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Survey of recent developments

Lloyd R. Kenward

To cite this article: Lloyd R. Kenward (2004) Survey of recent developments , Bulletin of Indonesian Economic Studies, 40:1, 9-35

To link to this article: http://dx.doi.org/10.1080/0007491042000205187

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ISSN 0007-4918 print/ISSN 1472-7234 online/04/010009-27 © 2004 Indonesia Project ANU DOI: 10.1080/0007491042000205187

SURVEY OF RECENT DEVELOPMENTS

Lloyd R. Kenward

Victoria, Canada

SUMMARY

The economy continues along the general trajectory described in recent Surveys. Growth is picking up, led by consumption but restrained by investment. Inflation has fallen well below Bank Indonesia’s current target rate. Most interest rates have followed suit, including key lending rates. Bank lending has been expand-ing at around 20% p.a. for the past year or so, and international portfolio investors are again interested in Indonesia. But a scare in the mutual funds indus-try and scandals at two state banks remind that trouble still simmers just below the surface in the financial sector.

Fiscal policy continues its conservative stance. The government is likely to have achieved its 2003 deficit target, and the budget for 2004 envisages further narrowing of the deficit. Still, the deadline for achieving a modest budgetary sur-plus has slipped two years, to 2006. Draft amendments to the income tax law foreshadow a probable reduction in corporate tax rates, increases in personal rates, and removal of certain key exemptions. Proposed administrative changes would give tax officials significantly greater powers of investigation and prose-cution; observers foresee increased scope for extortion by unscrupulous officials. Monetary policy has become increasingly expansionary, given the central bank’s desire to support economic recovery and its success in driving inflation down. This is reflected in quite rapid base money growth and sharp falls in policy inter-est rates, notwithstanding some efforts by Bank Indonesia to slow their decline. Trade policy has been dominated by increasing signs of resurgent protectionism, including a shift away from a transparent tariff regime to rent-generating systems of licensing.

On the political front, opinion polls in advance of the national elections sug-gest a considerable shift in the parliament, away from PDI-P in favour of Golkar. The size of this shift will be critical in determining the choice of candidates for the subsequent presidential elections. At present, Megawati Sukarnoputri remains the front-runner, but almost any combination of major parties could still form a coalition and make a credible run at the presidency.

With elections looming, little further progress can be expected on the economic policy front in 2004. In these circumstances, the focus for progress shifts to a polit-ically independent Bank Indonesia. With strong policies in its areas of responsi-bility—inflation, monetary policy and financial sector development—further progress is achievable even during an election year. This would lay a solid foun-dation for robust economic recovery, hopefully policy driven by the next admin-istration.

INDONESIA STEPS OUT ON ITS OWN

Macroeconomic stability has been restored and the economy is growing again, albeit only moderately. Almost without exception, macroeconomic indicators are favourable or improving. By way of a few examples, the exchange rate has been remarkably stable for the past several months; the international reserves position is very strong; public debt is looking much better; and the government’s upcom-ing bond issue has received an enthusiastic international response. Even the Jakarta Stock Exchange had a banner year in 2003, and record successes contin-ued in early 2004. At the end of 2003, the IMF program concluded without a hint of trouble, and the relationship with the aid donor consortium seemed headed into a new era marked by less financial dependence and more ownership from the Indonesian side. Concurrently, the country is preparing for national elec-tions, including, for the first time, direct presidential elecelec-tions, which pose a new range of challenges and opportunities. In short, this is a time for greater self-determination and informed choices, including on economic policy.

The Final LOI

On 10 December, the Indonesian authorities signed their last letter of intent (LOI) with the IMF.1_{As foreshadowed by Ray (2003: 255), this marked the end of one} of the IMF’s most controversial programs, and its only remaining program from the 1997–98 Asian financial crisis. The LOI itself contains little of note, although participants did report that the review was difficult, owing to controversy over the amendment to the Bank Indonesia Law and the BNI (Bank Negara Indonesia) scandal (both discussed below) and to bureaucratic issues of timing in Washing-ton. Potentially more important, the ink was not dry on the last LOI before Bank Indonesia (BI) began discussing a shift in emphasis in the implementation of monetary policy away from base money, which is a cornerstone of IMF programs (seeImportant Shifts at BI?below).

Indonesia now enters a period of post-program monitoring by the IMF, with two monitoring visits per year by an IMF team. There will also be two other staff visits per year, one of which is the regular Article IV consultation. Effectively, the IMF will be monitoring with the same frequency as during the program, but will have far less leverage without its money on the table. The number of resident staff at the Jakarta office is expected to remain unchanged at about three persons. CGI Meeting

On 10–11 December 2003, the World Bank chaired the 13th meeting of the Con-sultative Group on Indonesia (CGI) in Jakarta. It had several notable aspects. First, the Indonesian side had impressive, high-level representation (including three coordinating ministers, five ministers and the governor of BI), seemingly determined to present a good image to the international community. Second, the agenda reflected efforts to integrate private sector, NGO and aid donor concerns. Third, and reflecting popular domestic sentiment, the coordinating minister for economic affairs raised the issue of reform of the CGI in his statement. He said that it is time for a new approach that maximises Indonesian ownership while increasing efficiency. (The national planning agency, Bappenas, is in charge of reform proposals in this regard.) Finally, donor pledges totalled $2.8 billion,2_up a little from last year.3

The minister is right: it is time to revamp the CGI. This body has lost its dom-inance as a source of public sector financing, partly because of new domestic and international commercial sources. At the same time, donors are rethinking their respective approaches around commitments to the Millennium Development Goals,4_{and CGI participation is becoming more diverse. Greater ownership of} the process by the Indonesian side would be a welcome development, reflecting the growing maturity indicated by the shift to commercial sources of financing.

THE REAL ECONOMY Growth

Two sets of national accounts were released during the period covered by this Survey. On 17 November, the central statistics agency, BPS, released estimates for the third quarter of 2003 that suggested that real GDP had increased by 3.9% (year-on-year), a mild acceleration from the previous quarter; there were few sur-prises in the details. On 16 February BPS released its estimates for the fourth quarter and the year 2003 (table 1); these indicated a further acceleration to 4.4%. This translates into average annual growth of 4.1%, and includes the impact of large revisions, which lifted the Q1 2003 level of real GDP by 0.8% over the pre-vious estimate.

TABLE 1 Components of GDP Growth (1993 prices; % p.a. year-on-year)

Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03

GDP 4.6 3.6 4.4 3.6 4.0 4.4

By expenditure

Private consumption 3.4 3.5 3.9 3.9 4.2 4.1 Government consumption 16.9 17.9 6.3 10.7 9.6 12.1

Investment 5.0 6.9 4.3 1.1 –0.4 0.7

Exports 2.8 4.5 2.9 4.0 2.8 6.5

Imports 0.4 10.6 5.5 0.0 0.8 1.8

By industry sector

Agriculture, livestock, forestry & fisheries 4.7 1.1 5.5 1.2 3.1 –0.2 Mining & quarrying 6.0 4.7 –1.1 1.0 –1.3 3.2

Manufacturing 3.0 1.7 3.1 3.4 3.6 3.9

Manufacturing excluding petroleum & gas 3.2 1.7 3.5 3.5 3.6 4.7 Electricity, gas & water supply 4.9 6.7 4.8 5.6 7.1 9.5

Construction 5.8 6.1 5.8 6.5 7.3 7.1

Trade, hotels & restaurants 5.6 4.1 4.4 3.6 3.0 4.1 Transport & communication 8.5 8.1 11.1 7.8 10.8 13.0 Financial, rental & business services 5.4 10.1 7.9 7.0 6.3 4.1

Other services 1.7 2.0 3.0 3.3 3.5 3.9

Non-oil & gas GDP 5.2 4.2 5.5 4.2 4.2 4.6

Source: CEIC Asia Database.

Growth by Expenditure. On the expenditure side of the national accounts, the composition of growth in 2003 is similar to that in the rest of the post-crisis period (figure 1). In particular, private consumption accounts for the bulk of GDP growth in both periods, whereas inventories have been a significant drag on growth. There are two notable differences between the two periods. First, invest-ment has been weak recently (Ray 2003: 249–50). And second, the contribution of net exports has picked up in 2003. This is due to weak imports, however; exports made a smaller contribution in 2003 than in 1999–2002.

Growth by Sector. On the industry side of the national accounts, by the end of 2003 output of all major sectors was higher than a year earlier, except for agricul-ture (–0.2%) (table 1). Transport and communication led the way, expanding by a remarkable 13.0%. Among the other sectors, construction continued to grow at a relatively high rate (as did the small utilities sector). Although manufacturing growth accelerated steadily over the last year it is still holding back the economy as a whole, reflecting weak exports and continuing shutdowns in labour-intensive industries (JP, 13/12/03). Whether manufacturing performance can continue to improve remains to be seen (JP, 3/01/04), particularly in light of the end of the international Agreement on Textiles and Clothing, scheduled for 2005 (James et al. 2003: 94). This stems in part from the aggressive minimum wage policies of 2000–02 (Suryahadi et al.2003)5_{and stiff competition from Vietnam and China.}

A late-breaking development concerns the outbreak of bird flu disease, pub-licly acknowledged by the government on 26 January after several months of

-3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0

1999–2002 2003

Private consumption Public consumption

Gross fixed investment Change in inventories

Net exports Total

FIGURE 1 Contributions to Growth of Outputa (% p.a.)

a_{Change during period in indicated component of GDP as % of base period GDP.} Source: BPS.

cover-up (JP, 26/01/04). Two days later the government announced a culling of infected chickens and a vaccination campaign for healthy birds (JP, 30/01/04). As of early February, no-one had died from the disease in Indonesia, and it seemed unlikely that the outbreak would have any noticeable macroeconomic impact.

