Jakarta, Indonesia
June 24, 1998

Indonesia Second Supplementary Memorandum of Economic and Financial Policies

1.  The revised economic program set out in the Memorandum of Economic and Financial Policies signed on April 10, despite a promising start, has been driven well off track by the social disturbances and political change that occurred in May. While the new government is strongly committed to rapid stabilization of the economy and the far-reaching structural reform described in the MEFP, significant changes to the macroeconomic framework and to monetary and fiscal policy—including to allow for a strengthened social safety net to cushion the escalating effects of the crisis on the poor—are now needed.
The most urgent priority is to repair the distribution system and ensure adequate supplies of food and other necessities to all parts of the country. Also, moving quickly to restructure comprehensively the banking system is of the highest priority. Achieving these objectives will, until the economy recovers, require considerable additional financial support from the international community.
This Supplementary Memorandum describes the changes to our economic program, with the modifications to the social safety net and banking restructuring highlighted in the attached appendices. A revised listing of all policy commitments under the program is shown in the attached matrix.

2.  As a result of the social and political upheavals in May, the economic situation and outlook have worsened considerably, and the economy faces a very serious crisis. The distribution network has been badly damaged, economic activity, including exports, generally disrupted, and business confidence severely shaken.
As a result, the exchange rate has substantially weakened, rather than appreciating as envisaged in the April program, and inflation is running higher than projected. Because of shortfalls in budgetary resources, expenditures have had to be compressed to unsustainable levels, with adverse consequences for social services and economic activity. In addition, large-scale liquidity support has had to be provided to meet runs on a major private bank, which has since been placed under the control of the bank restructuring agency (IBRA).

3.  Despite these unfavorable developments, Bank Indonesia has maintained firm control over monetary policy, effectively reabsorbing most of the liquidity provided to meet the bank run. Although base money is somewhat above the indicative target in the program, this mostly represents an increase in currency demand following the bank run; net domestic assets (NDA) remain within the April program target.
Also, by avoiding intervention in the foreign exchange market, net international reserves are still above the target established in the April program.
Another important positive development is that agreement was reached with the Steering Committee of creditor banks in Frankfurt in early June on the restructuring of interbank debt, on maintaining trade credit, and on a scheme for restructuring corporate debt. These agreements are a crucial element of our overall economic strategy, and should provide some immediate relief to the foreign exchange market, and facilitate the revival of trade and economic activity.

Macro Framework

4.  With the disruptions to economic activity and damage to business confidence in recent weeks, it is now expected that real GDP will decline by more than 10 percent in 1998. However, we believe that the decline in activity should bottom out as the program takes hold and confidence is restored.
The exchange rate, which in a thin market has been very volatile and dominated by sudden shifts in market confidence, is particularly difficult to forecast. The revised program is based on the conservative assumption that the exchange rate will stabilize by the last quarter of 1998 at around Rp 10,000 per dollar, but we expect a greater strengthening of the exchange rate.
Reflecting high inflation in the first quarter, inflation is likely to amount to about 80 percent during calendar 1998, but should slow rapidly during coming months. This revised macroeconomic framework is subject to unusually large uncertainty, and will be kept under review.

Fiscal Policy

5.  A central feature of the program continues to be the limitation of the budget deficit to a level that can be offset by additional foreign financing. The pressures on the budget, however, have intensified with the deepening of the crisis.
The depreciation of the exchange rate, through its impact on the cost of subsidies and debt service, the further decline in oil prices and weakening of output all add substantially to the deficit.
In addition, given the severity of the crisis and its disproportionate impact on the poor, there is an urgent need to strengthen the social safety net to alleviate the impact of higher unemployment and underemployment and the greater incidence of poverty.

