Report No. 27374 -IND

CGI Brief Beyond Macroeconomic Stability

CURRENCY EQUIVALENTS (As of December 3, 2003)

Currency Unit = Rupiah (Rp.) US$1 = Rupiah 8,495

FISCAL YEAR: January 1- December 31

December 2003

Acknowledgements This report was written by a core team consisting of Magda Adriani, Vivi Alatas, Jehan Arulpragasam, Mona Haddad (TTL), Joel Hellman, Bert Hofman, Yoichiro Ishihara, Menno Pradhan, Kurnya Roesad, P.S. Srinivas, and Megawati Sulistyo. The team received inputs from Jasmin Chakeri, Sudarshan Gooptu, Anne-Lise Klausen, Anthony Kuek, Kathy Macpherson, Neil McCulloch, Stefan Nachuk, Djauhari Sitorus and Anthony Toft. Peer Reviewers were Joachim von Amsberg, Chatib Basri (University of Indonesia) and Stephen Schwartz (IMF). The report was discussed with the Government on November 20 and 21, 2003. The Sector Director is Homi Kharas, the Country Director is Andrew Steer. Nina Herawati and Dewi Widuri formatted the document and prepared it for printing, with additional editing by Mohamad Al-Arief.

Regional Vice President: Mr. Jemal-ud-din Kassum Country Director: Mr. Andrew Steer Chief Economist: Mr. Homi Kharas Sector Director: Mr. Homi Kharas Task Team Leader: Ms. Mona Haddad

ABBREVIATIONS AND ACRONYMS ACC Anti Corruption Commission Adat Traditional land rights ADB Asian Development Bank AGO Attorney General’s Office ASABRI Pension Fund for Police, Civil

Servants and Military Defense Personnel

ASEAN Association of Southeast Asian Nations

ASKES Health Insurance BAPPENAS National Development Planning

Agency BAPPEPAM Capital Market Supervisory Agency BI Bank Indonesia BII Bank International Indonesia BKPM Investment Coordinating Board BKPMD Regional Investment Coordinating

Board BNI Bank Negara Indonesia BPK Supreme Audit Authority BPKP Central Government’s Internal Audit BPN National Land Agency BPR Bank Perkreditan Rakyat BPS Central Bureau of Statistics BRI Bank Rakyat Indonesia BTN Bank Tabungan Nasional BULOG National Logistics Agency CAR Capital Adequacy Ratio CDD Community Demand Driven

Development CEIC CEIC Data Company Ltd. CG Corporate Governance CGI Consultative Group on Indonesia CLSA Credit Lyonnais Securities Asia CPI Consumer Price Index DAK Special Allocation Fund DAU General Allocation Fund DGT Directorate General of Taxation DPR House of Representatives FATF Financial Action Task Force on

Money Laundering FDI Foreign Direct Investment FSN Financial Safety Net FY Fiscal Year GDP Gross Domestic Product GFA Gross Foreign Asset GOI Government of Indonesia GTZ German Technical Cooperation

Agency IAIS International Association of Insurance

Supervisors IBRA Indonesian Bank Restructuring

Agency ICRG International Country Risk Guide IGGI Inter Governmental Group on

Indonesia

ILGRP World Bank Financed Local Governance Project

ILO International Labor Organization IMF International Monetary Fund INPRES Presidential Instruction IPO Initial Public Offering I-PRSP Interim PRSP IPW Indonesian Procurement Watch ISIC International Standard Industrial

Classification JAMSOSTEK Provident Fund for Private Sector and

SOEs Kabupaten District KADIN Indonesian Chamber of Commerce KDP Kecamatan Development Project KEPMEN Ministerial Decree KEPPRES Presidential Decree KHL Adequate Living Needs KHM Minimum Living Needs Kota City KPK Poverty Reduction Committee KPKD Regional Poverty Reduction

Committee KPKPN Commission for the Audit of the

Wealth of State Officials LAP World Bank Land Administration

Project LNG Liquefied Natural Gas LP3ES Institute for Social and Economic

Research Education and Information LPS Deposit Insurance Corporation LTOs Large Taxpayers Offices MDG Millennium Development Goal MEMR Ministry of Energy and Mineral

Resources MFO Marine Fuel Oil MOF Ministry of Finance MOHA Ministry of Home Affairs MOPs Mid Oil Platts Singapore MOUs Memoranda of Understanding MPR People’s Consultative Assembly NCCT Non-Cooperative Countries and

Territories NGOs Non Governmental Organizations NPLs Non Performing Loans NTB Nusa Tenggara Barat NTT Nusa Tenggara Timur ODA Official Development Assistance OJK Financial Services Authority OPK Rice Subsidy Program OSS One Stop Service PEM Public Expenditure Management PERDA Regional Regulation PLN State Electricity Company PMDN Domestic Investment PMON State Debt Management Office

PP Government Regulation PPATK Financial Intelligence Unit PPM Post Program Monitoring PROPENAS National Five Year Development

Program PRS Poverty Reduction Strategy PRSP Poverty Reduction Strategy Paper Puskesmas Health Community Center RASKIN Rice for the Poor RBC Risk Based Capital RCA Revealed Comparative Advantage REER Real Effective Exchange Rates REPETA Annual Development Plan S&P Standard and Poors SAKERNAS National Labor Force Survey SARS Severe Acute Respiratory Syndrome SBI Bank Indonesia Certificates SGP Scholarship and Grant Program SITC Standard International Trade

Classification SMERU Social Monitoring and Early Response

Unit SMEs Small and Medium Enterprises SOEs State Owned Enterprises SUSENAS National Social and Economic Survey TAP Decision TASPEN Pension Fund for Civil Servants TI Transparency International Tim Inti The Core PRS Team UNCOMTRADE United Nation Commodity Trade UPP Urban Poverty Eradication Program UUPK Basic Forestry Law of 1967 VAT Value Added Tax WTO World Trade Organization

TABLE OF CONTENTS

PAGE NO.

INTRODUCTION

EXECUTIVE SUMMARY i

RINGKASAN EKSEKUTIF v

CHAPTER 1: MAINTAINING MACROECONOMIC STABILITY 1 RECENT DEVELOPMENTS 1

Political Developments 1 Market Sentiment 1 The Real Economy 2 Employment, Income and Poverty 4 Monetary Policy and Inflation 4 International Trade and Payments 4 Fiscal Policy 5 External Financing Needs in 2004 6 Medium-Term Macroeconomic Outlook 6 THE WHITE PAPER 7

Maintaining Macroeconomic Stability 8 Tax Reform 9 Tax Administration Reform 10 Public Expenditure Management 10 Decentralization 11 State Debt Management 12

CHAPTER 2: RESTRUCTURING AND REFORMING THE FINANCIAL SECTOR 15 RECENT DEVELOPMENTS 15

Improved Performance of the Banking Sector 16 IBRA is Ready to Close 18 Capital Markets and Mutual Funds 18 THE WHITE PAPER: RESTRUCTURING AND REFORMING THE FINANCIAL

SECTOR 19

Financial Sector Safety Net and Financial Stability 19 The Banking System 20 Anti-Money Laundering 21 Capital Markets 22 Insurance and Pensions 23

CHAPTER 3: INCREASING INVESTMENT, EXPORTS AND EMPLOYMENT 27 RECENT DEVELOPMENTS 27

Trends in Investment, Exports and Employment 27 What Affects Investors? 28 THE WHITE PAPER 29

Improving Investment Policy and Approvals 31 Promoting Industry and Trade 33 Harmonizing Regional Regulations 34 Employment 35 Infrastructure 37 Developing Small and Medium Enterprises, and Cooperatives 38

CHAPTER 4: MEETING INDONESIA’S GOVERNANCE CHALLENGES 39 GOVERNANCE AND THE WHITE PAPER 41

Public Financial Management 41 Legal and Justice Sector Reform 42 Public Administration Reform 47 ACCOUNTABILITY AND THE WHITE PAPER 50

CHAPTER 5: REDUCING POVERTY 51 INDONESIA’S POVERTY CHALLENGE 51

ADDRESSING THE CHALLENGE: THE WHITE PAPER AND BEYOND 52

An Emerging Poverty Reduction Strategy for Indonesia 53 Opportunity Creation 54 Empowerment and Accountability 56 Human Capital 57 Social Protection 60

TABLES IN TEXT

Table 1.1. Sovereign rating comparison 2 Table 1.2. Sources of growth comparison in 2002 2 Table 1.3. 2004 Financing needs and CGI disbursement request 6 Table 1.4. International comparison of major indicators upon the IMF

graduation 7

Table 1.5. Macroeconomic stability measures in the White Paper 9 Table 2.1. Indonesian financial sector in 2002 15 Table 2.2. Financial sector measures in the White Paper 20 Table 2.3. Market ranked by corporate governance by CLSA 23 Table 2.4. Insurance sector profile in 2002 24 Table 3.1. Indonesia revealed comparative advantage 28 Table 3.2. Main policy measures to improve the investment climate and

promote industry and trade 31

Table 4.1. Legal and justice sector reform measures in the White Paper 43 Table 4.2. Public administration reform measures in the White Paper 48

Table 5.1. Change in poverty headcount index from 1996 to 2002 51 Table 5.2. Poverty eradication measures in the White Paper 53

FIGURES

Figure 1.1. Markets are supportive 1 Figure 1.2. Non-oil and gas trade growth rate slowed 3 Figure 1.3. Exports were increasingly driven by foreign firms prior to

the crisis 3

Figure 1.4. Indonesia’s export to China and the world 3 Figure 1.5. Inflation further declining 4 Figure 1.6. Private capital account turns positive 4 Figure 1.7. Fiscal consolidation continues 5 Figure 1.8. Medium-term growth projection 7 Figure 1.9. Inequality among local governments 12 Figure 1.10. Government debt is further declining 12 Figure 2.1. Key financial indicators of banking system have improved 16 Figure 2.2. Interest rate spreads are on the rise 17 Figure 2.3. Mutual funds have soared 19 Figure 3.1. Indonesia’s export performance lags its neighbors’ 27 Figure 3.2. Competition from China is rising 27 Figure 3.3. Fewer firms are set up 28 Figure 3.4. Manufacturing employment is falling 28 Figure 3.5. Macroeconomic instability, policy uncertainty and

corruption are the main obstacle 29

Figure 3.6. Decentralization has exacerbated the problems 29 Figure 3.7. Time and cost of starting a business in Indonesia 32 Figure 3.8. Productivity has not matched increase in real wages 35 Figure 3.9. Comparison of value added by labor in selected sectors,

2000-2001 35

Figure 3.10. Few days lost on strikes 36 Figure 3.11. Perceptions of infrastructure quality 37 Figure 4.1. Extent of consensus within government 40 Figure 4.2. Perceptions of key elements of “governance” 2002 40 Figure 5.1. Where are the poor? 52 Figure 5.2. Many Indonesians lack access to basic services 52 Figure 5.3. Low land registration in Indonesia 55 Figure 5.4. Most roads in districts are of inferior quality 56 Figure 5.5. Road access is not equally distributed 56 Figure 5.6. Indonesia is behind its neighbors in science and mathematics

achievements 58

Figure 5.7. Causes of Vulnerability 60

BOXES

Box 1.1. Overseas treasures 5 Box 3.1. White Paper priorities of the business community 30 Box 4.1. The supreme court blueprints 44

Box 4.2. Reform of the law on the Attorney General’s Office (AGO) 46 Box 4.3. Integrity pacts in Solok 49 Box 5.1. The doctor is out… 59 Box 5.2. Expensive subsidized rice 61

STATISTICAL ANNEXES

INTRODUCTION

The year 2004 will mark another crucial step in Indonesia’s long-term transition. The country will go to the polls to elect new national and regional Parliaments, and for the first time in the history of the Republic, to directly elect a President. This milestone in the country’s democratization is accompanied by one in economic policy: for the first time since the onset of the crisis, the Government will not have a program supported by the IMF. The Government’s decision to graduate from its IMF program is warranted by the strong improvements in the country’s macroeconomic conditions, and has been broadly welcomed by the markets and the international community. The Government’s “Economic Policy Package Pre and Post IMF” or White Paper, issued as a presidential instruction on September 15th, has helped build confidence in the Government’s policies in the election year ahead. The policy package is intended to “bridge the credibility gap” as Minister Boediono expressed it, a gap as important as the financing gap to be filled after Indonesia’s exit from the IMF-supported program and Paris Club. The White Paper is a unique document: it is the first time that the Government commits itself transparently to a time-bound action plan to implement policies. Other Government documents, such as the annual plan (Repeta) and

five-year plan (Propenas), include policy directions, but none of these identifies specific policy actions and a specific timetable. The document shows continuity in macroeconomic policies and financial sector reforms, but also proposes a set of specific policy and institutional measures to address issues that have undermined the country’s investment climate. While the timetable for adopting these measures is a short term one – fifteen months – many of the proposed measures address fundamental longer term problems, and some will take several years to see through fully. The Government has set up a monitoring team in the Coordinating Ministry for the Economy. The private sector, which has a high stake in the measures in the paper, and civil society groups and think tanks have emerged as independent monitors. Since the White Paper is so central to Indonesia in the year ahead, much of this CGI brief is devoted to discussing it. Beyond recent developments, the report discusses and analyzes the policy actions from the White Paper we feel are critical. The report also points at the White Paper measures that may not necessarily be in line with the stated goals of the document. And finally, the report identifies policies that are needed beyond the White Paper to ensure Indonesia builds on the macroeconomic stability achieved to attain more rapid growth and poverty reduction.

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EXECUTIVE SUMMARY

Indonesia is entering a new phase in its economic management. At the end of 2003, the country will be the last among the countries affected by the Asian crisis to complete its IMF supported program. Over the last three years, Indonesia has made remarkable progress in achieving macroeconomic stability, in reducing the economy’s vulnerability, and in restoring external viability. The decision not to renew the IMF supported program was therefore broadly welcomed by the markets, the international community and Indonesians. The release of the Government’s “Economic Policy Package Pre and Post IMF,” better known as the White Paper, shows that Government is committed to continued sound macroeconomic policies and financial sector restructuring. The Paper also sets out an ambitious agenda of measures to increase investment, exports and employment creation. Together these measures could lay the basis for higher growth, more jobs, and lower poverty. Higher growth is a must: poverty benefited from macroeconomic stability, but is still at 16 percent of the population, and a majority of Indonesians earn less than two dollars a day. Keeping implementation of the White Paper on track will not be easy in the months ahead leading up to the elections of 2004, but the Government’s real challenge will be to ensure that critical measures are prioritized, and policy measures taken indeed support the White Paper’s goals. RECENT DEVELOPMENTS The markets reacted calmly to Indonesia’ decision not to extend a program with the IMF, reassured by the Government’s achievements in stabilizing the economy and reducing macroeconomic risks. Growth remains modest at 3.5-4 percent, but the economy has performed better than expected. The Marriott bombing, SARS, and the Iraq war all had a limited effect on growth, a testimony to the country’s reduced vulnerability. Over 80 percent of growth in 2002 and 2003 came from private consumption, which was boosted by declining interest rates and expanding credit. Investment has remained at 20 percent of GDP, some 10

percentage points below levels achieved before the crisis, and its composition shifted dramatically toward property investment. Exports have contributed less to growth than in other Asian countries, but exports to China grew by 60 percent in 2003. For 2004, the Government expects growth to reach 4.8 percent, supported to some extent by an improving international environment and low interest rates. A virtuous circle of improved macroeconomic indicators continues to build up. Inflation has shown a remarkable slowdown over the year, mainly on account of a stable exchange rate and modest base money growth. Lower inflation, now below 6 percent, enabled Bank Indonesia to bring down interest rates. Lower interest rates cut interest payments in the state budget, paving the way for further fiscal consolidation in 2003, despite higher fuel subsidies than initially budgeted. The 2003 state budget deficit is expected at 1.9 percent of GDP. Public debt as a share of GDP also continues to decline and will reach 67 percent by end-2003. The 2004 budget approved by parliament in November demonstrates the Government’s commitment to further fiscal consolidation; the budget deficit is projected at 1.2 percent of GDP. Financing needs would increase in 2004, despite further fiscal consolidation, as exceptional financing dries up with the end of the IMF program, and debt service will increase from 31 percent of revenue in 2003 to 37 percent in 2004. The amount being requested from the CGI is in the range of $2.5-3.0 billion. THE WHITE PAPER The White Paper promises continuity in macroeconomic and financial sector policies, and aims for reforms to improve the investment climate. The document, issued as a Presidential Instruction and a parallel central bank Governor decree, includes an impressive set of time-bound policy actions. The White Paper came about in a process of consultation with major stakeholders, and for its implementation the Government has set up a secretariat that keeps track of progress on the

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paper’s policy actions. Early implementation progress is promising: Of the 43 actions due end-September 2003, the government completed 36 on time. All the remaining action plans not completed in September were done in October. Of the 54 actions due in October, the Government completed 37 on time. Among those, the establishment of the Investment and Trade Team and the Presidential Decree on Government procurement stand out. Macroeconomic Stability. The White Paper comprises the measures needed to achieve a healthy fiscal position, lower inflation, and sufficient international reserves. The Government plans to offset lower exceptional financing with further fiscal consolidation through reforms and modernization of the tax system, increased efficiency in government spending, and effective debt management. In addition, and quite remarkable for an election year, the Government also remains committed to continued privatization—10 enterprises in total will be on the block to raise more domestic financing to cover the deficit. Together with the low domestic interest rates and stable exchange rate the central bank is aiming for, the zero deficit and “Maastricht norm” debt level the Government is aiming for by 2006 are well within reach. Financial Sector Reform. The White Paper lays out a host of measures to continue financial sector reform and restructuring. Progress has been made in restructuring and strengthening the banking sector. IBRA has sold several banks taken over during the crisis, the Government has begun reducing its stake in state-owned banks, and commercial banks balance sheets show significant improvement with reductions in non-performing loans and stronger capital adequacy ratios. Behind such improvements, weaknesses remain. Restructuring of non-performing loans was not always conducted on the basis of commercial viability. The improved capital-adequacy ratios may overstate the robustness of the banking system as government bonds and restructured loans in bank portfolios remain large. State-owned banks still comprise almost half of Indonesia’s banking sector, and they suffer from weak internal controls and governance as recent events in BNI and BRI illustrate. The financial sector is not well diversified, and relies heavily on the banking

sector, whereas capital markets remain underdeveloped, and their potential in financing development underutilized. The measures in the White Paper are steps in the right direction to strengthen the financial sector. The plans to complete a financial safety net are sound, but require careful sequencing, coordination and timing in their implementation. Completion of the sales of banks taken over will not only help the treasury, but also return more of the banking system to the private sector. The measures in the White Paper will need to be complemented with more forceful efforts to improve governance of state-owned banks, including full enforcement by the supervisor of prudential regulations for those banks, and by the Government of accountability for results. Beyond the White Paper, the Government should strive for diversifying the financial sector, and further develop the capital market and sound institutional investors such as insurance and pension funds. This would yield the longer term risk financing that more rapid growth requires. Investment Climate . Recognizing the dire shape Indonesia’s investment climate is in, the White Paper aims to improve it. Indeed, according to a recent survey among firms, a host of issues is holding back investment. Critical obstacles are policy uncertainty, legal uncertainty, and corruption in both national and local governments. Many of these obstacles have resulted from weak institutions, including tax and customs administration and the judicial system. The White Paper is a good start to tackle some of these difficult issues, and the Investment and Trade Team established under the White Paper can play a major role in driving this agenda forward. The policy actions are helpful in their aim to simplify investment and clarify the roles and responsibilities of the various levels of Government. It also promises to address the excessive regional taxes issued since the onset of decentralization. On infrastructure, the announced implementation of Law 20/2002 and a regulatory body for Telecom are the most important steps. A better investment law would be helpful in increasing investment, although the current one is probably not a major bottleneck. Improving it will require extensive

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consultations with stakeholders before the draft is sent to Parliament. Trade. The measures proposed on trade are less promising, and hardly support the goal of accelerating export growth. Already, protectionist measures such as import registration and licensing have cropped up in recent years. The setback in the WTO negotiations have probably increased the pressures for protectionist measures, notably in agriculture. Indeed, higher tariffs on rice, soybeans, and corn—all staples for the poor—are being contemplated. And BULOG, the logistics agency, seems to be keen to use its new status as a non-profit enterprise for expanding its role in the trade of these commodities. The proposed trade law could in this respect be helpful, but could also be used to justify more of the same. The forthcoming draft law should therefore be carefully scrutinized. The announcement of an expansion of counter-trade seems unproductive. Apart from the fiduciary concerns such measures bring with them, the measures do not help Indonesia’s image of a country that has overcome the crisis, and restored external viability. Governance. Better governance is key for reducing policy and legal uncertainty, and therefore for improving the investment climate. Five years after Reformasi, governance continues to be the Government’s biggest challenge. Corruption has become less predictable, not least because of decentralization. Unpredictable and inconsistent court rulings issued by an unreformed justice sector continue to haunt investors, and tax administration and customs remain a major nuisance for business. It is important to recognize that these governance problems exist within a framework of tremendous political, economic and institutional changes. These changes have marked Indonesia’s transition to a more open, competitive society and provide new opportunities for improving governance. The results of these remarkable changes are evident in the new level of transparency and competition in Indonesian public life, but now need to be complemented by rebuilding the institutions that would match this increased transparency with more accountability. The White Paper is a step along this journey. Measures supporting better government fiduciary

management, the Anti-Corruption Commission, the judiciary commission, and the reform blueprints of the Supreme Court are all encouraging. These initiatives need to be matched by the measures, budget, and people it takes to create strong institutions. A litmus test in that respect is the Anti-Corruption Commission, whose members are about to be selected at the same time the CGI meets. On other areas, the White Paper measures need more work: the draft revised law on the attorney general’s office falls short of the necessary overhaul of this institution, and the planned public services law will do little for services without complementary civil service reforms. Poverty Alleviation. Poverty reduction is not the main focus of the White Paper, but the macroeconomic stability and higher growth the paper aims for is one of its pillars. The other is better services for the poor, and Indonesia is lagging in this respect. More than half of Indonesians do not have access to one of the basic services in health, education, water, or sanitation, and better governance is required to improve this. The White Paper reconfirms the Government’s commitment to develop a comprehensive Poverty Reduction Strategy Paper (PRSP) by mid-next year, and presents a number of measures that can create opportunity for the poor, improve their human capital, and safeguard the vulnerable. The success of the forthcoming PRSP will depend on whether it will ultimately yield an enhanced poverty focus of government policies and programs. To this end, the strategy needs to be integrated with existing budgeting and planning procedures and sector strategies. The measures to improve services for the poor included in the White Paper need to be complemented with those that make decentralization work, and improve governance in service delivery. Access to land can catalyze credit for the poor and SMEs, and the Government is encouraged to scale up its rather modest commitment on land titling made in the White Paper. Finally, the plans to revamp Indonesia’s social safety net need wide consultation to ensure that the desire for a more just society is matched with the Government’s goal to create more productive jobs.

