1. On behalf of the Indonesian authorities, we would like to thank Executive Directors and Management for their continued support for Indonesia. The authorities would also like to express their appreciation to staff for the constructive policy discussions in Jakarta during the recent Fund mission and for the balanced report and useful Selected Issues paper.

2. The authorities are in general agreement with the staff’s assessment of the challenges faced and the policy initiatives to revive the economy and create job opportunities in the immediate future. They are particularly pleased to note that the staff are supportive of the government’s policy priorities and the medium-term economic strategy which is aimed at promoting high and sustainable growth led by the private sector, as well as reducing unemployment and combating poverty in line with the Medium Term National Development Plan (RPJMN 2005-2009).

Recent Developments and Prospects for 2006

3. Despite experiencing several external shocks in 2005, Indonesia’s economy recorded its highest growth in 9 years with GDP growth of 5.6 percent, achieving a sustainable path of public finance, a continued current account surplus with a healthy build up in international reserves, and further improvement in the banking sector. Inflation trended downwards, but remains high due to pass-through of the domestic fuel price adjustment last year.

4. Macroeconomic fundamentals continued improving over the first half of 2006, albeit with growth moderating in recent quarters. The recent earthquake and floods in some parts of the country have had minimal impact on the Indonesian economy. Inflationary pressures continued receding while fiscal sustainability has been maintained. The balance of payments has improved, reflecting strong growth in exports as well as a capital account surplus. This has contributed to a significant increase in international reserves and modest exchange rate appreciation which is nevertheless in line with economic fundamentals as reflected in the continued increase in non-oil and gas exports. The banking sector is profitable and well capitalized, and has gradually resumed its financial intermediation role. Although the loan to deposit ratio (LDR) is still low, bank financing to the small and medium scale enterprises, which absorb a large portion of the labor force, has increased steadily in recent years. The authorities are pleased that Indonesia’s sovereign as well as banking and corporate sector vulnerabilities have been declining over time as also pointed out in the Selected Issues paper.

5. Going forward, maintaining macroeconomic stability, accelerating the implementation of structural reforms, and improving the investment climate, including concerted efforts against corruption, will continue to be of the highest priorities for the current government. The main goals are to revive and sustain growth, further reduce inflation, expedite budget execution, and strengthen the banking sector while improving its financial intermediation. The authorities, however, recognize the risks and uncertainties surrounding the global financial markets and international oil prices as well as the formidable challenges ahead in allocating resources for emergency assistance and reconstruction in the aftermath of the tsunami and the recent natural disasters.

6. Against this backdrop and coupled with the authorities’ full commitment to implement the reform agenda, growth is expected to accelerate in the second half of the year, resulting in an annual GDP growth forecast close to 6 percent for 2006. This growth forecast is underpinned by a cautious easing of monetary policy, timely budget execution, the dissipating impact of the domestic oil price hikes as well as continued non-oil and gas export growth. This growth outlook is shared by staff, although the authorities are slightly more optimistic. Growth is projected to exceed 6 percent for 2007. As inflationary pressures recede, BI is confident that inflation towards end-2006 will be within the target range of 8 percent (+/-1 percent) and further reduced to 6 percent (+/- 1 percent) in 2007. The positive prospects for Indonesia’s economy are also shared by investors and rating agencies as reflected in the recent improvement of ratings for Indonesia by Moody’s and Standard & Poor’s. Over the medium term, the economy is expected to achieve its growth potential and be more resilient to external shocks given the structural reforms that have been put in place.

Fiscal Policy

7. The authorities are fully committed to maintaining prudent fiscal policy while recognizing the need for moderate fiscal stimulus in 2006, and increased growth generating expenditures and social spending over the medium term. To this end, the government has recently submitted a revised budget to the Parliament comprising an increase in the central government deficit from the initial target of 0.7 percent to 1.2 percent of GDP for 2006, including the carry over spending of the 2005 unspent budget of about 0.3 percent of GDP. This will enable the government to allocate more resources for education, the reconstruction of places affected by the recent earthquake, floods and tsunami, in addition to the larger expenditures needed for the increase in interest payments and fuel subsidies. Nonetheless, even with the envisaged increase in the deficit, the public debt to GDP ratio is expected to decline further to about 40 percent in 2006 and 30 percent by 2010.