Exports. A closer look at merchandise exports shows an erratic pattern in BPS monthly data late in 2003, with a mild pick-up in non-oil exports (figure 2). For 2003 as a whole, total and non-oil exports (measured in dollars) increased by 6.4% and 4.7%, respectively. But most of this growth was early in the year and analy-sis by BI (2003b) indicates that export prices have been rising rapidly, by some 15% year-to-date through August. Consequently, volumes may have declined for 2003 as a whole. Nonetheless, BPS national accounts data indicate a jump in real exports of goods and services in the last quarter of 2003.

Fiscal Update

In late September, the parliament approved a revised version of the government’s mid-year review of the 2003 budget (table 2). The changes were minor relative to the original budget (Ray 2003: table 2). In brief, the budget deficit for 2003 was widened to 1.9% of GDP from 1.8%. Both revenues and expenditures were revised upwards, mainly due to increased world oil prices, more revenue being transferred to the regions, and higher subsidies. Additional financing for the larger deficit came from non-bank domestic sources, namely, more asset recovery and increased net bond issuance. Illustrating the continuing challenge of

main--20 -10 0 10 20 30 40 50 60

Jan-03 _Mar

-03

Ma

y

-03

Jul-03 _Sep

-03

Nov-03

Oil & gas Non-oil & gas Total

FIGURE 2 Export Growth ($ values, % p.a.)

Source: BPS.

taining fiscal discipline, the government also amended its plan to balance its budget by 2004. The deadline for achieving a modest surplus has been pushed back to 2006.

On 10 November the parliament passed a revised 2004 state budget into law. The changes relative to the government’s proposal (Ray 2003: table 2) were mod-est, and generally reflected updated assumptions. Both revenue and spending were revised up a little, owing largely to higher oil revenues and increased fuel subsidies and transfers to regions. The deficit was unchanged at 1.2% of GDP.

In mid January, the government released preliminary fiscal results for 2003 (table 2). The deficit for 2003 was in line with the approved mid-year budgeted amount (1.9% of GDP). Both revenue and spending fell short of budgeted amounts in rupiah terms, with the spending shortfall accounted for by both cur-rent and capital spending by the central government; transfers to regions were a little higher than budgeted. Among the components of current spending, all cat-egories fell short of budgeted amounts except for fuel subsidies. On revenues, income taxes were lower than expected, partly because of falling deposit rates that limited withholding tax receipts. On financing, a shortfall in foreign financ-ing was partly offset by greater domestic financfinanc-ing, most notably receipts from privatisation.

Impending Changes to Tax Policy

Around the end of 2003, the Directorate General of Taxation completed draft amendments to Income Tax Law No. 17/2000 and General Tax Procedure Law No. 16/2000. The former deals with tax rates, brackets and exemptions, the latter with tax administration. Copies were leaked to the press in January (JP, 14/01/04; 15/01/04).

Precise details are sketchy. However, it appears that the amendments to the income tax law would set the corporate tax rate at 28% (versus 30% at present); double the threshold income for personal taxes; double the minimum personal tax rate (from 5% to 10%); and set the highest personal tax rate at 35% (versus 30% at present). The amendment seems to leave open the possibility of reducing the highest corporate and personal tax rates to 25% and 30%, respectively, through special regulations. Overall these changes seem intended to respond to business concerns that Indonesia’s corporate tax rates are high relative to the rest of the region.

The amendment would also broaden the tax base somewhat, for example, by imposing VAT on parking services and making grants taxable, and by finally clos-ing the VAT and luxury tax loophole in the industrial growth centre of Batam. Also, the exemption for mutual funds will probably be phased out (see box below).6_{The main issue associated with these amendments seems to be whether} they are revenue neutral and, if they are not, whether the amendments to tax administration compensate.

The tax procedure amendments are more controversial. Most importantly, they give the tax department full authority to investigate a tax crime without consul-tation with the police, and to detain major tax evaders without trial. There is also provision for sizable fines for lesser violations, such as late or failed submission of various tax documents. Business people have warned against increasing the scope for extortion and corruption by unscrupulous tax officials (JP, 14/11/03).

TABLE 2 Budgets for 2003 and 2004

2003 2004

Budgeta _Actualb _Budgetc Rp trillion % GDP Rp trillion % GDP Rp trillion % GDP

Total revenue & grants 342.8 19.1 341.2 19.4 349.9 17.5

Domestic revenue 330.9 18.4 329.7 18.7 337.4 16.9

Tax 236.9 13.2 230.6 13.1 260.3 13.0

Income tax 122.4 6.8 114.8 6.5 134.0 6.7

VAT 75.9 4.2 76.8 4.4 86.3 4.3

Land & building tax 8.9 0.5 8.8 0.5 10.7 0.5

Excises 26.1 1.5 26.4 1.5 27.7 1.4

Other 3.6 0.2 3.8 0.2 1.6 0.1

Non-tax 94.0 5.2 99.1 5.6 77.1 3.9

Natural resources 65.0 3.6 67.1 3.8 47.2 2.4 SOE dividendsd _{12.3 0.7 12.6 0.7 11.5 0.6}

Other 16.7 0.9 19.4 1.1 18.4 0.9

International trade taxes 11.5 0.6 11.1 0.6 11.9 0.6

Grants 0.3 0.0 0.4 0.0 0.6 0.0

Expenditures 377.2 21.0 374.8 21.3 374.4 18.7

Central government 257.9 14.4 254.1 14.4 255.4 12.8

Current 191.8 10.7 189.1 10.8 184.5 9.2

Personnel 50.4 2.8 47.3 2.7 56.7 2.8

Materials & services 16.2 0.9 13.9 0.8 17.3 0.9 Interest payments 72.2 4.0 69.2 3.9 65.7 3.3

Subsidies 34.7 1.9 43.9 2.5 26.4 1.3

Other 18.3 1.0 14.8 0.8 18.4 0.9

Capital 66.1 3.7 65.0 3.7 70.9 3.5

Transfers to regions 119.3 6.6 120.7 6.9 119.0 6.0

Overall balance –34.4 –1.9 –33.7 –1.9 –24.4 –1.2

Financing 34.4 1.9 33.7 1.9 24.4 1.2

Domestic 31.5 1.8 32.2 1.8 40.6 2.0

Use of bank deposits 8.5 0.5 8.3 0.5 19.2 1.0

Non-bank 23.0 1.3 23.9 1.4 21.4 1.1

Privatisation 6.4 0.4 7.3 0.4 5.0 0.3

Asset recovery 19.6 1.1 19.7 1.1 5.0 0.3 Bonds (net) –3.0 –0.2 –3.1 –0.2 11.4 0.6

Foreign (net) 2.9 0.2 1.6 0.1 –16.2 –0.8

Gross borrowings 20.5 1.1 17.7 1.0 28.2 1.4 Repayments –17.6 –1.0 –16.1 –0.9 –44.4 –2.2 a_{As approved by parliament September 2003.}

b_Preliminary.

c_{As approved by parliament November 2003.} d_{SOE = state-owned enterprise.}

Source: Ministry of Finance.

Apparently, the Ministry of Finance has become frustrated by the ability of cor-rupt businesses to evade taxation, and has decided to take matters into its own hands. It is doubtful that this approach will yield much more in terms of tax col-lections, however, as that would require a major overhaul of the legal apparatus and much greater professionalism on the part of the tax collectors.

Trade Policy Update

The signs of resurgent protectionism in Indonesia’s trade policy environment (detailed in Ray 2003: 257–61) accelerated during this pre-election period. Most importantly, on 10 January the minister of trade and industry signed a decree banning the import of rice for one month in advance of the main harvest and for up to two months after that harvest (Bisnis Indonesia, 12/01/04), with the timing of the main harvest to be determined by the Ministry of Agriculture. On 13 Janu-ary it was confirmed that rice imports would be banned for six months, begin-ning in January (Bisnis Indonesia, 13/01/03). It also appears that there will be a system of licensing for registered importers, who will have to submit a request to the ministry for every shipment. Officially, the ban is intended to protect farmers from abundant supplies of cheap imported rice. But it bears all the signs of a sig-nificant shift away from a transparent (30%) tariff regime in favour of an opaque, rent-generating system of licensing.

As reported in the press, the 10 January decree also requires that imported rice be verified at the port of origin by a designated surveyor, and that the rice be unloaded only at the destination mentioned in the import document. The moti-vation for these requirements is unclear, but they may be intended to ensure that rice is not imported through ports that are near some major centres of production.

