Jakarta, Indonesia
October 19, 1998

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington DC 20431

Dear Mr. Camdessus:

The Government of Indonesia's economic program, now being supported under an extended arrangement, was set out in the Memorandum of Economic and Financial Policies attached to the letter sent to you on July 29 and in the Supplementary Memorandum sent to you on September 11. The program is on track, and remains appropriate to Indonesia's circumstances. Recent developments and several measures to further strengthen the program, especially in the areas of banking system and corporate debt restructuring, are described in the attached Supplementary Memorandum.

We have complied with the performance criteria for end-September 1998 on net domestic assets of Bank Indonesia and net international reserves of Bank Indonesia. As data are not available for the end-September 1998 performance criteria relating to (i) the central government balance; (ii) the contracting or guaranteeing of new external debt; and (iii) the short-term external debt outstanding, we request that the applicability of these performance criteria be waived with respect to the October review. Additionally, while the draft law to institutionalize Bank Indonesia's autonomy is nearing completion, following extensive consultation with international advisors, it has not yet been submitted to Parliament. We expect to submit the draft law by mid-November 1998. Also, while we have only been able to sell shares in one listed company, given weak market conditions, no sales were initiated in the domestic and international telecommunications corporations. We therefore request waivers for the nonobservance of these two structural performance criteria on schedule.

We have agreed to transform into performance criteria the previously established indicative targets for monetary, fiscal, and external variables for end-December, and these are set out in the attached table. As you are aware, we have already agreed on structural performance criteria and benchmarks for end-December 1998.

Jakarta, Indonesia
October 19, 1998

1.  The Government of Indonesia's economic program remains on track. Net domestic assets of the central bank and net international reserves were well within their respective performance criteria for end-September; and base money and liquidity support were substantially in line with indicative targets (see Table). The fiscal balance, however, was much stronger than programmed, and the slower-than-targeted pace of development spending remains a concern. The rupiah has strengthened considerably, especially in recent days, to below Rp 9,000 per U.S. dollar. It has now appreciated beyond the end-year program assumption and may well appreciate further. This welcome development reflects continued strong policy implementation and the increased external financing under the program, most recently through the rescheduling agreement reached with official bilateral creditors in September. The priority for economic policy now is to foster a recovery in output, while consolidating stabilization and strengthening programs to protect the poor from the crisis. The program (see Matrix) continues to be developed in consultation with the IMF, World Bank, and Asian Development Bank.

Output and Prices

2.  Real GDP declined by about 2 percent on a seasonally adjusted basis between the second and third quarter, in line with expectations and much less than in the two preceding quarters, and we believe that the decline in output is now bottoming out. Non-oil and gas export volumes continued to expand strongly, in response to the exchange rate depreciation, although values showed only modest increases because of weaker world prices for many goods. The consumer price index rose by 3.8 percent in September (75 percent during January-September), well below that in preceding months despite a sizeable impact on the index of increases in food prices in August and early September. The rate of inflation should decline substantially further in the fourth quarter, reflecting the strengthening of the rupiah and the stabilization of food prices.

Monetary Policy

3.  We intend to continue adhering to the monetary program already established for the remainder of 1998. Nevertheless, there is concern about the impact of high interest rates on the banking system (including the effects of negative spreads between deposit and lending rates, which are adding to the banks' insolvency and the eventual costs of bank restructuring) and the corporate sector. It is encouraging that the rate on one-month central bank certificates (SBIs) has declined by about 10 percentage points to below 60 percent since early September. In view of this decline in interest rates, we initiated in mid-October monthly sales of three-month SBIs, to lengthen the maturity structure of monetary instruments and strengthen monetary control. Taking into account the increase in base money allowed under the monetary program from October to December, we expect that there is scope for further gradual reductions in interest rates in the coming weeks, provided the rupiah remains strong and inflation falls further as expected. However, in order not to jeopardize the stability that is being achieved, monetary policy will remain flexible and would be tightened if there are signs that inflation is not declining, or if the exchange rate weakens.

Development Spending

4.  The central government budget recorded a small cash surplus during the first five months of the fiscal year (April-August), in contrast to the programmed deficit of 2 percent of GDP, mainly because development spending was much lower than targeted. Progress was especially slow in implementing new initiatives in health, education, and employment generation. First, there were administrative delays because of substantial revisions to the original budget, the last of which was approved by Parliament only in July. Second, high inflation meant that allocations for individual projects needed to be revised, requiring adjustments both at the center and in the provinces. Third, there was a growing sense of urgency to strengthen systems of budgetary control and monitoring to protect against leakages and corruption.