8. The 2006 budget will be financed from domestic sources, mainly through the issuance of government bonds while net-foreign financing is targeted to be negative with debt re-payments exceeding new borrowings so as to reduce external debt vulnerability. The authorities are thankful to the Consultative Group on Indonesia and other development partners for their continued support, including the concessional financing for reconstruction in the hard-hit natural disaster areas. The 2007 budget that is being finalized for submission to the Parliament in August will remain prudent with the central government deficit capped below 1 percent of GDP.

9. On the expenditure side, the government has taken steps to address the obstacles of budget execution, both at the central and local government levels, by streamlining the procurement procedures and improving the capacity of local governments while maintaining proper governance, transparency, and accountability. The existing cash transfer scheme that has successfully targeted the poor is being further improved to sharpen its focus. The new scheme will directly link the cash transfer with the needs of the beneficiary for education and health expenses. As discussed in the staff report on the Observance of Standards and Codes (ROSC) Fiscal Transparency Module, Indonesia has taken impressive steps in recent years to improve fiscal transparency and further actions in this direction are well underway. The recent establishment of a fiscal policy office and a new debt management unit are expected to further strengthen the assessment of fiscal risks and public debt management. On the revenue side, the implementation of modern tax offices is to be expanded to medium and small tax payers’ offices. The tax and customs reforms that are expected to be passed by the Parliament by end-2006, will help expand the tax base and enhance revenue collection over the near-and-medium term.

Monetary and Exchange Rate Policies

10. The overriding objective of BI in the conduct of monetary policy is to contain inflation. Monetary policy was significantly tightened towards end-2005 and remained so until Q1-2006 so as to limit the second-round effects of the sharp increase in domestic fuel prices. As inflationary pressures eased, BI cautiously reduced the SBI rate by 25 bps in May. BI is nevertheless well aware that an excessive decline in the domestic interest rate could undermine the credibility of monetary policy, and in this connection, although inflationary pressures clearly receded in June, BI only cut its rate in early July by another 25 bps to 12.25 percent to take into account the developments in international financial markets. BI will continue to be cautious and interest rates will be reduced only when inflationary pressures show clear signs of abating. Furthermore, BI has intervened in the foreign exchange market to smooth abrupt movements in the exchange rate without targeting any specific exchange rate level. The authorities also concur with the view, as expressed in the Selected Issues paper, that exchange rate stability needs to be maintained in order to support the convergence process of lowering inflation to regional levels.

11. BI has made considerable progress to further strengthen the implementation of the inflation targeting (IT) framework. Its communication strategy and analytical capabilities are being improved, while policy coordination with the government continues to be strengthened. For transparency, the monetary policy stance is announced to the public every month. BI has also strengthened its coordination with the Central Bureau of Statistics to improve the quality of statistics, including the contribution of administered and non-administered commodity prices to inflation, and key inflation indicators like core inflation, so as to enable BI to conduct effective inflation surveillance and monitoring. The authorities concur with the staff that the flexible exchange rate system has served the economy well. They are committed to maintaining the system which is supportive of the IT framework.

Financial Sector Policy

12. BI has made further progress in strengthening banking supervision and prudential regulations to comply with international best practices. Early this year, BI issued a banking regulation package, including the provisions on promoting governance and enhancing customer protection. To facilitate the banking consolidation process in line with the Indonesian Banking Architecture (API), BI plans to introduce a single-presence-policy that will bar a single shareholder from owning a dominant stake in more than one bank. A major shareholder who already has a “controlling interest”, as defined by BI, in more than one bank will be given options to merge the banks, reduce the stake, or set up a special holding company in Indonesia. The policy is expected to encourage mergers and enhance effective banking supervision. While agreeing on the policy to privatize state-owned banks, the authorities, at this time however, attach greater priority on improving the performance of the state banks before contemplating a specific time frame for privatization. To further strengthen the banking infrastructure, BI has improved the existing Debtor Information System (DIS) so that all borrowers of banks as well as a large number of nonbank financial institutions are now covered under the new system. The authorities have also made progress through the introduction of retail bond transactions, beginning this month as part of the overall strategy to develop the domestic bond market.