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RINGKASAN EKSEKUTIF

Indonesia sedang memasuki sebuah fase baru dalam pengelolaan ekonominya. Pada akhir tahun 2003, Indonesia akan menjadi yang terakhir di antara negara-negara yang terkena pengaruh krisis di Asia yang akan mengakhiri program yang didukung oleh IMF. Selama tiga tahun terakhir, Indonesia telah membuat kemajuan luar biasa dalam mencapai kestabilan makro-ekonomi, dalam mengurangi kerentanan perekonomian, dan dalam memulihkan daya tarik internasional. Karena itu keputusan untuk tidak memperbaharui program yang didukung oleh IMF umumnya disambut baik oleh pasar, masyarakat internasional maupun masyarakat Indonesia. Diumumkannya oleh Pemerintah “Paket Kebijakan Ekonomi Pra dan Pasca IMF,” yang lebih dikenal sebagai White Paper, memperlihatkan bahwa Pemerintah memiliki komitmen untuk melanjutkan kebijakan-kebijakan makroekonomi yang sehat dan restrukturisasi sektor keuangan. White Paper juga menetapkan sebuah agenda yang ambisius berisi langkah-langkah untuk meningkatkan investasi, ekspor dan penciptaan lapangan kerja. Secara serempak langkah-langkah ini dapat menjadi basis peningkatan pertumbuhan yang lebih tinggi, penciptaan lapangan kerja yang lebih banyak, dan penurunan tingkat kemiskinan yang lebih rendah. Tingkat pertumbuhan yang lebih tinggi merupakan keharusan: upaya mengatasi kemiskinan akan dibantu oleh kestabilan makro-ekonomi, tetapi kemiskinan masih terdapat di antara 16 persen dari penduduk, dan mayoritas masyarakat Indonesia mendapat penghasilan kurang dari dua dollar sehari. Mempertahankan pelaksanaan White Paper pada jalur yang benar tidak akan mudah di bulan-bulan mendatang menjelang pemilihan di tahun 2004, tetapi tantangan sesungguhnya bagi Pemerintah nantinya adalah memastikan bahwa langkah-langkah penting tersebut ditempatkan menurut prioritas, dan langkah-langkah kebijakan yang diambil benar-benar mendukung sasaran-sasaran White Paper.. PERKEMBANGAN TERAKHIR Pasar bereaksi dengan tenang terhadap keputusan Indonesia untuk tidak memperpanjang program

dengan IMF, karena diyakinkan oleh prestasi-prestasi Pemerintah dalam menstabilkan perekonomian dan mengurangi risiko-risiko makroekonomi. Pertumbuhan masih tetap terbatas pada 3,5-4 persen, tetapi perekonomian telah memperlihatkan kinerja yang lebih baik daripada yang diharapkan. Pengeboman hotel Marriott, kasus SARS, dan Perang Irak semuanya hanya berpengaruh secara terbatas terhadap pertumbuhan, suatu bukti bahwa kerentanan negeri ini telah berkurang. Lebih dari 80 persen pertumbuhan pada tahun 2002 dan 2003 berasal dari konsumsi pribadi, yang didorong oleh turunnya suku bunga dan berkembangnya kredit. Investasi masih tetap pada tingkat 20 persen dari PDB, kira-kira 10 persen di bawah tingkat yang dicapai sebelum krisis, dan komposisinya bergeser secara dramatis kepada investasi properti. Kontribusi ekspor kepada pertumbuhan masih kurang dibandingkan dengan di negara-negara Asia lainnya, tetapi ekspor ke Cina meningkat 60 persen pada tahun 2003. Untuk tahun 2004, Pemerintah memperkirakan pertumbuhan akan mencapai 4,8 persen, sedikit banyak didukung oleh faktor eksternal yang membaik dan suku bunga yang rendah. Sebuah lingkaran yang sehat berupa indikator-indikator makroekonomi yang lebih baik terus dibangun. Inflasi telah memperlihatkan penurunan luar biasa selama tahun tersebut, terutama karena stabilnya kurs tukar dan terbatasnya pertumbuhan stok uang minimum. Inflasi yang lebih rendah, sekarang di bawah 6 persen, telah memungkinkan Bank Indonesia mengurangi suku bunga. Suku bunga yang lebih rendah telah mengurangi pembayaran bunga dalam anggaran pemerintah, sehingga merintis jalan bagi konsolidasi fiskal lebih lanjut di tahun 2003, meskipun subsidi bahan bakar lebih tinggi daripada yang dianggarkan semula. Defisit anggaran pemerintah tahun 2003 diperkirakan 1,9 persen dari PDB. Hutang publik sebagai bagian dari PDB juga terus menurun dan akan mencapai 67 persen pada akhir tahun 2003. Anggaran tahun 2004 yang disetujui oleh parlemen pada bulan November memperlihatkan komitmen Pemerintah terhadap konsolidasi fiskal lebih lanjut;

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defisit anggaran diperkirakan 1,2 persen dari PDB. Kebutuhan pembiayaan diharapkan dapat meningkat pada tahun 2004, meskipun adanya konsolidasi fiskal lebih lanjut, karena pembiayaan khusus akan habis dengan berakhirnya program IMF, dan penutupan hutang akan meningkat dari 31 persen dari jumlah pendapatan pada tahun 2003 menjadi 37 persen pada tahun 2004. Jumlah yang sedang diminta dari CGI berkisar $2,5-3,0 milyar. White Paper White Paper menjanjikan keberlanjutan dalam kebijakan-kebijakan makroekonomi dan kebijakan-kebijakan sektor keuangan, dan bermaksud melakukan berbagai reformasi untuk memperbaiki iklim investasi. Dokumen tersebut, yang diterbitkan sebagai Keputusan Presiden serta sebuah keputusan yang paralel dari Gubernur bank sentral, mencakup seperangkat tindakan-tindakan kebijakan terjadwal yang mengesankan. White Paper muncul dalam sebuah proses konsultasi dengan para stakeholder utama, dan untuk pelaksanaannya Pemerintah telah membentuk sekretariat yang akan terus mengikuti sampai sejauhmana kemajuan tindakan kebijakan White Paper. Kemajuan setelah pelaksanaan awal sudah cukup menjanjikan: Dari ke-43 tindakan yang diharapkan pada akhir-September 2003, pemerintah telah menyelesaikan 36 secara tepat waktu. Semua rencana tindakan selebihnya yang tidak diselesaikan pada bulan September telah dilaksanakan pada bulan Oktober. Dari ke-54 tindakan pada bulan Oktober, Pemerintah telah menyelesaikan 37 secara tepat waktu. Antara lain, yang menonjol adalah pembentukan Tim Investasi dan Perdagangan serta Keputusan Presiden mengenai pengadaan barang/jasa Pemerintah. Kestabilan Makro-ekonomi. White Paper mencakup langkah-langkah yang diperlukan untuk mencapai suatu posisi fiskal yang sehat, tingkat inflasi yang lebih rendah, dan cadangan internasional yang mencukupi. Pemerintah merencanakan untuk mengimbangi pembiayaan khusus yang lebih rendah dengan konsolidasi fiskal lebih lanjut melalui berbagai reformasi dan modernisasi sistem pajak, efisiensi yang lebih baik dalam pengeluaran pemerintah, dan manajemen hutang yang efektif. Di samping itu, dan cukup luar biasa untuk sebuah tahun pemilihan umum,

Pemerintah juga masih tetap memiliki komitmen untuk melanjutkan privatisasi— seluruhnya 10 badan usaha akan dilelang untuk meningkatkan lebih banyak pembiayaan yang bersumber dari dalam negeri untuk menutupi defisit. Bersama dengan rendahnya suku bunga dalam negeri serta stabilnya kurs tukar yang menjadi sasaran bank sentral, defisit nol dan tingkat hutang “Norma Maastricht” yang menjadi sasaran Pemerintah untuk 2006 sudah cukup terjangkau. Reformasi Sektor Keuangan. White Paper menguraikan sejumlah besar langkah-langkah untuk melanjutkan reformasi dan restrukturisasi sektor keuangan. Kemajuan telah dibuat dalam restrukturisasi dan pemantapan sektor perbankan. BPPN telah menjual beberapa bank yang diambil alih selama krisis, Pemerintah telah mulai mengurangi investasinya pada bank-bank milik negara, dan neraca bank-bank umum memperlihatkan peningkatan signifikan dengan berkurangnya pinjaman yang tidak menghasilkan laba serta rasio kecukupan modal yang lebih kuat. Di balik peningkatan-peningkatan demikian, kelemahan-kelemahan masih tetap ada. Restrukturisasi pinjaman yang tidak menghasilkan laba tidak selalu dilakukan berdasarkan kelayakan komersial. Rasio kecukupan modal yang lebih baik bisa memberi kesan berlebihan mengenai kekuatan dan kesehatan sistem perbankan karena obligasi pemerintah dan pinjaman yang direstrukturisasi pada portfolio bank masih tetap besar. Bank-bank milik negara masih mencakup hampir separuh dari sektor perbankan Indonesia, dan bank-bank milik negara ini menderita akibat lemahnya pengendalian internal dan tata kelola seperti diperlihatkan oleh insiden baru-baru ini di BNI dan BRI. Sektor keuangan tidak didiversifikasi dengan baik, dan sangat bergantung kepada sektor perbankan, sedangkan pasar-pasar modal masih tetap kurang dikembangkan, dan potensinya dalam membiayai pembangunan kurang dimanfaatkan. Langkah-langkah dalam White Paper sudah tepat arahnya untuk memantapkan sektor keuangan. Rencana-rencana untuk menyelesaikan sebuah jaring pengaman keuangan sudah baik, tetapi masih dituntut penetapan urutan, koordinasi dan penetapan waktu yang cermat dalam pelaksanaannya. Penyelesaian penjualan bank-

vii

bank yang diambil alih tidak saja akan membantu anggaran negara, tetapi juga akan mengembalikan lebih banyak dari sistem perbankan ke sektor swasta. Langkah-langkah dalam White Paper akan perlu diimbangi dengan upaya-upaya yang lebih dinamis untuk meningkatkan mutu tata kelola bank-bank milik negara, termasuk penegakan sepenuhnya peraturan-peraturan mengenai kehati-hatian bagi bank-bank tersebut oleh pengawas, serta penegakan pertanggungjawaban Pemerintah atas hasil-hasilnya. Selain White Paper, Pemerintah perlu berupaya melakukan diversifikasi terhadap sektor keuangan, dan lebih lanjut mengembangkan pasar modal dan para investor kelembagaan yang sehat seperti dana asuransi dan dana pensiun. Ini diharapkan dapat menghasilkan pembiayaan risiko lebih berjangka panjang yang dituntut oleh pertumbuhan yang lebih pesat. Investasi, Perdagangan, dan Lapangan Kerja. Menyadari parahnya keadaan iklim investasi Indonesia saat ini, White Paper tersebut bermaksud untuk memperbaikinya. Memang, menurut sebuah survei baru-baru ini di antara berbagai perusahaan, sejumlah besar masalah masih menghambat investasi. Rintangan-rintangan yang serius adalah ketidakpastian kebijakan, ketidakpastian hukum, dan korupsi di dalam pemerintah nasional dan pemerintah daerah. Banyak dari rintangan-rintangan ini diakibatkan oleh lemahnya lembaga-lembaga, termasuk administrasi pajak dan bea cukai serta sistem peradilan. White Paper merupakan permulaan yang baik untuk menanggulangi beberapa dari masalah-masalah yang sulit ini, dan Tim Investasi dan perdagangan yang dibentuk berdasarkan White Paper dapat memainkan peran penting dalam mendorong agar agenda ini terus bergerak maju. Tindakan-tindakan kebijakan berguna dalam upaya mereka untuk menyederhanakan investasi dan mengklarifikasi peran serta tanggung jawab berbagai tingkatan Pemerintah. White Paper juga berjanji untuk memberi perhatian kepada pajak-pajak daerah yang terlalu banyak dikeluarkan sejak awal desentralisasi. Mengenai infrastruktur, diumumkannya pelaksanaan Undang-undang No. 20/2002 dan sebuah badan regulator untuk bidang Telekomunikasi merupakan langkah-langkah paling penting. Sebuah undang-undang investasi yang lebih baik diharapkan dapat berguna dalam meningkatkan investasi, walaupun undang-undang

yang ada saat ini kemungkinan sekali bukan faktor penghambat yang utama. Untuk memperbaikinya akan menuntut konsultasi yang ekstensif dengan para stakeholder sebelum rancangannya di kirim ke Parlemen. Perdagangan. Langkah-langkah yang diusulkan mengenai perdagangan kurang menjanjikan, dan hampir tidak mendukung sasaran untuk mempercepat pertumbuhan ekspor. Sampai saat ini, langkah-langkah proteksionis seperti registrasi dan perizinan impor telah muncul pada tahun-tahun belakangan ini. Kemunduran dalam negosiasi-negosiasi WTO kemungkinan sekali telah meningkatkan tekanan untuk mengambil langkah-langkah proteksionis, khususnya di bidang pertanian. Memang, tarif yang lebih tinggi untuk beras, kacang kedele, dan jagung—semua ini merupakan bahan-bahan pokok bagi rakyat miskin—sedang dipertimbangkan. Dan BULOG, badan yang mengurus logistik, tampaknya sangat ingin menggunakan status barunya sebagai sebuah badan usaha yang tidak mencari laba untuk memperluas perannya dalam perdagangan komoditas-komoditas ini. Undang-undang perdagangan yang diusulkan dalam hal ini bisa berguna, tetapi juga bisa digunakan untuk membenarkan apa yang baru disebutkan. Karena itu rancangan undang-undang yang akan datang perlu diperiksa dengan cermat. Diumumkannya suatu perluasan imbal-dagang tampaknya tidak terlalu bermanfaat. Selain dari kekhawatiran fidusier yang timbul bersama langkah-langkah demikian, langkah-langkah tersebut tidak membantu citra Indonesia sebagai sebuah negara yang telah mengatasi krisis, dan telah memulihkan daya tarik internasionalnya. Tata Pemerintahan. Tata pemerintahan yang lebih baik merupakan kunci untuk mengurangi ketidakpastian kebijakan dan hukum, dan karena itu juga untuk memperbaiki iklim investasi. Lima tahun setelah Reformasi, tata pemerintahan terus menjadi tantangan terbesar bagi Pemerintah. Korupsi semakin tidak dapat diperkirakan, terutama karena desentralisasi. Keputusan-keputusan pengadilan yang tidak dapat diperkirakan dan tidak konsisten yang dikeluarkan oleh sebuah sektor peradilan yang tidak direformasi terus menghantui para investor, sedangkan administrasi pajak dan bea cukai masih

viii

tetap menjadi gangguan utama bagi bisnis. Penting untuk disadari bahwa problem-problem tata pemerintahan ini masih terus ada di dalam sebuah kerangka perubahan yang sangat besar di bidang politik, ekonomi dan kelembagaan. Perubahan-perubahan ini telah menandai transisi yang terjadi di Indonesia menuju sebuah masyarakat yang lebih terbuka, kompetitif dan yang menyediakan kesempatan-kesempatan baru untuk meningkatkan mutu tata pemerintahan. Hasil-hasil dari perubahan-perubahan yang luar biasa ini jelas terlihat dalam tingkat transparansi dan persaingan yang baru dalam kehidupan publik di Indonesia, tetapi sekarang perlu diimbangi oleh pembangunan kembali lembaga-lembaga yang diharapkan dapat mengimbangi peningkatan transparansi ini dengan pertanggungjawaban yang lebih besar. White Paper tersebut merupakan sebuah langkah sepanjang perjalanan ini. Langkah-langkah yang mendukung manajemen fidusier pemerintah yang lebih baik, Komisi Anti-Korupsi, komisi peradilan, dan cetak-biru reformasi untuk Mahkamah Agung semuanya menggembirakan. Inisiatif-inisiatif ini perlu diimbangi oleh langkah-langkah, anggaran, dan sumber daya manusia yang dibutuhkannya untuk menciptakan lembaga-lembaga yang kuat. Sebuah uji penentu dalam hal tersebut adalah Komisi Anti-Korupsi, yang anggota-anggotanya akan segera dipilih pada waktu yang sama dengan pertemuan CGI. Di bidang-bidang lain, langkah-langkah White Paper tersebut membutuhkan lebih banyak pekerjaan: rancangan revisi undang-undang mengenai kejaksaan agung kurang memenuhi tuntutan perbaikan yang perlu terhadap lembaga ini, dan undang-undang pelayanan publik yang telah direncanakan tidak akan berbuat banyak bagi pelayanan publik tanpa diimbangi oleh pembaharuan aparatur negara. Peringanan Beban Kemiskinan. Pengurangan kemiskinan bukan merupakan fokus utama White Paper, tetapi kestabilan makro-ekonomi dan tingkat pertumbuhan lebih tinggi yang menjadi sasaran buku tersebut merupakan salah satu pilarnya. Pila r lainnya adalah pelayanan yang lebih baik bagi rakyat miskin, dan Indonesia masih melambat dalam hal ini. Lebih dari separuh masyarakat Indonesia tidak memiliki akses ke salah satu pelayanan dasar di bidang kesehatan, pendidikan, air bersih, atau sanitasi, dan tata

pemerintahan yang lebih baik dibutuhkan untuk memperbaiki keadaan ini. White Paper menegaskan kembali komitmen Pemerintah untuk mengembangkan sebuah Dokumen Strategi Pengurangan Kemiskinan (PRSP) yang komprehensif menjelang pertengahan tahun depan, dan menawarkan sejumlah langkah yang dapat menciptakan kesempatan bagi rakyat miskin, meningkatkan mutu modal daya manusia mereka, dan melindungi kelompok yang rentan. Keberhasilan PRSP yang akan datang akan bergantung pada apakah dokumen tersebut pada akhirnya akan menghasilkan suatu fokus yang lebih baik mengenai strategi pengurangan kemiskinan dalam kebijakan-kebijakan serta program-program pemerintah. Untuk itu, strategi tersebut perlu diintegrasikan dengan berbagai prosedur penganggaran dan perencanaan serta strategi-strategi sektor yang ada. Langkah-langkah untuk meningkatkan mutu pelayanan bagi rakyat miskin yang tercakup dalam White Paper tersebut perlu diimbangi dengan langkah-langkah yang akan membuat desentralisasi bekerja, dan memperbaiki tata pemerintahan dalam hal pemberian pelayanan. Akses ke tanah dapat mendorong pengadaan kredit bagi rakyat miskin dan UKM, dan Pemerintah dianjurkan untuk meningkatkan komitmennya yang agak terbatas sehubungan dengan pemberian hak atas tanah yang dinyatakan dalam White Paper tersebut. Akhirnya, rencana-rencana untuk membenahi jaring pengaman sosial Indonesia membutukan konsultasi yang luas demi memastikan bahwa keinginan untuk mewujudkan sebuah masyarakat yang lebih adil diimbangi dengan sasaran Pemerintah untuk menciptakan berbagai lapangan pekerjaan yang lebih produktif.

1

CHAPTER 1: MAINTAINING MACROECONOMIC STABILITY RECENT DEVELOPMENTS Indonesia’s decision to move to a post-program monitoring arrangement with the IMF marks the next phase in the country’s economic recovery. Indonesia is the last of the former crisis countries to graduate from an IMF supported program, and this step was generally welcomed. Over the last few years, the country has regained macroeconomic stability. Although maintaining it will remain a challenge, Indonesia is much better placed to do so than three years ago. Macroeconomic indicators continue to improve and vulnerability is down. Growth, however, remains a modest 3.5-4 percent, and poverty is stuck at 16 percent. An improving international environment may notch this up a bit over the coming year, but investment has yet to revive to levels that would sustain higher growth in the medium term. Maintaining macroeconomic stability remains key to achieve such growth, as is tackling the remaining structural reforms, improving the investment climate, and addressing poor governance. The Economic Reform Package Pre and Post IMF attempts to address these issues. The White Paper, as it is popularly known, lays out an impressive time-bound program of economic reforms to maintain macroeconomic stability, restructure and reform the financial sector, and increase investment, exports, and employment. The challenge now lies in implementation, and in ensuring that individual measures are not only implemented on time, but contribute to the stated goals of the program. Political Developments The political situation remains stable, but electoral politics are expected to intensify in advance of next year’s general elections. Laws on the Presidential Election, Political Parties, and Membership of the DPR and MPR were passed during the year. During the next Parliamentary elections, voters have the possibility to “write in” candidates on party lists. But parties have the right to recall elected representatives if they diverge from party lines. For the first time in Indonesia’s history, the President and Vice President will be directly

elected. Only parties or coalitions that have won 3 percent (in future elections 15 percent) of the Parliamentary seats in the April 2004 can propose candidates for the Presidential elections. The Presidential elections are likely to take two rounds: a first round in July, and if none of the candidates achieves a straight majority, a run-off between the two top candidates in September. Presidential candidates run on one ticket with the Vice Presidential candidates, whom they are required to announce before the first round of elections without the possibility of change after the first round. Some fear that the long election process, which may take up to 6 months, could create uncertainty and slow down political decision making, which in turn may affect Indonesia’s economy. Others point out that campaign spending may actually support the economy. Market Sentiment Market sentiment has remained broadly favorable despite several shocks over the past year (Figure 1.1). Indonesia was less affected by the Iraq crisis in March and the SARS outbreak than neighboring countries. The Marriott bombing in August briefly hit the markets, but they recovered quickly with the Rupiah stabilizing at around Rp. 8,500 and the Jakarta Stock Exchange index reaching a 3-year high in October, on the back of a global recovery in stock markets. The rating agency Moody’s upgraded Indonesia’s rating from B3 to B2 in September followed by Standard and Poor’s from

350 400 450 500 550 600 650 700

Jan-03 Feb Mar May Jun Aug Sep 7600 7800 8000 8200 8400 8600 8800 9000 9200

stock index (1983=100) exchange rate (Rp/$) stock index

exchange rate

Marriott bombing

Source: CEIC.

Figure 1.1. Markets are supportive

2

Table 1.1. Sovereign rating comparison S&P Moody’s

Country Before crisis

Current Before crisis

Current

Indonesia BBB B Baa3 B2 Korea AA- A- A1 A3 Malaysia A+ A- A1 Baa1 Philippines BB+ BB Ba2 Ba1 Thailand A BBB A2 Baa3 Note: investment grades are BBB- for S&P and Baa3 for Moody’s. Source: World Bank staff based on data from S&P and Moody’s .

Table 1.2. Sources of growth comparison in 2002 (1997=100)

IDN KOR MYS PHL THA

GDP 98 124 111 117 105

Private consumption 109 118 112 118 105

Government consumption 112 105 142 108 114

Investment 69 94 65 103 61

Exports 96 184 126 96 148

Imports 70 136 108 94 116

Note: IND- Indonesia, KOR- Korea, MYS- Malaysia, PHL- Philippines, and THA- Thailand. Source: CEIC, staff calculation.

Private consumption accounted for over 80

percent of growth

B- to B. These ratings have gained importance with the Government’s plans to issue a global bond to finance the 2004 budget deficit. Current ratings are still only at the level of early 1998, or 5 notches below investment grade (Table 1.1). The Real Economy Growth is still modest, but the economy performed better than expected. Since the crisis, Indonesia’s growth has by and large relied on consumption, and government consumption in particular. In other former crisis countries, reliance on investment (Korea, Philippines) or exports (Malaysia, Thailand) has been much stronger (Table 1.2). The Bali bombings, SARS, and the Iraq war all had a limited effect on Indonesia’s growth, although it did strongly affect the tourism industry. GDP growth is expected to be in the range of 3.5-4 percent in 2003, slightly short of the Government’s expectation of 4 percent. An improving international environment and further declines in interest rates could support growth in the year ahead, although lagging investment is likely to put limits on GDP expansion in the medium term. Private consumption remains the main source of growth, accounting for 91 percent of GDP growth in 2002 and 83 percent in the first three quarters of 2003. The recent decline in interest rates contributed to higher consumption growth, notably in durables. Bank Indonesia’s retail sales index sharply increased since mid-2003, and motorbike sales and car sales jumped by 32 percent (yoy) and 20 percent (yoy) in Q3 2003. The growth in food consumption has also accelerated since the third quarter of 2002, and may continue to rise with the

likely positive impact of the 2004 election (in the 1999 general election food consumption growth reached an all time high since the crisis at 5 percent). However, private consumption is increasingly fueled by consumer credits: in September 2003 credit-financed consumption reached 31 percent of total, up from 26 percent in the previous year.

Investment is still sluggish at 20 percent of GDP, some 10 percentage points below pre-crisis levels. The composition of Indonesia’s investment has been shifting to property investment, which now takes up almost 80 percent of the total. In contrast, investment in machinery and equipment declined from 23 percent of total in 2000 to 18 percent in the first three quarters of 2003, a trend confirmed by the 50 percent decline in machinery imports shown in the most recent trade statistics. Continued macroeconomic stability could support a revival in investment in the coming year, but without major improvements in the investment climate (Chapter 3) such a rebound is likely to be modest.

3

Figure 1.3. Exports were increasingly driven by foreign firms prior to the crisis

(share of manufacturing output exported, by foreign and domestic firms )

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Domestic Firms

Foreign Firms

Note: Domestic firms have less than 30% foreign ownership. Source: Industrial Census, BPS.

Figure 1.4. Indonesia’s export to China and the world (growth rate)

-30

-20

-10

0

10

20

30

40

50

60

70

2000 2001 2002 2003

yoy growth rate (%)

to China

to World

Note: growth rate for 2003 is for the first quarter (yoy). Source: DOTS IMF.

Exports to China rose by 60 percent in 2003

Indonesia’s export performance has been mixed. Strong export growth in the first quarter of 2003, driven largely by rising commodity prices, slumped in the course of the third quarter. For the first half of 2003, overall exports increased by 11 percent (yoy) to $30 billion, while oil and gas exports, aided by high oil prices in the aftermath of the Iraq conflict, rose by 24 percent. Non-oil exports grew by 8 percent (Figure 1.2), mainly driven by higher exports in palm oil, metal ores, rubber, and copper, which all benefited from a rise in international prices. i The slow growth in manufacturing exports may reflect increased competition from countries such as China and

Vietnam, which compete in the same low-skill labor-intensive products in which Indonesia has a comparative advantage. It also likely reflects the dismal performance in FDI over the years since the onset of the crisis: foreign-invested firms were the main driver for export growth prior to the crisis, but have been losing ground in recent years (Figure 1.3). The real effective exchange rate, which has been appreciating since 2001, may also explain some of the weak export performance such as textile, even though it is still 20 percent below the pre-crisis, a level comparable to other countries in the region. Indonesia took advantage of booming trade with China. Most observers have tended to focus on concerns about growing import competition from China. However, the country is rapidly emerging as a center for regional production networks and a market for exports of intermediate inputs from elsewhere in East Asia . The inputs are assembled in China for export to the rest of the world or for consumption within China. While Indonesia’s exports to the world grew at 3 percent in 2002, its exports to China grew at 32 percent and as much as 60 percent (yoy) in the first half of 2003 (Figure 1.4).

Figure 1. 2 . Non - oil and gas trade growth rate slowed

(year - on - year growth rate)

-60% -40% -20%

0% 20% 40% 60%

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

2001 2002 2003

non-oil exports

non-oil imports

Source: BPS, staff calculation .

4

Figure 1.6. Private capital account turns positive (Private capital flows in the balance of payments)

-10

-8

-6

-4

-2

0

2

4

6

Q197

Q3 Q198

Q3 Q199

Q3 Q100

Q3 Q101

Q3 Q102

Q3 Q103

US$ billion

Source: Bank Indonesia.

Figure 1.5. Inflation further declining (yoy growth rate of CPI)

-5

0

5

10

15

20

Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03

(yoy, %)

overall CPI

food prices

Source: BPS.

Employment, Income and Poverty Modest growth failed to make a dent in unemployment. By February 2003, 8.5 percent of the labor force is out of a job, one percentage point more than the year before. ii Despite unemployment, minimum wages were raised significantly since 2000, when they began re-emerging as a key element of economic and social policy. As a result, their levels in real terms in 2002 were considerably higher than their pre-crisis levels. Low growth and rising formal sector wages are likely to have affected formal sector employment. While industrial workers’ real wages rose by 7.1 percent (yoy) in Q3 2003, rural wages (a proxy for the informal sector) rose by only by 1.6 percent (yoy) in June-August 2003. The trend in minimum wages is starting to change, however: the increase for the Jakarta minimum wage in 2004 was in the order of 6.4 percent, in line with inflation. Achieving higher growth, perhaps 6 percent per annum, would be critical if Indonesia is to absorb the 2-2.5 million new labor market entrants each year. Higher growth would also be critical to further reduce poverty. Macroeconomic stability helped reduce poverty to pre-crisis levels, as prices of key commodities fell; more of the same is unlikely to happen going forward. Moreover, income per capita is still some 10 percent below the pre-crisis levels—20 percent, if measured by the World Bank’s Atlas method. Monetary Policy and Inflation Monetary indicators have continued to improve in 2003. Inflation has shown a remarkable slowdown over the year, mainly on account of a stable exchange rate and well-controlled base money growth. Inflation reached 5.3 percent in November 2003 (yoy) or more than 5 percentage points lower than the same month in 2002 (Figure 1.5). Although inflation may increase later in the year due to seasonal factors, the Government’s revised target of 6 percent is still well within reach. Declining inflation enabled Bank Indonesia to bring down policy interest rates. The SBI 1-month rate stood at 8.5 percent as of mid-November 2003, some four percentage points lower than at end-2002. The decline in the policy rate contributed to lowering domestic interest payments in the state budget, but its impact on the real sector was

limited, as commercial banks’ lending rates remained relatively high. iii International Trade and Payments Indonesia’s balance of payments continued to improve. The current account surplus reached $7.8 billion in 2002, and its trade balance registered a surplus of $23.5 billion. Although Indonesia’s deficit of $15.7 billion on the services account is typical for a developing country, it is under-performing in one promising area: workers’ remittances (Box 1.1). Since the second half of 2002 net private capital has improved markedly. In part this is due to a rise in portfolio investment (Figure 1.6), but private exceptional financing (arrears and write-offs) still play a significant role as well.iv Recorded net FDI also turned positive in

5

Box 1.1. Overseas treasures

As typical of developing countries, Indonesia is a net importer of services (the services balance was in deficit by $15.7 billion in 2002). But it could step up its services exports.