Effective 1 January 2004, the minister of trade and industry also banned the import of 46 items of used capital goods (Bisnis Indonesia, 7/01/04). These include trucks over 24 tons; photocopiers; motorcycle spare parts; and vehicles for load-ing goods. The chair of the Association of Indonesian Automotive Industries (Gaikindo) praised the policy as good for the local automotive industry (JP, 8/01/04). The ban is scheduled to remain in effect until December 2005. In late January, the Ministry of Fisheries and Marine Resources got into the act, announcing plans to ban shrimp imports from countries named in a US anti-dumping petition (JP, 29/01/04). On 16 December, Parliamentary Commission V (for industry, trade and cooperatives) urged the government to ban sugar imports (JP, 16/12/03), which would be a significant step beyond existing restrictive arrangements (MacIntyre and Resosudarmo 2003). However, this is unlikely to happen because it would eliminate the existing, potentially lucrative system of licensing. In a relatively minor example of the trend towards trade restrictions, in late November the minister of trade and industry announced plans to impose an export tax of 2–3% on cocoa to protect supplies for the local processing industry in the face of rising international cocoa prices (JP, 10/11/03). At the time of writ-ing, no official steps had been taken in this regard, possibly owing to intentional delays by the Ministry of Finance, which must sign off on tax-related policies.

These developments illustrate three important issues. First, the case of cocoa points to the importance of a strong Ministry of Finance in implementing an open, competitive trade regime. Second, the case of rice indicates the undesirable courses of action that are still available to other ministries if the Ministry of

Finance opposes politically popular demands. And third, there is poor coordina-tion among the economic ministries.

INFLATION AND MONETARY POLICY DEVELOPMENTS

One of the key macro developments during the review period was a continuing decline in inflation. After holding steady from mid year through October, con-sumer price inflation fell in November and finished the year just over 5% (year-on-year; figure 3). Data based on the newly rebased consumer price index (CPI) (box 1) suggest that it eased a bit further in January. Among the major CPI com-ponents, the deceleration towards year-end is mainly accounted for by food and processed food (figure 3), which, taken together, represent almost 40% of the CPI. Housing also came down noticeably; all other major components were either sta-ble or rising.

The inflationary outcome for 2003 is very good by Indonesian standards. Still, global inflation has all but disappeared; the rupiah continues strong, at least rel-ative to the dollar; domestic fiscal policy is supportive of low inflation; and there have been no special problems, such as supply disruptions affecting food prices. It is something of a disappointment that Indonesia did not do even better in 2003, but there is now an opportunity to improve in 2004. The country has had oppor-tunities like this before (e.g. in 1999) but failed to capitalise. An assessment of its chances on this occasion is provided later.

-4 -1 2 5 8 11 14

Jan-03 _Mar

-03

Ma

y

-03

Jul-03 _Sep

-03

Nov-03 Jan-0

4

Food (non-processed) Processed food & beverages

Housing CPI

FIGURE 3 CPI Inflation and Selected Components (% p.a.)

Source: BPS.

-10 0 10 20 30 40

Jan-0

2

A

p

r-02

Jul-02 _Oct-02 Jan-03 _Apr-03 Jul-03 _Oct-03 Jan-0

4

FIGURE 4 Growth of Base Money (% p.a.)

Source: BI.

BOX1 CPI REBASED

On 2 January, BPS announced that the Consumer Price Index would be re-based to 2002 = 100, with new weights re-based on the 2002 Consumer Expen-diture Survey. The previous weights were based upon a 1996 survey, and BPS believed that the financial crisis had outdated this survey as a basis for CPI weighting. The main characteristics of the 2002 survey are:

• A larger sample size: 70,000 households versus 60,360 in the 1996 survey. • More cities covered: 45 versus 43.

• More commodity coverage: 283–397 items (depending upon the city) com-pared with 249–353 in the old survey.

• A wider spread of household spending covered: Rp 1,150,669–2,765,601 (depending upon the city) versus Rp 423,013–1,152,704.

• Different city weights: 0.24–27.66 versus 0.22–34.76 in the old CPI.

The announcement also mentioned some minor technical changes in the CPI calculation (e.g. use of geometric rather than arithmetic means for 30 commodities) and the introduction of sampling in modern markets. No infor-mation was provided on changes in the weights for the major CPI compo-nents, or on the likely impact on measured inflation.

Source: BPS, ‘Perkembangan Index Harga Konsumen/Inflasi [Developments in the CPI/Inflation]’, 2 January 2004: 11.

Key Developments in Monetary Policy

Monetary policy has become increasingly expansionary since the third quarter of 2002, characterised by a significant increase in the growth rate of base money and continuing declines in interest rates on key policy instruments, to near-record lows. There have been several noticeable shifts in some details of monetary pol-icy during 2003, an appreciation of which is important for understanding aspects of BI’s operating procedures, and how they might change before long.

During the first several months of 2003, BI held the growth rate of base money (the monetary liabilities of the central bank) fairly steady at around 7.5%, which is a notch higher than in the second half of 2002 (figure 4). The central bank turned more expansionary in early May when the growth rate of base money rose to a new plateau of around 9.7% for several months before rising again to 11.6% through October. By early 2004 (when the gyrations of the Ramadan period had ended), base money growth exceeded 15%, which is getting very high. This pat-tern of monetary expansion is broadly consistent with an inflation targeting regime when inflation is running well below target. Taking a slightly longer-term view, the base money growth rate has been accelerating since around August 2002, rising from 5.5% to more than 15% by late January 2004.

Movements in key policy interest rates are in line with the base money inter-pretation of policy (figure 5). However, they also indicate several periods during which BI tried to slow the pace of interest rate decline. After the early months of 2003 the central bank reduced its policy rates aggressively. The overnight FASBI

0 4 8 12 16

Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 SBI (1-month)

FASBI

Deposit guarantee ceiling

FIGURE 5 Policy-Determined Interest Ratesa (% p.a.)

a_{The deposit guarantee ceiling is the level up to which banks are eligible for the} govern-ment’s deposit guarantee.

Source: BI.

(Fasilitas Simpanan BI, BI Deposit Facility) rate was reduced on six occasions between early March and mid year, for a total of 238 basis points;7_{this included} the unusually aggressive step of reducing FASBI twice in the same month in both May and June. The SBI (Sertifikat Bank Indonesia, BI Certificate) rate followed FASBI downwards, encouraged by BI policy that accepted an average of barely 70% of bids at the weekly SBI auctions.8

Around mid year, interest rate policy turned more cautious. BI accepted more bids at the weekly SBI auctions, slowing the pace of decline in SBI rates. In sup-port, FASBI was reduced less frequently, on two occasions through October (for a total of 125 basis points). In late October, BI reduced the overnight FASBI one more time and began to resist further declines in SBI rates. The FASBI rate went unchanged through year-end, and the 1-month SBI rate only inched downwards.

As discussed later, inflation was well below BI’s targets during almost all of 2003. Nonetheless, according to senior BI officials, the central bank was reluctant to reduce interest rates more quickly during 2003 for two reasons. First, base money was essentially on track with BI’s indicative targets and the IMF pro-gram.9_{And second, BI believed that part of the inflation reduction during this} period was only temporary. Consequently, the further BI pushed rates down at this time, the more it would have to raise them in the future, when the temporary inflationary declines unwound.

Important Shifts at BI? By early 2004, BI’s policy was quite different from a year earlier. As noted, the growth of base money had accelerated significantly, and pol-icy rates had fallen to very low levels. This corresponds with BI staff rethinking their policy instruments and processes, giving consideration to increasing the emphasisplaced on interest rates and reducing the emphasison base money (ital-ics reflect discussions with BI officials). As of mid January, there had been no offi-cial announcements to this effect, but late in 2003 BI had been ‘sooffi-cialising’ the concept of interest rate targeting with commercial bank economists, and in early January traders and dealers were called in to the central bank for discussions on formalising interest rate targeting.

On preliminary indications, BI is considering moving towards a target corridor for interest rates, as its instrument for ‘soft’ inflation targeting. The mid-point would be defined by the overnight interbank rate; the lower band by the overnight FASBI rate; and the upper band by some collateral-based ‘repo’ rate (which is rarely used at present).10_{The target band would be announced once} every three months.

A wide range of other policy and operational changes are currently under dis-cussion at BI (often with input from a broad group of private sector economists); for example: substituting government bonds (T-bills) for SBIs as the central bank’s monetary instrument; developing the repo market; consolidating the two FASBI windows; eliminating the FASBI window altogether; increasing reserve requirements; introducing a secondary reserve requirement; re-invigorating the interbank market; and changing the SBI auction from weekly to twice per month. This is a wide agenda, indicating the welcome breadth of rethinking among policy-oriented BI staff.

Policy Options: Base Money vs Interest Rate Targeting. BI’s possible shift in emphasis in operational targets reflects several factors, but in particular institu-tional frustration in trying simultaneously to hit two intermediate targets

est rates and base money, the final target being inflation) with its one policy instrument, open market operations.

The best choice between these two intermediate targets is a matter of contro-versy that cannot be resolved here (for some of the discussion in the Indonesian context, see McLeod 1997, 2003 and 2004; Grenville 2000; Fane 2000; and De Brouwer 2003). The most important point for present purposes is that either inter-mediate target will probably work, but its use will entail some volatility in the other, unused, intermediate target. In the end, BI must be prepared to use its cho-sen policy instrument with commitmentif it wants to achieve its long-term target for inflation. The markets can almost certainly learn to live with the residual volatility in the unused intermediate target, whichever it is.

Likely Outcomes. It is possible that these shifts will be more apparent than real, because BI has been looking very closely at interest rates for some time, as indi-cated by the preceding discussion. However, if a policy of interest rate targeting gains momentum, it will mean more volatility in interest rates while BI fine-tunes its policy levers, and more volatility in base money after the central bank learns to use its new tools. With inflation currently well below BI’s targets, such a pol-icy would probably also entail higher base money growth and lower interest rates, which is popular policy at present. The true test as to whether it is good pol-icy will come sooner or later, when BI needs to increase interest rates because inflation starts to rise excessively.

