Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. P.;073-T.ND

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED LOAN

IN AN AMOUNT EQUIVALENT TO US$350 MILLION

TO THE

REPUBLIC OF INDONESIA

FOR

PRIVATE SECTOR DEVELOPMENT

MAY 16, 1989

This document has a restricted distribution and may be used by recipients only In the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS

Currency Unit = RupiahU3S$1.00 Rupiah (Rp.) 1,759Rp.l million - US$569

GOVERNMENT OF INDONESIA FISCAL YEAR

April 1 - March 31

SYSTEM OF WEIGHTS AND MEASURES

Metric

ABBREVIATIONS AND ACRONYMS

API - Importer identification numberBAPPENAS - National Development Planning AgencyBKPM - Investment Coordinating BoardBULOG - The National Logistics AgencyCCCN - Customs Coordination Council NomenclatureCD - Certificate of DepositGOI - Government of IndonesiaHGB - Right of BuildingHGU - Right of ExploitationHS - Harmonized System (of trade classification)IGGI - Inter-Governmental Group on IndonesiaIP - Importir Produser (actual user importer)IU - Importir Umum (general importer)MLT - Medium and long-termNPWP - Taxpayer identification numberNTB - Non-tariff barrierO&M - Operations and maintenanceOTC - Over-the-counterP4BM - Implementing agency for May 6 schemePERUMTEL - Telecommunication utilityPLN - Power utilityPMA - Joint venture companyPSDL - Private Sector Development LoanREPELITA - National Five-Year Development PlanSBI - Bank Indonesia certificatesSBPU - Money market securitiesSGS - Societe Generale de Surveillance S.A.SIUP - Operating licenseSOE - Statement of ExpenditureTPAL - Trade Policy Adjustment LoanVAT - Value-added tax

FOR OMCUIL USE ONLY

INDONESIA

PRIVATE SECTOR DEVELOPMENT LOAN

Table of Contents

Page no.

LOAN SUMMARY

I. BACKGROUND ............. .................................. 1

II. THE ROLE OF THE PRIVATE SECTOR IN INDONESIA .... .......... 2

A. Overview of the Changing Role of the Private Sector .. 2

Past Development of the Private Sector .... ....... 2Current Government Policy Towards the PrivateSector ............. ............................ 3

B. The Environment for Private Sector Development ...... 4

Progress on Macroeconomic Conditions .... ......... 4

Domestic Incentives ....... ....................... 7Trade Policy ......... .......................... 7Domestic Pricing Policies and Subsidies .... .... 10Export and Investment Incentives ..... .......... 10

Legal and Regulatory Framework ..... .............. 11Investment and Capacity Licensing .... .......... 11Foreign Investment Regulations ..... ............ 13Local Regulations ....... ....................... 14Land Tenure and Property Rights ................ 14Labor Laws and Regulations ..... ................ 15Corporate Legal Framework ...... ................ 15

C. Changing Policies Towards Public Enterprises .... ..... 15

D. Infrastructure and Supporting Services ..... .......... 17

Provision of Basic Infrastructure ..... ........... 17Transport and Other Services ..... ................ 18Education and Health Services ..... ............... 19

E. Financial Sector Development ...... ................... 20

Background . ...................................... 20Recent Policy Reforms ....... ..................... 21

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

III. THE BANK STRATEGY FOR PRIVATE SECTOR DEVELOPMENTIN INDONESIA ......................................... 23

Macroeconomic Policies ............................... 23

Incentives and Regulatory Framework ...... ............ 23

Public Enterprise Refoms ........... ................. 24

Infrastructure and Supporting Services ..... .. ......... 24

Financial Sector Development ...... ................... 26

IV. THE PROPOSED LOAN . ....................................... 27

A. Loan Rationale and Objectives ...... .................. 27

B. Loan Administration .......... ........................ 28Disbursement . ....................................... 28Procurement .............................. 29Accounts and Audits .............................. 29

C. Monitoring and Follo,.-up ............................. 29

D. Program Benefits and Risks ........................... 31

V. RELATIONS WITH IMF .................................. 31

VI. RECOMMENDATION ................................... 31

TABLES:

Table 1: Selected Economic Indicators for Indonesia ............... 6Table 2: Impact of Reform Packages on Import Licensing Coverage ...8Table 3: Changes in Tariff Schedule ...................... 9..* .....9Table 4: Summary of Investment Restrictions in the Industrial

Sector ................................................. 12ANNEXES:

I. Key Economic Indicators .. 32II. The Status of Bank Group Operations in Indonesia ........ 34III. Supplementary Data Sheet ...... 38IV. Government's Statement on Economic Policy ............... 39V. Policy Framework ........................................ 49VI. Implementation and Impact of Reforms Supported by

Earlier Adjustment Loans ................................ 53VII. Details of Recent Policy Measures ....................... 60

INDONESIA

PRIVATE SECTOR DEVELOPMENT LOAN

Loan Sunmary

Borrower: Republic of Indonesia

Executing Agencies: Bank Indonesia and Ministry of Finance

Amount: US$350 million equivalent

Terms: 20 years, including 5 years of grace, at the standardvariable interest rate

Project Descriptions: The objectives of the proposed loan are to developthe private sector by: (a) supporting thesubstantial policy measures undertaken by theGovernment of Indonesia (GOI) during 1988 and early1989, and ensuring that they are implemented well;(b) assisting GOI to bring about an early recovery ineconomic activity, consistent with external andinternal financial stability; and (c) maintaining thepolicy dialogue on further reforms to promote theefficiency and longer-term viability of the economy.The loan of US$350 million equivalent would financegeneral imports of goods to meet part of Indonesia'snear-term foreign exchange requirements, and play acatalytic role in mobilizing fast-disbursingassistance from other donors. Satisfactory progresson implementing recent reforms and follow-up actionon the core policy agenda could form the basis for asubsequent loan in about a year.

Benefits and Risks: The policy measures taken by the Government over thepast year will substantially improve the climate forprivate sector development, by: (a) providing astable macroeconomic setting; (b) developing a lessdistortionary trade regime; (c) reducing regulatoryrestrictions on investment and maritime transport;and (d) promoting a more competitive and responsivefinancial system. Positive benefits of the ongoingadjustment process are already evident in the recentperformance of the economy, especially the stronggrowth of non-oil exports, investment approvals andmanufacturing activity. In all of these areas, theprivate sector is now playing a much larger role thanin the early 1980s. The principal risk is that thefar-reaching nature of these reforms could encounterdomestic opposition as they are implemented andextended. This risk is offset by the positiveresponses to earlier reforms and the Government'sdemonstrated commitment to carry out difficult andsensitive policy measures.

Estimated Disbursement: US$350 million will be disbursed by March 31. 1990.

Economic Rate ofReturn: Not applicable.

Appraisal Report: None.

REPORT AND RECOMMENDATIONS O! THE PRESIDENTOF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE EXECUT!VE DIRECTORS ON A PROPOSEDPRIVATE SECTOR DEVELOPMENT LOAN TO INDONESIA

1. I submit the following report and recommendation on a proposedPrivate Sector Development Loan to Indonesia for the equivalent ofUS$350 million. The proposed loan would have a term of 20 years, including5 years grace, at the standard variable interest rate.

2. An economic report, entitled "Indonesia: Strategy for Growth andStructural Change" (No. 7758-IND, dated May 3, 1989) was distributed to theExecutive Directors in May 1989. Annex I gives selected economic indicatorsfor the country.

PART I - BACKGROUND

3. Policies towards the public and private sectors have undergonedramatic changes in Indonesia since the early part of the 1980s. TheGevernment has embarked upon a wide-ranging program of reforms that isdesigned to promote the role of the private sector. This is being done bystrict adherence to macroeconomic policies that improve the efficiency andprofitability of private sector investment, through reforms of the incentiveand regulatory framework, and through the development of the financial sector.At the same time, the role of public enterprises concerned with the productionof goods (e.g., in agricutlture and manufacturing) and in the provision ofservices (e.g., in finance and transport) has undergone reexamination.Budgetary support for pvolic enterprises has been cut back, and programs arebeing developed to transfer several of these activities to the private sector.

4. The Bank has provided direct support to the Government's adjustmentefforts through two trade policy adjustment loans of US$300 million each: thefirst was approved on February 3, 1987 and the second on May 10, 1988. Thesetwo loans supported the adjustment measures taken by the Government inresponse to the deteriorating external environment, and in particular thepolicy reforms in trade, industry and investment regulations. Implementationof the measures has proceeded well with no significant delays or problems.More importantly, the results to date in terms of exports, investment and therecovery of growth have been outstanding and well beyond expectations. Animportant element underpinning this successful adjustment has been quickdisbursing assistance from official donors. Both directly, and through itscatalytic role, the Bank's adjustment loans mobilized US$3.7 billion inspecial assistance to support the adjustment process. Annex VI provides adetailed assessment of the implementation and impact of the reform programsupported by the earlier adjustment loans.

5. Over the past year, the Government has pushed ahead aggressively withits program of adjustment. A central element has been maintenance of prudentand stable macroeconomic policies, to control inflation, promote non-oilexports and avoid crowding out of private sector investment. The new budgetfor 1989/90, announced early January, gives strong emphasis to public resourcemobilization, in order to offset declining oil revenues and maintain a prudent

fiscal stance. The Government has also broadened and intensified its effortsto improve domestic incentives and the regulatory environment for thz% privatesector. A series of major reforms has been announced over the past sixmonths. These reforms stem from a conscious strategy on the part of theGovernment to expand the role of the private sector and a clear recognition ofthe constraints to private sector development that need to be addressed. Assuch, the recent packages have focussed on areas of reform that had beenidentified as the most urgent by the Bank and the Government in removing theimpediments to private sector develolien.t. The highlights include:

o another major package of reforms in trade policy, including theremoval of import licensing restrictions in such areas asplastics, fertilizers and agricultural products;

o adoption of a short negative investment list, to open up newareas to domestic and foreign investment, and introduce greatertransparency into the system;

o a major package of reforms in the financial sector that providesfor expansion of the private sector and greater competition inthe banking system, as well as development of capital markets;and

o wide ranging reforms in the maritime sector that virtuallyremove all restrictions on entry by domestic and foreign lines,and allow shipping companies complete freedom in determiningtheir routes and schedules.

6. These recent measures are more sweeping thax those supported underthe earlier loans and will substantially improve the c'imate for privatesector development. The purpose of the proposed loan is to support thesemeasures and, thereby, to expand the role of the private sector in thedevelopment of the country.

PART II - THE ROLE OF THE PRIVATE SECTOR IN INDONESIA

A. Overview of the Changing Role of the Private Sector

Past Development of the Private Sector

7. The private sector in Indonevsia has traditionally played an importantrole in smallholder agriculture, small and medium industry, and the provisionof many services, particularly transportation and trade. However, since theearly days of Independence, there has also been a tradWtion of heavygovernment regulation of private sector activity and direct public sectorinvolvement in many spheres of economic activity. Following thenationalization of foreign (mainly Dutch) enterprises in the late 1950s, therewas a steady increase in public sector involvement in agricultural andmanufacturing activities, and in construction, transportation and bankingservices. For much of the 1970s and early 1980s, the expansion in the role ofthe public sector was made possible by the rapid increase in oil revenues.During 1974-82, public investment grew on average by about 92 per annum inreal terms and accounted for almost half of total investment. Much of the

increase in public investment was directed to the expansion of the country'sphysical infrastructuret irrigation. roads, power and telecommunications. Butthe role of the public sector was seen also to be important to balance theeconomic power of the large business groups, and to push industrialdevelopment into upstream and high-technology areas. By the early 1980s, theCentral Government owned some 214 enterprises in virtually all sectors of theeconomy. e&rms with public involvement accounted for 37Z of industrialproduction (and over 0S in the chemicals, non-metallic minerals and basicmetals sul"sectorp). The expansion in the role of the public sector, combinedwith a strong domestic market orientation and a philosophy of close guidanceof the private sector, led to a proliferation of trade and investmentrestrictions. As a result, the regulatory environment for private sectoractivity became less transparent and distorted domestic incentives. Theperformance of supporting services, especially in the financial and transportsectors, was also constrained by regulatory controls over competitiou and thedominance of public sector institutions.

Current Government Policy Towards the Private Sector

8. Since 1982, there has been a major shift in policy towards the rolesof the private sector and public enterprises. Following the decline in oilprices, the Government found that it no longer had sufficient resources tosustain public investment at historical levels. Over the past five years,public investment has been cut by more than 25Z in real terms. Budgetcontributions to public enterprises have been virtually eliminated and strictlimits have been placed on the access of public enterprises to non-concessional external funds. The Government has recognized that publicenterprises have become a considerable burden to the economy, and that theirrole should be reduced. Accordingly, b review has recently been completed ofthe financial performance of most public enterprises to identify suitablecandidates for divestiture or reorganization. It is expected that someenterprises will enter into joint ventures wit-. the private sector and otherswill issue shares to the public in the near future.

9. At the same time, and in parallel with trends elsewhere in the world,the Government also recognized that the private sector must be encouragel toplay a more active role in the development of the country by supporting thegrowth of employment, incomes and exports. The basic objectives of thestrategy towards the private sector are to: (a) promote more rapid growththrough increased efficiency; and (b) provide wider participation andownership for the private sector in economic activities. This shift in policystemmed from a major reexamination of the constraints to private sectordevelopment, namely: a distorted incentive regime, a restricted ownershippolicy, a cumbersome regulator framework, deficiencies in infrastructure andsupporting services, and weakt.c.3ses in the financial sector that adverselyaffect the availability and cost of credit. Beginning in 1985, the Government2mbarked upon a drive to reduce and simplify economic regulations. This drivegathered momentum over the past two years, culminating in the major series ofreforms announced since October 1988 on trade policy, investment licensing,financial bector development and maritime regulations.

10. The changing role of the public sector, and the importance attachedto private sector development, are clearly reflected in the draft five-yearplan (REPELITA V) presented to Parliament in early 1989. The plan projects

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the private sector's share in total investment to average 55Z over the nextfive years.l/ While this share is lower than in recent years, when publicinvestment has been sharply curtailed, it is above the trend levels of thelate 1970s and early 1980s. To achieve this objective, the plan recognizesthe need to develop a 'healthy and dynamic investment climate' throughattractive incentives, simplified regulations and procedures, and theprovision of appropriate infrastructure. Given the higher priority for O&M,physical infrastructure anI human resource development, direct investment inindustry is projected to account for onlv 2Z of development expenditure duringREPELITA V (down from a peak of 9Z in 1985186). As a result, almost all ofthe increment in manufacturing capacity, for example, will have to come fromthe private sector.

B. The Environment for Private Sector Development

11. As pointed out in the recent World Bank Review Group Report onPrivate Sector Development,21 a supportiv2 environment for private sectordevelopment must include three key elements: a stable macroeconomic setting,economic incentives that promote efficient resource allocation by the privatesector, and laws and regulations that protect the public interest, jut do notunnecessarily interfere with private initiative. Indonesia's past record ineach of these areas, including the recent policy reforms, as well as the mainchallenges ahead are summarized below.

Progress on Macroeconomic Conditions

12. Macroeconomic conditions in a country have a pervasive influence onthe private sector through their effects on the production and investmentclimate in which private producers operate. In Indonesia, despite the adverseimpact of external shocks, the Government has succeeded in maintaining astable macroeconomic environment in recent years. Prudent fiscal policieshave protected the private sector's access to limited financial resources,while al3o helping to reduce domestic inflation. Flexible exchange rate andinterest rate policies have in turn prevented capital flight, and providedappropriate signals for efficient resource mobilization and allocation.Through these sound policies, the Government has been able to avoid moredraconian cuts in aggregate demand and preserve its creditworthiness infinancial markets, with obvious benefits to the private sector.

13. As the external environment faced by Indonesia deteriorated duringthe 1980s, the Government adopted more austere macroeconomic policies in twosuccessive stabilization programs (1982-85 and 1986-88). The Rupiah wasdevalued in 1983 and 1986, and the flexibility of the exchange rate hassubsequently been increased through a more actively managed float. Because ofprudent fiscal and monetary policies, the real effective exchange rate is nowlower than immediately after the devaluation in September 1986. Fiscaldiscipline has been maintained through severc cuts in public sector spending.Many large capital-intensive projects were rephased in 1983, with estimated

1/ Private investment, as defined by GOI, is total investment lessdevelopment expenditure by the Central Government.

21 Report of the Private Sector Development Review Group, submitted to theBoard on July 25, 1988.

foreign exchange savings of US$10 billion. Over the past three years, civilservice salaries have been frozen and real capital spending by the CentralGovernment has been cut by more than 20S. The 1989190 budget provides forincreases in civil service salaries (152). This is appropriate under currentcircumstances. However, because of the emphasis given to raising non-oilrevenues, the overall fiscal stance remains cautious, with a primary surplusand declining net domestic expenditure.

14. In order to ensure that the public sector can meet its spendingpriorities and debt commitments, while reducing the fiscal deficit tosustainable levels, the Government is pursuing an aggressive program of publicresource mobilizatirn. Following the major tax reforms of the mid 1980s, andsubsequent improvements in tax administration, non-oil taxes have been raisedfrom 7.42 to 10.8? of non-oil GDr over the past six years. Even so, thisperformance is still well short of potential and lower than for most othercountries in the Region. Over the next five years, budget resources willcontinue to be restrained by weak oil prices and high debt payments. Torespond to this situation, the Government is preparing a comprehensive programof actions to mobilize public resources during 1989/90.3/ Several importantcomponents have already been announced: (a) power tariffs were raised onaverage by 252 on April 1, 1989; (b) VAT has been extended to the wholesalelevel and most services; (c) the rates and number of items subject to luxurytax have been increased; and (d) the Government intends to eliminate pesticidesubsidies during the coming year.

15. To help relieve the short-term resource constraint, and support theGovernment's policy measures, the donor community has provided specialassistance in the form of fast-disbursing and untied aid. Disbursements ofspecial assistance have totalled an estimated US$3.7 billion over the pastthree years.41 These additional resources have enabled the Government to pushahead with its deregulation measures, and by cushioning the economy againstthe deflationary impact of the drop in oil prices. have facilitated therecovery in private investment and growth. Special assistance has alsoenabled Indonesia to improve the term structure of its external debt, whilemaintaining financial market and investor confidence about the viability ofthe Government's adjustment program. Our balance of payments projectionsindicate that requirements for commitments of special assistance will totalUS$1.8 billion in 1989/90. This is substantially down on the level ofUS$2.4 billion pledged for last year. This declining trend reflects theGovernment's commitment to narrow the financing gaps by developing non-oilexports and non-oil budget revenues, so as to phase out special assistanceover the next few years.

16. As a result of the prompt stabilization measures taken in response tothe external shocks of 1986, the current account deficit was contained to 61of GNP in 1986/87 and reduced to below 32 of GNP over the past two years (see

31 The 1989190 budget projects non-oil tax and non-tax revenues to grow by31? and 502 respectively over the estimated base for this year.