6.  The overall budgetary cost of social safety net programs is now estimated at about 7½ percent of GDP. Food, fuel, electricity, medicine, and other subsidies are estimated, with present prices, to amount to about 6 percent of GDP in 1998/99, about 4 percentage points higher than envisaged in April.
In addition, the government is expanding employment-generating programs, targeted to poor and vulnerable regions and households, supported by the World Bank, the Asian Development Bank, and bilateral donors.
The UN World Food Program is establishing food-for-work programs, concentrated in drought-affected areas. Budgetary allocations for health are being increased, with emphasis on spending directed to the vulnerable groups, including village health centers and immunization programs.
To minimize the decline in school enrollment, the government is expanding the block grant program, strengthening the school lunch program, and instituting a scholarship program for poor students.
Further details of social safety net programs are shown in Annex I.

7.  Without offsetting measures, the budget deficit could increase to an unmanageable level in 1998/99. The viable options for reducing the deficit are few, given the weakness of the economy.
Significant revenue measures are not feasible in the short term, although over the medium term we intend to overhaul the revenue system, and we intend to request IMF technical assistance to this end. Further increases in the administered prices of staple foods and fuels would exacerbate the impact of the crisis on the poor, and will have to be delayed until the economy has begun to improve.
It remains our objective, however, to phase out subsidies as output and household incomes recover, and a system for adjusting administered prices on a regular basis will be developed by the end of this fiscal year. Some savings are envisaged from improvements in efficiency in the management of state-run operations, including through the renegotiation of existing contracts, and from resources previously utilized outside the budget. Most of the needed savings, however, will have to come from cuts in infrastructure projects.
We have reviewed investment spending in the budget carefully, and in close collaboration with the Asian Development Bank and World Bank have cut or delayed projects amounting to about 2.5 percentage points of GDP.

8.  These cuts reduce the projected budget deficit to 8.5 percent of GDP in 1998/99, a level that we believe can be offset by additional foreign financing. A deficit of this magnitude, while justified by the severity of the present crisis, is not sustainable. We envisage that the overall deficit in the 1999/2000 budget will be substantially smaller in relation to GDP, partly as a result of measures to raise revenue and reduce subsidies.

Monetary Policy and Banking System

9.  Tight monetary policy continues to be essential if the exchange rate is to stabilize and inflation decline. Given the recent weakness of the rupiah and the danger of an inflationary spiral, we intend to hold base money and NDA broadly constant during the third quarter.
As in the April program, allowance has been made in the monetary program for the repayment of arrears on interbank debt and trade credit under the agreement with foreign banks, which will imply a fall in net international reserves (NIR) of about $1 billion and a corresponding increase in NDA in late June.
Once the economy has stabilized, some modest increase in NDA and base money will probably be needed to accommodate a recovery in economic activity. Because of the considerable uncertainty about the demand for rupiah, however, monetary policy will be kept under continuous review, and adjusted as necessary, including in light of developments in the exchange rate and inflation.

10.  To strengthen monetary management, BI intends to switch from the current system in which interest rates on central bank paper (SBIs) are set administratively to an auction system for these instruments. This changeover will begin with auctions of one month paper in July, and later expand to a full range of maturities.
It is expected that auctions of SBIs will have become the primary means for conducting open market operations by end-September. In addition to strengthening monetary control, this will enable a fully market-determined term structure of interest rates to emerge. Given the need to hold NDA and base money constant, interest rates are likely to remain high in the near term, but should decline as markets stabilize.
In order to provide BI with the autonomy for conducting monetary policy, the preparation of legislation on central bank independence is being accelerated and will be submitted to Parliament by end-September.

11.  The condition of banks has deteriorated further in recent months, and implementing a comprehensive solution for the banking system is being given the highest priority. This is an essential precondition for the recovery of the corporate sector. The objective is to resolve the financial difficulties of the weak banks and establish a sound functioning banking system quickly.
A key element of the revised strategy involves measures to strengthen relatively sound banks partly through the infusion of new capital. The approach to the weak banks will involve moving swiftly to recapitalize, merge or effectively close them, while maintaining the commitment to guarantee all depositors and creditors.
Decisions regarding individual banks will be based on uniform and transparent criteria, drawing as appropriate from the results of portfolio reviews by international accounting firms.
A presidential decree will be issued providing appropriate legal powers to IBRA, including its Asset Management Unit by mid-July 1998. Also, a high level Financial Sector Advisory Committee is being established to advise on the coordination of all the necessary actions for bank restructuring. The strategy for the banking system is described in more detail in Annex II.

