World Bank Document · Document of The World Bank Report No.: 27177 PROJECT PERFORMANCE ASSESSMENT REPORT INDONESIA BANKING REFORM ASSISTANCE (LOAN NO. 4255-IND) POLICY REFORM SUPPORT

Document of The World Bank

Report No.: 27177

PROJECT PERFORMANCE ASSESSMENT REPORT

INDONESIA

BANKING REFORM ASSISTANCE (LOAN NO. 4255-IND)

POLICY REFORM SUPPORT LOAN I (LOAN NO. 4368-IND)

POLICY REFORM SUPPORT LOAN I1 (LOAN NO. 4470-IND)

November 4,2003

Country Evaluation and Regional Relations Operations Evaluation Department

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Currency Equivalents (annual averages) Currency Unit = Rupiah (Rp)

us $1.0 = 1996 1997 1998 1999 2000 2001 2002 2003 First quarter

2,342 2,909 10,013 7,855 8,422 10,26 1 9,3 1 1 8,906

Abbreviations and Acronyms

ADB ADDP AMC AMU ASEAN BCA B I BRAP BULOG CAS GDP GNP IBRA IBRD ICR IDA IFC IMF INDRA JITF MIGA MOU NPLs OED PPAR PRSL SBA SFO SOE

Asian Development Bank Agreed Due Diligence Procedures Asset Management Credit Asset Management Unit Association o f South East Asian Nations Bank Central Asia Bank Indonesia Banking Reform Assistance Project National Logistics Agency Country Assistance Strategy Gross Domestic Product Gross National Product Indonesia Bank Restructuring Agency International Bank for Reconstruction and Development Implementation Completion Report International Development Association International Finance Corporation International Monetary Fund Indonesia Debt Restructuring Agency Jakarta Initiative Task Force Multilateral Investment Guarantee Agency Memorandum o f Understanding Non-Performing Loans Operations Evaluation Department Project Performance Assessment Report Policy Reform Support Loan Stand-By Arrangement Special Financial Operations State-Owned Enterprise

Fiscal Year Government: January 1 -December 3 1

Director-General, Operations Evaluation : Mr. Gregory K. Ingram Director, Operations Evaluation Department : Mr. Ajay Chhibber Task Manager : Ms. Laurie Effion

I I OED Mission: Enhancing development effectiveness through excellence and independence in evaluation.

About this Report The Operations Evaluation Department assesses the programs and activities of the World Bank for two purposes:

first, to ensure the integrity of the Bank's self-evaluation process and to verify that the Bank's work is producing the expected results, and second, to help develop improved directions, policies, and procedures through the dissemination of lessons drawn from experience. As part of this work, OED annually assesses about 25 percent of the Bank's lending operations. In selecting operations for assessment, preference is given to those that are innovative, large, or complex; those that are relevant to upcoming studies or country evaluations; those for which Executive Directors or Bank management have requested assessments; and those that are likely to generate important lessons. The projects, topics, and analytical approaches selected for assessment support larger evaluation studies.

A Project Performance Assessment Report (PPAR) is based on a review of the Implementation Completion Report (a self-evaluation by the responsible Bank department) and fieldwork conducted by OED. To prepare PPARs, OED staff examine project files and other documents, interview operational staff, and in most cases visit the borrowing country for onsite discussions with project staff and beneficiaries. The PPAR thereby seeks to validate and augment the information provided in the ICR, as well as examine issues of special interest to broader OED studies.

Each PPAR is subject to a peer review process and OED management approval. Once cleared internally, the PPAR is reviewed by the responsible Bank department and amended as necessary. The completed PPAR is then sent to the borrower for review; the borrowers' comments are attached to the document that is sent to the Bank's Board of Executive Directors. After an assessment report has been sent to the Board, it is disclosed to the public.

About the OED Rating System The time-tested evaluation methods used by OED are suited to the broad range of the World Bank's work. The

methods offer both rigor and a necessary level of flexibility to adapt to lending instrument, project design, or sectoral approach. OED evaluators all apply the same basic method to arrive at their project ratings. Following is the definition and rating scale used for each evaluation criterion (more information is available on the OED website: http://worldbank.org/oed/eta-mainpage. html).

development priorities and with current Bank country and sectoral assistance strategies and corporate goals (expressed in Poverty Reduction Strategy Papers, Country Assistance Strategies, Sector Strategy Papers, Operational Policies). Possible ratings: High, Substantial, Modest, Negligible.

Efficacy: The extent to which the project's objectives were achieved, or expected to be achieved, taking into account their relative importance. Possible ratings: High, Substantial, Modest, Negligible.

Efficiency: The extent to which the project achieved, or is expected to achieve, a return higher than the opportunity cost of capital and benefits at least cost compared to alternatives. Possible ratings: High, Substantial, Modest, Negligible. This rating is not generally applied to adjustment operations.

Sustainability: The resilience to risk of net benefits flows over time. Possible ratings: Highly Likely, Likely, Unlikely, Highly Unlikely, Not Evaluable.

lnstitutional Development Impact: The extent to which a project improves the ability of a country or region to make more efficient, equitable and sustainable use of its human, financial, and natural resources through: (a) better definition, stability, transparency, enforceability, and predictability of institutional arrangements and/or (b) better alignment of the mission and capacity of an organization with its mandate, which derives from these institutional arrangements. Institutional Development Impact includes both intended and unintended effects of a project. Possible ratings: High, Substantial, Modest, Negligible.

Outcome: The extent to which the project's major relevant objectives were achieved, or are expected to be achieved, efficiently. Possible ratings: Highly Satisfactory, Satisfactory, Moderately Satisfactory, Moderately Unsatisfactory, Unsatisfactory, Highly Unsatisfactory.

implementation through appropriate supervision (including ensuring adequate transition arrangements for regular operation of the project). Possible ratings: Highly Satisfactory, Satisfactory, Unsatisfactory, Highly Unsatisfactory.

Borrower Performance: The extent to which the borrower assumed ownership and responsibility to ensure quality of preparation and implementation, and complied with covenants and agreements, towards the achievement of development objectives and sustainability. Possible ratings: Highly Satisfactory, Satisfactory, Unsatisfactory, Highly Unsatisfactory.

Relevance of Objectives: The extent to which the project's objectives are consistent with the country's current

Bank Performance: The extent to which services provided by the Bank ensured quality at entry and supported

Contents

Principal Ratings ................................................................................................................ v

Key Staff Responsible ..................................................................................................... vu

Preface ................................................................................................................................ ix

Summary ............................................................................................................................. 1

..

1 .

2 .

3 .

4 .

5 .

Introduction .................................................................................................................. 3

Social and Political .................................................................................................. 3 Economic ................................................................................................................. 3 World Bank Group Relations with Indonesia and other Donors ............................. 5

World Bank Assistance Strategy ............................................................................. 6 Context for the Three Loans .................................................................................... 7 Loan Objectives and Design .................................................................................... 8

Policy Reform Support Loans I and I1 ......................................................... 9 Implementation Experience ...................................................................................... 12

Banking Reform Assistance Project ...................................................................... 12 Policy Reform Support Loans I and I1 ................................................................... 15

Banking Reform Assistance Project ...................................................................... 17 Policy Reform Support Loans I and 11. .................................................................. 21

The Loans: Context, Objectives, and Design ........................................................... 6

Banking Reform Assistance Project ............................................................ 8

Outcome and Assessment .......................................................................................... 17

Lessons ........................................................................................................................ 27

Annex A . Basic Data Sheet .............................................................................................. 29

Annex B . List o f People Met ........................................................................................... 33

Annex C . Conditions under PRSL I and I1 ................................................................... 34

This report was prepared by Mr . Ashok Khanna (Consultant). who assessed these projects in January 2003. under supervision o f Ms . Laurie Effron (Task Manager) . Ms . Roziah Baba provided administrative support .

1 -1 : Key Economic Indicators ............................................................................................. 4 4.1 : Banking System .......................................................................................................... 18 4.2: Summary ratings for PRSL I and I1 ............................................................................ 26

Boxes

2.1 : Anatomy o f failed banking reform ............................................................................... 8 4.1 : Measures o f Governance ............................................................................................ 24

V

Principal Ratings

EAP Region OED ~~

ICR** ES* PPAR

Banking Reform Asst. Loan (Ln. 4255) Outcome Sustainability Institutional Development Impact Borrower Performance Bank Performance

Policy Reform Support Loan (Ln. 4368)

Outcome Sustainability Institutional Development Impact Borrower Performance Bank Performance

Second Policy Reform Support Loan (Ln. 4470) Outcome Sustainability Institutional Development Impact Borrower Performance Bank Performance

Nov. 28, 2001 Unsatisfactory

Unlike I y Modest

Unsatisfactory Unsatisfactory

March 1, 2000 Satisfactory Uncertain

Partial Satisfactory Satisfactory

July 26, 2000 Satisfactory

Likely Modest

Satisfactory Satisfactory

Jan. 29, 2002 Unsatisfactory

Unlikely Modest


June 12, 2000 Satisfactory Uncertain

Substantial Satisfactory Satisfactory

Sept. 7, 2000 Moderately Satisfactory

Non-evaluable Modest

Satisfactory Satisfactory

Nov. 4, 2003 Unsatisfactory Non-evaluable

Modest Unsatisfactory Unsatisfactory

Nov. 4, 2003 Moderately Unsatisfactory


Unsatisfactory Satisfactory

Nov. 4, 2003 Moderately Unsatisfactory



* The Implementation Completion Report (ICR) is a self-evaluation by the responsible operational division of the Bank. The Evaluation Summary (ES) is an intermediate OED product that seeks to independently verify the findings of the ICR. ** ICRs do not include an option for moderate ratings (moderately satisfactory, moderately unsatisfactory) on outcomes, nor the non-evaluable rating for unsustainability.

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Key Staff Responsible ~

Project Task Manager/Leader Sector Director/ Country Sector Manager Director

Banking Reform Asst. Loan (Ln. 4255) Appraisal Completion

Policy Reform Support Loan (Ln. 4368) Appraisal

Completion

Second Policy Reform Support Loan (Ln. 4470) Appraisal

Completion

Vikram Nehru Michael Edwards

Lloyd McKay

Lloyd McKay (field) Sudarshan Gooptu (HQ)



Jonathan Fiechter Margery Waxman

Pieter Bottelier (acting)

Homi Kharas

Tamar Manuelyn Atinc (acting)

Homi Kharas

Dennis de Tray Mark Baird

Dennis de Tray

Mark Baird

Mark Baird

Mark Baird

ICR for Banking Reform was prepared by Miguel Navarro-Martin, Paula Perttunen. ICR for Policy Reform was prepared by Thang-Long Ton. ICR for Second Policy Reform was prepared by Thang-Long Ton.

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Preface

This i s a Project Performance Assessment Report (PPAR) on the Indonesia: Banking Assistance Reform Project (BRAP) for US$20 mi l l ion and the Policy Reform Support Loans I and II (PRSL) for US$1 bi l l ion and US$500 million, respectively. Japan Bank for International Cooperation (JBIC) provided US$lOO mil l ion in co-financing for PRSL 11. This report i s based on the President’s Reports for the projects, summaries o f Board discussions, legal documents, project fi les, related economic and sector work, Implementation Completion Reports (ICRs) (prepared by the East Asia Region) for the projects. In addition, discussions with Indonesian officials, other donors, other stakeholders, and World Bank Group staff were valuable inputs into the report.

An Operations Evaluation Department (OED) mission visited Indonesia in January 2003 to discuss the effectiveness o f Bank assistance wi th government officials, donors and other stakeholders. Their cooperation and assistance in preparing this report i s gratefully acknowledged.

Regional comments were incorporated into a draft report, which was then sent to the Government o f Indonesia; no comments were received from the government. A copy o f the report was also sent to JBIC that co-financed PRSL II operation, and they had no comments.