Other Interest Rates and Credit

After peaking around the end of 2001, 1-month deposit rates have been in steady decline (figure 6), partly reflecting the impact of falling inflation on expectations. Deposit rates have been dragged downwards by lower FASBI and SBI rates, and pushed down by continuing declines in the guarantee ceiling (figure 5). As of early 2004, many banks’ posted deposit rates (1-month, as published in Bisnis Indonesia) were down close to 6%, far lower than at any time since deposit rate deregulation in the early 1980s.

Lending rates, as published by BI, remain high in nominal terms (figure 6). But there is a problem with interpretation of these rates, which are the average on out-standing loans, whereas the current lending rate is more relevant for comparison with short-term deposit rates. Bankers report that in early 2004, first class credi-tors could borrow at 11% or even less at select national banks.11 _{For most} cus-tomers, rates of 13–15% seem more typical on new loans than the 15–19% range apparent in figure 6. With expected inflation somewhere around 5%, this leaves typical new lending at real rates in the range 5–10%. This is not exceptionally high by Indonesia’s historical standards.

It is a little surprising that declining loan rates have been accompanied by a mild slowdown in rupiah-denominated lending since around March 2003 (fig-ure 7), when such lending had been expanding very rapidly, at about 35% p.a. on average, for several months. This pace of lending seems inconsistent with fre-quent complaints about limited availability of bank credit. There are several explanations. First, the actual increase is from a small base; the absolute increases are still less than half pre-crisis amounts in real terms. Second, an unknown (but probably moderate) portion of the increase is accounted for by sales of existing loans owned by IBRA (the Indonesian Bank Restructuring Agency) back to the

banks. Third, a sizable portion of the new lending is by Bank Mandiri (the nation’s largest bank, formed through the merger of four troubled state banks in the wake of the crisis); often this lending appears to be politically connected rather than market driven. And fourth, the largest percentage increases in lend-ing are by the regional development banks, which are generally located far from Jakarta’s financial commentators.

The slowdown is traceable to lending by the private national banks and the state banks (which have roughly equal market shares, accounting for some 85% of total lending these days). In particular, their lending to manufacturing has flat-tened out considerably since mid 2003. Lending by the regional development banks continues to grow apace at some 35% year-on-year. Lending by the foreign/joint banks has accelerated a little, but remains relatively subdued, expanding at around 10% year-on-year.

MORE ON INFLATION TARGETING

One important dimension of monetary policy in recent years has been BI’s adop-tion of ‘soft’ inflaadop-tion targeting in early 2000. Each year, BI has announced targets for inflation (table 3), in line with its mandate to preserve the value of the rupiah. However, BI’s success in this regard has been mixed, and preliminary targets for 2004–06 look questionable.

BI began inflation targeting at a time of considerable uncertainty (Cameron 1999: 9–10). In particular, inflation had fallen sharply to very low levels in late 1999 (figure 8), and it was unclear how much was due to unsustainable factors.

0 5 10 15 20 25

Jan-0

2

A

p

r-02

Jul-02 _Oct-02 Jan-03 _Apr-03 Jul-03 _Oct-03

Consumer loans Working capital loans Investment loans Deposits (1-month)

FIGURE 6 Commercial Bank Interest Rates (% p.a.)

Source: BI.

-30 -20 -10 0 10 20 30 40

Jan-0

2

A

p

r-02

Jul-02 _Oct-02 Jan-03 _Apr-03 Jul-03 _Oct-03

Rupiah

Foreign currency (in $) Total (in Rp)

FIGURE 7 Growth of Bank Lending (% p.a.)

Source: BI.

TABLE 3 Bank Indonesia’s Inflation Targets and Outcomes, 2000–04 (% p.a.)

Year Target Outcome Notes Range

2000 5–7 9.4 Target of 3–5% for core inflation plus 2% allowance for government policies on prices and incomes. 2001 6–8.5 12.6 Target of 4–6% for core inflation plus 2–2.5%

allowance for government policies on prices and incomes. Forecast revised upwards in May 2001. 2002 9–10 10.0 Distinction between core and non-core inflation

abandoned. Target announced of 6–7% to be reached by 2006. Indicative linear path indicated in BI (2002): table 11.9.

2003 8–10 5.1 Target of 9% with a ± 1% margin of error due to unforeseen events or shocks.

2004 4.5–6.5 … No official announcement on targets; 5.5% ± 1% is BI’s ‘prediction’ for 2004.

Sources: 2000: BI (1999): 110; 2001: BI (2000): 3; 2002: BI (2001): box: ‘Fixing the Bank Indo-nesia Inflation Target’; 2003: BI (2002): 216; 2004: BI press release, 8/1/04.

Not surprisingly, BI took the unusual step of initiating its inflation targeting regime with a risingtarget for inflation. Inflation quickly accelerated through the 2000 target range, and by year-end it was 2.35 percentage points above target. Alamsyahet al. (2001: footnote 9) attribute the inflationary pressures to rupiah depreciation, administered wage and price increases, and inflationary expecta-tions in the face of limited scope for tightening monetary policy in a very weak economy.

The targets for 2001 were set on a more conventional, gentle downward slope. But again, inflation quickly accelerated over the upper end of the target range and continued to increase. In May of 2001, BI raised its inflation forecast for the year (Alamsyah et al.2001: footnote 9), implicitly acknowledging that it was not willing to tighten monetary policy sufficiently to achieve the original target. Infla-tion finished the year at 12.5%—four percentage points over target. Of this, BI attributed some 1.5% points to larger than expected administered price increases (BI 2001).

For 2002, BI changed its approach in two significant ways. The distinction between ‘core’ and ‘non-core’ inflation (McLeod 2003: 314–18) was abandoned, and a medium-term target was added for overall (‘headline’) inflation. Surpris-ingly, BI also narrowed the target range from 2.5% to only 1%. In the event, BI missed the end 2002 target by a very narrow margin, and inflation targeting looked to be on a successful track.

-4 0 4 8 12 16

Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Actual

FIGURE 8 Bank Indonesia’s Moving Inflation Targetsa (% p.a.)

a_{The parallel lines are representations of BI targets as defined at various points in time} (table 3). The jagged line is the actual inflation rate (12-month percentage change). Source: BI.

The targets for 2003 tried to build upon the success of 2002, and the first-year range was widened from one to two percentage points. By mid year, it was clear that inflation was headed below the lower end of the target range and BI began revising its forecast for 2003, following the actual track of inflation downward. By year-end, inflation was far below target, owing in part to factors that BI seems to believe are temporary (BI 2004a: 6).12

As of early February, BI had yet to announce the inflation targets for 2004 and beyond. However, it was predicting inflation of 4.5–6.5% for 2004, and may keep the medium-term target unchanged.13_{Effectively, this is a remarkably forthright} statement of BI’s thinking, if it becomes the official position. By reinstating an upward inflation target, it says that the central bank believes some of the factors that drove inflation down in 2003 are temporary; and that, as these factors unwind, BI is not prepared to tighten policy enough to offset them, for fear of undermining economic recovery.

Purists will find room for criticism in this current set of targets. In particular, they will argue that any central bank explicitly forecasting rising inflation for the next three years is not sufficiently committed to using careful monetary policy to achieve price stability.14_{Those doubting the importance of political economy in} this aspect of monetary policy in Indonesia should note Alamsyah et al. (2001: 319): ‘For the time being, BI feels unable totally to ignore pressures from out-side—for example, urging it to avoid raising interest rates too far’. And herein lies the most basic problem with inflation targeting in Indonesia: until any central bank establishes credibility in its commitment to hitting its inflation targets— including by convincingly tightening policy when inflationary pressures start to build—it will have only limited influence on long-term inflationary expectations.

SEISMIC TREMORS IN THE FINANCIAL SYSTEM

Three recent events serve as reminders that trouble continues to simmer just below the surface of Indonesia’s financial system.

The Mutual Funds Scare

On 11 November, a story broke in the Singapore Business Timesthat Indonesia’s mutual funds industry (box 2) was faced with ‘massive redemptions’ and ‘in dan-ger of a meltdown’. The report stated that the country’s largest fund manadan-ger (Prima Investa, a joint product of Bank Danamon and MeesPierson Finas Invest-ment ManageInvest-ment) had received an emergency loan (from the investInvest-ment man-ager’s overseas head office) to cover massive redemptions. Reportedly (Bisnis Indonesia,12/11/03; 13/11/03), fund managers were alarmed by the possibility of plunging bond prices and lack of clarity in asset pricing and mark-to-market practices.