Total workers’ remittances to Indonesia amounted to $1.3 billion in 2002, barely 0.5 percent of GDP. The dollar value of these remittances rose sharply following the financial crisis, but they remain lower than other neighboring countries such as the Philippines where remittances reached $7.2 billion in 2002, or 9.2 percent of GDP. Like many other developing countries, Indonesia holds a comparative advantage in the supply of services delivered through the temporary movement of individuals (so-called Mode 4). Occupational categories in which Indonesian workers enjoy exportable competitive abilities cover a wide range of skill levels —from professions such as nurses, midwives, physiotherapists and accountants, to medium and lower skilled occupations such as construction crew, oil and gas workers, sailors and providers of personal care. Apart from issues of access, which Indonesia could help to solve in WTO’s Doha round, ineffectual protection of overseas workers, and exploitation at home deter more Indonesians from going abroad. As a result, Indonesia is missing out on a relatively stable revenue stream that for many other countries is far larger than aid and export credits combined. If Indonesia would solve these issues much of the hole in the service account could be filled.

Figure 1.7. Fiscal consolidation continues (budget deficit as a percent of GDP)

4.8%

3.7%

2.5%

1.8%

1.2%

1.6%

2.7%

1.7%1.9%

0%

1%

2%

3%

4%

5%

6%

2000 2001 2002 2003 2004

Budgeted

Actual

Revised budget

Source: Ministry of Finance.

the second quarter of 2003, although this is mainly due to technical factors such as definition changes rather than actual resumption of long-term private investment.v External debt outstanding has been stable at around $130 billion, but while government debt outstanding has increased gradually, the private sector has further reduced its external obligations. Short term debt over reserves continued its declining trend, further reducing Indonesia’s vulnerability to external shocks. International reserves topped $34.7 billion by mid-November 2003, $3 billion higher than at end-2002. Reserves are also considerably higher than previously expected, a fact that reinforced the Government’s decision to graduate from the IMF-supported program, and Paris Club rescheduling. Fiscal Policy Fiscal consolidation continues (Figure 1.7). The 2003 state budget is well on its way to achieve the targeted deficit of 1.9 percent of GDP.vi Although the January 2003 decision to postpone fuel price increases almost doubled spending on ill-targeted fuel subsidies, this is likely to be offset by higher oil and gas revenues. Persistent under-spending of development expenditures remains a concern. During the 2003 budget discussion last year, parliament opted for higher development expenditures to stimulate the economy and improve the deteriorating infrastructure which was underfunded during the crisis. As a result, budgeted development expenditures were

increased from 2.8 percent to 3.4 percent of GDP. But actual spending has remained well below budgeted, in part because of continued delays in the release of spending authority to the project management units. The 2004 budget approved by parliament in November demonstrates the government’s commitment to further fiscal consolidation. The budget deficit is projected at 1.2 percent of GDP. Non-oil and gas domestic tax revenues are projected to increase from 11.7 percent in the 2003 budget to 12.3 percent through reforms in tax administration. Such reforms will be critical for fiscal consolidation. On the expenditure side, fuel subsidies are expected to decline substantially,

6

Table 1.3. 2004 Financing needs and CGI disbursement request

US$ billion

1. Gross financing needs (=2+3) 10.5 2. Budget deficit 1/ 2.9 3. Amortization 7.6 o/w domestic 2/ 2.4 o/w external 5.2 4. Sources of financing (=5+6+7+8+9) 10.5 5. Bank financing 3/ 2.2 6. Government bond issuance 4/ 3.8 7. Privatization and IBRA asset sales 1.2 8. Non-CGI foreign financing 5/ 0.5 9. Total CGI financing requested 2.5-3.0 1/ including grants in revenue 2/ scheduled amortization and debt buyback 3/ draw down of deposits 4/ including domestic and external bonds 5/ including export credits Source: staff estimates.

At $2.5-3 billion, the request for CGI

financing is similar to that of last year

from Rp. 24.5 trillion in the revised 2003 budget to Rp. 14.5 trillion. This is wholly on the account of lower international oil prices, as there is no plan to resume the fuel price mechanism at the moment. Although higher than projected oil prices ($22/bbl) will lead to higher fuel subsidies, a $1 increase in oil prices would have a net positive impact by roughly Rp.1.5 trillion. A 1 percent increase in oil production would benefit the budget roughly Rp. 0.5 trillion. Fiscal consolidation is tightly linked to macroeconomic stability. Domestic interest payments are likely to decline in 2004 on account of lower domestic interest rates, which in turn depend on inflation and perceived risks. A 1 percent decline in SBI interest rate roughly reduces domestic interest payments by Rp. 2 trillion or 0.1 percent of GDP. External debt interest payments are less affected by changes in international interest rates, as around 70 percent of external government borrowing has a fixed rate. In contrast, a weakening of the Rupiah still has a small positive impact on the deficit. The Government made significant progress in debt management. Public debt as a share of GDP continues to decline and is projected to reach 67 percent in end-2003, almost half of this is domestic. But the Government’s financing needs will sharply rise in 2004, and developing the domestic bonds market is therefore crucial for fiscal sustainability. Successful auctions and buybacks in 2003 are therefore encouraging. vii External Financing Needs in 2004 Despite a lower deficit, the Government’s financing needs will be larger in 2004 than the year before. First, amortization is some $2.6 billion higher than in 2003. And second, Paris Club rescheduling, which contributed some $3 billion to financing in 2003, is no longer available. Therefore, the government has to raise $10.5 billion from various financing sources. The Government is increasingly relying on domestic sources for financing. The approved budget projects to raise some $2.2 billion from domestic bank financing, and almost $3.8 billion from bonds issue (sum of domestic and external). The remaining assets of IBRA, and privatization,

should raise another $1.2 billion. Foreign financing remains necessary, however, not least to limit pressures on the balance of payments and the currency. Other non-CGI sources, such as export credits, could finance in the order of $0.5 billion. This would imply a financing need from the CGI of about $2.8 billion. Given the uncertainty that usually surrounds these numbers, the projected amount being requested from the CGI is in the range of $2.5-3.0 billion (Table 1.3), around the same order of magnitude as last year. Medium-Term Macroeconomic Outlook GDP growth is likely to accelerate in the coming years. On the back of a projected international recovery, and assuming absence of major disturbances in the run-up to next year’s election, growth is 3.5-4 percent in 2003 to 5 percent in 2006 in the base case scenario (Figure 1.8). The

7

Table 1.4. International comparison of major indicators upon IMF graduation 1/

Country Last purchase Credit rating (S&P)

Real GDP growth rate

Inflation rate Budget balance (% of GDP)

Indonesia Dec 2003 B (current) 3.5-4 6.5 -1.9 Korea May 1999 BBB 10.9 0.8 5.8 Thailand June 1999 BBB- 4.4 0.3 6.7 Brazil Dec 1999 B+ 0.8 8.9 5.0 Mexico Dec 1995 BB -6.2 35.0 -0.2 1/ Indicators are at year of graduation; Indonesia’s economic figures are the World Bank’s estimates. Source: World Bank staff.

base case scenario assumes continued macroeconomic stability, and a gradual improvement in the investment climate. The external environment is expected to be favorable—the World Bank’s Global Development Prospects 2004 projects world GDP growth to accelerate from 1.9 percent in 2002 to 2.9-3.0 percent in 2004-05, and world trade volume growth to increase from 3 percent in 2002 to 7.9 percent in 2004-2005. The Government’s growth projection of 4.8 percent for 2004 lies within the range of the possible, albeit at the higher end of it. In this scenario, growth will increasingly be driven by investment rather than consumption. Increasing Indonesia’s investment to GDP ratio is key to the medium term growth prospects of the country, but it will not be easy to achieve. The saving rate declined to just above 20 percent in 2002 from well over 30 percent in the pre-crisis period (although arguably the pre-crisis level may not have been sustainable). In addition, the increase in external debt service pressures in the coming years means less financial resources for investment. Indonesia’s external debt service is projected to increase from US$20 billion in 2003 to US$23 billion in 2004. It is therefore critical that Indonesia attracts new foreign savings to satisfy its investment needs by improving its investment climate. Stronger reforms could lead to higher growth. Continued macroeconomic stability, a rapidly improving investment climate (Chapter 3), and better investment decisions by a stronger financial sector (Chapter 2) would lead to higher and more productive investments that would accelerate growth. The World Bank foresees that growth in such a reformist scenario could reach 6 percent by 2006. Many of the needed reforms are included in the Government’s own Economic Policy Package Pre-and Post IMF. Performance on this package is

therefore crucial for higher growth. THE WHITE PAPER The Government’s decision not to renew its IMF supported program was made in August 2003. This followed a 2002 MPR decree and an examination of the options the Government had after the expiration of the Extended Fund Facility in end-2003. The decision was broadly welcomed by the markets and the international community, and is warranted by the strong improvements in the country’s macroeconomic conditions in recent years and the achievement of external viability. Indonesia’s macroeconomic indicators are now broadly similar to those of other countries at the time of graduation (Table 1.4). Indonesia’s collaboration with the IMF will continue through the post-program monitoring, a mechanism that allows for regular discussions between authorities and IMF on key policy issues. The Government’s “Economic Policy Package Pre and Post IMF” or White Paper was issued on September 15th as a presidential instruction (Inpres No.5/2003). A separate instruction of the

Figure 1.8. Medium-term growth projection

3.0%

4.0%

5.0%

6.0%

7.0%

2002 2003 2004 2005 2006 2007

Percent

Base Case Scenario

High Case Scenario

Source: staff estimates.

8

Governor of the central bank regarding monetary policy, and other measures within the competency of Bank Indonesia was issued at the same time. The objective of the new package is threefold: (i) maintaining macroeconomic stability, (ii) restructuring and reforming the financial sector, and (iii) increasing investment, exports, and employment. The document came about in a round of consultations with a variety of stakeholders. The Government set up a monitoring team in the Coordinating Ministry for the Economy. The team is responsible not only for monitoring but also for prioritizing issues. The Coordinating Minister for the Economy every month reports the progress and prioritized issues to the President and relevant Ministers at a policy level. The Chairman of the monitoring team calls for follow-up meetings at the technical level. The private sector has also emerged as an independent monitoring body for the implementation of the White Paper, and academic groups plan to establish the same mechanism. In the end the success of the Economic Policy Package will depend on its implementation, and the Government will face several challenges in doing so. First, the sheer number of measures is large, and keeping these on track will require careful monitoring and management of the agenda. Second, the individual measures are clearly of different orders of priority. Some have major importance, such as new investment approval legislation and changes in the decentralization laws to reduce policy uncertainty. Others are minor measures that came in on the behest of a ministry or agency in the (wrong) understanding that inclusion in the White Paper would guarantee additional resources. Prioritizing among the measures is therefore crucial. Third, several of the policy actions included could be good or bad, depending on the substance of the measures, which the White Paper does not describe in detail. For instance, the quality of a Trade Law or a Law on Small and Medium Enterprises will

depend on their contents. Ensuring that the individual measures indeed contribute to the stated goals of the White Paper will require vigilance on the part of the monitoring team, especially in the run-up to the elections. This holds equally for measures not included in the White Paper, but that could derail those proposed for, which could undermine Indonesia’s prospects for employment creation. Initial progress in implementing the policy package is promising. The White Paper contains over a hundred actions to be undertaken over the next 18 months. Of the 43 action plans with a deadline in end-September 2003, the government completed 36 action plans on time. Further progress was achieved in October. All the remaining action plans not completed in September were done in October. Of the 54 action plans in October, the Government completed 37 on time. In addition, the Government completed 3 action plans ahead of schedule. Maintaining Macroeconomic Stability The objective of the White Paper’s macroeconomic package is to maintain macroeconomic stability over the medium term. This complements the measures included in the Instructions of the Governor of Bank Indonesia that aims to continue the prudent monetary policy of recent years. To maintain stability, the government has set the following direction for fiscal policy: • Reduce the budget deficit gradually to

achieve a balanced position over the period 2005-2006;

• Reduce the stock of government debt to GDP to a safe position;

• Reform and modernize the national tax system to create a reliable revenue source;

• Increase the efficiency of government expenditures;

• Develop an effective debt management system.

9

Table 1.5. Macroeconomic stability measures in the White Paper

Action Plans Outputs Date

• Increase tax revenues, competitiveness and improve the investment climate by simplifying the tax structure and rates comparable to best practice countries

Draft of amendment of tax law

Dec 2003

• Broaden the tax base Add 60 thousand individual tax payers and 50 thousand companies

Dec 2003

• Deliberate the Draft Law on State Treasury Operation Treasury Law After law passed

• Reorganize the Ministry of Finance by splitting the budget and treasury function

Presidential Decree Mar 2004

• Continue policy to limit regional borrowing in 2004 consistent with Law No.17/2003 and Government Regulation No.23/2003

Ministerial Decree 2004

• Move the State Debt Management Office (PMON) to the Treasury Operations, consistent with MOF reorganization

Presidential Decree Mar 2004

• Optimize control of the money supply through SBI auctions and money market instrument and other monetary policies

Board of Governor Decision

On-going

• Foreign exchange sterilization / intervention to reduce Rupiah exchange rate volatility

Board of Governor Decision

On-going

• Maintain a safe current account balance with increasing support from non-oil and gas exports, tourism, overseas worker remittances

Increased non-oil and gas exports

2004-2006

• Maintain adequate foreign exchange reserves to cover imports and official foreign debt service payments

- On-going

Source: World Bank staff based on Presidential instruction No. 5/2003.

The White Paper contains appropriate policies to maintain macroeconomic stability—including maintaining a low inflation rate, a realistic exchange rate, and sufficient foreign exchange reserves. It also pushes the reforms to their next phase by focusing on building critical institutions and systems (tax administration and customs, debt management unit), establishing procedures for checks and balances (government procurement, treasury, accounting standards), and strengthening the regulatory framework to improve public expenditure management and the fiscal decentralization system (Table 1.5). Such reforms would provide a much stronger and more sustainable foundation for fiscal consolidation. The government now has a proven record in adequately managing macroeconomic policies, although with the IMF exit and the elections the economic and political environment ahead is more challenging. Implementation of the deeper institutional reforms—including tax administration, customs administration, and public expenditure management—would provide a

stronger basis for fiscal consolidation in the years to come. Tax Reform The objective of the tax policy reforms in the White Paper is to create a sound and competitive tax system that encourages investment in Indonesia and is comparable to best-practice countries. Indonesia’s tax system is sound—it has in place a modern value added tax (VAT) and income tax, it relies little on import duties, and it has a balanced reliance on income and consumption taxes. But Indonesia’s non-oil and gas tax revenue to GDP is relatively low at about 13 percent in the 2004 budget. Indonesia still relies on oil and gas revenues, which account for about 20 percent of total revenue, but these are subject to fluctuations depending on oil prices. Strengthening the tax system—mainly through improved tax administration but also through tax policy—would solidify fiscal consolidation, given that a large part of the government’s expenditures are non-

10

discretionary. For that, the tax system can be further simplified and its economic efficiency improved. Tax Administration Reform Tax administration in Indonesia is weak. Not only is enforcement poor and collection low, but corruption in the tax administration is widespread. The coverage ratio (revenue collected/revenue potential) is slowly rising, but it remains low at around 75 percent in 2002. Moreover, weak implementation of tax policy, such as VAT rebates, undermines the efficiency of the tax system and adds a burden to taxpayers. The various action plans in the White Paper aimed at improving tax administration are in line with a major reform program in tax administration recently carried out by the Directorate General of Taxation (DGT), which includes: (i) an annual revenue generation program aimed

at increasing tax collection in the short term through closer monitoring and enforcement;

(ii) a preliminary set of structural reforms designed to create a foundation for strengthening the operations of the DGT; and

(iii) a comprehensive modernization program. DGT continues to make strong progress in implementing its reform agenda. However, the revenue generation initiative is not likely to fully achieve tax revenue targets for 2003. Further actions need to be taken, including the expansion of the large taxpayers offices (LTOs), extending the DGT’s governance framework to tax offices beyond LTOs; implementing a strategy for administering small and medium taxpayers on a pilot basis; enhancing the flow of information between the budget and tax authorities; and simplifying refund and audit procedures. In particular, the VAT refund mechanism critically needs to improve as it is especially important for exporters. For that, it would be important to allow DGT not to automatically audit all claimants; reimburse interest on the refund; discontinue blanket requirements for all refund claimants to submit all original invoices and the DGT to examine each invoice; accelerate the introduction of modern procedures for auditing refunds and making payments.

Public Expenditure Management The White Paper contains several policy actions to increase the efficiency of government expenditure. These include reorganization of the Ministry of Finance by splitting the budget and treasury functions, increase the efficiency and transparency of government procurement, develop a new classification of government expenditures consistent with international practice, and gear up for performance-based budgeting. Indonesia has now established the conditions from which to implement fundamental public expenditure management reforms. The passing of the State Finances Law (No. 17/2003) and the release of the MOF restructuring blueprint provide an organizational and legal launching pad which to tackle public expenditure management reforms. The amount of effort shown in the past year from the Financial Management Reform Committee is most impressive. The action plans to improve public expenditure management have different levels of implementation difficulty and priority. The complexity of introducing a new expenditure classification (from sectoral to functional) should not be underestimated; and more time may be needed for its implementation (a draft classification is proposed for December 2003). Similarly, transition to a medium term expenditure framework and more performance-oriented system needs to be carefully-staged. There are a number of difficult conceptual challenges in moving towards performance-oriented budgeting, not the least defining clearly what is meant by “performance”. Nevertheless, pushing budget processes in this direction for the next budget round is a worthy goal, as long as it is understood these reforms are likely to take several years to take hold. The authorities’ decision to reorganize the MOF and create a new directorate general of Treasury in the near future is expected to accelerate the ongoing reforms in PEM. Key reforms awaiting implementation at the DG Treasury on its creation are: a comprehensive overhaul of the obsolete government payment and receipt systems; a consolidation of the government cash resources currently held in thousands of bank accounts; a

11

The richest local government had 32 times more revenues than the poorest one

transition in measured steps to an accrual based government accounting and reporting system; and above all enhancing the internal control framework and transparency of government treasury operations. In addit ion to measures spelled out in the White Paper to increase the efficiency of government expenditure, it is important for the maintenance of macroeconomic control that the scope of entities covered in the state budget and their fiscal risks be expanded, and the information presented to Parliament be progressively enhanced to include a medium-term fiscal position. Moreover, decentralization of services to lower government levels does not remove the central government’s responsibility for general government fiscal management, and there remains a need for coordination of fiscal policy across government levels. Decentralization The White Paper commits the government to revising the key decentralization laws; Law 22/1999 and Law 25/1999, by September 2004; and Law 34/2000 on Regional Revenue by June 2004. The revisions, if well coordinated, can be an important factor in securing the medium- to long-term success of decentralization. Regional autonomy is now more firmly embedded in the country’s constitution. But the rapid decentralization and its hasty preparation have left much unfinished business. Some remaining issues could undermine the potential efficiency gains of decentralization and even trigger fiscal imbalances and macroeconomic instability in the longer run. Among the key issues that the actions in the White Paper should address are:

(i) Clarify principles of functional assignments across levels of government (Law 22). The intergovernmental fiscal system needs to be, first and foremost, based on expenditure responsibilities, which are unclear at the moment.

(ii) Firmly embed the principles on which the distribution of transfers should be based, and clarify the institutional arrangements, thereby creating a greater degree of transparency and certainty in the allocation of resources. Over time, the transitional elements in the DAU could then be phased out, and its equalizing function strengthened. Current inequalities are unacceptably high: in 2002, the richest local government had 32 times the revenues per capita of the poorest one (Figure 1.9). At the same time, the role of the DAK could be expanded, particularly to assist poorer regions in priority areas.

(iii) Expand the regions’ revenue raising authority, while banning nuisance taxes by transferring control over more significant taxes (such as the Land and Building Tax) to local governments. The proliferation of nuisance taxes (see Chapter 3) shows that local governments are looking for ways to boost their locally raised revenues. An expanded, but closed, list of local taxes would help curb this trend. Supervision of local regulations—on tax and others—should be strengthened in tandem.

The revisions of Law 22 and 25 are ongoing, and are scheduled to be completed by the end of 2003. However, it is not clear whether this target is realistic. Law 34 was scheduled to be revised in parallel, but the MOF has not yet received a presidential instruction to prepare a revised draft. The White Paper sets a measure to improve regional government accounting systems in line with State Finances Law (No. 17/2003). All matters related to financial management, including accounting standards and systems, would thus be governed by the State Finances Law and the forthcoming Treasury Law, as well as their respective implementing regulations. Implementation of this measure would help remove the confusion created recently when the Ministry of Home Affairs issued a decree

12

Figure: 1.10. Government debt is further declining (Debt as a percent of GDP)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2001 2002 2003 2004 2005 2006 2007

Actual Projection under the Base Case Scenario

Source: staff estimates.

(Kepmendagri 29/2002) which introduces new guidelines on regional financial management, including a new budget structure based on performance budgeting. This overlaps with the State Finances Law which stipulates that regional budgets have to be based on the accounting standards to be issued by the Central and Regional Accounting Standards Committee. As a result, 56 percent of regions are using the new format for their 2003 budgets, based on the MoHA Decree 29, creating difficulties for the MOF to capture regional budget information in a consistent manner. Implementation of the White Paper measure would help put in place a consistent framework to ensure adequate fiscal monitoring. State Debt Management Although the Government’s debt is projected to decline further (Figure 1.10) its level is still high, and prudent debt management remains of paramount importance. The White Paper proposes two measures to consolidate state debt management. First, continue to limit regional borrowing in 2004. In the proposed measure, the MOF will issue a decree explicitly banning regional governments from taking out loans, except through the central government. This

measure would provide another year for the government to work out the regional borrowing framework, strengthen local government fiscal capacity, and put in place a local fiscal monitoring system. There also needs to be an inventory of all liabilities of sub-national (including municipal) governments and quasi-governmental entities owned and operated by them, in order to get a handle on emerging (quasi) fiscal risks. Second, move the state debt management office (PMON) to the Treasury Operations, consistent

Figure 1.9. Inequality among local governments (per capita local government revenue in Rp. thousand, consolidated per province, 2002)

0 500 1000 1500 2000 2500 3000 3500

Kalimantan Timur

Nanggroe Aceh

Maluku

Sumatra Barat

Sulawesi Tengah

Gorontalo

Bengkulu

Yogyakarta

Jawa Timur

BantenCarry-OverOwn Source RevenueBorrowingOtherTax Shared RevenueNon-Tax Shared RevenueDAUDAK

Source: Staff estimates based on information from MOF.

13

with MOF reorganization. The proposed consolidation of the public debt management functions under a newly established Treasury Department in the MOF is an essential first step towards comprehensive public debt management. Care should be taken to establish formal and frequent channels of interaction between the other entities that will be involved in domestic and foreign public debt related transactions (such as Bank Indonesia and the Ministry in-charge of monitoring State owned enterprises). Moreover, measures need to be taken to ensure adequate debt management. International good practice calls for the consolidation of authority within the Government Debt Management Offices, with a clear separation from fiscal and especially from monetary policy; sound organizational structures allowing internal control; better information systems; and more technical staff. In Indonesia, two key legislations need to be made consistent (i.e. the Government Bond Law 2002, and the draft External Debt Law) so as to make comprehensive public debt management in the Indonesian government possible. Public debt management under the Treasury Department is likely to mitigate operation risks, since policies and managements are expected to be conducted in the department. Apart from manage sub-national and SOEs debt, the challenge for the department is (i) handling market risks such as interest rate risks, liquidity and refinancing risks, and exchange rate risks, and (ii) developing secondary government bond markets. The measures in the White Paper give confidence macroeconomic stability will be maintained in the year ahead. But accelerating growth and creating jobs requires more: (i) a financial sector that efficiently and safely intermediates between savers and investors is crucial for financing growth without the risks that triggered Indonesia’s past financial crisis; (ii) an investment climate that entices levels of investment significantly higher than the current 20 percent of GDP; and (iii) policies that ensure that all Indonesians benefit from higher growth. The White Paper contains measures in each of these areas, and it is to those this report now turns.

i US dollar prices for non-oil primary commodities rose 5 percent in 2002 and are expected to increase another 7 percent in 2003, after having slumped a cumulative 33 percent during 1997-2001. ii These figures are based on the latest quarterly labor statistics in February 2003. The sample household number (15k thousands) is less than Sakernas (Annual Survey). The annual survey shows the unemployment rate increased from 8.1 percent in 2001 to 9.1 percent in 2002. iii Working capital lending rate declined less than 2 percent during the first eight months of 2003. Overall loan outstanding grew by 21 percent in September (yoy), but consumer credits outstanding grew faster at 34 percent (yoy). The surge in consumer credits supported strong private consumption of durable goods, but households are accumulating debt. iv Exceptional financing is the gap between actual payment and scheduled payment, and includes debt rescheduling, write-off and accumulation of arrears. v To be consistent with IMF BOP manual version 5, privatization and IBRA asset sales purchased by foreign entities are now included in FDI. Thus, international sales of Indosat and several IBRA banks was now counted as FDI. vi The original target was 1.8 percent. While the deficit did not increase, nominal GDP turned out lower. vii In April 2003, the government auctioned Rp. 2.7 trillion of bonds in the domestic market, with a coupon interest rate of 12 percent and an 8-year maturity. MOF also arranged for a successful debt buy-back falling due in 2004 and 2005 in August. This was followed by a less successful treasury bonds auction in October, but the November auction again became a success, albeit at a yield that was higher than in April, following the international trend towards higher yields.