Structural Reforms

13. The authorities are intensifying their structural reform agenda to further improve the investment climate, increase public infrastructure, and strengthen the financial sector intermediation that are necessary for improving efficiency of the economy and accelerating growth. A time-bound investment policy package was introduced in February this year, which involves a series of measures and actions to improve the investment climate. Key elements of the package include strengthening service institutions, synchronizing regional and central regulations, and improving customs, taxes, and labor regulations. Towards this end, a draft investment law has been submitted to the Parliament in March. Furthermore, there is increasing clarity on the proposed tax law, including key revisions to the initial draft to redress the balance between taxpayer’s rights and the retention of power with the tax officer. The new management teams installed recently in the tax and customs offices, together with the modernization of the tax and customs laws, unequivocally reflect the willingness of the authorities to address private sector concerns. The problem of illegal local tax is also being addressed through a plan to move from an open to a closed system, which will curtail local governments’ imposition of illegal taxes and levies. Steps have also been taken to streamline various regulations on trade licensing, delegating more authority to the regional governments for business licensing, and simplifying the immigration procedures for foreign investors and workers. A preliminary draft of the revised labor law designed to increase labor market flexibility ran into opposition from labor groups and is currently being re-examined in consultation with the business community and labor unions.

14. Two other policy packages covering infrastructure and the financial sector were issued as an integral part of the investment policy package. The authorities are well aware of the need for the smooth implementation of infrastructure projects with active participation from private investors. In this connection, the government has further improved the regulation on the risk sharing mechanism for infrastructure projects under the umbrella of public-private partnerships (PPP). The new regulation clearly specifies the criteria for financial support that can be provided by the government for PPP investment projects while avoiding unfunded liabilities for the budget. The new guidelines complement the existing regulations on electricity toll roads, water piping systems, and land acquisitions for public use issued last year and are expected to provide sufficient incentives for private investors to participate in the PPP schemes.

15. The government and BI has jointly launched a financial sector package early this month aimed at improving policy coordination and advancing the regulation and supervision of both banks and non-bank financial institutions. The policy package covers time-bound initiatives to strengthen financial system stability and banking institutions, including specific action plans to address the NPLs of state-owned banks by allowing these banks to give haircuts on loan principal, reforming the non-bank financial institutions, and improving the efficiency of capital markets.

Regional Cooperation

16. Efforts to strengthen trade and investment cooperation are being intensified. Indonesia has made commitments in the framework of the ASEAN + 3¹ to reduce import tariffs so as to further enhance regional cooperation. In May, Indonesia signed Preferential Trade Agreements (PTAs) with the D-8 member countries² aimed at promoting trade through the reduction of tariffs to the predetermined rates within a 4 to 8 year time frame. Indonesia also recently signed a Framework Agreement on Economic Cooperation with Singapore aimed at developing Special Economic Zones (SEZs) in the Indonesian islands of Batam, Bintan, and Karimun. It is expected that the SEZs will facilitate FDI and improve the country’s international competitiveness. Intensive bilateral negotiations with major trading partners are also being pursued to revitalize trade activities going forward.

Conclusion

17. Despite experiencing several external shocks in recent years, Indonesia has made significant progress in strengthening its economic fundamentals. The authorities are well aware of the remaining challenges and are strongly committed to intensifying the reform agenda while maintaining macroeconomic stability. The goal is to enhance the country’s international competitiveness through improvements in efficiency and economic productivity, which are essential for private sector-led growth, ultimately leading to a reduction in unemployment and poverty. The authorities would also like to thank Management and Executive Directors for the technical assistance provided to Indonesia in various areas that has helped the country make significant progress in recent years. Finally, the Indonesian authorities remain committed to transparency and consent to the publication of all staff reports, with necessary deletions of market sensitive information.