Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. P-4794-IND

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED LOAN

IN AN AMOUNT EQUIVALENT TO US$300 MILLION

TO THE

REPUBLIC OF INDONESIA

FOR A

SECOND TRADE POLICY ADJUSTMENT LOAN

April 19, 1988

This document has a restricted distribution and may be used by recipients only in the performance oftheir ofricial duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS

Currency Unit G RupiahUS$1.00 - Rupiah (Rp) 1,660Rp 1 million - US$602

GOVERNMENT OF INDONESIA FISCAL YEAR

April 1 - March 31

SYSTEM OF WEIGHTS AND MEASURES

Metric

ABBREVIATIONS AND ACRONYMS

BAPPENAS - National Development Planning AgencyBKPM - Investment Coordinating BoardBULOG - Badan Urusan Logistik (The National Logistics

Agency)CCCN - Customs Coordination Council NomenclatureCBU - Completely built-upCKD - Completely knocked-downEKUIN - Coordinating Ministry for Economic MattersGOI - Government of IndonesiaIGGI - Inter-Governmental Group on IndonesiaIPEDA - Iuran Pembangunan Daerah (the old land tax)NTB - Non-tariff barrierO&M - Operations and maintenanceP4BM - Implementing agency for May 6 schemeREPELITA - National Five-Year Development PlanSBI - Central Bank certificatesSBPU - Private Sector Promissory NotesSGS - Societe Generale de Surveillance S.A.SOE - Statement of ExpenditureTIPSC - Trade and Industrial Policy Steering CommitteeTPAL I - First Trade Policy Adjustment LoanVAT - Value-added tax

Import License Categories:

AT - Ager. Tunggal (licensed agent)IP - Importir Produser (actual user)IT - Importir Tardaftar (approved trader)IU - Importir Umum (general importer)KS - PT Krakatau SteelPI - Produsen Importir (producer importer)TT - PT Tambang Timah

FOR OMCLIL USE ONLY

INDONESIA

SECOND TRADE POLICY ADJUSTMENT LOAN

Table of Contents

Page No.

LOAN SUMMARY *..........i i..........i.......... .......

It BACKGROUND ....... ....... to...... ... to..................*.... .*.....1

II. THE FIRST ADJUSTMENT PERIOD, 1982-85 .................. .... 1

III. THE SECOND ADJUSTMENT PERIOD, 1986-89 ................... . 3

A. The Initial Policy Response . ....................... 3B. Continuing Macroeconomic Adjustment ......... . 3C. Continuing Structural Adjustment ..................... 5

Trade Policy Reform ..................................... 5Industrial Deregulation and Foreign TnvestmentPolicies ... ...................................... 7

Financial Sector Reforms .... ... ... .... ... ..... . 8D. Assessment of Performance and Costs of Adjustment-.... 9E. Management of External Capital Accounts .............. 10

IV. THE REMAINING POLICY AGENDA AND PROSPECTS FOR A RECOVERYIN GROWTH . ........... to......... **................................ 11

A. Continuing Measures for Economic Stabilization ....... 11B. Further Structural Adjustment Reforms ........ ........ 12C. Growth Prospects .......... . .. . ............to... ....... ... . ..... . 13D. External Capital Flows and Debt Management ........... 15

V. BANK'S OPERATIONAL STRATEGY .... ....... . .................. . 16

VI. THE PROPOSED LOAN ................ .......... .. . 18

A. Loan History ......................................... 18B. Loan Objectives .... .................................. 19C. Loan Administration ........... ............... ........ 19

Disbursement ............... ...... ........ . 19Procurement ..................................................... 19Accounts and Audits ....................... .. ........... 20

D. Monitoring and Follow-up ... .............. ................ . 20E. Program Benefits and Risks ........ * ........ 20

VII. RELATIONS WITH IMF ..................... ............. ...... 20

VIII. RECOMMENDATION ........ ............... .. ... ............ 21

This document ha a rtdcted disibution and may be used by rfipints only in the perfonnameaof their offAcil dutiest ts contents may not otherise be discloed without Wodd Bank authorhatioj.

TABLES:

Table l Recent Economic Developments ............................ 2Table 2: Central Government Budget ............ .... *...... * 4Table 3s Effect of Reform Packages on Import Licensing Coverage

Since 1986 .... ............. ..... . .. .. .. ..... *.. *.*. **.*****.............*** 7Table 4: Medium-Term Projections ............ ..................... 14Table 5s Balance of Payments Projections ............... 15

ANNEXESs

ANNEX I s Key Macroeconomic Indicators ........................ . 22ANNEX II s The Status of Bank Group Operations in Indonesia ....... 25ANNEX IIls Supplementary Data Sheet .............. ** . ....... 29ANNEX IV s Government's Statement on Economic and Trade Policy .... 30ANNEX V s Policy Framework .... . ................. .. ... . .. 39ANNEX VI s Trade Policy Reforms and Industrial Deregulation ....... 42

HAP: IBRD No. 11038R1.

INDONESIA

SECOND TRADE POLICY ADJUSTMENT LOAN

Loan Summary

Borrower: Republic of Indonesia

Executing Agencies: Bank Indonesia and Ministry of Finance

Amount: US$300 million equivalent

Terms: 20 years, including 5 years of grace, at thestandard variable interest rate

Project Descriptions The proposed loan would: (a) support the substantialreforms, especially in the area of trade policy,undertaken by the Government of Indonesia (GOI)during 1987, and ensure that they are implementedwell; (b) assist GOI to bring about an earlyrecovery in economic activity consistent withexternal and domestic financial stability; and (c)maintain the policy dialogue on further reform,including the preparation of a medium-term plan fortariff rationalization. The loan of US$300 millionequivalent would finance general imports of goods tomeet part of Indonesia's near-term foreign exchangerequirements, while supporting GOI's commitment topromote the efficiency and longer-term viability ofthe economy. It is envisaged that further suchactions could form the basis for a subsequent loanin about a year.

Benefits and Risks: The adjustment measures taken by GOI over the pasttwo years will provide balance of payments andfiscal stability, in the face of lower oil prices,and help develop the non-oil economy over the mediumterm. In particular, the recent trade policy anddomestic licensing reforms represent substantialprogress in GOI's efforts to reduce long-standingdistortions in Indonesia's highly protectedindustrial structure; improve internationalcompetitiveness of non-oil exports; and increasepotential for foreign investment, especially inexport-oriented industries. In addition, greatertransparency and administrative simplicity has beenintroduced into Indonesia's trade regime. Theprincipal risk is that the far-reaching nature ofthe reforms could encounter domestic opposition asthey are implemented and extended. This risk isoffset by the positive response, especially of non-oil exports, to earlier reforms and GOI'sdemonstrated commitment to carry out difficult andsensitive policy measures.

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Eetlmated Disbursements US$300 million will be disbursed In FY89.

Economlc Rate ofReturns Not applicable.

#nraisal Reports None.

NapDt IBID No. 11038R1.

REPORT AND RECOHQENDATION OF TEE PRESIDENTO THE INTERNATIONAL BANR FOR RECONSTRUCTION AND DEVELOPMENT

TO TEE EXECUTIVE DITECTORS ON A PROPOSED SECOND TRADEPOLICY ADJUSTMENT LOAN TO THE REPUBLIC OF INDONESIA

1. I submit the following report and recommendation on a proposed SecondTrade Policy Adjustment Loan to the Republic of Indonesia for the equivalentof US$300 million. The proposed loan would have a term of 20 years, including5 years of grace, at the standard variable interest rate.

2. An economic report, entitled *Indonesia: Strategy for EconomicRecovery" (No. 6694-IND, dated May 5, 1987) was distributed to the ExecutiveDirectors in May 1987. Annex I gives selected economic indicators for thecountry.

PART I - BACKGROUND

3. During the 19709, the Indonesian economy grew at almost 82 per annum.This growth was supported by a rapid expansion of net oillLNG export earnings,which rose from US$0.6 billion in 1973174 to a peak of US$10.6 billion in1980181. In that year, oil/LNG accounted for 751 of export earnings and 702of budget revenues. Compared to many oil exporters, Indonesia used theseresources well, bringing significant improvements in education, health andfamily planning, and a rapid growth in agriculture, especially rice.Indonesia also maintained sound macroeconomic management and, following thePertamina crisis of the mid-1970s, a conservative external borrowing strategy.By the end of the decade, the current account of the balance of payments wasIn surplus and debt-service payments were below 132 of exports.

4. The sharp drops in oil prices in the 1980s and associated changes inthe international economy have drastically altered the economic environmentfor Indonesia. In response, the Government has made two types of policyadjustments. First, since 1982, the Government has adopted more austeremacroeconomic policies. In comparison to the efforts of many countries duringthis period, the Government's macroeconomic stabilization programs are widelyregarded as very successful. Second, the vicissitudes of the oil market andthe sharp decline in the real price of oil have led to a major and on-goingprogram to restructure the economy over the medium to longer term, so as toreduce Indonesia's heavy dependence on oil as a source of foreign exchange andbudgetary revenues. The key elements of this structural adjustment programinclude a range of measures to strengthen domestic resource mobilization,expand non-oil exports, and promote a more competitive and dynamic non-oileconomy.

PART II - THE FIRST ADJUSTMENT PERIOD. 1982-85

5. The first period of stabilization followed the weakening of the oilmarket in 1982, the onset of a worldwide recession, and the decline in theprices of several important primary exports (e.g., rubber, palm oil and tin).By 1982183, Indonesia's current account deficit had widened to US$7.2 billion(7.81 of GNP). In response, the Government initiated a broad-based adjustmentprogram, designed to maintain balance of payments and fiscal stability, whilereducing the economy's dependence on oil revenues. The competitiveness ofIndonesia"s non-oil exports was improved by a 282 devaluation of the Rupiah in

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March 1983 followed by more flexible exchange rate management; and publicexpenditure was sharply reduced through the rephasing of many large projectsand cutbacks in budgetary subsidies. At the same time, the foundations of aprogram of structural adjustment were established: resource mobilization wasimproved following comprehensive financial and tax reforms; and majorefficiency improvements were made in customs, ports and shipping.l/

6. By 1985186, these measures had succeeded in restoring macroeconomicstability (see Table 1). The current account deficit declined toUS$1.9 billion (2.42 of GNP) in 1985186; and significant progress was made incontrolling inflation, which was brought below 5Z. These adjustments led toshort-term costs in the form of slower growth of output and incomes, reducedprivate and public investment, low rates of capacity utilization, and theemergence of financial problems among industrial enterprises. Problems in theindustrial sector were compounded by high and variable levels of protectionprovided by a proliferation of import licensing restrictions. Nevertheless,prior to the unexpected collapse of oil prices in 1986, Indonesia seemed tohave largely overcome its balance of payments and macroeconomic adjustmentproblems, and was set on a path that potentially would have restored stablegrowth to the economy.

Table 1: RECENT ECONOMIC DEVELOPMENTS /a

Actuals Est. Proiected1978-82 1982-85 1986 1987 1988 1989

Real growth rates (S p.a.)GDP 5.3 3.8 3.6 3.7 3.6 4.5Non-oil GDP 6.9 4.0 3.8 4.3 4.4 4.6- Agriculture 5.0 3.7 2.5 2.3 2.5 3.0- Industry 10.1 1.8 4.8 6.0 6.1 6.3- Services 9.4 7.4 4.3 4.8 4.7 4.7National income .. 2.2 -2.5 4.1 3.5 4.2Non-oil exports 10.5 17.2 2.8 25.3 13.1 7.9Non-oil imports 13.8 -10.7 -12.4 1.6 4.4 4.0

Ratios (S) JbBudget balance/GDP -4.0 -2.8 -5.0 -2.4Current accountIGNP -7.8 -2.4 -6.1 -3.1 -2.7 -2.2Debt service/exports /c 16.4 25.4 36.9 34.6 39.6 38.2Fixed investment/GDP 25.9 20.7 20.4 18.6 18.6 18.7

PricesOil price (US$/bbl) /b 32.9 25.0 12.5 17.0 16.0 16.0Terms of trade(1983/84-100) /b 109.3 93.3 62.6 69.3 68.1 67.9

Domestic inflation(2 p.a.) 13.9 8.4 9.1 9.3 5.0 5.0

la Balance of payments data are for fiscal years (starting April 1). Otherindicators are for calendar years.

/b For last year of multi-year periods.Ic Debt service excludes prepayments.

Source: Central Bureau of Statistics and World Bank staff estimates.

1/ More details on those measures are provided in paras. 5-9 of thePresident's Report for TPAL I (No. P-4429-IND, December 30, 1986).

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FART III - THE SECOND ADJUSTMENT PERIOD, 1986-89

A. The Initial Policy Response

7. In 1986, the economy again suffered a series of setbacks. Averagecrude oil prices fell by almost one-half from US$25/barrel in 1985186 to belowUS$13/barrel in 1986/87. The loss of oil revenues was equivalent to one-thirdof both domestic budget revenues and merchandise exports. Indonesia sufferedfurther external shocks from the weakening of non-oil commodity prices and thesharp depreciation of the US dollar. Indonesia was vulnerable to the declineof the US dollar because its exports were mostly dollar denominated andbecause about 602 of its external debt was in appreciating currencies. Thesetrends led to a 34S deterioration in the terms of trade and a jump in thedebt-service ritio from 261 in 1985 to 372 in 1986. Although the Governmenthad been adjusti*%% appropriately since the first signs of a deterioratingexternal environcent in the early 1980s, nothing could have prepared theeconomy for the magnitude of the new external shocks. Nor could theGovernment afford to make up this loss through additional commercialborrowing, as the decline in oil revenues was unlikely to be transitory andIndonesia already had a large overhang of external debt.

8. Once again, GOI took timely actions to restore macroeconomicstability. These included: (a) the introduction of an austere Budget forFY86/87 with investment spending cut by one quarter in real terms; and (b) a311 devaluation of the currency on September 12, 1986. In addition, theGovernment broadened its program to restructure the economy over the mediumterm. The main emphasis was on a package of trade policy reforms designed tobuild on the reforms introduced in 1985. These new measures signalled theGovernment's intention to shift from non-tariff barriers (NTBs) to tariffs asthe primary instrument of import policy, and were supported by the first TradePolicy Adjustment Loan, appro,ved by the Executive Directors on February 3,1987 (Loan 2780-IND). ¶%e policy measures taken contained the current accountdeficit to US$4.2 ;.iiiion in 1986/87. Inflation was also curbed, withconsumer prices rising by only 92 in 1986. Although real GDP growth in 1986was remarkably strong at 3.62, national income fell due to the deterioratingterms of trade.