4/ Special assistance includes two World Bank trade policy adjustmentloans, the local-cost financing of World Bank projects by Japan EximBank, and extra program aid and local-cost financing from other IGGImembers, especially Japan.

Table 1). Inflation has also been held to about SZ per annum over the pasttwo years, preserving the competitive advantage provide.d by the 1986devaluation. In response to the real exchange rate adjustment, andaccompanying deregulation measures, non-oil e-ports have increasedsubstantially from US$6.7 billion in 1986/87 to an estimated US$12.1 billionin 1988189, a real increase of 202 per annux. Much of this growth has comefrom a diversifying base of manufactured goods, with many small and medium-sized private firms contributing substantially. There is also evidence of aresurgence in private investment, especially in export-oriented activities.Approvals by the Investment Coordinating Board (BKPM) rose by 230Z fordomestic investment and 430? for foreign investment over the past two years.Overall, Indonesia not only succeeded in sustaining growth in the non-oileconomy despite the severe challenges posed by the adverse externalenvironment, but has been able to put the economy back on the path of morerapid growth. Non-oil GDP growth, in real terms, is estimated to have risento around 5.6Z in 1988, compared with an average of 4.12 per annum over thepast three years. With the resurgence of investment and the momentum of theexport drive, there is every expectation that this recovery will be sustained.

Table 1: SELECTED ECONOMIC INDICATORS FOR INDONESIA

Actual Projected1978-82 1982-86 1986-88 1989 1990 1990-95

Real growth rates (2 p.a.)GDP 5.3 3.8 4.3 5.2 4.6 5.2Non-oil GDP 6.9 4.0 5.1 5.6 5.9 6.2Non-oil exports 10.5 13.6 19.5 11.9 9.8 7.2Fixed investment 10.7 -5.0 4.4 7.0 8.5 8.9

- Public 12.6 -8.8 2.2 3.6 6.6 7.7- Private 9.1 -1.2 6.2 9.6 9.9 9.7

Other key indicators /aOil price (US$Ibbl) 33.2 12.5 15.0 15.5 16.6 22.0Current account/GNP (Z) -7.9 -5.9 -2.5 -2.1 -1.9 -1.0Debt service ratio (Z) lb 16.8 37.3 36.3 37.1 34.4 23.8

/a End of period./b Debt service excludes prepayments.

Source: Central Bureau of Statistics and World Bank staff estimates.

17. To absorb the rapidly growing labor force at higher levels ofproductivity, the non-oil economy will have to grow by 5-62 per annum in realterms over the medium term. This will require improvements in efficiency anda strong investment effort. Accordingly, substantial buildups of productioncapacity in the agriculture and manufacturing sectors, as well as insupporting improvements in physical infrastructure, are incorporated into ourprojections. Fixed investment is projected to rise from 20? of GDP in 1988 to

252 of GDP by 1995. Private investment is projected to grow on average by 102per annum in real terms over this period. Investment and growth in turn willlead to higher import demand, at a time when net earnings from oil arestagnating. However, the impact on the balance of payments will be offset bya steady improvement in the terms of trade and strong growth of non-oilexports. Non-oil exports are expected to grow on average by 102 p.a. in realterms over the next three years and 72 p.a. over the medium term. As aresult, the current account deficit will continue to decline as a share ofGNP, and be stabilized at around 12 of GNP by 1995.

18. Indonesia's external debt burden has increased sharply since theearly 1980s. The debt service ratio is estimated to have risen from 172 in1982 to 372 in 1986, and then stabilized around this level over the past twoyears. Similarly, the stock of MLT debt outstanding and disbursed has doubledover the past five years to about US$47 billion. A large portion of theincrease in the debt burden was due to factors beyond the control of theGovernment, especially the depreciation of the US Dollar and the fall in oilprices. Because of the favorable debt structure (reinforced by theavailability of special assistance) and the strong economic recovery(especially for non-oil exports), Indonesia is projected to make rapidprogress in reducing its debt burden and improving its debt servicingcapacity. The debt service ratio, for example, declines from 36Z in 1988 to242 by 1995. As a result, Indonesia is expected to remain creditworthy,ensuring access to adequate levels of external funding from both official andprivate sources.

Domestic Incentives

19. The incentive framework is an important determinant of efficientprivate sector development. Distortions in the incentive framework in thepast had led to widespread inefficiencies in resource allocation, created asubstantial anti-export bias, and, together with the domestic licensingsystem, stifled competition and created a climate of 'rent seeking' in theeconomy. The main instruments for incentives policy in Indonesia are: thetrade policy regime, domestic pricing policies and incentives, and export andinvestment incentives.

20. Trade policy. The trade regime has played a pervasive role inshaping the structure and efficiency of private sector activity in Indonesia.Throughout the 1970s and early 1980s, Indonesia's trade and industrialpolicies were inward-looking, promoting investment in highly protectedactivities geared to supply the domestic market. At the start of the decadethe primary instrument of protection was a high and disparate import tariffstructure. As pressures began to build from the slowdown in the domesticeconomy in the early 1980s, tariff protection was supplemented by aproliferation of non-tariff barriers (NTBs) in the form of import licenses.In 1985, the Government introduced an across-the-board reduction in tariffs,lowering the ceiling for most items from 2252 to 602 and reducing the numberof tariff levels from 25 to 11. However, the effect of this change wassignificantly muted by the introduction of many specific duties and theincreased use of NTBs. By the end of 1985, more than 1,700 items (CCCNcategories) were subject to import license restrictions, accounting for over40X of total import value and traded domestic production.

21. The sharp drop in oil prices in early 1986 drastically reduced exportand tax revenues, further exposing the danger of pursuing an inward-lookingdevelopment strategy. In response, the Government embarked upon anaccelerated and more sweeping program of trade and industry policy reform tocomplement the 312 currency devaluation of September 1986. The first step wastaken on May 6, 1986, when the Government announced measures to provideinternationally-priced inputs to exporters. Subsequent reform measures havebeen designed to move away from a trade regime based on import licenseprotection towards one based on tariffs. The cumulative impact of the tradereform packages announced between October 1986 and end-1987 is shown inTable 2. In brief, these measures resulted in the removal of 544 items fromlicense control accounting for 31? of all items and 41? of total import valuepreviously restricted. More importantly, the share of manufacturingproduction protected by import licensing declined from 52? in mid-1986 to 35?by end-1987. The reduction in NTBs was concentrated in activities with thehighest effective rates of protection, such as chemicals, iron and steel,engineering goods, paints and dyes, tires and tubes, glass and textiles.

Table 2: IMPACT OF REFORM PACKAGES ON IMPORT LICENSING COVERAGE

Coverage Mid-1986 End-1987 End-1988

6 of CCCN items 31.5 21.7 16.32 of import value 42.9 25.2 20.82 of total domesticproduction 41.4 37.6 28.9

Memo item:2 of domestic production in:Manufacturing 52.0 35.3 26.0Agriculture 65.5 64.6 50.2Mining and minerals 0.2 0.2 0.2

Source: World Bank staff estimates.

22. A major package of new trade policy measures was aDnounced inNovember 1988. A further 25'! items have been removed from restrictive importlicenses, accounting for an additional 17? of all items and 10? of importvalue previously restricted. The impact on the share of total domesticproduction protected by import licensing is much larger than previouspackages, declining from 38? at end-1987 to 292 by end-1988.5/ This reflectsan effort to push the reform effort into the agriculture, food and beveragessectors (e.g., tobacco, rubber, fruits, palm/coconut oil, processed meat,

5 Of the 29? of domestic production remaining under NTBs:3, 16 percentagepoints relate to rice, where the Government maintains importrestrictions for food security objectives. Indonesia is an efficientproducer of rice for the domestic market.

cigarettes), which constitute a large share of domestic value added and hadbeen largely untouched by earlier reforms. With respect to manufacturing, theNovember package is significant in that it removed all license restrictions onfertilizers as well as plastics, a hitherto difficult area of reform, and madefurther in-roads into the steel and textile subsectors. The November packagealso adjusted tariffs and/or surcharges on 191 items, including 25 items forwhich specific duties have been replaced by ad valorem duties. Apart from 11footwear items, all tariff and surcharge changes remain within the lowerceiling (60Z) established in March 1985. In addition, Indonesia moved to thenew Harmonized System of coding and classifying items from January 1, 1989.

23. To fully benefit from the measures taken to date, it is importantthat the private sector is aware of the new rules and that the bureaucracyimplements them efficiently. As noted in the Policy Statement, the Governmentintends to continue removing import licensing restriccions over the comingyear, especially in those sectors where they still provide high protection todomestic production. The end objective is to eliminate all NTBs on imports,except for a small group of products that are harmful to health, strategic tonational defense or involve special economic or social considerations. Thestrategy of moving away from NTBs inevitably increases the importance of thetariff structure. As shown in Table 3, the cumulative effective of tariffchanges since 1985 has been to reduce the range of dispersion, with littleeffect on the average tariff rate. However, in moving off NTBs, split tariffsand surcharges were used to protect some domestic producers.61 As a result,there are still marked differences between and within sectors in the level anddispersion of tariffs. This reinforces the importance of broadening the trade

Table 3: CHANGES IN THE TARIFF SCHEDULE La

Pre-1985 1985 1988 1989

Average tariff rates (Z)Unweighted 37.3 27.0 24.0 24.4Weighted by:

- Import value 22.0 13.0 14.5 14.5- Domestic production 26.0 17.1 16.6 17.0

Index of dispersion Lb 61.5 107.8 90.0 84.4

/a Tariffs are inclusive of surcharges and specific duties have beenconverted to ad valorem equivalents.

/b Measured by the coefficient of dispersion.

Source: Ministry of Finance and World Bank staff estimates.

6/ Split tariffs are used to subdivide a standard seven or nine digitCCCNIHS product description into finer product groups with differentialtariffs or NTBs applied. Surcharges are also used as a de facto anti-dumping device.

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reform effort to include a comprehensive rationalization of the tariffschedule. In this regard, the Government intends to prepare a medium-termplan for tariff reform over the coming year, including proposals to reduce therole of split tariffs and surcharges, and to implement a phased reduction inthe level and range of tariff rates. To help prepare proposals for furthe-reform, the Government has set up a high-level team on tariffs, withresponsibility for related issues of trade and industrial policy. Technicalassistance will be required to build up the analytical capacity of this team.

24. Domestic pricing policies and subsidies. Domestic price controls arenot pervasive in Indonesia. Rice prices are stabilized through the marketoperations of BULOG, but without any significant deviation from world priceson trend.71 Some other agriculture prices, such as for soybeans and sugar,are above world prices because of import restrictions. The most importantprice controls are on energy (petroleum products, power) and agriculturalinputs (pesticides, fertilizer). Power tariffs were raised on average by 25?on April 1, 1989, to improve the financial performance of the power utility(PLN) and the efficiency of electricity consumption. It is important thatfuture adjustments in power tariffs be undertaken on a more regular andautomatic basis. At projected prices for 1989/90, there are no budgetsubsidies for petroleum products. However, domestic petroleum prices arestill substant-' ly lower than elsewhere in the Region, with cross-subsidization of some products (e.g., kerosene and diesel). The Government iscurrently undertaking a comprehensive review of these and other energy pricingissues. As regards agricultural inputs, pesticide and fertilizer prices wereincreased substantially in October 1988: by 33? for pesticides, 22? for ureaand 2CX for TSP. Even so, subsidies remain high. The Government hasannounced its intention to eliminate pesticide subsidies in 1989/90, and isstudying ways to reduce the fertilizer subsidy.

25. Export and investmant incentives. Indonesia abolished its exportcertificate scheme (a form of subsidy) after acceding to GATT in 1986. TheGovernment is also committed to eliminate export credit subsidies by the early1990s. Instead, the non-oil export drive is now being supported by acompetitive exchange rate, improvements in the trade regime and regulatoryframework, and the provision of promotional and information services by theGovernment. One exception is the imposition of some new xport bans (e.g.,semi-processed rattan, lowest-grade rubber) during 1988. These are intendedto increase domestic value added and/or protect the environment. However,their justification needs to be reviewed, taking into account marketconditions for these products and the impact of the bans on domesticemployment and income distribution. The Government has asked the IMF and theWorld Bank to undertake a joint study of export policies, including the roleof export bans, quotas and approved traders. As regards investment, allfiscal incentives for domestic and foreign investment were eliminated duringthe tax reforms of 1984. The Investment Coordinating Board (BKPM) hassubsequently been restructured, to focus on investment promotion rather thanregulation. Related changes in the regulatory framework are discussed below.

7/ Because of the drought, and the Government's policy of no imports,domestic rice prices rose by about 50? over the year to August 1988.

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Legal and Regulatory Framework

26. Apart from distortions in incentive policies, the performance of theprivate sector has been hindered by a regulatory framework characterized by aheavy reliance on direct controls. Together with overlapping and unclearjurisdictional mandates at the central and local levels, this approach led toexcessive and sometimes contradictory regulations. Both foreign and domesticentrepreneurs have had to contend with a complex regulatory environment which,together with a protective import regime, stifled competition, inhibitedflexibility, encouraged "rent seeking" and retarded productivity improvements.Rather than promote private sector development, the regulatory frameworkdiscouraged new private sector investment and undermined the development of anefficient private sector. The main elements of the regulatory framework thathad been built up and put in place by the early 1980s were: a restrictiveinvestment and capacity licensing system; extensive regulations of foreigninvestment; a proliferation of provincial and local level regulations; andrigid land and laoor laws and regulations. Moreover, the legal code of thecountry remains outmoded.

27. Investment and capacity licensing. In the early 1980s, Indonesia hada highly regulated investment licensing system. At the heart of theinvestment licensing system was the Investment Priority (DSP) List, whichregulated entry into specific lines of activity for both foreign and domesticinvestors. While the original objective of the DSP list was to promoteinvestment, over time the list became increasingly restrictive and cumbersome.This was partly because of the many ad hoc adjustments that were introduced.But the fact that the DSP list was specified as a positive approval list whichvaried from year to year meant that investments became more and more subjectto regulation and hence to administrative discretion and uncertainty.

28. Over the past three years, the Government has taken a number of stepsto relax investment licensing. The investment process was streamlinedsubstantially in 1985. In 1986, fields of investment open to privateinvestors were specified more clearly and the number of areas open to privateand foreign domestic investment was expanded. A number of further steps weretaken in 1987 to relax the investment and capacity licensing system. Theseincluded: (a) automatic approval to firms to increase production by up to 30Xof their licensed capacity; (b) 'broad banding' of investment categories,which promoted greater competition by permitting firms to diversify productionand improve their operational flexibility; (c) opening additional fields ofinvestment to domestic and foreign private investors; and (d) streamliningfurther the requirements for investment licenses.

29. The response to the relaxation of investment (and more favorableoverall economic climate) has been impressive. Domestic investment approvalsby the Investment Coordinating Board (BKPM) which had sagged since 1983, rosefrom Rp.4.4 trillion in 1986 to Rp.10.3 trillion in 1987 and Rp.14.9 trillionin 1988, an increase of 230Z over two years. Unlike the 1970s and early1980s, when much of private investment was oriented towards importsubstitution, the bulk of new investment approvals are directed towards exportactivities. Another important feature of this surge in private investment is

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that it is broad based covering virtually all sectors of the economy. This istestimony that the private sector can indeed play the vital role that isneeded for the development of the non-oil economy.

30. Despite the measures taken, and the encouraging trends in bothdomestic and foreign private investment, the incomplete coverage of the theDSP list and the large number of restricted sectors and conditions allowedconsiderable discretion and restrictiveness in investment licensing. Theinvestment package announced in May 1989 is, therefore, a very important stepin the relaxation of the investment licensing system and ma,.ks a fundamentalshift in the approach to investment licensing. Through this package, theGovernment has replaced a long and incomplete list of areas open to investmentapproval by BKPM by a short negative list. In formulating the negative list,there has been a conscious attempt to keep the number of restricted sectors toa minimum and to remove the ad hoc conditions that had been introduced overthe years. There are two additional important features of the new list:first, it does not distinguish between domestic investment that can beprocessed by BKPM (PMDN investment) and non-PMDN investment for whichdiscretionary approval was required; and second, with the exception offinished rattan products, all areas in the industrial sector that are open todomestic investment are also open to foreign investment.8/ As showr. in

Table 4: SUMMhARY OF INVESTMENT RESTRICTIONS IN THE INDUSTRIAL SECTOR(Number of investment (KKI) Categories)

1987 NewDSP List Negative List

PHA InvestmentOpen 3,172 6,564Restricted /a 1,801 162Not Specified lb 1,753 0

PMDN InvestmentOpen 4,062 6,565Restricted /a 911 161Not Specified /b 1,753 0

la Closed or subject to restrictions./b Not specified in the DSP list.

Source: BKPM and World Bank staff estimates.

8/ There are, however, differential restrictions on foreign investment inagriculture and other sectors.

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Table 4, the result is that many more areas are now open to foreign (PMA) anddomestic (PMDN) private investment, and the areas restricted are specifiedmore clearly. By opening the vast majority of investment categories to PHAand PMDN investment, and by specifying clearly the areas in which theGovernment intends to regulate investment, the new investment list willsystematize and extend the relaxation in investment licensing, increasetransparency and reduce the scope for discretion. This will lead to a morefavorable and stable investment climate for private investors.

31. The adoption of a negative investment licensing list will providealso a clear cut framework for reviewing the validity of remainingrestrictions. In addition to the sectors still restricted in the BKPM list,it would be important to review the restrictions that limit entry only tosmall scale manufacturing. Although these restrictions are loosely applied,elimination of a large proportion of these restrictions is warranted in thecurrent environment and will lead to a further simplification of theinvestment licensing system. Eventually only a few activities would beregulated on special economic and social grounds.

32. Foreign investment regulations. For many years, foreign firmswishing to invest in Indonesia have been subject to even more stringentregulations than domestic firms. In addition to generally more restrictiveinvestment licensing, foreign firms have been treated differently fromdomestic firms in three respects: (a) minimum initial local ownership andspecific regulations on the transfer of the company from foreign ownership tolocal ownership; (b) prohibition of domestic trading of outputs and marketingof Indonesian export goods as well as restrictions on the purchase of domesticinputs; and (c) limited access to domestic capital including export finance.Since 1986, many of these restrictions have been relaxed or eliminated. Thefirst steps taken were to ease somewhat the ownership controls and permitgreater access to domestic capital markets. Further steps were taken throughthe December 1987 package including: (a) removal of restrictions prohibitingforeign companies from marketing Indonesian export goods; (b) permittingforeign firms to purchase domestic inputs without restriction; (c) relaxingrules regarding hiring of expatriate personnel; and (d) further easing ofownership controls. As described below, additional measures have been takenunder the November 1988 packages to liberalize the entry of foreign banks intothe financial sector and of foreign shipping companies into the maritimesector.