5.  We are determined to accelerate development expenditure sharply in the second semester, and intend to maintain the overall budget framework. To this end, we have held meetings with provincial governors and planning offices, to impress upon them the urgency to accelerate project implementation and increase development expenditure. In this context, the authority to adjust contracts to reflect changes in costs and prices has been devolved to regional administrations. To further streamline project implementation, regulations will be issued allowing contractors to be paid up to 40 percent of the contracted amount as downpayment, double the proportion permitted earlier.

6.  We are also strengthening our monitoring of the development expenditure budget. The Ministry of Development Planning (BAPPENAS) has been sending officials into the field to assess problems and bottlenecks in project implementation. It is also improving the flow of information between the provinces and the center, especially regarding expenditure monitoring of the special programs for the poorest villages. The government is forming a high-level task force, headed by and with other members from the civil society, to monitor the implementation of the social safety net and assist with the coordination of programs. Steps are being taken to ensure that timely and accurate information is collected on expenditure disbursement (with Fund technical assistance) and on progress in project implementation, which will be reviewed monthly with the World Bank and the Asian Development Bank.

Privatization

7.  The government has completed the preparation of its masterplan for the reform of state-owned enterprises, which sets out the objectives and framework for restructuring and privatization, and outlines an action plan for each individual enterprise. The objective of the state enterprise restructuring and privatization is to enable these underperforming enterprises to improve their efficiency, profitability, and service delivery, and thereby lay the foundation for growth, as well as to strengthen the public finances and broaden ownership. It is proposed to privatize all but a few selected enterprises within the next decade, starting with an aggressive sales plan for the coming three years. The Ministry of State-Owned Enterprises intends to publish this document in October.

8.  However, the implementation of plans in the current fiscal year for the divestment of shares in seven non-listed state enterprises and the sale of additional shares in five listed enterprises is running behind schedule mainly due to weak domestic and external market conditions. The divestment of an additional 14 percent of shares in the listed PT Semen Gresik was completed in mid-October. We started in October the marketing process to potential strategic investors of shares in the international telecommunication concern, interests in port and airport companies, and the largest palm oil plantation in Indonesia. Extensive preparatory work has been undertaken in each of these projects, although the precise timing of their sale will depend on the evolution of market conditions. Progress with additional divestiture of state-owned enterprises has been slower than planned, and some will probably slip into the next fiscal year. This includes the sale of additional shares in the domestic telecommunications concern and three mining companies.

Rice Situation

9.  Retail and wholesale rice prices have declined by 5-10 percent in most regions of the country since early September. We have increased our releases from public stocks at prices closer to, but still below, prevailing market prices and are implementing the other elements of the seven-point strategy for rice that was adopted in September. Import parity prices have declined as the rupiah has strengthened, and the gap between domestic and international prices is now modest, eliminating incentives to smuggle rice from the domestic market. To maintain a higher level of releases from public stocks until the main harvest in February-March, we have taken steps in September to ensure adequate imports through public tenders and direct contracting. In addition, a ministerial decree was issued in late September that authorized the import of rice by any private trader.

10.  To ensure that the poorest have continued access to rice, the government is rapidly expanding the highly subsidized targeted program to deliver 10 kilograms of rice monthly to poor families at a price of Rp 1,000 per kilogram (about one-third of the market price). The program was extended to reach 5.6 million very poor families by September, and is expected to expand to 9.5 million target families by the end of October. The government is considering to broaden the scope of the program by increasing the target group to possibly 17 million families nationwide, and to increase the monthly delivery per family.

11.  We are making strong efforts to streamline distribution procedures and make adequate food supplies available to the most vulnerable groups. Key challenges include ensuring that poor families are better targeted in all localities, especially in urban areas. The government is now consulting with the World Bank on how to coordinate with private voluntary organizations specializing in food assistance and bilateral donors to marshal appropriate technical expertise, particularly for improved targeting and community monitoring. The World Food Program is exploring ways to supplement targeted rice distribution with additional aid, including an expanded food for work program, and the government will launch in October a supplementary feeding program for children and pregnant women.

Banking Sector Reforms

12.  The government's bank reform strategy in the coming months focuses on: (i) the government-assisted recapitalization program for potentially viable private banks; (ii) the resolution of non-viable private banks; (iii) the merger, reform and recapitalization of the state banks; (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia (BI); and (v) a strengthened banking supervision system. Parliament approved amendments to the banking law on October 16. They will facilitate the restructuring process by strengthening the legal powers of the Indonesian Bank Restructuring Agency (IBRA) and its asset management unit (AMU). A new central bank law, providing BI with substantially enhanced autonomy, has been drafted and is expected to be submitted to Parliament shortly.