B. Continuing Macroeconomic Adiustment

9. A successful program of stabilization in Indonesia is likely to takeabout three years to restore internal and external financial stability (ifsupported strongly by official external capital). With this in mind, theGovernment has maintained its prudent approach to macroeconomic management. Asecond austere budget was adopted for 1987188, with ni increase in civilservice salaries and additional cuts in the public investment program.Although higher oil/LNG revenues, resulting from the strengthening of oilprices in 1987, and special assistance from the Inter-Governmental Group onIndonesia (IGGI) eased the budgetary situation somewhat in 1987/88, investmentexpenditure will be substantially lower than the previous year in real terms.As a result, the budget deficit declined to 2.42 of GDP from 5.02 of GDP in1986/87 (see Table 2).

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Tablo 2s CENTRAL GOVERNMENT BUDGET(ip trillion)

Actuals Estimate Budget1984/85 1985186 1986/87 1987188 1988/89

Revenue and grants 19.0 18.9 16.8 20.3 22.0Oil/LNG taxes 13.4 10.7 6.3 9.7 8.9son-oil taxes 4.8 6.6 8.2 9.3 11.7Other 0.8 1.6 2.3 1.3 1.4

Current expenditure la 10.8 12.7 13.5 1S.8 15.4Interest on external debt 1.6 1.8 2.8 3.8 4.4Subsidies 1.5 1.1 0.5 1.5 0.5Other 7.7 9.8 10.2 10.5 10.5

Government savings 8.2 6.2 3.3 4.5 6.6

Capital expenditure 7.6 8.9 8.4 7.3 7.4

Overall balance 0.6 -2.7 -5.1 -2.8 -0.8Financed bys

- External loans (net) 2.4 1.8 4.2 2.5 0.8- Asset drawdown -3.0 0.9 0.9 0.3 0.0

Ratios (Z of GDP)Revenues and grants 21.3 19.8 16.4 17.3 17.1

- Oil/LNG taxes 15.0 11.2 6.2 8.2 6.9- Ron-oil taxes 5.4 6.9 8.0 7.9 9.1

Total expenditure 20.6 22.7 21.4 19.6 17.7Government savings 9.1 6.6 3.2 3.8 5.2Overall balance 0.7 -2.9 -5.0 -2.4 -0.6

la Routine expenditure adjusted to exclude amortization payments and toInclude both the fertilizer subsidy and the recurrent component ofdevelopment expenditure.

Sources Ministry of Finance and World Bank staff estimates.

10. The GOI also employed monetary policy to complement fiscal policy inrestraining domestic demand and curbing inflationary pressures. In 1987,monetary management was complicated by speculative pressures on the Rupiah.Z/

21 These pressures emerged towards the end of 1986 and intensifiedduring May-June 1987. Subsequently, with the reversal of capitalflows, net foreign assets of the banking system rose from US$9.4billion at end-June to US$11.1 billion at end-1987.

These pressures were met by a firm policy response, as the authoritiescountered the loss of foreign exchange by curbing domestic credit, allowingdomestic interest rates to rise and providing more flexibility in monetarymanagement. These measures succeeded in reversing capital outflows, allowingforeign exchange reserves to rise to more adequate levels and permitting theauthorities gradually to ease monetary policy to relieve some of the pressureon domestic interest rates. Overall, the expansion of domestic liquidity wastightly controlled in 1987, representing a continuation of the policies ofdomestic demand restraint in support of the etabilization program.

C. Continuing Structural Adiustment

11. In the first period of adjustment (1982-85), the Governmentimplemented policies to mobilize domestic resources (the financial and fiscalreforms of 1983) and launched a program of trade reforms (the maritime andtariff reforms of 1985). The latter program was reinforced by the secondround of trade policy reforms in 1986, which were supported by the first TradePolicy Adjustment Loan. Since 1986, the Government has intensified itsprogram of structural adjustmwnt bys (a) extending the program of trade policyreform; (b) beginning to deregulate industry; (c) relaxing policies governingforeign investment; and (d) extending its 1983 financial sector reforms. Theprimary objective of these reforms, in conjunction with the aforementionedmacroeconomic adjustment measures, is to raise economic efficiency and toincrease earnings from non-oil exports. It is this new set of measures thatwould be supported by the Second Trade Policy Adjustment Loan.

12. Trade Policy Reform. In general, the trade regime of the 19709 andearly 1980. was inward looking, promoting industrial investment with highprotection from imports. At the start of this decade, Indonesia's importregime was characterized by high and disparate tariff rates. Pressures:esu'ting from the slowdown of the domestic economy led to an increase of non-tariff barriers (NTBs) in the early 19808, in the form of import licensing.Recognizing the adverse effects of the trade regime on the cost competitive-ness of the economy, GOI undertook two major trade-related reforms during1985s first, an across-the-board reduction in tariffs which reduced the leveland dispersion of tariffs and lowered the ceiling from 225Z to 60X; and,second, a complete overhaul of customs, ports and shipping operations.Reductions in these distortions increased the relative importance of NTBs. Bythe end of 1985, more than 1,700 items (CCCN categories) were subject toimport licensing.31 These items accounted for over 402 of both total importvalue and traded domestic production. Although import licenses variedconsiderably in their degree of restrictiveness, by 1986, the import licensingsystem was the most important distortionary influence in the trade regime,contributing not only to the high level and variability of protection but alsofostering unproductive 'rent-seeking' behaviour.

31 Of the 1700 items, only 296 had a formal quota imposed. Inaddition, there were 24 products under import ban (includingautomobiles, motorcycles, televisions and radios as completelybuilt up units).

13. During 1986, GOI moved to the next stage of trade policy reformthrough a two-pronged approacht first, to insulate exporters from the adverseeffects of the import regime; and second, to begin to dismantle the importlicensing system. In May 1986, the Goveranent announced a package of measuresthat gave major exporters access to unrestricted and duty-free imports. TheMay 6 scheme was seen as a useful mechanism by which to help exportersovercome the cost raising effects of NTBs and high tariffs, until more directmeasures could be taken. In October 1986, following the 312 devaluation ofthe previous month, GOI embarked upon a more fundamental program of reforms.The intention was to initiate a phased program to reduce import licenses andmove towards an import regime based solely on tariffs. Under the Octoberpackage, import restrictions were removed altogether on 197 items, accountingfor 112 of all items and 19X of total import value previously restricted. Asa result, the shere of manufacturing production under import licensingdeclined from 49% to 42Z.41 These reforms have been implementedsatisfactorily. Over US$1 billion of imports have been processed under theMay 6 scheme and, although there have been some bureaucratic delays, therelaxation of import restrictions and lowering of tariffs resulted in a sharpincrease in the imports of these items.

14. GOI maintained the momentum on trade policy reform in 1987 throughtwo major packages announced on January 15, 1987 and December 24, 1987, and aseries of smaller policy actions. These measures, havet (i) continued theshift from import restrictions to tarifi based protection; (ii) adheredstrictly to the lower tariff ceiling in setting tariff rates on the productsremoved from NTB protection; (iii) taken initial steps toward tariffrationalization; (iv) broadened the scope of the system giving exportersaccess to inputs at internationally competitive prices; and (v) reducedremaining export restrictions. A detailed analysis of these recent tradereforms is presented in Annex VI of this report.

15. The January and December packages of 1987 (which are being supportedby the Second Trade Poliy Adjustment Loan) marked substantial progress inGOI's primary objective of moving away from a trade regime dependent on NTBs.The combined impact of the January and December packages has been the removalof an additional 342 items from license control, accounting for 20? of allitems and 23Z of total import value previously restricted. More importantly,the share of manufacturing production protected by import licensing declinedsubstantially from 42? at the end of 1986 to 352 at the end of 1987 (seeTable 3). As shown in Annex VI, the reduction in NTBs has been concentratedin activities with the highest effective rates of protection. In addition tothe removal of import licensing restrictions, the January and Decemberpackages have relaxed some of the remaining restrictions, particularly in thetextile and engineering goods sectors, by placing them under the IP (actualuser) license category. This is the least restrictive license, and allows allproducers who require these items as inputs to import them freely. As aresult of the measures taken during 1987, virtually all production in textilesfalls under the unrestricted or IP license category. Given, in addition, therelatively easy access of exporters to the May 6 scheme, the textile sector isnow largely free of import licensing restrictions. Similar progress has beenmade in many branches of the engineering goods sector, although several finalgoods remain under restrictive license or import bans.

41 In addition, there was a significant relaxation of licensing foran additional 105 items.

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Table 3: EFFECT OF REFORM PACKAGES ON TMPORT LICENSING COVERAGE SINCE 1986

Before After After AfterShare Covered Under Reforms Oct. 1986 Jan. 1987 Dec. 1987Import Licensing (X) (mid-1986) Reform la Refoms lb Reforms lb

Import Items 31.4 27.9 25.7 21.7Value of Imports 42.9 34.9 31.5 25.2Manufacturing Production 49.1 42.4 38.8 34.8

la Measures supported under TPAL I.b Measures supported under the proposed loan (TPAL II).

Sources Annex VI, Table VI.1

16. The second main element of the 1987 trade reforms related to tariffpolicy. Tariff adjustments during this stage of trade reform have aimed atconforming to the reduced level and dispersion of the new tariff structureIntroduced in 1985. Under the two trade reform packages of 1987, tariffs for121 items were adjusted upwards and tariffs for 178 items lowered. Temporarysurcharges were also imposed on 51 import items. The increases in tariffscompensated for the effects of the removal of import licensing restrictions,but remained within the lower tariff ceilings set in 1985. The reductions intariffs in the January 1987 package (as in the earlier October 1986 package)concentrated on products not locally produced, and were intended to offset thecost-raising effects of tha September 1986 devaluation. The Decemberreductions went beyond this limited objective by reducing tariffs on somedomestically produced items that were removed from import license restrictionin earlier decrees, thereby marking an important beginning towards the nexttrade reform objective of further tariff rationalization.

17. Lastly, the December package has made more substantial progress thanthe previous two packages in eliminating some of the direct impediments toexports. The need to obtain a special export license was abolished; severalexport bans and quotas have been removed; and access by exporters to the May 6scheme has been broadened. These reforms will reduce the impediments toexporters by eliminating redundant regulations. Furthermore, they willsubstantially reduce the anti-export bias of the trade regime for existingexporters, thereby increasing the relative profitability of exports andbolstering the export drive.

18. Industrial Deregulation and Foreign Investment Policies. Progress intrade policy reform has highlighted the need for complementary measures onindustrial deregulation. The performance of the industrial sector has beenhindered by a multitude of domestic regulations and licensing procedures,particularly investment and capacity licensing. Moreover, additionalregulations controlling the activities of foreign investment companies haverestricted the flexibility of these firms and reduced the attractiveness of

Indonesia to foreign investors. Recognizing these impediments to privatesector growth and investment, the Government has taken a series of steps tosimplify and relax the regulatory framework (a more detailed analysis of thesemeasures is presented in Annex VI. Section B).

19. A start was made in 1985 when the investment process was streamlined.In 1986, fields of investment open to both foreign and domestic companies werespecified more clearly and the number of areas open to private foreign anddomestic investment was expanded substantially. Moreover, foreign investmentcompanies were given greater access to domestic capital and financialinstitutions, and domestic ownership requirements were eased.

20. The Government's drive to revitalize the private sector and encourageforeign investment gained momentum during 1987. A number of major steps weretaken to relax the investment and capacity licensing system and ease foreigninvestment regulations. As a result of measures taken in June, firms are nowallowed to increase production by up to 30S of their licensed capacity withoutrequiring new investment approval. More significantly, firms have beenpermitted to diversify production within much broader product categories,thereby Improving the operational flexibility of firms and promoting greatercompetition. Furthermore, the requirements for investment licenses werestreamlined and additional fields of investment opened to private domestic andforeign investors. The December package included a series of measures torelax foreign investment regulations: domestic ownership requirements wereeased significantly; restrictions prohibiting foreign-owned companies frommarketing Indonesian export goods were removed; foreign firms are now allowedto purchase domestic inputs without restriction; and rules regarding thehiring of expatriate personnel were relaxed. These steps have addressed keyconcerns expressed by foreign investors in Indonesia and will reducedifferences in treatment between foreign and domestic firms. Together withthe broader regulatory measures, they have removed many of the disincentivesto foreign investors and have improved substantially the climate for foreigninvestment in Indonesia.

21. Financial Sector Reforms. In June 1983, GOI launched a comprehensivereform of the financial sector, which included a liberalization of mostinterest rate controls on state bank deposits, the elimination of creditceilings for all banks, and a reduction in the number of programs qualifyingfor new Bank Indonesia liquidity credits. These reforms have had a far-reaching impact on the financial system, successfully increasing domesticresource mobilization, promoting greater competition and market orientation,and improving the allocation of credit. Over the past three years, BankIndonesia has also introduced a range of new monetary instruments (e.g., SBIs,SBPUs)51 to improve monetary management and encourage development of an activeinterbank money market. In July 1987, an auction system was introduced todetermine SBI and SBPU volume and discount rates, which, in combination withother monetary measures, helped ease the speculative pressure against theRupiah.

22. Concerns about the longer-term effect of high interest rates onInvestment and the financial viability of enterprises, and the relative lackof term transformation in the banking system, led GO0 to undertake specific

5/ 8BI are Central Bank certificates and SBPUs are private sectorpromissory notes held by banks, and rediscounted by the CentralBank.

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measures in December 1987 to strengthen the role of equity markets. First, toincrease the supply of securities, listing requirements on the Jakarta StockExchanges which now lists only 24 companies with a market capitalization ofabout US$60 million, were simplified through the elimination of all but threepieces of essential documentation. Second, supportive measures wereintroduced to improve the institutional framework (e.g., pricing mechanisms)and the operation of capital market institutions (e.g., underwriters,guarantors, stock traders). Third, G00 created an over-the-counter (OTC)market to enable smaller, less well-established companies to mobilizeinvestment requirements through the capital market. Finally, in an attempt tostrengthen the demand for securities, 001 will encourage the issue of bearershares and will allow foreign investors to purchase shares in the OTC market.