33. These measures have responded to many of the major concerns expressedby foreign investors and significantly reduced the differences in treatmentbetween foreign and dozestic firms. Together with the broader regulatorymeasures, they have removed many of the disincentives to foreign investors andhave improved substantially the climate for foreign investment in Indonesia.Recent trends in foreign investment reflect the shift in policy as well asattitudes on the part of foreign investors. After recording a sharp andbteady decline since 1983, foreign investment approvals rose fromUS$0.8 billion in 1986 to US$1.4 billion in 1987 and to Us$4.4 billion in1988, a level that surpasses even other East Asian economies.

34. As noted above, the investment package announced in May 1989, byequalizing the treatment between domestic and foreign investment in theindustrial sector, and by adopting a small negative list, will expand

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substantially the scope for foreign investment in Indonesia. In order toensure that Indonesia can build on this recent progress in mobilizing foreigninvestment, it will be important to continue reviewing ownership restrictionsthat mav still impede new investment, and land restrictions that hinderforeign investment in agriculture.

35. Local regulations. In addition to investment and operating licenses,a firm must also acquire a number of licenses and permits at the provincialand local levels. Although most countries have similar licensing objectivesin terms of land zoning, spatial and environmental concerns, in Indonesia theprocedures for obtaining these licenses are, and represent a potential barrierto entry in terms of time, money and uncertainty with respect to the outcome.The Central Government is encouraging provinces to adopt a "one-door" approachto investment approvals. However, implementation still varies from provinceto province. As a result, the entire process can still take more than twoyears from the investment proposal stage. The major steps in the localregulatory process are; (a) location approval, which entails obtaining theland reservation and location permits; (b) land rights and acquisition, whichinvolves registering and titling the land; and (c) construction approval,which involves obtaining the nuisance license and construction permit. Themajor problems with this process are: (a) the complexity of applicationprocedures; (b) the lack of institutional coordination, so that investors mustsecure approvals at several levels of local government and from variousagencies; and (c) limited administrative capacity at the local level,including shortages of trained staff in most agencies.

36. To date, the Central Government has focussed on the nation-wideframework. With progress in this area, greater emphasis will have to be givento the problems at the provincial level. A major overhaul of local levelregulations is needed to make the system timely and transparent. This islikely to be a time-consuming and difficult process, since practices varyamong provinces and there is often limited administrative capacity at thelocal levels. Accordingly, considerable attention will have to be given tostreamlining existing regulations and practices, while also developinginstitutional capacity so that legitimate concerns bach as environmentaleffects can be effectively addressed.

37. Land tenure and property rights. The laws governing land ownershipare extremely restrictive in Indonesia and the procedures for acquiring,registering and obtaining a title to land are complex. Despite the BasicAgrarian Law of 1960 which was intended to end the duality of land lawsestablished in the colonial period, a substantial proportion of land inIndonesia remains unsurveyed, unregistered and untitled, and is governed bytraditional (or the adat) law. Thus, less than a quarter of agricultural landis properly titled or registered. Even the land that is officially registeredis subject to several types of land rights with varying degrees of tenure.Private corporations (both domestic and foreign) are not allowed to have rightof ownersbip of land; this right is confined to private Indonesian individualsand governmment entities. Agricultural lands for plantations are usually giventhe Right of Exploitation (HGU), whereas factories and business premisesusually have the Right of Building (HGB). The maximum time limit on these landrights are 20 to 30 years. The short duration of these land rights (althoughextendable) creates considerable uncertainty. The acquisition of land can bealso very costly and time consuming.

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38. It is clear that fundamental changes are needed in land laws andprocedures. The Govermnent recognizes the seriousness of the situation andhas recently created a new agency for land directly under the President. Athorough review of land regulations and practices is needed now to draw up anaction program for reform. Such a program of reform could include: (a) anintensive program to complete cadastral surveys and to register and to titleland; (b) streamlining of procedures for land acquisition; (c) clarificationof the role of the new land agency and strengthening of its institutionalcapacity at the central and provincial levels; and. (d) relaxation ofownership restrictions and clarification of tenure rights.

39. Labor laws and regulations. There are five main areas of laborregulations in Indonesia: (a) protection and supervision of workers thatincludes specific regulations on hours worked and overtime, and, wages andworker welfare; (b) reporting requirements by the company; (c) safety andhealth standards; (d) hiring, retrenchment and movement of labor betweenprovinces; and (e) employment of expatriate workers. Taken together, theseregulations are extremely cumbersome, adding to costs and reducing operationalflexibility. For example, the retrenchment laws discourage employment at themargin. Many of the stated objectives are not met because of lack ofenforcement capacity. There are also many superfluous regulations andreporting requirements which need to be eliminated or streamlined.

40. Corporate legal framework. A well-functioning legal system is animportant prerequisite if the shift towards a less regulated environment forthe private sector is to be successful. The Indonesian legal system fallsshort in this regard. Most basic laws date back to the colonial period andhave not been reformulated in the face of changing conditions. There are alsonotable gaps in the legal framework, for instance, on intellectual propertyrights and the legal and accounting framework for financial transactions. Asa result of the general character of most statutes, implementation is oftendependent upon subsequent regulations and decrees. The most importantweakness in the legal system is enforcement, with a cumbersome court process,that lacks transparency and precedents. Nor are there any effectivearbitration mechanisms outside the court system. Addressing theseshortcomings is necessarily a complex and time consuming task that willrequire substantive revisions of laws, reform of legal procedures andreorientation of institutions. To ensure that the legal system does notbecome a major constraint to the deregulation process, it is critical thatreform of the legal system be revitalized.

C. Changing Policies Towards Public Enterprises

41. As noted earlier, there has been a major shift in policy towardspublic enterprises in Indonesia, fueled by a growing recognition of the burdenthat public enterprises place on the economy. Although there are many publicenterprises in Indonesia that operate efficiently and profitably, the overallperformance of the sector is poor. Estimates for a sample of 135 enterprisessuggest that the after-tax return on total assets averaged only 1.1 during

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the 1982-86 period. Negative returns were recorded for public enterprises inseveral industrial subsectors (e.g., paper, metal products, textiles andsteel). Not only have public enterprises constituted a financial burden onthe budget and the banking system, but some public enterprises havecontributed to the high costs and lack of competitiveness of the economy bysupplying basic industrial inputs of poor quality at high prices.

42. There is now a clear consensus that in parallel to an expanded rolefor the private sector, the role of public enterprises should be reduced andmodified. As a first step, the Government has recently completed a review ofthe financial performance of most public enterprises, to identify potentialcandidates for divestment or reorganization. It is expected that a number ofpublic enterprises will enter into joint ventures with the private sector orissue shares to the public. This latter option was dependent upon recentmeasures to develop the capital markets (see Section E). The Government isworking on the rules for divestiture, and a package of measures is expected tobe finalized in the near future. A number of practical difficulties have tobe addressed, iDcluding:

o the transparent definition of rules for divestiture to ensurefairness in valuation and bidding;

o minimizing the burden on government of compensation forretrenchment (an earlier effort at restructuring several tradecompanies had resulted in a costly burden of severance payments);

o developing a concensus on divestiture with the sectoral ministriesresponsible for these enterprises; and

o determining the phasing and sequencing of divestiture (i.e.,whether to proceed gradually and on a case-by-case basis or movemore quickly).

43. Beyoid these issues concerning divestiture, the Government alsorecognizes the need to look into broader issues related to the policyframework for enterprises remaining in the public sector. The starting pointhas to be a careful review of the Government's objectives for the publicenterprise sector, given the present focus on efficiency and private sectordevelopment, followed by an appropriate classification of areas and activitiesin which public enterprises will continue to operate. Public enterpriseperformance can then be improved by: (a) setting clear objectives forenterprises which can be translated into monitorable targets; (b) selectingmanagers capable of operating a commercial venture and compensating themadequately; (c' providing managers with sufficient autonomy to achieve agreedobjectives; and (d) holding managers accountable for results and linkingincentives to performance. The Government intends to review these issues overthe coming year. Based on this review, a plan of action will be prepared, toguide the future direction of public enterprise reform.

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D. Infrastructure and Supporting eervices

44. An important requirement for the rapid development of the privatesector is the concommitant development of basic infrastructure, supportservices and human resources. The Government will continue to provide thebulk of basic infrastructure, but there is an interest in an expanded role forthe private sector in selected areas (e.g., transport terminals, toll roads).On supporting services, government policy has shifted towards a greater rolefor the private sector and improving the efficiency of services by fosteringcompetition and lowering costs.

Provision of Basic Infrastructure

45. After the recent declines in public investment in infrastructure, aprudent expansion will soon be needed to achieve higher growth and avoidinfrastructure bottlenecks in the 1990s. In particular, private sectoractivity will need to be supported by t'ne development of physicalinfrastructure, such as irrigation and roads, which will remain largely in thepublic domain. In addition to a carefully formulated investment program, twopriority areas in the public provision of infrastructure are a strongoperations and maintenance (O&0) p,olicy and emphasis on cost recovery. O&H isvital for maintaining and improving the productivity of the massiveinvestments in infrastructure made in the 1970s and early 1980s andstrengthening tlhe quality of services. Greater cost recovery will promotemore efficient use, whilte also improving the quality of service, by helping tofinance better O&M practices.

46. The Government's strategy of export-and manufacturing-led growthimplies rapid growth in the demand for utilities, which have so far largelybeen in the public sector. With regard to power, PLN has been quitesuccessful in meeting domestic demand and improving the reliability of supply.However. PLN remains both highly regulated and dependent on the Government. Anumber of organization and sector policy issues will have to be addressed, ifthis demand is to be met in an effective and efficient manner. These includepolicies on electricity pricing and distribution, the development of a least-cost investment program, sector organization and structure (including the roleof the private sector), and the internal organization and efficiency of PLN.The telecommunications sector is also dominated by a single public entity,PERUMIEL, and faces a number of similar issues related to the policy andregulatory framework, weaknesses in PERUMTEL's organization and managementaffecting its program execution capability, and lack of competition indomestic manufacturing of components. it will be important to develop acomprehensive action plan to address these constraints, if the increasinglyimportant needs for telecommunications services are to be met.

47. One area where the private sector has assumed an increasinglyimportant role in the provision of infrastructure is housing. TheGovernment's housing program. which provides the bulk of formal sector housingand was previously dominated by public sector developers, is now characterizedby an increasing private sector presence. Private sector produced housing inthis program has increased from 532 at the beginning of F-EPELITA IV to 752currently. The opportunities afforded to the private sector in the housingprogram have resulced in higher production and lower costs. Private sector

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efficiency and willingness to produce smaller units has enabled the Governmentto provide 25,000 more units (8Z) than originally programmed for the sameinvestment, while the average cost per unit produced by the program hasdeclined by 13Z.

Transport and Other Services

48. Most services in the economy (transport, trade, etc.) have long beenprovided by the private sector. But these seccors have been also highlyregulated. This has led to high costs and poor quality of service. However,government policy has changed markedly, most noticeably ir the transportsector. Until recently, the sector was highly regulated with controls ontariffs, licenses on routes and a range of other permits. This restricted newprivate investment in the sector, reduced flexibility and raised transportcosts to very high levels. The most deleterious regulations were in themaritime subsector. A start was made in 1985 to reform the transport sectorwhen the Government replaced customs services with a private sectororganization and restructured port operations. As a result of those reforms,cargo clearance and ship turnaround times were reduced substantially, freightrates for exports and imports declined markedly on many routes, and thequality of services to shippers and consignees improved as internationalservices were extended to more ports. However, the performance of nationalshipping companies continued to be constrained by excessive controls overinvestment and operating decisions and by the policy of compulsory scrappingof ships beyond a certain age that was introduced in 1984. The scrappingpolicy reduced capacity and raised costs even further.

49. The Government has introduced a sweeping range of reforms in 1988 toaddress these concerns. First, the compulsory scrapping policy was suspendedin February 1988. This was followed by the announcement of a second packageof maritime reforms on November 21, 1988. This package:

o reduces the categories of shipping business licenses from five totwo;

o relaxes vessel ownership restrictions;

o permits national and foreign lines to establish joint venturecompanies to serve domestic and international routes;

o eliminates the separate shipping operating license;

o frees companies to transport own products and raw materialswithout a shipping business license;

o permits shipping lines to determine their own route structures,vessel assignments and sailing frequencies without governmentapproval;

o permits national lines to charter foreign flag vessels to servedomestic routes without government approval;

o allows Indonesian companies to buy or sell Indonesian vessels, ordock them, without government approval; and

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o lifts the freeze on the issue of general cargo shipping businesslicenses -- in effect since 1976 -- and simplifies andstreamlines the application process.

50. By reducing and simplifying business licensing procedures, byallowing shipping lines to determine their own route structures and schedules,and by sasing entry by both foreign and domestic companies, this oomprehensiveset of reforms has removed virtually all regulatory impediments to developmentof an efficient and responsive maritime transport industry. Our preliminaryjudgement is that as a result Indonesia now has a more open and unregulatedshipping industry than most otheL maritime nations. In response to this majorshift in the policy environment, over 40 new shipping companies have alreadybeen licensed. This resurgence of competition will have a strong positiveeffect on the quality of shipping services and transport costs.

51. The Government is now working to implement these reforms and toestablish appropriate arrangements for monitoring their operation. The nextpriority for reform is in the road transport subsector, where the keyregulations date back to the mid-1930s and have since been subjected tofrequent piecemeal amendments. Here the problems caused by excessive economicregulation--which is exercised principally through business and routelicensing procedures and tariff controls--are compounded by poor delineationof- the responsibilities of the many central and regional government agenciesinvolved in administration and enforcement. Their impact is most evident inthe passenger transport field, and particularly urban bus services, althoughroad freight transport is also affected to a lesser extent. Regulationspertaining to vehicle weights and dimensions limits, which are intended toprotect public road infrastructure from excessive damage by heavy commercialvehicles, also have an important bearing on road transport system efficiencyand costs, and the limits presently applying to the key interurban links havealready been shown to be too low. The required increases, however, will needto be harmonized with road construction standards and changes in the road usercharge regime, and should be introduced progressively in line with apublicized program of road and bridge improvements which will provide a basisfor planning within the vehicle assembly and road transport industries. TheGovernment is currently developing a modern and comprehensive body of roadtraffic and transport regulations, which is also expected to provide forsubstantial improvements in areas pertaining to safety. Implementation ofthese regulations is of high priority. Attention also needs to be given toestablishing a more satisfactory regulatory regime for public road transport,and a clearer and more appropriate division of responsibilities for roadtraffic and transport matters between central and regional governmentagencies.

Education and Health Services

52. A skilled and productive labor force is an essential ingredient forrapid private sector development. A strong and well designed program of humanresource development is therefore a priority for public policy. The pastpublic investment effort focussed on expansion of facilities for education,health, family planning, water supply and sanitation. This effort has paidoff, as reflected in large improvements in literacy rates altd healthstandards, as well as lower fertility rates. But there are growing concerns

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about the quality of many of.these essential services. In the l990s, theGovernment's main emphasis vill be on quality improvements, with selectiveexpansion. For example, the key to improving the quality of the labor forceis enhanced quality of schooling, starting at the p. imary level. As withgeneral education, there is a need to emphasize the quality of vocationaleducation. The private sector already plays a major role in meeting thedemand fox secondary and tertiary education. The Government intends tomaintain incentives for private participation in providing education andhealth services while introducing better accreditation procedures to improvestar.dards. Over the longer term, private employers should also play asignificantly larger role in providing and bearing the cost of high qualitytraining. The Government can assist this process by Improving labor marketinformation about employment and training, including costs and benefits ofdifferent training schemes and by developing programs which better respond toprivate sector needs. In the short to medium term, it will also be necessaryto ensure better utilization and improved efficiency of existing governmenttraining facilities. It is essential to link the use of these facilities withactual employment by entering into cost-sharing arrangements with employers.

E. Financial Sector Development

53. With the saajor shift on emphasis towards the private sector alreadyunderway, the Government realizes that a key ingredient for success will bethe further development of the financial system. The future demand forfunding by the private sector is expected to greatly exceed current levels asthe economy recovers and a larger share of activity shifts to the privatesector. Private investment is projected to average Rp.24 trillion per annumover the next five years, double the level in the 1984-88 period, whiledecreasing oil revenues in the future may limit government support forinvestment. Clearly, mobilizing private resources for long-term loan andequity funding, in addition to meeting growing working capital needs, willpose a significant challenge for the financial sector. Furthermore, thegrowth of non-oil export activities and the emergence of new privateindustries will require changes in financial practices: increased cash-flowrather than asset-based lending, access to venture capital and equity, andrapid credit processing.

Background

54. The organized financial sector in Indonesia is dominated by itsbanking system which controls over 852 of all assets. The banking system, inturn, is dominated by the five large state banks. Until 1983, Bank Indonesiaimposed monetary control through credit ceilings and by setting most statebank interest rates. Lending was influenced directly through a complexliquidity credit mechanism, which provided subsidized loans to eligibleprograms. The combination of interest rate controls, credit ceilings and theunlimited provision of liquidity credits reduced the incentive to mobilizefinancial savings and resulted in segmented deposit and loan markets.

55. In June 1983, the Government took the first steps toward reformingthe financial sector, by deregulating state bank interest rates, replacingcredit ceilings with a system of reserve money management, and raising andsimplifying interest rates on subsidized credit programs. These reforms wereeffective in spurring a rapid expansion in deposits and, to a limited extent,

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increased competition among banks. Financial assets held by the bankingsystem rose from 18Z of GDP in 1982 to 29X in 1987, and private banksincreased their market share in spite of regulatory curbs on their expansion.Yet, despite these improvements, differential regulations amonginstitutions--on branching, capital adequacy, lending limits and financialservice--resulted in continued fragmentation of the credit market,characterized by large differences in access to credit and its cost for:.ndividual borrowers. Such segmentation dampens competition, impedesdevelopment of banking services and increases the cost of borrowing. The paceof financial innovation after 1983 was also slow. With the exception of newmonetary instruments introduced in 1984 and 1985, the range of financialassets and services has not widened appreciably. As a result, there are notenough financial instruments available for either risk dispersion, or the termand size transformation of funds.

Recent Policy Reforms

56. In response to these concerns, the Government announced majorfinancial sector reforms in October and December 1988.91 The basicobjectives of these reforms are to enhance financial sector efficiency byencouraging competition and to increase the availability of long-term financeby promoting the development of the capital market. Steps were also taken toimprove the stability of the financial system, by strengthening prudentialregulations and monetary control.