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Summary 1. Reform Assistance Loan (BRAP) for US$20 mi l l ion for technical assistance; Policy Reform Support Loan I (PRSL I) for U S $ l billion; and Policy Reform Support Loan 11 (PRSL 11) for US$500 million. BRAP became effective in April 1998 and closed in May 2001, about seven months behind schedule, with some US$9 mi l l ion canceled. PRSL I became effective in July 1998 and closed on schedule in June 1999. PRSL 11 became effective in June 1999 and closed on schedule in October 1999. Japan Bank for International Cooperation (JBIC) co-financed it with $100 million.

Attached i s the Project Performance Assessment Report on the Indonesia: Banking

2. crisis and build a foundation for a sound, efficient banking system that would contribute to sustained economic growth. PRSL I sought to restore macroeconomic stability and facilitate structural adjustment to rebuild confidence in Indonesia and restore economic growth, while shielding the poor. PRSL I I ’ s objective was to consolidate economic stabilization and deepen the structural reforms initiated under PRSL I.

BRAP s objective was to provide technical support to resolve Indonesia’s banking

3. growth has been restored, although Indonesia’s income per capita has not reached i t s pre- crisis level. Fiscal risks arising from incomplete banking reforms remain substantial, however, despite a fiscal cost o f bank bailouts o f more than 50 percent o f GDP. While the banking system has stabilized, it remains largely under government ownership. Corporate debt restructuring has progressed slowly as has privatization o f state enterprises. Moreover, elements o f a strategy for resolving banking issues and financial sector development have only recently begun to emerge. The main reforms remain incomplete. Other reforms foreseen under PRSL I and 11 in trade, competition policy, forestry management, governance, and protection o f the poor have been mostly implemented, but their outcomes are mixed.

Progress in macroeconomic stabilization has been significant and modest economic

4. The outcome o f BRAP i s rated as unsatisfactory and o f PRSL I and I4 moderately unsatisfactory. The sustainability rating for al l three loans i s non-evaluable, mostly because government’s commitment to pursuing reforms in most areas i s unclear and there has been some backtracking on trade and competition reforms. The institutional development impact o f BRAP i s rated as modest, because even though a new agency, Indonesia Bank Restructuring Agency (IBRA), was established, it was plagued by staff and management turnover and serious governance problems for most o f BRAP ’s implementation; although these aspects have improved in the last few years (after BRAP closed), IBRA i s due to be wound up in 2004. The institutional development impact o f PRSL I and 11 i s rated as modest for both. The Bank’s performance for PRSL I i s rated as satisfactory, while under BRAP and PRSL 11 it i s rated unsatisfactory, in part because quality at entry for these two loans was not good. The Bank lacked a strategy for dealing with the crisis and timely support from senior Bank management was inadequate. Although government counterparts cooperated in designing the PRSLs and implementing al l three loans under difficult circumstances, ownership o f the main structural reforms has been lacking, as evidenced by slow progress in crucial areas.

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5. The main lessons from these loans are:

0 In a country with deeply rooted and widespread govemance issues, and where the authorities are not committed to deep reforms, the Bank needs to have realistic expectations about the outcome o f i t s interventions. In Indonesia, the ability to affect fundamental reforms with adjustment and technical assistance support has been limited. The effort requires a more comprehensive and long-term approach, including diagnostic work and involvement o f c iv i l society.

The dilemma o f supporting a country in crisis i s highlighted by PRSL I and, more especially, by PRSL II The Bank needs to provide the Board with a frank rationale for i t s intervention, even where the rationale i s limited to providing special shorter- term liquidity support for modest reforms.

0 The experience in Indonesia highlights the importance o f avoiding delays in banking crises: unless resolved quickly and decisively, the fiscal costs mount and vested interests further impede resolution.

0 In a major crisis, Bank management and top technical specialists should give priority to resolving issues that arise in the context o f Bank assistance addressing the crisis, even if the vehicle for the assistance i s in the form o f a relatively modest technical assistance loan.

0 Coordination among donor agencies i s essential in countries in crisis and needs to be made explicit. In Indonesia, coordination was successful only after an initial period o f uncertainty, mainly because the IMF was able to take the lead.

0 The Bank’s consultant fee structure and procurement rules caused delays and impeded a rapid response to Indonesia’s banking crisis, and excluded or discouraged the few service providers with appropriate technical expertise. These rules should be reviewed with a view to allowing exceptions to policy under certain well-defined circumstances.

0 The Bank’s central unit (Special Financial Operations (SFO)) enabled the Bank to respond to Indonesia’s need for technical expertise, but the unit was not well integrated into the Bank’s organization and was unfamiliar with i t s operational procedures, causing bureaucratic and practical problems. For future crisis response, the Bank should consider establishing a “virtual” crisis unit o f specialists working in the Regions, available to respond to a specific crisis inside the relevant regional management structure.

Gregory K. Ingram Director-General

Operations Evaluation

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1. Introduction

Social and Polit ical

1.1 In 2001, Indonesia was the fourth most populous country in the world with a population o f 214 mi l l ion and a per capita income o f US$680 (Atlas method). Between 1970 and 1996, the share o f Indonesia’s population l iving below the poverty l ine had declined from 60 percent to 1 1 percent; this translated into a drop in the number o f poor from 70 to 22.2 million by 1997. Poverty reduction was associated with impressive improvements in education: universal primary education was achieved in the early 1980s and secondary school enrollment improved almost threefold between 1970 and 1996. Basic social indicators for Indonesia, such as infant mortality, l i f e expectancy at birth, adult illiteracy and fertility also improved rapidly and by 2002 were comparable with most Asian countries, and better than for low-income countries. During the financial crisis (1 997- 1999), however, poverty rates more than doubled, to 27 percent in 1999, declining again by 2002 to 16 percent.’

1.2 President Soeharto’s regime held power firmly for over thirty two years, from 1965 to 1998. In June 1999 the f i r s t open elections were held and, since then, four cabinets and two presidents have held office. Moderate religious leader Wahid emerged as the new President in 1999 from a multiparty post-election negotiation process, but the backlash against concentration o f power under Soeharto produced a weakened executive and an increasingly assertive, but divided, Parliament. Vested interests, regional conflicts, and the military’s reluctance to disengage from politics raised the political temperature, impeded consensus on political reforms, and created instability. President Wahid was impeached in July 2001 and Vice-president Sukarnoputri assumed the Presidency; the country has been relatively stable since then.

Economic

1.3 percent per annum for 25 years; per capita GNP reached U S $ l ,100 (Atlas method) in 1997. Subsequent events showed that some o f the impressive growth was fragile, however, because it was based in part on an unhealthy expansion o f credit and an unsustainable build up o f private sector debt.

Indonesia’s economic growth prior to the crisis was impressive, averaging 7

1.4 appears lower in Indonesia than other ASEAN countries. During the 1970s and 1980s, the focus was on agricultural development, and because over hal f the population, and 80 percent o f the poor, depended on agriculture during that period, i t s strong growth rate o f over 4 percent per year, combined with expanded infrastructure and delivery o f social services, led to sustained poverty reduction.

Economic growth was broad based and labor intensive. Thus, income inequality

’ World Bank. 2003. Indonesia: Maintaining Stability, Deepening Reforms. World Bank Brief for the Consultative Group on Indonesia, Report no. 25330. Washington, D.C.: The World Bank. p. 44. Poverty estimates for 1999 and 2002 made on the basis o f Susenas data.

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1.5 Trade and financial sector liberalization began in 1983, with a second round o f reform in 1988. The banking sector was opened to new private banks and foreign joint venture banks. Significantly, Indonesia deregulated foreign inflows to corporations, allowing borrowing from abroad, sales o f securities to non-residents and foreign investment in the domestic stock market. Generally, growth was sustained without excessive reliance on foreign savings. By the early 1990s, domestic investment rates reached almost 30 percent o f GNP. Prudent budgetary management avoided fiscal imbalances, aided by a balanced budget r u l e adopted in 1968, which precluded domestic financing. At the same time, governance issues emerged, internal trade restrictions proliferated, and industry expanded into heavily protected sectors.

In the mid-1 980s, labor-intensive manufactures became the main source o f growth.

1.6 The devaluation o f the Thai Baht in July 1997 marked the beginning o f the Asian Crisis, but it did not engulf Indonesia until the end o f that year. Indeed, Indonesia’s stock market and non-oil exports peaked in July 1997. But when the crisis struck Indonesia, it was virulent; economic and domestic political conditions combined to exacerbate i t s impact. The proximate causes o f the crisis were the rapid increase prior to 1997 o f unhedged short-term private external debt and shortcomings in Indonesia’s banking system, including connected lending, large exposures to single clients, significant non- performing loans, and weak supervision. At the same time, Indonesia was hit by the worst drought o f the century, a collapse in regional demand, and the lowest international o i l prices in decades. The country’s weak institutions and endemic corruption amplified the financial crisis because the government, in spite o f considerable support from the international financial institutions, proved unable in the early months to deal decisively with the crisis and the external shocks. Finally, Soeharto’s i l lness in December 1997 triggered long-standing concerns over political transition.

Table 1.1 Key Economic Indicators

1997 1998 1999 2000 2001 2002++

GDP Growth (an %) 4.9 -1 3.0 0.3 4.9 3.3 3.4 Gross Dom. Sav./GDP 30.6 24.9 28.8 25.2 24.7 23.4 Gross Dom. Inv./GDP 30.9 15.5 20.8 14.6 17.0 19.0 Overall Budget Bal./GDP 0.9 -2.0 -1.5 -1.6 -2.7 -1.6 Current Act. Bal./GDP -0.8 4.1 4.1 5.3 4.7 4.0 Cons. Prices (av % chg)* 6.6 58.5 20.5 3.7 11.5 11.9 Exchange Rate (REER)# 58.7 62.3 68.8 59.4 62.5 76.5 Real Interest Rate+ 8.7 -1 9.4 2.9 8.6 4.9 3.3 Source: Country Assistance Strategy Papers 1999,2001 and 2002. *Indonesia: Central Bureau o f Statistics; # Year End Real Effective Exchange Rate (6/97=100), IMF (decrease indicates depreciation); ++ Figures are for Jan-Sept; + Based on consumer prices and 3 month SBI interest rate; latest estimates from the Resident Mission.

1.7 In less than two months, between end-November 1997 and end-January 1998, the Rupiah depreciated by 75 percent against the dollar, far exceeding the exchange rate depreciations in Thailand and Korea. Inflation peaked at 80 percent. By May 1998, c iv i l unrest had led to Soeharto’s resignation and a new government. Thereafter, government became more consistent in their policies, secured debt re l i e f from foreign creditors for the corporate sector and from official creditors for the public sector, and began to take f irmer measures to restructure the banking sector. Business confidence was not yet restored,

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however, and so private investment failed to rebound; output continued to shr ink, so that instead o f a projected increase in GNP o f about 8 percent in 1998, it fe l l by 13 percent, making the Indonesian crisis the worst among the East Asian countries. B y end-1998, the situation began to stabilize and economic growth gradually turned positive and inflation came down rapidly. By 2000, the economy had rebounded to a growth rate o f almost 5 percent, and has remained above 3 percent per year since then, driven mainly by consumption, fuelled by rapid increases in the minimum wage and expanding consumer credit. Although investment increased somewhat in 1999, it has not come close to regaining i t s pre-crisis level (as a percent o f GDP) because o f political uncertainty and currency volatility.

1.8 Recent improvements in macroeconomic management have led to a slowdown in private capital outflows and a recovery in private capital inflows, partly attracted by sales o f intervened banks’ assets, bank and telecommunications privatizations, and renewed interest in the stock market. These inflows strengthened the Rupiah through 2002. Indonesia is, however, the only East Asian crisis country that has not yet reached pre-crisis levels: GDP remains about 10 percent below i t s 1997 level.