D. Assessment of Performance and Costs of Adiustment

23. The combination of austere fiscal and monetary measures has beenextremely successful in limiting the inflationary effects of the September1986 devaluation. Despite the magnitude of the devaluation (452 in domesticcurrency terms), inflation in 1987 was contained at less than 10. Moreover,exchange rate policy during 1987 has maintained stability in the Rupiah/US$rate. As a result, not only have the gains of the September 1986 devaluationbeen fully preserved, but the real exchange rate has depreciated subsequentlyby an additional 82, further strengthening competitiveness.

24. In response to the real exchange rate adjustment, as well as therecent deregulation measures, non-oil exports have increased substantially.Currently, non-oil exports are running at more than US$900 million per monthand are estimated to total US$9.5 billion in 1987188. This represents a 412increase in nominal terms and a 252 increase in real terms over 1986187.'hile increases have occurred in Indonesia's traditional exports (e.g., woodproducts, palm oil), about 65Z of this increment has been contributed by arapidly expanding and diversifying base of manufactured exports. This strongnon-oil export performance and the increase in oil earnings in 1987/88permitted a nominal increase in non-oil imports, while paring down the currentaccount deficit from US$4.2 billion in 1986/87 (6.1S of GNP) to US$2.0 billionin 1987/88 (3.1S of GNP).

25. Given the severity of the macroeconomic adjustment, GDP growth,though modest, has been surprisingly robust. Non-oil GDP growth averagedabout 41 in 1986 and 1987. The momentum for growth in 1987 has come from theindustrial sector, linked to export expansion, as the agricultural sector,particularly rice, has been adversely affected by drought. The continuationof economic growth under difficult circumstances reflects the promptness ofthe macroeconomic policy response, and the positive results from thestrengthening of competitiveness and improvement in the investment climate dueto deregulation. A noteworthy element has been the strong recovery in privateinvestment. Approvals of domestic investment by the Investment CoordinatingBoard (BKPM) jumped more than 1301 in rupiah terms in 1987, whereas foreigninvestment approvals rose by 761 in dollar terms, in both cases directedprimarily towards export activities. The surge in private investmentapprovals reflects renewed investor confidence and, in creating new exportcapacity, augurs well for the future of non-oil export earnings.

26. There has also been some recovery in incomes during 1987, based onthe expansion of domestic output and an improvement in the terms of trade.Zven so, in per capita terms, national income at the end of 1987 will still be

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lower than in 1981. GOI has acted to contain the social costs of this incomeloss by: (a) giving priority to public spending on agriculture and localinfrastructure; (b) promoting non-oil exports, which are generally more labor-intensive; and (c) adopting a more supportive attitude toward activities inthe informal sector, particularly in urban areas. For example, the share ofagriculture and regional development programs in development expenditure wasincreased from 18.3X in 1985/86 to 26.21 in the 1988189 budget. Socialprograms were also protected, with the share of education, health and urbanservices remaining flat at about 20S, although the level of absolute cuts hasbeen substantial.

27. While slower growth in domestic demand and greater import competitionhave affected some activities, broad-based export growth and the recovery ofprivate investment have had a salutary effect on employment growth. Many ofthe fastest-growing export items--including agricultural products, textilesand garments--are labor-intensive and important employment-generatingactivities. Nevertheless, despite these positive factors which have moderatedthe social costs of adjustment, the Government remains concerned aboutemployment and income growth as Indonesia's labor force is expected to expandby about eight million over the next five years.

28. An additional area of concern in this adjustment period is theeffects of devaluation and high real interest rates on the financial positionof firms. Although there is little overt evidence of a rise in bankruptciesor widespread financial stress, the portfolios of some financial institutionsremain weak, and will require careful monitoring to ensure that the financialsystem can adequately support the adjustment process.

E. Management of External Capital Accounts

29. Despite the dramatic reduction in the current account deficit toabout US$2 billion, Indonesia has had to contend with a substantial increasein amortization payments in 1987/88 due both to the large share of its debt inappreciating currencies, and to the rising repayment obligations resultingfrom the increase in commercial borrowing in the early 1980s. Indonesia'sforeign exchange requirements for 1987/88 amounted to some US$7.3 billion, tofinance the current account deficit, amortize loans and support a rebuildingof foreign exchange reserves. These requirements were largely met bydisbursements of some US$5.9 billion of public MLT loans. An important partof the financing arrangements for 1987/88 was the extraordinary financingprovided by a number of the IGGI members--some US$1.3 billion of grossdisbursements--most notably the disbursements from the first Trade PolicyAdjustment Loan, the local cost financing of World Bank projects by Japan EXIMBank and extra program aid and local-cost financing from other donors. InApril 1987, Indonesia also obtained US$606 million from the IMF's CompensatoryFinance Facility (CFF). As a result of the impressive recovery of exports,the strong support from IGGI members, and restrained use of commercial credit,Indonesia's debt-service payments also stabilized at 352 of export earnings in1987, while net official reserves stood at about US$5.8 billion at end-December 1987, equivalent to 4.9 months of imports. This relatively highlevel of reserves is considered appropriate, given Indonesia's open capitalaccount and the need to ride out occasional episodes of speculation.

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PART IV - THE REMAINING POLICY AGENDA AND PROSPECTS FOR A RECOVERY IN GROWTH

30. Adjustment in Indonesia is proceeding well. Substantial progress hasbeen made in reducing external and internal imbalances. Moreover, exchangerate depreciation, trade reforms and industrial deregulation have strengthenedcompetitiveness, reduced production costs and improved allocative efficiencyin the economy leading to a sharp increase in exports and a strong revival ofprivate investment. Nonetheless, the lower price of oil and the steepincrease in debt service suggest that stabilization efforts must continue toreduce fiscal and external deficits to sustainable levels during the next twoyears.

31. At the same time, investment must be maintained at its current rateand eventually increased to support the export drive and to provide the basisfor economic recovery. Over the medium term, the non-oil economy must grow atleast 52 per annum to absorb the growing labor force and permit a meaningfulreduction in the level of poverty. This will require policies that continueto restructure the economy while stimulating investment. Since much of themomentum for growth will come from export expansion and improvements ineconomywide efficiency, a strategy of growth with adjustment also will providethe best means to protect and improve the creditworthiness of the economy.Improved domestic resource mobilization and non-oil export growth willsteadily close internal and external resource gaps, providing the basis forgrowth without recourse to special external support.

A. Continuing Measures for Economic Stabilization

32. The two key constraints faced by Indonesia over the near to mediumterm are the low and uncertain price of oil and the large overhang of externaldebt. The price of crude oil is projected to remain at $16/barrel (in nominalterms) through 1990, so that net oil earnings could remain depressed for theremainder of this decade. Moreover, Indonesia faces high debt service becauseof a bunching in its debt obligations. These two factors will continue to putpressure both on Indonesia's external balance, through lower oil exportearnings and rising interest and amortization payments, and on internalbalance, through lower oil/LNG tax revenues and the need to devote a risingproportion of current expenditures to interest payments.

33. The restoration of internal and external financial stability thuswill require continued domestic austerity for another year or so, evenassuming no further serious deterioration in oil prices or the internationaleconomic environment. The key elements of the macroeconomic program ares(a) tight expenditure management to reduce the budget deficit; (b) carefulscrutiny of the public investment program to maximize returns from limitedresources; (c) supportive monetary policies to restrain aggregate demand andcurb inflationary pressures; and (d) timely steps to ensure that thecomi;etitive gains from the real exchange rate adjustment are preserved.

34. These objectives are clearly enunciated in the Government's PolicyStatement (Annex IV). GOI has indicated its strong commitment to maintain aprudent fiscal and monetary stance. The recently announced Budget for 1988/89calls for further restraint in both current and capital expenditures. For athird year in a row, the Government has decided to freeze civil service

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salaries, and real capital spending Le projected to fall. Seun if some budgettargets are not realized, the budget deficit is projected to decline furtherduring the 1988189 fiscal year. GOI will also focus on the composition of thepublic investment program, giving priority tot (a) the completion of ongoingprojects; (b) counterpart funds for foreign-aided projects; (c) projectsserving equity and employment objectives; and (d) funding of operating andmaintenance (O&M) expenditures. As a result, there will be very little scopefor new projects, and many locally-funded projects have already beencurtailed. These expenditure priorities are appropriate to the current stageof macroeconomic adjustment.

35. Indonesia's competitive exchange rate has been one of the primaryfactors accounting for the strong performance of non-oil exports in the pastyear. The Government remains committed to the present foreign exchangesystem, including the open capital account. In its Policy Statement, theGovernment has emphasized that exchange rate and supporting macroeconomicpolicies will be geared to maintaining the competitiveness of Indonesia's non-oil exports, taking account of price and exchange rate movements in tradingpartners and competitor countries.

B. Further Structural Adjustment Reforms

36. A recovery in economic growth to around 52 per annum by the beginningof the 19908 is critical to Indonesia's employment and poverty alleviationneeds as well as for the long-term viability and creditworthiness of theeconomy. This suggests that the structural adjustment program must bevigorously pursued to set the stage for more rapid growth. The next steps insuch a program must center around further improvements in policies for:

o domestic resource mobilization;o the trade incentive regime;o the industrial regulatory framework; ando the financial sector.

37. Improved domestic resource mobilization over the next few years willprimarily depend on non-oil tax revenues and the performance of publicenterprises. Indonesia has made major strides in raising non-oil tax revenuessince the 1983 tax reform. GOI must now mount a concerted effort to maintainthis momentum, based primarily on better tax administration.6/ Steps havealso been taken to contain investment by public enterprises. Tight controlhas been kept on utilization of non-concessional import-related credits since1984185 and equity participation in public enterprises funded through theBudget has been held to a minimum. With IMP assistance, a preliminaryconsolidation of the financial accounts for 135 public enterprises wascompleted in January 1988. The financial position of a large number of publicenterprises remains weak, and constitutes a potential drain on domesticresources. The Government is undertaking a review of the financialperformance of all public enterprises, to identify potential candidates for

61 Specific measures to improve tax administration as well as otheractions to raise non-oil tax revenues are discussed in therecently completed World Bank study on "Issues in Public ResourceManagement", Report No. 7007-IND, March 11, 1988.

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rehabilitation, merger or divestiture. As noted in the Policy Statement, theGovernment intends to take appropriate action in this area in the near future.The Government also plans to review the regulatory framework, with theobjective of improving the efficiency and operating performance of publicenterprises over the medium term.

38. In the case of the trade incentives regime, the Government'sobjective is to eliminate gradually all NTBs, except on a small group ofproducts that are harmful to health, strategic to national defense or involvespecial economic or social considerations. As the earlier discussionindicates, steps to reduce the role of import licensing are now well underway.The next step of trade reform is to maintain this momentum through a furtherelimination of import licensing, especially in areas where such restrictionsare still important and provide high protection to domestic production. Overthe medium term, it will also be necessary to rationalize the tariff structurein erder to reduce excessive and disparate protection. A start has alreadybeen made through the tariff reductions announced in December 1987 on itemspreviously removed from import license restrictions. To help analyze tradepolicy issues and prepare proposals for further reforms, a Trade andIndustrial Policy Steering Committee (TIPSC) has been recently establishedwithin GOI. As an input to the work of TIPSC, the Bank has financed a studyon effective protection (which was completed in December 1987) and furtherlong-term technical assistance under ongoing Bank projects.

39. The industrial deregulation measures taken during 1987 are a welcomedevelopment and complementary to the trade policy reforms. Additionalmeasures will, however, be needed to simplify further the regulatory frameworkand to reduce the scope of industrial licensing. A first step is to ensurethat the 'broad-banding' measures introduced in 1987 are implemented well, andthat additional areas are opened to domestic and foreign private investment.Preparatory work to identify further steps in the deregulation process isbeing undertaken by TIPSC, and Bank staff are working with TIPSC on a study ofIndustrial regulations. Xey areas of focus would be investment and capacitylicensing, domestic content programs, regulations affecting domestic trade,and foreign investment policies.

40. An additional area of concern is the capacity of the financial systemto support the process of economic restructuring and recovery. The cost andavailability of credit, particularly for long-term investment funds, is apotential constraint, more so for newer export-oriented and small-scale firms.At the same time, segments of the corporate sector are facing financialdifficulties, as a result of the sluggish economy and the cost impact ofdevaluations in 1983 and 1986. Steps to address these problems are underway,but a more systematic review is needed of the current financial situation andof the market and institutional constraints that impede restructuring and newinvestment. In particular, careful attention must be paid tos (i) theportfolio problems of commercial banks and the effects of non-performing loanson intermediation costs to new borrowers; and (ii) the development of newinstruments that make term financing more widely available to investors.

C. Growth Prospects

41. With continued successful implementation of the stabilization programand further progress in structural reform, the outlook over the next two yearsis for a recovery in the GDP growth rate to 52 per annum by 1990. A recoveryFi agricultural production for domestic and export markets and further rapid

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increases in industrial exports are expected to provide the impetus for thehigher GDP growth. Non-oil exports, which grew by 251 in volume terms in1987, are expected to expand on average by 101 per annum over the next twoyears. Much of this export growth has come from using existing capacity inresponse to the sharp Improvement in relative profitability of exportactivities. Sustained growth in exports over the medium term will requiresubstantial additional investment in new productive capacity. In the case oftree crops, there has already been a major expansion in plantings in the 1980sthat will lead to further increases in exports in coming years. In the caseof industrial exports, there is substantial evidence in the current pattern ofloan approvals by domestic banks (for example, under the Export DevelopmentProject, Loan 2702-IND, approved in 1986) and direct foreign investmentapprovals, that a build up in export capacity is already underway.