57. The highlights of these measures are as followss

o the entry of new private banks, including joint ventures withforeign banks, has been reopened;

o restrictions on opening new branches of banks and non-bankfinancial institutions (NBFIs) have been eased;

o new rural banks may now be established in districts (outsidecapitals);

o the requirements to become a foreign exchange bank have beeneased;

o public enterprises are now permitted to place up to 502 of theirdeposits with private banks and NBFIs;

o NBFIs are now allowed to issue certificates of deposit (CDs);

o a 152 v:thholding tax has been levied on time deposits and CDs,to eliu...ate the discrimination against other financial assets;

o an aver-the-counter (OTC) market has been established to enablesmaller firms to issue shares;

o the private sector is now allowed to operate stock exchanges inJakarta and other major cities;

91 Some of these measures were subsequently clarified on March 25, 1989.

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o banks and NBFIs are allowed to raise capital by issuing shares;

o entry into insurance, leasing, venture capital, consumer financeand securities activities has been eased;

o loan concentration ratios have been defined for banks and NBFIs;

o minimum capital requirements have been specified for banks andNBFIs, and solvency ratios for insurance companies;

o the differential reserve requirements for banks and liabilitycategories have been replaced with a uniform and lower rate of22;

o the maturities on monetary instruments have been extended, andsteps taken to develop the secondary market; and

o the premium on foreign exchange swaps has been related tointerest rate differentials.

58. These actions represent a dramatic departure from the past whenregulations facilitated the domination of state banks and prevented thedevelopment of other segments of the financial market. The relaxation ofentry barriers will allow the private sector, domestic and foreign, to competewith public financial institutions on a more equal basis. The resulting gainin efficiency, together with the lower reserve requirements, should decreaseintermediation costs and improve banking practices. While implementation ofthese changes will obviously take time, there are already signs that thefinancial sector will be significantly altered. In response to the newmeasures, there have been a large number of applications for setting up newbanks. By the end of February 1989, licenses had been approved for 7 newnational commercial banks, 3 joint ventures with foreign banks and47 secondary banks. Several foreign banks are considering opening branches.In addition, activity on the Jakarta stock exchange has picked up sharplysince October 1988, and the first issue on the new OTC market was successfullycompleted in early 1989. Not surprisingly, monetary conditions were initiallyunsettled after the financial sector reforms were announced. However, thesituation has now returned to normal, with inter-bank rates around 12-152 andno evidence of private capital flight.

59. In response to the recent reforms, the financial sector is expectedto undergo a major restructuring over the next few years, with increasedcompetition over a broader range of financial services among a larger numberof institutions. The immediate priority for follow-up is therefore tostrengthen further the Government's capacity for prudential regulation,especially in the area of bank supervision. Technical assistance for thispurpose has been requested from the DMF and ADB. After monitoring thefinancial sector's response to the recent deregulation measures, theGovernment plans to introduce new legislation to codify and streamline theregulatory framework for the central bank, commercial banks, insurancecompanies and pension funds. At the same time, it will be important toconduct audits of the state banks, to identify needs for restructuring and

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recapitalization. Finally, the Government is committed to reducing the roleof subsidized credits from Bank Indonesia, by reducing the share of bankcredit channelled through this mechanism, limiting the number of eligibleprograms, and bringing interest rates closer to market levels. These changeswill have a positive impact on the allocative efficiency of investment andbanking system incentives.

PART III - THE BANK STRATEGY FOR PRIVATE SECTOR DEVELOPMENT IN INDONESIA

60. By any standard, the Government's efforts to restore macroeconomicstability and to accelerate the process of structural change have beenremarkably successful. The agenda for policy reform has been welldeveloped and the Government's credibility for making difficult but correctdecisions has been clearly established in the period since 1983. The WorldBank has played an important role in these accomplishments. In particular,the Bank has maintained a very close policy dialogue with the Governmentbased on the economic and sector work program and technical assistance fromthe Resident Staff in Indonesia. At the same time, the annual economicreports, combined with the two adjustment loans (TPAL I and II), haveenabled the Bank to play a catalytic role in mobilizing substantialadditional external assistance from the Inter-Governmental Group onIndonesia (IGGI) to support the adjustment effort.

Macroeconomic Policies

61. The Bank's analysis and policy dialogue have supported theGovernment's efforts to define appropriate policy responses to emergingissues of macroeconomic management. Since the collapse of oil prices in1986, we have focussed on five major policy areass (a) exchange ratemanagement, to respond to external shocks and maintain the competitivenessof non-oil exports; (b) prudent fiscal and monetary policies, to reduceaggregate demand and control inflationary pressures; (c) public resourcemobilization, through more effective tax administration and improved costrecovery; (d) more focussed expenditure priorities, especially for O&M andpoverty-related programs; and (e) external debt management and borrowingstrategy. During the coming year, we expect to continue working with theGovernment on its macroeconomic policies, with special emphasis on externaldebt management, public resource mobilization and fiscal policy.

Incentives and Regulatory Framework

62. The World Bank prepared major studies on trade and industrialpolicy issues in 1981 and 1985. These studies helped to identify the costsof the complex regulatory environment in Indonesia, and to show the broaddirections for future policy change. With the subsequent decline in oilprices, the push for reforms within Indonesia gathered momentum. Tosupport this effort, the Bank provided analytical inputs on reforms in thetrade regime and regulatory environment. Measures taken in 1986 and 1987were supported under two trade policy adjustment loans. The relatedanalysis provided by Bank staff will be formally presented in two studies--on enterprise regulations and on trade policy reform and implementation--to be completed later in 1989. A follow-up study on the corporate legal

- 24 -

framework is to start shortly. Bank staff will also continue to workclosely with the officials involved in preparing trade policy andregulatory reforms, and provide technical assistance as required to developthe Government's own analytical capability.

63. One of the important lessons that has emerged from restructuringprograms in other countries has been that broad changes in trade andregulatory policies must be complemented with more specific programs ofassistance to help individual firms adjust to the new policy environment.For this reason the Bank is planning a series of operations to assistindividual industrial enterprises respond to the changing trade andregulatory framework and to overcome the effects of past constraints. Thefirst Industrial Restructuring Project, approved by the Board in April1989, will support restructuring of enterprises in the textiles, pulp andpaper, and engineering sectors. Subsequent operations could focus on woodprocessing, electronics, agro-industries and packaging. In addition tofinancial assistance (through the banking system), these operations willprovide technical assistance for the development and strengthening ofsubsector-specific support services, and will also help to implement andmonitor environmental standards.

64. We have approached domestic pricing issues through a number ofavenues. A Bank-financed energy pricing policy study is currentlyunderway, and will provide a basis for furthering our dialogue on thepricing of primary energy resources. We have also had extensivediscussions with the Government over the past year on power tariffs, in thecontext of preparing two major power projects (scheduled to be presented tothe Board in June 1989). The case for reducing fertilizer and pesticidesubsidies was raised in the recent agricultural incentives study andfertilizer industry sector report. Our dialogue with the Government onthese issues is continuing, and related policy changes could form part of apackage to be supported by a proposed agriculture sector loan.

Public Enterprise Reforms

65. As already noted, the Goverument is expected to divest orreorganize several public enterprises in the near future. The IFC issupporting this effort through a study of private participation in state-owned hotels. In addition, follow-up action will be required to review therelationship between the Government and the remaining public enterprises,to ensure proper autonomy and accountability in their operations. To date,the Government has not requested World Bank assistance in this area.However, we have highlighted these issues again during a recent missionand, as noted in the Policy Statement, the Government recognizes the needto formulate a broader plan of action for the public enterprise sector.

Infrastructure and Supporting Services

66. The Bank has a long history of involvement with the development ofinfrastructure in the economy. In the past, about 42? of our lending hasgone to direct support of infrastructure investments in power, roads andother transport facilities, irrigation, municipal water supply andsanitation. In the next five years, we plan to allocate about half oflending to these sectors.

- 25 -

67. In the housing sector, continuing Bank support for the expansionof the housing finance system and its integration into the financial sectorvill provide increasing opportunities for the private sector in mortgagefinance as well as housing production.

68. In the case of the power sector we have made a major contributionnot only to the expansion of physical capacity but also to improving themanagement and financial performance of the public utility (PLN). It nowhas the capacity to implement an annual investment program of more thanUS$1.0 billion, with annual new consumer connections exceeding one million.Key objectives for future Bank support includes improving the efficiency ofPLN operations; enabling PLN to become more commercially-oriented andfinancially self-supporting; maintaining electricity prices at economicallyand financially appropriate levels; assisting in the preparation andimplementation of a least-cost investment program; and guiding andsupporting institutional development in the sector to meet evolving needs.Two major power projects are scheduled to be presented to the Board in June1989. An important review of options for further institutional developmentin the sector, based on a panel of experts, is currently underway and isreceiving high-level support from government officials.

69. Direct support for the telecommunications sector is more recent.A technical assistance project for the telecommunications utility(PERtMTEL) is now under implementation, and the Bank's five-year lendingprogram includes two projects to assist in the expansion of physicalcapacity and the further strengthening of PERUMTEL. A majortelecommunications sector review has been initiated to identify ways toincrease the productivity and efficiency of the sector, and the resultswill be incorporated in the design of those projects. Issues to be coveredinclude, inter alia, the autonomy and commercial orientation of PERUMTEL,the regulation and supervision of the sector, and the scope for greaterprivate sector participation.

70. Past Bank involvement in the transport sector has focusedprimarily on the expansion and maintenance of the road network, with somefinancial assistance for national ports development and technicalassistance for the railways sector. While the roads network has expandedsignificantly, transport sector efficiency (including inter-modalconnections), and the overall quality of transport services, is low. Thepriority being given to the development of the non-oil sectors of theeconomy, and especially the expansion of non-oil exports, has led toincreasing Government awareness of the need for a more coherent strategyand policy framework for this sector. The Bank's Transport Sector Overviewwas recently discussed with the Government and the results are expected tobe incorporated into future lending, including two sector-wide, policy-based operations over the next three years. Policy reforms will focusprimarily on improving the regulatory framework for the roads and maritimesubsectors, including an expanded role for private sector firms. Banksupport for the urban sector is rather more advanced, with the concept ofintegrated urban infrastructure development programs (IUIDP) now underimplementation in most of the larger urban centers. Further progress in

- 26 -

key policy areas, including the devolution of authority to localgovernments for the development and maintenance of urban infrastructure, isbeing supported by the FY87 Urban Sector Loan.

71. To ensure the availability of skilled labor, the Bank's lendingand ESW programs include substantial support for the improvement ofeducation quality at all levels, the expansion of primary education andincreasing attention to non-formal education. Support for higher-levelskills development has included science and technology training,accountancy development and human resource development in the health andtree crops sectors. In addition, a number of training modes for employmentin the private sector are also being developed under two ongoing projects,and are expected to assist the Government in developing an overall trainingstrategy.

Financial Sector Development

72. Financial sector performance will have to improve significantly tosupport increasing private sector investment. This will require improvedresource mobilization Rnd allocation, and better operating efficiency offinancial institutions, some of which may need restructuring to remainviable. Private financial savings will be encouraged by extending thebanks' branch network, introducing a broader range of assets with a varietyof term, risk and return profiles, and by developing an active capitalmarket. Resource allocation will have to be improved by reducing the roleof subsidized credits. Increasing competition in the sector is expected toresult in better operating efficiency of financial institutions, especiallyin strengtheaing their capacity for project appraisal and loan collections.Finally, some financial institutions with poorly performing loan portfolioswill have to be restructured and prudential supervision for the sectorimproved to ensure the future health of the financial system.

73. At the request of the Government, the Bank initiated a major studyof the financial sector in 1988. The main mission visited Indonesia inJuly 1988 and its preliminary findings fed into the reforms announced laterin the year. The completed report will be the basis for a continuingdialogue with the Government on financial sector policies. Progress inreforming the sector is expected to continue focussed on: increasingprivate sector participation in savings, financial institution growth andloans; and, improving allocative and operational efficiency by encouraginggreater market orientation. During this reform phase, the Bank willcontinue to support operations in the productive sectors that use thefinancial sector as an intermediary, provided these operations reinforcethe direction of financial sector reforms. In agriculture, rural financialinstitutions need to be strengthened, and an integrated market-orientedcredit delivery system has to be developed in parallel with theconsolidation and phasing out of subsidized credit schemes. In industry,the Bank will continue to support credit lines to finance small- andmedium-sized firms with substantial export potential that are currentlyunable to secure financing on appropriate terms. In addition to financialsupport, technical assistance will be incorporated in these operations toenhance the appraisal capacity of the participating banks and non-bankfinancial institutions.

- 27 -

PART IV - THE PROPOSED LOAN

A. Loan Rationale and Objectives

74. As reviewed in Part III, the World Bank has maintained a close andconstructive dialogue with the Government of Indonesia on the ongoingadjustment program and policy reforms related to private sectordevelopment. Actions taken in 1986 and 1987 were supported by two tradepolicy adjustment loans (TPAL I and II).101 Since then, the Governmenthas continued to make good progress on the "areas for follow-up" noted inthe Policy Framework for TPAL II. Macroeconomic management has remained ontrack, with a clear Government commitment to and success in maintaining acompetitive exchange rate, maintaining prudent budgetary and external debtpolicies, and expanding non-oil tax revenues. Implementation of theearlier trade reforms has been generally quite effective, and significantadditional steps have been taken to reduce NTBs. A revised tariff schedulebased on the harmonized system was introduced on January 1, 1989.Furthermore, the deregulation drive has been extended, with major reformsin investment licensing, maritime transport regulations and financialsector policies.

75. The objectives of the proposed loan of US$350 million equivalentare to develop the private sector by: (a) supporting the substantialreforms undertaken by the Government during 1988 and early 1989, andensuring that they are implemented well; (b) assisting the Government tobring about an early recovery in economic activity, consistent withexternal and internal financial stability; and (c) maintaining the policydialogue on further reforms to promote the efficiency and longer-termviability of the economy. These objectives would bc achieved in partthrough support to the balance of payments provided by the proposed loanand in part through our ongoing dialogue on policy issues. As part of thisdialogue, the Bank will complete during 1989 studies on enterpriseregulations, financial sector development, and trade policy reform andimplementation. The loan would directly contribute to the financing needsfor quick disbursing assistance, and would provide the rationale formobilizing a targetted level of US$1.8 billion of quick-disbursingassistance from official donors, needed to finance the balance of paymentsand underpin the adjustment program during 1989/90.

76. The justification for the loan is based on che actions taken bythe Government over the past year in the following five areas:

o Macroeconomic management. Implementation of a prudent budget for1988/89, including a major effort to increase non-tax revenues andfurther cuts in capital spending. The primary balance isestimated to be in surplus, while net domestic expenditure fellfrom 3.8? of GDP in 1987/88 to 2.22 in 1988/89. The realeffective exchange rate depreciated by 4? over the year to October1988.

10/ The Project Completion Reports for TPAL I and II were submitted to OEDin June 1988 and May 1989 respectively.

- 28 -

o Trade policy. Further removal of import licensing restrictions inareas such as plastics, fertilizer and agricultural products.Coverage of NTBs reduced from 382 to 292 of domestic production.Apart from 11 footwear items, all related tariff and surchargechanges remain within the lower ceiling (60Z) established in March1985. Indonesia moved to a tariff schedule based on the newHarmonized System on January 1, 1989.

O Investment licensinR. Move to a short negative investmentlicensing list in April 1989. This change opened up additionalsectors to domestic and foreign investment, and made the licensingprocess transparent and less discretionary.

O Maritime transport. Suspension of the compulsory scrapping policyfor ships in February 1988. Second package in November 1988completed deregulation of shipping industry by: (a) reducing andsimplifying business licensing procedures; (b) allowing shippinglines to determine their own route structures and schedules; and(c) allowing national lines to charter foreign flag vessels andform new joint venture companies with foreign lines.

O Financial sector development. Introduction of major reforms toenhance financial sector efficiency by encouraging competition andto increase the availability of long-term capital by promoting thedevelopment of the capital market. Entry has been reopened forprivate banks, including joint ventures with private banks. Stepshave also been taken to improve the stability of the financialsector, by strengthening prudential regulations and monetarycontrol.

77. The Private Sector Development loan is conceived as the third in aseries of loans (following TPAL I and TPAL II) aimed at adjustment andstructural change. Further adjustment lending would be contingent uponsatisfactory progress in undertaking additional policy reforms in the coreareas identified in Section C below. The Government's commitment to thispolicy agenda is set out in the Policy Statement (Annex IV).

B. Loan Administration

Disbursement

78. The proposed loan of US$350 million equivalent would be available fordisbursement upon loan effectiveness and would be used to reimburse 100% offoreign expenditures for eligible imports for which payments are made afterthe date of loan signing. The list of ineligible imports for the purposes ofthis loan would be standard, i.e., goods intended for military or paramilitarypurposes, or for luxury consumption; goods financed from other officialmultilateral or bilateral sources; uranium; and goods procured under contractsof less than US$100,000. Disbursement for reimbursement of eligible importexpenditures would be based on documentation prepared by Societe Generale deSurveillance S.A. (SGS) in the course of their customs inspection services.In the case of Indonesia, SGS certification provides particularly strong

- 29 -

assurance under the system established by INPRES 4/1985. The SGS certificateprovides verification of the goods being imported including the quality andquantity of imports and the applicable prevailing C&F export market price inthe country of supply. The SGS certificate is also required for the releaseof the goods at the port of entry. The SGS certificate would, therefore.provide all the information needed to ensure compliance with eligibilityrequirements for purposes of the Bank loan. Disbursement for eligible importexpenditures would be based on Statements of Expenditure (SOEs) for importsvalued at less than US$5 million; for imports valued above this amount fulldocumentation would be provided. Applications for withdrawals based on SOEswould be submitted in amounts not less than US$1 million and supportingdocumentation would be retained by Bank Indonesia. All of the proceeds of theproposed loan are expected to be disbursed by March 31, 1990.

Procurement

79. Both private and public sector imports would be eligible forfinancing. Contracts for goods and services estimated to cost US$5 million ormore each, would be procured through International Competitive Bidding inaccordance with Bank Guidelines. Contracts under US$5 million each would beawarded on the basis of normal procurement practices of the purchaser andwould be processed on the basis of statement of expenditures described above.

Accounts and Audits

80. Bank Indonesia would maintain loan accounts and supportingdocumentation, as in the case of the previous two trade policy adjustmentloans. An audit review of the loan accounts and supporting documentation ofthe first Trade Policy Adjustment Loan is to be completed shortly. For thePrivate Sector Development Loan, an audit would be carried out by independentauditors acceptable to the Bank within nine months of the closing of the GOIfiscal year in which final disbursements under the loan are made.

C. Monitoring and Follow-up

61. The Bank will monitor closely, through frequent consultation with theGovernment, progress on implementation of the recent policy measures andfollow-up actions. The main areas for follow-up to support private sectordevelopment are set out in Annexes IV and V. This is a very broad agenda,reflecting the progress already made on stabilizing the economy and theGovernment's commitment to push the process of regulatory reform into newareas. In determining the priorities for policy reform within this broadagenda, a number of principles will be important. First, sound macroeconomicmanagement will remain a key prerequisite for improving the incentives forprivate sector activities. Second, it is important for the Government toensure that recent reform measures--in the areas of trade policy, investmentlicensing, maritime transport and the financial sector--are fully implemented,so that the benefits are fully realized by the private sector. Third, theGovernment needs to continue with the process of regulatory reform. In someareas--such as removal of NTBs, opening new sectors to investment, publicenterprise divestiture and improving banking supervision--the priorities forthe coming year are clear. However, in others--such as rationalizing tariffs,revising local regulations and the corporate legal framework, and improving

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the policy framework for public enterprises--the next step is to undertakefurther analysis, in preparation for future reforms.

