial structural reforms including asset sales, and the government's insistence on amending the central bank law, a move the IMF feared would undermine Bank Indonesia's independence. The new Megawati government resumed discussions with the IMF in August 2001 and concluded a new LOI in September.

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