World Bank Group Relations with Indonesia and other Donors

1.9 Indonesia was among IBRD’s biggest borrowers by the early 1990s - i t s share o f a l l IBRD debt outstanding and disbursed exceeded 10 percent. During the 1990s, lending to Indonesia declined, partly because the government had access to large levels o f private foreign capital, partly because the Bank was reaching i t s exposure limits and the Bank shifted i t s approach to smaller, diversified projects. Indonesia’s total debt outstanding to IBRD and IDA was over $1 1 bi l l ion in 2002.’

1.10 chairs the Consultative Group for Indonesia, consisting o f some 20 bilateral and 10 multilateral organizations. With the onset o f the crisis, the IMF assumed a larger, more prominent role and the Bank eventually developed a productive working relationship, playing a key role in the government’s Extended Arrangement with the IMF. The Bank also works closely with the Asian Development Bank (ADB), which included collaboration on the financial sector.

The Bank has been closely associated with Indonesia’s economic development and

’ IFC’s loans and equity investments outstanding amounted to about $400 million in 2001, The inhospitable investment policy environment caused a temporary halt to new IFC investments. I t cautiously restarted financing activities in 2002, with a close watch on progress in contract enforcement. MIGA’s guarantees have continued to be available to potential investors. I t s exposure in Indonesia was about US$57 million in 2001.

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2. The Loans: Context, Objectives, and Design

World Bank Assistance Strategy

2.1 unchanged from those o f the previous 1995 strategy, focusing on macroeconomic stability; increasing efficiency and productivity in the public and private sectors; reducing poverty; and sustainable management of natural resources. Although the 1997 country assistance strategy recognized the potential risks to stability o f a fragile banking system, volatile capital flows, and contagion from neighboring East Asian countries, and although it was discussed at the Board in July 1997, one week after the float o f the Thai baht, the Bank management considered it unlikely that all these factors would combine to produce a severe economic shock. By mid-August, the Indonesian rupiah had lost 20 percent o f i t s value, but even then, the Bank did not revise i t s strategy or develop a contingency plan for addressing the deteriorating situation. In fact, Bank Management informed the Board in August 1997 that the contagion had been contained and, given Indonesia’s exemplary long term record o f economic management, there was l i t t le cause for concern.

The objectives o f the Bank’s 1997 country assistance strategy remained broadly

2.2 and the Bank put together a technical assistance loan to the financial sector, discussed below, to address some o f the problems. I t took until mid-1998, however, when the f i rst large adjustment loan dealing with the crisis was presented to the Board, for Bank management to articulate a strategy which addressed the unfolding crisis in more specific terms. The February 1999 Country Assistance Strategy (CAS) Progress Report focused on restructuring the financial and corporate sectors and providing direct support to reinforce the social safety net, and intensified coordination with IMF, ADB, and other donors. It also sought to strengthen institutions to support sustainable development, including public sector reform and anti-corruption measures. These strategic objectives remained prominent in January 2001 CAS and July 2002 CAS Progress Report, as the crisis abated and macroeconomic performance improved.

By October 1997 i t was clear that the July assistance strategy no longer applied,

2.3 crisis. The Bank had been involved in Indonesia’s financial sector through project lending and were familiar with the banking system’s precarious state. The IMF had carried out portfolio reviews o f 62 private banks in 1994 and concluded that 26 were insolvent and that Bank Indonesia (BI) supervision was inadequate. Moreover, bank insolvencies had occurred between 1993 and 1996. Thus, between 1994 and 1996, a series o f Bank and IMF missions raised concerns over the deep structural distortions in Indonesia’s banking system.

Bank staff were aware o f the potential country risk for a few years prior to the

2.4 Consultative Group meetings and Country Economic Memoranda between 1995 and 1997. Given that problems in Indonesia’s financial sector were well known, the Bank was relatively ill-prepared to respond to the crisis with any sort o f comprehensive approach to the badly-needed financial sector restructuring. The absence o f a contingency plan prior to the crisis and o f a strategic approach to financial sector development following i t s onset were two significant weaknesses in the Bank’s assistance strategy for Indonesia over the period 1995-2002.

These financial sector issues and country risk factors were mentioned in several

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Context for the Three Loans

2.5 summer o f 1997, but escalated rapidly and continued well into 1999, partly because o f large capital outflows and financial sector weakness, and partly because the government failed to act decisively and consistently to reassure the markets.

Indonesia’s crisis started as contagion from developments in Thailand in the

2.6 In November 1997, the IMF announced a $38 bi l l ion bai l out package for Indonesia, and as part o f this package, approved a three-year stand-by arrangement (SBA) for $10 billion. The Bank committed $4.5 bi l l ion to the package, the ADB $3.5 bi l l ion and other donors the remaining amount. The operations under review in this assessment were a part o f this large support package.

2.7 The initial IMF assistance program was designed on the assumption that Indonesia’s economic problems were moderate and could be addressed through relatively conventional means: appropriate fiscal and monetary policy and financial sector reforms involving closure o f the weakest banks. The expectation that growth would quickly rebound to i t s pre-crisis level proved to be overly optimistic, however, because the extent o f the underlying problems was vastly underestimated.

2.8 Problems o f corruption and cronyism in the corporate sector and weak governance, poor portfolio quality, and weak supervision in the financial sector proved too deep-seated to be resolved by quick reforms. In October 1997, the Bank, the IMF and ADB examined banks representing some 85 percent o f the banking system and, on the basis o f poor data from BI, concluded that (only) some 50 banks out o f 238 required interventions. In negotiations with the BI, however, agreement was reached to close only 16 banks. These closures were announced in November 1997. N o t only did this fail to stem the problems, but within a month most o f the remaining banks were experiencing runs, the Rupiah had depreciated by about 40 percent from i t s July 1997 level, there were no signs o f an economic rebound, and the crisis had taken on political as well social dimensions. In early December, President Soeharto became ill and ethnic riots had broken out. I t was clear that the crisis had deeper roots and was more widespread than in other Asian countries. In December 1997, in the midst o f this deepening crisis, the Bank approved the Banking Reform Assistance Project (BRAP).

2.9 In January 1998, the IMF and government negotiated a revised program, with more relaxed fiscal targets, more specific and time-bound conditions, and a more comprehensive approach to the banking sector, including the creation o f the Indonesian Bank Restructuring Agency (IBRA). Once again, however, liquidity support for banks, tardy structural measures, reversals o f deregulation and liberalization measures by well- connected individuals, and the failure to address the large external indebtedness o f private f i r m s led the program off-course. Public pronouncements by President Soeharto against the IMF conditions created uncertainty in international financial markets. The economic downturn deepened and inflation accelerated. S t i l l another, more comprehensive program was formulated with the IMF in April 1998; with the economy spiraling into a cycle o f currency depreciation and inflation, the main objective o f this IMF program was currency stabilization. The program also sought to limit the decline in output and protect the poor from the effects o f the crisis. Policies included tight monetary policy, higher interest rates

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and an adjusted fiscal framework to allow for bank restructuring and social protection costs. It was in this context that the first Policy Reform Support Loan (PRSL I) was negotiated.

Box 2.1: Anatomy of Failed Banking Reform

The first wave of bank closures was poorly handled on several counts. First and most important, there was no comprehensive and agreed strategy for addressing systemic weaknesses in the banking system. As a result, Government and well-connected individuals were able to reverse or undermine the reform efforts. The President’s family immediately challenged the legality of closing one of i ts banks and one of his sons bought a small bank and transferred the assets of the closed bank to the newly created one. Second, the absence of reliable information about the true state of banks led to an underestimate of how widespread the problems were; and the extent and impact of poor governance and corruption were not fully appreciated. Third, communication with the public was poorly handled. The government announced a guarantee for deposits up to $6,000 in the 16 closed banks, but no announcement was made about the coverage for deposits in other banks. As government also initially issued a statement that further bank closings would occur if and when other banks became insolvent, it was unclear whether and how depositors would have access to their funds, leading to considerable concern by the public. Then, the Government reversed position, and announced that there would be no more bank closures. In addition, as the process of bank closure had been handled in a non-transparent way, there was understandably widespread public concern that the criteria for closing banks were unclear; other seemingly equally troubled banks were allowed to stay open. Hence, the attempted closure of 16 banks led to lack of confidence in the banking system, and, ultimately, to bank runs.

2.10 Civ i l unrest led to President Soeharto’s resignation on May 21, 1998. Economic activity was disrupted, banking paralyzed, and food prices soared. By July 1998, when the PRSL was approved by the Bank, the Rupiah had dropped to an all-time l o w against the dollar, with a cumulative depreciation o f 85 percent from one year before. Restoration of economic activity and improving the social safety net became key priorities.

2.11 formed under President Habibie. Both the corporate sector and public sector secured debt re l ie f and the government began to address more decisively the underlying structural problems. Price stability was gradually re-established and the Rupiah appreciated in the latter half o f 1998, although output continued to decline and business confidence and private investment were slow to recover. By mid- 1999, when the second Policy Reform Support Loan (PRSL 11) was approved, the worst o f the economic crisis was over, but significant structural and governance issues remained.

In August 1998, the IMF negotiated another program with the new government

Loan Objectives and Design

Banking Reform Assistance Project

2.12 Board in December 1997. It was intended to be the first part o f the Bank’s $2 billion commitment to respond to the Indonesian crisis, but it took longer than expected (and

The Banking Reform Assistance Project (BRAP, $20 million) was approved by the

9

longer than in other East Asian countries3) for the Bank and the government to agree on the reforms to be supported with large adjustment lending and for adequate progress to be made to present the loan for Board approval. As a result, between October 1997 when the depth o f the problems in Indonesia was acknowledged and July 1998, the BRAP was the only Bank-funded operation in Indonesia to address crisis related issues. Relative to the scope o f support needed, i t was a modest effort, prepared in the absence o f a large comprehensive framework (para. 2.2).

2.13 BRAP’s objectives were to assist the government to resolve the financial crisis and build a foundation for a sound, efficient banking system that would contribute to sustained economic growth. The technical assistance financed by the project was to: (a) evaluate financially troubled private banks’ portfolios and design rehabilitation plans; (b) restructure state-owned banks to improve their efficiency; (c) strengthen BI’s regulatory and supervision capacity; and (d) conduct a diagnostic review o f the legal and institutional infrastructure for financial sector development. The Secretariat o f the Monetary Board, the institution responsible for coordinating financial sector reforms in Indonesia, was the executing agency for BRAP.

2.14 As the project was prepared quickly in response to the emerging crisis, i t s design and specific components were not discussed with government counterparts, who were in fact not yet identified even by the time the project was presented to the Board. In addition, the division o f responsibilities between the Bank, IMF and ADB had not been clarified. Thus, the design was intentionally flexible, to evolve with changing circumstances. For example, once IBRA was created in January 1998 to restructure banks and resolve bad bank assets, the focus on building capacity under BRAP shifted from BI to IBRA even before BRAP was declared effective.

Policy Reform Support Loans I and 11

2.15 At the time o f the Board discussion o f BRAP, Bank management informed the Board that i t intended to put in place both a financial sector operation and a Structural Adjustment Loan.4 In the event, a Policy Reform Support Loan (PRSL I, $1 billion) was approved in July 1998 which combined support for macroeconomic management and reforming the financial sector. I t s main objective was to support Indonesia’s efforts to rebuild confidence and quickly restore rapid economic growth, while shielding the poor. The first tranche o f $600 mi l l ion was to be disbursed on effectiveness immediately after approval, and the second tranche o f $400 million, after twelve conditions were met.

2.16 The f i rs t tranche actions included:

(a) measures to increase efficiency in the public sector and prevent an unsustainably large fiscal deficit, involving deferring or canceling public investments and government subsidies for corporations;

I n Thailand and Korea, the Bank-funded technical assistance projects either followed adjustment lending or

World Bank. 1999. Indonesia Country Assistance Note, Report no. 19100. Washington, D.C.: The World

were followed within three months with a series o f adjustment loans.