14

15

Table 2.1. Indonesian financial sector in 2002 Assets

(Rp. trillion) Share

(percent) No. of

institutions Banking 1,099 88.9 2,261 Commercial bank 1,089 88.2 138 BPR 9 0.8 2,123 Insurance 62 5.0 169 Life insurance 21 1.7 58 General insurance 15 1.2 102

Social Insurance 26 2.1 5 Reinsurance 1 0.1 4 Pensions 37 3.0 331 Employer Pension 33 2.7 307 State-owned 26 2.1 71 Private 8 0.6 236 Financial Institution 3 0.3 24 Multi-Finance 28 2.3 116 Securities firms 8 0.6 171 Pawn shop (pegadaian)

2 0.2 1

TOTAL 1,273 100.0 3,380

Source: Infobank Magazine (August 2003), ADB, Bank Indonesia, Investor Magazine (July 2003).

The banking sector accounts for around

90 percent of financial assets

CHAPTER 2: RESTRUCTURING AND REFORMING THE FINANCIAL SECTOR

The health of Indonesia’s financial sector has improved significantly since the 1997-98 crisis. Progress has been made in restructuring and strengthening the banking sector. IBRA has sold several banks taken over during the crisis, largely to foreign investors. The Government has begun reducing its stake in state-owned banks. Banks have reduced their non-performing loans and increased their capital-adequacy ratios. And regulation and supervision of the financial sector is now better than before. However, recent events such as large banking frauds and volatility in the mutual funds emphasizes that much remains to be done to satisfactorily restore its function as a sound intermediary and financier of growth in Indonesia. The key issue facing the sector is to move from a crisis management mode to a longer-term development mode. This requires first and foremost finishing the agenda of restructuring the banking sector and creating an appropriate financial sector safety net. Second, it requires increasing the role of non-bank financial institutions in the sector, as they are better suited for development finance, and more eager to buy government bonds. The White Paper measures go a long way in addressing the banking sector agenda. The Government needs to go beyond the White Paper measures to lay a solid basis for the further development of Indonesia’s non-bank financial institutions. RECENT DEVELOPMENTS Indonesia’s economy traditionally relied predominantly on the banking sector to finance growth. The banking sector still accounts for around 90 percent of financial system assets (Table 2.1). In order to finance higher levels of growth that the Government expects to achieve, credits from the banking sector would need to grow substantially. i Can the banking sector deliver such growth in a sustainable and a prudent manner? With state-owned banks still comprising half of Indonesia’s banking sector, and weak internal controls and governance difficulties already manifesting themselves at two banks, it will be a

challenge to ensure that the banks operate on strictly commercial principles, while delivering high rates of credit growth. Diversifying sources of finance is an important element of reducing the vulnerability of the economy as well as strengthening the financial sector. Capital markets, non-bank financial institutions, and institutional investors such as pension funds and insurance companies need to be strengthened to ensure that they mobilize and efficiently invest long-term domestic resources.

16

Improved Performance of the Banking Sector Key indicators of the Indonesian banking system have drastically improved since the crisis, and are now at par with other East Asian countries (Figure 2.1). But the numbers alone hide some of the underlying weaknesses of the sector. Loan quality has been improving due to the on-going loan restructuring in the Indonesian banking

sector. As of mid-2003, the non-performing loan (NPL) ratio stood at 7 percent, down from 12 percent a year ago. However, some banks reduced their NPLs by converting them into shares of unlisted and often financially distressed companies. While allowed by central bank regulations, such practice raises concern whether these banks can recover much on these converted loans in the future. Furthermore, some banks simply extended the tenor of overdue loans, rather

Figure 2.1. Key financial indicators of banking system have improved

0 10 20 30 40 50 60

Thailand

Philippines

Malaysia

Korea

Indonesia Dec 1998 Dec 1999

June 2003

Dec 1999 June 2003

NPLs in commercial banks percent of total

percent

Dec 1998

1997 1998 1999 2000 2001 2002 2003 -10

-8 -6 -4 -2 0 2 4 6 8

Indonesia

Philippines

Thailand Korea

Malaysia

percent

Interest margins of banks percent

1997 1998 1999 2000 2001 2002 2003 -20 -18 -16 -14 -12 -10

-8 -6 -4 -2 0 2 4

percent

Malaysia

Indonesia

Thailand

Korea

Philippines

Profitability of the banking system

rates of return

Capital adequacy ratios of the banking system

1997 1998 1999 2000 2001 2002 2003 -20

-10

0

10

20

percent

Indonesia

Thailand Korea

Malaysia

Philippines

Source: World Bank. East Asia Update: Progress in Financial and Corporate Restructuring, November 2003.

17

The Capital Adequacy Ratio of banks

reached 23 percent

than restructuring them based on commercial viability of the borrower. Many of these loans could return to problem status in the future. The decline in the NPL ratio also reflects the rapid growth of new loans, the quality of which will only become evident over time. Banks have rapidly expanded lending on a gross basis since 2002, in particular in consumer credit. New bank loans amounted to Rp. 80 trillion in 2002, an increase of 40 percent over the previous year. As of August 2003, new loans had reached Rp. 50 trillion or a similar level compared with the same period in 2002. Banks have improved their profitability on the back of increased spreads. The decline in deposit rates, and hence funding costs, was not matched by a similar decline in lending rates (Figure 2.2). Hence interest margins—and profit margins—increased in 2002 through the first half of 2003. Reflecting this, rates of return to assets and equity also showed continued improvement in 2002 and the first half of 2003. Banks have also reduced their reliance on government bonds for profits. Government bonds currently account for 30 percent of total bank assets, compared to 36 percent a year ago. The proportion of banks’ income from interest on government bonds declined to 17 percent of total income, compared to 22 percent a year ago. Apart from the Government’s repayment of bonds due, much of this decline can be ascribed to the shift of recapitalization bonds from banks’ balance sheets into mutual funds. Recent changes in regulations

governing mutual funds, and ongoing significant redemptions by mutual fund investors could reverse this trend. Higher profits, combined with recent bonds issues of some banks allowed the banks to restore their capital base. The capital adequacy ratio (CAR) of the banking system as a whole reached 23 percent in June 2003, indicating that for the banking system as a whole capital positions are adequate to support loan growth in the short-term. However, the large volume of government debt, many restructured loans in bank portfolios, and the existing off-balance sheet commitments to future lending suggest that these CAR figures overstate the robustness of the system. In addition, several banks have bought NPLs from IBRA in recent auctions, against which they may have to provision in the future. To sustain higher rates of credit growth, banks will have to further strengthen their capital positions. Risk management remains an issue in most banks, both with respect to assessment of credit risk and management of operational risk. Weak credit assessment skills as well as the unwillingness to take on fresh credit risks partly explain the current situation where many banks are still holding excessive liquid assets, usually in the forms of SBI (Bank Indonesia’s short-term certificates) and interbank loans, and are unwilling to make fresh commercial loans. Excessive liquidity is also created due to the fact that most of the deposits in the banking sector are short term. Around 66 percent of time deposits are of 1-month duration and 17 percent are of 3-month duration. With such a short funding duration, banks are unwilling to provide much-needed long-term financing as it would lead to significant asset-liability duration mismatches. Banks also face constraints on the overall quality of human resources. In areas such as credit origination, risk management, and technology, human resources are particularly weak, and institutions and programs to provide the

Figure 2.2. Interest rate spreads are on the rise (percentage difference between deposit and lending

rate)

0

2

4

6

8

10

12

Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03

Consumption

Working Capital

Investment

Percentage

Source: Bank Indonesia.

18

IBRA is on track to meet its budget

contribution of Rp. 26 trillion

necessary skills are important for the overall development of the sector. Bank Indonesia’s regulations have been significantly upgraded over the years and are now broadly in line with international norms. However, the key issue remains one of consistent supervision and enforcement, especially with regard to state-owned banks. Some important recent regulations (i) limit banks ability to buy loans from IBRA; (ii) require banks to include market risk in calculation of capital adequacy ratio; (iii) limit banks equity investment in financial institutions; (iv) rule BI’s short-term lending; and (v) set risk management requirements in banks. Bank Indonesia recently commissioned a study of banking architecture (or banking landscape) to develop a vision for the future of the banking sector, based on six “pillars”: effective regulatory system; sound banking structure; strengthening internal conditions of banks; independent and effective supervisory system; reinforcement of supporting infrastructure; and protection and empowerment of customers. The study is expected to form the basis for detailed planning for each of the six pillars. Implementation is expected from 2004 to 2014. IBRA is Ready to Close IBRA’s five-year mandate is to end in February 2004 and the Government has announced that it will be closed on schedule. IBRA has already been gradually moving into a closure mode this year while continuing its various asset disposal initiatives. IBRA is on track to meet its full-year 2003 budget contribution of Rp. 26 trillion. Until September 2003, it had collected cash and bonds amounting to Rp. 15.2 trillion. But it is likely that IBRA will continue to hold some assets as of its scheduled closing date. The Government has

approved IBRA’s proposal to establish holding companies to house these residual assets for eventual return to the private sector and to resolve the legal claims. Closing IBRA on schedule would signal a clear break from the crisis, and can be positive. However, the Government should ensure that some of IBRA’s major responsibilities in the banking sector are to be transferred to other institutions and these are satisfactorily implemented. IBRA currently administers the deposit guarantee scheme and handles resolution of troubled banks. The Government has already planned to establish a deposit insurance corporation (LPS) to assume these functions. A draft law on LPS has been submitted to parliament. The Government intends to establish a new unit in the Ministry of Finance to take over IBRA’s deposit insurance role in the transition to the LPS. The White Paper includes several other measures that together would constitute the country’s financial safety net. Capital Markets and Mutual Funds Indonesian equity markets have been one of the best performing equity markets in the world this year. The Jakarta Stock Exchange index was up almost 43 percent in Rupiah terms and over 50 percent in US dollar terms year-to-date (as of Nov. 17, 2003). IPOs of Bank Mandiri and BRI have added considerably to market capitalization, which stood at about $30 billion as of end 2002. Government and corporate bonds have been trading in over-the-counter markets and in the Surabaya Stock Exchange. Recent developments in mutual funds are worrisome. Mutual funds have recently increased enormously in size (Figure 2.3). Some recapitalized banks in cooperation with fund managers have created mutual funds, whose underlying asset is government (recapitalized) bonds. These mutual funds buy recap bonds from the recapitalized banks, create an underlying pool of assets, and sell claims on them to the public in the form of mutual fund shares. Under the current tax regulation, returns from mutual funds are tax-exempt for the first five years. With this year’s significant decline in interest rates on banks time deposits, these mutual funds became attractive as a

19

substitute, and the proportion of time deposits in total banks deposits declined. Since October 2003, mutual funds have witnessed rapid redemptions. Almost Rp. 6 trillion worth of funds were withdrawn from mutual funds in October alone and the trend is expected to continue. While some of the redemptions could be driven by liquidity requirements, a more likely reason is the fear caused by recent clarifications issued by Bapepam that these funds are not covered under the blanket guarantee. Some banks are bringing recapitalization bonds previously put into mutual funds back on to their own books. Thus far, these sizeable redemptions have not caused stress to the system, but close monitoring by the Government is needed to ensure no liquidity problems for banks. THE WHITE PAPER: RESTRUCTURING AND REFORMING THE FINANCIAL SECTOR The White Paper aims at restructuring and reforming the financial sector. Specific proposed actions include (see also Table 2.2): • establishment of a financial sector safety net,

including creation of a deposit insurance corporation, establishment of a lender of last resort facility at Bank Indonesia, and establishment of a financial services authority (OJK);

• continuation of the bank restructuring program, including improving the health of the banking sector and strengthening state bank governance;

• tightening the oversight of money laundering activities;

• improving capital market supervision; • consolidation of insurance and pension

industries. The White Paper also addresses issues relating to improving the performance and governance of state-owned enterprises and advancement in the development of public accounting. The Government’s commitments in the White Paper, if implemented, are steps in the right direction to strengthen the financial sector. It is an ambitious agenda, though uneven in terms of emphasis across the segments of the financial sector. It is also far less specific in terms of timing than some of the other measures in the White Paper, largely because many actions hinge on parliamentary approval of legislation. In the near future, measures proposed in the White Paper will need to be complemented more forcefully with efforts to put more public banks in the hands of the private sector, diversify the sources of financing in the economy by further developing the capital market, develop sound institutional investors such as insurance and pension funds that can mobilize long-term domestic resources and allocate them efficiently, and improve corporate governance so as to reduce risk premiums associated with corporate lending and allow increased lending under prudential regulations. Financial Sector Safety Net and Financial Stability As scheduled in the White Paper, the Government has prepared the financial safety net (FSN) concept note and submitted to parliament the draft deposit insurance (LPS) law as well as relevant amendments to BI law with respect to the lender of last resort function. Once these laws are approved, the next steps involving establishment of the LPS and phased reduction in the current blanket guarantee can be implemented. The Government has also submitted to parliament the draft OJK law which, upon approval, will permit the creation of a unified financial regulatory authority. The Government has also proposed several steps to foster financial sector stability. A key component of this effort—the development of a forward-

Figure 2.3. Mutual funds have soared

0

20

40

60

80

100

120

140

160

180

200

1996 1998 2000 2002 Jan-03 Mar-03 May-03 Jul-03 Sep-030

10

20

30

40

50

60

70

80

90

100Number of funds (LHS)

Net asset value (RHS)

Rp.trillion

Source: Bapepam.

20

Table 2.2. Financial sector measures in the White Paper

Action Plans Output Date

• Prepare for the establishment of a Financial Services Authority (OJK).

OJK blueprint and work plan

After OJK law passed

• Conduct surveillance on financial institutions, markets, and infrastructure as well as foster market discipline.

Financial stability review Regular basis (every

semester) • Prepare for the bank action plans. Risk management action

plans by public banks April 2004

• Divest IBRA majority shares (after parliament approval) in Bank Lippo, BII and Bank Permata.

Budge revenues Better banking sector

Nov 2003/ Nov 2003/ Feb

2004 • Strengthen the governance structure of state-owned banks

(Bank Mandiri, Bank BNI, Bank BRI and Bank BTN). Various outputs Sep 2003- Dec

2004 • Amend Law No.15/2002 on Money Laundering. Amend Law No.15/2002 Done • Finalize paper on mutual fund grand strategy. Final concept Dec 2003 • Reorganize Bappepam in line with MOF reorganization. Presidential decree Mar 2004

Source: World Bank staff based on Presidential instruction No.5/2003.

looking blueprint for the Indonesian banking architecture report—has been finalized and awaits implementation. Overall, the Government is broadly on track with its own implementation schedule for actions in the FSN area. The set of actions proposed are also fairly comprehensive and address key issues. The main concern is one of implementation capacity and transition arrangements. Once the LPS law is passed, the phase out of the blanket guarantee will have to be done with great care to ensure that market confidence is not adversely affected at any step of the process. Transition issues also exist for the OJK. There is uncertainty regarding the extent of OJK’s supervisory mandate (for example, whether it would include bank supervision). A clear stand on this issue by the Government would help market confidence. Some key issues that need to be addressed in the context of establishing the FSN have not been touched upon in the White Paper: (i) establish a formal coordinating mechanism between BI, MOF, LPS, and OJK regarding provision of support to and intervention of banks that may need assistance in future; (ii) explicitly provide prompt corrective action to intervene and close financial institutions without political interference (in the past, corrective action has not forced banks to deal promptly with problems, raise new capital, or close); (iii) ensure that each of the public

institutions involved in the safety net has the necessary capacity to undertake its assigned functions during the process of such coordination. The Banking System Measures in the White Paper to improve the banking system include divesting banks under IBRA; strengthening governance of state-owned banks; and improving banking regulations, supervision, and enforcement. Divest banks under IBRA. The White Paper calls for divesting more than 20 percent of IBRA’s share in Bank Niaga, divesting IBRA’s majority shares in Bank Lippo, BII, and Bank Permata, and divesting IBRA’s minority shares six banks. Since the publication of the White Paper, IBRA has disposed of 20 percent of its shares in Bank Niaga and finalized the sale of BII. IBRA’s attempts to sell Bank Lippo were not successful due to the bids being too low. A re-launch of the sale of Bank Lippo and the launch of the sale of Bank Permata are planned in the coming months. IBRA continues to divest its other assets—NPLs, property, equity, and quasi-equity—broadly in line with the Government’s proposed time frame. Strengthen governance structure of state -owned banks. The White Paper provides for specific actions to improve governance of four state-owned banks (Mandiri, BNI, BRI, BTN). In that regard,

21

Internal controls at State Banks such as BNI are still weak

the Government has appointed independent commissioners at Mandiri with appropriate technical expertise. It has also completed the sale of 40.5 percent of BRI’s equity for $500 million and the bank is now listed on the Jakarta Stock Exchange. Actions relating to BNI and BTN have not yet been completed. While these are important actions, there is a need for much greater emphasis on improving the governance of state-owned banks. The recent case of a large fraud—involving $200 million—that has come to light at BNI shows that internal controls at the bank are still weak and opportunities for collusion between bank employees and third parties remain. Media reports have been speculating as to whether this is a problem unique to BNI or is more widespread. The Government needs to take urgent action to ensure that confidence in the banking sector is not adversely affected. Enforcing accountability both for those directly involved as well as for senior management will assist in sending the right message to the markets and begin to restore confidence. Beyond this short term action, the Government should be seen as proactively implementing steps to significantly upgrade internal controls and standard operating procedures both at BNI and other majority-state owned banks. These issues gain greater urgency in light of recent plans for rapid increase in lending unveiled by some state-owned banks. In addition, a longer-term strategy involving greater privatization of state-owned banks also needs to be developed. Finally, there is an urgent need to upgrade skills in general—and risk management skills in particular—in the banking sector. Strong human resource capacity in the banking sector is key to its long-sustainability. The institutional framework for providing

technical training in banking needs to be established. Improve banking regulations, bank supervision systems, and enforcement of prudential regulations. Several actions are included in the White Paper to fully comply with 25 Basel Core Principles and to improve enforcement of prudential regulations. These are important measures that need to be undertaken by Bank Indonesia. By bringing these measures into greater compliance with the Basle Core Principles, further strengthening of BI’s regulatory and supervisory capacity as well as its enforcement capacity, especially with regard to state-owned banks, would be also needed to truly improve confidence in the banking sector. Anti-Money Laundering Presidential decrees with regard to the organization, authority, remuneration systems and staffing of the Financial Intelligence Unit (PPATK) have been effected. Law No. 15/2002 on money laundering has been amended to bring it in line with the guidelines of the FATF. PPATK has signed Memoranda of Understanding (MOUs) with several domestic agencies including Bapepam, Ministry of Finance, Customs, and Tax. Additional actions on witness protection programs, guidance to financial institutions on analyzing and reporting suspicious transactions, and public dissemination of issues related to anti-money laundering efforts are in progress. Thus far, the actions have largely been in line with the schedule outlined in the White Paper. Despite these efforts, Indonesia continues to remain on the FATF list of non-cooperative countries and territories (NCCT) with regard to anti-money laundering.ii While the legislative measures have been appreciated, the key issue now is to ensure that the PPATK, as well as the overall financial system, effectively implement anti-money laundering measures. Being on the FATF NCCT list creates hurdles for international investors as they are required to give special attention to businesses and transactions with persons, including companies and financial institutions in Indonesia. FATF sanctions would be much more harmful to the economy. Indonesia would therefore need to

22

Indonesia’s capital markets are small and

underdeveloped

focus on sound implementation of its anti-money laundering framework, especially in light of its increased need to interact with the global financial community in the years ahead and its efforts to enhance its investment climate. Capital Markets The White Paper’s action plans to strengthen and develop capital markets include: • strengthening financial and operational

capacity of securities companies, • restructuring of the Stock Exchange,

strengthening regulation and supervision of mutual funds,

• improving corporate governance, • reorganize Bapepam. While these are undoubtedly important issues, they continue to be focused on the current functions of capital markets. Going forward, however, much more will be required of Indonesian capital markets than has been the case thus far. Therefore, an important priority for the Government should be a focus on the future role of capital markets in Indonesia. Indonesia’s capital markets are small and underdeveloped, in comparison both to the domestic banking sector as well as capital markets in other countries in the region. Equity markets have thus far not been a significant source of financing for the corporate sector. Government bond markets have also only recently begun developing. In addition to macroeconomic and political instability, high concentration of ownership, weak corporate governance, inadequate supervision and regulation, weak protection of minority shareholder rights, a small institutional investor sector, and competition from international exchanges have all played a role in the low level of development of Indonesia’s capital markets. Many of these issues need to be addressed by the Government going forward. With a significant

privatization program for state-owned enterprises (SOEs) on the agenda, Indonesia will need an active and institutionally strong equity market to absorb forthcoming issues. There is also an urgent need to develop a sound market for government bonds—as the Government plans to raise more resources from the domestic markets to finance the budget deficit. A thriving bonds market could also play a role in domestic financing of infrastructure and other long term investments key for developments. A vibrant capital market will reduce the dependence of the economy on bank financing for these purposes, and thereby reduce the vulnerability of the economy to stresses in the banking sector. Strengthen Bapepam’s regulatory, supervisory, and enforcement role. Bapepam is the regulator of capital markets. The White Paper simply states that Bapepam needs to be reorganized in line with MOF reorganization. Beyond this, the Government could focus on: strengthening Bapepam’s regulation, supervision, and enforcement and bringing them in line with internationally recognized standards; rationalizing and strengthening the securities industry which currently has a large number of relatively small participants; enhancing market infrastructure, including trading systems and clearing and settlement systems; exploring options to strengthen the ability of stock exchanges to raise capital for their expansion, including consolidation and demutualization; and enhancing and enforcing disclosure norms for listed companies. Improve corporate governance. The White Paper measures relate to regulations on audit committees of public stock companies and responsibility of management for the companies’ financial reports. Deeper reforms in corporate governance are needed, especially given the link between corporate governance and the financial sector. The ownership structure of companies in Indonesia is characterized by concentrated ownership, family-owned businesses, and controlling shareholders. The business culture is relationship-based rather than rule -based. Indonesia is making progress in improving its corporate governance;

23

Table 2.3. Markets ranked by corporate governance by CLSA

Ranking from 1 (worst) to 10 (best)

Rules and regulations Enforcement

Political and regulatory

environment

Adoption of IGAAP

Institutional mechanisms

and corporate governance

culture

Country score

2002 2003 2002 2003 2002 2003 2002 2003 2002 2003 2002 2003 Singapore 8 8.5 7 7.5 5.5 6 9 9 8 8 7.4 7.7 Hong Kong 8 8 6 6.5 7 6.5 9 9 7 7 7.2 7.3 India 8 8 5 6 6 6 6 7.5 6 6.5 5.9 6.6 Taiwan 7 7 5 5 5 5 7 7 6 6 5.8 5.8 Korea 6 7 3 3.5 4 5 7 7 5 6.5 4.7 5.5 Malaysia 9 9 2.5 3.5 3 4 6 7 6 6.5 4.7 5.5 Thailand 7.5 7.5 2 3 3 4 5 6 4 4.5 3.8 4.6 China 4.5 5 3 4 5 5 7 5 3 3 4.4 4.3 Philippines 6 6.5 2 2 2 2 6 6 4 4 3.6 3.7 Indonesia 4 4.5 1 1.5 5 4 4 5 2 2.5 2.9 3.2

Source: CLSA, Emerging Markets (2002, 2003).

however, like all countries in East Asia, it needs to intensify its efforts to create business environments for investors that are based on rule of law and that promote transparency and accountability (Table 2.3).iii But while Korea and Malaysia continue to make significant progress, Indonesia continues to be ranked below several other countries in the region. The White Paper measures on corporate governance are limited; deeper measures are needed to reform corporate governance and establish a rule -based culture. First, strengthen enforcement of laws and regulations is weak. Corporate officials in the position of trust need to be held accountable when they violate the law. Sanctions should go beyond fines, and the incentive system should be changed so that violators are truly discouraged and good corporate behavior is promoted. The amendments to the Company law should explicitly refer to the fiduciary duties of directors and managers for violation of securities laws. Second, increase the transparency and reliability of financial reports and the adequacy of disclosures. While Indonesian accounting standards are consistent with international standards, there is a wide gap between those standards and actual practices. Public perception and confidence in the reliability of company financial reports and disclosure remains low. There is a need for greater disclosure and transparency in annual reports and financial statements, and for better quality audit of

public companies. Financial reporting should be de-linked from tax reporting, as companies report income often in a way that avoids paying taxes. Third, increase independence of directors. Although the concept of independent directors has been introduced, whether these directors act independently from the controlling shareholders and exercise effective oversight remains an issue. The process for nomination and selection of independent directors needs to be strengthened. Conducting training and promoting awareness among all stakeholders is critical to changing the business culture. Efforts to enhance the skills and knowledge of independent board members need to be expedited. Improving the roles and responsibilities of the audit committees should be a high priority. Separation of management from the owners and appointment of professional managers needs to be further promoted. Insurance and Pensions The life insurance and pensions sectors combined control about Rp. 91 trillion of long-term domestic resources, with almost 26 million participants. It is important that the Government takes a strategic view of these segments of the financial sector and the potential for their contribution to broader development objectives of the Government. The sectors can prove essential risk management products for the population, as well as mobilize significant amounts of long-term domestic financing resources. These resources can be channeled into a variety of uses that support the

24

Table 2.4. Insurance sector profile in 2002 (Rp. billion)

General Life Reinsurance Social Total No. of insurance company 102 58 4 5 169 Total assets 14,925 20,537 773 25,649 61,884 Equity 8,082 3,963 236 2,861 15,143 Net premium 4,326 8,850 383 3,379 16,939 Investment return 419 894 33 3,485 4,832 Technical reserves 3,119 15,131 419 4,466 23,134 Net profit 848 188 29 1,570 2,636

