Catalog

1. Political Conditions

2. Since the economic crisis in 1997, Indonesia has been undergoing a fundamental political transition from centralized rule to a decentralized multi-party democracy. The election of the President and Vice-President by Parliament in October 1999 was a key element in this process, which included the national multiparty Parliamentary and several hundred local elections. Although the transition to a new Government was completed peacefully, the more difficult task of developing strong democratic institutions is just beginning. An independent civil society is rapidly gaining strength as a significant “voice” of the people. The media is free and is a major catalyst of public debate on critical issues facing the nation. Public expectations of genuine reform are high as demands for reform are widely voiced.

3. Social and regional tensions have often led to violent conflict in certain parts of the country. During 2000, there were significant threats to public security in four disparate regions.² Managing regional tensions to preserve national unity poses perhaps the most difficult political challenge for Indonesia. The new Government has shown a strong commitment to resolving these complex issues peacefully. However, the problems have evolved over a long period and will take time to resolve.

4. Parliament enacted two landmark laws on decentralization in 1999 to transfer major administrative and fiscal responsibilities to local governments, largely at the district (kabupaten) level.³ An extremely ambitious transfer of responsibilities and financing decentralization is said to involve the largest peacetime transfer of government staff in history. There are considerable risks, as the process demands a very complex set of plans and actions to effect implementation on 1 January 2001. It will have major implications for the planning, design, processing, and implementation of all development projects.

2. Structure of Economic Growth and Transport Infrastructure

5. The rapid growth of Indonesia during the decades before the 1997 economic crisis led to fundamental changes in the standard of living and in the structure of the economy. Indonesia's overall gross domestic product (GDP) growth exceeded 7 percent per year for over two decades, transforming it from a country with widespread poverty into a middle-income country. In the 1990s, the contribution to aggregate GDP of the non-oil and non-gas manufacturing sector—just under one quarter of GDP by 1996— surpassed that of agriculture. Similarly, service sectors including finance and construction grew rapidly. The introduction of cellular phones and other changes in the industry have dramatically improved communications in the country. Despite this, agriculture provided employment for more than 43 percent of the labor force in 1999 and agriculture and natural resources are the base of much manufacturing, especially for export markets.

6. The highly centralized economic system relied upon state monopolies in many sectors, especially in energy. Indonesia is Asia’s second-largest oil-producing country and the world’s largest liquefied natural gas exporter. State-owned enterprises (SOEs) are responsible for major operations in the energy sector: PERTAMINA in oil and gas (with PGN in some gas subsectors) and PLN (state power company) in the power sector. Indonesia also has a wide spectrum of renewable resources such as hydropower, geothermal energy, solar energy, wind energy, and biomass, but they have been relatively neglected in past policy determination and investment programs.

7. The Government complemented and supported high economic growth with investment in social development—family planning, health, and education. Fertility rate and population growth dramatically declined. By the early 1990s, Indonesia's strong economic performance suggested that the country might graduate out of external assistance by the end of the 20th century.

8. The geography of Indonesia is that of an archipelago—thousands of islands, encouraging fragmented economies unless there is adequate transport. The transport system of Indonesia is multimodal, relying predominantly on public road networks within each island; relatively small railways in Java and Sumatra; inland waterways systems in Kalimantan, Sumatra, and Irian Jaya; extensive interisland and coastal shipping; and air networks. With some exceptions, these systems often offer little support to businesses in the form of efficient, low-cost service: restructuring and investment are badly needed. The crisis has undermined the ability of the country to maintain its transport systems.

3. The Economic Crisis and Recent Developments

9. Instead the country was engulfed in the Asian financial crisis in 1997 and suffered an unprecedented economic setback. The sequencing and partial nature of reforms in the 1980s and early 1990s was a major factor underlying the crisis. Liberalizing external trade and the financial sector ahead of other necessary reforms exacted a heavy toll. At first, however, it led to large capital inflows and investment as the private sector was encouraged to borrow from external sources. The capital inflows occurred in an environment of weak financial governance, of undeveloped regulatory and supervisory institutions, and misplaced expectations regarding the sustainability of the exchange rate. External debt obligations relative to foreign reserves increased sharply. Finally, the rupiah came under massive speculative attack in the wake of the financial crisis in Thailand, and plummeted. Due to the massive depreciation and the insolvency of many enterprises the weak financial sector collapsed when the crisis struck.

10. The result was a stunning reversal of Indonesia's development gains achieved over more than two decades. Prudent macroeconomic management supported by the international community restored macroeconomic stability by the third quarter of 1998. The recession also bottomed out in late 1998 and economic recovery, though slow throughout 1999, has been under way since then. Overall GDP grew by 3-4 percent annually in the first six months of 2000, after 0.2 percent growth in 1999 and the severe contraction of 13.2 percent in 1998 (Appendix 1). The recovery was initially sparked by fiscal stimulus, but later driven by rising private consumption. Exports also turned around, rising since early 2000. Although investments contracted for the second consecutive year in 1999, the decline slowed markedly and growth was positive in early 2000, following the pickup in exports. Continued increases in investment are crucial for sustaining and broadening the recovery.

11. Macroeconomic stability set the stage for recovery. Year-on-year inflation at the end of 1999 was only 1.9 percent compared with 78 percent at the end of 1998 and is forecast at 7-9 percent in 2000. Declining food prices, rupiah appreciation, and a tight monetary policy together caused the sharp drop in inflation in 1999. The rupiah’s volatility was significantly contained in 1999; however, the currency weakened sharply in the second quarter of 2000, reflecting market anxiety over delayed reforms and the deteriorating political situation. Low inflation and rupiah stability had permitted interest rates to fall below precrisis levels, but the weakening of the rupiah undercut this positive trend.

12. As one impact of the crisis, the authorities’ freedom of action will be severely constrained by the large public sector debt. Public debt spiraled in the aftermath of the crisis—rising from $53 billion (24 percent of GDP) in 1997 to $152 billion (93 percent of GDP) in 2000, excluding the public sector’s contingent liabilities. Over 75 percent of the rise in public debt reflect the cost of recapitalizing the banking sector. As presented at the October 2000 Consultative Group Meeting for Indonesia (CGI), the Government’s economic program shows that the public debt burden is sustainable, under a scenario that assumes GDP growth rising from 3.5 percent in 2000 to 6 percent in 2004, large public asset sales, the exchange rate stabilizing at Rp7,000=$1 in 2000, and primary fiscal surplus (revenues minus expenditures net of interest payments). In this scenario, Indonesia’s public debt will decline to about 60 percent over seven years. A crucial assumption is that the tax effort would increase from 11 percent of GDP to 15.4 percent from 2000 to 2005. However, the country's tax effort has been around 11 percent since well before the crisis and, as other countries have found, dramatic increases in tax revenue efforts are always difficult to achieve. Moreover, there are major unresolved issues in the further sale of Indonesian Bank Restructuring Agency (IBRA) assets, such as hard-to-enforce bankruptcy laws that make asset recovery difficult. There are also contingent liabilities, representing obligations and contracts with private companies in sectors such as power, that may be of the same order of magnitude as the formal public sector debt.⁴

13. In February 2000, Indonesia entered into its third arrangement with International Monetary Fund (IMF) since the economic crisis began—an extended fund facility (EFF) for $5 billion over 2000-2002. Progress on structural reforms under the EFF program will be critical to Indonesia’s future economic prospects. In September, IMF accepted a letter of intent (LOI) from the Government, completing the second review of the program and releasing a tranche support of slightly under $400 million.