Table 4s MEDIUM-TERM PROJECTIONS la

Actual Estimate Projected1986 1987 1988 1989 1990 1990-95

Real growth rates (2 p.a.)GDP 3.6 3.7 3.6 4.5 4.9 4.5Non-oil GDP 3.8 4.3 4.4 4.6 5.0 5.7- Agriculture 2.5 2.3 2.5 3.0 3.5 3.5- Industry 4.8 6.0 6.1 6.3 6.8 8.3- Services 4.3 4.8 4.7 4.7 5.1 5.7National income -2.5 4.1 3.5 4.2 5.0 5.7Non-oil exports 2.8 25.3 13.1 7.9 6.1 5.8Non-oil imports -12.4 1.6 4.4 4.0 6.2 7.3

Ratios (2)Current account/GNP -6.1 -3.1 -2.7 -2.2 -1.6 -0.3/bDebt service/exports /c 36.9 34.6 39.6 38.2 35.3 22.4/bFixed investmenttGDP 20.4 18.6 18.6 18.7 19.2 23.2/b

PricesOil price (US$Ibbl) 12.5 17.0 16.0 16.0 16.0 28.1/bTerms of trade (1983/84-100) 62.6 69.3 68.1 67.8 67.9 84.7/bDomestic inflation (2 p.a.) 9.1 9.3 5.0 5.0 5.0 5.0

La Balance of payments data are for fiscal years (starting April 1). Otherindicators are for calendar years.

Jb For 1995./c Debt service excludes prepayments.Source: Central Bureau of Statistics and World Bank staff estimates.

42. Although private investment is already beginning to rise, theGovernment's program of fiscal restraint means that public investment cannotbe expected to recover before about 1990. Successful implementation of

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measures to improve domestic resource mobilization in the public sector wouldlay the foundations for a recovery in public investment by that time, whenprudent expansion in public investment would contribute to faster growth.Priorities for increased levels of public investment would be in services foragricultural and rural development, basic infrastructure, and human resourcedevelopment programs in education and health.

D. External Capital Flows and Debt Management

43. The growth of non-oil exports and the improvement in domesticresource mobilization will provide the underpinnings for rapid sustainablegrowth in the 1990s. With a continuing conmitment to current policies, thecurrent account deficit is projected to decline to abou'; 1.62 of GNP by1990/91 and 0.3X by 1995196 (Table 4). These deficits would require a levelof caipital inflows that would be well within the limits of what Indonesiashould expect from official and private sources while maintaining prudent debtmanagement policies.

Table 5: BALANCE OF PAYMENTS PROJECTIONS(US$ billion)

Estimate Projections1987188 1988/89 1989/90 1990/91 1995/96

Oil/LNG earninas (net) 3.7 3.4 3.4 3.6 6.3Exports 8.4 8.1 8.6 9.0 14.2Payments -4.7 -4.7 -5.2 -5.4 -7.9

Non-oil earnings (net) -5.7 -5.3 -5.1 -4.9 -6.7Exports 9.5 11.2 12.5 14.0 24.3Imports -11.7 -12.6 -13.5 -14.8 -26.1Services (net) -3.5 -3.9 -4.1 -4.1 -4.9

Current account balance -2.0 -1.9 -1.7 -1.3 -0.4

Public MLT loans (net) 2.0 1.9 1.8 1.4 0.5Disbursements /a 5.9 6.4 6.4 6.0 5.5Amortization -3.9 -4.5 -4.7 -4.6 -5.0

Other capital (net) lb 1.4 0.7 0.8 0.7 1.3Use of net foreign assets -1.4 -0.7 -0.8 -0.9 -1.4

La Includes special assistance from IGGI members in the form of program aidand local-cost financing.

Lb Includes direct foreign investment and private borrowing.

Source: World Bank staff estimates.

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44. Over the next two years, however, Indonesia will require additionalspecial assistance -- in the form of untied and conceesional fast-disbursingaid -- to support the adjustment in the balance of payments and the Budget tolower oil prices and adverse exchange rate changes. Program aid and local-cost financing provide free foreign exchange for the balance of paymentsduring the adjustment period. For the Budget, program aid has the addedadvantage that it can be used flexibly to finance all expenditures related toproject implementation (e.g., land acquisition) and project effectiveness(e.g., O&M, or tertiary canals for an irrigation system). Without thissupport, import and investment levels would be further constrained, therebyadversely affecting economic growth, the non-oil export effort and medium-termdevelopment prospects. This assistance will also provide an important signalto world financial markets that the IGGI members support the Government'sadjustment program and have confidence in Indonesia's economic prospects. Atthe same time, the provision of special assistance has to be seen as atemporary expedient, matched by the Government's efforts to improve non-oilexport performance and public resource mobilization. As the external anddomestic financing gaps are narrowed, special assistance can and should bephased out.

45. While Indonesia's debt burden has risen rapidly in dollar termslargely because of the effects of the dollar depreciation, its debt structureis relatively favorable with a high proportion of concessional and long-termdebt. Moreover, its debt burden is projected to grow much more slowly overthe medium term than in the past several years. A key indicator ofcreditworthiness is the ratio of debt to exports, which has risen sharplysince 1984, from 127X to 2512 at end 1986, because of the decline of oilprices and the depreciation of the US dollar. However, as a result of thestrong non-oil export performance, this ratio declined to 242? in 1987 despitethe adverse effects of the US dollar depreciation on the level of debt. Theratio is projected to decline steadily in the future, reaching 1362 in 1995.The debt service ratio which rose to 372 in 1986, is now projected to peak atclose to 401 in 1988, and then decline to 352 by 1990 and 222 by 1995.

PART V - BANK'S OPERATIONAL STRATEGY

46. Since 1983, the Bank's strategy in Indonesia has been to supportadjustment of the economy to lower oil revenues through maintenance ofmacroeconomic stability and a transition from oil-dependency to a morediversified and industrialized economy. The Bank has maintained a close andconstructive dialogue with the Government on emerging adjustment issues andthe design of suitable responses, including those supported by this loan. Inour policy discussions with the Government and our analytical work, there hasbeen increased emphasis on macroeconomic adjustment and key issues ofstructural reform such as rationalization of the trade regime, industrialderegulation and reform of pricing and other policies to enhance resourcemobilization and allocation. The strategy has been pursued in diverse ways,ranging from the preparation of major studies, including one on PublicResource Management, through major restructuring of existing operations, togreater emphasis in new projects on cost recovery, operation and maintenanceof existing facilities, and sector-specific policy and institutional changesto support increased efficiency and decentralization. The Bank has alsoprovided direct lending support for the Government's adjustment effortsthrough the first Trade Policy Adjustment loan, and has played an importantcatalytic role in mobilizing special assistance from other donors -- which isa critical requirement for the success of the adjustment program.

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47. During the next three years, the Bank will continue to support theGovernment's adjustment program, with a view to reviving investment andpromoting the resumption of strong economic growth. In volume terms, theBank's lending program is expected to contribute one-fifth of Indonesia'sgross capital requirements and to serve as an important catalyst in attractingfunds from other agencies, including fast-disbursing assistance (such as theproposed loan) to relieve balance of payments pressures. To allow for exportgrowth to continue, Bank lending will be concentrated in two sectors: industryand agriculture.

48. In the industrial sector, the Bank hopes to achieve three objectives.Pirst, it will foster GOI's efforts to deregulate trade and industry, and toestablish appropriate incentives for investment in manufacturing industry,through a general policy dialogue and related loans, of which the proposedoperation would be the second. Subsequent loans may support furtherderegulation of trade and industry, as well as financial sector reforms.Second, the Bank will assist firms directly to respond to changed incentivesthrough a series of industrial restructuring operations, under whichparticular subsectors (textiles, pulp and paper, engineering, wood processingand, possibly, electronics, pharmaceuticals, agro-industry and packaging) willbe aided successively with technical assistance and finance, as appropriateincentive frameworks for each subsector are developed and implemented. Andthird, the Bank will support firms with substantial employment and exportpotential that are currently unable to secure financing on appropriate terms.Employment generation will be the focal point of a proposed Small and MediumIndustrial Enterprise Project, and export growth, of a second ExportDevelopment Project, under which term credit at market rates will be madeavailable to firms that might otherwise have little access to investmentfinance.

49. In agriculture, with its importance for incomes and employment, foodsecurity and exports, Bank assistance will focus on raising the efficiency ofproduction and farming systems, maintaining self-sufficiency in staple foods,and expanding exports. Our strategy will address issues of incentives, costrecovery and institutional development, particularly in sector planning andpolicy analysis, research management, extension services, and credit deliverymechanisms. It will involve specific programs and projects to achievebalanced regional development, reach specific target groups (mainly the ruralpoor and women), and promote sustainable development through efficient use ofresources and conservation and protection of the environment.

50. To support industrial and agricultural growth, the Bank's programwill continue to stress the improvement of infrastructure, education andhealth and family planning services. As mentioned above (para. 46), there hasalready been increased emphasis on the rehabilitation and maintenance ofexisting facilities in recent operations (such as the Urban Sector Loan,Irrigation Subsector Loan and Second Rural Roads Development Project). Thisemphasis will continue, while Indonesia's resource position remains tight,until it becomes possible to expand capacity. In transportation, the Bank isfocusing on efficiency improvements in the maritime sector and on improvingthe national network of highways and rural roads. In urban development andwater supply, efforts are being made to strengthen local government andregional enterprises, in order to minimize demands on the Central GovernmentBudget and decentralize the responsibility for addressing basic needs.

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51. Progress in poverty alleviation has slowed considerably as a resultof the macroeconomic difficulties facing Indonesia since 1983. Compared withan average growth of 6.2Z per annum between 1971 and 1984, real per capitaconsumption is estimated to have declined by about 1? per annum between 1984and 1987. A resumption of investment and strong economic growth, along thelines described earlier In this report, should help to reverse this situationagain. In the meantime, Government programs of agricultural development,transmigration, educational services, urban development (water supply,sanitation, housing and transportation) and health and related social serviceswill remain important in cushioning the poor from the full costs of economicadjustment. During the last five years, just over half of the Bank's lendingprogram (522) has supported these key Government programs, and about 30X oftotal lending is estimated to have had a direct Impact on people below thepoverty line.

52. At the same time, there has been increased recognition of theenvironmental aspects of growth and adjustment in Java and the Outer Islands.increasingly, therefore, the Bank has been exploring ways and means ofassisting the Government to ensure more sustainable growth. To help theGovernment develop an appropriate strategy, the Bank is preparing a study ofselected environmental issues (including land and water use on Java, forestrymanagement on the Outer Islands, and industrial pollution on Java). Theresults of this initial review will be discussed at the IGGI Meeting In June1988. Future Bank projects will deal increasingly with issues of water supplyand quality on Java and better land use on the Outer Islands.

PART VI - THE PROPOSED LOAN

A. Loan History

53. Direct Bank support to the Government's adjustment efforts, and inparticular, its trade policy reforms, was provided under the first TradePolicy Adjustment Loan. That loan was based on policy changes introduced In1986, and was intended to support both the implementation of those measuresand further progress in macroeconomic stabiliaation and structural reforms. Acomparison of actual steps taken since that loan was approved with the 'areasfor follow-up" noted in the Policy Frameworkl7 clearly indicates theGoverrment's commitment to the adjustment program. Implementation of theearlier trade policy measures has been generally quite effective and, asdiscussed above, significant steps have been taken to further improve thetrade regime through the reduction of import licensing and reforms of exportpolicies. In the area of industrial regulation, the Government's efforts wentbeyond what was stated in the Policy Framework by actually initiating measuresto relax investment licensing and taking steps to simplify and ease foreigninvestment regulations. Regarding public enterprises, the Government (withIMF assistance) completed a preliminary consolidation of the financialaccounts of public enterprises, but an actual program of reform has yet to beannounced. Finally, GOI has pursued, as suggested in the Policy Framework,appropriate macroeconomic policies through a prudent fiscal and monetarystance and sound exchange rate management.

7/ Annex V of the President's Report for TPAL I (No. P-4429-IND,December 30, 1986).

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54. The proposed loan was prepared following GOils announcement of theDecember 24 reform measures and builds on ongoing active consultations betweenthe Bank and GOI on macroeconomic management, and trade and industrial policyissues. The loan was appraised in January 1988; negotiations were held inWashington from March 31 to April 1, 1988. The Indonesian delegation was ledby Mr. Boediono (BAPPENAS), and included representation from the Ministry ofFinance and the Indonesian Embassy. Supplementary loan data are provided inAnnex III.

B. Loan Objectives

55. The objectives of the proposed loan of US$300 million equivalent areto: (a) support the substantial reforms, especially in the area of tradepolicy, undertaken by the Government during 1987, and to ensure that they areimplemented well; (b) assist GOI to bring about an early recovery in economicactivity consistent with external and domestic financial stability; and(c) maintain the policy dialogue on further reforms for promoting theefficiency and longer-term viability of the economy, including the preparationof a medium-term plan for tariff rationalization. These objectives would beachieved in part through support to the balance of payments provided by theproposed loan and in part through ongoing dialogue on policy issues andimproved institutional arrangements for analysis of the trade and industrialpolicy regime. As part of this dialogue, the Bank will complete during 1988 astudy on industrial regulations and a study on financial sector efficiency anddevelopment.

C. Loan Administration

56. Disbursement. The proposed loan of US$300 million equivalent wouldbe available for disbursement upon loan effectiveness and would be used toreimburse 1002 of foreign expenditures for eligible imports for which paymentsare made after the date of loan signing. The list of ineligible imports forthe purposes of this loan would be standard i.e., goods intended for militaryor paramilitary purposes, or for luxury consumption; goods financed from otherofficial multilateral or bilateral sources; uranium; and goods procured undercontracts of less than US$100,000. Disbursement for reimbursement of eligibleimport expenditures would be based on documentation prepared by SocieteGenerale de Surveillance S.A. (SGS) in the course of their customs inspectionservices and which is routinely provided to Bank Indonesia. T'ae SGScertificate provides verification of shipment of goods and their value as wellas other information needed to ensure compliance with eligibility requirementsfor purposes of the Bank loan. Disbursement for eligible import expenditureswould be based on Statements of Expenditure (SOEs) for imports valued at lessthan US$5 million; for imports valued above this amount full documentationvwuld be provided. Applications for withdrawals based on SOEs would besubmitted in amounts not less than US$1 million and supporting documentationwould be retained by Bank Indonesia. All of the proceeds of the proposed loanare expected to be disbursed by March 31, 1989.