82. The actual pace of policy reform during the coming year will dependin part upon the completion of background analyticsl work and the timing ofpolitical opportunities. However, we will work with the Government to makeprogress as rapid and broad-based as possible. As discussed in Part III,parts of the policy agenda--especially in the areas of agriculture,infrastructure and human resource development--will be supported through otheroperations of the Bank. The core areas of actions for the immediate futurewould include:

o Prudent macroeconomic management during 1989/90 to: (a) maintain aprimary surplus in the Central Government's budget; and (b) avoid anyreal effective appreciation of the Rupiah. Given the projectedexternal environment, these policies are expected to hold the currentaccount deficit to below 31 of GNP and inflation within thesingle-digit range.

O Implementation of the Government's program for public resourcemobilization, including strengthened tax administration, extension ofthe tax base, and improvements in cost recovery for public services.Raise the ratio of non-oil tax revenues to non-oil GDP by at leastone percentage point during 1989190.

o Prudent external borrowing strategy, including a strict limit onimport-related credits and reduced dependence on special assistancein 1989/90. Strengthen institutional arrangements for external debtmanagement.

o Further progress on reducing NTBs and rationalizing import tariffs,based on improved capacity within the Government for analysis oftrade and industrial policy issues. Reduce the proportion ofdomestic production covered by NTBs from 292 to the range of 20-242.

O Continued relaxation and simplification of regulatory framework.Open up new sectors to domestic and foreign investment. Relaxownership and other restrictions on foreign investment. Reviewremaining constraints in local regulations, land and labor laws, andthe corporate legal framework.

o Implementation of proposed divestiture and reorganization of publicenterprises (including joint ventures with the private sector andshare issues). Review the policy framework for the sector andprepare a broader plan of action for public enterprise reform.

o Implementation of recent financial sector reforms. Strengthen theGovernment's capacity for bank supervision. Introduce newlegislation to codify and simplify the regulatory framework, andundertake audits of the state banks. Reduce the role of subsidizedcredits by reducing the size and scope of eligible programs, andraising interest rates closer to market levels.

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The Government's commitment to this policy agenda is set out in the PolicyStatement (Annex IV).

D. Program Benefits and Risks

83. The policy measures taken by the Government over the past year willsubstantially improve the climate for private sector development, by:(a) providing a stable macroeconomic setting; (b) developing a lessdistortionary trade regime; (c) reducing regulatory restrictions on investmentand maritime transport; and (d) promoting a more competitive and responsivefinancial system. Positive benefits of the ongoing adjustment process arealready evident in the recent performance of the economy, especially thestrong growth of non-oil exports, investment approvals and manufacturingactivity. In all of these areas, the private sector is now playing a muchlarger role than in the early 19809. The principal risk is that the far-reaching nature of these reforms could encounter domestic opposition as theyare implemented and extended. This risk is offset by the positive responsesto e,rlier reforms and the Government's demonstrated commitment to carry outdifficult and sensitive policy measures.

PART V - RELATIONS WITH IMF

84. The latest IMP Consultation Report was issued on April 6, 1989. TheGovernment of Indonesia has not had any standby or extended arrangements withthe IMF since 1973. The Government's last purchase from the IMF was forSDR 463 million in May 1987 under the Compensatory Financing Facility (CFF).This purchase increased Indonesia's total outstanding IMF obligations toSDR 463 mlillion at the end of 1988. After the last Consultation Report (in1988), the IMF Executive Board expressed its satisfaction that "Indonesiamaintains an exchange system which is free of restrictions on payments andtransfers for current international transactions.' Effective May 7, 1988, theGovernment of Indonesia has accepted Article VIII status.

PART VI - RECOMMENDATION

85. I am satisfied that the proposed loan would comply with the Articlesof Agreement of the Bank and recommend that the Executive Directors approvethe proposed loan.

Barber B. ConablePresident

by Moeen A. QureshiAttachmentsWashington, D.C.May 16, 1989

- 32 -ANNEX I

Page 1 of 2KEY NACROECONOIIC INDICATORS La

Esti-Actuals mates Projections

1982 1985 1986 1987 1988 1989 1990 1991 1992 1993

GOP Growth Rate -0.3 1.7 3.7 3.9 4.7 5.2 4.6 5.0 5.0 5.2Non-oil GOP Growth Rate 4.2 3.8 3.9 4.6 5.6 5.6 5.9 6.1 6.2 6.3GNP Growth Rate -0.8 2.7 4.9 4.1 4.7 5.7 4.7 5.1 5.2 5.3GNP/Capita Growth Rate -2.8 -0.4 2.9 2.1 2.7 3.7 2.7 3.3 3.3 3.5Consumption/Capita Growth Rate 3.9 -1.3 0.7 1.3 2.9 2.2 2.2 1.9 3.1 2.5

Total DOD /b (in USS billion) 23.0 31.6 37.6 46.8 47.5 51.1 53.3 55.5 57.0 58.3DOD/XGS /c 115.9 158.9 247.7 Z36.8 220.8 216.9 204.0 192.5 179.6 166.8DOD/GDP 24.2 37.2 49.4 67.0 61.0 60.1 57.7 55.1 51.9 48.8Debt Service (in USS billion) 3.3 4.8 5.7 6.7 7.8 8.7 9.0 9.0 9.6 10.3Debt Service/XGS 16.8 24.4 37.3 33.9 36.3 37.1 34.4 31.4 30.4 29.3Interest/XGS 7.5 10.5 16.1 14.0 13.8 13.1 12.3 11.3 10.6 9.8Interest/GDP 3.6 2.0 2.0 1.5 1.3 1.2 1.1 0.9 0.8 0.7

Gross Investment/GDP 29.1 24.3 23.4 23.2 22.2 22.6 22.8 23.7 24.1 24.9Domestic Savings/GDP 26.4 27.1 ?2.7 25.6 25.5 25.5 25.7 26.8 27.2 28.0National Savings/GDP 22.6 22.0 17.9 19.9 19.8 20.4 20.9 22.2 22.9 23.9Marginal National Savings Rate 6.5 -0.5 1.7 0.6 0.3 0.3 0.3 0.4 0.3 0.4Public Investment/GOP 12.3 10.9 9.8 9.5 9.3 8.9 9.0 9.2 9.4 9.6Public Savings/GDP /d 8.2 8.6 5.2 5.9 5.6 6.0 6.9 7.5 8.0 8.4Private Investment/GDP 13.6 9.9 10.7 10.4 11.0 11.8 12.5 13.1 13.5 14.0Private Savings/GDP /d 14.4 13.4 12.7 14.0 14.2 14.4 14.0 14.7 14.9 15.5Ratio of Public/Private Investmert 90.4 109.5 91.7 90.9 84.7 76.1 71.8 70.8 70.0 68.5ICOR /e 8.1 6.1 5.3 5.1 4.3 4.1 4.0 4.0

Government Revenues/GDP 18.3 19.8 16.4 18.3 17.3Government Expenditures/GDP 22.7 22.6 20.3 20.7 20.1Deficit (-) or Surplus (+)/GDP -4.4 -2.8 -3.9 -2.4 -2.8

Export Growth Rate -13.1 -1.4 4.6 6.1 5.3 6.5 4.6 3.9 3.1 3.3Non-oil Export Growth Rate -1.1 10.1 3.2 25.8 13.6 11.9 9.8 8.0 7.9 8.0Exports/GDP 20.9 23.4 20.0 28.3 27.6 27.7 28.3 28.6 28.9 29.3Import Growth Rate 3.3 -7.3 -17.4 1.5 3.7 6.6 6.7 6.2 6.8 7.1Imports/G6P 28.8 26.0 25.5 30.9 30.4 30.2 30.5 30.4 30.4 30.6Current Account (USS billion) -7.3 -2.0 -4.0 -1.6 -1.9 -1.8 -1.7 -1.4 -1.3 -1.2Current Account/GDP -7.7 -2.3 -5.3 -2.2 -2.4 -2.1 -1.8 -1.4 -1.2 -1.0Terms of Trade Index 109.5 93.2 62.5 71.5 69.7 68.6 70.4 72.2 74.7 77.3Oil Price (US$/bbl) 33.2 25.0 12.5 17.6 15.1 15.5 16.6 17.6 18.6 19.7

La Balance of payments and budget data are for fiscal years (starting April 1). Other indicators are forcalendar years.

Lb Debt outstanding and disbursed.Lc Exports of goods and services.id These are "national" not "domestic" savings./e Five-year average, one year lag.

- 33 -ANNEX I

Paoe 2 of 2BALANCE OF PAYMENTS La

(USS billion at current prices)

Est i-Actual$ mates Projections _ _ __

1982 1985 1986 1987 1988 1989 1990 1991 1992 1993

A. Exports of Goods S NFS 19.0 19.1 14.4 18.8 20.8 22.8 25.4 28.0 30.8 34.01. Nerchandise (FOB) 18.7 18.5 13.7 18.0 19.8 21.5 23.8 26.3 28.9 31.92. Non-factor Services 0.3 0.6 0.7 0.8 1.0 1.4 1.6 1.7 1.9 2.1

B. Imports of Goods & NFS 22.6 16.8 15.0 16.6 18.3 20.4 22.6 24.8 27.4 30.31. Merchandise (FOB) 20.6 14.4 12.7 14.3 15.5 17.5 19.4 21.4 23.7 26.32. Non-factor Services 2.0 2.5 2.3 2.3 2.7 2.9 3.2 3.4 3.6 3.9

C. Resource Balance -3.7 2.2 -0.6 2.2 2.5 2.4 2.8 3.2 3.5 3.8

D. Net Factor Income -3.8 -4.4 -3.7 -4.2 -4.8 -4.6 -5.0 -5.2 -5.3 -5.51. Factor Receipts 0.8 0.7 0.7 0.7 0.6 0.6 0.6 0.7 0.8 0.82. Factor Payments 4.6 5.1 4.4 4.9 5.4 5.2 5.6 5.9 6.1 6.3

(interest payments) 1.7 2.5 2.8 3.1 3.5 3.7 3.8 3.8 3.9 3.9

E. Net Current Transfers /b 0.1 0.2 0.3 0.4 0.4 0.4 0.5 0.5 0.5 0.61. Current Receipts - 0.1 0.2 0.3 0.4 0.4 0.4 0.5 0.5 0.5 0.6a. workers remittances 0.0 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.2b. other curr. transfers 0.1 0.2 0.2 0.3 0.3 0.3 0.4 0.4 0.4 0.4

2. Current Payments 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

F. Current Account Balance .7.3 -1.9 -4.0 -1.6 -1.9 -1.8 -1.7 -1.4 -1.3 -1.2(Including Off. Trans.)

G. Long-Term Capital Inflow 3.9 2.2 3.1 3.0 3.4 2.6 2.9 3.0 2.4 2.31. Direct Investment 0.3 0.3 0.3 0.5 0.3 0.5 0.6 0.8 0.9 1.02. Net LT Loans (ORS) 4.0 1.3 2.7 2.2 2.7 1.8 1.8 1.8 1.0 0.8

a. Disbursements 5.1 3.9 5.2 6.1 7.1 6.5 6.6 6.3 5.9 6.1b. Repayments 1.1 2.5 2.5 3.9 4.4 4.7 4.8 4.5 4.9 5.3

3. Other LT Inflows (net) -0.4 0.6 0.1 0.3 0.4 0.3 0.5 0.5 0.5 0.5

H. Total Other Items 0.1 0.7 -2.0 -0.2 -2.2 0.0 -0.1 -0.1 -0.0 -0.01. Net Short-term Capital 1.0 -0.2 -0.2 1.1 0.5 0.0 0.0 0.0 0.0 0.02. Capital Flows N.E.I. -0.9 0.9 -1.9 -1.3 -2.8 0.0 -0.1 -0.1 -0.0 -0.03. Errors a Omissions 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

1. Changes in Net Foreign Assets 3.3 -0.9 3.0 -1.1 0.8 -0.9 -1.2 -1.5 -1.1 -1.11. Net Credit From IMF 0.1 -0.3 0.0 0.6 0.0 0.0 -0.2 -0.3 -0.2 0.02. Other Changes 3.3 -0.7 3.0 -1.7 0.8 -0.9 -1.0 -1.2 -0.9 -1.1

Shares of GDP (Current USS):1. Resource Balance -3.9 2.6 '-0.7 3.1 3.2 2.8 3.0 3.2 3.2 3.12. Total Interest Payments 1.8 2.9 3.4 4.3 4.5 4.3 4.1 3.8 3.5 3.33. Current Account Balance -7.7 -2.3 -5.0 -2.3 -2.4 -2.1 -1.8 -1.4 -1.2 -1.04. LT Capital Inflow 4.1 2.6 3.8 4.1 4.4 3.1 3.1 2.9 2.2 1.9S. Net Credit from IMF 0.1 -0.3 0.0 0.8 0.0 0.0 -0.2 -0.3 -0.1 0.0

Foreign Exchange Reserves:1. Inter. Reserves (IFS) 3.1 5.0 4.1 5.62. Sold (London Price) 1.4 1.0 1.2 1.53. Total Net Foreign Assets 7.5 12.6 9.6 10.8

Exchange Rates (Ruoiah/USS):1. Rom. Off. X-Rate (IFS) 661.0 1111.0 1283.0 1643.8 1696.22. Real Eff. X-Rate(1983-100) 122.8 94.1 72.5 53.3 51.4

La These are Indonesian fiscal year accounts./b Includes official grants.

- 34 -Annex II

Page 1 of 4

THE STATUS OF BANK GROUP OPERATIONS IN INDONESIA

A. STATEMENT OF BANK LOANS AND IDA CREDITS(as of March 31, 1989) la

Loan/ Amount (US$ million)Credit Fiscal (less cancellations)number year Purpose Bank IDA Undisbursed

Sixty-three Loans and forty-seven Credits fully 4,469.30 890.45 -disbursed

946 1980 Yogyakarta Rural Development - 12.00 1.901835 1980 Nucleus Estate and Smallholders IV 30.00 - 6.811840 1980 National Agricultural Research 35.00 - 5.951904 1981 University Development 45.00 - 1.942007 1981 Nucleus Estate and Smallholders V 116.56 - 35.022049 1981 Jakarta-Cikampek Highway 85.00 - 27.422066 1982 Second Seeds 15.00 - 1.032079 1982 Bukit Asam Coal Mining Development 183.86 - 15.192101 1982 Second Teacher Training 79.59 - 13.302102 1982 Second Textbook 25.00 - 0.052118 1982 Sixteenth Irrigation 37.00 - 2.382119 1982 Seventeenth Irrigation (East Java) 70.00 - 10.632126 1982 Nucleus Estate and Smallholders VI 49.00 - 28.982214 1983 Twelfth Power 300.00 - 78.102232 1983 Nucleus Estate and Smallholders VII 135.23 - 87.172235 1983 Provincial Health 24.80 - 5.462236 1983 Jakarta Sewerage and Sanitation 22.40 - 7.692258 1983 Public Works Manpower Development 30.00 - 2.062275 1983 East Java Water Supply 30.60 - 0.80

/a The status of the projects listed in Part A is described in a separatereport on all BankI1DA financed projects in execution, which is updatedtwice yearly and circulated to the Executive Directors on April 30 andOctober 31.

- 35 -

Anne% IIPage 2 of 4

Loan/ Amount (US$ million)Credit Fiscal (less cancellations)number year Purpose Bank TDA Undisbursed

2277 1983 Fifth BAPINDO 177.90 - 29.052288 1983 Transmigration IV 53.50 - 28.572290 1983 Second Polytechnic 107.40 - 22.722300 1983 Thirteenth Power 279.00 - 22.082341 1984 Third Agricultural Training 63.30 - 13.072344 1984 Nucleus Estate and Smallholder Sugar 70.30 - 1S.862355 1984 Second Nonformal Education 43.00 - 5.542404 1984 Highway Department 240.00 - 20.902408 1984 Fifth Urban Development 39.25 - 6.072431 1984 Second Swamp Reclamation 65.00 - 37.912443 1984 Fourteenth Power 210.00 - 33.082472 1985 Secondary Education and Management

Training 78.00 - 41.492474 1985 Upl&nd Agriculture and Conservation 11.30 - 9.522494 1985 Smallholder Rubber Development II 109.00 - 86.232529 1985 Fourth Population 35.13 - 17.252542 1985 Second Health (Manpower Development) 39.00 - 28.092543 1985 Kedung Ombo Mulipurpose Dam and

irrigation 156.00 - 83.132547 1985 Second University Development 147.00 - 95.802560 1985 West Tarum Canal Development 43.40 - 28.642577 1985 National Ports Development 111.00 - 82.632578 1985 Transmigration V 97.00 - 45.002599 1986 Science and Technology Training 93.00 - 36.762628 1986 Smallholder Cattle Development 32.00 - 18.622632 1986 Second East Java Water Supply 43.30 - 13.882636 1986 Second Nutrition and Community Health 33.40 - 22.102638 1986 Nusa Tenggara Agriculture Support 33.00 - 19.602649 1986 Central and West Java Irrigation 166.00 - 128.622690 1986 Gas Distribution 34.00 - 25.032702 1986 Export Development 64.50 - 21.782705 1986 Manpower Development and Training 58.10 - 35.442717 1986 Highway Maintenance and Betterment 300.00 - 47.162725 1986 Housing Sector Loan 200.00 - 16.47

- 36 -

Annex IIPage 3 of 4

Loan/ Amount (USS million)Credit Fiscal (less cancellations)number year Purpose Bank IDA Undisbursed

2748 1987 Third National Agricultural Extension 55.00 - 43.112757 1987 Telecommunications Technical Assistance 14.50 - 7.612773 1987 Fisheries Support Services 24.50 - 21.622778 1987 Power Transmission & Distribution 226.00 - 173.542800 1987 BRIIKUPEDES Small Credit 101.50 - 45.052816 1987 Urban Sector Loan 270.00 - 34.252817 1987 Regional Cities Urban Transport 51.00 - 27.112879 1988 Industrial Energy Conservation 21.00 - 20.172880 1988 Irrigation Subsector 234.00 - 158.722881 1988 Second Rural Roads Development 190.00 - 174.722891 1988 Railway Technical Assistance 28.00 - 25.702930 1988 Forestry Institutions & Conservation 34.00 - 31.852932 1988 Jabotabek Urban Development 150.00 - 144.002940 1988 Accountancy Development 113.00 - 111.002944 1988 Higher Education Development 140.30 - 123.302979 1988 Second Export Development 165.00 - 161.492992 1989 Tree Crop Human Resource Development 18.40 - 17.893000 1989 Tree Crop Processing 118.20 - 118.203031 1989 Agriculture Research Management la 35.30 - 35.30

Total Bank loans and IDA credits 11,005.82 902.45

Of which has been repaid 1,383.98 41.42

Total now outstanding 9,621.84 861.03

Amount sold to third party 88.08 -

Total now held by Bank and IDA lb 9,533.76 861.03

Total undisbursed 2,948.60

/a Not yet effective.b Prior to exchange adjustment.