Source: Asian Development Bank and Investor Magazine, July 2003.

long-term development of the economy, such as infrastructure investments. Insurance. The insurance sector is fragmented, but only a handful of large insurance companies account for most of the total assets and income (Table 2.4). The state controls the social insurance market and has a sizeable presence in the life insurance market together with the joint ventures. In the general insurance market, domestic companies dominate the market. The sector also has a large number of small insurers that are undercapitalized and less competitive. In addition to an uneven distribution of assets and income among insurance firms, implementation of more robust regulatory requirements and, in particular, improved capital requirements, has been weak. Starting in 2000, the Government has required insurance companies to calculate Risk Based Capital (RBC) as a measure of solvency. Under the new legislation, companies are required to maintain a ratio of assets to liabilities of at least 120 percent. The requirement is being implemented in stages (5 percent in 2000, 40 percent in 2001, 75 percent in 2002, 100 percent in 2003, and 120 percent in 2004) to encourage the industry to rehabilitate itself through rationalization and consolidation. So far the authority has identified a number of insolvent insurers and has imposed a ‘limited business restriction’ on them, which is to be followed by revocation of business licenses. The Insurance Directorate within MOF is responsible for regulation and supervision of the industry. The Government is aware of the need to modernize and upgrade the insurance sector regulatory and supervisory regimes as well as regulatory and supervisory capacity. Current insurance regulations are still weak and incomplete

particularly in dealing with issues of bankruptcy and liquidation of insolvent insurers, protection of policyholders rights, and insurance frauds. There is also a need for a clear process for discipline, sanctions, intervention and liquidation of troubled companies within the sector. In addition, creating a framework in which policy holders are adequately safeguarded is key to maintaining public confidence in the financial sector. MOF has proposed an amendment of the current insurance law to the parliament to address some of these issues. However, these amendments are part of an overall package of legislation including that for the integrated financial services authority and it is unclear when parliamentary approval will be obtained. The White Paper includes steps to help restructure and reform the insurance sector mainly through a series of government regulations and decrees. The Government has issued several decrees relating to regulation and operations of insurance firms in line with the proposed schedule in the White Paper. A decree to begin implementing a risk-based approach to supervision has also been issued. Efforts are underway to establish a framework for policy-holder protection and bring regulation and supervision into line with the IAIS principles. The actions proposed in the White Paper are important elements of strengthening the insurance industry. However, several issues beyond the White Paper need attention: resolving weak and insolvent insurance firms expeditiously, strengthening regulation and supervision, and enhancing the confidence of policy holders through development of a policy holder protection scheme. Pensions. Indonesia has three large retirement funds: ASABRI (pension fund for the police, civilian and military defense personnel), TASPEN

25

(pension fund for civil servants), and JAMSOSTEK (provident fund for employees in the private sector and in SOEs). In addition, over 300 employers, including many state-owned enterprises, have retirement funds for their employees. As of December 2002, all these retirement funds had combined assets of about Rp. 50 trillion. The governance, regulation and supervision, and investment policies of pension funds have been poor and not tied to the overall development priorities of the country. Both TASPEN and ASABRI are poorly funded relative to their benefit promises and hence are proving to be increasing drains on the national budget as opposed to being sources of long-term capital.iv ASABRI is controlled by the Ministry of Defense, TASPEN is under the Ministry of Finance, while JAMSOSTEK is under the Ministry of Manpower and Transmigration. The first two entities are effectively unsupervised, while JAMSOSTEK and the employers’ pension funds have reporting obligations to MOF. All pension funds have suffered from lack of transparency and disclosure, weak management information systems and internal corporate governance, and directed investments under political influence. The vast majority of the assets of these retirements funds are invested in short-term bank deposits—a clearly sub-optimal use of these funds. A relatively small proportion of these assets is invested in the capital markets and other private securities. The White Paper aims at improving the pension fund management. All measures are scheduled to be implemented in 2004, and include certification for pension fund managers and regulations on contributions, investments, and aspects of corporate governance. While these are important steps, the White Paper focuses exclusively on employer-sponsored pension funds that are within the regulatory purview of the Ministry of Finance. As in insurance, a strategic view of the pensions sector is needed. A comprehensive approach to the sector including all the various different pension plans, a clear articulation of the role this sector should play in the economy, as well as development and implementation of a set of reforms to put these institutions on a sound footing should be a priority. Key steps involved in the process are development of an overall framework for pension provision in Indonesia, actuarial and

financial assessments of the various systems, and greater integration of the policy framework for institutions in this segment with overall macroeconomic objectives. Outside the framework of the White Paper, the Government is preparing plans for more comprehensive social insurance, including health care, unemployment, and workers’ accident insurance (Chapter 5). The current proposals for a comprehensive health insurance require further thought, and extensive consultations with stakeholders, including employers’ and employees’ organization. The universal nature of the scheme, although theoretically desirable, may in fact undermine existing arrangements that are working well. The Government’s idea to levy a six percent tax on the wage bill to finance the scheme could, at least in the short run, undermine its goals to maximize employment creation. And the proposed management of the funds by a state-owned company would, in light of the experience with state-owned pension funds, far from guarantee that the intended benefits indeed materialize. i Unofficial estimates are that new credit might need to grow by about 25 percent per year. ii Other countries on the list are Cook Islands, Egypt, Guatemala, Myanmar, Nauru, Nigeria, Philippines, and Ukraine. iii The following macro factors (and weightings, in percent) are accorded by CLSA in country rankings: Clear, transparent and comprehensive rules and regulations (10); Committed and effective enforcement of rules and regulations (30); Political and regulatory environment affecting CG and ability of companies to maximize value without arbitrary restrictions (20); Adoption of International Generally Accepted Accounting Principles (20); Institutional mechanisms to promote awareness and a culture of good governance (20); The scale for country ranking is 1 to 10. iv The Asian Development Bank estimates that TASPEN was in a cash-flow deficit (excess of payouts over contributions) of Rp. 13.5 trillion in 2000 while ASABRI was in a cash flow deficit of Rp. 30 billion in the same year. These deficits are funded out of the Government’s general budgetary resources and are expected to grow dramatically over the coming years, thereby becoming a part of the fiscal problem for the government.

26

27

CHAPTER 3: INCREASING INVESTMENT, EXPORTS AND EMPLOYMENT “Economic growth of 4 percent is not sufficient to address problems of unemployment, increase incomes, and reduce poverty; the key to raising economic growth—thus improving employment opportunities and people’s welfare—is to increase investment and exports” (White Paper). RECENT DEVELOPMENTS Trends in Investment, Exports and Employment Indonesia’s investment has been the slowest to pick up among the former crisis countries. Investment as a share of GDP is only 20 percent, 10 percentage points lower than before the crisis. And investment approvals—admittedly not including approvals in oil and gas, and financial sectors—are sluggish. Domestic investment approval in January-October of 2003 was Rp.18 trillion, some 14 percent lower than last year, and 65 percent below the same period in 2001. Foreign direct investment approval in the same period was $9.3 billion i or 26 percent higher than last year. Even so this level is a fourth of the pre-crisis level. Indonesia’s recent export performance has been relatively poor as well. In 2002, the country’s export share in GDP was still below the 1997 level,

while that of Korea, Malaysia, and Thailand all exceeded their pre-crisis levels by a significant margin (Figure 3.1). Indonesia lost world market share in its top 30 non-oil exports in recent years—from 2.9 percent to 2.7 percent. Within the region, most of the competition came from China, which increased its world market share in Indonesia ’s top 30 non-oil exports from 10 percent in 1997 to 14 percent in 2001 (Figure 3.2). This competition was especially strong for plywood, fabrics, digital processing, furniture, jerseys, and footwear. Competition from Vietnam is also rising in specific products, mainly crustaceans, natural rubber, and footwear. But not all is gloom for Indonesia’s exports. First, China is becoming an increasingly important export market for Indonesia (Chapter 1). Second, Indonesia is gaining in comparative advantage in other products—the percentage of products in which Indonesia has a comparative advantage ii rose from 27 percent of its exports in 1995 to almost 33 percent in 2001 (Table 3.1). Admittedly, the country’s comparative advantage seems to be shifting in the direction of resource-intensive products rather than in the direction of technologically-advanced products. Third,

Figure 3.1. Indonesia’s export performance lags

its neighbors’ (Index of 2002 export share of GDP, 1997=100)

0 20 40 60 80

100 120 140 160 180 200

Indonesia Korea Malaysia Philippines Thailand

Source: staff calculation.

Figure 3.2. Competition from China is rising

(percentage change of China’s market share in 1997-2001 on Indonesia’s top export products)

-5 0 5 10 15 20

Peripheral electical units

Sound recorders and reproduceGarments & clothing

FootwearElectrical wire andcable

Complete digital central processingRadio-broadcast receivers for motor

Jerseys,pull-overs,twinsetsYarn

Printing paper & writing paperGold,non-monetary

Copper ores & concentratesNatural rubber latex

Trousers,breeches etcUnder garments,knitted of cotton

Source: staff calculation based on UNCOMTRADE data.

28

Indonesia’s competitiveness is

shifting to resource based products

Indonesia’s export base is diversifying: between 1995 and 2001 the share of the 3 largest and 10 largest exports fell from 28 percent to 24 percent and from 48 percent to 40 percent, respectively. The lack of economic activity and the weak investment climate led more manufacturing firms to close down and downscale, and fewer firms to set up shop (Figure 3.3). Labor-intensive sectors such as textile, clothing, and footwear felt the

pinch of increased competition from countries like China and Vietnam, and were particularly affected by the rise in minimum wages in recent years.iii As a result, employment in this sector dropped more rapidly than that in manufacturing as a whole (Figure 3.4), a trend that continued in 2003. iv Profitability was also down considerably: profit margins in manufacturing dropped from 16.4 percent in 1995-96 to 2.5 percent in 2000-01. What Affects Investors? Indonesia’s investment climate and competitiveness have not received high marks since the crisis. Indeed, the World Economic Forum recently ranked Indonesia’s competitiveness at 60 out of 90 countries, well behind Malaysia (26), Thailand (31) and China (46), but before the Philippines (64). To find out

Table 3.1. Indonesia’s revealed comparative advantage

Product 1995 2001 Fish etc. 3.9 3.3 Coffee, tea etc. 4.3 4.1 Tobacco 0.9 1.5 Crude rubber 15.9 8.9 Cork and wood 1.1 1.4 Pulp and waste paper 2.0 3.2 Metalliferous ores and metal scrap 4.6 4.8 Coal, coke and briquettes 5.2 7.0 Petroleum, petroleum products 3.1 1.9 Gas, natural and manufactured 15.8 8.0 Fixed vegetable oils and fats 5.6 9.7 Animal-vegetable oils-fats 8.1 3.5 Fertilizers 2.0 0.9 Cork and wood manufactures (excl. furniture) 16.7 9.5 Telecommunications & sound recording 1.0 1.3 Furniture and parts thereof 1.9 2.3 Travel goods, handbags 0.9 1.6 Articles of apparel and clothing 2.4 2.7 Footwear 6.2 4.3 Out of 63 2-digit SITC products: No of products with RCA>1 17 21 % of products with RCA>1 27 33 Note: A country’s revealed comparative advantage in exports (RCA) in a product captures the extent to which the country exports a higher proportion of the product that the average country. RCA>1 shows that the country has a comparative advantage in a product. The greater the RCA the greater the comparative advantage. Source: Staff calculation based on UNCOMTRADE data.

Figure 3.3. Fewer firms are set up (percentage in total companies)

0.0

1.0

2.0

3.0

4.0

5.0

6.0

new down-scaled closed

2000

2001

2002

Source: staff calculation based on BPS industrial census data.

Figure 3.4. Manufacturing employment is falling (percent growth rate of manufacturing employment)

-4.0 -3.0

-2.0 -1.0

0.0 1.0 2.0 3.0 4.0

1999 2000 2001 2002 Source: staff calculation based on BPS industrial census data.

29

Macroeconomic stability, policy uncertainty and corruption top

investors’ concerns

what exactly keeps firms from investing in Indonesia, the World Bank and ADB asked investors about their concerns.v Investors worry most about three issues: macroeconomic instability, policy uncertainty, and corruption (Figure 3.5). The reason that macroeconomic instability tops the list of concerns is in part due to long memories of investors, but is also witness to the damage that large swings in exchange rate, inflation, and interest rate can inflict upon firms. Macroeconomic stability thus remains a critical pre-requisite for higher investment. Policy uncertainty, including legal uncertainty, influences the risks and returns to investment. It has increased as the process of democratization and decentralization led to many inconsistencies in rules and regulations, and in their application and

enforcement. Corruption, both in the central and local governments, also ranks high among investors. Other important obstacles to investment include power shortages and local and national labor regulations. In contrast to findings in many other countries, most of these obstacles are felt more strongly by larger firms than smaller firms. Investors’ concerns have been exacerbated by decentralization (Figure 3.6), notably regarding corruption, policy uncertainty, and business licensing. THE WHITE PAPER The White Paper recognizes the role of the Government in improving the investment climate. The Government’s role, according to the paper, is to provide an enabling environment for the private sector through good policies and institutions. The Government’s recognition of weaknesses in the investment climate is encouraging, and many measures proposed indeed support the goal of improving the investment climate. At the same time, this section of the White Paper is a bit of a mixed bag. Of the many measures proposed, numerous ones—such as the improvement in licensing, tax and customs administration, and the revamping of infrastructure—indeed support the

Figure 3.5. Macroeconomic instability, policy uncertainty and corruption are the main obstacle

Figure 3.6. Decentralization has exacerbated the problems

0.00 0.50 1.00 1.50 2.00 2.50 Telecommunication

Transportation Licensing by central government

Licensing by local government Tax administration

Electricity National labor regulation

Local labor regulation Legal system

Cost of financing Tax rates

Corruption by central government Corruption by local government

Policy uncertainty Macroeconomic instability

Corruption

Policy uncertainty

Business licensing

Labor regulations

Large Firms Medium Firms

Small Firms

-0.80 -0.70 -0.60 -0.50 -0.20 -0.30 -0.40 -0.00 -0.10

Average score from 0 for none to 4 for severe

Source: World Bank-ADB Private Investment Climate Survey, 2003 (preliminary results).

Average score from –2 for worsened to 2 for improved

Note: Large firms: more than 500 workers, medium firms: between 101-500 workers, small firms: less than 100 workers. Source: World Bank-ADB Private Investment Climate Survey, 2003 (preliminary results).

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Box 3.1. White Paper priorities of the business community

A Monitoring Committee consisting of members of the Indonesian Chamber of Commerce (KADIN), representatives of the Jakarta Japan Club Foundation, AmCham Indonesia, the International Business Chamber, and a number of independent economists, has been set up to monitor the progress in implementing measures in the White Paper of interest to the business community. The Committee stresses that “the main job of government is to create a conducive climate (for investment and trade) through good policies and institutions”, and highlights three priorities:

Legal reforms. Laws should be introduced only after they have been thought through properly and discussed publicly with important stakeholders outside the government. They should be more facilitative than restrictive. The hierarchy of law should be strictly adhered to. Immediate action should be taken to: (i) eliminate inconsistencies and contradictions between regional and national laws and regulations, presidential decrees, ministerial decrees and interpretations; (ii) improve capacity and performance of law enforcement officers; and (iii) improve the government’s inter and intra ministry/department coordination so that passed laws are consistently upheld, applied, and honored in a timely manner (e.g., enforcement of recent tax court decisions).

Development of small and medium enterprises. Priority policy measures/action plans are: (i) improve SMEs’ access to funds; (ii) remove the excessive requirement on SMEs of additional collateral/fixed assets outside of the project; and (iii) look for breakthrough measures to encourage banks to extend credits to SMEs by implementing land certification processing, strengthening credit guarantor and insurance schemes, and expanding linkage program between commercial banks, rural banks and micro finance institutions to reach SMEs located in remote areas.

Skill increase and empowerment of the poor. The Committee supports the policy of poverty eradication outlined by the GOI to help. Concrete actions could be made to put in place education services and health infrastructure and services that are managed and paid for by the government through the normal budgetary process without additional tax levies. Another important action is to simplify the land certification program, including national registration. This will benefit all levels of society by providing legal security to what is the most important asset of most families.

Source: Press release of the Private Sector Monitoring Committee, November 2003.

stated goals. Others, such as measures proposed in trade, seem to cater to special interests, and could well add to the policy uncertainty that firms say keeps them from investing. More so than for other parts of the White Paper, setting priorities and keeping the proposed measures focused on the goals is needed. The Government should also heed the advice of the private sector—the people that should in the end do the much-desired investment. The private sector Committee that monitors the progress and problems in the White Paper implementation has already gone on record with its priorities (Box 3.1), and the Government is willing to listen. A regular dialogue between the business community and the Government on investment climate issues would indeed be healthy, and the cabinet level Investment and Trade Promotion Team—already set up under the White Paper—could become the vehicle for such a dialogue. Moreover, the Team could become the catalyst for reforms that would improve the investment climate beyond the White Paper, and could forge the consistency of policies affecting investors that they so direly need.

The key elements of the White Paper to increase investment, exports, and employment include (Table 3.2): • improve investment policy and processes by

introducing a new investment law, setting up a one-stop licensing shop, and setting up a National Investment and Export Team to assess intersectoral problems;

• promote industry and trade by improving international market access through trade promotion centers and counter-trade deals, introducing a new trade law, and changing trade policy to reflect changes in competitiveness;

• develop small and medium enterprises; • improve tax and customs services (Chapter 1); • improve the legal environment by eliminating

corruption, improving the commercial court performance, improving the capacity and performance of law enforcement officers (see Chapter 4);

• harmonize regional regulations; • build and rehabilitate infrastructure to ensure

services in electricity, transportation, energy,

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Table 3.2. Main policy measures to improve the investment climate and promote industry and trade

Policy me asures Action plans Target date Investment climate:

• Provide legal certainty to businesses (see also legal reforms)

Revise the negative investment list Complete and present a draft law on investment

December 2003 December 2003

• Simplify the licensing process Set up a one-stop shop October 2003 • Eliminate obstacles to investment

and exports Set up a National Investment and Export Team October 2003

Industry and trade: • Increase exports through increased

promotion and market penetration Increase non-oil exports to non-traditional markets

through counter-trade as long as it is in line with the budget

On-going

• Restructure business support agencies

Submit a trade law to Parliament November 2003

• Fulfill the agricultural needs of domestic industry with domestic production

Increase the output and quality of agricultural commodities, and completely supply agriculture input needs (corn and soybeans)

On-going

• Simplify procedures for exports and imports

Harmonize import tariffs for commodities consistent with changing competitiveness

On-going

Small and medium enterprises: • Increase the access of small and

medium enterprises and cooperatives to productive resources

Increase land certification program gradually to increase access to bank credit

On-going

Source: World Bank staff based on Presidential instruction No.5/2003.

telecommunications, and water resources; • improve employment prospects by introducing

new labor regulations. In addition to these measures, the third part of the White Paper also includes measures to improve governance (Chapter 4) and alleviate poverty (Chapter 5). This is an ambitious and comprehensive agenda. It covers important measures that will address the policy uncertainty concern of investors, including in areas such as tax and customs administration reforms, legal reforms, and harmonization in regulations across levels of governments. Some measures remain vague, and would need to be well defined in their substance and well implemented to have a meaningful impact. Improving Investment Policy and Approvals New investment law. A key policy in the White Paper for improving the investment climate is to complete a new unified law on investment

currently being prepared. The new law will replace both the 1968 Domestic Capital Investment law and the 1967 Foreign Investment law. It will provide for equal treatment of domestic and foreign investors, as well as a range of incentives such as tax holidays. The law will also regulate investment in all sectors, with the Investment Coordinating Board (BKPM) serving as a one-stop shop for prospective investors. The draft law is a step forward in consolidating the framework for investment. Although the principles behind several key issues are generally in line with best practice, they are still vague and details of the law’s actual implementation are relegated to supporting regulations and decrees. As such, the law will contribute little to restoring investors’ confidence unless its substance is further spelled out. The option currently included in the draft law of providing tax incentives needs to be reassessed as international experience has shown that they rarely work to attract investment, and end up subsidizing foreign treasuries rather than firms.vi

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A big hurdle is the 60 days it takes the

Ministry of Justice to register a firm

One -stop licensing office. The White Paper promises to simplify the licensing process by setting up a one-stop licensing office at BKPM. If effectively implemented, this could greatly ease the licensing and business processing problems faced by investors. A key objective should not be only to simplify the process, but also to reduce the number of licenses and permits, and the number of procedures needed to obtain them. Currently, investors can easily secure an “in principle” approval for an investment license from Indonesian embassies, BKPM or the Regional Investment Coordinating Board (BKPMD) in the provinces. The delays occur when investors begin

the process of registering and implementing their project. vii According to laws and regulations, starting a business in Indonesia entails 11 procedures and takes 168 days, costs 14.5 percent of the average income, and requires a minimum capital of three times the average income (Figure 3.7). Although the “official” cost of starting a business is not high compared to the rest of East Asia, it almost takes triple the time to do so. Moreover, each procedure is a point of contact, and an opportunity to extract a bribe. The biggest problem is to register at the Ministry of Justice—for ratification of the deed of establishment and a registration certificate. The Ministry of Justice approves or rejects the application within 60 working days, but there is no automatic approval even after that. The use of notaries to prepare for company registration duplicates the due diligence undertaken by the Ministry’s internal legal assessment on company formation. In many countries, business registration is an administrative process not a legal one, and it is a registration system, not an approval system. After registering the business, many steps remain before a project can be implemented. The investor would apply to BKPM or BKPMD to obtain a limited importer

Figure 3.7. Time and cost of starting a business in Indonesia

0

50

100

150

200

1 2 3 4 5 6 7 8 9 10 11 Procedure

Time, days

0 2 4 6 8 10 12 14 16

Cost, % of income per capita

Time (left axis)

Cost (right axis)

1. Obtain the standard form of the company deed 2. Notarize deeds 3. Certificate of criminal record 4. Certificate of domicile 5. Obtain NPWP (tax file number) 6. Apply for the business trading license

7. Deposit capital in a bank 8. Apply for publication 9. Pay registration fee at Treasury 10. Register at Ministry of Justice 11. Social security

Source: Doing Business in 2004, Indonesia Country Profile, http://www.worldbank.org/doingbusiness.

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license; a customs approval letter for capital goods and a customs approval letter for raw materials after verification of the list of proposed imported capital goods, machinery, equipment and raw materials requested for exemption from import duties; a foreign manpower plan approval for the required local training; and an expatriate work permit. In addition, the investor would need to obtain from the local government a location permit that gives the right to the investor to use the land for specified purposes; a land title and a building construction permit; and a nuisance act permit for environmental purposes. The Government is drafting a Presidential Instruction on BKPM One Stop Service (OSS) that would allow it to authorize approvals of new projects and expansions, setting up of foreign companies representative office, and issuance of six types of licenses (including hiring of foreign workers, importers license, expansion license and facility to liberalize/reduce import fees of raw materials and other fiscal facilities). This is an important step towards removing or consolidating some of the hurdles involved. At the same time, an effective OSS will necessarily have to work closely with all involved authorities. In the Philippines, where a One Stop Action Center was established in 1987, investors continued to complain about cumbersome procedures and delays; for some administrative requirements, a double licensing procedure was in effect imposed, with the investors having to apply to both the One Stop Action Center and the licensing body. The true strength of an OSS lies in identifying shortcomings in the administrative implementation of a country’s investment policy and in implementing policy reforms, rather than short-term, ad hoc solutions to problems investors face. Beyond the investment law and processes, Government must clarify the responsibilities of the regions. Law 22/1999 which entrusts local authorities the responsibility for facilitating and approving investment. Many regional investment boards have claimed full responsibility under this law to process investment applications, but other regulations say BPKM continues to play a role. Without clarity on who does what, the licenses issued may not convince banks and other financial institutions to put money into an investment.

Promoting Industry and Trade Indonesia is a very open economy and in the past has greatly benefited from its export-oriented growth strategy. As observed before, Indonesia’s competitiveness in some of its traditional exports may be declining. So far, the Government has responded to these pressures by resorting to ad hoc measures such as import licenses in key garment and agricultural products. The White Paper is not encouraging in this respect: the proposed measures seem to express a desire to continue this same ad hoc protectionist trend, rather than take a more strategic view on Indonesia’s trade policy. The measures proposed to promote industry and trade include (i) increased reliance on counter-trade deals as the basis for export promotion, (ii) a move towards self-sufficiency in key agriculture commodities, and (iii) an attempt at increasing protection as a way of shielding against shifts in comparative advantage. But the White Paper addresses important elements too, including speeding up tax rebates which are especially important to exporters. Submission of a trade law to Parliament is timely, but it needs to be brought in line with international best practice. First, the White Paper proposes to use counter-trade deals to increase non-oil exports to non-traditional markets. In 2003, the Ministry of Industry and Trade has arranged counter-trade deals with Russia ($193 million) exchanging raw materials (mainly palm oil) for defense equipment; and with Thailand ($21 million) exchanging heavy metal products (train cars) for raw materials import (mainly rice). A counter-trade deal with Libya ($540 million) is being negotiated. Counter-trade deals are sometimes used by less developed countries to relieve overcapacity in some industries or to alleviate liquidity constraints; but they become quickly counter-productive. They are opportunistic, promote rent-seeking behavior, and cannot support a sustainable and efficient export base. Moreover, government involvement in counter-trade financing may cause problems with fiscal management. The Russia deal, for instance, was pre-financed by BULOG, the state logistics agency. But when the Government wanted to reimburse the agency, it was heavily criticized by Parliament for having spent without authorization.