Corporate Debt and Bankruptcy Legislation

12.  The financial restructuring of the corporate sector is crucial for economic recovery, and an essential counterpart to banking system restructuring—a sound corporate sector is necessary for a sound banking sector.
The scheme agreed in Frankfurt provides a framework through the Indonesian Debt Restructuring Agency (INDRA) for the voluntary restructuring of the debt of corporations to foreign banks on terms that are consistent with Indonesia’s overall external payments capacity, and that would give cash flow relief to domestic corporations.
It is envisaged that domestic as well as foreign creditors will participate in debt workouts for individual companies, with all creditors sharing in the burden of providing the necessary relief. In some cases debt writedowns will be needed. IBRA, especially its asset management unit, will be the major participant in many workouts.

13.  An effective bankruptcy system is an essential part of the corporate debt restructuring strategy, without which debtors may be reluctant to negotiate with their creditors. A government regulation in lieu of law was issued in April 1998 to modernize the bankruptcy system and provide for the fair and expeditious resolution of commercial disputes. It will take effect on August 20, 120 days after the date of enactment of the regulation.
The new system will enable receivers and administrators to be drawn from qualified professionals in the private sector. A commercial court will be established (within the domain of the District Court) to handle matters under the bankruptcy regulation.
Procedural rules are designed to ensure certainty and transparency in the proceedings, especially to prevent unjustifiable delays in the adjudication of bankruptcy. Substantive rules are being introduced to provide better protection to the assets of the estate.
A committee was set up in June to oversee the selection of judges from the District Court and the Supreme Court for the bankruptcy jurisdiction; the provision of a separate organizational structure for the Commercial Court, including its own personnel, facilities, and equipment; the establishment of a training program in bankruptcy and related issues for the judges that will be selected for the Commercial Court; and the establishment of a system for the selection, training and licensing of suitably qualified receivers and administrators. The government has submitted the bankruptcy regulation to Parliament for ratification.

Food Security and the Distribution System

14.  The government is placing considerable emphasis on ensuring that there are adequate supplies of essential commodities, especially rice, and that these are available easily through the distribution system at affordable prices. Toward this end, BULOG has increased its import target for rice in 1998/99 from 2.85 million tons to 3.1 million tons.
Special measures are being introduced to ensure that domestic markets have adequate supplies of cooking oil at reasonable prices. As noted earlier, food subsidies have been increased substantially this year, as part of a broader effort to ensure food security for the poor.
To improve purchasing power in rural and urban areas, the government plans to set up public works projects throughout the country to boost incomes of the poor, the unemployed and the underemployed. To supplement these efforts, food-for-work programs are being implemented in drought-stricken areas of the country.

15.  A critical aspect of the government’s efforts to improve food security is to rehabilitate and strengthen the distribution system following the disruptions and damage caused by the recent social disturbances.
While private trading appears to be returning to normal in many parts of the country, the government feels that additional temporary measures are required to further improve the distribution system.
The Ministry of Industry and Trade has established a special monitoring unit to identify potential shortages of foodstuffs or distribution bottlenecks so that the government can take early corrective action. In key parts of the country, the government has been extending special security arrangements for the transport of essential commodities.
Where retailing has been disrupted severely, the government is trying to reactivate the retail network through the rehabilitation and construction of traditional markets. In some especially poor and remote regions of the country, where transport costs have risen sharply due to a shortage of spare parts, the government is considering providing facilities for the direct distribution of food by government agencies.
The Ministry of Home Affairs has instructed regional governors and local authorities to mobilize support for the private retail and wholesale sector, including streamlining licensing procedures to facilitate interprovincial trade.