- 37 -

Annex I1Page 4 of 4

B. STATEMENT OF IFC INVESTMENTS(as of March 31, 1989)

(US$ million)

UndisbursedOriginal Total including

Fiscal Type of commitments held participantsyear Obligor business Loan Equity Total by IFC portion

1971174 P.T. Primatexco Textiles& fibers 4.0 0.8 4.8 -

1971 P.T. Unitex Textiles& fibers 2.5 0.8 3.3 0.8 -

19711731 P.T. Semen Cibinong Cement 46.0 5.8 51.8 1.6 -

741761841971 P.T. Kabel Indonesia Cables 2.8 0.3 3.1 -1972177179 P.T. Daralon Textile Textiles

Manufacturing Corp. & fibers 5.9 1.5 7.4 -1973189 P.T. Jakarta Tourism 9.8 2.7 12.5 2.7 -

International Hotel1974 P.T. Private Development

Development Finance finance - 0.5 0.5 0.4 -

Company of Indonesia1974 P.T. Monsanto Electronics 0.9 - 0.9 -1974 P.T. Kamaltex Textiles 3.7 0.8 4.5 -1980 P.T. Papan Sejahtera Housing

finance 4.0 1.2 5.2 1.2 -

1980 P.T. Supreme Indo- Dinnerware 11.1 0.9 12.0 - _American

1980/85187 P.T. Semen Andalas Cement 48.5 5.0 53.5 22.6 -1982185 P.T. Saseka Gelora Leasing 5.0 0.4 5.4 0.4 -

Leasing1985 P.T. Asuransi Jiva Insurance - 0.3 0.3 0.3 -

1986 P.T. Bali Holiday Tourism 11.3 - 11.3 3.5 -1987 P.T. Monterado Mining 8.0 2.0 10.0 5.5 0.4

Total 163.5 23.0 186.5 39.0 0.4

1987 P.T. Kalteng La Mining - 1.4 1.4 1.4 1.41989 P.T. Agro Muko la Agri. bus. 10.5 2.2 12.7 12.7 12.7

La Agreements not yet signed as of March 31, 1989.

-38 - ANME III

IMDONESIA

PRIVATE SECTOR DEVELOPMENT LOAN

Supplementary Data Sheet

Section I: Timetable of Key Events

(a) Time taken to prepare project I 3 months

(b) Agency which prepared project t BAPPENAS

(c) Pirst presentation to the Bank s December 1988

(d) Departure of appraisal mission s February 1989

(e) Completion of negotiations 5 May 1989

(f) Planned date of effectiveness s June 1989

Section II: Special Bank ImPlementation Actions

None

Section III: Special Conditions

None

ANNEX IVPage 1 of 10

Jakarta, May 10. 1989

Mr. Barber ConablePresidentThe World Bank1818 H St., N.W.Washington, D.C.USA

Dear Mr. President:

Government's Statement on Economic Policy

1. The Government of Indonesia wishes to request a loan from the World

Bank in support of private sector development. This loan would be the third

in a series of ad4ustment operations, following two earlier loans for trade

policy adjustment (approved in February 1987 and May 1988). This letter

provides a description of the current economic situation, the measures which

the Government has taken and the direction of future policy actions.

Progress on Economic Adjustment

2. The external environment faced by Indonesia has worsened considerably

since the early 19809. The combination of sharply lower oil prices and, more

recently, depreciation of the US Dollar has severely constrained the resource

position in the balance of payments and the budget. The Government has

responded to this challenge by taking decisive actions to restrain domestic

demand, mobilize additional resources and set in train the structural changes

needed to develop the non-oil economy. In our previous two letters to you,

dated December 19, 1986 and February 29, 1988, we described the various

measures taken in 1986 and 1987. These included austere budgets for 1986/87

and 1987188, the 31Z devaluation of the Rupiah in September 1986, and a series

of trade and industrial policy reforms. Over the past year, these adjustment

efforts have been sustained and extended.

3. A central element of the Government's adjustment program has been

prudent and sound macroeconomic policies. Another austere budget has been

implemented during 1988/89, with no increase in civil service salaries and

further reductions in real development spending. Expenditure priorities

-40- ANNEX IVPage 2 of 10

emphasized operations and maintenance (O&M) and various poverty-related

programs: social services, agriculture and regional transfers. Special

attention was given to improving the non-oil tax effort, to offset the loss of

oil revenues and maintain an appropriate fiscal stance. Monetary policy was

also tightened, as reflected in the declining growth rate of reserve money.

These prudent fiscal and monetary policies have helped to contain domestic

inflation. At the same time, the nominal value of the Rupiah has been

gradually depreciated against a basket of currencies. As a result, the real

effective exchange rate has continued to decline, preserving the competitive

advantage provided by the devaluation in September 1986.

4. The Government's macroeconomic policies have created a stable

environment for private sector development. In addition, the Government has

promoted efficient development of the private sector through a series of

regulatory reforms. As reviewed below, substantial progress has been made

over the past year in the areas of trade policy. investmenw licensing,

maritime transport and financial sector development. Together with the

competitive exchange rate, the recent regulatory reforms have supported a very

encouraging expansion of non-oil exports. Non-oil export earnings are now

expected to reach US$12 billion in 1988189, almost 80? higher than two years

ago. Because of this strong performance, we expect to achieve our target of

reducing the current account deficit from over US$4 billion in 1986187 to less

than US$2 billion in 1988189. The deregulation drive has also provided a

needed boost to economic activitys non-oil GDP growth is estimated to have

risen to above 52 in 1988 and private investment (domestic and foreign) has

recovered strongly from the low levels of the mid-1980s.

5. During the adjustment period, Indonesia has been greatly assisted by

special assistance from the donor community, in the form of fast-disbursing

program aid and local-cost financing. We are grateful for the direct support

provided by the World Bank through the two Trade Policy Adjustment Loans and

the catalytic role played by the Bank in mobilizing support from other donors.

During 1988189, total disbursements of special assistance reached an estimated

US$2.2 billion. These additional resources have enabled the Government to

push ahead with its deregulation measures and, by cushioning the economy

against the deflationary impact of the drop in oil prices, have facilitated

- 41 - ANNEX IVPage 3 of 10

the recovery in private investment and growth. Special assistance has also

enabled Indonesia to improve the term structure of its external debt, while

maintaining financial market and investor confidence about the viability of

our adjustment program. Because of the Government's prudent external

borrowing strategy, and the improved export performance, the debt service

ratio stabilized around 362 in 1988 and is expected to decline steadily in

future years.

6. With the restoration of external and domestic balance, the policy

focus will increasingly shift towards sustaining a higher growth path. This

is essential to absorb the expanding labor force at adequate levels of

productivity and incomes. In the draft five-year plan (REPELITA V) for

1989190 to 1993/94, GDP growth is projected to average 52 p.a. Given the

resource constraints facing the public sector, and the need to diversify the

sources of growth, achievement of this objective will require a substantial

contribution from the private sector. To promote efficient private sector

activities, the plan gives priority to developing a healthy and dynamic

investment climate throuSh appropriate incentives, simplified regulations and

procedures, and the provision of supporting infrastructure. The broad

directions of the Government's policies to support economic adjustment and

private sector development are set out below.

Macroeconomic Hanagement

7. The Government remains committed to appropriate macroeconomic

policies to reduce the current account deficit, control inflation and preserve

a competitive exchange rate. The budget announced for 1989190 is consistent

with the dual aims of reducing macro imbalances in the economy, while also

supporting a recovery in investment and productive activities. Although

provision is made for increases in civil salaries and real capital spending,

the overall fiscal stance remains cautious. This is because of the major

effort underway to increase public resource mobilization through improved tax

administration, selective expansion of the tax base (for VAT and luxury

taxes), and better cost recovery on public services (e.g., by eliminating

pesticide subsidies). Expenditure priorities will be focussed on O&M,

physical infrastructure and human resource development.

- 42 - ANNEX IVPage 4 of 10

8. The Government will continue to maintain a prudent external borrowing

strategy during 1989190. Strict limits will be placed on import-related

credits and borrowing by public enterprises, with all proposals for large

capital-intensive projects subject to careful scrutiny. Requirements for new

commitments of special assistance are expected to be reduced from

US$2.4 billion in 1988/89 to US$1.8 billion in 1989190. This trend is in line

with the Government's commitment to phase out special assistance over the next

few years. Steps will also be taken to improve the Government's capacity in

the area of debt management. In particular, a unified debt reporting and

analysis system will be established to provide up-to-date and comprehensive

information on the status of Indonesia's external debt. In addition,

technical assistance will be sought to develop a more active strategy for

asset and liability management.

9. The Government maintains its strong commitment to the current foreign

exchange system. Exchange rate policy will continue to emphasize the

objective of maintaining international competitiveness of Indonesian exports,

taking account of price and exchange r- e movements in trading partners and

competitor countries. Through approptiate fiscal, monetary and exchange rate

policies, the Government aims to hold inflation within the single-digit range

and avoid any real effective appreciation of the Rupiah during the coming

year.

Trade Policy Reform

10. The Government remains strongly committed to the objectives of trade

policy as set out in our previous two letters, namely:

- establishing a protection structure based on tariffs rather than

import licenses, thereby providing a more uniform and transparent

level of protection to Indonesian producers;

- reducing the past bias in incentives against export activities and in

favor of import substitution; and

- 43 - ANNEX IVPage 5 of 10

- limiting the level of protection, with special provision for infant

industries which would enjoy higher levels of protection for

specified time periods.

11. The trade reform measures supported by TPAL I and II represented the

first steps in a process of moving away from restrictive importer

arrangements. This momentum has been maintained over the past year. In

November 1988, a further 295 items--including plastics, fertilizers and

various agricultural products--were removed from import licensing

restrictions. The impact on the share of total domestic production protected

by import licensing is much larger than previous packages, declining from 382

at end-1987 to 29Z by end-1988. We expect to make further tangible pLogress

in this direction within the coming year, especially in those areas where

import licensing restrictions still provide high protection to domestic

production. Over the longer term, the Government intends to eliminate all

non-tariff barriers on imports except for a small group of products that are

harmful to health, strategic to national defense or involve special economic

and social considerations. The Government confirms that the reregistration of

importers was completed in February 1989, with 99Z of all applications

approved. Import licenses will now be valid indefinitely.

12. The Government has also continued to review and revise import tariff

rates. In November 1988, tariffs and/or surcharges were adjusted on

191 items, including 25 items for which specific duties have been replaced by

ad valorem duties. Apart from 11 footwear items, all tariff and surcharge

changes remain within the lower ceiling (602) established in March 1985. In

addition, Indonesia moved to the new Harmonized System of coding and

classifying tariff items from January 1989. The cumulative effect of tariff

changes since 1985 has been to reduce the range of dispersion, with little

effect on the average tariff rate. However, there are still marked

differences between and within sectors in the level and dispersion of tariffs

(especially where surcharges and split tariffs are prevalent). The Government

therefore intends to prepare over the coming year a medium-term plan for

tariff reform, including proposals to reduce the role of split tariffs and

- 44 - ANNEX IVPage 6 of 10

surcharges, and to implement a phased reduction in the level and range of

tariff rates. The Government confirms that import surcharges will be imposed

on a temporary basis only, and their justification will be regularly reviewed.

13. To help prepare proposals for further reform, the Government has set

up a high-level team on tariffs, with responsibility for related issues of

trade and industrial policy. This team is chaired by the Junior Minister of

Finance, and includes representatives from EKUIN and the Ministries of

Finance, Industry and Trade. The Government would welcome technical

assistance to build up the analytical capacity of this team. In addition, the

Government has asked the IMF and the World Bank to undertake a joint study of

export policies, including the role of export bans, quotas and approved

traders.

The Regulatory Framework

14. Recogaizing the impediments to private sector growth and development

stemming from the past regulatory framework, the Government initiated a series

of reforms over the past three years to simplify and relax regulations as a

complement to trade policy reform. In this, the Government focussed on the

two most important areas of concern: investment and capacity licensing, and

foreign investment regulations.

15. The Government has taken further steps in these two areas in the

current round of reforms. First, as part of the November 1988 package, the

Government has relaxed the domestic marketing restriction on foreign firms by

allowing them to establish joint ventures to sell their products in domestic

markets. Second, the Government has taken a major step to simplify and relax

the investment licensing system by adopting a negative investment (DSP) list

in May 1989. By replacing a long but partial investment list that included

many restrictions with a short and clearly specified negative list, the

recently announced reform will reduce the restrictiveness of the investment

licensing system, make the system transparent to all investors and ensure that

the investment approval process becomes even more automatic.

- 45 - ANNEX IVPage 7 of 10

16. The Government recognizes that despite the measures taken to date,

and the encouraging trends in domestic and foreign private investment, the

regulatory framework still remains complex and cumbersome for new and existing

enterprises. The Government will continue, therefore, to identify ways to

relax and simplify the regulatory framework. As a follow-up to the adoption

of the negative investment list, the Government intends to open additional

areas to domestic and foreign private investment so that eventually only a few

activities would be regulated on national security or special economic and

social grounds. At the same time, the Government will review the scope for

further elimination of investment-related licenses and reduction in

requirements for license approval. The Government also intends to make local

content programs more flexible. With regard to foreign investment, the

Government intends to review remaining ownership and operating restrictions

faced by foreign firms, and make any further adjustments that are needed to

maintain an attractive investment climate.

17. While the Government has focussed so far on core regulations in the

areas of trade and investment, greater attention will now have to be given to

other elements of the regulatory framework including land and labor laws and

practices, other local-level regulations, and the legal framework. Reforms in

these areas will be complex and time-consuming as they will require

substantive revisions of laws, modification of procedures and reorientation of

institutions. Nevertheless, the Government recognizes the importance of early

actions and has already taken some important steps, for instance by creating a

new land agency directly under the President. To formulate an action program

for reform, the Government will over the next year undertake a review of land

and labor regulations, and initiate a review of local-level regulations and

the corporate legal framework.

Maritime Transport

18. The Government initiated maritime transport reforms in 1985, when

customs services and port operations were restructured, and restrictions on

foreign-flag vessels were removed. Substantial further progress on

deregulating the shipping industry has been made over the past year. In

February 1988, the compulsory scrapping policy for ships was suspended. This

- 46 - ANNEX IVPage a of 10

was followed in November by a major deregulation package which reduced and

simplified business license procedures, allowed shipping lines to determine

their own route structure and schedules, and allowed national lines to charter

foreign flag vessels and form new joint venture companies with foreign lines.

In response to this major shift in the policy environment, over 40 new

shipping companies have already been licensed. This resurgence of competition

is expected to have a strong positive effect on the quality of shipping

services and transport costs. The Government will continue to monitor the

implementation and impact of these reforms closely, to ensure that the

potential benefits are fully realized.

Financial Sector Development

19. The financial sector reforms in 1983, which eliminated most interest

rate controls and credit ceilings, have had a very positive impact on resource

mobilization. However, differential regulations among institutions continued

to dampen competition and impede the development of new financial instruments.

Therefore, over the past year, the Government has introduced a further round

of reforms in the financial sector. Competition in the banking system is to

be stimulated by facilitating entry of new banks (including joint ventures

with foreign banks), easing restrictions on establishing new branches, and

permitting public enterprises to place up to 502 of their deposits with

private banks. The tax exemption for time deposits has been withdrawn, to

redress the discrimination against other financial assets. Other measures to

encourage long-term capital mobilization include the establishment of an over-

the-counter (OTC) market, and easing of entry restrictions into insurance,

leasing, consumer finance and securities activities. To strengthen prudential

regulations, the Government has defined loan concentration ratios and minimum

capital requirements for banks and NBFIs, and solvency ratios for insurance

companies.

20. These measures represent a dramatic departure from the old system

where the state banks dominated the banking sector and other segments of the

financial market were poorly developed. Lmplementation of these changes will

obviously take time, but there are already signs that the structure of the

financial sector will be significantly altered. In the banking sector, new

ANNEX IVPage 9 of 10

licenses have been issued for 7 national commercial banks, 3 joint ventures

with foreign banks and 47 secondary banks. Several foreign banks are actively

considering opening branches. As regards capital markets, there has been a

significant increase in activity on the Jakarta stock exchange since October

and the first issue on the new OTC market was successfully completed in early

1989.

21. Not surprisingly, monetary conditions were initially unsettled after

the deregulation measures were announced. However, the situation has now

returned to normal, with inter-bank rates around 12-15Z. To improve monetary

management, the Governme-nt now allows the reswap premium on foreign exchange

transactions (to provide cover against exchange risk) to be determined by

interest rate differentials. The maturities of money market instruments (SBIs

and SBPUs) have also been extended, and institutional arrangements have been

improved to develop the secondary market. Finally, reserve requirements have

been reduced and unified at 2S for all banks and liabilities. In order to

contain the potential expansionary effects of this change, banks were

initially required to hold 80 of the reserve money thus released in SBIs.

22. Over the coming year, the Government will continue to monitor the

impact of these reforms very closely. The immediate priority for follow-up is

to strengthen Bank Indonesia's capacity for bank supervision. Technical

assistance for this purpose is being provided by the IMP and ADB. Draft

legislation will also be presented to Parliament in the near future to codify

and streamline the regulatory framework for the central bank, commercial

banks, insurance companies and pension funds. Audits of the state banks are

to be undertaken, to identify needs for restructuring and recapitalization.

Finally, the Government is committed to reducing the role of subsidized

credits from Bank Indonesia, by reducing the size and scope of eligible

programs, and bringing interest rates closer to market levels.

Public Enterprises

23. Following the weakening of oil prices in the early 1980s, the

Government took steps to contain investment by public enterprises. Several

large capital-intensive projects were rephased in 1983. Subsequently, tight

ANNEX IV- 48 - Page 10 of 10

control has been kept on utilization of non-concessional import-related

credits and equity participation in public enterprises funded through the

budget has been reduced to minimal levels. Over the past year, the Government

has completed a review of the financial performance of most public

entreprises. Based on this review, the Government intends to divest or

reorganize several public enterprises in the near future. Some of these

enterprises vill enter joint ventures with the private sector and others will

issue shares to the public. Over the coming year, the Government intends to

review the policy framework for those enterprises remaining in the public

sector, to ensure that it encourager 3fficient operations. Particular

attention will be paid to issues of autonomy and accountability in the

relationship between the enterprises and the Government. Based on this

review, a plan of action will be prepared, to guide the future direction of

public enterprise reform.

Sincerely yours.