57. Procurement. Both private and public sector imports would be eligiblefor financing. Contracts under US$5 million each would be awarded on thebasis of normal procurement practices of the purchaser. Contracts for goodsand services estimated to cost US$5 million or more each, would be procuredthrough International Compet#tive Bidding in accordance with Bank Guidelines.

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58. Accounts and Audits. Bank Indonesia would maintain loan accounts andsupporting documentation. Audits would be carried -ut by independent auditorsacceptable to the Bank within nine months of the closing of the GOI fiscalyear in which final disbursements under the loan are made.

D. Monitoring and Follow-up

59. The Bank would monitor closely, through frequent consultation withGOI, the progress on implementation of GOI's trade policy and industriallicensing reforms, as well as on macroeconomic management. Particularattention would be given tot (a) further measures to reduce NTBs andrationalize the tariff structure; (b) continued progress on simplifying theregulatory framework and reducing the scope of industrial licensing; (c) thestudy of complementary reforms in the financial sector, to support industrialrestructuring and recovery; (d) appropriate fiscal and monetary policies, toreduce the current account deficit, control inflation and preserve acompetitive exchange rate; and (e) prudent external debt management; includinglimits on Import-related credits and careful scrutiny of proposals for largecapital-intensive projects. Satisfactory progress in these areas could be thebasis for a third adjustment loan from the Bank in about a year.

E. Program Benefits and Risks

60. The adjustment measures taken by GOI over the past two years willprovide balance of payments and fiscal stability in the face of lower oilprices, and help develop the non-oil economy over the medium term. Inparticular, the recent trade policy and domestic licensing reforms representsubstantial progress in GOI's efforts to reduce long-standing distortions inIndonesia's highly protected industrial structure; improve internationalcompetitiveness of non-oil exports; and increase potential for foreigninvestment, especially in export-oriented industries. In addition, greatertransparency and administrative simplicity has been introduced intoIndonesia's trade regime. The principal risk is that the far-reaching natureof the policy reforms could encounter domestic opposition as they areimplemented and extended. This risk is offset by the positive responses,especially of non-oil exports, to earlier reforms and GOI's demonstratedcommitment to carry out difficult and sensitive policy measures.

PART VII - RELATIONS WITH IMF

61. The latest IMF Consultation Report, under Article IV, was released inMarch 1987. This year's consultation mission has cecently been completed andthe Board discussion of the staff report will be in May. GOI has not had anystandby or extended arrangements with the IMP since 1973. GOI1s last purchasefrom the IMP was for SDR 463 million in May 1987 under the CompensatoryFinancing Facility (CFF). This purchase increased Indonesia's totaloutstanding IMF obligations to SDR 505 million at the end of 1987. After thelast Consultation Report, the IMF Executive Board expressed its satisfactionthat 'Indonesia maintains an exchange system which is free of restrictions onpayments and transfers for current international transactions.'

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PART VIII - RECOMMENDATION

62. T am satisfied that the proposed loan would comply with the Articlesof Agreement of the Bank and recommend that the Executive Directors approvethe proposed loan.

Barber B. ConablePresident

AttachmentsWashington, D.C.April 19, 1988

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KEY HACROECONOHIC INDICATORS /a

Esti-Actuals mates Projections

1981 1985 1986 1987 1988 1989 1990 1991 1992

A. PricesOil price (US$/bbl) 35.4 25.0 12.5 17.0 16.0 16.0 16.0 17.9 20.0Terms of Trade

(1983I84m100) 111.9 93.3 62.6 69.3 68.1 67.8 67.9 71.3 74.7- Non-oil 96.6 96.5 95.1 96. 97.5 97.9 100.0 101.3 102.6

Domestic infla-tion (Z p.a.) 12.2 4.4 9.1 9.3 3.0 5.0 5.0 5.0 5.0

B. National income (t p.a.)GDP 7.2 1.7 3.6 3.7 3.6 4.5 4.9 4.2 4.4Non-oil GDP 9.3 3.8 3.8 4.3 4.4 4.6 5.0 5.6 5.7GNY 1.0 -2.5 4.1 3.5 4.2 5.0 5.3 5.7GNY per capita -1.1 -4.3 2.1 1.4 2.2 2.9 3.2 3.6Consumption per capita 1.4 -0.1 -0.8 2.3 1.8 1.7 1.7 2.0

C. Investment andsavints (2 of GDP) lbFixed investment 24.3 20.7 20.4 18.6 18.6 18.7 19.2 19.9 20.6Domestic savings 33.9 26.0 21.7 22.5 23.8 24.2 25.0 26.1 27.2National savings 30.3 20.5 16.5 16.4 17.6 18.1 19.2 20.4 21.7

D. GO1 Budget (2 of GDP)Total revenue and

grants 20.9 19.8 16.4 17.2 17.1Non-oil taxes 5.4 6.9 8.0 7.9 9.1Total spending 22.3 22.7 21.4 19.6 17.7Capital spending 8.4 9.4 8.2 6.2 5.8Deficit or surplus -1.4 -2.9 -5.0 -2.4 -0.6

E. Balance of paymentsExport growth

(Z p.a.) -9.5 -1.8 4.1 6.2 6.5 6.2 5.6 1.4 1.1Exports/GDP (2) 25.6 24.6 24.7 25.3 26.0 26.4 26.6 25.9 25.3Non-oil export

growth (2 p.a.) -8.2 9.9 2.8 25.3 13.1 7.9 6.1 6.2 5.5Non-oil exports/GDP (S) 7.4 8.0 7.9 9.5 10.4 10.7 10.9 11.1 11.3

Import growth(2 p.a.) 20.5 -9.2 -16.9 0.0 3.6 4.1 5.2 5.8 6.2

Imports/GDP (2) 19.8 17.6 14.1 13.6 13.6 13.5 13.6 13.8 14.2Current account

(US$b) -2.7 -1.9 -4.2 -2.0 -1.9 -1.7 -1.3 -0.r -0.7Current account/

GNP (2) -3.0 -2.4 -6.1 -3.1 -2.7 -2.2 -1.5 -0.8 -0.6

F. External MLT debtDebt service (US$b) 2.6 5.5 S.6 6.7 9.0 8.8 8.9 8.9 9.5Debt service/exports (2) 10.4 25.4 36.9 34.6 39.6 38.2 35.3 32.0 31.0

Debt service/GDP (2) 2.8 6.4 7.3 9.6 12.1 11.0 10.3 9.5 9.3

/a Balance of payments and budget data are for fiscal years (starting April 1).Other indicators are for calendar years.

lb At current prices;

- 28 -ANNEX"Pgeo 2 of 3

BALANCE OF PAYMENTS(USS billion at current prices)

Actuals sates Proloctlone1991/82 19S6/80 1986/8? 18?/88 lsae/99 1989/90 199O/91 1891/92 1992/98

A. Exports of goods and NFS 28.3 19.1 14.4 13.7 20.8 22.1 24.2 27.0 29.9Morchandise (fob) 23.0 18.5 13.7 17.9 19.3 21.1 23.0 26.7 28.4Non-factor cervices 0,3 0.6 0.7 0.8 0.9 1.1 1.2 1.8 1.6

S. Importo of goods and NFS -22.9 -10.5 -14.9 -16.6 -17.0 -18.9 -20.5 -22.5 -24.8Merchandloo (cif) -20.0 -14.2 -12.7 -14.1 -16.1 -16.7 -17.6 -19.4 -21.6Non-factor corvicoo -2.9 -2.3 -2.1 -2.4 -2.5 -2.7 -2.8 -3.0 -3.8

C. Reeourco balance 0.4 2.6 -0.6 2.8 2.7 3.3 3.8 4.6 6.1

0. Not factor Incoso -3.2 -4.8 -3.9 -4.6 -4.8 -5.2 -6.4 -S.7 -6.0Fector roceipto 1.7 0.8 0.8 0.7 0.9 0.9 0.9 0.9 0.9Factor peymonto -4.9 -5.4 -4.e -5.2 -5.7 -6.1 -4. -4.8 -7.0(Interest pets.) -1.8 -2.7 -2.9 -3.4 -3.8 -8.9 -3.0 -3.3 -3.8

E. Not Current transfers /a 0.1 0.1 0.2 0.2 0.2 0.2 0.8 0.3 0.8

F. Current account balance -2.7 -1.9 -4.2 -2.0 -1.9 -1.7 -1.3 -0.9 -0.7

0. MLT capital Infloe 2.6 1.7 3.1 2.6 2.6 2.5 2.2 1.7 1.4irec t In teedztnt 0.1 0.8 0.3 0.4 0.6 0.6 0.7 0.8 0.9Not pubilc MLT loans 2.2 1.4 2.b 2.0 1.9 1.8 1.4 0.8 0.7Dieburoreento 3.3 8.9 6.4 5.9 8.4 8.4 6.1 6.3 6.6Repsymonts -1.1 -2.6 -2.6 -3.9 -4.6 -4.7 -4.6 -4.5 -4.9

Otbor ULT inflows (net) 0.2 0.0 0.0 0.1 0.2 0.2 0.1 0.1 -0.1

M. Total other Itemo -0.4 0.7 -1.4 0.9 0.0 0.0 -0.1 -0.1 -0.1Not abort-torn capital -0.2 -0.1 1.0 0.0 0.0 0.0 0.0 0.0 0.0Capital f leo nol -0.2 0.8 -2.5 0.9 0.0 0.0 -0.1 -0.1 -0.1

I. Use of not foreign asset. 0.5 -0.6 2.6 -1.4 -0.7 -0.8 -0.9 -0.7 -0.7Not XIF credit 0.0 -0.3 0.0 0.6 0.0 0.0 -0.8 -0.3 0.0Other renorve change. 0.6 -0.2 2.5 -2.0 -0.7 -0.8 -0.6 -0.4 -0.7

Shareo of CDP (X)Resource balance 0.6 3.0 -0.6 8.2 8.6 4.0 4.3 4.7 4.9Total lnterst payeento -1. -8.2 -4.0 -4.8 -6.1 -4.8 -4.4 -3.0 -3.7Current account balanceo -2.9 -2.8 -5.8 -2.9 -2.5 -2.1 -1.5 -0.8 -0.6lLT capital Inflow 2.8 2.0 4.2 8.6 3.4 8.1 2.5 1.7 1.4Not IMF credit 0.0 -0.3 0.0 0.6 0.0 0.0 -0.8 -0.3 0.0

Foreign exchange reserves

International reeerves 6.2 4.9 4.0Gold 1.1 1.0 1.1Total offleial resorves 6.3 5.8 6.1(In aonths of isoprte) 8.8 4.9 4.8Total not foreign easotu 10.8 12.1 9.6

Exchange rates (Rp/USS)Neoinal official ER 688.5 1120.2 1411.6Real offectivo ER 111.7 85.8 62.8

La Ineludes offtetal grants.

- 24 -ANNEX IPage 3 of 3

EXTERNAL FINANCING AND MLT DEBT(Annual averages in US$ billion)

FY85-87 PY88-90 FY91-93

A. Gross disbursements 5.1 7.3 6.8Multilateral 1.0 2.0 2.1

of which: IBRD 0.8 1.5 1.5Bilateral 1.1 2.3 1.8Private la 3.1 2.8 2.9IlW purchases 0.0 0.2 0.0

B. Net disbursements 2.3 2.7 1.4Multilateral 0.8 1.6 1.4

of whichs IBRD 0.6 1.1 0.8Bilateral 0.6 1.4 0.7Private la 1.0 -0.5 -0.5IMP purchases -0.1 0.2 -0.2

C. Principal repayments lb 2.8 4.7 5.2Multilateral 0.2 0.5 0.8

of which: IBRD 0.2 0.4 0.6Bilateral 0.5 0.9 1.0Private /a 2.1 3.3 3.4

D. Interest payments 2.3 3.1 3.3Multilateral 0.4 0.9 1.2

of which: IBRD 0.3 0.7 0.9Bilateral 0.4 0.6 0.7Private /a 1.5 1.7 1.3

E. Rey ratios (Z) 1987188 1988189 1989190 1990191 1991192 1992193Interest/XGS 14.5 15.1 14.4 13.1 11.7 10.7DODIXGS 242.2 234.8 224.3 211.7 194.8 177.9Net disb./interest 76.4 64.3 58.9 47.1 27.2 16.3Net transfer/GDP -0.9 -1.5 -1.7 -2.0 -2.5 -2.7

/a Includes private guaranteed and nonguaranteed debt./b Includes repayments to the IMF.

- 25 -

ANNEX IIPage 1 of 4 pages

THE STATUS OF BANK GROUP OPERATIONS IN INDONESIA

A. STATEMENT OF BANK LOANS AND IDA CREDITS(as of March 31, 1988) /a

Loan/ Amount (US$ million)Credit Fiscal (less cancellations)number year Purpose Bank IDA Undisbursed

Fifty-three Loans and forty-seven Credits fully 3,175.00 890.45 -disbursed

946 1980 Yogyakarta Rural Development - 12.00 2.571751 1980 Nucleus Estate and Smallholders III 92.00 - 2.551835 1980 Nucleus Estate and Smallholders IV 30.00 - 12.101840 1980 National Agricultural Research 35.00 - 15.501872 1980 Ninth Power 218.18 - 3.891904 1981 University Development 45.00 - 10.021958 1981 Swamp Reclamation 22.00 - 0.731972 1981 Fourth Urban Development 43.00 - 0.812007 1981 Nucleus Estate and Suallholders V 127.16 - 54.052049 1981 Jakarta-Cikampek Highway 85.00 - 38.572056 1982 Eieventh Power 170.00 - 9.212066 1982 Second Seeds 15.00 - 2.612079 1982 Bukit Asam Coal Mining Development and

Transport 183.86 - 22.552083 1982 Rural Roads Development 85.00 - 10.052101 1982 Second Teacher Training 79.59 - 32.592102 1982 Second Textbook 25.00 - 7.092118 1982 Sixteenth Irrigation 37.00 - 6.392119 1982 Seventeenth Irrigation (East Java

Province) 70.00 - 21.352126 1982 Nucleus Estate and Smallholders VI 52.07 - 34.322153 1982 Coal Exploration Engineering 25.00 - 1.17

/a The status of the projects listed in Part A is described in a separate report onall Bank/IDA financed projects in execution, which is updated twice yearly andcirculated to the Executive Directors on April 30 and October 31.

