Regions and Countries

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Country Strategy and Program Update 2002-2004: Indonesia

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I. Development Situation

A. Recent Political and Social Developments

1. Although the first half of the year was affected by political uncertainties, caused by the deteriorating relations between the ex-President and Parliament, the appointment of a new President in late July 2001 created expectations of an improvement in the general political and economic environment. Political violence exists in many areas, especially the Moluccas, Central Kalimantan, West Timor, Irian Jaya, Aceh, Jakarta, and East Java. The Government estimates that the civil disturbance created over 1 million internal refugees. The situation is a barrier to development and discourages investment. The Government has started a wide-ranging process of decentralization, transferring major administrative and fiscal responsibilities to local governments, largely to the districts. While much of the initial changeover has gone relatively smoothly, the process faces challenges, including how to channel foreign aid to local levels.

B. Economic Assessment and Outlook

2. This year’s growth will likely be 3–3.5 percent, less than 2000’s 4.8 percent. First quarter gross domestic product (GDP) growth was only 2.6 percent . Exports, strong in 2000, will face weaker markets. Private investment is unlikely to recover, and public sector spending is constrained by the large public sector debt, falling world oil and gas prices, a depreciating currency, and higher domestic interest rates. A serious budgetary shortfall and differences over the Central Bank Law have delayed agreement with the International Monetary Fund on the release of the latest tranche from the Extended Fund Facility, putting at risk the Paris Club agreement and heightening investor concerns. Addressing this will be amongst the first tasks of the new administration.

3. The failure of real wages to rise suggests that poverty reduction, which began as the crisis ended, has not continued. Yet, Indonesia has a relatively flexible labor market and saw aggregate employment increase by 2 percent in 2000 over 1999. Inflation, however, continues to rise at roughly 1 percent per month, considerably higher than the 5–7 percent annual target levels, due to the rupiah’s renewed weakness and higher fuel and electricity costs resulting from reduction of subsidies. Higher energy tariffs are likely to push prices up further.

C. Implications for the Country Strategy and Program

4. The weakening of the recovery process and the Government’s ongoing fiscal difficulties imply that protecting poverty gains, and providing for sustainable recovery will remain major challenges. In the current context, this likely translates into a continued need for budgetary support through program lending. However, the gridlock between Parliament and the President had stalled reforms, including in areas of particular importance to the Asian Development Bank (ADB), such as power, transport, the financial sector, and small and medium-size enterprises (SMEs), and constrained private sector development, especially foreign investment. ADB must be flexible in its support of reform but also aware of the country’s political and economic weaknesses. The program must emphasize poverty reduction. Decentralization provides an opportunity to support ongoing reforms. The challenge is to build capacity in a sustainable fashion and in coordination with the international community. Political uncertainty, policy drift, and implementation problems associated with decentralization will obstruct the program and likely introduce considerable variability in the annual lending levels for the next few years.

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