34

Counter-trade is counter-productive

Given the reputational risks involved in counter-trade, this seems hardly the way to go for Government in promoting industry and trade. Second, the White Paper suggests to “fulfill agricultural needs of domestic industry with domestic production, by completely supplying agriculture input needs in corn and soybeans.” This could mean protecting these two commodities in order to become self sufficient in their production. But there is no rationale for this policy. Corn and soybeans currently feature relatively open borders with zero tariff. Although Indonesia is a net importer of both commodities, they compete successfully with imports and do not seem to require protection. Furthermore, the interests of the agricultural sector are not uniformly advanced by the introduction of higher tariffs or any kind of protection that would raise their prices within the country. As both commodities are used as inputs into livestock feeding, this will raise the cost of those livestock feeds, most significantly in the large poultry industry. The measure would thus undermine competitiveness in an industry with higher value added than crops. Moreover, an increase in the price of soybean would also hurt the poor for whom soybeans (tempe and tahu) are the main source of protein. Third, the White Paper suggests to “harmonize import tariffs in key commodities, including agriculture products, in line with changing competitiveness.” While it is not clear what this measure would entail, recently there has been a tendency towards creeping protectionism. Indonesia has a very open trade regime, with an average tariff around 7 percent. A host of new restrictive import-licensing arrangements and export bans and licenses were introduced in the past two years, mainly by the Ministry of Industry and Trade. Such measures are more distortive and less transparent than tariffs, the latter being the responsibility of the Ministry of Finance. One

justification for such trade interventions brought forward by the Ministry of Industry and Trade is the need to combat smuggling, but it seems rather odd to assume that smugglers would actually register. Moreover, import licenses are likely to exacerbate smuggling by increasing the differential between domestic and international prices. Rather than protection, the Government could opt for measures that accelerate the reallocation of labor from declining industries to growing ones. Harmonizing Regional Regulations Since decentralization took off in 2001, regional taxes have become a menace for businesses. The lack of proper revenue sources has provided strong incentives to introduce new forms of taxation and retribusi. Many of these restrict or tax trade within or between kabupaten and provinces as they are easy to implement (by positioning officials at key strategic locations, such as city boundaries, weigh stations, ports, or bridges). For example, Kabupaten Bima imposes a tax on virtually every commodity or product sent beyond the district borders. Similarly, Lampung Province imposes a “license fee” on 180 commodities exported from the province. These taxes and restrictions interfere in domestic trade and undermine internal market efficiency. This makes them illegal according to law 34/2000 on regional taxes, but supervision remains weak. The policy measure in the White Paper that deals with harmonization of regional regulations would need to be forcefully implemented. Although Law 34/00 already allows for the central government to conduct reviews of newly introduced local taxes and annul any that are found to be in conflict with higher regulations or statues, such reviews must be completed within 30 days of the central government receiving a copy of the regional ruling in question. This stipulation was clearly intended to speed up the process, but central government has been unable to keep pace with the thousands of new regulations. To ensure no local taxes and fees that damage the investment climate are introduced, the current 30-day approval mechanism for local perdas could be replaced with a closed list of allowable revenue instruments to local governments; such list would need to include instruments that can substantially increase revenue

35

at the local level, such as the property tax. At the same time, the capacity of the central government to review local regulations needs to be strengthened. Employment Labor cost, labor productivity, and good labor relations are crucial for the competitiveness of firms. The recent increases in minimum wages in Indonesia have tended to exceed inflation by a significant margin. In Jakarta, minimum wages for industrial workers more than tripled during 1997-2002, from Rp. 172,500 per month to Rp. 632,000; as a result, real minimum wages were 50 percent higher than their pre-crisis level. But Indonesia’s minimum wages are still in line with those of other countries in the region, although both Vietnam and China have more competitive wages. The problem is that the increase in labor productivity has not matched the increase in real wages (Figure 3.8). Labor productivity remains relatively low compared to other countries. In textiles, garments and electronics, value added per labor in 2001 was much lower in Indonesia than in India and China, and for every dollar spent on a worker, China and India were getting much higher value added than Indonesia (Figure 3.9). At the same time, labor relations are increasingly perceived as difficult. The sheer number of unions (65 federal unions, 140 labor unions, and 11,000 enterprise-based unions) has also made it difficult to establish coherent labor relations, as unions are frequently in disagreement among themselves.

The tug-of-war between labor unions and employers on the two new labor bills—the Manpower Bill and the Labor Dispute Settlement Bill—may have also contributed to perceptions of deteriorating relations. Despite the rhetoric, labor unrest remains limited, and days lost due to strikes are low. In contrast, absenteeism seems to be a bigger problem, and is more pronounced for foreign-owned firms (Figure 3.10). With these developments in the Indonesia’s labor market over the past few years, the need for coherent labor policies becomes crucial for the investment climate. This is well recognized by the government and is strongly reflected in the White Paper. Essentially, the White Paper aims to instill investor confidence by setting firm deadlines for the completion of two fundamental measures governing labor issues: the Law on Dispute Settlement in Industrial Relations that should be passed by the DPR in December 2003; and implementing regulations of the Manpower Law No.13/2003 that should be finalized by July 2004. The key to these measures is to maintain a balance between protecting labor and maintaining flexibility in working practices so that businesses can remain competitive. The Government will need to take great care in crafting these regulations, and will need to continue consultation with the unions and the business community.

Figure 3.8. Productivity has not matched increase in real wages

-40

-30

-20

-10

0

10

20 30

1994 1995 1996 1997 1998 1999 2000 2001 2002

annual growth rate (percent)

real wages

labor productivity

Source: BPS, Sakernas.

Figure 3.9. Comparison of value added by labor in selected sectors, 2000-2001

(value added per labor cost)

1 2 3 4 5

Garments

Textiles

Electronics India

China

Index: Indonesia=1

Source: World Bank Private Investment Climate Survey for China and India, 2002.

36

Industrial dispute settlement bill. The completion of the Industrial Dispute Settlement Bill is key to resolving labor tensions and thus helping improve the uncertainty in labor relations. Currently, the draft Bill proposes to use a mix of arbitration and labor courts to settle disputes. Under this system, labor disputes should be first addressed in bi-partite committees between employer and labor representatives. If this fails, both sides can use a mediator (government official), a conciliator (private person), or an arbiter (private person) to come up with a solution. Decisions made by the first two are non-binding, while decisions by the arbiter are binding. If no agreement is reached under a mediator or a conciliator, the dispute is delegated to a labor court. viii From an investment perspective, this ‘obligatory mediation’ approach should help reduce cases fought in labor courts and consequently bring down costs. But there are still reservations on the side of labor, which objects to the fact that decisions made by an arbiter are binding, arguing that the option to go to labor courts should still be open. There are also doubts as to whether the new labor courts will have sufficient capacities to do the job. Manpower law. The new Manpower Law addresses a comprehensive and integrated range of issues, covering important areas such as employment arrangements (contract work,

outsourcing, worker placements by professional employment agencies), retrenchment, severance pay and minimum wages, equal opportunities, job training, labor protection, and industrial relations. The Government plans to complete 27 Ministerial decrees by December 2003, and 9 government regulations and 6 Presidential decrees by mid-2004. From an investment perspective, the completion of the Manpower law is good news, as it is based on a consensus between business and the majority of trade unions. But some regulations have the potential to significantly increase the cost of doing business in Indonesia, and implementing regulations need to be carefully prepared. First, outsourcing work will become more difficult for a firm, as it can only outsource work strictly outside the firm’s core business. This limits the firm’s capability to cut labor costs. On the other side, labor unions argue that the increased use of outsourced workers in recent years has weakened regular workers’ position. Second, fixed term contracts will be limited to temporary and seasonal jobs and can only be granted for a maximum of three years, after which the worker receives a permanent status. While this clearly limits the firm’s ability to hire cheaper labor on a longer-term basis, the new arrangement favors unions’ bargaining power. Nevertheless, the worldwide trend to outsourcing means that Indonesia could face serious competitiveness effects if domestic legislation is interpreted too stringently in this regard. Third, formation of tri-partite wage councils at the national, provincial and district level. Those councils (representing government, employers, and unions) will provide inputs and recommendations in formulating wage policies, including minimum wages. The New Manpower Law allows Governors to set the minimum wage, with inputs from provincial wage councils and district heads/city mayors. Minimum wages are derived from estimations on Minimum Living Needs (KHM) and Adequate Living Needs (KHL). The Ministerial Decree on setting KHL expected in December 2003 will help control regional divergences in estimating the KHM and KHL, as provinces and districts will have to adopt guidelines from the central government. The Presidential Decree on tri-partite wage councils,

Figure 3.10. Few days lost on strikes (number of days of production lost in 2002 as a result of

different causes)

0

2

4

6

8

10

12

14

16

18

20

strikes and labor disputes employee absenteeism

days

Note: foreign firms: foreign ownership is higher than 30 percent, domestic firms: foreign ownership is lower than 30 percent Source: World Bank-ADB Private Investment Climate Survey, 2003 (preliminary results)

37

expected to be issued in July 2004, will help ensure a balanced approach to minimum wage setting. Infrastructure The overall quality of infrastructure in Indonesia has deteriorated since the crisis (Figure 3.11), as public spending had to be reduced sharply in real terms, and many committed and planned private infrastructure projects were suspended. Indonesia faces major challenges in its infrastructure sectors as it seeks to consolidate and accelerate its still fragile economic recovery, improve its international competitiveness, and increase access to basic public services. Roads in and around major cities are heavily congested, while many inter-urban and rural roads are in poor and deteriorating condition. The prospect of imminent power shortages hangs over Java and many outer island regions are now suffering regular outages. The picture is brighter in the telecommunications sector, which has seen explosive growth in mobile phone use since the market was opened, but Indonesia’s teledensity lags well behind that of its neighbors. In seeking to address these challenges through mobilizing increased investment, the Government is forced to confront the sensitive issue of tariffs. Tariffs in many sectors are well below what is needed to support new investment. In some sectors, the Government has shown strong political resolve by pushing ahead with significant increase despite strong public opposition. The average electric power tariff has been raised from below $2

cents per KWh in 1998 to close to its pre-crisis level of around $6.7 cents per KWh. But further tariff increases will likely be necessary to finance the massive investments required to serve a projected doubling of demand by 2010. Concerns about social unrest, and the approaching elections, led to postponement or restrictions in tariff increases in several sectors, including power, water, phone, and rail transport. Even with firm resolve on tariffs and cost recovery, it will take time to accelerate the flow of new investment to needed levels. Public budgets are tightly constrained, local governments are slowly adjusting to their new responsibilities after decentralization, and private investors are still wary of the situation. Against this background, several measures are set out in the White Paper to improve infrastructure, but it will be challenging to implement them within the timeframe set. They consist largely of investment projects, but without clarification on how they will be financed, how their financing will fit with fiscal consolidation, and what accompanying policies will be implemented (such as tariff changes). In roads, many issues now have to be addressed at the local government level. Their capacity to handle expanded road sector responsibilities needs to be strengthened. In power, where the government has made commendable efforts over the past few years at resolving key issues (by passing a modern electricity law, preparing implementing regulations, and raising tariffs substantially), the

Figure 3.11. Perceptions of infrastructure quality

Overall infrastructure quality Quality of electricity supply

0 1 2 3 4 5 6 7

Singapore (4)

Malaysia (16)

Taiwan (23)

Sri Lanka (26)

Thailand (29)

China (52)

Indonesia (64)

Vietnam (71)

Philippines (74)

0 1 2 3 4 5 6 7

Singapore (15)

Malaysia (29)

Taiwan (36)

Thailand (37)

China (54)

Indonesia (69)

Philippines (70)

Vietnam (72)

Sri Lanka (73)

Note: Ranking 1=worst; 7=best; Numbers in countries’ in parenthesis is country ranking out of 80 countries. Source: 2002-2002 Global Competitiveness Report.

38

White Paper rightly focuses on the implementation of Law 20/2002 as outlined in MEMR’s blueprint. At the same time, the action plan centers around investment projects rather than needed policy actions, such as higher tariffs or improved public management. A financial restructuring plan for PLN is also needed. In telecom, the establishment of a regulatory body stated in the White Paper is critical. The specific steps and timetable need to be spelled out. Developing Small and Medium Enterprises, and Cooperatives In the White Paper, the Government has positively steered the policy direction of developing SMEs by improving land certification in order to give better credit access to small businesses instead of subsidizing various schemes. Many cases show that small businesses have land but cannot collateralize it for bank loans because obtaining certificates is problematic. Simplifying procedures within the land agency, BPN, would also be needed. The benefit of land certification has been proven to improve credit flow in rural areas. Under the World Bank Land Administration Project (LAP), BPN has recently managed to issue two million certificates over a five-year period. As a result, credit flow increased by nearly 30 percent among the land owners who were then able to collateralize their certificates, and their land value increased by an average of 65 percent. Compared to that, the White Paper target of 41,600 land certificates is decidedly modest, especially if one considers that only 25 percent of Indonesia’s total land is registered. The intent of the announced law on micro, small, and medium enterprises is for now unclear. The law could provide more legal certainty for these enterprises, if they are not yet covered by the company law or the civil code. On the other hand, such a law may add to the administrative burden on this very dynamic part of the economy. Worse, the law could result in preferential treatment and credit quota’s for these enterprises—much like in the law of cooperatives which is now under revision. Clarifying the intent of the measure is therefore a priority for Government.

i However, one large project approved in October accounts for a third of the total. Oil refinery projects in Nusa Tenggara Barat and Aceh, whose approved values are $2.8 billion. ii A country’s revealed comparative advantage in exports (RCA) in a certain product captures the extent to which the country exports a higher proportion of the product than the average country, and is measured as the ratio of the share of the product in that country’s exports to the share of that product in overall world exports. Thus the RCA of country j in exports of product i is defined as: RCAij = (Xij/Xj)/(Xiw/Xw), where Xij is country j’s exports of good i, Xj is total exports of country j, Xiw is worldwide exports of good i, and Xw is total worldwide exports. A value of RCA > 1 (<1) implies that the share of product i in country j’s exports is greater (smaller) than the share of product i in world exports). iii Suryahadi, Asep, Widyanti, Wenefrida, Perwira, Daniel and Sumarto, Sudarno (2003), “ Minimum Wage Policy and its Impact on Employment in the Urban Formal Secotor. Bulletin of Indonesian Economic Studies Vol. 39, No.1 (April 2003), pp.29-50. The authors found that the estimated elasticity of total employment to minimum wage is statistically significant at –0.1 percent, translating roughly to a 1 percent reduction in employment for a 1 percent increase in minimum wages. iv Jakarta Post December 3 2003, page 13: 94,000 workers fired in first 10 months. v These are preliminary results of a survey of about 400 firms mainly located in Java. vi The literature on tax incentives generally finds that tax incentives can be costly and are rarely the most important determinant of investment. For instance, analysis on the investment tax credit in the US shows that investments have not been significantly higher when a business tax credit was offered (based on a percentage of investment in equipment) than during periods it was not (Karier, 1994). Similarly, Fletcher (2002) confirms the general results in the literature. He finds that while low overall rates of taxation may promote investment, there is no evidence that complicated regimes of discriminatory tax incentives are more effective in promoting investment than simple tax regimes with low uniform rates of taxation. vii The process described is for foreign investment especially since it involves registration of a new company, acquiring a tax registration number and expatriate work permits. Approval for domestic investments or PMDN is relatively straight forward if it involves an operating entity with the complete documentation for company registration and tax record but in the case of a joint venture, the foreign partner would still have to go through the process of company registration. viii The labor court consists of one judge nominated by the High Court and two ad-hoc judges nominated by the labor and employer sides. There are plans to install labor courts in every province, with additional labor courts in major industrial areas such as in Jabotabek or Batam Island.

39

CHAPTER 4: MEETING INDONESIA’S GOVERNANCE CHALLENGES

The achievements of the past few years in maintaining macroeconomic stability, restoring modest economic growth, and securing political stability in a difficult international environment continue to be clouded by widespread concerns about governance and corruption across Indonesian society. The high hopes that the Reformasi movement would break the hold of the vested interests behind the corruption, cronyism, and nepotism of the Soeharto era have not been realized. Few have been held to account for the massive theft of public resources that occurred towards the end of the New Order period. There are increasing signs that old elites and a set of new players, especially at the regional level, are using “money politics” to solidify privileged positions in the new political system. Institutional reforms that threaten the interests of these elites—in particular to strengthen the effectiveness of the justice sector—have been consistently undermined. While corruption captures headlines, the issues created by Indonesia’s weak governance institutions have wider implications (Figures 4.1 and 4.2). The “please your boss”, upward-looking accountability and reward system of Indonesia’s overly-centralized New Order civil service regime lingers on at the expense of citizen participation and accountability for results. A whole new mindset is needed, including tools, instruments and capabilities of modern, responsive government. Though it is nearly impossible to compare the actual levels of corruption under the New Order and Reformasi regimes—taking into account the impact of decentralization as well—it is clear that corruption has become less predictable in this more competitive and uncertain environment. Moreover, the unfulfilled expectations that Reformasi would quickly bring a new integrity to

public life have generated resentment, fuelling perceptions that corruption has become endemic in the new system. For the donor community, corruption has become a triple threat: it undermines progress on the country’s broad development objectives, it remains a serious risk to the effectiveness of donor programs, and it continues to weaken public credibility in development assistance overall, which is still too often portrayed within segments of the community as contributing to the problem. Nevertheless, it is important to recognize that these remaining governance problems exist within a framework of tremendous political, economic and institutional changes that have marked Indonesia’s transition to a more open, competitive society and that provide new opportunities for improving governance. Constitutional reforms securing direct elections have created a new accountability framework between public officials and their constituents at all levels of the political system. Decentralization is bringing control over resources and the delivery of public goods and services closer to the clients, providing new opportunities for participation and monitoring to make local governments more responsive. The opening of the media and surge of new collective organizations within civil society are giving rise to powerful demands for good governance. The results of these remarkable changes are evident in the new level of transparency and competition in Indonesian public life. Yet these critical gains in participation, competition and transparency are not leading to concomitant improvements in the overall quality of governance. Much of the problem lies with the weak implementation of many of the major policy and institutional reforms introduced under Reformasi. Bold and ambitious legislation is often undermined by weak and contradictory implementing regulations and procedures. Public revelations of corruption and wrong-doing sparked by an activist media, watchdog groups, and independent auditors are rarely followed through to a satisfactory conclusion in the legal system.

Corruption has become less predictable under

decentralization

40

0 2 4 6 8

Indonesia

Philippines

Korea

China

Thailand

Malaysia

Figure 4.1. Extent of consensus within government

Index 1999

2003

Source: I MD World Competitiveness Yearbook, 2003.

worse better

Indonesia has achieved transparency without accountability; the tremendous gains since the fall of the New Order have not been matched by genuine government accountability for demonstrable results in restoring integrity to the public sector and reducing corruption. As a result, there is a risk that this increased transparency will continue to generate frustration and resentment, rather than promote improved governance. The governance agenda in Indonesia needs to focus urgent attention on improving the institutions and mechanisms to implement the ambitious reforms introduced in the past few years and to strengthen government accountability for achieving demonstrable results from those reforms.

Nor

mal

ized

gov

ernm

ent e

ffec

tiven

ess

inde

x Government effectiveness

CHINA

THAILAND

MALAYSIA PHILIPPINES

VIETNAM

INDONESIA

- 3

- 2

- 1

0

1

2

3

195 Countries

HIGH

LOW

Political stability and absence of violence 2002

INDONESIA VIETNAM

MALAYSIA

THAILAND

CHINA

PHILIPPINES

-3

-2

-1

0

1

2

3

186 Countries Nor

mal

ized

pol

itica

l sta

bilit

y an

d lo

w v

iole

nce

inde

x

HIGH

LOW

Control of corruption

MALAYSIA

THAILAND

CHINA

PHILIPPINES VIETNAM

INDONESIA

-3

0

3

195 Countries

Nor

mal

ized

cor

rupt

ion

inde

x

HIGH

LOW

Rule of law MALAYSIA

THAILAND

CHINA VIETNAM PHILIPPINES

INDONESIA

-3

-2

-1

0

1

2

3

195 Countries

Nor

mal

ized

rule

of l

aw in

dex HIGH

LOW

Note: The dots represent estimates for the 2002 governance indicators for each country, and the thin vertical lines represent standard errors around these estimates. The large dots represent the 1996 comparator. Source: “Governance Matters III: Governance Indicator for 1996-2000” by Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi, 2003.

Figure 4.2. Perceptions of key elements of “governance” 2002

41

Of particular importance in achieving these goals are comprehensive reforms in three areas: i) lega l reform and the justice sector; ii) public administration; and iii) public financial management. These are the institutions and mechanisms that implement and enforce government policies and that are critical to breaking the bottlenecks that weaken the links between participation and transparency on the one hand and greater accountability and improved governance on the other hand. Though reform blueprints have been proposed by various organizations in each area, only in the area of financial management is progress being made on a new comprehensive framework of reform. Similar efforts are now necessary to break through the bottlenecks in the justice sector and civil service reform. GOVERNANCE AND THE WHITE PAPER The Government’s White Paper is not intended as a comprehensive governance strategy. Its initial intention was to substitute for the commitments normally made in an IMF letter of intent with a strong focus on the macroeconomic policy framework. However, to the extent that the White Paper seeks to address the problems that hinder economic growth through a focus on improving the investment climate, issues of governance naturally arose. The White Paper, therefore, addresses a set of specific governance concerns that are directly related to the quality of the investment climate. A more comprehensive approach to governance reform in Indonesia would be beyond the scope of an IMF graduation program. Moreover, given the political uncertainties of an election year, a more ambitious program would ultimately have confronted the realities of electoral politics, thus undermining the credibility of a comprehensive governance strategy from the very start. Though there are important steps to improve governance across all of the categories of measures specified in the White Paper, this chapter will review the White Paper targets and progress to date in the three areas described above as critical to strengthening the framework for accountability in Indonesia: public financial management, legal and justice sector reform, and public administration.

Public Financial Management Perhaps the most important measures in the White Paper to reduce corruption and improve governance are to be found in the section on maintaining macroeconomic stability. This section not only lays out the targets of fiscal policy, but identifies specific measures to enhance the efficiency and effectiveness of the mobilization, allocation, and use of public resources. While such measures are vital to promote and sustain macroeconomic stability over the medium-to-long term, they might also be considered at the operational center of efforts to reduce corruption and improve governance. The misuse or misallocation of public funds for private gain is part of the basic definition of corruption. Measures to reduce discretion of individual public officials over the flow of public resources through greater transparency, stronger ex ante control functions, and better ex post verification and auditing mechanisms constitute the basic nuts and bolts of any anti-corruption strategy. They are also essential for holding public officials more accountable for their performance. In Indonesia, there is an additional factor that links public financial management to the issues of corruption and governance: the chronic under-funding of key public institutions. The World Bank’s recent report on corruption (Combating Corruption in Indonesia, 2003) demonstrates how politicians and policy makers create perverse incentives for such essential institutions as the military and the police, among other service providers, by failing to provide them with the resources to do their job. It is estimated that less than a third of the military and police expenditures are met from official budget allocations. Allocations for operations and maintenance tend to be very low and have declined in real terms. Budget allocations are released late in the year, creating uncertainty and providing little time to spend them wisely. To cope with the systemic under-funding and budgetary uncertainty, it became common practice under the New Order for public agencies to raise their own resources to meet the gaps. And such practices have persisted under Reformasi. Among the most common survival strategies are shifting recurrent expenditures to the development budget, levying

42

The lack of confidence in the justice sector is

pervasive

unauthorized charges for services delivered, and running enterprises, foundations and other resource mobilization ventures. The practice of permitting enterprises to be run by the military and the police is a particularly serious problem leading to allegations of involvement in drug smuggling, protection and prostitution rackets, and, following their formal separation, to open conflicts between the police and the military when their business interests clash. These practices blur public-private boundaries, weaken accountability for funds and provide a ready excuse for rent-seeking activities. The White Paper brings together a set of ongoing measures designed to address key weaknesses in the public financial management system. First, it commits to modernizing the revenue system through revisions of taxation laws, expanding the large tax payers’ office, and reforming customs. Second, it addresses the efficiency, effectiveness, and transparency of government spending through revised procedures on government procurement, reorganization of the Ministry of Finance, establishment of a separate treasury and a treasury single account, and implementing regulations for the state finances law. These measures, and the progress to date in implementing them, are discussed in more detail in Chapter 1. The purpose here is not to repeat that assessment, but to stress the role that such reforms play in the broader struggle to reduce the opportunities to engage in corruption and to lay the foundation for more accountable government. While popular perceptions of the fight against corruption tend to be influenced most by high-profile enforcement measures, such as arrests and prosecutions, the more mundane areas of procurement reform, budget preparation and execution procedures, classification and accounting methods, and financial monitoring and audit systems are often where the most important steps will be taken to prevent corruption and reveal abuses. Recent progress in these areas as well as prospects for further progress in the coming year, as Chapter 1 demonstrates, should be taken into account in assessing overall developments in combating corruption and improving governance.

Legal and Justice Sector Reform The weaknesses of the Indonesian justice sector have long been seen as the main obstacle to fighting corruption and improving governance in this country. Public opinion polls show that the majority of Indonesians lack confidence in justice sector institutions. External ratings for Indonesia consistently cite problems in the justice sector as a key component in the country’s poor ranking on perceptions of corruption, governance and the quality of the investment climate. Over the past year, these trends have continued and indeed intensified somewhat as the prospect of elections has begun to intensify political competition. Both local and foreign press have continued to run stories on a regular basis about alleged widespread abuses of power within the national police and the Attorney General’s Office, and about allegations of corruption within the judiciary. Clearly, accusations of slow progress on legal and justice sector reform are likely to figure prominently in the upcoming elections as politicians attempt to capitalize on the perceived gaps between the promise and reality of reforms to bring about a new integrity in Indonesian public life following the fall of the New Order.

Against this background, the White Paper recognizes the importance of enhancing “legal certainty” as a key component of improving the investment climate. It identifies four reform areas under the broader heading of legal reform: (i) eliminate corruption; (ii) improve the performance of the Commercial Court; (iii) harmonize regional regulations; and (iv) improve the capacity and performance of law enforcement officers. It commits the Government to clear targets for implementing a set of long-delayed measures to establish an institutional framework for investigating and prosecuting corruption cases and for redefining the management of the court system.

43

Table 4.1. Legal and justice sector reform measures in the White Paper

Action Plans Outputs Date

• Appoint team to select candidates for the Anti-Corruption Commission.

Presidential decree Sept 2003 (completed)

• Appoint the members of the Anti-Corruption Commission. Presidential decree Dec 2003

• Increase the capability of prosecutors and judges responsible for corruption cases through training, internal directives and policies, and assistance programs.