The response from Jakarta was fast and well orchestrated (Bisnis Indonesia, 12/11/03). Bapepam (the Capital Market Supervisory Agency), Bank Danamon and MeesPierson all issued statements in short order to calm the markets. Bank Lippo expressed interest in buying the underlying assets if they were commer-cially profitable. And the governor of BI announced that Bank Mandiri and Deutsche Bank stood ready to buy bonds in the event of redemptions by mutual fund customers (Bisnis Indonesia, 15/12/03). All in all, the response was very

effective, but only as a public relations exercise to calm the markets. It is to be hoped that the regulators will respond to this experience by addressing the tax exemption issue and tightening regulations before a more serious crisis develops. Déjà Vu: Scandals at State Banks

The BNI Scandal. In October, a $200 million fraud came to light at the country’s second largest bank, BNI (which is 99% state owned). Allegedly, BNI released the funds to a local company against fake letters of credit, issued for fictitious exports during 2002 and 2003 (JP, 3/11/03). The case turned political when one of the sus-pects issued a letter that implicated General (ret.) Wiranto, a possible presidential candidate for Golkar, previously the government party under former President Soeharto (JP, 20/11/03). Wiranto denied the charges (JP, 2/12/03). The scandal widened a little on 14 January, when police announced that a BNI branch in Cen-tral Java was involved in a new scandal, this one worth $3.2 million (JP, 14/01/03).15

BRI’s Lesser Scandal.16 _{Less than one month after the successful public listing} on 10 November of BRI (Bank Rakyat Indonesia, the Indonesian People’s Bank), a scandal came to light involving some $35 million at three of its branches (JP, 4/12/03). In early December, the bank’s CEO announced that internal supervi-sion had uncovered the fraud in September; loans had been disbursed with the backing of fictitious deposits as collateral. The Attorney General’s Office (AGO) disputed the CEO’s version of events (JP, 5/12/03), claiming that BRI had ini-tially been obstructive when the AGO investigated the matter in October on a tip from the public. He stressed that BRI management only filed a formal complaint with the AGO after it became clear that a cover-up was pointless.

Surprisingly, the scandals do not appear to have hurt either bank financially. BRI plans to go ahead with the issue of Rp 500 billion in 10-year bonds. Likewise, BNI still expects to divest government ownership through a rights issue in the first half of 2004, and its reported profits remain high (JP, 25/12/03).

The Significance of the Scandals. There are several positive aspects to these scan-dals. First, the facts have been openly discussed. Second, parliament announced that it would oversee the work of the police and prosecutors (JP, 11/12/03). Third, the nation’s president has spoken out and given clear directions (JP, 9/12/03). And fourth, seven of BNI’s nine-member board of directors were fired at an extraordinary shareholders meeting on 15 December (JP, 16/12/03), and a number of respected persons have now been appointed to senior positions.17 These are all welcome developments, but it remains to be seen whether the polit-ical will to investigate will be any greater than in the case of the Bank Bali affair (JP, 12/12/03; Booth 1999: 4–7).

Nonetheless, the immediate evidence is clear: internal controls remain weak at the state banks, especially over branch offices; staff are still open to opportunities for collusion; and BI’s banking supervision was unable to detect the frauds. The government needs to get out of the business of owning banks and to concentrate more on supervision and law enforcement.18 _{Without more progress in this} regard, political connections will continue to count more towards loan approval than commercial viability; the banking system will continue to be high cost; fraud will recur from time to time; and substantial public funds will remain at risk.

BI’s Blueprint for Improving Fundamentals

In early January, BI launched the implementation of its ‘Banking Architecture’, a framework for development of the banking system over the next 5–10 years (BI 2004b). The announcement was strong on objectives—for example, achieving parity with other nations in banking supervision in the next five years, and

set-BOX2 INDONESIANMUTUALFUNDS

Mutual funds (reksadana) are an investment vehicle designed to allow rela-tively small investors to hold diversified portfolios of financial assets. The investor buys ‘units’ in a fund comprising a range of assets determined by the fund’s charter, and normally repriced daily in accordance with market movements. They were first introduced into Indonesia in 1996, but remained of minor significance through 2001 (Kenward 2003). Business began to boom in 2002, initially driven by financial innovation at two major banks that had been recapitalised by the government following the 1997–98 crisis. Mobilised funds soared from less than Rp 8 trillion at the end of 2001 to around Rp 80 trillion in September 2003, equivalent to 60% of base money.

The great bulk of reksadana (about 80% in September 2003) hold fixed income assets, i.e. corporate and government bonds, because their coupon income from bonds is exempt from the 20% withholding tax. The after-tax yield on these assets is much higher than that on time deposits (which are subject to withholding tax); consequently, large amounts of deposits have shifted into mutual funds during the recent boom.

This is good business all round. Bank customers benefit from higher after-tax returns. The banks earn fee income on the transactions and charge custodian fees. The fund manager receives a management fee, and there are normal brokering fees for buying and selling assets.

Development of mutual funds has been an objective of government pol-icy for some time because it provides a more stable form of wealth accumu-lation than, say, investment in the stock market. It has spread the ownership of, and deepened the market for, bonds, which assists both the government and corporates in debt management. In short, the migration of deposits and government bank recapitalisation bonds to reksadanahas shrunk banks’ bal-ance sheets, and thus reduced the banks’ dominbal-ance of the financial system. There are prudential risks associated with reksadana, however. For exam-ple, a large run could force fund managers to sell their bonds into a very thin secondary market; bond prices could plunge and long-term interest rates soar. Such liquidity problems could spill over into the banking system, because of banks’ hidden liabilities to their mutual fund affiliates or because a sponsoring bank feels obliged to support its reksadana. Furthermore, rules appear weak and enforcement lax in some areas, as regulators struggle to catch up with the boom. Finally, the fiscal cost to the government of the tax exemption is getting large, at a roughly estimated Rp 1.5 trillion in 2003.

ting up six ‘working programs’ for progress in 2004–13. On specifics, the main policy levers look to be minimum capital requirements, licensing and branching.

Other important points in the announcement included references to specific numbers of banks ‘envisaged’ for the optimum structure of the banking industry. For example: 2–3 banks emerging as ‘international champions’ (with capital above Rp 50 trillion); 3–5 ‘national champions’ with a broad scope of business

BOX3 AMENDMENT TOLAWNO. 23/1999 ONBANKINDONESIA

On 19 December the parliament passed an amendment to Central Bank Law No. 23/1999 (McLeod 1999). It involved three main issues and a fourth that could become controversial.

The least controversial issue concerned a lender of last resort function. Law No. 23/1999 had made no provision for such a function (apart from a small overnight facility). The amendment (article 11) allows for an emer-gency funding facility, the financing of which is clearly stated as the burden of the government (thereby avoiding problems associated with last resort lending during the crisis; see Djiwandono 2004, in this issue; MacIntyre and Resosudarmo 2003: box 1). Details are to be provided in separate lawful reg-ulations to be issued before end 2004. An interim Memorandum of Under-standing between BI and the Ministry of Finance is under preparation (JP, 29/01/04).

The second issue concerned the Financial Services Authority (Otoritas Jasa Keuangan, OJK), an institution for consolidated financial supervision. BI and the Ministry of Finance staked out opposing positions on the OJK some time ago. A compromise has been reached through a clause (article 34) that says the OJK will be set up by 2010 at the latest. As of early February, the draft law on the OJK was awaiting parliamentary discussion, which will be the first occasion to define progress on this matter.

The third and most difficult issue proved to be the oversight body for BI. Many observers considered that BI’s independence under Law 23/1999 was not balanced with accountability. In the end, a compromise was reached that marginally reduces BI’s independence. A supervisory board (compris-ing five members) has been established, but its authority concerns only internal operations. BI’s instrument independence (Alamsyah et al. 2001: 310) has been maintained.

The fourth issue concerns BI’s goalindependence. The elucidation to the amendment contains a clause that says (in unofficial translation) that ‘The target for the inflation shall be determined by the Government. In determin-ing that target, the Government shall coordinate with BI’ (point 4, article 10, paragraph 1). As of early February, it was not clear how this would play out in practice, but there is room for conflict between whatever institution sets the target (perhaps the Ministry of Finance) and BI, which is expected to achieve it.

and operating nationwide (with capital of Rp 10 to Rp 50 trillion); 30–50 spe-cialised banks focused according to the capability of each (with capital of Rp 100 billion to Rp 10 trillion); and an unlimited number of rural banks and banks with limited scope of operations (with capital of less than Rp 100 billion). The announcement also contained a surprising reference to the ‘development of an adequate loan guarantee scheme’.

It is difficult to know what to make of this announcement. The goals are worth-while—indeed, in some cases laudable—and some vision is needed for develop-ment of banking in Indonesia. But the references to specific numbers of banks for specific purposes are worrisome, as these might become ends in themselves. Indonesia needs more good banks, not specific numbers of banks. Also, the upper end capital requirements are enormous (more than four times Bank Central Asia’s present level). Furthermore, any ‘loan guarantee scheme’ would be a mistake—a certain recipe for more financial losses to the guarantor (i.e. the government).

INSTITUTIONAL ISSUES Recent Economic Legislation

Three notable pieces of economic legislation were passed by parliament during late 2003: an amendment to the 1999 Central Bank Law (box 3), a new State Trea-sury Law and a new Law on the Settlement of Industrial Disputes.

The State Treasury Law, passed in the week of 19 December, is a follow-up to the State Finance Law (Ginting 2003). The legislation is intended to improve the management of state funds and assets, thereby reducing corruption. Most notably, it deals with process for the sale of state assets, requiring among other things that sales be conducted through tender.19_{As of early January,} implement-ing regulations were beimplement-ing prepared, with completion expected by late 2004. Finance minister Boediono praised the legislation (JP, 19/12/03). But the chair of the Supreme Audit Agency, ‘Billy’ Joedono, was pessimistic (JP, 20/12/03), because he felt that the law did not provide independence for state treasurers.

