Regions and Countries

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Country Strategy and Program Update 2004-2006: Indonesia

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I. Current Development Trends and Issues

A. Economic and Social Developments¹

1. The security situation remains fragile with a continuation of acts of terrorism following the Bali bombings in October 2002 such as the recent Mariott Hotel bombing in August 2003. Renewed hostilities in Aceh have also worsened the overall security outlook. The elections of 2004 have started generating political activity and political posturing leading to uncertainties regarding high-level decision making in Government.

2. While decentralization has been carried out with no major dislocations in public service provision, there has also been little improvement. Recent regional expenditure studies (including by the Asian Development Bank [ADB]) indicate that there are concerns as to overall real spending on development. Increased spending by the regions may not have compensated for lower spending by the center. The aggregate picture, moreover, hides major regional variations. Concerns continue regarding the non-equalizing nature of the revenue-sharing arrangements and the lack of adequate central fiscal instruments to reduce regional disparities.

3. There is now a general consensus in Indonesia that lack of investment is the economy’s primary constraint to growth and poverty reduction. The economy grew by only 3.7% in 2002 and is likely to grow by 3.4% in 2003. This has caused increased unemployment and persistence of high poverty (para. 8). A document² recently issued by the National Development Planning Agency (BAPPENAS) lists several obstacles including problems over security, insufficient legal and judicial reform, a fettered labor market, and insufficient tax incentives. A workshop to discuss improved private sector participation organized for the country strategy and program update (CSPU) by the Indonesia Resident Mission (IRM) noted similar constraints. The investment law being drafted could remedy some of these. The Labor Law passed in February 2003 may improve labor relations.

4. Despite difficulties, the Government has continued its fiscal consolidation measures, and has managed to control inflation and stabilize the currency. The burden of public debt is easier to bear owing to lower interest rates. The country has also experienced a period of relative political stability. These achievements have been favorably noted by external credit rating agencies (such as Standard and Poor’s), which have upgraded Indonesia’s credit rating. 5. The current International Monetary Fund (IMF) Extended Fund Facility is likely to end in December 2003. The Government is preparing to meet the financing and credibility “gaps” that would arise. To address the former, increased tax efforts, further sales of state-owned enterprises (SOEs), issuance of bonds, and program loan funding from the World Bank and ADB will be needed. To address the latter, the Government is preparing for adoption a schedule of structural reforms (a “white paper”).

B. Implications for Country Strategy and Program

6. The country strategy and program (CSP) finalized in September 2002 addresses the main medium-term needs of the economy, stressing (i) improvements in governance, (ii) meeting local needs through decentralization, (iii) human development, (iv) environmental management and sustainable use of natural resources, and (v) raising long-term growth prospects and economic potential. There are no major developments since the CSP that would appear to warrant any amendment to the overall approach of the CSP. Certain areas may need additional focus, however. Concerns regarding governance continue to be stressed at every forum and a return of private investment, particularly foreign direct investment (FDI), will require a substantial improvement in the governance environment and continued efforts at economic reforms, particularly in the financial sector. In addition, public investment will be needed to sustain growth, while some private investors in infrastructure may be persuaded to return only through publicprivate partnership arrangements. Given the problems associated with the possible IMF exit, the Government may request additional program loans and help in its bond flotation program through ADB’s guarantee instruments.

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