Bank. p. 9.

10

(b) reforms to rebuild an effective and competitive financial sector; these include portfolio reviews o f al l banks carried out by internationally recognized f irms, and revised prudential norms;

(c) actions to raise private sector efficiency and improve governance, including tari f f reduction on 2000 items; liberalization o f cement marketing; and elimination o f a wide range o f trade restrictions, including: special privileges for the national car program, import monopolies on key commodities such as wheat, sugar, and soybean, export taxes on selected items, the export cartel for plywood, inter and intra provincial trade restrictions, the monopoly on clove marketing, and restrictions on foreign investment in o i l palm plantations and in wholesale and retail trade; and

(d) programs to shield the poor from the effects o f the crisis, including price subsidies on selected food items and expansion o f labor intensive public works.

2.17 the implementation o f the measures begun under the first tranche. The twelve conditions included:

The second tranche release conditions (listed in Annex C) focused on strengthening

(a) maintaining a sound macroeconomic framework;

(b) increasing public efficiency and transparency in public sector management and maintaining discipline in public expenditure through: carrying out a public expenditure and investment review and adopting an action plan for recommendations emerging from the review; adopting guidelines for private participation in infrastructure; identifying seven public enterprises to be privatized by March 3 1 , 1999 and another five that will be prepared for privatization by that date;

(c) continuing to rebuild the financial sector while containing further bank losses and protecting corporate losses; this required the completion o f the portfolio reviews o f banks under IBRA, establishing an independent committee to oversee IBRA; and defining Government’s role in restructuring private corporate debt; and

(d) improving governance and transparency, increasing competition, and creating a more market-friendly policy environment. Specific actions were proposed for the forestry sector, including a system o f resource use o f royalties and reducing export taxes on forestry product exports; reducing export controls on palm oil; liberalizing clove marketing; assure a level playing field for private importers (in commodities other than rice) and BULOG, the commodity import agency; and adopting an action plan for introducing legislation on competition and corporate restructuring.

2.18 $500 million, to be disbursed upon loan effectiveness, co-financed by Japan Bank for International Cooperation (JBIC) for $1 00 million. The objectives were to consolidate economic stabilization and protect physical and human assets during the crisis. I t sought to

PRSL 11 was presented to the Board in M a y 1999 as a single tranche operation for

11

deepen reforms initiated under PRSL I, particularly those focusing on the financial sector and governance. These objectives would be achieved by eighteen conditions relating to:

(a) good macroeconomic management to consolidate stabilization and realign public expenditures to fund programs that alleviate poverty;

(b) reforming the banking sector and facilitating corporate and debt restructuring by: empowering IBRA both legally and financially; transferring bank assets to an Asset Management Unit; closing 38 banks; nationalizing 7 others; recapitalizing 9 banks; and merger o f 4 state banks; facilitating corporate restructuring; and establishing the Jakarta Initiative Task Force (JITF) to facilitate out o f court settlements o f corporate debt; and

(c) enacting laws to prosecute corruption and exercise o f market power; decentralization o f administrative and fiscal powers; implementing forestry reforms to increase the efficiency o f private and public sector activities; publishing a master plan for state-owned enterprise (SOE) reform; and issuing environmental regulations.

2.19 It can be argued, however, that PRSL II effectiveness conditions (Annex C for details) were diffuse and in some areas, relatively weak. Except for the group o f eight conditions concentrated on bank and corporate restructuring, the other ten conditions touched on a wide range o f areas: macroeconomic stability, social safety nets, state owned enterprise reform, corruption, forestry, energy sector, decentralization, competition law, and the environment. O f these, social safety nets were already covered in more detail under the concurrent Social Safety Net Adjustment Loan and one o f the forestry conditions (on export taxes) had already been a condition under PRSL I that had purportedly been met. In addition, conditionality for state enterprise reform (a master plan), corruption, decentralization, and o i l and gas (draft laws to be submitted to Parliament) required detailed fol low through to have any impact. In the absence o f fo l low up operations, the Bank’s approach to these reforms under PRSL II can thus be considered somewhat superficial.

2.20 least two (the establishment o f the JITF and legal empowerment o f IBRA) had occurred by October 1998, well before the release o f the second tranche o f PRSL I, In addition, by the time PRSL II was negotiated in April 1999, it was clear that both the speed and transparency o f the bank restructuring were problematic (paras. 3.4-3.9, and by establishing numeric targets for bank restructuring (in three conditions), the PRSL II conditionality addressed only the first o f these problems. The weaknesses in design may have been a consequence o f the Bank’s earlier commitment to participate in a rescue package for Indonesia fol lowing the crisis, a commitment which reduced i t s leverage in terms o f loan amount, conditionality, and timing. This, in turn, raises the larger issue o f the most appropriate role for the Bank in times o f crisis.

O f the eight conditions in PRSL II relating to bank and corporate restructuring, at

2.21 PRSL IIprocessing had one unusual feature. To protect against the possibility that the loan proceeds might be ill-used by the government to influence the upcoming elections in June 1999, the World Bank requested and received a letter from the Government, indicating that the loan funds would not be used until after end-June. The request by the

12

Bank for such a letter highlights the pressures to make such loans in crisis situations, under conditions o f poor governance. Had such pressures been absent, the Bank could have waited another month until the elections were over to approve the loan. The request for a comfort letter shows the extreme time pressure to lend, possibly to signal markets and creditors, and the attempt by the Bank to seek risk mitigation o f a “second-best” kind.

3. Implementation Experience


3.1 months behind schedule. At closing, about $1 1 mi l l ion or 55 percent o f the original loan amount was disbursed, the remainder canceled at government’s request.

BRAP became effective in April 1998 and closed on May 9,2001, about seven

3.2 decided to create a new agency, IBRA, to address bank restructuring, rather to rely on BI, and thus the focus o f BRAP shifted to support for IBRA. It took some four months for the government to nominate a project manager, which was a condition for loan effectiveness, and during this time the economy, political situation, and social fabric continued to spiral downward (paras. 2.8-2. lo), deepening the banking crisis which BRAP was to help address. After effectiveness in April 1998, implementation suffered from IBRA’s lack o f formal legal status, inadequate financial resources, unclear responsibilities, frequent management turnover, and changing board members and government officials. Discussions among the Bank, IMF, and ADB on division o f responsibilities in the financial sector had implications for the focus o f the project and thus further delayed i t s effective start up. By mid-1998, once it was agreed that the IMF would take the lead in capacity development in BI and changes in banking laws, BRAP resources were concentrated on two o f the original four objectives, evaluating and rehabilitating private banks and restructuring state owned banks. These two components eventually used 89 percent o f disbursed funds, the remaining 11 percent being used for technical assistance directly to IBRA (para. 3.9).

At the outset, BRAP was beset with problems. After loan approval, government

3.3 The f i rst component, focusing on private banks, financed Agreed Due Diligence Procedures (ADDP) and the evaluation o f business plans by international audit f i r m s in about 40 banks. In parallel, the ADB financed due diligence reviews on other banks so that virtually every significant bank, over 100 altogether, was subject to such a review.

3.4 recapitalization and closure. In addition, an inter-ministerial committee was established to supervise the process using transparent and consistent measures for medium-term bank viability. Nevertheless, those involved in the process noted that ethnicity (Chinese versus Indonesian) and political pressures played a role in the selection o f the eight banks to be recapitalized. BRAP also financed technical assistance to help draw up the investment and management contracts which were part o f the recapitalization process.

The findings o f the ADDPs were to be used as the basis for deciding between

3.5 and IBRA management, the BI, IBRA, and the Ministry o f Finance eventually reached

By mid 1999, after further delays due to continued changes in government officials

13

consensus on closing 50 banks and nationalizing 12 others. As part o f this process, IBRA acquired the non-performing loans (NPLs) and other assets o f the closed, restructured, and recapitalized banks. Given the substantial value o f assets that eventually came under i t s control (at i t s peak, it controlled some $60 bi l l ion in nominal value), IBRA was subject to political pressures, other external influences, and law suits, and there were growing concerns about i t s internal controls and accounting practices, particularly after the Bank Bal i scandal emerged in August 1 999.5 As a result, and although an Oversight Committee had been established at the end o f 1998 (as a condition o f PRSL 0, an Operational Governance Review and Reform Program (OGRRP) was launched in late 1999 to strengthen IBRA’s internal and external governance, which BRAP was asked to help fund. The program was, however, ultimately funded from IBRA’s own resources.6

3.6 Once IBRA had taken control o f intervened bank assets, BRAP focused on supporting IBRA to improve i t s capacity for transparent asset disposition. O f the NPLs acquired by IBRA, 96 percent was held by 2 percent o f the debtors, the remainder being small loans (under Rp 5 billion, or roughly $600,000). IBRA’s tasks thus included auctioning the small loans, restructuring large loans through a lengthy seven step process, instituting legal actions against recalcitrant debtors, and setting up an asset investigation and tracing unit to find and document bank fraud.’

3.7 2000 and 2001, it did so mainly by loan collections, rather than loan and other asset disposal. This was worrying, because the ultimate objective was to return loans to the private sector, and reduce the fiscal cost and govemment’s role in the banking system. In 2002 (after BRAP closed), IBRA auctioned some Rp. 80 tr i l l ion (about $8.6 billion) o f small loans, yielding a 27 percent recovery rate. Nevertheless, some IBRA sales allegedly allowed debtors to buy back their loans at a steep discount through third parties, against i t s rules, raising further concerns about transparency.8 The large loans are s t i l l in the process o f being restructured, and as a result o f the complexity and time required to resolve these loans (para 4.1 S), IBRA remains the largest single creditor in Indonesia, with a book value o f $1 6 bi l l ion in loan assets as o f end-2002, representing some 20 percent o f total corporate debt classified as non-performing.

IBRA has been slow to recover loans. Although it met i t s debt recovery targets in

3.8 The second component o f BRAP involved support for restructuring the state banking sector. BRAP financed technical assistance to draft the terms o f reference for, participate in the selection process of, and review the diagnostic process o f the banks (but

Bank Bali was under IBRA’s control when it was found to have paid over $75 million to an Indonesian firm to collect on debts held by IBRA but guaranteed by government. The scandal created major internal political problems, was another blow to restoring international confidence, and caused World Bank lending to be suspended for some months, until the end o f FYOO.

The Bank could not fund the selected consultant because of Bank rules concerning conflict o f interest (consultants were not allowed to take on assignments whose terms o f reference they had helped draft).

The BRAP was asked to fund technical assistance to this forensic unit, established in 2000, but delays in the Bank in approving terms o f reference and changes in IBRA senior management delayed the process and the function was ultimately transferred to the Attorney General’s office.

The issue here i s not whether debtors bought back their loans, a practice that occurs elsewhere, but that it should have been done transparently.

7

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did not finance the diagnostic work itself). In late 1998, Bank Mandir i was created by a merger o f four state-owned banks (BBD, Bapindo, BDN and EXIM) and their NPLs were transferred to IBRA’s Asset Management Credit (AMC). The state-owned banks were eventually recapitalized with fixed rate government bonds in 2000, at a cost that accounted for some 60 percent of total bank recapitalization costs. In addition, management performance contracts were signed, which established a strategy for each public bank and charted an extensive restructuring program to improve credit practices, risk management, and internal controls. The Ministry o f Finance established a monitoring unit, supported by bilateral technical assistance, to track compliance with the contracts. Although the unit i s functioning and issuing monthly reports, i t s mandate i s limited to reporting, and it has no clear responsibilities for monitoring governance, audits, or preparation for privatization.

3.9 (para 3.2). In addition to the specific activities listed above (mainly the due diligence reviews o f banks), BRAP also funded legal advice covering IBRA and i t s Asset Management Unit (AMU),9 recapitalization transactions, and draft Investment Agreements, and provided support to IBRA in negotiations.