- 26 -

ANNEX IIPage 2 of 4 pages

Loan/ Amount (US$ million)Credit Fiscal (less cancellations)number year Purpose Bank IDA Undisbursed

2214 1983 Twelfth Power 300.00 - 121.552232 1983 Nucleus Estate and Smallholders VII 135.23 - 104.302235 1983 Provincial Health 27.00 - 12.202236 1983 Jakarta Sewerage and Sanitation 22.40 - 12.742248 1983 Transmigration III 94.00 - 10.062258 1983 Public Works Manpower Development 30.00 - 7.542275 1983 East Java Water Supply 30.60 - 2.562277 1983 Fifth BAPINDO 208.90 - 77.382288 1983 Transmigration IV 53.50 - 35.642290 1983 Second Polytechnic 107.40 - 45.932300 1983 Thirteenth Power 279.00 - 59.892341 1984 Third Agricultural Training 63.30 - 20.322344 1984 Nucleus Estate and Smallholder Sugar 70.30 - 24.872355 1984 Second Nonformal Education 43.00 - 15.472375 1984 Second Provincial Irrigation Dev. 89.00 - 14.462404 1984 Highway Department 240.00 - 35.242408 1984 Fifth Urban Development 39.25 - 12.542430 1984 Third Small Enterprise Development 204.65 - 5.322431 1984 Second Swamp Reclamation 65.00 - 44.862443 1984 Fourteenth Power 210.00 - 79.302472 1985 Secondary Education and Management

Training 78.00 - 58.662474 1985 Upland Agriculture and Conservation 11.30 - 10.562494 1985 Smallholder Rubber Development II 109.00 - 97.322529 1985 Fourth Population 35.13 - 28.532542 1985 Second Health (Manpower Development) 39.00 - 33.512543 1985 Kedung Ombo Mulipurpose Dam and

Irrigation 156.00 - 124.512547 1985 Second University Development 147.00 - 119.762560 1985 West Tarum Canal Development 43.40 - 35.132577 1985 National Ports Development 111.00 - 93.422578 1985 Transmigration V 97.00 - 67.062599 1986 Science and Technology Training 93.00 - 66.002628 1986 Smallholder Cattle Development 32.00 - 23.282632 1986 Second East Java Water Supply 43,30 - 25.812636 1986 Second Nutrition and Community Health 33.40 - 27.232638 1986 Nusa Tenggara Agriculture Support 33.00 - 24.56

- 27 -

ANNEX IIPage 3 of 4 pages

Loan/ Amount (US$ million)Credit Fiscal (less cancellations)number year Purpose Bank IDA Undisbursed

2649 1986 Central and West Java Irrigation 166.00 - 146.122690 1986 Gas Distribution 34.00 - 33.832702 1986 Export Development 64.50 - 46.132705 1986 Manpower Development and Training 58.10 - 46.922717 1986 Highway Maintenance and Betterment 300.00 - 196.682725 1986 Housing Sector Loan 200.00 - 116.282748 1987 Third National Agricultural Extension 55.00 - 50.552757 1987 Telecommunications Technical Assistance 14.50 - 12.282773 1987 Fisheries Support Services 24.50 - 23.172778 1987 Power Transmission & Distribution 226.00 - 215.382800 1987 BRI/KUPEDES Small Credit 101.50 - 81.712816 1987 Urban Sector Loan 270.00 - 142.032817 1987 Regional Cities Urban Transport 51.00 - 42.312879 1988 Industrial Energy Conservation 21.00 - 20.752880 1988 Irrigation Subsector 234.00 - 224.002881 1988 Second Rural Roads Development 190.00 - 190.002891 1988 Railway Technical Assistance /a 28.00 - 28.00

Total Bank loans and IDA credits 10,027.02 943.52

Of which has been repaid 1,054.05 34.75

Total now outstanding 8,972.97 908.77

Amount sold to third party 79.21 -

Total now held by Bank and IDA h 8,893.76 908.77

Total undisbursed 3,515.77

/a Not yet effective./b Prior to exchange adjustment.

- 28 -ANNEX IIPage 4 of 4 pages

B. STATEMENT OF IFC INVESTMENTS(as of March 31, 1988)

(US$ million)

UndisbursedOriginal Total including

Fiscal Type of comitments held participantsyear Obligor business Loan Equity Total by IFC portion

1971/74 P.T. Primatexco Textiles& fibers 4.0 0.8 4.8 - -

1971 P.T. Unitex Textiles& fibers 2.5 0.8 3.3 0.8 -

1971/73/ P.T. Semen Cibinong Cement 46.0 5.8 51.8 4.8 -74/76/841971 P.T. Kabel Indonesia Cables 2.8 0.3 3.1 - -1972/77/79 P.T. Daralon Textile Textiles

Manufacturing Corp. & fibers 5.7 1.5 7.2 - -1973 P.T. Jakarta Tourism 9.8 1.6 11.4 1.6 -

International Hotel1974 P.T. Private Development

Development Finance finance - 0.4 0.4 0.3 -Company of Indonesia

1974 P.T. Monsanto Electronics 0.9 - 0.9 - -1974 P.T. Kamaltex Textiles 3.7 0.7 4.5 - -

1980 P.T. Papan Sejahtera Housingfinance 4.0 1.2 5.2 1.2 -

1980 P.T. Supreme Indo- Dinnerware 11.1 0.9 12.0 - -American

1980/85/87 P.T. Semen Andalas Cement 48.5 5.0 53.5 22.1 -1982/85 P.T. saseka Gelora Leasing 5.0 0.3 5.3 0.3 -

Leasing1985 P.T. Asuransi Jiwa /a Insurance 0.4 - 0.4 0.4 0.41986 P.T. Bali Holiday Tourism 9.8 - 9.8 3.5 3.51987 P.T. Monterado Mining 8.0 2.0 10.0 5.5 6.41987 P.T. Kalteng /a Mining - 1.4 1.4 1.4 1.4

Total 162.4 23.0 85.4 42.0 11.7

/a Agreements not yet signed as of March 31, 1988.

- 29 -ANNEX III

INDONESIA

SECOND TRADE POLICY ADJUSTMENT LOAN

Supplementary Data Sheet

Section I s Timetable of Key Events

(a) Time taken to prepare project s 3 months

(b) Agency which prepared project X BAPPENAS

(c) First presentation to the Bank t December 1987

(d) Departure of appraisal mission : January 1988

(e) Completion of negotiations : April 1988

(f) Planned date of effectiveness X June 1988

Section IIs Special Bank Implementation Actions

None

Section IIIs Special Conditions

None

-30- ANNE IVPage I of 9

MINISTER COOROINATOR FOR THE ECONOMY, FINANCE,INDUSTRY ANO OEVELOPMENT SUPERVISION

REPUBLIC OF INDONESIA

Jakata, Febnury 29, 1988

Mt. Barber ConablePresidentThe World Bank1818 H St., N.W.Washington, D.C. 20433U. S. A.

D-w Mr. President:

Gove=ment's Statemnt on cniLBc and Trade Policy

1. The Covermnt of Idonesia wishes to request a sea:d loan frm the

World Bank in support of a program of ecxmoic adjutsu It, especially in the

area of trade poliy. This letter provides a description of the current

situatio, the measures uhich the Govement has taken and th. direction of

future policy actions.

Progss on Ecmmic AdJusfmnt

2. In mly last letter to you, dated Decenber 19, 1986, I dscribed the

impact of the sbarp drop in oil prices an Indonsia's balance of paymants and

the GDvenunt's Budget during 1986, and the actions that the ovemnent had

taken in respose. Of particula mprtance we the austere Budget

nimplmited during 1986/87, the 31% devaluation of the Rupiah in September

1986 and the pacae of trade re6f lttiatd in October.1986. 77he

Goverwmt has continuad and extended its eonamc adjustuI progm during

1987. Another austere Budget has been impleinted during 1987/88, with no

increase in civil service salaries and further reductios in real deelopmt

spendLig. With the exception of som foreign-aided projects, there were no

mojor nur imse8ns started with gowrment funding in this fiscal year.metary policy ws also tightened, leading to a slowdoa of liquidLty

expasim and revwrsing pressuces against the R1upih in mid-1987.

-31 - ANNEX IVPage 2 of 9

MINISTER COORDINATOR FOR THE ECONOMY, FINANCE.INDUSTRY AND DEVELOPMENT SUPERVISION

REPUBLIC OF INDONESIA

-2 -

The Governrnt's prudet fiscal and mxntary policies have helped to containXe8tic inflation below 97. and preserve the coupetitive advntage provided bythe 1986 devaluatio.

3. lhe GDvenmrnt has also maintained the mntum of dereation intrade policy and industrial licensing durn the past year. Ihse measure,togetber with the coopetitive exchange rate, have supported a very encouraginge:nsimon of non-oil exports. Non-oil export earin8e are na projected to

exceed US$ 9 billion in 1987/88, one third hite than last year. Becme ofthis strong performance, we expect to acieve our target of reducing thecurnent account deficit frmn over US$ 4 billion in 1986/87 to less thanUS$ 2 billion In 1988/89. During the transition period, Indmesia has beengreatly assisted in financing its balance of paynmts by ncessicnal progrnaid and loca;-cost fhding frn the IGGI. Beas of the Gver t'sprudmt debt mte strategy, and the iproved export performue, thedebt service ratio is expected to stabilize axond 37% this year. 7hederegulaton drive has also provided a needed boost to econuic activity: (SPgrowth has been sustaired at arond 37 p.a. and private imnesftt (dmstic

and foreign) has reoovered strongly frmm the low 1986 levels.

4. With the resmtoration of external and doustic balance, it isessential to revive growth of the non-oil econom to abot 57 p.a., in orderto absorb the growing labor force at adequate levels of productivity andinms. The adjusmtent mmsaes taken by the Govenn.nt, including theonaoing progran of trade and industrial policy refom, are mnsidered to bean inportat prerequisite for econmic recovery. The adjustment process ust,therefore, continue. The ontinud expansio of non-ol exports is a keyelmemt of this strategy, for thir direct contribution to production andealoymnt, as mell as their role in reduclng tha burdn of external debt andluproving Indeesia's creditwrthness in world financial umakats. In the

-32 - ANNEX rVPage 3 of 9

MINISTER COORDINATOR FOR THE ECONOMY, FINANCELINDUSTRY AC OEVELOPMENT SUPERVISION

REPUBLIC OF INDONESIA

- 3-

umante, aontinmd support frao the ernt o ity will be requlredto finoce the izport rA IImtas related to the export drv andrestim of the indiutrial sector. The proposed loan frn the World Baekvould prvide sudh financing during the ctung year, while also bwsangsupport obr the G 'wsrunt's grawth-orLented adjusbint progm. As aud, itcm gLw an iqzortmnt siual to otber dmrs to extend apropriate assistawsIn cantzud suport of the adjustxitt process.

5. Us Govermint's strategy of grorthwith adj3stsit will requLtefurther structural reform in three key areas: trade policy, lnUtrialregulatio and the financial sector. The broad dLrections of the Gbwrment'spolicies in these areas, as wll as supporting polcies to imntain a stable_ucrceo~i.c -imir-Im, are set out below.

Trade ReyPafon.

6. The Govrnmet rSmln stongly owt itted to the objectives of tradepolcy as set out In my December 1986 letter, namely:

- establishing a protection strwture based an tariffs rather thdniuzport licanises, thereby providing a rmre imifor and traispaMtlawl of protection to Indonsian prodnr;

- reducing the past bias in incentiws against expor activities and Infavour of i4Port substitution; and

- liudting the level of protection, with special provision for infntind'stries ich would enjoy higber lewls of protectim forspecified time periods.

TD adie these objectivs, the Gtiunt has put into place a mallfirctiong _ndwi_ that allow exporters to hbw easy acces to inpus atntatintafly prices, IAile lt pbty ing out exot

- 33 - ANNEX IVPage 4 of 9

MINISTER COORDINATOR FOR THE ECONOMY, FINANCE,INDUSTRY AND DEVELOPMENT SUPERVISION

REPUBLIC OF INDONESIA

- 4 -

subsidies. The Gowmmt has also focussed on el ating rening exportestrictioms and s thenin sutort for e2port infrstrtue and

service. I bzing the sstained growth of ron-oil exports will require abroad based ipro t in the structure of incentives, the Goverment hasInitiated a major progran to reduce and rionalie Import prtection. Stepsto reduce the role of inport licensing restrictims and noe tocwdtariff-only based protecticn are now wall underWy.

7. The trade rfom mumaus amwmced in October 1986 and supported underthe first Trade Policy Adjustmit loan represeted the first step in a processof 3vlng my fra restrictive porter s

reinfced by two sdmqunt reform padcages a moed in Jauary and Deuber

1987. lhese t padcags remned import licensing rstrict on 313 itemin the teiles, steel, and machinery sectors. Mudh of the iint in themchiaury sector was gained by reducing the nuber of Dods rectricted to soleagent (AT), with soms 111 of these being remuNed from license cntrol. 'ibisinolved removing most of the AT license restrictions that hae bem addedsince the origlna Presidential Decree of 1972. The Dlcenber packag als

nade a start on remvivng 1..ases in the previously untouched area of food andbeverages. Owrali, about 237 of the Import value previously restricted hasbeen remod frou liesming ontrol during 1987, bringing the total to 42Xsince October 1986. We expect to mike furr tangible progess in thisdirection within the next year, espcially in those areas iiere iuport14csing restrictions still provide high protection to dcmstic production.