Saleh AfiffMinister of State for NationalDevelopment Planning/Chairman

of Bappenas

DOiESIA - PRIVATE SECTOR DEVeLPMi LOAN: POI ICY >RAiEfl

Actions tUen 19848 Action. token 19687 Actions tahon 190649 Arose for follow-up

A. Mromcnl. Policie

196. Rupiah devalued by 2M A the 1966. RuPioh devaIus by 811 & Rupiah d percitnd ateedily Presrve a ompetitive exch.neexchange re subeeqouently et by ub-oquently *llowed to depreciate e inot the US Collor. b October rate, through eoordinnted fiscnl,a managed floet against basket with the US Dolar. I i the REt was 71 lower then monetary A exchange rote policios.of currencet. aftar the 196 devauation

Avoid any real effectiveap;ociation of the Rupish in

FimI Pal Iea c Extrma l Debt

19S. MIny large capital-Intenalvo Au.tare budgete implemented for Jan 1O8. AMther *uotare budget Monitor *xpenditure in 1959/90, toprojects rephaed. major 1966/6 A 1967/88. No increae In anounced for 19W8/89. No increase saintain a priaart budgot surplusinvoeteete affected Included civil service *clariea A capital In civil *ervice salrles A real reduce net doeabac expenditure.bintan Alumina, Plnju arosatic. seending eut by 27m. Priority capital saendin, growth hold to Primaerly use any windfall froeihue refinery, Aceh oleftino gsven to R. Sas priorities tc for higher oil prices to reduce externalsoveral power projocts. Total - Completion of ongoing projects. prvitou 2 years. brrowirn .foroe exchanga savings *atimted - Counterpart fund" for foreign-et 111410 billIon, aided projects. Jun 1968. ICI pledl USti2.4 Impement pndin, prioritlaa for

- Pro jat aerving ea.loysmt A billion in special asesitance for REP*9,TA V Winfrestructure Aequity ob;ectivea. 198/9 hunmn r rce development.

Maintain prudent external borrowingatratey in 1969/90

- Reduce doepndnnce on epecialmal atanum.

-Kee strict limits on impart-related credits & borroing bypublIc entarpriese.

- Corefully scrutinize pr"o loIfor large capitatl-inteneiveprojecta.

Strengthen Institutionalrranento for debt magesnt:- Prowide a atrexolined & unIfied

debt reporting A analysis system.- Davelop a more active atratgy

for asset * Itnbiity I snagesnt.Public Resource Mobilixation

1964. tneom tax reform included: 1966. Ma property tax replaced 7 Through improveent In tax Fully implement ravnue masuree- Simplified tax structure, based ordinances including the old land adoaietn ation Ce.g., income tax announced for 1989/90.

on relatively low ratee (S11, a net weath txxes. The now law audits) non-oil texoe increexcd28 8 J S}) A Isited deduction. is simplor. bed on a proportion from 9.4 of non-aI CDP In Further improve tax adminiatration

- gf- es ta of tax of the market value of land A 1967/88 to 10.i In 19081/9. by:Ilability, with ephbass on buildings, a a Single tax rate of - Introducing full *udit of VATwithholdifn at ourc. 0.i. Power tariff. raised on avoage by return.

- Simplification of the tax code, 268 from April 1, 1969. - Increasing property vxlues forincluding revised procedures tax collection,for appeals & refun. Anouned extenion of tax bae

for 1=989/9 t.b th These measures are expected to raise1968. 0U VAT replaced xoles taxes. - Ex 'a,T to th olle Th t - I *x o r toLtitd to owuf cturtne level. but level A to mot ervIcea, non-oll CDP by 1 percentage pointincreseed revenue potential by: - Raixing the number of its A during 1969/90.- Subjcting dometic *ales of ratoe for luxury taxes.

serol ear & tobacco products to Improve cost recovery by:NAT.in Announced decision to eliminate - Fe. retention A hIgsher fee levels

- Impoeleg an additional tax (10- pesticide subsidies in 1989/90. for crtin heath * duetion20)on luxury good". servicess. (

- Adjusting petrolem product P4prices to generate a budgetsurplus A reduce cross-subsidization of kerosnme 0diesel. 6

- Reducing fertilizer subeidisethrough price incrass * aswl Wooas improved efficiency inproduction A distribution.

DCC13IA - PRIVATE SETaR DEVELPENT LO, POLICY FRAMWI

Action, taken 1988-0 Actions tken 1986-87 ActionS taken 1988-0 Aroma for fol Iow-up

b. Incentiyesa & RAulatory Frsno,rk

Trade Pal icY Reform

1985. Tariff ceiling reduced from 186. Export certificate. NoY 1908. A furthor 295 items EnSur proper implomnttion of

22tS to S0 (Ibarring a fea abolished, following Indoneoic'- remoyad froe licenee control. Ste_ reent refor. including

exceptiono) & nubier of tariff uacestion to 0ATT Code on include agricultural producto (e.g. reregistration process.

categories reduced from 25 to 11. Subsidios A Countorvallin# Duttas. palo/coconut oil tobacco,rubber).Ibeever, Wile continue to proc_ee fruit I mat cigarette., Reduce the coyerage of NT80 from 291

proliferate. by nd-t9do, moe 1986. 'Producer exporters' allowd fertilizers. plastice more steel to 20-24J of domeatic production oev

than 700 Items were subject to to import inputs, exept fro & textile product. Coyerae of tho next year. Focus on areas wher.

Wile of one fora or another, duties & licence restrictions. NT8 reduced frm: NTSa proyide high protection toOther exportre a IIowed to import - 28S to 211 for Import yalue. doeetic production. Eventually,inputs (aith duti es refunded), if - 301 to 29l for total production, eliminate all NiM. except for adomotic suppliers not able to - 351 to 281 for wmnu. produetion, euaIl grouP of product for heaitho

eupply them at coepetitlyo priceo. defenc or moctal conaideratonte.N.Y 19w88 Tariffs A/or murchargee

1986-87. trade reform pacekges changed on 191 iteom fneure that *11 tariff chaneworemoved S44 itemo from licence - Loered (28 items) cher local conform to the lower tr"ff bands.control. Items included cheoiclal, price. below existing teriffs or Prpare a systemtic indium-termIron A steel, ent,neosrng Goods there is no domstic capacity, plan for tariff reform, including

points A dyes, tires a tuboo, 91isae - Raised (89 Ie) to partially proposals to reduce tho role ofA tactile.. Coverage of Nio coepensate for tWo remoyol of split tariffs & surcharge, a toreduced fromf NTsI. impleamnt a phased reduction in the- 48 to 251 for ixport ylui. - Specific duteso replaced by ad leYvl A range of tariff rates.* 41S to 881 for total production. valorem dutie (25 item)- 821 to 851 for menu, production. - Tariff. split into toriff a Roview justifieation for curreont

surchargeo (82 item), export restrictions, particularly1968-7. Nominal tariffs adjueted us of export bano, quotas Ato lower the cost of imvorted Nov 1908. Al I Importers to be approved trader arrangement.Inputs A moderate the impact of rergieterod, Licanes subsequently

Nil reovsI , vaild indefinitely. Strengthen 00C capacity for analysison trade A in-dustrial policy leaumo.

1987. Export Incentives improyed Jan 1989. Nw tariff echdule Arrango technical asetance for thby: baead on Hromonixed System tariff te. o

- Abolishing e port Itcsnees. introdue d. L

- Removing export ban on 10 itemsOa eaport quts on 24 item..

- Improving tho "ay 6 Schoem.

Inveotmnt and Camacite Licensint

198. Procedures or approv I 1986. Fields of investment open to Moa 1988. Foreign firms allowed to Open up more sectors to doestic

;mplementation of private foreitn a domestic cepanies core oatbl i;h Joint ventures for for#ein inestment so thut

inve;t_ent simplifled. Major *xpanded substantially A pocified doe_tic mrketicno of own products evntually only a 4W sectors

reonization of b(P almo more clearly. Foreign Investmnt at the *holoele level Operatin could be reuiated due to national

eowlis td r flecting chonf.I co panies were given greateor :ec_ lienae valid Indefinitely A ecurity or eacil considerationa.

fexcu- frm inYot_nt rfew ction to domestc ftnncn a domestic throuehout Indonmtni

to promotion. cenaraip rule. were eased. Roduce remining constraint.t on

eo AroeeeXon er hip rulm ecro *no d hy 1909. DSP list tranoformed foreign invoetent° including7. Ingetant c apacity to a short negative lit, making restrictiona on ooers h;p, export-

lIcensing system relaxed: the licnoing proces more orIented fi*r (;ncluding in- Automtic approval to firm to automtic a opening naw eactors to agriculture) A doo_tic marketing

increas production by up to a01 dometic foro;en Investors, by foreign firm.of licensed caacity.

- Broed banding' of investmnt Make local content program morecateories, allowing firom to fleWible, by gradually eliminatingdiversify production. imort bano A import Ilcsnslng

- Additional fioldos f investmnt restrlction on final compoents Aopened to dome_tic a foreign component., A by continuing to relaxInvstm deletion echodules.

- Rquirem_nt for investentliense further streolined.

197. Fbregn i mnvetmntreulationes relaxed:

oo- Foreln -caned companis allowed

to amrket Indonesian export.- Foretgn firm altloed to

s

purchase domestic Inputs withoutrestrictIon.

- Rules rerding hiring ofexpatriate personel relaxed.

IXNPYA - PRIVATE SECOR DEV11111"HEW LAAN, POLICY FRAMI9K

Actiona taken 1983-8 Action, taken 198647 Actions taken 196869 Areas for fol low-up

Other Rulationa

Rev;ew local-level reaulation., aland a lobor love & practices, toensure they provide an appropriateframeork for private sectordevelopment.

Revitalize reform of the corporatelepal system, including a review of

*xieti;n laov & interim 'proceescheng,e.

C. Public nterDriee Refor.

1986. Prealdent rewueat review of Implemont proposed program to divestthe financial performance of public A reorganixe selected publicenterprise, to tdentify candidatee enterpriee, Including throughfor diveetMent or reorganiation joint venturee with the private

eector A ehare iseuee to the publ iC.

Initiate a review of th, policyframework for public enterprises,including ieeu*s of sectoro&Jsctivee organization, autonomy.account biit a perforanceevaluation Prepere plan of actionfor public enterprise reform.

0. Infrastructure and Suveort Service.

1965. Import and expott procedures Februtry. Compuleory scrapping Ensure proper implementation ofredue*d to a otn Im: porte ere policy for sip. ouepended. el hipplng deregu ition e surem.now inodected at the ports f Von ein by0C1-appointed suveyor. November. Major derelulation of(SOS) *hteIs exporte A inter- the chIpping induetry to:tloEnd traffic are no loner - Reduce A simplify busineeseubject to cuoto_e inspection. Itcensing procedure.Port charge siaplifled A -Allow chopping line. toreduced, A reetrictona on determine their own routeforeign-flag veeele removd structure. a chedulee.

- Allow national line. to charterforelgn flag weeele A form newjoint venture copeanite withforeign line.

090

0

. _~~~~~~~~~~~

ISMXIA - PRIVATE SETOR DEV Et'MB41 LOMN: POLICY FRAMAR(

Actions taken 1988-8 Actiono taken 1986-7 Actieon taken 198889 Areas for follow-up

E. Financial Sector Oev.eloeent

1988. Financial reform to: 1987. Equity mrkets strengthened: Oct 19S8. "asurem to enhance Strenethen prudential raulation,- Rovoe met intreet rate - Inetitutlonal framework for competition. increase the eupaly of * pecap ily for bank mupervision:

controle on state bank deposit. capital markets improved, long-tars funds A prote stabt I ity - Apply coneistont regulaetions- Eliminate credit ceilings for - Listing requirements on the in the financial eyete: for state & private bank.all bank. Jakarta stock exchange - Isoue nw licence. for banks. - Develop n early rni system

- Reduce the number of liquidity simplified. including joint ventures with for montorin, benk pe-forsnC.ecredit program. - OTC market proposed for newer foreign banks. - Improve the eyetos of bank

I em well -established compntIes. - Eaee restrictions on opening evaluation A ratings.- Foreign Investors allowed in new branches of banks A lFIo.

OTC market. - Allow new rural banke to be Introduc new logislation to codifyestablished In districts e stroealino rogu latery fra_ work(outside capitals). for central bant comercial banko,

- Ease the requirements to become inurnce cocPanies A pension funds.- foreign exchange bank.

- Allow public enterprises to Conduct audits of the state banks. &place o01O of their dposits prepare a program for restructuringwith private banks A NBFIs. p recplttlixtion. Improve the

- Allow NBFI to ieeue We. legal *ccounting framework for- Levy a 1*5 withholding tax on the financial eector.

time deposits A Ce to removediecrimin"tion against other Reduce the role of subsidizedfinancial aesota. liquidity credits by:

- Allo banks & NOFrs to raieT - Rtducing tho *hare of bank creditcapital from securities mrket, channeled through this mechanism.

- Oefine lon concentration ratios - Liomting the number of Oltibl.A minimum capital requirements pr"ogrms.for banks A lNI&. - Bringing interest rates cloeer

- Establish a uniform A lower to market levels.reserve roqutresent (21) for

- Extend the mturities onmonetary instru-ments A developthe secondary market.

-Relate the reewap premium to uinterest eate differentials.

Dec 1988. Additional measure tostrengthen the capital market:- The private sector can now

operate stock exchange- Simplify entry Into ineurance.

leating, consumr finance.capita? A securities activities.

- Specify solvency ratios forinsurance companies.

Nar 1989. Ceiling on offshoreborrowing by banks A NIFIe reved,A replaced with geenral eoundnesecriteria.

40

Mit

- 53 - ~~~~ANNEX VIPase 1 of 7

IMPLEMENTATION AND IMPACT OF REFORMS SUPPORTEDBY EARLIER ADJUSTMENT LOANS

Introduction

1. The external environment faced by Indonesia has worsened considerablysince the early 1980s, with sharply lower oil prices, and more recently, thedepreciation of the US Dollar. The Government of Indonesia (GOI) hasresponded effectively to this challenge, taking decisive actions to restraindomestic demand, mobilize additional resources and set in train the structuralchanges needed to develop the non-oil economy. The World Bank has supportedGOI's recent reform efforts through two adjustment loans: Trade PolicyAdjustment Loan I (TPAL I) approved on February 3, 1987 and Trade PolicyAdjustment Loan II (TPAL II) approved on May 10, 1988. Both loans were forUS$300 million.

2. The objectives of these two adjustment loans were to: (a) supportthe substantial reforms, especially in the area of trade policy, undertaken byGOI since 1986, and ensure that they are implemented well; (b) assist GOI tobring about an early recovery in economic activity consistent with externaland domestic financial stability; and (c) maintain the policy dialogue onfurther reforms for promoting the efficiency and longer-term viability of theeconomy. These objectives were to be achieved partly through our ongoingdialogue on policy issues and partly through balance of payments support. Inaddition to providing direct financing for general imports, the loans played acatalytic role in mobilizing US$3.7 billion of fast-disbursing specialassistance over the past three years. These additional resources have enabledGOI to push ahead with its deregulation measures, and by cushioning theeconomy against the deflationary impact of the drop in oil prices, havefacilitated the recovery in private investment and growth. The findings of arecent assessment of measures supported under TPAL II are summarized below.

Implementation of the Reform Program

3. A key prerequisite for the success of GOI's reform program has beensound macroeconomic policies. Over the past three years, civil servicesalaries have been frozen and real capital spending by the Central Governmenthas been cut by more than 202. At the same time, a strong effort has beenmade to increase budget revenues, primarily through improvements in taxadministration. As a result, the ratio of non-oil taxes to GDP has risen from8.42 in 1985/86 to 10.82 in 1988/89 (see Table 1). The combination ofexpenditure restraint and tax effort has helped to improve the fiscal positionof the Central Government, with a decline in net domestic expenditure as aratio to GDP and generation of a primary surplus. Monetary policy was alsotightened, as reflected in the declining growth rate of reserve money. Theprudent fiscal and monetary stance has helped to contain domestic inflation toabout 92 per annum over the past two years. At the same time, the nominalvalue of the Rupiah has been gradually depreciated against a basket ofcurrencies. As a result, the real effective exchange has continued todecline, preserving the competitive advantage provided by the devaluation inSeptember 1986.

- 54 - ANNEX VIPage 2 of 7

Table l IMPLEMENTATION OF POLICY REFORMS

1985 1986 1987 1988

1. Fiscal policy /aNon-oil taxes (2 of non-oil GDP) 8.4 9.8 9.4 10.8Net domestic expenditure (2 of GDP)/b 8.5 3.8 4.1 2.2Primary balance (2 of GDP) -0.9 -1.1 0.8 0.4

2. Monetary policyReserve money growth (t p.a.) 17.6 21.3 11.0 -5.7

3. Real effective exchange rate -2.9 -23.0 -26.6 -2.9(2 change) Ic

4. Coverage of NTBs (2)CCCN items 31.5 27.9 21.7 16.3Import value 42.9 34.9 25.5 20.8Domestic production 41.4 39.5 37.6 28.9Manufacturing production 52.0 43.8 35.3 26.0

5. Investment approvals /dDomestic (Rp. trillion) 3.7 4.4 10.3 14.9Foreign (US$ billion) 0.9 0.8 1.5 4.4

/a All data relate to the Central Government only.lb The domestic content of expenditure less non-oil revenues.jc Based on annual average data.id By BKPM.

4. In the area of trade policy reform, the loan was based on measurestaken .aring 1987 to reduce the coverage of non-tariff barriers (NTBs).Through two packages, in January and December 1987, GOI removed 342 itemsfrom import licensing restrictions. As shown in Table 1. these reformsaccounted for 202 of all items and 222 of import value previously restricted.More importantly, they reduced the coverage of NTBs from 442 to 352 ofmanufacturing production. Most of the reforms were in highly-protectedmanufacturing subsectors--s-ch as textiles, garments and footwear, basicmetals and engineering goods--where import licensing restrictions had the mostdeleterious effect on international competitiveness and allocative efficiency.l/Follow-up discussions with GOI and interviews with firms suggest that these

11 Because of the dominant role of agriculture, and the limited reforms inthis sector, the coverage of NTBs for the economy as a whole fell onlyslightly, from 402 to 382 during 1987. Follow-up measures to extendthe reforms into the agriculture sector were taken in 1988 (see para.14). These have significantly reduced the share of domestic productionunder NTBs.

- 55 - ANNEX VIPage 3 of 7

measures have been implemented smoothly. The issuance of import licenses isfairly quick and non-discriminatory, and information regarding the reforms isbeing disseminated to the firm level.21

5. Additional measures were taken during 1987 to eliminate some of thedirect impediments to exports: (a) the need to obtain a special exportlicense was abolished; (b) sevr q export bans and quotas were removed;3/ and(c) access by exporters to inte _tionally-priced inputs (through the May 6scheme) was broadened As shown in Table 2, utilization of the May 6 schemehas continued to expiAd rapidly, in terms of number of firms and import valuecovered, while average processing times have been reduced.

Table 2: IMPLEMENTATION OF MAY 6 SCHEME

Value of imports Processing timeNo. of (USS million) (no. of days)Firms Approved Realized Exemptions Drawbacks

1986 la 242 236 65 12 241987 482 902 297 7 171988 1,098 2,447 626 6 13

la From July.