During the same week, parliament passed the new Law on the Settlement of Industrial Disputes. There are several positive aspects to this legislation, which sets the institutions, rules and procedures for resolving industrial disputes.20 Most importantly, employers and unions generally support the new law, which was written in full consultation with unions, employers, the government and par-liament (JP, 19/12/03). The main problems in the legislation appear to be poten-tial confusion over which process to follow, and insufficient scope for the disputing parties to use mediation and arbitration to resolve some disputes. Sunset Institutions: JITF and IBRA

On 18 December, the government shut down the Jakarta Initiative Task Force (JITF), on schedule following a one-year extension to its original mandate.21_The agency had been set up in November 1998 to act as facilitator in corporate debt restructurings (Deuster 2002). It eventually facilitated restructuring of debts worth some $27 billion for 102 cases, leaving unresolved a relatively small pro-portion (perhaps 20%) of the cases originally assigned to it. These will probably

be referred the National Mediation Center (Pusat Mediasi Nasional), which has been founded by former members of the Task Force to serve the same purpose as JITF. It may be some time before JITF’s effectiveness becomes clear. For example, it may be that fundamental restructurings have just been delayed, not resolved. IBRA, whose mandate was due to expire at the end of February, has been more controversial, largely because it controlled major amounts of public assets (in contrast to JITF, which was merely a facilitator of debt workouts). Set up in early 1998 (Kenward 2002: 68), it eventually controlled many billions of dollars of loans and properties, and an array of corporate assets taken over from failed banks and bank owners, and these were inevitably coveted by powerful politicians and business people.

As indicated to the IMF (LOI dated 10 December 2003: para 8), IBRA’s remain-ing assets will be transferred to several self-liquidatremain-ing holdremain-ing companies for future disposal. These holding companies will be managed by the Ministry of State-Owned Enterprises, a fact that raises issues of capacity and independence. Until the new deposit insurance agency is established, IBRA’s deposit insurance responsibilities will be transferred to the Ministry of Finance. Its bank resolution functions will be handled by BI for individual cases, and by the government in coordination with BI for systemic cases.

In mid January, the economics coordinating minister announced that a new state enterprise, the State Asset Managing Company (Perusahaan Pengelola Aset Negara, PPAN), would be created to handle IBRA’s remaining Rp 40 trillion in assets. In the meantime, IBRA continues to pursue delinquent debtors and sell assets (Bisnis Indonesia, 7/1/04; 13/1/04; JP, 8/1/04), but its effectiveness must surely be compromised as the end of its mandate approaches. Also, PPAN may simply turn into IBRA by another name, and little will be accomplished by this handover, which will inevitably entail administrative delays.

An Interim ‘Report Card’ for IBRA. Any adequate assessment of IBRA’s effec-tiveness would be a major piece of work, and should be undertaken when more of the post-crisis dust has settled. Indications to date are mixed and confused. By way of examples, initial progress was slow (Kenward 2002: 68–70), but the breadth of IBRA’s mandate was unclear at the outset and its operations were con-strained by a parliament that dreamed of a 70% recovery rate on assets. Indeed, IBRA’s reported recovery rate of 28% (JP, 15/12/03) is surprisingly high; perhaps congratulations will be in order after closer examination. Also, on the positive side of IBRA’s record, its bank closures improved over time, and these soon became more professional operations (Kenward 2002: 90, 106–7). Furthermore, its recent property sales have been praised (JP, 24/02/04).

On a less positive note, IBRA’s initial policy as concerns the sale of restructured assets was flawed.22 _{Similarly, implementation of the bank shareholder} agree-ments was very slow and IBRA was notably unsuccessful in taking its cases to the courts. Moreover, controversy persists (JP, 15/12/03) amid suspicions of improper practices and reports of former chairpersons being police suspects in the misappropriation of funds (JP, 26/01/04). Finally, IBRA maintains ownership in several private banks (see footnote 18), despite excellent market conditions for divestiture in late 2003 and early 2004.

RECENT POLITICAL DEVELOPMENTS

Political developments through late 2003 were dominated by the pre-election process and by manoeuvring to form possible coalitions. Concerning process, on 7 December the General Elections Commission (KPU) announced that 24 politi-cal parties were eligible to contest the two-tiered 2004 elections.23_{Two aspects of} this announcement are notable. First, analysts point out that many of the eligible parties have links with the New Order (that is, the Soeharto regime). This has aroused concern in some quarters that democratic reform may come under threat from ‘cronies’ of the New Order. Second, there was no violence in support of minority parties that failed the selection process. The KPU’s fair and transparent working procedures have been given credit in this regard (JP, 9/12/03).24

As reminders of the possibility of violence during this election campaign, there have been reports of politically related death threats and murders of National Awakening Party (PKB) clerics and party executives in East Java (JP, 8/12/03). Also, in late December the Elections Supervisory Committee (Panitia Pengawas Pemilu, Panwaslu) warned that security concerns might disrupt elections in Aceh, Maluku, Papua and Central Sulawesi. In late January, the Center for Secu-rity and Peace Studies lengthened this list to 15 locations, of which eight are on Java (JP, 21/01/04).

Further on process, 29 December was the deadline for the 24 eligible political parties to register their legislative candidates at the KPU. Weeks earlier, contro-versy had swirled around the list of candidates proposed by the president’s Indo-nesian Democratic Party of Struggle (PDI-P), when outspoken party members were excluded (JP, 22/11/03), apparently as a follow-up to the president’s verbal lashing of defiant party members several weeks previously (Straits Times, 19/11/03; JP, 19/11/03).

In early 2004, political developments seemed to have entered a new phase in the run-up to the legislative election campaign, which lasts from 11 March to 1 April. The main emerging issue seems to be whether the authorities will be able to ensure even-handed treatment of election candidates. For example, the Jakarta General Elections Commission reported two political parties to the police for campaigning ahead of the 11 March kick-off. Likewise, in South Kalimantan offi-cials questioned 17 political leaders who allegedly started their campaigns early (JP, 15/01/04). PDI-P joined the list a few days later, after the Surakarta Regional Elections Supervision Committee reported it to the police.

Individually, the reliability of Indonesian opinion polls is suspect. However, the trend in the polls to date is clear—they suggest a sizable shift in the national parliament from PDI-P to Golkar. This is largely due to internal PDI-P disorder,25 and the party’s failure to deliver better economic results to the average voter. Nonetheless, Megawati is still the front-running presidential candidate, not least because of Golkar’s slow progress in fielding a strong contender, and because of lack of unity among the Islamic parties.

Other parties’ capacity to challenge Megawati will depend to a large extent upon their success in the legislative elections.26_{For example, a strong showing by} Golkar might lead to an alliance with some of the smaller Islamic (or ‘New Order’) parties to challenge her leadership directly. By contrast, a weaker result

for Golkar might lead to a PDI-P/Golkar coalition, with the Golkar leadership accepting the vice presidency. Indeed, at the time of writing almost any combina-tion of major parties could still form a coalicombina-tion and make a credible run at the presidency.

Below the national level, the most interesting development has been the dis-qualification of all PDI-P candidates for the East Kalimantan provincial legisla-ture. Apparently the party failed to submit a valid list of candidates owing to bitter disputes among party members (JP, 31/01/04). At time of writing, the same outcome looked possible in Banten.

The Four Daughters: SARS Indonesia-style

The list of contending parties indicates that three eligible parties are chaired by daughters of former President Sukarno. Megawati heads the PDI-P; Sukmawati is chair of the Marhaenisme Indonesian National Party;27_{and Rachmawati leads} the Pioneer Party. Of the three, only Megawati appears to have established sup-port at the grassroots level, which Sukarno claimed to represent.

A fourth presidential daughter coyly approached the starting gate in early December (JP, 4/12/04). Soeharto’s eldest daughter, Siti Hardiyanti Rukmana, better known as ‘Tutut’, had been recruited by the Concern for the Nation Func-tional Party,28_{chaired by her close associate General (ret.) R. Hartono. The former} governor of the National Resilience Institute (Lemhannas), Sayidiman Suryo-hadiprojo, interpreted her possible candidature as indicative of the failure of the reform movement to benefit the majority of the people (JP, 9/12/03). Constitu-tional expert Satya Arinanto had a simpler explanation—grassroots Indonesians were suffering from SARS—Sindrom Aku Rindu Soeharto (‘I Miss Soeharto Syn-drome’) (JP, 11/12/03).29_{He could just as well have substituted ‘Sukarno’ for} ‘Soeharto’.

16 February 2004 NOTES

1 Available at www.imf.org. As follow-up, on 19 December the IMF Executive Board approved the release of the final tranche (equivalent to about $505 million) of the 2000 Extended Fund Facility arrangement.

2 A further $600 million was pledged in the form of export credits and technical assis-tance to regional governments and NGOs.

3 By way of comparison, CGI pledges peaked at almost $8 billion during the crisis, and they averaged around $5.25 billion pre-crisis.

4 At the United Nations Millennium Summit in September 2000, world leaders agreed to a set of goals for economic development, called the Millennium Development Goals (United Nations Resolution Number 55/2, dated 8 September 2000). These high ideals have become a focus for many bilateral aid donors.

5 During 2001–02, nominal minimum wages doubled; by 2002 they were 10% over pre-crisis levels in real terms. Since then, policy has been less aggressive in this regard. In 2003, the national average increase was 14%; in 2004, the rise in Jakarta was 6%. 6 Moreover, from 1 February 2004, the Director General of Customs and Excise has the

authority (under government regulation PP No. 44/2003) to collect sizable (Rp 30,000 to Rp 100,000) non-tax revenues on six services, including export and import docu-ments (Bisnis Indonesia, 3/01/04).