BRAP’s third and fourth components were not implemented, as noted above

3.10 BRAP suffered throughout i t s implementation from frequent changes in officials, IBRA management, and IBRA staff. Between the time BRAP became effective and i t s closing, Indonesia had four presidents and almost twice as many cabinets; because o f the deepening crisis, key government counterparts were under tremendous strain and not focused on technical and detailed issues involving bank restructuring. IBRA had seven chairmen and the staff in IBRA responsible for BRAP changed several times and had no initial knowledge o f government procurement and financial management regulations or World Bank operations and procedures. In addition, the BRAP task managers from the Bank had no previous experience in managing Bank projects, which added to delays.

3.1 1 Moreover, qualified consultants with experience in financial crisis resolution were scarce and expensive and many were occupied with similar assignments in Thailand, Malaysia, and Korea. The Bank’s and Trust Funds’ compensation limits were inadequate to attract qualified consultants and procurement rules on conflict o f interest sometimes precluded hiring otherwise eligible consultants or resulted in f i rms ’ unwillingness to accept assignments. Consequently, procurement under BRAP took a long time, especially in the early and most acute stage o f the crisis.

3.12 comprehensive approach and a clear government commitment to financial sector restructuring. BRAP was an $1 1 mi l l ion input into the efforts to resolve a crisis that involved hundreds o f billions o f dollars o f assets, about 100 banks, scores o f corporations and well-connected individuals, and touched on many legal, institutional, business, and governance issues that could not be resolved by BRAP alone. Had BRAP been part o f a large, integrated, and sustained effort, it might have been implemented more smoothly and with greater success.

Most important, however, was the absence throughout BRAP’s implementation o f a

The AMU was established in IBRA to manage investment in banks taken over; this i s separate from the unit established in IBRA (AMC) to manage the non-performing loans.

15

Policy Reform Support Loans I and I1

3.13 f i rs t tranche o f US$600 mi l l ion was released upon effectiveness and the second tranche o f US$400 mi l l ion was released in February 1999, upon fulfillment o f the agreed conditions. The government complied with al l loan covenants, although several conditions were met somewhat later than originally expected. PRSL 11 became effective in June 1999 and closed on schedule in December 1999. I t was a one tranche operation and the full loan amount o f US$500 mi l l ion was released upon effectiveness.

PRSL I became effective in July 1998 and closed on schedule in June 1999. The

3.14 a series o f IMF programs, with which the Bank had been closely associated, whose only visible outcomes were worsening macroeconomic indicators, caused by inconsistent measures, policy reversals, and political upheaval (paras. 2.8 - 2.1 1). By the time the PRSL was approved in mid-1998, restoring market confidence had become even more dif f icult than six months earlier: there was a lack o f public support, and the IMF and Bank had lost credibility in the market as well as leverage with the government.

Macroeconomic Stability: The period prior to PRSL approval was characterized by

3.1 5 a sound macroeconomic framework was gradually restored. The government managed to maintain a cautious monetary policy and a prudent fiscal balance, even though the international economic environment was improving and the government could have been tempted to relax these policies. Since 2000, beyond the period o f PRSL II implementation, fiscal consolidation has continued, with budget deficits remaining consistently below projections, although contingent liabilities o f the banking system may undermine this discipline in the future."

During the PRSL I and PRSL II implementation period from mid- 1998 to end-1 999,

3.16 Review was completed in 1998 and the government incorporated most o f i t s recommendations in i t s FY98/99 budget: public investments were deferred or canceled; the Investment Fund was incorporated into the budget; and support for the airplane manufacturer was discontinued. Further sector dialogue contributed to preparing the FY99/00 budget, and procedures for bidding and project evaluation were issued to improve competition and transparency, especially for private sector participation in infrastructure, as agreed, although to date there has been l i t t l e progress in attracting private investors into infrastructure.

Increasing Public Sector Efficiency: As agreed under PRSL I, a Public Expenditure

3.17 Under PRSL I, government was to identify at least seven public enterprises to be privatized by March 1999 and another five to be prepared for privatization by that date; government was also to adopt a plan to sel l i t s shares o f companies listed on the Jakarta stock exchange. Under PRSL II, it was to publish a master plan for SOE reforms. Government met al l o f these conditions, in the sense that it did identify the twelve enterprises to be privatized or prepared for privatization by March 1999; announced a plan to divest shares in five listed state-owned companies, and published a master plan for SOE

lo In PRSL ZZ, fiscal deficits were projected for FYOO, 01, and 02 at 5.8, 5.0, and 2.0 percent o f GDP, respectively; in fact, fiscal deficits were well below, at 1.6,2.7, and 1.6 percent, respectively.

16

reforms. Actual privatization has been quite slow, however, because o f widespread opposition and depressed market conditions (para. 4.17).

3.18 Bank under BRAP, and from ADB, the government completed comprehensive portfolio reviews o f banks under IBRA’s supervision, as agreed under PRSL I, and also carried out due diligence reviews o f two state banks and 15 private banks not under IBRA supervision. Government set up an independent review committee, as agreed under PRSL I, to provide oversight to IBRA, although within six months a major scandal emerged involving IBRA, requiring additional measures to strengthen governance (para. 3.5). To enable bank restructuring to proceed, Government set up an Asset Management Unit in IBRA, as stipulated under PRSL 11, so that IBRA could proceed with the closure, nationalization, recapitalization, and/or merger o f banks (paras. 3.5-3.7). Nevertheless, progress was slow and uneven (paras. 3.7, 3.8, 3.10).

Banking Reforms and Corporate Sector Restructuring: With support from the

3.19 To address this critical area, PRSL I had stipulated that government establish an appropriate framework for i t s participation in restructuring private corporate debt, and conditions for PRSL 11 had specified further specific actions (changes in laws, regulations, administrative procedures, and tax treatment). The government met these conditions. To give further impetus to the process, the Jakarta Initiative Task Force (JITF) was created and supported by the Bank under another technical assistance project, to mediate between debtors and creditors and to provide incentives to reach out-of-court settlements, thereby also limiting public sector cost. The process has nevertheless been cumbersome and slow (para. 4.16). Government also established the Indonesian Debt Restructuring Agency (INDRA) to eliminate foreign exchange risk on future debt service payments by Indonesian companies. The agency had only one client, however, and closed operations in mid-2000.

A major factor in banking reform was, and remains, restructuring corporate debt.

3.20 increase competition among marketers, exporters, and importers. Quantitative export controls on palm o i l were eliminated and export taxes were reduced to a maximum o f 40 percent by the time o f second tranche release, as agreed under PRSL I; they were to have come down further to 10 percent by December 1999 (after tranche release), but in fact have been reduced further to 5 percent. The clove marketing board was abolished, as agreed, and with internal trade allowed at unregulated prices, the market price for cloves had risen substantially by early 1999. PRSL I conditionality concerning B U L O G (the National Logistics Agency that had the monopoly for importing rice and other grains, soybeans, and sugar) was respected, and it withdrew from al l commodities other than rice, laying the foundation for competition in imports by private companies. Under PRSL I, government allowed foreign investors into wholesale and retail trade in 1998, and promoting further competition under PRSL II, an anti-monopoly and competition policy was approved by Parliament in February 1999, and a Commission was established to implement the law. Since then, however, there has been some backtracking (para. 4.21).

Improving Competition. A number o f wide-ranging reforms were introduced to

3.2 1 Improving Governance, Transparency, and EfJiciency. Under PRSL 11, draft laws were submitted to Parliament for: the Evaluation o f Corruption Criminal Acts that would increase penalties for those convicted; the establishment o f a commission for investigating

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alleged corruption in the public sector; Fiscal Equalization between the central and regional governments (to establish decentralized service delivery); and a competition law for O i l and Natural Gas, to attract private investment into exploration and production, with the aim o f encouraging competition and ensuring open access in key infrastructure. All o f these laws were eventually passed, but with the exception o f decentralization, most had limited impact (paras. 4.22-4.24).

3.22 The conditions under PRSL I to improve forest management were substantially complied with. A rational system o f forestry resource royalties had been introduced (it was a condition o f second tranche release, but had been done in M a y 1998, prior to PRSL approval), and export tax rates on logs, sawn timber, and rattan had been reduced in two steps to 20 percent. Amendments to forestry regulations were made in January 1999 which went beyond PRSL’s second tranche conditions (to establish a framework for sound forestry management), such that forestry concessions could be sold and the buyer need not commit to developing a processing facility. The concession period was lengthened and concession performance bonds introduced as an instrument o f compliance with regulations. In addition, a consultative group was established to el ici t public recommendations for solving problems in forestry. The biggest single problem in the sector, however, has been the illegal logging, and these measures did not address this (para. 4. 25).

3.23 L a w were issued for Hazardous Waste Management and Marine Pollution Control. An Inter-Agency Committee o f ministers was established to develop an action plan for reducing air pollution from petroleum fuels.

Environment: Under PRSL 11, ru les to implement the Environment Management

3.24 Social Safety Net; The PRSL 11 condition covering social safety nets was detailed more thoroughly in a concurrent social sector adjustment loan. The government doubled the subsidy allocations (from 3.1 percent o f GDP in the FY98 budget to 6.2 percent in FY99, including food subsidies, grants, labor intensive public works) and expanded public expenditures for health and education. Progress in developing a system for monitoring social indicators was slow, however. The Bank, with support from UNDP and several NGOs, launched a Social Sector Monitoring and Early Response Unit with research staff throughout Indonesia. It produced useful reports and newsletters.

4. Outcome and Assessment


4.1 Relevance. BRAP objectives were consistent with the Bank’s country and sector assistance strategies and goals, and during i t s implementation, the assistance provided by BRAP helped IBRA to address restructuring needs o f the banking system.

4.2 banks down to 145 in March 2002 from 237 at the time o f the crisis. Their reported Capital Adequacy Ratio at the end o f August 2002 was a strong 23.2 percent, although this reflects the leading banks’ low volume o f loans (risk-weighted assets under BIS rules), rather than the overall health o f the banking system (para. 4.4). Credit outstanding has increased recently, but from very l o w levels.

Outcome. The banking system’s consolidation has continued, with the number o f

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Table 4.1: Banking System

June 1997 March 2002 (%) Market Share

Private Banks 160 80 40.0 Foreign and Joint Venture Banks 43 34 10.0 State Owned Banks 7 4 }47.1

2.9 IBRA 5 1 Regional Development Banks 27 26 Total 237 145 100

Source: Prof. Dr. A. Nasution’s presentation at NBER conference on Indonesia, August 2000; Bank Indonesia Booklet 2002; and Resident Mission estimates.

4.3 Nevertheless, in spite of substantial technical assistance from BRAP, as well as from other Bank operations, the IMF and ADB, Indonesia’s financial sector problems remain substantially unresolved, more than five years after the crisis began. The banking sector remains largely in government hands, with some 70 percent o f deposits under government control. Although IBRA has recently been meeting i t s targets for sale o f banks, asset disposal has been slow, and large loans remain mired in complex proceedings. In the recapitalized banks, government bonds average about 65 percent o f assets, and the banks thus remain highly dependent on interest income from these bonds. Furthermore, their tepid performance has affected their marketability, and selling holdings in these banks has been difficult and slow. For example, as part o f the SBA with the IMF, the government agreed to divest a majority stake in Bank Central Asia (BCA) and Niaga during 2001, but the transactions could not be completed until a year later, in 2002.’’