Improved professionalism Nov 2003 (completed)

• Publish blueprint on the role of the Judicia l System in reducing corruption.

Blue print Nov 2003 (completed)

• Complete Judicial Commission Law. Law on Judicial Commission

After law passed

• Complete revision of Law No. 5/1991 on Attorney General.

Amended Law After law passed

• Issue revised Law on Bankruptcy. Law After law passed

• Update blueprint on Commercial Court. Blue print Nov 2003 (completed)

• Revoke regional regulations that are inconsistent with higher laws/regulations and public interest.

Ministerial decree Ongoing

• Training for investigators, prosecutors, judges. Improved professionalism Ongoing

• Improved education curriculum for law enforcement officers.

Improved professionalism Ongoing

Source: World Bank staff based on Presidential instruction No. 5/2003.

The Supreme Court blueprints constitute

an important first step

Table 4.1 lists the specific actions, outputs and target dates, several of which have been prominent on the agendas of previous CGI meetings. Taken together, these commitments demonstrate a recognition that the poor reputation of the Indonesian judiciary is not just of relevance to the issue of social cohesiveness in a democratizing Indonesia, but that the lack of legal certainty that is an inevitable product of a weak judiciary and a fragmented political power structure is a major impediment to attracting on a sustained basis the levels of investment required to generate significant economic growth. More importantly, it sets out clear Government commitments and a timeframe in this area that hold out the prospect

that meaningful institutional reform within the justice sector may yet be embarked upon. By far the most promising of the measures set out in the White Paper has been the development and adoption by the Supreme Court in October 2003 of

44

Box 4.1. The supreme court blueprints The blueprints are the outcome of a collaborative process between members of the Supreme Court and an Indonesian law reform advocacy group to identify areas of weakness in the Indonesian judiciary and map out a reform path for a systematic set of initiatives to address such weaknesses. The blueprints were funded by a Dutch-funded IMF assistance program and the Asia Foundation. The blueprints cover 5 broad areas: (i) reform of the Supreme Court; (ii) the setting up of a Judicial Commission to address the issues of appointments to the Supreme Court and the supervision of the conduct of judges; (iii) reform of personnel management within the judiciary; (iv) reform of the judicial education system; and (v) reform of financial management of the judiciary. Each blueprint sets out a reform agenda, including time -frames for the carrying out of the various steps identified. Appropriately, these time -frames acknowledge the long-term nature of many of the initiatives. What the blueprints do not elaborate upon are the mechanisms by which the proposed reforms are to be managed. This is a key issue that has to be addressed if the promise of the blueprints is to have a realistic prospect of success. It will be particularly important that the Supreme Court recognize that, while other Indonesian state institutions, as well as the donor community, have important contributions to make to the reform process if they are to succeed, by far the most important effort required will have to come from within the judiciary itself.

a series of blueprints for the future development of the judiciary (Box 4.1). The breadth and coverage of the blueprints indicates that the Supreme Court (or at least significant elements within the court) recognizes that the judiciary indeed suffers from system-wide weaknesses that in turn require a systemic and systematic response. This is a major and positive development for Indonesia, inasmuch as it constitutes a frank recognition of the extent and depth of the problems in the judiciary, which is an essential foundation for moving forward. At the same time, it is clear that the blueprints represent only a first, albeit very important, first step along a path that, even if kept to and pursued with vigor, will take many years to complete. Beyond the Supreme Court blueprints, the focus of the White Paper on integrity issues is welcome. Of the many facets of this challenge, combating corruption is probably the one most Indonesians would agree is most needed. It is also the most problematic, given the fact that the law enforcement institutions are widely viewed as being themselves deeply corrupt. The Anti-Corruption Commission—and its corollary the Anti-Corruption Court—is clearly intended to be the anchor of a new institutional framework to address this weakness. The gestation of the Anti-Corruption Commission (ACC) has been disappointing. There have been

serious delays in moving forward with the selection of potential commissioners which raised doubts about the Government’s commitment to this body. However, assuming the timetable established by law is adhered to, commissioners for the ACC will be appointed at about the time this document is released. The challenge and need for immediate action by Government will not stop at that point and goes well beyond the target set in the White Paper: • The success of the ACC will depend on its

public credibility, which will, in turn, be a function of the quality of individuals selected as commissioners and the transparency of the process by which they are selected. The delay in appointing a selection committee coupled with the Government’s legal commitment to establish the ACC by the end of December 2003 have created a tight time frame for any meaningful public consultation in the selection process. This must be addressed with some urgency to ensure that the ACC does not start out under a cloud of public suspicion.

• The ACC cannot operate effectively until the professional staff has been selected, appointed and equipped to carry out its investigative and prosecutorial responsibilities. Although this should have been in place promptly upon appointment of the commissioners, the dilatory preparatory steps make this an unlikely

45

The draft laws on the AGO do not promise

the badly needed overhaul

prospect. This should be remedied as a matter of urgent priority for the Government in the weeks after the commissioners’ appointment.

• An equally important priority for the Government at the very inception of the ACC will be to ensure it is adequately funded. The need for this is clear: under-funding of the existing law enforcement agencies has been a major contributing factor to their failings including, significantly, the corruption that pervades them.

• A very important function that the ACC will assume when it commences operations is that of the KPKPN, which oversees the declaration of assets by public officials. While that agency has suffered from a number of significant problems, it has nevertheless demonstrated a preparedness to challenge a number of high level officials—acts of courage that will need to be repeated if a credible anti-corruption campaign is to be pursued. The challenge for Government is to ensure that the weaknesses of the successor unit to KPKPN are addressed and that credible sanctions for non-compliance with its reporting requirements are established.

An equally important challenge set out in the White Paper will be the establishment of a credible Anti-Corruption Court. Recent experience with the Commercial Court suggests that the new Anti-Corruption Court will be viewed with considerable skepticism from its inception. A number of steps can be taken to give the Anti-Corruption Court a real opportunity to perform professionally and with authority. The Indonesian authorities, coordinated by Bappenas and assisted by Indonesian civil society advocacy groups, are engaged in a process to draw up a policy document that identifies these steps. The White Paper calls for this document, again called a Blueprint, to be completed by November 2003. It identifies various measures including notably the establishment of a professional and accountable recruitment mechanism, provision of proper funding and the setting of conditions of employment (including career development) that adequately guarantee judicial independence. Most of these will be matters for the Supreme Court to address. However, the Government will have the responsibility to ensure that the budgetary

resources of the Supreme Court are sufficient to ensure that the adequacy of resources available to the new Anti-Corruption Court does not become an impediment to its effective functioning. The Government has been engaged in the development of a solid funding mechanism that reflects real and legitimate court costs, including salary adjustments and an institutional overhead depending on case load (‘the Needs Assessment’). Rather than the somewhat arbitrary funding mechanism currently generally in use, that new funding mechanism is being applied to the new Anti-Corruption Court. A budget application based on this assessment has been submitted by the Supreme Court which hopefully will be honored.

The White Paper calls for a revised Attorney General’s Office Law to be passed. The two drafts before the DPR are limited in their scope (Box 4.2) and neither can be seen as the answer to the many calls for a thorough overhaul of the Attorney General’s Office (AGO). The AGO has, within the last year, invited a group of prominent “outsiders” to assist the AGO in developing reform measures. While this initiative is welcome, there remain concerns about the prospects for a meaningful reform agenda to emerge from this process. Given the critical importance of this institution, the reform of the AGO needs to go beyond the draft law set out in the White Paper and should entail the adoption of a reform agenda that addresses the serious flaws in the organization that were identified in the institutional audit conducted by Pricewaterhouse-Coopers under the auspices of the ADB. The example set by the Supreme Court in the development and adoption of the blueprints is one that would be very appropriate for the AGO to

46

Box 4.2. Reform of the law on the Attorney General’s Office (AGO) Two draft laws have been prepared: (i) a version prepared by the AGO, which draft, if adopted, would replace Law 5/1991; and (ii) a version prepared by the staff of the DPR, which would amend certain provisions of that Law. Among the changes proposed in these drafts are the following: • Both drafts contain provisions describing the AGO as independent. While the AGO version would retain

the concept of the AGO being a “government institution,” both eliminate the current provision that the AG reports to the President. Recognition of the value of the AGO being free of political interference is welcome. However, it is equally important that appropriate accountability mechanisms be established. Neither draft contains much detail in this regard.

• The AGO version proposes that the Attorney General must be appointed from within the ranks of the AGO. The DPR is silent on this matter. While insider experience is always an asset, and while reform is best likely to succeed if there is institutional ownership of the process, the likelihood is that the thorough-going reform that the AGO needs (as convincingly described in the ADB-financed Price Waterhouse Coopers governance audit carried out in 2000) will be embraced by a leadership nurtured by and within the current system appears problematic. The AGO version also would require the Vice-AG and each Deputy-AG to be appointed from within the ranks of the AGO. This reflects the current law. The DPR version appears not to change this requirement.

• Both versions propose that the mandatory retirement age of senior prosecutors be extended to 60 and top officials to 65. Given that senior prosecutors are likely to be the most resistant to reform, this provision would appear to complicate further the prospects for reform of the AGO.

• Neither version makes any reference to the Anti-Corruption Commission. This omission could result in the sort of tensions that have characterized relations between the police and the AGO with respect to the investigation of corruption allegations in recent years. Arguably both drafts could be interpreted as requiring that prosecutors conducting prosecutions for the Anti-Corruption Commission would nevertheless be part of the AGO. Lack of clarity on this issue, and the failure to acknowledge any role of the Anti-Corruption Commission in the prosecution of corruption cases, does not augur well for the Commission.

follow. For this to occur, strong leadership from the Government is required. The White Paper does not propose any specific initiatives for the national police beyond improving the education curriculum. Nevertheless, this is an institution that few would argue does not face a major credibility problem with the citizenry of Indonesia, notwithstanding the very impressive performance of the police in its investigation of the Bali bombings. There are a number of indications that the police leadership is aware of the need to improve its standing with the public. For example, in the past year the police have engaged in a dialogue with an NGO umbrella organization called Indonesia Police Watch. However, a concrete and comprehensive reform agenda for the police is still to be developed. A governance audit along the lines followed for the AGO in 2000 and/or the development of a reform agenda in the manner carried out by the Supreme Court would be appropriate steps for the national police to follow.

The White Paper also targets the work of the Commercial Court by committing to a revised blueprint for the court and the adoption of the draft Law on Revisions to the Bankruptcy Law, which is currently with the DPR. Passage of the law would send a signal that the Government remains committed to the objective of ensuring Indonesia has a credible bankruptcy regime, which remains an issue of strong concern among the business community. However, the problem with the bankruptcy regime does not appear to be with the quality of commercial court decisions. An on-going in-depth study of commercial court decisions by a team involving experienced foreign lawyers indicates that up to 70 percent of the commercial court decisions could be characterized as good law. However, evident problems in certain high-profile cases have clearly raised serious credibility concerns. More importantly, the principal problem appears to be more in the area of enforcement, which goes beyond the capacity of the courts.

47

Only 31 bankruptcy cases were handled in

2003

The Commercial Court continues to be the principal pilot of institutional reform of the judiciary. Among the innovations first introduced by this Court have been: the appointment of ad hoc outside judges, the publication of all decisions, the issuance of dissenting opinions, the option to comment on decisions through the internet, strict timelines for court decisions, the issuance guidelines governing the relationship between judges and the Bar (receivers), a mandatory code of ethics, and the introduction and application of the concept of disbarment. Nevertheless, it is clear that credibility remains an issue for the court as only 31 bankruptcy cases were handled in 2003. Again, serious problems with enforcement go a long way towards explaining these credibilit y problems, but it still would be desirable to improve the clarity of the law and to enhance the effectiveness of bankruptcy proceedings where appropriate. These considerations lie behind the draft law, that, responding to commercial court experience over the past years, includes a long set of definitions, standardizes time lines further, boosts commercial court jurisdiction, ties down appeal, and clarifies restructuring procedures and the position of both creditors and debtor therein.

Public Administration Reform The White Paper includes a welcome recognition that the goal of increasing investment, exports and employment to enhance growth is dependent, in part, on the quality of public services and, hence, the performance of public administration. Indonesia continues to suffer from a legacy of over-centralized service delivery systems and an administrative culture that is driven by top-down commands rather than client-driven demands. Though decentralization and community empowerment offer important new opportunities for service improvement by bringing authority for public service provision closer to the client, the

initial confusion resulting from inconsistent decentralization laws and from capacity constraints have dampened the potentially positive impacts of these reforms in the near term. It has long been recognized that fundamental reforms are required in the recruitment and training of civil servants, the definition and transparency of administrative procedures, and the structure and pay scales of the civil service, yet there has been little progress to date in these areas. In the area of public administration, the White Paper places primary emphasis on increasing the transparency of public services through the development of a draft Law on Public Service Delivery, the publication of public service delivery standards, and the move towards e-government. Table 4.2 provides a more detailed list of the public administration reforms incorporated in the White Paper. The idea of a single law to provide an overall framework for the delivery of all major public services is quite unusual in light of standard international practice. According to the Ministry of Administrative Reform, the purpose of the law is twofold: (i) to set out the obligations of government to deliver public services to a minimum standard in terms of quality, efficiency, and access; and (ii) to establish the right of the citizens to receive such services and the obligation to value and care for public facilities. It is intended that with these minimum standards, rights, and obligations set out in law, citizens will be able to take complaints to the formal legal system and, in so doing, place pressure on public service providers at different levels of government to deliver. It has even been suggested that such transparency will put pressure on government to undertake more comprehensive civil service reforms to meet these new standards. Moreover, by combining this law with the publication of standards for the delivery of all public services and the spread of e-government systems, the government hopes that increasing the transparency of service standards will generate greater accountability for public service providers. While greater transparency in this area is surely welcome, this approach to improving public administration misses the fundamental problem in

48

Table 4.2. Public administration reform measures in the White Paper

Action Plans Outputs Date

• Propose Draft Law on Public Service to Parliament (DPR) Draft law 2004 • Review regulations related to public service delivery; deregulate

and reduce bureaucratic hurdles Ministerial decree 2004

• Require public service agencies to publish all services rendered, time, and costs needed

Ministerial decree June 2004

• Speed up the implementation of Inpres No.3/2003 on National Policy and Strategy on Development of E-Government and prepare supporting tools

Guidance on e-Government

Dec 2004

• Finish deliberation draft law on Freedom of Information Law • Revise Law No. 22/1999, on relations between provincial and

regional governments Draft Amendments Sep 2004

• Revise Law No. 25/1999 on financial balance formula and supervision, consistent with Law No. 17/2003

Draft Amendments Sep 2004

• Revise Law No. 34/2000 on greater discretion and responsibility for regional governments to collect regional taxes and charges, while avoiding barriers to business and investment

Draft Amendments June 2004

• Improve regional government accounting systems in line with Law No. 17/2003

MoF decree Oct 2004

Source: World Bank staff based on Presidential instruction No. 5/2003.

The White Paper does not address the

fundamental problems of public

administration

the Indonesian context discussed earlier, namely the apparent disconnect between transparency and accountability. Without a credible public complaints mechanism or court system that can adjudicate and enforce legal decisions, the added transparency promised by these reforms in the White Paper are highly unlikely to have much of an impact on the performance of Indonesia’s public administration. Indeed it is not the lack of transparency that is responsible for poor public service delivery, but an inefficient and corrupt civil service, poor planning and budgeting systems, systematic under-funding in key areas, weak institutional capacity, and poor coordination across different sectors and levels of government. These fundamental problems of public administration are not addressed in the White Paper and this constitutes a major weakness of the program. A civil service reform could potentially have a much greater impact on the quality of public service delivery than a new Public Service Law, because it is one of the reforms, which together with the performance budgeting, could promote qualitative change in the operation of regional governments. Voices from the regions demand greater freedom to design and implement local civil service reforms to match their newly

delegated responsibilities over public expenditures and public service delivery. The provincial government in Yogyakarta has embarked on a reorganization and rightsizing exercise. Other regions have taken initiatives aimed at cleaning up corruption (Box 4.3). Still others have introduced open and transparent processes to recruit some civil servants (Tanah Datar, Kebumen). There is an increasing call for a pay reform where employment and promotion can be linked to performance and to seniority. Nevertheless, top-down decrees (like PP 8/2003), which determine a rigid, nation-wide ‘echelon’ structure for senior positions in the local administrations continue to stifle local level reforms. There is also a threat that

49

Box 4.3. Integrity pacts in Solok Kabupaten Solok has invented a “Pact of Integrity” to be signed by civil servants to achieve greater accountability for its public spending and its civil servants. The Pact will be implemented from January 2004. The Pact of Integrity in Solok is an expansion of the compulsory Pacts of Integrity to be signed in all public procurement (Keppres 80/2003). Both public servants and bidders in a procurement process sign a pledge that no bribes, gifts, favors or other advantages will be demanded, accepted or offered. It is supported by GTZ’s Good Governance Project. Civil society organizations will monitor through scrutiny of relevant documents and decisions. In the first year local CSOs and the Kabupaten administration will get assistance from Transparency International (TI) and Indonesian Procurement Watch (IPW) to monitor and implement the pact. A local government regulation (Perda) on transparency and public participation, planned as one of the entry requirements for the World Bank financed local governance project (ILGRP), provides the legal framework for civil society organizations’ access to monitor government decisions. All payments made will be disclosed. Arbitration is used as a conflict resolution mechanism. A pre-announced set of sanctions for any violation of their commitments or undertaking by a bidder or public servant involved will be used to discipline failures. In Solok, the ‘Pact of Integrity’ is extended beyond procurement matters and it includes all civil servants under the jurisdiction of the Kabupaten (currently about 3500). The Pact itself comprises a range of good governance principles such as accountability, transparency, participation, surveillance, efficiency and effectiveness. For their pledge to be “clean and uncorrupt” the public servants will receive a payment incentive. The level of payment will initially be determined by the individual’s position level in the career system. The amount is made transparent in a publicly available chart. The total incentive scheme is at the level of the accumulated personnel costs related to projects in the development budget. Starting with the budget year 2004 the routine budget and the development budget will be merged and this is expected to increase the transparency in budget spending and the Pact of integrity can be developed further and more easily monitored in the new budget system. At a later stage it is planned to include the private sector, the police, the judiciary and the local parliament to build an ‘integrity system’.

the ongoing revision of the Decentralization Law (Law 22/1999)—a target of the White Paper—is likely to pull senior civil service appointment functions back to the central government, thus exacerbating the mismatch between regional responsibility for public service delivery and the lack of regional autonomy over the civil service that delivers those services. To get started on civil service reform, there are a number of necessary measures beyond the scope of the White Paper. First, there is urgent need to establish a proactive leadership for a civil service reform process. Establishing the Civil Service Commission, as envisaged under Law 43/1999, and staffing the Commission with people of integrity and providing it broad autonomy to move on a reform agenda, could provide such a vehicle. Second, there is a need to disentangle the complex and confusing web of pay and employment policies and introduce greater transparency and reduced discretion on total compensation levels.

More homework is needed on a compensation package for the civil service through careful pay comparator studies and labor market analysis. Third, rationalizing civil service salaries will likely have no results on corruption unless it is accompanied by the introduction of strong rewards and punishments that significantly shift incentives in the civil service. Establishing clear ethical codes and administering them through an independent ethics commission within the civil service and ensuring that corrupt behavior is punished severely will be the most effective check on corruption. Fourth, though transition to a rules-based meritocratic civil service will take time, opening the top positions in regions to external recruitment and staffing them with men and women of the highest quality will be the fastest way to change the culture of the civil service. Such measures would address some of the more deep-rooted problems that systematically weaken Indonesia’s public administration.

50

ACCOUNTABILITY AND THE WHITE PAPER Though this chapter focuses on only three areas covered by the White Paper that could promote greater accountability for improved governance in Indonesia, it must be recognized that one important step towards such accountability has already been taken by the very formulation and publication of the White Paper itself. The White Paper is a mechanism designed to commit the government in a transparent way to a set of policies in what promises to be a challenging environment over the next 18 months. A key test of governance in Indonesia will be whether the government can implement the policies set out in the White Paper and live up to its commitments. One already positive sign is the extensive monitoring efforts that are being mobilized to hold the Government accountable to these commitments. Beyond the Government’s own monitoring team under the Coordinating Minister for the Economy, which has put monthly monitoring reports of the White Paper on the web, independent monitoring efforts are being developed by representatives of the private sector, universities and other research institutes. These efforts are themselves important examples of the development of stronger accountability framework in Indonesia, which will have an impact on governance outcomes.

51

1996 1999 2002 National poverty lines Gov of Indonesia 17.5 23.4 18.2

World Bank 15.7 27.1 16.0 International Poverty Lines 1 dollar a day 7.8 12.0 7.4 2 dollar a day 50.5 65.1 53.4

Table 5.1. Change in poverty headcount index from 1996 to 2002 (percentage)

e

Source: World Bank and BPS Staff estimates.

The majority of Indonesians earn less than two dollars a day

CHAPTER 5: REDUCING POVERTY

Macroeconomic stability and modest growth have brought income poverty back to pre-crisis levels. But progress is lagging in other aspects of poverty reduction, with basic services are often still failing for the poor. The White Paper reconfirms the Government’s commitment to develop a comprehensive Poverty Reduction Strategy Paper (PRSP) by mid-next year, and presents a number of measures that can create opportunity for the poor, improve their human capital, and safeguard the vulnerable. The success of the forthcoming PRSP will depend on whether it will ultimately yield an enhanced poverty focus of government policies and programs. To this end, the strategy needs to be integrated with existing budgeting and planning procedures and sector strategies. The measures to improve services for the poor included in the White Paper need to be complimented with those that make decentralization work, and improve governance. INDONESIA’S POVERTY CHALLENGE With inflation and the exchange rate under control, expenditure poverty dropped back to pre-crisis levels from 27 percent in 1999 to 16 percent in 2002, the latest number currently available (Table 5.1). The reduction in expenditure poverty since the crisis appears to have benefited almost all regions: indeed all but one province captured in the 2002 household survey experienced an improvement in poverty rates, including strong

recoveries from some regions in the East. While the headcount index is relatively low, many Indonesian households who are not currently poor are vulnerable to falling into poverty. This is due to the clustering of a large share of households just above the poverty line: 7.4 percent of Indonesians fall under the dollar-a-day poverty line whereas 53.4 percent fall under the two dollars-a-day poverty line. (The national poverty line is currently approximately $1.55 a day.)

The national headcount index masks wide disparities in poverty incidence across the country. While the poverty rates are 15.7 percent and 4 percent on Java and Bali, the Eastern Islands lag, with poverty rates of 36.8 percent (Figure 5.1). The severity of poverty is also more serious in the Eastern Islands, with the depth of poverty at 7.8 percent in NTT/NTB (Nusa Tenggara Timur/Barat) provinces compared to 2.5 percent in Java and Bali. Despite regional disparities, 78 percent of Indonesia’s expenditure poor live in Java, Bali, and Sumatra. Addressing poverty in Indonesia will not only require efforts of bringing along the lagging regions but also tackling the poor in non-lagging regions. Moreover, other dimensions of poverty remain serious in Indonesia. Some 53 percent of Indonesians lack access to at least one of basic services (Figure 5.2), particularly with respect to water and sanitation. Inadequate service delivery is failing the poor and is itself a cause of poverty and deprivation in Indonesia. This is also reflected in poor MDG outcomes, especially in health. i Women in particular suffer problems of access to quality services and bear the consequences: for example, Indonesia’s maternal mortality rate is two

52

Figure 5.2. Many Indonesians lack access to basic services

0 10 20 30 40

births attended by traditionalhealers

children age 7-12 not in primaryschool

children age 12-15 not enrolledin junior high school

households without access tosanitation

households without access towater

percent share of households lacking services

Source: World Bank Staff calculations.

53 percent of Indonesians lack access to at least one of basic

services

Headcount Index:

0.236 to 0.4 (6)0.194 to 0.236 (5)0.077 to 0.194 (5)0.041 to 0.077 (6)all others (4)

Figure 5.1. Where are the poor?

Source: Susenas 2002 (Rural Areas)

times higher than the Philippines and five times higher than Vietnam. Directed efforts to improve the delivery of basic services is thus a critical facet of any effort to reduce multidimensional poverty in Indonesia. Traditional attempts at targeted income transfers or relying only on expanding access to credit will not solve these problems. Regional multidimensional poverty maps show strong geographic correlations between expenditure poverty measures and other measures of poverty at the provincial level, with Nusa Tenggara having low levels of service access in general. Overall, Bengkulu, West Kalimantan, Central Java, East Java and Nusa Tenggara lag behind other provinces with respect to

multidimensional poverty measures. ADDRESSING THE CHALLENGE: THE WHITE PAPER AND BEYOND The White Paper (Table 5.2) addresses poverty through various channels: continued macroeconomic stability, improved investment climate, strengthened governance and institutions, and increased financial capability of regions to

53

Table 5.2. Poverty eradication measures in the White Paper

Action Plans Outputs Date • Develop poverty

eradication strategy and put in place poverty eradication institutions.

National and local Poverty reduction strategies; Central and local Poverty Eradication Committee and Financial consultant to assist small enterprises access the banking sector.

May 2004

• Increase financial capability of regions.

Improve DAK to assist lagging regions to improve basic services. Jan 2004

• Increase opportunities for entrepreneurs and workers.

Large scale land certification in 200 sub-districts and 50,000 households in transmigration areas.

2004

• Empower the poor. - Increase farmer income by developing small and micro scale enterprise for 74,000 farmers.

2004

- Increase Kecamatan Development Program, Urban Poverty Program, and Costal Area Development program.

2004

- Put in place clean water and sanitation for 1.5 million people. 2004 - Develop village infrastructure in 4 districts. 2004

• Increase skills of the poor.

- Put in place health services (medicine equipment and health infrastructure) in 383 districts.

2004

- Put in place education services (scholarships and infrastructure) for 8.1million students.

2004

• Social support for the vulnerable.