Structural Policies

16.  The government remains committed to implementing all of the structural reforms agreed earlier, in collaboration with the World Bank.
The resource rent tax on logs and sawn timber has been introduced and procedures are being established for regular reviews of the rate to reflect changes in world prices. The ban on palm oil exports has been effectively lifted. Environmental guidelines have been issued to clarify the procedures for foreign and domestic investment in palm oil plantations. The clove marketing board has been dissolved and cigarette manufacturers are now free to purchase supplies from any source.
Efforts are continuing to create means by which private sector enterprises can compete effectively with BULOG in the importation and marketing of wheat, soybean, and sugar, although it is proving more difficult to complete arrangements than had been expected.
Finally, international standard audits will be undertaken of the financial accounts of Pertamina (the state petroleum corporation), PLN (the state electricity corporation), BULOG, and the Reforestation Fund.

17.  The privatization program is proceeding on schedule. Despite the depressed state of the economy, taking into account the interest that has been expressed by foreign investors, we are confident that the projected receipts from privatization of $1.5 billion for the 1998/99 budget can be realized.
The planned sales of shares in the domestic and international telecommunication corporations will provide a substantial part of this total.
The Minister of State Enterprises has issued a statement confirming that sales of shares in all enterprises would be conducted through transparent competitive processes consistent with international best practices.
International investment bankers have been selected to advise on the sale of each of the twelve enterprises that were identified for privatization in April. In parallel, international experts are being engaged to advise on sector structure and regulatory oversight issues. This approach will ensure a high-quality technical foundation for reforming state enterprises.
The World Bank and the Asian Development Bank will finance these technical assistance services in key policy and strategic areas. This will include the preparation of a master plan on the reform of state enterprises, comprising programs of corporate restructuring and privatization for individual companies by September 30, 1998.

Monitoring

18.  High priority is being given to effective monitoring of the economic program. The Monetary Monitoring Committee—comprising representatives of Bank Indonesia, the IMF, the U.S. Treasury, and the Bundesbank—has been meeting frequently since April.
External debt monitoring is being undertaken on a daily basis by Bank Indonesia, with IMF assistance. A committee to monitor structural reforms has been established under the chairmanship of the Minister of Planning, with representatives from other government agencies, the World Bank, the Asian Development Bank, and the IMF.
Additionally, we intend to ask the IMF to provide a high-level expert to the Minister of Finance to establish budgetary monitoring mechanisms including to ensure expenditure releases are consistent with agreed priorities.

External Issues

19.  The large decline in trade credit in recent months is a major concern, particularly as it jeopardizes exports. Part of the problem has been the unwillingness of foreign banks to confirm letters of credit, but this is being addressed through the assistance recently provided by JEXIM, export cover from a number of export credit agencies, and the Frankfurt trade facility agreement with foreign banks.
A major remaining problem is the reluctance of domestic banks to open letters of credit except on a cash basis, or to provide pre-shipment credit, because of the weak state of the corporate sector.
As a temporary solution, Bank Indonesia will establish during July a pre-shipment export guarantee program to facilitate import and pre-shipment export financing for exporters holding export letters of credit. The guarantee will be provided for a fee on a loan-by-loan basis, and will be partial, so that risk is shared with the domestic bank.
The program would be temporary and initially be limited to about $0.5 billion; the risk associated with the guarantee would be borne by the government rather than Bank Indonesia. We believe this approach is warranted by the severity of the current crisis.

20.  The external financing needs of our economic program are large. Despite the recent weakening in the exchange rate, the external current account surplus is likely to be significantly smaller this year than envisaged earlier, as export markets have been lost as a result of concerns on the part of foreign buyers about disruptions to supplies.
In addition, recent political disturbances have caused further capital outflows, and weakened the prospects for a resumption of capital inflows in the near term. The deterioration in the regional economic situation is also adversely affecting the balance of payments.
Although the agreements reached in Frankfurt regarding private sector obligations to banks are expected to ease external pressures, the capital account will be in substantial deficit.
Despite the considerable support that is being provided by bilateral and multilateral sources, additional balance of payments support in 1998/99 of $4–6 billion from these sources is needed to close the financing gap. At this critical moment, we are seeking the further support of the international community to ensure the success of our economic program.