4.4 capital base. At the end o f 200 1 , for example, some banks, even those recapitalized, could not meet BI’s capital adequacy requirements. Although the government i s committed to designing a divestment strategy for the state banks,” it may need to consolidate the banking system s t i l l further, possibly bringing even more o f it under i t s control. Further measures may be necessary to make the banks under government control fully viable, both financially and operationally. Governance issues remain largely unresolved and there appears to be l i t t l e appetite for enforcing discipline. The government recently reviewed compliance o f former bank owners with their settlement agreements with IBRA and the President instructed IBRA to release and discharge compliant former bank owners from their obligations. N o action has been taken against recognized defaulters. As o f early 2003, the government had only started to draft legislation for a consolidated financial supervisory regulator and begun building the prerequisites for a self-funding deposit insurance scheme to substitute for the existing blanket guarantee. Bank supervision remains weak.

All banks suffer from narrow or even negative margins, weakening their fragile

BCA was sold to a foreign group, and IBRA retained 9 percent. A majority holding in Niaga was sold to a Malaysian bank; IBRA retained 49 percent. Danamon, Lippo, BII and Permata, the biggest remaining banks in IBRA’s portfolio, are slated for privatization in 2003. If these transactions are completed on schedule, IBRA wi l l have divested all sizeable banks in its portfolio before i t s liquidation in 2004.

I’ Including Bank Mandiri, Indonesia’s largest bank as measured by deposits and loans, which i s slated for privatization in 2003.

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4.5 difficult because the project was intentionally flexible, and the objectives shifted, appropriately so, in light o f the changing circumstances and agreements on the role o f other donors. It accomplished part o f i t s f i rst objective, evaluating troubled private banks. I t accomplished a modified third objective, strengthening IBRA (rather than BI as originally included). I t s fourth objective (reviewing legal infrastructure for finance) was dropped entirely. But the heart o f the project became focused on helping IBRA to restructure public banks (second objective), and, in addition, to rehabilitate private banks, dispose o f assets o f these intervened banks, and privatize or re-privatize the banks under i t s control. As described above, although IBRA has been selling banks according to targets, the basic objective remains largely unmet. Thus, BRAP s outcome is rated unsatisfactory, similar to OED’s Evaluation Summary rating.

Evaluating the outcome o f BRAP in light o f i t s originally stated objectives i s

4.6 Sustainability. BRAP was designed to provide technical assistance to the Indonesian government in financial crisis resolution and restructuring. The sustainability o f whatever benefits have emerged depends on the government’s commitment and ability to carry through the reforms. The current government appears more committed than previous ones to staying the course, and i s developing a strategy for the financial system, which i s s t i l l weak and substantially government owned. Privatization has been slow and, for individual banks, incomplete and governance remains problematic. IBRA i s due to be liquidated in 2004, and decisions have not yet been taken on how assets s t i l l under i t s control will be handled. I t i s difficult to judge whether the government i s sufficiently determined and in particular, able, to implement further and deeper reforms. Thus, the sustainability of reforms supported by BRAP is non-evaluable at present. OED’s Evaluation Summary rated sustainability as unlikely.

4.7 Institutional development impact. Because o f the magnitude o f the crisis, a new institution, IBRA, was established with a mandate to restructure banks, manage assets, dispose o f loans and equity in nationalized banks, dispose o f loan collateral, restructure debt and manage the govemment’s blanket guarantee. From i t s inception, IBRA struggled to balance in-house capacity development with extensive outsourcing. I t s ability to fulfill i t s mandate was hampered by frequent changes in leadership and staff, and poor governance. This was improved after 2000, following an external audit, a robust Corrective Action Plan to improve internal controls, and a more pro-active Oversight Committee. In the end, IBRA managed to carry out substantial tasks, supported in part by BRAP’s technical assistance and Bank staff supervisions which helped define i t s mandate and build capacity. Although it was eventually able to contribute to a gradual rebuilding o f Indonesia’s banking system, IBRA will be wound-up in 2004, and whatever capacity has been built i s likely to be dispersed, if not lost entirely. Institutional development impact is rated modest, consistent with OED’s Evaluation Summary.

4.8 unfolding crisis. BRAP’s design was based on economic and sector work and incorporated lessons from relevant projects in Indonesia and Thailand, while allowing flexibility to respond to the evolving situation and shifting responsibilities among donor agencies. The rapid preparation, however, did not permit adequate institutional capacity analysis: there were no identified counterparts, or project management (the executing agency was to be the Secretariat o f the Monetary Board, and BI was expected to have a key role, neither o f

Bankperformance. BRAP was prepared in a matter o f weeks, to respond to the

20

which happened), and no clear government ownership o f objectives or design. The project was not ready for implementation. Bank staff accurately assessed the risk o f project failure as high. Thus, in spite o f the Bank’s rapid preparation and flexible design, quality at entry was unsatisfactory.

4.9 During implementation, Bank staff involvement and coordination efforts with the IMF were intense. Over a period o f eighteen months, between February 1998 and July 1999, nine joint Bank-IMF missions were fielded, with cooperation improving over time. In July 1998, the Bank stationed a task manager in Jakarta to supervise BRAP with the support o f the headquarter-based team, which had two bank restructuring experts, one banking expert and one asset management specialist. Given the scope o f the crisis and i t s spillover into political and social dimensions, such focused and intense effort was appropriate. By contrast, and in spite o f the magnitude o f the crisis in a major Bank borrower and the public commitment to make substantial financial assistance available to the country, senior Bank management and technical advisors remained remarkably uninvolved in the operation that was for some time the only one directly addressing the crisis. In addition, the Bank’s matrix management system complicated the process and made it difficult to harness appropriate staff resources q ~ i c k 1 y . l ~ In a crisis o f such magnitude, Bank management should have given priority to addressing the issues in Indonesia, even if they were in the context o f a relatively small technical assistance loan.

4.10 One shortcoming o f the early supervision efforts was that the Bank staff assigned to the project were new to the BankI4 and had no experience with internal Bank procedures or the requirements o f supervising Bank operations. As a result, the first few supervision missions, prior to project effectiveness, were undocumented within the Bank (no project status reports were prepared). Although Bank supervision responded flexibly to changing circumstances and provided substantial technical guidance during implementation, it f e l l short in resolving Bank procurement issues, which impeded getting high quality and timely technical assistance. In spite o f the substantial contribution made by staff directly involved in crisis resolution, who worked diligently at an exacting pace for several years, given the unsatisfactory quality at entry and the mixed quality of supervision, Bank performance is rated unsatisfactory in agreement with OED’s Evaluation Summary.

4.1 1 Borrower performance at the national level was mixed, as it was at the agency level. Government’s commitment to financial sector reforms was weak for most o f the period o f BRAP implementation, resulting in a non-transparent process o f bank restructuring and bank asset resolution. Throughout the project’s l ife, Indonesia was enmeshed in the largest financial crisis o f i t s history and severe political turmoil. It had no experience dealing with such a systemic crisis and, in any case, lacked the appropriate skil ls. Government counterparts were over-stretched by the political changes and the crisis, which contributed to delays in identifying and establishing an appropriate implementing agency and to frequent changes in i t s leadership. After initial delays,

l3 By contrast, the IMF Managing Director communicated directly with the staff a regular basis. With more resources at stake and senior management involved, the IMF took the lead in the resolution process.

l4 In January 1998 the Board authorized special funding to address financial sector issues in crisis countries, and a Special Financial Operations (SFO) unit was set up and staffed with specialists. SFO was not integrated into Regional strategies, and its existence created tensions with Regional units.

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funding and legal powers o f IBRA were adequate. O n agency performance, IBRA did not appoint full-time staff to manage BRAP resources, and frequent staff rotation exacerbated the problem; IBRA staff were not familiar with Bank procurement procedures, resulting in delays. For that reason, Bank staff and consultants contributed disproportionately to selecting and supervising technical assistance providers. Over time, IBRA’s management o f BRAP improved. Although under difficult circumstances Indonesia made substantial progress, it f e l l short in resolving the banking crisis. Because of its wavering commitment and lack of follow-through, the borrower’s performance is rated unsatisfactory, in agreement with OED’s Evaluation Summary.

Policy Reform Support Loans I and I1

4.12 that supported Indonesia’s foreign exchange and budgetary needs. Their policy conditionality was consistent with Indonesia’s needs and with the Bank’s country assistance strategy. Although both were relevant for addressing structural issues at the heart o f Indonesia’s emergence from the crisis, PRSL I was arguably both better focused on priority areas and likely to have greater impact than PRSL 11, which was too diverse and involved conditionality, such as announcing master plans (for privatization) and passing laws (on corruption), that required substantial fol low up’’ and enforcement to have impact. Thus, the quality of entry of PRSL I is considered satisfactory, while that of PRSL 11 is considered unsatisfactory.

Relevance. These loans were an integral part o f the multi-donor assistance package

4.13 2000. Good progress has been made in macroeconomic management, although it has been uneven. By early 2000, the monetary and exchange rate situation was poised to become more supportive o f economic recovery, but instead, slippage in reforms and increasing political uncertainty contributed to downward pressure on the Rupiah; inflation picked up toward the end o f 2000. Since mid-2001, however, tightened monetary conditions and the change in government contributed to the Rupiah’s recovery and declining inflation and interest rates. The budget has been well managed, and the budget deficit has been contained well below targets, and (except for 2001) below 2 percent o f GDP, although future debt service payments constitute a fiscal risk even though the debt/GDP ratio i s declining (from 100 percent o f GDP in 1998 to 72 percent in September 2002). The balance o f payments current account was in surplus from 1998 to 200 1, but continued capital outflows (while official net flows turned negative private inflows began to recover) has put reserves under pressure. Macroeconomic outcomes should be considered satisfactory.

Macroeconomic outcomes. Growth rates o f 3-5 percent have been achieved since

4.14 Macroeconomic sustainability. Despite overall progress in macroeconomic management, however, Indonesia’s recovery i s at risk, because o f slow structural reforms. The investment climate remains weak; gross domestic investment i s s t i l l about half o f i t s

The Region has noted that there was and continues to be follow up in a number o f areas: to help meet the privatization targets, the ADB provided technical assistance, which helped in the recent passage o f a law that provides a legal basis for privatization o f state-owned enterprises; and Bank work on public expenditure management contributed to the passage o f a law on State Finances, which the Region thinks may be a major step forward in transparency and accountability in the use o f public funds.

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1997 level, although in 2003 it has picked up momentum. Resolving the banking crisis, restructuring corporate debt, and bank and enterprise privatization have not made the expected progress, and because o f a continued blanket deposit guarantee, bank liabilities remain contingent government liabilities. Sustainability of macroeconomic outcomes is non-evaluable at this time.

4.15 Outcome and sustainability: increasing public sector efJiciency. The main instruments for achieving this objective were public expenditures reviews leading to more streamlined public expenditures, introduction o f a strategy for private participation in infrastructure, and privatization o f SOEs. Although the specific conditions were met in al l o f these areas, progress on outcomes has been very slow. First, decentralization o f part o f government’s fiscal revenues, that took place in 200 1, has complicated the process o f controlling public expenditures (para. 4.24). Second, although a strategy for private participation in infrastructure was announced and a law passed to allow private investments in o i l and natural gas, l i t t le progress has been made (as in most countries during this period) in attracting private investors into the long term commitments required by these sectors. Third, the privatization o f SOEs, in spite o f Government’s announced programs, has been limited to a few actions, including sale o f over 50 percent stake in one o f the 12 companies on the l i s t o f enterprises to be privatized by March 1999, and sale o f shares o f a cement company which did not succeed in reducing Government’s ownership to below 50 percent. The privatization program progressed very slowly since PRSL I and II. Outcomes of this objective are unsatisfactory and the sustainability of the little that has been done is considered non-evaluable.