PmWrtory wok is currently underay in a number of subsectors. TheGovezent's end objective is to elininate all no-tariffctis ports e.oept on a mull group of products that are haImful to heath,

strtegic to natia defnse or invlve special eccx4c and social.w ANTRI

-34- ANNEX IVPage 5 of 9

MINISTER COORDINATOR FOR THE ECONOMY, FINANCE.INDUSTRY AND DEVELOPMENT SUPERVISION

REPUBLIC OF INDONESIA

- 5 -

8. The Governmnt has also continued to review and revise inport tariffrates. In Deeber 1987, tarif were increased on 121 item and temporarysurduirges were iuposed on 50 items, most of which were remDved frmrestrictive inport licensing. lhis shift toward tariff-only protection is inline with the objectives set out above. At the sax tins, tariffs on 179

item mere loered during 1987. These reductions were initially focussed oninported inputs wt produced locally, so as to offset the cost-raising effectsof the 1986 devaluain. However, in December 1987, the Govenrut alsolowered the tariffs on scm item remDved fram license restrictions under anearlier decree (e.g., paper products). Over the nedium term, it will also benecessary to rationalize the structure of tariffs in order to reduce excessive

and disparate leuels of protection. For this purpose, the Governe=nt is

preparing a revised tariff schedule based on the hazivnized aytem, as part of

a mudmn-term plan for tariff reform. Substantial prgregs in this area is

expected during the caming year. Already, a start has been mde on reviewingand reducing s tariffs raised in earlier reform packages. The GDenuenthas also clarified that iuport surcharges will be imposed on a temporary basisonly, and thir justification will be regularly reviewd.

9. The Deenber packag also addresses export restrictions and simplifiesexporter procedures. The APE (Exporter Identification Number), APES(Provisional Export Identification Nbaer) and the APET (Limited ESxporterIdentifica ion Nhxiber) have wnw been abolished. Under the ne regulations,both domestic and joint ventures will only have to present their BusinessPermit to prove their exporter identity. The only exceptions are for productssubject to intemational trading L S t or wbere Ihndnesia is a mjorsupplier to world markets, Export bans on 10 item (primarily processed woodproducts) and export qwDtas on 24 item8 (e.g., refined cocmut and palm oil,

tires, jewmllery) have also been abolisUed.

- 35 - ANNEX IV

Page 6 of 9

MINISTER COORDINATOR FOR THE ECONOMY, FINANCE,INDUSTRY AND DEVELOPMENT SUPERVISION

REPUBLIC OF INDONESIA

-6 -

10. To help prepare proposals for further refrm, the GDverrg.nt has

recently set up the Trade and Industrial Policy Steerig Cardttee (TIPSC).

The World Ba* is providing assistance to develop the technical capability of

TIPSC and undertake studLes of trade and industrial policy issues. A study on

effective protection rates has already ben cgmpleted.

Dke tic Licensing Pfornm

11. The Government recognizes that trade poLicy reforms need to be

caplemnted by measures to siuplify and relax other aspects of the regulatory

frammork. neiderable progress in this area has been made during 1987.

Early in the year, several new sectors were opened to foreiga and donestic

private investors, the nuier of licenses required to establish and operate

fim were sigoificantly reduced, and greater flexdbility was introduced into

production decisions tbrougi the 'broad-banding!' of product categories.

FurEier steps were taken in the Deceaber pakWe to support the export drive.

Joint vnture trading conanies may now be established to export industrial

products and joint venture production comnies may market both their om and

others' industrial products. havpleeuitary regulations haNe been promgated

to 1ower the local particip requir5unts for joint ventures and relax

rules for the eaployment of expatriate personnel. To promDte tourism

develoment, the number of licenses required to construct hotels and other

tourist facilities has been drastically reduced and the sector has been fully

opened to foreign investment.

12. Desite these in nts, the regulatory n nt in Inmnsia

remains cmplex and often damting to potential new investors. To better

understmd the critical bottlene&cs, lPSC with Wbrld Ban assistance will

coWlete a study on industrial regulation issues durIng 1988. This study will

be used to frmulate and invlmnt a phased psm of dereRulation over the

-36 - ANNE IVPage 7 of 9

MINISTER COORDINATOR FOR THE ECONOMY. FINAN.INDUSTRY AND DEVELOPMENT SWUERVISION

REPUBLIC OF INDONESIA

msdiuu tem During the oaiLng year, the Govarwunt expects to iDnk further

proges on siplfyizg and relaxng dPmstic licQuug estrictions.Priority will be gLven to openng additional sectors to dstic and fooipprivate Investait, and stirdng liocese applicati promedues. Pbr theelectrnics subsector, a nw policy is being fonmlated to oauiple nt irecent trade refoun In this area. she Govenuint will also mew the systsmof capacity licensing to ensue that firm can bmfit fully fum thebroad-banding" mwu ms adopted in 1987.

FinAncial Sect Reform

13. he Indmesian financial system has mderm co le ane sincethe 1983 reSorm., udid eliunated mst interest rate oAntrols and credit

Coilins. Ihese refou hav had a very positive lupact on resoce4ilization, with tim and savins deposits Aising by more thm 170X ovr the

past four years. In order to diversify the rge of financ inrimtnnts,the Gvownz mowced furte nassres to strugthe the Tole of equity=zkets in Dectuber 1987. Listing re-ui- s on the Jakarta stoi Excne

haw been simplified and actios taken to inproe the operations of capitalwet institutis. The Govrizent has also anrmed the creatin of an

over-th-comter (OX) umtet to erable maller, less wall-established

caiwes to nxbilize inws8nt eougt h the capital markt. Inorder to strengtI the duAnd for securities, the Govnuwt will e ragwthe ism of bearer shares and allw foreign inestors to purchae shares inthe OTC markt.

14. Despite these inprowunts, the Gowint is sti conced aboutthe capacity of the finncial system to support the process of ecoomtcWFMtrl t and recovary. The C0st and availability of credit, especiallyfor lowg-term invaestwt finds, will critically detendine the abilty of

- 37 - ANNEX IVPage 8 of 9

MINISTER COORDINATOR FOR THE ECONOMY, FINANCE.INOUSTRY AND DEVELOPMENT SUPERVISION

REPUBLIC OF INDONESIA

- 8 -

bu s nprises to take advmntage of the n pross currentlyuzdey. Pelated issms of finmcial sector efficiency and developmnt willbe addessed in a joint World Bank-Govenuent study to be cupleted during1988/89. The toennnt intends to use the findings of this study in thedesign of future flnanial sector refom.

Macroconcc Wanase

15. A stable macroeowic enviroM0nt is irtant in prulDting anoutwrd-orieted industriAl stuture ad enhancing productive effc . As

noted earlr, regaining stability in the balance of paymnts in the face of

lamr oil pricss is a prim:y objective of the Govemrnut and onsiderable

pmrge in this direction has already beem made. To sustain the process of

adjustn.t, another austere Budget has been an ned for 1988/89. The Budgetis based on a prudent oil price assumption of US$ 16/barrel and emphasizes the

iqDoxncem of continued i-nr-vemnts in non-oil tax administration. For the

third year in a raW, no provision has been mde for an increase in civil

service salaries (this will only be considered if the resource position is

better than expected) and development spending is budgeted to fall in real

terms. In allocating expenditures, the hi4mest priority will be given to

operatLons and uintenance, to improse the productivity of exdstinginfrastrwture. Now projects will be undertacken only Aen they are shown to

have very high ec uic returns and where foreigi assistance is available an

suitable te.

16. Th GDvenmet has also take steps to cotain inestUt by public

enteprises. Tight control has been kept on utilization of xnm-ccmcessional

inport-related credits and equity participatioin public enterpries funded

terou& the Budget has been reduced to mlnmil levels. These policies are to

be maintalned 4ing 1988/89. With IW assistance, a prneimhwary

-38 - ANNEX IVPage 9 of 9

MINISTER COORDINATOR FOR THE ECONOMY. FINANCE,INDUSTRY AND DEVELOPMENT SUPERVISION

REPUBLIC OF INDONESIA

_ 9 _

consolidatin of the finanal accounts of public enterprises was caipleted inJanary 1988. lhe President of Indmesia has also requested a revew of thefinancial performace of all public enterprises, to identify potentialcanidates for rehabilitation, murger or divestitune. Ihe data for thisreview hale xxw been collected and the Goenmmnt Intends to take apprpriateaction in the near future. The Government also intends to ontinue its reviewof tihe regatory fruie4*, with the objective of improving the efficiencyand operating perrnce of public enterprise over the umdiun term.

17. The Govenent maintains its strong comutmnt to the present foreigp

exhane system. Echange rate policy will contine to ew size the

objective of Daintai interational competitiveness of the In&mesian

eomny, taling account of price and ecag rate novmnts in tradingparers and cwpetitive countries. The austere Budget annouced for 1988/89will help restrain tic demand and monetary expansion. With thesepolicies, the Govenumt aims to reduee the inflation rate to below 77. p.a.dwing 1988 and thereby maintain a competitive exchange rate.

18. As in this past, the Government will act promptly to make the requisitepolicy adjustnuts if an u cted cc disequlium e es.

QS7nerely yours,

Ali WardhmaaMinister ordinr for theEoaXK!y, Finane and industry

INDONESIA

SECOND TRADE POLICY ADJIUSTMIT LOAN

Policy Framework

Actions taken 1903-05 Actions taken 1986 Actions taken 1987 Areas for follow-up

A. Trade Policy Reforms

1985. Import and export procedures reduced April. Export certificates abolished. fol- January. 119 industrial products (primari- Monitor tipact of recent measures on bel-To1 minimat: imports are now inspected at logIIj Indonesia'e accession to CATT. Duty TyE 7xiTles) were opened to general Import- ance of payments. dometic prices andthe ports of origin by government-appointed drawback/exemption scebme Introduced. ers eod another 121 to actual users. Industrial acttvity.aurveyors (SOS), "hIle exports and inter-island traffie are no longer subjeet to . "Producer exporters' allowed to ns Tariffs reduced to 0-lOS on 55 educe further the role of WMs. Over thecustoms inApection. Port charges simpli- Mport itputs. witout restriction and RWHITpE r tIsily coeponents/CtD kits for next year, further eliinate tImportfied and reduced, and restrictaons on exempt from Import duties. Other exporters the me "henics1 end electrical equipoent licening, especially in are"a where suchforeign-flag vessels reoved. also alloeed to Import inputs (with duties subsectors). restrictions provide high protection to

refunded) I f domestic suppliers not able domestic production. Eventually, eliminate1985. Tariff ceiling reduced from 225S to to provide them at competittve prices. November. Requtrement for spinners to pro- all NTIs. except for * smll group of1U1 barring a few exceptions. Number of cure t of their cotton locally suspended. products for bealth, defense or socialtariff categories reduced from 25 to II. October. 197 tnduatrial tnputs (e.g., Together with January reforms this removed considerations.hovever, nontariff barriers (NTis) continue ttres, glass, pper, vehicle parts) were all NTBs on cotton Imports.to proliferate, By the end of 1985, core opened to general importers and anotber 105 Ensure that all tariff adjutments conform Wthan 1,700 items were subject to NTBe of (eg*., chemicals, aecinery) to actual December. A further 228 products (primart- to the lower tariff bends. Prepare a 'Done form or another, users and licensed agents. For about half ly stee, mechanical and electrical equip- medium-teorm plan for tariff ratiotalias-

of these Item, tartffs were Increased to mint prepared food products) opened to tion.1985. Deeision to accede to CATT Code on limit the impact on the balance of payments general importers. For 93 of theose item,

Wwidies and Countervailing Duties. and provide transitonal protection for taritfs were ncreased to provide trakst-domestic tAdustries. tional protection for domestic iadustries.

October. Tariffs redue d on 152 Items December. Tariffs reduced on 124 Itemte.g., ertain chemieles steel products, paper and paperboard articles, steelelectrical components), with most cut to and a`uminum products, mechanical codpo-O-SX. These are primrily industrtal nents). Many tariffs for steal and a1ui-Inputs not produced domestically, where nua products were reduced to 0-102; othercosts were Increased by the dvevlustton. reductions lowered protection to producers

of Items liberalixed under an arrliardecree (e.g., paper products from 60X to40X and hinge, bolts and staples from 8$0to 602.

December. Restriettons on exporter eased.TM-MVfor a separate exporter license(APE) abolished, with the existing businesspermit now acceptable as proof of exporterIdentity (except for products subject tointernational tradiag arrangements or whereIndonesia ti a *ejor supplier). Exportbans on 10 item and exprt quoes non 24ltem abolished. Also tobacco exports nolonger restricted to a list of approvedexporters.

cetl_me tab.., 1903-83 hel..ct tot" 1966 Aetiom tab" 17 Are" for follow-up

S. 9uootieA ldMetIelW enftaial Ilefoe

!w7yIeeoiare g _pprewi aW Impli.- Ila. tb i tea for entry of foreig capi- .otteor the Implementation of the dbed-a.Of private IDnweemeet avl- seve NuW operating "iaewiemt in- %sieFaatei.inutyrlgd dag'wa masures to oensur that flaw aermjo rosisatiS of Mr t s rs latable to bta ttit fully gasthese rtbem.nino COWileted. ref ectieg Cho"p to infomEC"s tree luemet gsgnAatie to pno cc prtiipatna t jin: ates. ipoorue .tob..raqtreent odontl. vaidty ttof tIoreleter stect erto; (IIA) thle edditiel lices.tA the e_an or Implemet * _hsd prga o teatinte thes tidit e|d wetm licensee ea enldto d iy rout. r=ce of *imllftye the reuletory

eataree with majority local patnicipetice 1t.rcb-Jue. VW? list considerably otapt- trtia liensiG. As t finl astp peneased. 1WTOiberaleed. Produc-t eleooif ice- udditlemeltactore to domatl an& foreig1tloe tn industrial pemto also Ireedened, private inwuatmnt.Octeber. fogeigs tevetore panted Omt to prvide pester rleUbIlit1. in ptoduc-

146irea.mu withI demetc iawstors. ties doesclaom. by f fins aWe am requirela ponertcer: Wi foreiga Inwsetmnt ame to obtain ouly I operatieg lienos.e mem*llewd to euletita ftrm In prtority see- wlid tog the life of the entrprtes end antot. estcally for euport (it) iewt- espeelo. porert for ceeity irmes-eset by meltleotteal financal institutions gatfter th. 3Su.treated ao atte_s pertticpatiomn (tit)foriet -ietuent e_mpnse 1. eee ecmer. te of deregletico masreoto expert edtit an saw term en damettic WINid to priNte ean-oil eapo. Iofir.g a" (tv) foretir- tmeat camp p.rticwlern () joint-vent re euort tred-atl dlle_d to eport pocto of otber Iag Cempanes my am he tebtihed; (ti)coe_pen t. joist-vtere prdcttem campeelea myr-

part their oem ead eXthe. erodre liii)requirement. for local partlclatio(e *iJoist weotem furthBer reletd; ed Civ)rate tr tbh opl= of expetriates re-tleoc to tbe tortom setor. the _ubrof license reqired to eosetrect I stilt- 0tie reIceId to 2 (previously 31 for 0hotelt) ed the sector o_maid tully toforeign inetment.

fn ial ttoleticMw. rixnmance refors included, Cl) Octebsr. Panmev cetilin. en foreign- Jone. Ibeeary Policy oevowsly tightened Study My, to, imrowe further the efficien-i,lof mout ntereet raet ecmtroet em WMI& weap fecilities offered by Imming UVughao higher interet rate..n UsmAtatY ey end capacity of the banking system andstat bea deeits; (i) olmlnatim Of system. iaatsae (3. s5o.) en conversion of to d_wlop altaretiw finacil imtte-credit cetilag for all honk.l end (lit) peblic-uarerprise deposits Into sale. tec- eotas.reductio n Ia,mbebr of Program. qualify- caudal in revereing epeculetiwre too aieattag for nem lank Indemuel liquidlity the Depiab.