7 The FASBI rate virtually defines the floor for interest rates in Indonesia. BI stands ready to accept unlimited amounts of banks’ excess funds through this window, formerly known as the ‘intervention rate’, at two administered rates, the morning rate (shown in figure 5) and the afternoon rate, which is half the morning rate. Normally, banks place perhaps Rp 15 trillion per day in the overnight FASBI facility. Lately, the amount outstanding has increased to some Rp 20–30 trillion, evidence of a very liquid banking system.

8 BI controls the SBI interest rate by choosing the proportion of winning bids at the SBI auction. When BI accepts a relatively low proportion of bids, this reduces the average SBI rate. At the same time it increases the outstanding amount of SBIs, with a corre-sponding contractionary impact on base money. These sales of SBIs reduce base money, sterilising the impact of other (expansionary) factors, as noted by Grenville (2000: 48). The process gains momentum from one week to the next as commercial banks read the signals from BI and adjust their bidding strategy for the subsequent week. The prob-lem, of course, is that there is no assurance that BI’s preferred interest rate is consistent with its base money target (see Policy Options in the main text).

9 For performance relative to BI’s indicative targets, see BI (2003a: graph 18). BI missed the IMF program’s performance criterion for base money at the end of December by about 3% on the high side, owing to the rapid expansion of base money in early Janu-ary (figure 4). (The performance criterion is calculated as a 30-day moving average cen-tred on month-end.)

10 The ‘repo rate’ is the rate at which BI might enter into a repurchase agreement with a commercial bank in need of temporary liquidity. Under such an arrangement, BI would buy some financial instrument (say an SBI or a government bond) from a bank at some price, including an agreement to sell it back to the bank at a different price at a specific point in time. The difference between the two prices (expressed as an annu-alised interest rate) is called the ‘repo rate’.

11 For a 1-year renewable loan. In comparison, the yield on ‘riskless’ government bonds was around 9.25% (1-year maturity) in mid January.

12 Also, BI’s measures of ‘core inflation’ have been running well above ‘headline infla-tion’ (BI 2003a).

13 Another possibility, more in line with maintaining the integrity of inflation targeting, would be to extend the time horizon by two years, to 2008 (the 2006 horizon was set two years ago) and to reduce the medium-term target to, say, 4–5%. As of early Febru-ary this still seemed to be under consideration.

14 BI staff are quick to point out that their forecast for ‘core’ inflation (which they do not announce) is still on the decline.

15 Initially the scandal was incorrectly reported as involving Bank Mandiri.

16 BRI is the nation’s fourth largest bank, and 51% state owned (100% prior to November 2003).

17 As follow-up inside BNI, a compliance division has been set up, which strengthens that function. Also, branch compliance officers, who used to report to the branch manager, now report to head office.

18 The government still owns 99% of Bank BNI; 80% of Bank Mandiri; 51% of BRI; and all of Bank Tabungan Negara. It plans to divest more of BNI in the first half of 2004, and another 10% of Bank Mandiri has been approved by parliament for sale. As for the banks taken over during the crisis, the government (through IBRA) owns 98% of Bank Permata; 55% of Bank Lippo; 45% of Bank Niaga; 28% of Bank Danamon; 22.5% of Bank Internasional Indonesia; and 8% of Bank Central Asia. IBRA may divest its major-ity stakes in Lippo and Permata before its mandate expires in February, but both sales seem unlikely to go ahead on the schedule envisaged.

19 Just a month earlier, a controversy had surfaced over the involvement of President

be referred the National Mediation Center (Pusat Mediasi Nasional), which has

been founded by former members of the Task Force to serve the same purpose as

JITF. It may be some time before JITF’s effectiveness becomes clear. For example,

it may be that fundamental restructurings have just been delayed, not resolved.

IBRA, whose mandate was due to expire at the end of February, has been more

controversial, largely because it controlled major amounts of public assets (in

contrast to JITF, which was merely a facilitator of debt workouts). Set up in early

1998 (Kenward 2002: 68), it eventually controlled many billions of dollars of loans

and properties, and an array of corporate assets taken over from failed banks and

bank owners, and these were inevitably coveted by powerful politicians and

business people.

As indicated to the IMF (LOI dated 10 December 2003: para 8), IBRA’s

remain-ing assets will be transferred to several self-liquidatremain-ing holdremain-ing companies for

future disposal. These holding companies will be managed by the Ministry of

State-Owned Enterprises, a fact that raises issues of capacity and independence.

Until the new deposit insurance agency is established, IBRA’s deposit insurance

responsibilities will be transferred to the Ministry of Finance. Its bank resolution

functions will be handled by BI for individual cases, and by the government in

coordination with BI for systemic cases.

In mid January, the economics coordinating minister announced that a new

state enterprise, the State Asset Managing Company (Perusahaan Pengelola Aset

Negara, PPAN), would be created to handle IBRA’s remaining Rp 40 trillion in

assets. In the meantime, IBRA continues to pursue delinquent debtors and sell

assets (

Bisnis Indonesia

, 7/1/04; 13/1/04;

JP

, 8/1/04), but its effectiveness must

surely be compromised as the end of its mandate approaches. Also, PPAN may

simply turn into IBRA by another name, and little will be accomplished by this

handover, which will inevitably entail administrative delays.

An Interim ‘Report Card’ for IBRA.

Any adequate assessment of IBRA’s

effec-tiveness would be a major piece of work, and should be undertaken when more

of the post-crisis dust has settled. Indications to date are mixed and confused. By

way of examples, initial progress was slow (Kenward 2002: 68–70), but the

breadth of IBRA’s mandate was unclear at the outset and its operations were

con-strained by a parliament that dreamed of a 70% recovery rate on assets. Indeed,

IBRA’s reported recovery rate of 28% (

JP

, 15/12/03) is surprisingly high; perhaps

congratulations will be in order after closer examination. Also, on the positive

side of IBRA’s record, its bank closures improved over time, and these soon

became more professional operations (Kenward 2002: 90, 106–7). Furthermore, its

recent property sales have been praised (

JP

, 24/02/04).

On a less positive note, IBRA’s initial policy as concerns the sale of restructured

assets was flawed.

22

_{Similarly, implementation of the bank shareholder}

agree-ments was very slow and IBRA was notably unsuccessful in taking its cases to the

courts. Moreover, controversy persists (

JP

, 15/12/03) amid suspicions of

improper practices and reports of former chairpersons being police suspects in

the misappropriation of funds (

JP

, 26/01/04). Finally, IBRA maintains ownership

in several private banks (see footnote 18), despite excellent market conditions for

divestiture in late 2003 and early 2004.

30 Lloyd R. Kenward

BIES Apr 04 25/2/04 4:16 PM Page 30

RECENT POLITICAL DEVELOPMENTS

Political developments through late 2003 were dominated by the pre-election

process and by manoeuvring to form possible coalitions. Concerning process, on

7 December the General Elections Commission (KPU) announced that 24

politi-cal parties were eligible to contest the two-tiered 2004 elections.

23

_{Two aspects of}

this announcement are notable. First, analysts point out that many of the eligible

parties have links with the New Order (that is, the Soeharto regime). This has

aroused concern in some quarters that democratic reform may come under threat

from ‘cronies’ of the New Order. Second, there was no violence in support of

minority parties that failed the selection process. The KPU’s fair and transparent

working procedures have been given credit in this regard (

JP

, 9/12/03).

24

As reminders of the possibility of violence during this election campaign, there

have been reports of politically related death threats and murders of National

Awakening Party (PKB) clerics and party executives in East Java (

JP

, 8/12/03).

Also, in late December the Elections Supervisory Committee (Panitia Pengawas

Pemilu, Panwaslu) warned that security concerns might disrupt elections in

Aceh, Maluku, Papua and Central Sulawesi. In late January, the Center for

Secu-rity and Peace Studies lengthened this list to 15 locations, of which eight are on

Java (

JP

, 21/01/04).

Further on process, 29 December was the deadline for the 24 eligible political

parties to register their legislative candidates at the KPU. Weeks earlier,

contro-versy had swirled around the list of candidates proposed by the president’s

Indo-nesian Democratic Party of Struggle (PDI-P), when outspoken party members

were excluded (

JP

, 22/11/03), apparently as a follow-up to the president’s verbal

lashing of defiant party members several weeks previously (

Straits Times

,

19/11/03;

JP

, 19/11/03).

In early 2004, political developments seemed to have entered a new phase in

the run-up to the legislative election campaign, which lasts from 11 March to

1 April. The main emerging issue seems to be whether the authorities will be able

to ensure even-handed treatment of election candidates. For example, the Jakarta

General Elections Commission reported two political parties to the police for

campaigning ahead of the 11 March kick-off. Likewise, in South Kalimantan

offi-cials questioned 17 political leaders who allegedly started their campaigns early

(

JP

, 15/01/04). PDI-P joined the list a few days later, after the Surakarta Regional

Elections Supervision Committee reported it to the police.

Individually, the reliability of Indonesian opinion polls is suspect. However,

the trend in the polls to date is clear—they suggest a sizable shift in the national

parliament from PDI-P to Golkar. This is largely due to internal PDI-P disorder,

25

and the party’s failure to deliver better economic results to the average voter.

Nonetheless, Megawati is still the front-running presidential candidate, not least

because of Golkar’s slow progress in fielding a strong contender, and because of

lack of unity among the Islamic parties.

Other parties’ capacity to challenge Megawati will depend to a large extent

upon their success in the legislative elections.