Source: BPKEIPDL.

6. Under the two trade reform packages of 1987, tariffs for 121 itemswere raised and tariffs for 178 items were lowered. Temporary surcharges werealso imposed on 51 import items. The tariff increases compensated for theeffects of the removal of import licensing restrictions, but remained withinthe lower tariff ceiling set in 1985. The tariff reductions in the January1987 package were concentrated on products not produced domestically, and wereintended to offset the cost-raising effects of the September 1986 devaluation.The reductions in December 1987 went beyond this limited objective by reducing

21 More recently, in November 1988, all existing import license holders(some 4,880) were required to reregister. By February 1. 3,667 hadreapplied and 3,645 (992) had been approved. Some 42 new importerswere also registered during January and February 1989. Import licensesare now valid for as long as the importer remains in business, whereaspreviously licenses had to be renewed every 3 to 5 years.

3/ During 1988, some new export bans (e.g., semi-processed rattan, lowest-grade rubber) were imposed to increase domestic value added and/orprotect the environment. The justification for these bans needs to bereviewed, taking into account market conditions for these products andthe impact of the bans on domestic employment and income distribution.

- 56 - ANNEX VIPage 4 of 7

some tariffs on domestically-produced goods that were removed from licenserestrictions under earlier decrees. As shown in Table 3, the cumulativeeffect of tariff changes since 1985 has been to reduce the range ofdispersion, with little effect on the average tariff rate. However, in movingoff NTBs, split tariffs and surcharges were used to protect some domesticproducers.41 As a result, there are still marked differences between andwithin sectors in the level and dispersion of tariffs. This reinforces theimportance of broadening the trade reform effort to include a comprehensiverationalization of the tariff schedule. Progress in this area has been slowerthan expected, due to delays in strengthening GOI's institutional capacity toundertake trade and industrial policy analysis. Technical assistance for thispurpose will be required.

7. A number of major steps were taken during 1987 to relax and simplifythe investment and capacity licensing system. Firms are now allowed toincrease production by up to 302 of their licensed capacity without requiringnew investment approval and to diversify production within much broaderproduct categories, thereby improving the operational flexibility of firms andpromoting greater competition. Furthermore, the requirements for investmentlicenses were streamlined and additional fields of investment opened toprivate domestic and foreign investors. The December package included a

Table 3: CHANGES IN THE TARIFF SCHEDULE /a

Pre-1985 1985 1988 1989

Average tariff rates (2)Unweighted 37.3 27.0 24.0 24.4Weighted by:

- Import value 22.0 13.0 14.5 14.5- Domestic production 26.0 17.1 16.6 17.0

Index of dispersion /b 61.5 107.8 90.0 84.4

/a Tariffs are inclusive of surcharges and specific duties have beenconverted to ad valorem equivalents.

/b Measured by the coefficient of dispersion.

Sourcet Ministry of Finance and World Bank staff estimates.

41 'Split tariff" positions are used to subdivide a standard seven or ninedigit CCCNIHS product description into finer product groups withdifferential tariffs or NTBs applied. Surcharges are also used as ade facto anti-dumping device.

57 ANNEX VIPage 5 of 7

series of measures to relax foreign investment regulations: domesticownership requirements were eased significantly; restrictions prohibitingforeign-owned companies from marketing Indonesian export goods were removed;foreign firms are now allowed to purchase domestic inputs without restriction;and rules regarding the hiring of expatriate personnel were relaxed. Thesesteps have addressed key concerns expressed by foreign investors in Indonesiaand reduce differences in treatment between foreign and domestic firms.Together with the broader regulatory measures, these changes in the investmentand capacity licensing system have significantly improved the environment forprivate investment. This is reflected in Table 1, which shows that investmentapprovals by BKPM have risen by 230Z for domestic investors and 430Z forforeign investors over the past two years.

Impact of the Reform Program

8. The two core objectives of GOI's adjustment program are:(a) restoration of financial stability; and (b) sustained recovery of growth.Progress has been good on both fronts. As regards financial stability, theprompt stabilization measures taken in response to the external shocks of 1986contained the current account deficit to around 61 of GNP in 1986/87 andreduced it to below 3Z of GNP over the past two years (see Table 4).

Table 4: IMPACT OF POLICY REFORMS(growth rates, 2 p.a.)

1985 1986 1987 1988

Economic activityGDP 1.7 3.7 3.9 4.7Non-oil GDP 3.8 3.9 4.6 5.6

Fixed investment -6.0 -7.0 1.9 7.0Public 2.4 -19.6 -1.7 6.3Private -13.8 6.8 4.9 7.6

External tradeNon-oil exports 10.1 3.2 25.8 13.6Non-oil imports -13.3 -13.6 5.0 6.6

Other indicatorsDomestic inflation /a 4.7 5.8 9.5 8.5Current account/GNP (2) -2.4 -5.9 -2.3 -2.5Debt service ratio (Z) /b 24.4 37.3 33.9 36.3

la As measured by the urban consumer price index (adjusted).lb Debt service excludes prepayments.

Source: World Bank staff estimates.

ANNEX VI- 58 - Page 6 of 7

Inflation has also been held to about 9S per annum over the past two years,preserving the competitive advantage provided by the 1986 devaluation.Indonesia's debt burden remained high in 1988, with the debt service ratioover 36Z. However, a number of debt indicators (e.g., debt exports, debtlGNP)have already started to decline and all debt indicators are projected toimprove steadily over the next few years. This trend reflects the favorabledebt structure (reinforced by the availability of special assistance) and thestrong economic recovery (especially for non-oil exports). GOI remainscommitted to servicing its debts on schedule.

9. The measures taken have helped to provide the basis for a sustainedrecovery of growth in three wayss

(a) In response to the real exchange rate adjustment, and accompanyingderegulation measures, non-oil exports have increased substantiallyfrom US$6.7 billion in 1986187 to an estimated US$12.1 billion in1988/89, a real increase of 20S per annum. Much of this growth hascome from a diversifying base of manufactured goods, with many smalland medium-sized private firms contributing substantially.

(b) There is also evidence of resurgence in private investment,especially in export-oriented activities. The sharp increase ininvestment approvals by BKPM is noted above. Implementation of theseapprovals is reflected in Table 4, where the growth of privateinvestment is estimated to have accelerated to 8Z in 1988. Togetherwith the severe constraint on public investment, this has led to achange in the structure of investment, with the private sector nowaccounting for about 542 (up from 492 in 1985).

(c) The recent reform measures have also had a positive effect oneconomic efficiency. As shown in Table 5, the return per unit ofinvestment had declined sharply in 1982-85, as the pace of economicgrowth began to slow and NTBs were imposed to protect inefficientdomestic industries. This trend is also reflected in the high ICORand fall in total factor productivity (TFP). However, after 1985,there has been a noticeable improvement in all three of theseefficiency indicators.

Table 5: MACROECONOMIC EFFICIENCY INDICATORS

1974-81 1981-85 1986-88

Rate of return on investment (S p.a.) 31.4 13.1 21.8ICOR 2.8 7.8 5.2Total factor productivity change (2 p.a.) 0.9 -2.5 1.0

Sourcet World Bank staff estimates.

59 ANNEX VIPage 7 of 7

These positive developments have supported a steady increase in the growthrate of non-oil GDP from 3.82 in 1985 to an estimated 5.6Z in 1988. With theresurgence of private investment and momentum of the export drive, there isevery expectation that this recovery will be sustained.

10. The recovery in economic growth has helped to contain the socialcosts of adjustment. GOI has also acted directly to reallocate publicspending to poverty-related programs. For example, the shares of developmentexpenditure allocated for social services and agriculture have beensignificantly increased over the past five years. An effort has also beenmade to protect regional transfers, which normally finance small-scale andlabor-intensive infrastructure projects at the local level. Even so, becauseof the overall budget constraint, the availability and quality of many basicservices has weakened. More fundamentally, because of the severe terms oftrade loss, per capita incomes are still lower than in 1981. The main burdenof adjustment has fallen on earnings, with real labor earnings in agricultureand services probably stagnating or declining during the recent adjustmentperiod. However, part of the adjustment in the labor market has occurred asan increase in the _ate of open unemployment in urban areas, especially amongyoung school leavers. These trends reinforce the importance of sustaining ahigher growth path over the medium term, to absorb the rapidly expanding laborforce at higher levels of productivity and income. By restoring stability andpromoting restructuring in the economy, GOI's reform program is laying a solidfoundation for achievement of this objective.

- 60 - ANNEX VIIPage 1 of 6

DETAILS OF RECENT POLICY MEASURES

Trade Policy Reforms

1. Another in a series of trade policy packages was announced onNovember 21, 1988. As in the past, this package focussed on the removal ofnon-tariff barriers (NTBs), by moving items from restrictive import licensecategories to the general importer license category (IU or IU+).1/ A total of295 items have been deregulateds2/

o 78 chemical items, including most fertilizers (urea, ammoniumsulphate, TSP) and all plastics.

O 11 iron and steel items (although most flat products remainprotected).

o 110 textile items (many of which had become less restricted inearlier packages, but are now deregulated).

* 50 food and beverage items, including palm/coconut oil, someprocessed meats and all cigarettes.

o 46 agriculture items, including tobacco, rubber and some fruits.

2. World Bank analysis suggests that these measures will reduce thecoverage of NTBs as follows:

o From 21.7Z to 16.32 for CCCN items.O From 25.21 to 20.82 for import value.o From 35.32 to 26.02 for manufacturing production.O From 37.62 to 28.92 for total production.

3. The package also requires all general importers to reregister, toensure that they: (a) hold an importer identification number (API); (b) holda taxpayer identification number (NPWP); and (c) have not violated anyexisting regulations. This reregistration process was to be completed by theRegional Offices of the Ministry of Trade by December 31, 1988 (subsequentlyextended to January 31, 1989). Of the 4,880 import licenses existing beforereregistration, 3,667 reapplied and 3,645 (992) were approved. Access by newimporters to import licenses remained open during, and after, thereregistration process. New entrants required the same documentation as thosereregistering, and some 42 new importers were reregistered during January andFebruary 1989. All import licenses will now be valid as long as the importerremains in business (rather than be renewed every 3 to 5 years as before).

11 IU licenses were converted to IU+ licenses following the reregistrationprocess (see para. 7).

2I This total excludes 6 items moved from IU to IU+. For another 17items, the license iestrictions have been eased. These include 15steel items previously imported by Krakatau Steel only but now open toall actual users (IP).

- 61 - ANNEX VIIPage 2 of 6

4. The package includes tariff (andlor surcharge) changes on 191 items:

o Tariffs were lowered on 25 items, where local prices were belowexisting tariffs or there is no domestic capacity.

O Tariffs were raised on 59 items, to compensate for the removal ofNTBs.

o Specific duties were replaced by ad valorem duties on 25 items.

O Tariffs were split into tariffs and surcharges on 82 items.

Apart from 11 footwear items, all of these changes leave the sum of tariffsand surcharges within the existing tariff ceiling of 60Z.

Investment Measures

5. As part of the measures announced in November 1988, the Governmentfurther relaxed the marketing restrictions on foreign (PMA) firms. Foreignfirms will now be allowed to establish joint ventures to distribute theirproducts at the wholesale level. Previously foreign firms could only markettheir products in domestic markets through fully Indonesian owned firms. Inaddition, the operating license (SIUP) is now valid throughout Indonesia andfor as long as the company remains in business.

6. In May 1989, the Government announced the adoption of a negative listfor investment licensing by the Investment Coordinating Board (BKPM). Thisnegative list replaces a long and incomplete list that had been used earlierfor the investment approval process. Bank analysis indicates that out of atotal of 6,727 investment categories in the industrial sector (according tothe Indonesian industrial classification system), 167 investment categorieswould be restricted by the negative list. Also, the new negative list doesnot distinguish between domestic investment that can be processed by BKPM(PMDN investment) and non-PMDN investment for which discretionary approval wasrequired; and for the industrial sector, all areas that are open to domesticinvestment are also open to foreign investment.

Maritime Transport

7. The compulsory scrapping policy for ships was suspended in February1988. This was followed by a major package of shipping deregulation measureson November 21, 1988. This package reduces and simplifies business licenseprocedures, allows shipping lines to determine their own route structures andschedules, and eases entry for both foreign and domestic companies. As aresult, Indonesia now has a more open and unregulated shipping industry thanmost other maritime nations.

8. The major measures announced on November 21, 1988 are as followst

o The number of shipping business licence types is reduced from five(ocean, interisland, local, special, and "peoples6) to two(international/domestic and ̂ peoples^). Licences are valid for as

- 62 - ANNEX VIIPage 3 of 6

long as the holder remains in business, unless revoked/suspended fornon-compliance with certain regulations.

O The prohibition on the issue of new shipping business licences,imposed in 1976, is removed.

O The requirement for shipping businesses to possess a separateoperating licence is removed. The business licence now serves alsoas the operating licence.

O Non-shipping companies need only obtain an operating licence tooperate ships for the transport of their own raw materials orproducts. This applies also to companies in the tourism field whichwish to operate vessels as an integral part of their main business.Provision is also made for such "own-account" operators to servethird parties subject to obtaining the permission of the Minister.

O Joint venture companies may be established between national andforeign shipping lines to serve domestic and/or international routes.

O The conditions which must be met in order to obtain a shippingbusiness licence are relaxed considerably. In particular, nationalshipping companies wishing to obtain an internationalidomesticlicence need only own or control (by leasing or charter) oneseaworthy Indonesian flag vessel. Previously it was necessary to owntwo vessels of specified sizes. Joint ventures are required to ownat least one Indonesian flag vessel. There is no longer a minimumworking capital requirement. Applicants are required to have a taxnumber (NPWP).

o Applications for shipping business licenses (and operating licencesfor non-shipping businesses) are required to be processed within 14working days. A written explanation must be furnished in the eventof an application being refused. Those which have been refused maybe resubmitted as soon as the applicant is able to comply fully withthe conditions for licence issue.

O National shipping lines are allowed to decide, individually or inconsultation with one another, which routes to serve and whichvessels to operate on them. These decisions, and any subsequentamendments, must be reported to the Director General of SeaCommunications (Seacom), but no approvals are required. Schedulesare required to be publicized in the mass media and advised to theCommodities Bourse.

O The Government may instruct a state enterprise to operate certainroutes which are not served by the private sector.

O Licensed national shipping lines may use foreign flag vessels,operated under a charter or some other agreement, on domestic routeswithout obtaining approval from Seacom. For this purpose, thebusiness licence is construed as being the *Flag ConditionsDispensation* required by the Shipping Law.

- 63 - ANNEX VIIPage 4 of 6

o National shipping lines no longer require approval from Secom fortransactions involving the domestic purchaselsale of vessels or thedocking of vessels. They must, however, report all such transactionsto Seacom.

o The Commodity Bourse is required to establish and maintain aninformation service designed to meet the needs of providers and usersof domestic and international cargo shipping services, and to providefacilities for the making of transactions.

Financial Sector Reforms

9. The Government announced major financial sector reforms on October 27,1988 and December 20, 1988. The main objectives of these measures were toenhance financial sector efficiency by encouraging competition and increasethe availability of long-term finance by promoting the development of thecapital market. Steps were also taken to improve tbh stability of thefinancial system, by strengthening prudential regulations and monetarycontrol.

10. The major measures announced on October 27, 1988 are as follows:

o The entry of new private banks, including joint ventures with foreignbanks, has been reopened. Paid-up capital requirements areRp.50 billion for joint-venture banks and Rp.10 billion for otherpr-ivate banks. Joint-venture banks require 152 domestic ownership,!ad 502 of their total credits outstanding must be export-relatedafter one year.

o Restrictions on opening branches have been eased. Private nationalbanks can now open bank branches throughout Indonesia. Foreign banksand NBFIs can open offices in seven major cities: Jakarta, Bandung,Semarang, Surabaya, Medan, Ujung Pandang and Denpasar. For sub-branch offices of foreign banks, 502 of their total creditsoutstanding must be export-related after one year.

O Rural credit banks may be established in districts outside thecapital, provincial capitals and municipalities. Paid-up capitalrequirements are Rp.10 million.

O The requirements to become a foreign exchange bank have been eased,based on soundness criteria and total assets of at leastRp.100 billion. Branch offices of foreign exchange banks no longerrequire separate licenses. Licenses for money changers will now bevalid indefinitely.

o Public enterprises are now permitted to place up to 502 of theirdeposits with private banks and NBFIs. Not more than 202 of theirdeposits can be placed in any one institution.

O Loan concentration ratios have been set for banks and NBFIs. Up to202 of own capital can be lent to any single borrower, 502 to anygroup of borrowers, and 52 to members of the Board of Commissioners.

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o NBFIs are now allowed to issue certificates of deposit (CDs). Netherbanks nor NBFIs require a license to issue CDs.

O A 15% withholding tax has been levied on tim.e deposits and CDs.Specified savings schemes are exempt. This tax eliminates theprevious discrimination against other financial instruments.

O Banks and NBFIs are now allowed to raise capital by issuing shares onthe capital market.

o Differential reserve requirements for banks and liabilities have beenreplaced with a uniform and lower rate of 2U. The previous reserverequirements were around 152.

O The maturities on Bank Indonesia certificate (SBIs) and money marketsecurities (SBPUs) have been extended from 7 days up to 6 months.The ceiling on interbank loans (previously 15S of funds mobilizedfrom third parties) has been removed.

O The premium on foreign exchange swaps is now to be based on marketconditions, namely the difference between the average domesticdeposit rate and LIBOR. The maximum maturity of swaps has beenextended from 6 months to 3 years.

11. The major measures announced on December 20, 1988 are as follows:

o The private sector will now be allowed to operate stock exchanges inJakarta and other major cities. The exchange company must have paid-up capital of Rp.500 million, and all shares must be owned byIndonesian citizens or corporations.

o New licenses will be issued for national and joint venture companiesin insurance, leasing, factoring, venture capital, consumer financeand securities activities. Licensing procedures have beensimplified. Paid-up capital requirements have been established forthese activities, and solvency ratios have also been set forinsurance companies.

12. Other measures in the financial sector are as follows:

o An over-the-counter (OTC) market has been set up to enable smaller,less-well-established firms to issue shares. This proposal wasannounced in December 1987, and the first share issue wassuccessfully completed in January 1989.

O In February 1989, development of the secondary market in monetaryinstruments was promoted by allowing the establishment of brokers andencouraging banks and NBFIs to function as market makers.

O On March 25, 1989, the Government removed the ceiling on offshoreborrowings by banks and NBFIs, and replaced it with general soundnesscriteria. This is intended to provide a source of lower cost fundsfor exporters, as export credit subsidies are phased out.

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o The March 25, 1989 measures also clarified the definitions for paid-up capital and loan concentration ratios under the October 1988package. The earlier requirement that existing rural banks upgradeto commercial banks or move out of capital cities has been relaxed.