4.16 competitive banking sector. The establishment o f tax changes and other administrative measures, combined with the creation o f the JITF (para. 3.19) did facilitate corporate restructuring: as o f December 2002, cumulative debt restructured reaching the Memorandum o f Understanding (MOU) signing stage amounted to $1 8.8 billion, with JITF mediating active cases amounting to $10.1 bi l l ion with 40 companies. I t s mandate was extended by one year until the end o f 2003 to allow completion o f i t s task. Nevertheless, the process remains slow: signing an M O U does not mean that the debt has been resolved; and some debtors are prolonging negotiations with the hope that they may settle at discounted values, similar to IBRA asset sales. Thus, although government took the necessary steps to facilitate the process, i t remains complex and time-consuming.

Outcome: facilitating corporate restructuring and building an effective and

4.17 In the banking sector, as noted above, l o w profitability and a weak capital base continue to affect the marketability o f banks. In addition, there has been l i t t l e material change in the incentive structure for banking; wrongdoers are s t i l l not held accountable, and the banking system continues to be vulnerable to unscrupulous bankers and regulators. The bank-bailout cost the government more than 50 percent o f annual GDP and the state s t i l l controls some 60 to 70 percent o f a weak banking system, which remains vulnerable to further shocks, and to guarantee al l bank liabilities, extending the period o f moral hazard.

4.18 New lending to businesses has been slow to resume, partly because economic growth and progress in debt restructuring has been slow. In any case, large companies have access to financial resources offshore. Most new lending over the 2000-2002 period was for consumption, but in 2003 there have been signs that investment lending,

23

particularly to smaller companies, has begun to expand. While banks and branches have been closed, l i t t le change has occurred in banking practices or business strategy, especially in state owned banks. Many bankers that use poor loan practices are s t i l l around, and non- performing loans are increasing. Thus, the banking system remains fragile and vulnerable to shocks. While Indonesia has been beset by a combination o f factors, such as the uncertain political situation, weak judicial system, and regional tensions, that has impeded reform progress, other countries in the region facing a similar crisis have revived their financial sectors and economies faster than Indonesia, which has paid more to bail out i t s banking system than any other country. The outcome of corporate restructuring and banking sector reforms is considered unsatisfactory.

4.19 Sustainability of corporate and banking reforms: The government has not exercised effective owner supervision o f i t s banks through IBRA, the Ministry o f Finance, or BI. BI’s supervision capacity remains weak and i t s independence under threat, as the parliamentary debate on the central bank law continues without resolution. The government prefers a domestic banking system that functions competitively with foreign banks and has been reluctant to sel l to foreign buyers. There are, however, few domestic buyers with the experience or resources (at least those they can declare) to purchase sizeable banks. Meanwhile, high valuations and employment, l ow profitability, and other social considerations pose an impediment to foreign buyers, although three banks have recently been sold to foreigners.

4.20 sunset i s approaching. Because banking contingent liabilities pose a considerable risk, financial sector reforms are key to future fiscal stability. Developing a lender o f last resort facility, improving bank supervision, and further consolidation o f the banking system are essential steps in the process. The sustainability of what has been accomplished to date is considered non-evaluable.

Government has only recently begun to develop a strategy, even though IBRA’s

4.2 1 range o f laws, decrees, and regulations to increase competition in many areas, including commodity trading, cement marketing, o i l palm plantations and trade. The measures covered reduction or elimination o f barriers to external trade and inter and intra-provincial trade, abolishing monopolies, and allowing entry o f the private sector and/or foreign investors. Overall, competition has increased, prices o f certain commodities have improved (lower for consumers; higher for producers) and domestic investors have recently entered a number o f markets. Since 2002, however, backtracking has occurred across a number o f commodities, with re-introduction o f trade restrictions and increased protection. Tariffs have been increased and import licenses introduced on sugar that limit quantities; sugar prices have doubled in 2002; procurement prices for rice have gone up, with consequent increases in consumer prices as well. A licensing system for clove imports was introduced in July 2002; and steel and textile imports are now subject to non- tari f f barriers. Internal trade i s also being affected by taxes imposed by local governments, which are mostly against a 2000 law, but which the central government has limited capacity to monitor. In spite o f some backtracking, overall competition has increased and the outcome o f this objective i s considered satisfactory. Given the recent moves by both central ministries and local governments to increase control o f trade, however, sustainability is considered non-evaluable.

Outcome and sustainability: improving competition. Government enacted a wide

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4.22 Outcome: improving governance. The laws enacted by Parliament covering anti- corruption were steps in the right direction, but implementation has been slow and their impact negligible to date. The Anti-Corruption Commission i s not yet operational, some four years after the passage o f a 1999 Anti-Corruption Law. More generally, perceptions o f corruption have worsened in the last several years, and most indicators o f overall investment climate have deteriorated since the crisis. Tax and customs administration, police, and judiciary systems are thought to be particularly problematic.'6 According to publicly available World Bank research on governance, Indonesia continues to rank at or near the bottom third o f al l countries, and although it has improved in several dimensions (such as Voice and Accountability) since 1998, when the PRSL I was approved, it ranks particularly poorly on Rule o f Law and Control o f Corruption. In this latter dimension, Indonesia remained in 2002 among the worst countries in the world (Box 4.1).

IBox 4.1: Measures o f Governance

The World Bank has compiled data from hundreds o f variables from 25 data sets gathered by 18 organizations and organized it into six dimensions o f governance. The table below shows Indonesia's ranking relative to 199 countries from four time periods, 1996 through 2002, where one i s the lowest ranking.

1996 1998 2000 2002 ---_________________ percentile ranking _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Political Stability 30 9 3 12

Voice and Accountability 16 12 32 35

Rule o f Law 40

Regulatory Quality 66

Government Effectiveness 66

14 15 23

47 28 26

27 33 34

Control o f Corruption 35 7 9 7

Source: Kaufmann, David, Aari Kraay, Massimo Mastruzzi. Governance Matters III: Governance Indicators for 1996-2002. Policy Research Working Paper No. 3 106. Washington, D.C.: The World Bank.

4.23 The single most significant change affecting governance in the past few years has been the radical and comprehensive decentralization, which went into effect at the beginning o f 200 1 , and which involved the transfer o f one quarter o f central government revenues to some 370 sub-provincial (district and municipal) governments. Although the process was smoother and involved less disruption in service delivery than expected, this massive shift in power has had major repercussions on governance (as well as fiscal equity) issues. Aside from the questions o f accountability for the quality and efficiency o f service delivery, there i s unclear responsibility for decisions on investments, mining and other land use licenses, as well as for taxation and other regulatory authority o f businesses; these uncertainties have created an entirely new range o f opportunities for corruption. There i s a common perception in Indonesia that decentralization has made corruption worse.I7 The outcome of this aspect of the reform program is considered unsatisfactory.

l6 Ibid, pp. 18-19,29-39.

l7 Op cit. World Bank. pp. 21-22.

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4.24 1998, democracy has been introduced and freedom o f the press has expanded (Indonesia ranks in the upper hal f o f about 200 countries on this measureI8). A donor-supported NGO, Partnership for Governance Reform, has become active and visible in surveys, diagnostic work, supporting anti-corruption commissions, and facilitating dialogue among government agencies; and overall perceptions o f Voice and Accountability have improved dramatically (Box 4.1). Although transparency has increased, it cannot be attributed to any actions or reforms supported by PRSL I and II,

Outcome: transparency. Indonesia has made some progress in this area. Since

4.25 governance, the conditionality specific to the forestry sector in PRSL I was met. Nevertheless, the objective o f improving forest management and making it more market oriented continues to be undermined by illegal logging and inadequate supervision. In 2000, the rate o f deforestation was estimated to have increased to an alarmingly high 1.7 mil l ion hectares per year, or 1.8 percent o f the forest cover,” and the export ban recently imposed on logs i s likely to have limited impact on this problem. Decentralization o f responsibility for forestry increases the potential for further degradation. The outcome of the forestry aspect is considered moderately unsatisfactory and unless effective measures can be put in place to stop the illegal logging, what has been accomplished to date is considered to be unlikely to be sustainable.

Outcome and sustainability: forestry sector. Under the general heading o f

4.26 Outcome and sustainability: improving the social safety net and protecting the poor. Under PRSL I and 11, the measures to assist the poor consisted o f agreeing on budgetary expenditures for sectoral allocations and social safety net programs, such as subsidized rice programs and education grants and subsidies. These programs were also supported by a $600 mi l l ion Social Safety Net Adjustment Loan (SSNAL), co-financed by the Japanese Bank for International Cooperation for another $600 million. Although the second tranche o f the SSNAL was canceled because o f lack o f progress on governance issues, data from that loan’s completion report indicate that, overall, specific programs did have an impact: school enrollments and use o f health services have recovered post-crisis, and malnutrition has not increased. Poverty rates have declined substantially since their peak in 1999, and by more than would be expected based on GDP growth rates alone. This i s largely attributed to a decrease in the relative food prices since 1999, and in particular to the decrease in the relative price o f rice. The poor are particularly vulnerable to changes in relative food and rice prices; in fact, the slight increase in poverty in 2002 i s thought to be due to the increased rice price, and measures to increase rice protection could serve mainly to increase poverty.2o In addition, although the recent decentralization starting in 200 1 has not had a visible adverse impact on the delivery o f health and education services, there are some signs that health charges may have increased, which would also harm the poor. The objective of protecting the poor, through subsidized programs and measures that have increased competition in commodities and thus lowered their relative prices, has been substantially met, and the outcome is considered satisfactory. Sustainability is non-

Ibid.

l9 Compared to about 1.5 million hectares per year between 1985 and 1997. Source: CAS, 2002, p. 12.

2o Op. cit. Indonesia: Maintaining Stabiliq, Deepening Reforms. p. 44-45.

26

evaluable, however, given decentralization, recent moves to increase protection levels on basic food commodities, and low growth.

4.27 made considerable progress in macroeconomic management to stabilize the economy, restore modest growth and reduce poverty, key structural reforms (resolving the banking crisis, privatization, improving governance) have not progressed and outcomes are considered generally unsatisfactory (Table 4.2 for a summary o f preceding discussion). Because these aspects remain substantially unresolved, the overall outcomes for PRSL I and PRSL 11 are both rated moderately unsatisfactory, compared with OED’s Evaluation Summary rating o f satisfactory for PRSL I and moderately satisfactory for PRSL II.

Overall outcome and sustainability ratings for PRSL I and II. While Indonesia has

4.28 program during a period o f political transition, and recent macroeconomic indicators are encouraging. The recovery i s fragile, however. Fiscal pressure, slow progress in resolving the banking crisis, corporate debt restructuring, privatization, and governance reforms

Sustainability. Indonesia implemented important elements o f a demanding reform

Table 4.2 Summary ratings for PRSL I and I1 Outcome Sustainability

Macroeconomic Satisfactory Non-evaluable Public sector efficiency Unsatisfactory Non-evaluable Banking reform Unsatisfactory Non-evaluable Increasing competition Satisfactory Non-evaluable Improving governance Unsatisfactory Non-evaluable Forestry sector Moderately Unlikely improvements Unsatisfactory Social safety nets Satisfactory Non-evaluable

remain significant r isks that could undermine the program’s sustainability. In spite o f certain elements in the reform program, such as increased competition, that are considered sustainable, sustainability of PRSL I and 11 is non-evaluable at this time, in agreement with OED’s Evaluation Summary ratings.

4.29 Institutional Development Impact presents a mixed picture.

On the one hand, institutions such as IBRA and the Anti Corruption Commission were created and procedures were put in place to empower them to address a wide arrange o f issues. Bank consolidation has occurred. Laws, regulations, decrees were passed to abolish protection, special privileges, and market power; competition has increased in a number o f areas. Decentralization was effected and i s now functioning. O n the other hand, l i t t l e progress was made on privatization. Few changes have occurred in the critical infrastructure sectors. Financial sector reform remains a significant challenge, in spite o f progress to date in banking consolidation. And the process o f improving governance i s s t i l l at a very early stage, with uncertain government commitment. Moreover, the problem remains o f the willingness o f the judiciary to enforce the laws and regulations, which undermines the impact o f the new institutions and laws. Thus, institutional development impact of both PRSL I and 11 are rated modest. OED’s Evaluation Summary rated PRSL I as making a substantial contribution and PRSL II a modest contribution to institutional development.