13.  Bank Indonesia announced on September 29 the key elements of the bank recapitalization program for the potentially viable private banks. In order to participate, a bank must (i) presently have a capital adequacy ratio, after full provisioning for all impaired loans (based on the findings of international auditors), of better than minus 25 percent but less than 4 percent of assets; (ii) inject new capital with the government also injecting funds and taking a commensurate equity position; (iii) make current all nonperforming loans to related parties and reduce their level to within new prudential requirements; and (iv) prepare an acceptable business plan showing how it can achieve medium-term viability, and compliance with all BI prudential regulations. Banks for which audit results are already available have been given one month to develop business plans acceptable to BI, with recapitalization expected to be completed by end-year. This is an ambitious but realistic timetable. Other banks will be subjected to a similar timetable, once audit results have been finalized.

14.  The resolution of financially troubled banks is the responsibility of IBRA, working in close consultation with BI. Banks deemed ineligible for recapitalization will be quickly either closed, merged, or sold (after transferring nonperforming loans to the AMU). In any event, depositors will be fully protected. We are finalizing plans to resolve the status of the four private banks taken over in August and expect to announce these plans by end-October. We also expect by end-November to have transferred all assets of the 10 banks frozen in April and August to the AMU and to commence the liquidation of these banks shortly after. Audits on a further 26 private banks currently subject to IBRA control are expected to be completed soon, and actions will be taken to resolve these banks by end 1998.

15.  The government announced on September 28, the formal merger of four state banks into the newly established Bank Mandiri. Loan decisions and treasury management of these banks are to be placed under centralized control by end-December, although the full integration of banking operations is expected to require about two years. Plans for the implementation of this operational merger are being developed, with the assistance of advisors from an international bank, and a detailed blueprint will be finalized by end-December 1998.

16.  IBRA has been engaged in discussions with the former owners of several private banks with a view to producing a financial settlement that yields repayment of liquidity support extended by BI, and that protects the government from bank losses attributable to the violation of prudential regulations. While negotiations are well advanced in three of these cases, issues remain to be resolved regarding some elements of the proposals, especially the arrangements for the realization of cash from the settlements. We are working to resolve the outstanding issues in a way that provides assurance that cash will be realized as early as feasible, while allowing adequate flexibility to ensure that the full amount of cash returns to the government. We expect that satisfactory agreements on these issues will be reached soon and approved by the Financial Sector Action Committee by October 29. Negotiations with other former bank owners are expected to yield appropriate settlements in coming weeks.

17.  Bank Indonesia, with technical assistance from the Fund, is continuing a comprehensive reform of its prudential regulations, and expects to issue by mid-November new regulations on loan classification and loss provisioning, including with respect to restructured loans. Further work is underway to amend regulations on connected lending, liquidity management, off-balance sheet activities, and foreign currency exposure, all of which will be issued shortly.

Corporate Restructuring

18.  After successfully launching the Jakarta Initiative on September 9, 1998, we have continued working to ensure that the appropriate legal and policy foundation is in place for corporate restructuring to occur under the framework of this initiative. The decrees necessary to give effect to the Task Force for the Jakarta Initiative have been signed and a chairman appointed, and we expect that it will be fully operational by end-October. Assistance to the Task Force is being provided by the World Bank and, for small and medium-size enterprises, by the Asian Development Bank. The Task Force has already met with approximately one dozen companies, with combined debt exposure in excess of $3 billion, with a view to initiating their participation in the restructuring process. We envision that negotiations between debtors and creditors under the framework of the Jakarta Initiative will be underway by end-November. Action under the Jakarta Initiative and the strengthened exchange rate will provide an impulse to the INDRA scheme.

19.  The removal of regulatory obstacles to corporate restructuring is also well advanced. A government regulation providing for tax neutrality for mergers and removing other tax disincentives for restructuring has been drafted with Fund technical assistance and will be signed by October 23. The regulation to remove obstacles on debt to equity conversions has also been drafted and will be signed by end-October. We also anticipate that by end-November a one-stop regulatory approval process will be in place for all filings related to corporate restructuring transactions.

Bankruptcy Reform

20.  We recognize that effective implementation of bankruptcy reform is critical for corporate restructuring. To that end, we are taking a number of measures to further enhance the effective operation of the Commercial Court. Special court fees will be introduced that will generate resources for the court system in a transparent manner. Also, arrangements are being made to ensure that Commercial Court decisions are made publicly available, as is also provided for under the law.

Other Issues

21.  We recognize the negative impact that capital controls have on investor confidence and do not intend to impose any restrictions on capital flows. Similarly, we do not propose to introduce an export surrender or repatriation requirement because this could also undermine confidence and the prospects for needed capital inflows. However, we intend to strengthen the monitoring system for foreign exchange transactions, in order to broaden the coverage of data collection, especially as regards capital flows, improve transparency, and better assess the short-term exposure of the corporate and banking sectors. The IMF will provide technical assistance for this purpose.