Provide food needs for the poor in 30 provinces. 2004

Source: World Bank staff based on Presidential Instruction No. 5/2003.

deliver the public services they are responsible for. While the White Paper is not intended to represent the Government’s comprehensive program for poverty reduction, it does commit to developing a medium-term strategy for poverty reduction. The White Paper confirms the timeframe to develop the Poverty Reduction Strategy, both at the national and regional levels, by May 2004. Strong commitment from the Government is needed to institutionalize the poverty focus across sector ministries and to ensure effective implementation of a new strategy. An Emerging Poverty Reduction Strategy for Indonesia In the White Paper, the Government reaffirms its commitment to develop a comprehensive, medium-term Poverty Reduction Strategy (PRS) by mid-2004. Such a strategy will address the multidimensional poverty issues facing Indonesia. It will be developed through a participatory approach, providing an opportunity for all Indonesian stakeholders, including the poor themselves, to have a say in its formulation. Indonesia is making progress in developing its Poverty Reduction Strategy. In early 2003, Indonesia completed its interim PRSP (I-PRSP)

which provided a road-map for completion of the full strategy. The I-PRSP laid out four thematic pillars that would support its full strategy: (i) creating opportunities; (ii) empowerment; (iii) human capital development and capacity building; and (iv) social protection. Since then, the Government has moved forward in setting up multi-stakeholder task forces, with common terms of reference, to address each of these themes. The development of the full Poverty Reduction Strategy by the four task forces was launched by the Coordinating Minister of People’s Welfare in June 2003 in his position as Chair of the of the inter-Ministerial Poverty Reduction Committee. The four task forces report to the Core PRS Team (Tim Inti), which will be responsible for pulling together the final national PRS. The Government will need to ensure effective management of the PRS process and a high level of political commitment to complete a useful Poverty Reduction Strategy. A number of challenges will need to be addressed to reap the full rewards of a Poverty Reduction Strategy. • Ensure that participation does not come at the

cost of substance. In setting up multi-stakeholder task forces to develop the PRSP, Indonesia is beginning what could be a process

54

4 million people would be pulled out of

poverty with 5 percent growth by 2006

that is more participatory than many other countries. While it is important that participation goes beyond those actually on the task forces, it is also important to draw on strong technical and analytical inputs to the process, including from Bappenas (formally responsible for addressing cross-cutting issues for all four task forces).

• Build upon existing sectoral strategies. Greater

effort is required to bridge the gap between the evolving PRS and sector strategies, focusing on how these strategies can be formulated to meet the needs of the poor.

• Integrate the PRS into the planning and

budgeting process. This means that Bappenas, the Ministry of Finance and the sector Ministries need to be closely engaged with the process. Indonesia’s PRSP faces a particular challenge in that currently planning processes are in a state of flux. There are uncertainties about the operative planning instrument for a new incoming Government in 2004. Currently Bappenas is developing a medium term plan and a long term plan, and a medium-term expenditure framework is being developed by an inter-ministerial group. On the other hand, the ongoing transition also represents an opportunity to use the PRS as a framework for planning and budgeting.

• Provide guidance, capacity, and incentives to

local governments in developing their PRS. Indonesia is developing its PRS in the context of a broad and evolving decentralization effort. Decentralization is in itself an important element of Indonesia’s efforts to combat poverty. It is in this context that the inter-ministerial Poverty Reduction Committee (KPK) mandated the establishment of subnational Poverty Reduction Committees (KPKD) to develop subnational Poverty Reduction Strategies. But capacity in districts is low and basic planning and budgeting processes are not well institutionalized. The PRS Core Team would need to provide guidance and best practice examples to regional governments, drawing on the experience of pilot regional PRSs. Incentives and fiscal instruments can also be used to

encourage regional governments in supporting the objectives and priorities of the national PRS.

Beyond committing to developing the PRSP, the White Paper details key short-term actions to reduce poverty, within the framework of the emerging PRSP: (i) opportunity creation; (ii) empowerment; (iii) human capital development and capacity building; and (iv) social protection. Opportunity Creation Growth has been the primary factor in reducing poverty between 1999 and 2002. If growth accelerates from 4 percent to 5 percent by 2006, as many as 4 million more people would be pulled out of poverty. The quality of growth—who benefits from growth—also matters. If income distribution had not deteriorated between 1999 and 2002, 12 percent of the population would be poor instead of 16 percent. Two factors deserve particular attention for a pro-poor growth strategy. In rural areas, where most of the poor (78 percent) live, the poor are increasingly reliant on off-farm income which now constitutes 50 percent of their total income. In urban areas, poverty is largely shaped by lack of jobs, with the urban unemployment rate for men over three times that in rural areas, and the urban unemployment rate for women greater than that for men. Measures to stimulate off-farm rural income and create jobs in urban areas thus need to be part of the poverty reduction agenda.

The White Paper: While much of the White Paper focuses on issues of opportunity creation through maintaining macroeconomic stability and improving the investment climate, three activities are identified to focus on the poor: land certification and policy; improving village

55

Figure 5.3. Low land registration in Indonesia

0

20

40

60

80

100

Thailand Malaysia Philippines Indonesia

percent share of registered land

Source: World Bank.

infrastructure; and increasing farmer incomes by developing small and micro-scale agribusiness. Land certification and policy. Land conflicts and disputes, highly concentrated ownership and tenure of land, and lack of legal protection of poor people’s rights over land adversely affect income and opportunities for the poor. Secure tenure increases access to credit. ii The Government has titled over a million parcels of land since 1997, increased capacity at the National Land Agency, and carried out a comprehensive review of the policy and legal reforms needed to modernize the land system under democratic, pro-poor principles. However, providing appropriate access to forest land, accommodating communal use of land in land titling, and accelerating land titling is needed. First, around 64 percent of Indonesian total land is classified by the Ministry of Forestry as forest land and is therefore administered under the Basic Forestry Law of 1967 (UUPK). UUPK precludes individual land tenure despite the fact there are private dwellings, farms, and even cities on this land. Moreover, some forest land overlaps with land that previously enjoyed traditional land rights (adat). Second, a large share of land off-Java is communal land and private titling of this land may work against the poor and increase conflict. Third, titling of non-forest land has been slow. Only about 25 percent of the nation’s estimated 80 million land parcels have been registered in the 40 years since land registration began (Figure 5.3). If the current pace of registration continues, it would be difficult for land registration to catch up with the growing number of parcels. Road infrastructure and the poor. Improving road infrastructure to connect the poor with markets and services is one of the most effective ways of promoting pro-poor growth. The White Paper actions to develop infrastructure for the poor—including development of village infrastructure and activities with strong infrastructure components, such as the Kecamatan Development Program (KDP), the Urban Poverty Eradication Program (UPP) and the provision of clean water and sanitation—are welcome. Two

issues require further consideration in developing an infrastructure program beneficial to the poor. First, additional resources are required. A Strategic Expenditure Planning Module developed by Bappenas since 1998 for the transport sector estimates that a primary road network that maximizes economic benefit would require Rp. 6.5 trillion per year. This is well below the Rp. 3.3 trillion spent on roads in 2002 by the central government. The shortfall is 15-20 percent for provincial roads and 30 percent for district roads. Second, expanding and improving the rural road network is needed. In particular, village-to-market access roads are critical for the rural poor. Kabupaten roads constitute 72 percent of classified roads and, when added to the large network of unclassified village roads, they make up 84 percent of all roads in Indonesia. But almost half of the Kabupaten road network is in poor or bad condition, and only 19 percent is in good condition (Figure 5.4). Moreover, there is large inequality between the poor and the well off in access to roads of adequate quality (Figure 5.5). The Government will clearly need to go beyond the White Paper’s commitment to develop village infrastructure in four Kabupatens in four provinces. It has set up a Coordinating Team on Rural Infrastructure Development headed by the Coordinating Minister of Economic Affairs. However, this needs to be reflected in increased spending allocations for rural infrastructure.

56

Figure 5.4. Most roads in districts are of inferior quality

0 20 40 60 80 100

National

Provincial

Kabupaten

Municipal

percent share of roads

bad

poor

fair

good

Source: World Bank, Public Expenditure Review, 2003.

Figure 5.5. Road access is not equally distributed

Percentage of people who live in a community with asphalt road access

0

20

40

60

80

100

1 (poor) 2 3 4 5 (rich)quintile

Percent

Source: Staff estimates based on Susenas.

Improving farmer incomes through small/micro agribusiness. The White Paper appropriately highlights the need for action to increase farmer incomes through small and micro-scale agribusiness. However, it does not specify how the Government proposes to help develop such businesses. The type of assistance matters. Improvements in land tenure security could help households access credit for small-scale agribusiness activities. Subsidized credit schemes have been conspicuous in their failure to help the rural poor, but pooling loans can improve access to credit to small poor borrowers. Farmers would also benefit from stable prices of agricultural commodities, which reduce risk and facilitate investment decisions; however, if these prices are kept above market prices (e.g., through import tariffs or licensing), they will lead to distortions and hurt poor consumers. Small entrepreneurs also need skills for diversifying into agribusiness and off-farm employment. The Government could assist by improving agricultural extension services, including training, and fostering voluntary linkages between small and larger businesses. Small landholdings and lags in productivity increases, as attested by low agricultural growth, means that off-farm rural income sources will be increasingly important. Empowerment and Accountability Corruption is one of the key issues in Indonesia today, and affects the poor disproportionately.

Because of weak information, poor organizational capacity, and lack of skills, the poor are unable to take effective, systemic actions to demand higher levels of accountability. The White Paper: The White Paper recognizes the importance of empowerment. For that, it suggests scaling up community driven development programs aimed at enhancing the voice, participation, and empowerment of local communities. Measures include expansion of the Kecamatan Development Program (KDP), including to conflict areas, the Urban Poverty Program (UPP), including in Eastern Indonesia and a Coastal Area Development Program. Demand-driven community and district development programs. These programs have been significant forces for both empowering Indonesian citizens economically and socially, and improving the quality of local governance. They can serve as a means for communities to make coherent demands upon and contribute to district-level reform initiatives; used as methods to address multiple dimensions of poverty simultaneously; and provide a platform from which citizens and communities can link with service providers to get higher quality and more access to basic services like water, health, and education. There is ample evidence that community-controlled projects are much better maintained than top-down projects that are placed in communities with little consultation. Scaling-up community driven development programs, however, will require special attention

57

Indonesia’s education quality is behind its

neighbors

to key factors in order to ensure sustainability and to maximize benefits. First, sustainability and local ownership can be enhanced if local governments are required to commit time and resources for community development programs. Initial experience from KDP has shown that there is significant interest on the part of local governments to do so. Second, there is a risk that marginalized groups will not benefit from expansion of CDD programs if insufficient time is allocated to socialization and capacity building. Expansion should go no faster than the communities’ ability to internalize the new approaches. Beyond the White Paper: While the White Paper stresses community driven programs as the means to empower the poor, Indonesia’s poverty reduction strategy should also address broader issues of empowerment and governance that have a direct bearing on the poor. Create clear national expectations and promote district-level reforms. The GOI can institute national campaigns that inform citizens of their rights to quality health and education services, which will stimulate demand for improved services. In addition the MDGs can be disaggregated by income group and/or gender, and they can be regionalized to create more appropriate and realistic targets for different regions. Local governance reform programs promoted by the central government (such as the Government’s ILGR program) can work with reform-minded district governments to create incentives for improved planning, budgeting, and improved implementation of laws. Rewarding reformist local governments can strengthen the hand of local champions who want to pursue a reform agenda. These rewards can include grants, enhanced recognition, more interest from potential investors, and greater popularity for elected representatives. Improve the predictability and fairness of rule enforcement. The justice reform agenda is summarized in Chapter 4, but in addition there are promising local-level initiatives that have demonstrated an ability to reduce corruption and improve rule enforcement for the poor at the local level. Recent evidence has demonstrated that well-organized communities in which local leaders had

strong grassroots and civil society support were more successful in pursuing justice through the court system and in reducing the amount of corruption associated with financial transfers, procurement, and construction activities. Improve information flows. Laws 22/1999, 25/1999, and 28/1999 require local governments to give citizens access to information on plans, budgets and all other information to permit adequate citizen oversight, though at present this is often not the reality. Governments must work with citizens and civil society to create greater access to information through use of innovative tools such as websites, one-stop shops, and regional newsletters. Successful approaches can be codified and expanded nationally. Human Capital Indonesia fares poorly relative to its Asian neighbors on social development indicators. Beyond reflecting deprivation in human development, poor social indicators adversely affect Indonesians’ ability to take advantage of opportunities in the labor market and Indonesia’s ability to compete.

Improvements in service provision, particularly in health and education, are critically needed; but the focus should be on quality rather than quantity. In education, whereas gross primary enrollment rate exceeds 100 percent, test scores of Indonesian students are low compared to other countries (Figure 5.6). Moreover, only between 21 and 35 percent of primary school teachers in Sulawesi have the minimum certificate level required; and absenteeism rates for primary school teachers is about 20 percent (Box 5.1). Improving outcomes will require more efficient management, better sectoral policies at the regional level, and

58

Figure 5.6. Indonesia is behind its neighbors in science and mathematics achievements

0 200 400 600 800

Singapore

Korea

Taiwan

Hong Kong

Japan

Malaysia

Thailand

Indonesia

Philippines

mean score

Science

Mathematics

Source: Trends in International Mathematics and Science Study 1999.

improved accountability measures so that service providers have incentives to deliver quality services to their clients. The White Paper: The White Paper emphasizes the need to increase the skills of the poor, and for that it suggests putting in place specific health services (medicine, equipment, and health infrastructure) and education services (scholarships and infrastructure). While the areas selected are important, the White Paper does not specify what needs to be done in these areas. Medicine . Increasing access to appropriate quality medicine for the poor is an important issue, but needs to be addressed in tandem with drug procurement policy. Post decentralization, district and municipal governments undertake their own drug procurement. This allows districts to ensure procurement of drugs according to local needs, but it raises several concerns: districts may opt to get the cheapest drugs, undermining quality; districts cannot take advantage of economies of scale from pooled procurement; remote and poor districts will have to pay a higher price for the same drugs which can lead to under-financing of real drug needs; and remote and poor districts may experience drug shortages due to delayed delivery. Drug procurement policies thus need to be revisited, and the role of the central government in

ensuring quality of procured drugs needs to be established. Health equipment and infrastructure . Many poor families do not have access to good basic medical services, as more and more doctors and midwives move out of remote areas and poor districts upon completion of their contract with government. Moreover, a very small share of poor families have access to hospital care. Targeted measures would work better for the poor than general expansion of health equipment and infrastructure. The central government could set up and fund a central medical corps for deployment in areas experiencing difficulties in attracting qualified medical and paramedical personnel, in close collaboration with the provinces. Scholarships. As donor funding of the Scholarship and Grant Program (SGP) will terminate soon, the Government has committed to continue supporting this program. It will increase the number of scholarships for all levels of students, and will cover marginalized youth (dropouts, unemployed youth). The government’s continuation of this program is welcome. Nevertheless, the program can be improved by transferring the targeting, implementation, and monitoring functions to the local level. More effective targeting can be achieved through the sub-district and school committees, and independent monitoring can be undertaken at the community level to enhance accountability. Moreover, the engagement of the district and other local authorities in the implementation process needs to be strengthened; lack of local ownership of the program results in flawed targeting, monitoring and evaluation, follow up and sustainability. Education infrastructure. Considering the large percentage of schools (especially at the primary level) that urgently needed rehabilitation, the government’s commitment to support infrastructure is timely. To improve the effectiveness of block grants to schools, better accountability measures can be introduced. Pilot projects involving communities as managers of school rehabilitation and construction funds have been successful.

59

Box 5.1. The doctor is out…

The 2004 World Development Report of the World Bank sponsored absenteeism surveys across countries. The survey results give one indication of the poor quality of service in health and education in Indonesia 1/. Among the countries surveyed, Indonesia ranks in the middle in terms of service-provider absence in education, and toward the bottom in health. The absenteeism rate among doctors in health clinics is an astounding 42 percent. In education, the average first-grade teacher attends school less than 3 hours a day, compared with 4.7 hours or more in each of the other (poorer) countries.

What causes staff absence? In primary schools: Teachers are more likely to be absent if (i) they are contract teachers (contract teachers are not civil servants and earn barely more than a third the salary of their civil service counterparts); or (ii) they work in schools with poor infrastructure; or (iii) they work in districts that do not have an award program for recognizing high-performing teachers. In puskesmas (clinics) : Medical staff are more likely to be absent if (i) they originally come from another province and have not requested this posting; or (ii) the facility has poor infrastructure, is remote, and is located in a district with less frequent inspections. 1/ The Indonesia survey was fielded by SMERU and relied on unannounced visits to 137 primary schools (100 of which were run by the government) and 100 puskemas, selected randomly from 10 randomly selected kabupatens and kotas. Each facility was visited twice—once in November 2002, and a second time in March 2003. Source: World Bank and SMERU (preliminary results)

Beyond the White Paper: Decentralization will likely affect the quantity and quality of education and health, as the responsibility for the delivery of these services was transferred to the districts (see Chapter 1). Within this new framework, several areas require attention. Set clear and well-defined functional assignments for service delivery. Many functions of different levels of government are not yet specified or clarified. For example, district government is responsible for hiring and paying teachers in public schools, but compensation for civil servants is set centrally, with districts providing supplementary benefits. This year the Ministry of Education recruited almost 200,000 contract teachers to be deployed in districts. The assignment of functions and roles should be guided by considerations of economies of scale, optimal market size, and the need to balance responsibilities borne by levels of governments with resources available to them. Moreover, some functions are best undertaken at the national and provincial level. For example, a central authority could coordinate the education system’s strategic directions, set and maintain core education standards and performance measurement, and

provide specialized services that may be shared across districts. Improve fiscal transfer mechanisms to ensure well planned and implemented programs. District level planning is complicated by the fact that the central government still finances a lot of district level expenditures in the social sectors. Central health expenditures still constitute about 50 percent of development and 25 percent of routine expenditures. Such central expenditure financing of district expenditures should be incorporated into the budget of the districts—for example through a central DAK transfer. The DAK can be used to achieve outcomes deemed to be a priority at the national level. Strengthen monitoring of health and education services. With decentralization, many of the institutional monitoring systems have deteriorated. Districts are often not reporting basic data on service delivery to the central government. Without access to information, it is impossible to effectively implement health and education policy that addresses the needs of the districts and pursues national priorities. The information system needs to be revived, although it should be different from

60

the pre-decentralization system—if performance-based budgeting becomes a tool in defining central allocations to districts, there will be a strong incentive for districts to overstate performance. Establish service standards. Efforts are underway to determine minimum service standards. In education, a list of such standards (covering issues relating to organization, expected learning by students, infrastructure, teaching methods, staffing, financing and community participation) has been drafted and an accreditation board to help schools achieve the minimum standards is planned. In health, a ministerial decree has been issued, setting minimum service standards for 25 areas and defining 7 additional areas for which the districts are required to deliver services according to their needs (covering immunization services, nutrition services, prevention of communicable diseases, curative services, and other). In refining these minimum standards, key principles can be used: (i) they should be firmly guided by the government’s overall budget constraint; (ii) if standards are to be national minimum standards, the resource base of the poorest district needs to be sufficient to reach the standards, or additional resources need to be provided to the poorest districts to meet the minimum standards; alternatively they could be set by provinces as dictated by the current law; (iii) minimum service standards should be standards on services (and not on inputs or outcomes); and (iv) while minimum service standards are potentially a good method of holding districts accountable for delivering on basic services, too much detail in these standards may undermine decentralization as it removes potential efficiency gains that districts could achieve by adjusting their education or health service delivery to local circumstances. Social Protection Households in Indonesia are extremely vulnerable to falling into poverty: more than half of the population lives under US$2 per day, and more than a third live on incomes between $1.55 (the national poverty line) and $2 per day. The poor are vulnerable to different shocks, most importantly to increases in rice prices (their main staple), catastrophic illness of household members, and crop failure (Figure 5.7). In addition, an

important source of vulnerability is conflict and related insecurity in many regions. Gender vulnerability is also a key issue, as women on average earn less than men and have more difficulty in securing good jobs, regardless of sector and level of education. Reducing vulnerability of households to poverty will mean lifting more people further above the poverty line through growth, mitigating the sources of vulnerability such as conflict and natural disasters, and enhancing informal and formal coping mechanisms for households, including through well targeted safety net programs. The White Paper: Raskin. The White Paper commits to reduce vulnerability by continuing delivery of the Raskin rice subsidy program. This is a reformed version of the emergency targeted rice subsidy program (OPK) introduced in August 1998 to protect food insecure low-income households and mitigate the impact of the financial crisis. The program, totaling around Rp. 4.8 trillion in 2003, is one of the main social protection transfer schemes currently implemented by the Government. The program is set up to deliver 20 kilograms of rice per household per month at a subsidized price of Rp. 1,000 per kilogram. As the average rice consumption of poor households is around 43 kg per month, the subsidy is not substantial, even among poor households. Evaluation of the Raskin program shows the following:

Figure 5.7. Causes of vulnerability (percentage of households that experienced negative shock

in the past year, by type of main shock reported)

0%

10%

20%

30%

40%

50%

60%

Employment No StapleAvailable

IncreasePrice of Rice

Death Crop failure LowerProfits

Source: Local Level Institution study, World Bank, 2002.

61

Box 5.2. Expensive subsidized rice

The RASKIN program, operated by BULOG, provides subsidized rice to poor families but at a substantial cost. In 2003 BULOG received a budget of Rp. 4.83 trillion to distribute 2.06 million tons of rice to 8.59 million households. Assuming BULOG paid the floor price of Rp. 2790/kg for the rice it purchased (in practice the market price was below this) and sold it to households at Rp. 1000/kg, then the subsidy to households was Rp. 3.69 trillion. Analysis of the 2002 Susenas indicates that only 26 percent of the Raskin recipients are poor. This implies only 0.96 Rp. trillion, or 18 percent of the Raskin’s budget, is provided as a subsidy to the poor, with Rp. 2.73 trillion going to the non-poor. The remaining Rp. 1.56 trillion or 30 percent of the RASKIN budget is retained by BULOG to cover their operating costs.

Distribution of BULOG budget

Subsidy received by the poor

18%Operating Costs and BULOG Profit

30%

Subsidy received by the non-poor

52%

Source: Bulog “Rencana Alokasi Operasi Pasar Khusus Beras, 2003-2004” except for market price (f).

• 64 percent of all the poor receive Raskin rice (up from 57 percent under OPK), making the Raskin the social protection program with the largest coverage of poor.

• 35 percent of the non-poor also receive Raskin

rice (through leakage); thus, 74 percent of those receiving the subsidy are not poor.

• Smaller quantities are often distributed among

a larger number of recipients. iii This partly explains the wide coverage. Instead of the intended allocation of 20 kilograms per household, the actual average amount of rice received per month by targeted households is estimated somewhere between 6 kilograms (Strauss et al.) and 10.4 kilograms (LP3ES survey 2000).

The consequence of poor targeting is that, of the Rp. 4.83 trillion allocated to BULOG in 2003, over half went as a subsidy to the non-poor, almost a

third was absorbed by BULOG in operating costs and profits, and only 18 percent went to the poor (Box 5.2). To improve the efficiency of targeting and reduce the cost of the program, several measures can be considered. First, geographical targeting and self-targeting for example, by selling lower-quality rice through the program, could be introduced. Using lower quality rice would also allow expansion of the program at lower cost. Second, the requirement that recipients pay for all their allotment at once should be removed, as it creates a barrier for the chronic poor in accessing this rice. Third, transportation to and from distribution points is an additional cost to recipients. Adding distribution points could alleviate this burden. Fourth, the contracting arrangements and delivery costs associated with this program need to be carefully reviewed in light of the significant budget being provided to Bulog as the contracted marketing agency to deliver this program.

62

74 percent of those receiving Raskin are

not poor

Beyond the White Paper: Developing a social protection system tailored to meet the risks and vulnerabilities of the poor. Beyond the White Paper, the Government needs to improve its effectiveness in helping the poor cope with shocks. Often the poor end up relying on coping mechanisms which undermine their long run ability to escape from poverty. Improving the effectiveness of government intervention in helping the poor requires mechanisms for better risk management of economy-wide shocks and effective reduction of the specific risks faced by the poor. Often the government does not sufficiently support the poor to access markets that could help them to overcome shocks. For example, widespread extraction from female migrant laborers reduces their ability to overcome poverty in their families. To address vulnerability, a social protection system is needed to reduce and mitigate risks on the one hand, and lessen the impact of shocks on the other. The Government has recently proposed a comprehensive social security system that would cover health insurance, work accident insurance, and unemployment insurance, as well as old age pension, public pension and life insurance. This system would replace existing institutions such as Jamsostek, ASKES, and the health card. The goal is to reach universal coverage, but the reforms would be phased over decades. A draft bill is still under development. While such a system could potentially play an important role in providing greater access to risk management tools for the poor, it needs to be carefully thought through to avoid potential pitfalls. Wide consultation and discussion before embarking on such a venture will be critical in this regard. Improving targeted pro-poor spending through decentralization. The Government also needs to ensure that the social protection programs are reaching the poor. Regional targeting is a convenient planning tool to improve targeting of social protection and public expenditure programs. But this alone is not the solution. Under the current decentralized setting, there are two main challenges: (i) the ability of the central government to reach poor districts; and (ii) the ability of local

government to reach their own poor, through pro-poor budgeting, policies and programs. Fiscal instruments such as the equalizing grant (DAU) and the special grant (DAK) will be important to the success of the central government in targeting and reaching poor districts. But much attention will be needed in improving the ability of local governments to reach their own poor. Incentive mechanisms and capacity building will be required to establish systems for pro-poor budgeting, spending, policies, and programs at the district level. Decentralization, as well as the development of regional poverty reduction strategies, provide an opportunity and a challenge to improve the targeting of public spending and make progress in this regard i The Government will imminently issue its MDG Report (not available at the time this report went to print). ii SMERU (2002) “An Impact Evaluation of Systematic Land Tilting under the Land Administration Project”, SMERU Research report, Jakarta. iii There is a tendency at the village level to spread benefits widely based on cultural belief that all should benefit equally form the government’s assistance. Olken (2003) estimates that around 18 percent of the distributed rice was missing. He reports that while some villages stole rice, some spread the rice to a larger number of recipients. He estimates that the welfare losses from corruption may have been large enough to offset the potential welfare gains from the redistributive intent of the program.