26

_{For example, a strong showing by}

Golkar might lead to an alliance with some of the smaller Islamic (or ‘New

Order’) parties to challenge her leadership directly. By contrast, a weaker result

for Golkar might lead to a PDI-P/Golkar coalition, with the Golkar leadership

accepting the vice presidency. Indeed, at the time of writing almost any

combina-tion of major parties could still form a coalicombina-tion and make a credible run at the

presidency.

Below the national level, the most interesting development has been the

dis-qualification of all PDI-P candidates for the East Kalimantan provincial

legisla-ture. Apparently the party failed to submit a valid list of candidates owing to

bitter disputes among party members (

JP

, 31/01/04). At time of writing, the same

outcome looked possible in Banten.

The Four Daughters: SARS Indonesia-style

The list of contending parties indicates that three eligible parties are chaired by

daughters of former President Sukarno. Megawati heads the PDI-P; Sukmawati

is chair of the Marhaenisme Indonesian National Party;

27

_{and Rachmawati leads}

the Pioneer Party. Of the three, only Megawati appears to have established

sup-port at the grassroots level, which Sukarno claimed to represent.

A fourth presidential daughter coyly approached the starting gate in early

December (

JP

, 4/12/04). Soeharto’s eldest daughter, Siti Hardiyanti Rukmana,

better known as ‘Tutut’, had been recruited by the Concern for the Nation

Func-tional Party,

28

_{chaired by her close associate General (ret.) R. Hartono. The former}

governor of the National Resilience Institute (Lemhannas), Sayidiman

Suryo-hadiprojo, interpreted her possible candidature as indicative of the failure of the

reform movement to benefit the majority of the people (

JP

, 9/12/03).

Constitu-tional expert Satya Arinanto had a simpler explanation—grassroots Indonesians

were suffering from SARS—Sindrom Aku Rindu Soeharto (‘I Miss Soeharto

Syn-drome’) (

JP

, 11/12/03).

29

_{He could just as well have substituted ‘Sukarno’ for}

‘Soeharto’.

16 February 2004

NOTES

1 Available at www.imf.org. As follow-up, on 19 December the IMF Executive Board

approved the release of the final tranche (equivalent to about $505 million) of the 2000 Extended Fund Facility arrangement.

2 A further $600 million was pledged in the form of export credits and technical

assis-tance to regional governments and NGOs.

3 By way of comparison, CGI pledges peaked at almost $8 billion during the crisis, and

they averaged around $5.25 billion pre-crisis.

4 At the United Nations Millennium Summit in September 2000, world leaders agreed to

a set of goals for economic development, called the Millennium Development Goals (United Nations Resolution Number 55/2, dated 8 September 2000). These high ideals have become a focus for many bilateral aid donors.

5 During 2001–02, nominal minimum wages doubled; by 2002 they were 10% over

pre-crisis levels in real terms. Since then, policy has been less aggressive in this regard. In 2003, the national average increase was 14%; in 2004, the rise in Jakarta was 6%.

6 Moreover, from 1 February 2004, the Director General of Customs and Excise has the

authority (under government regulation PP No. 44/2003) to collect sizable (Rp 30,000 to Rp 100,000) non-tax revenues on six services, including export and import

docu-ments (Bisnis Indonesia, 3/01/04).

32 Lloyd R. Kenward

BIES Apr 04 25/2/04 4:16 PM Page 32

7 The FASBI rate virtually defines the floor for interest rates in Indonesia. BI stands ready to accept unlimited amounts of banks’ excess funds through this window, formerly known as the ‘intervention rate’, at two administered rates, the morning rate (shown in figure 5) and the afternoon rate, which is half the morning rate. Normally, banks place perhaps Rp 15 trillion per day in the overnight FASBI facility. Lately, the amount outstanding has increased to some Rp 20–30 trillion, evidence of a very liquid banking system.

8 BI controls the SBI interest rate by choosing the proportion of winning bids at the SBI

auction. When BI accepts a relatively low proportion of bids, this reduces the average SBI rate. At the same time it increases the outstanding amount of SBIs, with a corre-sponding contractionary impact on base money. These sales of SBIs reduce base money, sterilising the impact of other (expansionary) factors, as noted by Grenville (2000: 48). The process gains momentum from one week to the next as commercial banks read the signals from BI and adjust their bidding strategy for the subsequent week. The prob-lem, of course, is that there is no assurance that BI’s preferred interest rate is consistent

with its base money target (see Policy Options in the main text).

9 For performance relative to BI’s indicative targets, see BI (2003a: graph 18). BI missed

the IMF program’s performance criterion for base money at the end of December by about 3% on the high side, owing to the rapid expansion of base money in early Janu-ary (figure 4). (The performance criterion is calculated as a 30-day moving average cen-tred on month-end.)

10 The ‘repo rate’ is the rate at which BI might enter into a repurchase agreement with a commercial bank in need of temporary liquidity. Under such an arrangement, BI would buy some financial instrument (say an SBI or a government bond) from a bank at some price, including an agreement to sell it back to the bank at a different price at a specific point in time. The difference between the two prices (expressed as an annu-alised interest rate) is called the ‘repo rate’.

11 For a 1-year renewable loan. In comparison, the yield on ‘riskless’ government bonds was around 9.25% (1-year maturity) in mid January.

12 Also, BI’s measures of ‘core inflation’ have been running well above ‘headline infla-tion’ (BI 2003a).

13 Another possibility, more in line with maintaining the integrity of inflation targeting, would be to extend the time horizon by two years, to 2008 (the 2006 horizon was set two years ago) and to reduce the medium-term target to, say, 4–5%. As of early Febru-ary this still seemed to be under consideration.

14 BI staff are quick to point out that their forecast for ‘core’ inflation (which they do not announce) is still on the decline.

15 Initially the scandal was incorrectly reported as involving Bank Mandiri.

16 BRI is the nation’s fourth largest bank, and 51% state owned (100% prior to November 2003).

17 As follow-up inside BNI, a compliance division has been set up, which strengthens that function. Also, branch compliance officers, who used to report to the branch manager, now report to head office.

18 The government still owns 99% of Bank BNI; 80% of Bank Mandiri; 51% of BRI; and all of Bank Tabungan Negara. It plans to divest more of BNI in the first half of 2004, and another 10% of Bank Mandiri has been approved by parliament for sale. As for the banks taken over during the crisis, the government (through IBRA) owns 98% of Bank Permata; 55% of Bank Lippo; 45% of Bank Niaga; 28% of Bank Danamon; 22.5% of Bank Internasional Indonesia; and 8% of Bank Central Asia. IBRA may divest its major-ity stakes in Lippo and Permata before its mandate expires in February, but both sales seem unlikely to go ahead on the schedule envisaged.

19 Just a month earlier, a controversy had surfaced over the involvement of President

Megawati’s son (Mohammad Rizki Pratama) in the development of a 17-hectare lot in

the Kemayoran fairground area of north Jakarta (JP, 20/11/03). Lawmakers criticised

the selection of Pratama’s company, suggesting preferential treatment without a pub-lic tender. Reportedly, Pratama subsequently ‘withdrew’ from the company that was

awarded the contract (JP, 19/12/03).

20 The bill establishes both judicial and extra-judicial mechanisms for industrial dispute resolution, with distinctions between different types of disputes; see Zimmerman (2002) for background discussion of the industrial relations framework and the draft law.

21 ‘Successful completion of the Jakarta Initiative Task Force’, Kantor Menteri Koordina-tor Bidang Perekonomian [Office of the Coordinating Minister for Economic Affairs]

press release, 18/12/03; JP, 19/12/03.

22 Parliament and/or IBRA preferred to restructure and then sell; critics doubted the capacity of IBRA to manage in the interim. IBRA’s strategy changed quickly after expe-rience showed the critics to be correct.

23 The 24 parties are eligible to contest the parliamentary elections scheduled for 5 April. To be eligible to field a candidate in the presidential elections, a party must win at least 5% of the total votes or 3% of the legislative seats in the 5 April election. The first round of the presidential elections will be held on 5 July. A second round will be held on 20 September if there is no clear winner (based upon the percentage of total and regional representation) in the first round. At this stage, a second round seems almost inevitable.

24 The first criticism of the KPU surfaced only in late January, for accepting many revised

candidate documents up to five hours after the deadline of 19 January (JP, 20/01/04;

21/01/04). Another controversy has simmered over the contract for ballot boxes (JP,

23/01/04).

25 On 20 January, party members went so far as to warn Megawati that it will be difficult

to repeat the party’s 1999 election success (JP, 21/01/04).

26 A key development in this regard was the Supreme Court’s exoneration of Akbar Tand-jung, the chair of Golkar and speaker of parliament, on charges relating to his role in a

corruption case involving the national logistics agency, Bulog (JP, 13/02/04). This

ver-dict on appeal clears away legal obstacles to his entering the presidential race; it has

also triggered violent demonstrations in several parts of the country (JP, 13/02/04).

27 ‘Marhaenisme’ was Sukarno’s vision of peasant-led nationalism. During the Soeharto years, use of the term was socially unacceptable.

28 Partai Karya Peduli Bangsa (PKPB).

29 This view was supported by a poll released by the Indonesian Survey Institute on 22 December. It reported that more than 60% of respondents considered Soeharto’s political system better than the current one. Notably, only 5% of respondents saw

cor-ruption eradication as important (JP, 23/12/03).

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