4.30 adjusted i t s country assistance strategy for Indonesia. Staff prepared both PRSL I and PRSL 11 expeditiously, as part o f a larger rescue package, and in coordination with other multilateral agencies and bilateral donors, and with government involvement and

Bankperformance. Following the onset o f the financial crisis, the Bank eventually

27

consultation with civ i l society. Risks were appropriately identified by staff, with monitoring and evaluation indicators adequately specified. Nevertheless, there were important differences in the focus and nature o f the conditionality in the two loans, and as noted above @ara 4.12), the quality at entry o f PRSL I i s considered satisfactory, while that o f PRSL 11 i s considered unsatisfactory. PRSL I and PRSL 11 were supervised by field staff, who identified problems, provided advice and responded flexibly in approving modifications, but could not ensure adequate progress in key reforms in the financial sector, corporate restructuring, privatization, or govemance. Overall, Bank performance for PRSL I is rated as satisfactory, while that for PRSL 11 is rated unsatisfactory, mainly because of the absence of signijkant conditionality that would move the reform program forward. These ratings compare to OED’s Evaluation Summary ratings o f satisfactory Bank Performance for both PRSL I and II. OED ’sjndings on Bankperformance, particularly for PRSL II, raise the issue of the extent to which the Bank’s commitment to participate in a rescue package can reduce its leverage in terms of conditionality and timing of loans.

4.3 1 PRSL I and 11, which involved many ministries. Despite several cabinet level political changes, the government’s ownership o f the program remained initially secure. I t benefited from extensive consultation with the public while preparing the reform program. Government officials responded well to the pressure o f meeting the conditionality under PRSL I, although there were delays in meeting several o f them and in providing adequate funding to agencies established as part o f the reform program. Progress has been slow, however, in key areas such as banking crisis resolution, corporate debt restructuring, and enterprise privatization, indicating tepid government ownership, and/or political opposition. In addition, there has been some backtracking on competition policies and forestry policies, and very limited commitment to addressing fundamental reforms needed to improve governance. For these reasons, Borrower performance under both PRSL I and 11 is rated unsatisfactory. OED’s Evaluation Summary rated Borrower performance as satisfactory in both o f these loans.

Borrower performance. Government officials played an active role in preparing

5. Lessons 0 In a country with deeply rooted and widespread govemance issues, where the

authorities are not committed to deep reforms, the Bank needs to have realistic expectations about the outcome o f i t s interventions. In Indonesia, the ability to affect fundamental reforms with adjustment and technical assistance support has been limited. The effort requires a more comprehensive and long-term approach, including diagnostic work and involvement o f c iv i l society.

0 The dilemma o f supporting a country in crisis i s highlighted by PRSL I and, more especially, by PRSL II. The Bank needs to provide the Board with a frank rationale for i t s intervention, even where the rationale i s limited to providing special shorter- term liquidity support for modest reforms.

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0 The experience in Indonesia highlights the importance o f avoiding delays in banking crisis: unless resolved quickly and decisively, the fiscal costs mount and vested interests further impede resolution.

0 In a major crisis, Bank management and top technical specialists should give priority to resolving issues that arise in the context o f Bank assistance addressing the crisis, even if the vehicle for the assistance i s in the form o f a relatively modest technical assistance loan.

0 Coordination among donor agencies i s essential in countries in crisis and needs to be made explicit. In Indonesia, coordination was successful only after an initial period o f uncertainty, mainly because the IMF was able to take the lead.

0 The Bank’s’consultant fee structure and procurement rules caused delays and impeded a rapid response to Indonesia’s banking crisis, and excluded or discouraged the few service providers with appropriate technical expertise. These rules should be reviewed with a view to allowing exceptions to policy under certain well-defined circumstances.

0 The Bank’s central unit (SFO) enabled the Bank to respond to Indonesia’s need for technical expertise, but the unit was not well integrated into the Bank’s organization and was unfamiliar with i t s operational procedures, causing bureaucratic and practical problems. For future crisis response, the Bank should consider establishing a “virtual” crisis unit o f specialists working in the Regions, available to respond to a specific crisis inside the relevant regional management structure.

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Annex A. Basic Data Sheet Annex A

BANKING REFORM ASSISTANCE (LOAN No. 4255-IND)

Key Project Data (amounts in US$ million) Appraisal Actual or Actual as % of estimate current estimate appraisal estimate

Total Droiect costs 20.00 11.01 55.05 Loan ambunt 20.00 11.01 55.05 Cofinancing Cancellation 8.99 44.95

Cumulative Estimated and Actual Disbursements FY98 FY99 FYOO FYOl

ADDraisal estimate (US$M) 1.75 20.00 20.00 20.00 Actual (US$M) ' 1.75 9.99 11.10 11 .oo Actual as % of appraisal 100 49.95 55.5 55 Date of final disbursement: May 9, 2001

Project Dates Original Actual

Identification Appraisal 1 1/10/1997 Negotiations Board approval 12/04/1997 Signing 12/15/1997 Effectiveness 04/08/1998 Closing date 09/30/2000 05/09/2001

Staff Inputs (in US$ '000) Actual

FY98 FY99 FYOO FYOl Total Lending 50 50 SupervisionlCompletion 136 133 189 82 540 Total 186 133 189 82 590

Mission Data Date No. of Staff days Specializations Performance Rating

(month/year) persons in field represented

Implementation Development Type of status Objectives Problems

Identification/ 10/13/1997 2 Fin. Sector Spec. Preparation 1 Economist Appraisal 1111 1/1997 2 Fin. Sector Spec.

11/13/1997 1 Economist Supervision 06/13/1998 6 Fin. Sector Spec. U S

Completion 09/2001 U S 1 Legal Specialist

Other Project Data Borrower/Executing Agency:

Operation Loan no. Amount Board date FOLLO W-ON OPERA TlONS

(US$ million)

Policy Reform Support Loan Second Policy Reform Support Loan

Ln. 4368-IND 1,000 July 2, 1998 Ln. 4470-IND 500 May 20, 1999

30


POLICY REFORM SUPPORT LOAN (LOAN No. 4368-IND)

Key Project Data (amounts in US$ mill ion) Appraisal Actual or Actual as % of estimate current estimate appraisal estimate

Total project costs 1,000 1,000 100% Loan amount 1,000 1,000 100% Cofinancing Cancellation

Cumulative Estimated and Actual Disbursements Appraisal estimate (US$M) 1,000 Actual (US$M) 1,000 Actual as % of appraisal

FY99

100 Date of final disbursement: February 8, 1999

Project Dates

Appraisal 11/1997 021 998

Original Actual Identification 1011 997 1211 997

0411 998 Negotiations 12/1997 Board approval 0411 998 07/02/1998 Signing 07/02/1998 07/02/1998 Effectiveness 07/02/1998 07/02/1998 Closing date 0 9 1 999 06/01/1999

Staff Inputs (staff weeks) Actual

Staff Weeks $(‘OOO) Preappraisal 48.0 197.8 Appraisal 4.8 13.0 Negotiations 0.5 6.6 Supervision 70.0 121.5 Completion 4.4 Total 127.7 338.9

Mission Data Date No. of Staff Specializations Performance Rating

(monthlyear) persons days in represented field /a

Implementation Development Type of status /b Objectives Problems /c

Supervision Id 8 /d EC, FA, LC S S

/a DO: Disbursement Officer; EC: Economist; EN: Engineer; FA: Financial Analyst; LC: Legal Counsel; 00: Operations Officer; RA: Research Analyst; RS: Resettlement Specialist; TE: Transport Economist; TS: Transport Specialist /b 1 : Highly satisfactory; 2: Satisfactory /c Typical problems included: implementation delays in technical assistance and studies. /d Supervision i s done by staff o f the World Bank Office Jakarta, Indonesia. There were no supervision missions from headquarters.

Other Project Data Borrower/Executing Agency:

Opera tion Credit no. Amount Board date

Second Policy Reform Support Loan Ln. 4470-IND 500 May 20, 1999

FOLLOW-ON OPERATIONS

(US$ million)

31


SECOND POLICY REFORM SUPPORT LOAN (LOAN No. 4470-IND) Key Project Data (amounts in US$ million)

Appraisal Actual or Actual as % of estimate current estimate appraisal estimate

Total Droiect costs 500 500 100 Loan amount Cofinancing

500 500 100

Cumulative Estimated and Actual Disbursements FY99

Appraisal estimate (US$M) 500 Actual (US$M) 500 Actual as % of appraisal 100 Date of final disbursement: June 18, 1999

Proiect Dates Original Actual

Identification Appraisal Negotiations Board approval 05/20/1999 Signing 05/28/1999 Effectiveness 0611 8/1999 Closing date 12/31/1999

Staff Inputs (staff weeks)

AppraisaVNegotiations 4.1 35.1 Supervision 3.7 15.1 Completion 7.5 36.6 Total 100.7 376.9

Mission Data Date No. of Staff Specializations Performance Rating

(monthlyear) persons days in represented field

Implementation Development Type of status Objectives Problems

Identification/ 09/1998 25 Econ: 5: Fin: 3: S S Preparation 12/1998

Appraisal 12/1998 8

Supervision Done in the 9 field by Staff in the Country Off ice

Corporate restructuring/PSD: 4; Energy: 2; Env: 1; Forestry: 2; Lawyer: 1; Social Sector: 1; Governance: 1; FMS: 1; Econ. Data: 2; ACS: 2

Econ: 2; Lawyer: 1; Social Safety Nets: 1; Banking: 1; Governance: 1; Forestry: 1; FMS: 1

Econ: 3; Lawyer: 1; Social Safety Nets: 1; Banking: 1; Governance: 1; Forestry: 1; PSD: 1

S

S

S

S

Completion 03/2000 3 Econ: 3 S S 06/2000

32 Annex A

Other Project Data Borrower/Executing Agency: FOLLOW-ON OPERATIONS Operation Credit no. Amount Board date

(US$ million)

Social Safety Net Adjustment Loan Ln. 4471 600 million May 20, 1999

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Annex B. List o f People M e t Bank Group Staff Vikram Nehru Michael Edwards Ruth Neyens Richard Roulier L i l y Chu Vince Polizatto Florence Cazenave Ijaz Nabi Millard Long Bert Hofman Bernard Drum Anthony Toft David Hawes Sarwar Lateef German Vegarra

International Monetary Fund Charles Enoch Sunderaj an Ashoka Mody

Other Donors Bill Heidt, US Embassy Michael Wash, Australian Embassy Karen Whitham, Australian Embassy Mike Ryan, Asian Development Bank

Indonesian Officials Dr. S. Sabirin, Governor, Bank Indonesia Mr. Sumintro, Head, INDR Mr. B. Ruru, Chairman, Jakarta Initiative Task Force Mr. Bambang Subianto, Ex-Minister o f Finance Mr. Sumantri Slamet, Vice Chairman o f IBRA Mr. Jonathon Zax, Bank Mandiri Mr. Glenn Yusuf, ex-Chairman IBRA

Private Sector Jack Garrity, Tang-Ling Holdings Catharina Widjaja, Gajah Tunggal Group Irwan Habsjah, MD ING Barings Pramukti Surjaudaja, President Bank NISP Michael Zink, Head Indonesia, Citibank Jonathon Cheng, JP Morgan Eugene Galbraith, President BCA Suhail Chander, VP ABN-AMRO Bank Jim Castle, President AMCHAM

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Documents

World Bank Document · Document of The World Bank Report No.: 27177 PROJECT PERFORMANCE ASSESSMENT REPORT INDONESIA BANKING REFORM ASSISTANCE (LOAN NO. 4255-IND) POLICY REFORM SUPPORT