J u cwtion eyet eatablithed to ise

through PaIOOIUSS.IOU O MUs Mass" bye %Ad IwnftDJtter. St uty markets etftretdand. tin

-- ortig --- actrod d to ironevte Inettnti l t Stats nd opertiof capital matt *n titetiem Ciii£) OIC mrket cestzed tor _aller, 1ee wll- eatablidehd cemnes; end Itv) t ot °oaherr _hree ed purcb.ee by foraiInvetor. allemad in OIC meghe.

Actito taken 19834S Actieon take 1986 ettios taken 19S7 Area for follow-up

C. Susortina Iero coeoic Policit"

tdsvalud by 28 en the e- S er. pab denvtu by 312. to de- Riab allowed to depr ecate witb US Preserve a competitive *exchang rate.c_s rate subsequently eet by a e e_ ts tle roptl/US dolltt rate. sonk doller. By November 1987 r t *ffective throoua coordiasted fiscal Monetary eaflot spinet a ea ket of currecle. d amow quota ftve md-rate and the exeeg rate we 72 lower then on per exchneo rato policiee.

S91 rote for tAe h.upieh. *artier.

Publie tuaeotmnt1983. Felarge capital-ntentsve proj J- Austere odgset annou_cd for ? . Austere bigot annoncd for Implemt nuetar budgt for 1980/19. baedsets re_ . major in tot af fee- 186/87. Real capttal spenWing cat by 242. 1987/18. Bea capital spendigs *eected to on spnding piriittie anoucd in Jauarted intclded atan alutiu, Plaon a r- Priority gtve to# (I) completion of easo- he cat by a fortber 13 S. Smespendina 1961.tices. tel refignry, Aceb olefin and ltn proetes; (ii) counterprt funds for prtorittte as for 1986/87.seral pinr projects. Total foreign foreiso-eldsd projectsl (lii) projects raintain prudent eaterm debt _en ot,ace_g sevinp esttitod at 218*10 bil- serving eqityt /plopont objectlvst; snd including reotrictieon oan i_pot-el edlto. (lv) funding of OWt. credtttand careftl eerutty of pr_psalo

for lar"e cpItel-lnteiwe projects.

eovelop a plan for t prowveg thu perfor-on"e of publit enterpriaes. includ pro-

posls for rebetiite tion nerger adivestiture.

NOn-Oil TAxtitol two" tax refote inceluedt (1) a am. Ibo property tax replaced seven Coettme to expand eowell ton reveonsa*iaptied tax atructure, based on ttree or tminces, iocluding the old tlad (tPMDA through iprovenoute tn tat admteLtrextin. 0Prelatively low rat" (252, 252 ad 352) end sat wesltb taxes. The e lA tw cos o-and atwted deductions; (i) W"olf- ceptunlly stipler. based on a proportion of*c_eseaent of tax liability. witlh _e- the _rket gal" of load an buildinp. andti so witholding ea sre; Nd (tit) a single tax rate of 0.5t.

slaplfiestteo of the tau code, tincudingrvised procedure, for _ppale andrefunds.

- 42 - ANM VIPage 1 of 11

TRADE POLICY REFORMS AND INDUSTRIAL DEREGULATION

A. Trade Policy Reform

Backtground

1. During the 1970s, GOI encouraged the development of domesticindustries by protecting them against competing imports. At' the start of thisdecade, Indonesia's import regime was characterized by high and disparatetariff rates. subsequently, pressures resulting from the slowdown of thedomestic economy, led to an increase of non-tariff barriers (NTBs) in theearly 19809. In 1985, the Government took two significant steps towardsaddressing these problems. First, the customs, ports and shipping operationswere reorganized by contracting customs operations to private surveyors andstreamlining shipping and ports procedures. This has reduced enormously thecosts and uncertainty of freight forwarding for both exports and imports.Second, the Government announced an across-the-board reduction in the rangeand level of import tariffs. The tariff ceiling was reduced from 2252 to 60Z;moreover, the percentage of items with tariffs below 302 was raised from 59?to 822. Although this resultad in an unequivocal improvement in the traderegime, its effect was muted by tba large number of NTBs. By the end of 1985,more than 1,700 items (CCCI categiries) were subject to import licensing.i/These items accounted for over 4 2 of both total import value and tradeddomestic production. In additi 4, there were 24 products under import ban(including automobiles, motorcycles, televisions and radios as completelybuilt up units). This pervasive system of import controls provided high anddisparate rates of protection to domestic production, and fostered thedevelopment of many high-cost and inefficient industries.

2. Measures Supported Under TPAL I. Responding to this situation, GOIembarked upon a major program of trade and industrial policy reforms. Thefirst step was taken on May 6, 1986, when 001 announced a package of measuresdesigned to provide internationally priced inputs to exporters. This wasfollowed by more fundamental reforms on October 25, 1986, which signalledG01's intention to move away from import licensing restrictions toward tariff-only protection. Under the October package, import restrictions were removedon 197 items, accounting for 11? of all items and 19S of total import valuepreviously restricted.21 As a result, the share of manufacturing productionprotected by restrictive import licensing declined by about 142. The Octoberpackage focussed on a number of highly protected activities such as chemicals,paints and dyes, tires and tubes, hides and leather, and glass. A start wasalso made in relaxing import licensing restrictions in the mechanical andelectrical equipment subsectors. The Vorld Bank supported this change in thedirection of trade policy, as well as G01's overall macroeconomic policies,through the first Trade Policy Adjustment Loan (TPAL I) approved by theExecutive Directors in February 1987.3/

3. Implementation of these reforms has been generally satisfactory. TheMay 6 scheme has worked smoothly, vith *arms-length' administration and

1/ Restricted to holders of an approved importer license, of which 296 hada formal quota imposed.

2/ In addition, import licensing restrictions were relaxed on 105 items.

3/ President's Report No. P-4429-IND, dated December 30, 1986.

- 43 - ANNEXVIPage 2 of 11

minimal delays in processing applications. As shown in Table VI.1, the schemehas provided exporters with almost US$1 billion of imports during the 18months through December 1987, accounting for about 6S of total non-oil importsover this period. These imports were allowed to bypass the approved-traderrestrictions and were exempted from US$430 million in taxes. Encouragingly,a:cess to the May 6 scheme has been broadened from the initial focus ontextile exports to include significant numbers of exporters in the processedfood, chemical and wood product sectors. The October reforms became effectiveimmediately through two decrees issued by the Departments of Trade andFinance. Imports have subsequently increased sharply for items removed fromlicensing restrictions or where tariffs were reduced. For example, thirdquarter comparisons from 1986 to 1987 show import value increases of 352 forbasic chemicals, 262 for dyes and tanning materials, 612 for textiles andfibers, and 352 for motor vehicle components. However, there have been somebureaucratic delays in clarifying license application requirements andprocedures (e.g., for sole agencies), while high tariffs have constrained theimport of some items removed from licensing restrictions (e.g., paperproducts). As noted below, a start has been made in tackling these problemsunder the 1987 reform packages.

Table VI.l: IMPLEMENTATION OF MAY 6 SCHEME laCUSS million)

Value of Imports Value of ExemptionsActivity Approved Import iuty VAT

Exports 989.4 310.0 122.5Textiles and garments 315.5 148.5 46.3Processed foods 329.3 104.9 37.0Chemicals 73.6 17.3 8.3Wood products 105.5 13.5 11.8Other 165.5 25.8 19.1

GOI projects Lb 168.6 31.8

Total 1,158.0 341.8 122.5

la From July 1, 1986 to December 31, 1987.lb The May 6 scheme also applies to contractors for foreign-assisted GOI

projects. However, the text discussion focuses on exporters only.

Sources Ministry of Finance.

4. Measures to be Supported Under TPAL II. GOI has maintained themomentum of trade policy reform during 1987. On January 15, 1987, GOIannounced a package that reduced import licensing restrictions in the textilesector and made limited progress in the iron and steel sector. This wasfollowed-up by a much wider-ranging series of decrees announced onDecember 24, 1987. This latest package pushes ahead on trade reforms through:(i) a further removal of import license restrictions focussing on the iron and

-44 ̂ ANNEX VIPago 3 of 11

steel, mechanical and electrical equipment, and engineering subsectorst(1i) some adjustments in nominal tariffs; and (Iii) a series of measures toreduce export restrictions and offset the anti-export bias of the policyregime. The measures under these two packages are assessed more fully below.

5. Imnort Licensing. The January and December packages markedsignificant progress towards the Government's primary objective at this stageof trade reform, i.e., to move away from a trade regime dependent on Mths toone based on tariffs. The combined effect of the January and Decemberpackages has been the removal of an additional 342 items from license control,accounting for 202 of all items and 23S of total import value previouslyrestricted.41 More importantly, the share of manufacturing productionprotected by Import licensing declined substantially from 42.42 at the end of1986 to 34.82 at the end of 1987 (see Table VI.2). Thus, the total effect ofthe three trade packages has been the removal of 539 items from licensecontrol, accounting for 31S of all items, 412 of total import value and 30S ofmanufactured production previously covered by licensing restrictions.51

Table VI.2s EFFECT OF REFORM PACKAGES ON IMPORT LICENSING COVERAGE SINCE 1986

BeforeShare Covered Under Reforms Post Post Post

Import Licensing (2) mid-1986 Oct. 1986 Jan. 1987 Dec. 1987

Import Items /a 31.4 27.9 25.7 21.7Value of Imports lb 42.9 34.9 31.5 25.2Manufacturing Production jc 49.1 42.4 38.8 34.8

/a CCCN categories based on 1985 Tariff Schedule. Total number of CCCN itemsestimated as 5,500.

Lb Based on BPS 1986 import data at seven digit CCCN level.c ZEstimated as the 1985 value of domestic production minus exports protected

by restrictive Import licenses as a share of total do9estic production,all at unassisted prices. Manufacturing defined as in Table VI.3.

Sources World Bank staff estimates.

41 A further 5 items were removed from license control but remain bannedunder an earlier decree. The analysis does not, therefore, treat theseitems as having been moved off license.

5/ The reforms to date have been focussed on the highly protectedmanufacturing sector where the import licensing restrictions had themost deleterious effect on International competitiveness and allocativeefficiency. For the economy as a whole, the proportion of domesticproduction covered by import licensing restrictions has declined from43.51 in aid-1980 to 41.51 after the October 1986 reforms to 39.51 atthe end of 1987, a total reduction of 91.

-45- ANNEX VIPage 4 of 11

6. It is important to note that these aggregate indicators are based ona very strict deflation of licensing restrictions, i.e., all licenses (otherthan for general imports) are assumed to be restrictive. In practice,however, the degree of protection provided by the different c.tpegories ofimport licenses varies significantly. The least restrictive of theselicenses, IP (actual ueor), allows imports by all producers who require theseitems as inputs into their production process. The January and Decemberpackages have placed many of the restricted items in the textile andengineering goods sectors under the IP license. As a result, virtually allproduction in textiles now falls under the unrestricted or IP licensecategory. Furthermore, as many textile producers export a large proportion oftheir total output, they also have access to the May 6 scheme which bypassesall import restrictions. Therefore, in practice, the (non-batik} textilesector is now largely free of Import licensing restrictions. In theengineering goods subsector, most unassembled kits can now be imported with anIP license, and most imports of components are free of license restrictions.61This has put more competitive pressure on domestic component manufacturers.However many final goods in the engineering goods sectors continue to remainunder restrictive license or import bans.

7. In addition to the reduction in share of overall manufacturingproduction covered by import licensing, an important measure of thesignificance of the reforms is the extent to which import licenses have beenremoved for the most highly protected manufacturing activities. Table VI.3shows how the share of domestic production protected by import licensing haschanged for individual subsectors, and Table VI.4 presents estimates of thelevel of nominal and effective protection for the same subsectors prior to themost recent reforms. It is clear from comparing the two tables that the mostrapid declines in the share of domestic production protected by importlicensing have occurred in the textile, clothing and footwear, basic metals,and engineering subsectors, all of which were afforded high levels ofprotection under the previous trade regime.

Table VI.3S EFFECT OF RF0RM PACKAGES ON MANUFACTURING SECTOR SINCE 1986(S of domestic production covered by import licenses) La

Before reforms Post Post PostCoverage mid-1986 Oct. 1986 Jan. 1987 Dec. 1987

Textiles, clothing & footwear 64.0 61.3 38.2 38.2Wood products 0.0 0.0 0.0 0.0Paper and printing 69.6 50.4 50.4 50.4Chemical products 59.9 52.1 51.1 51.1Non-metallic products 28.2 21.7 21.7 21.7Basic metals 45.5 44.6 38.6 29.2Engineering products 86.7 73.5 13.5 60.3Other manufacturing products 28.9 25.2 25.2 24.6

Manufacturing sector 49.1 42.4 38.8 34.8

La Estimated as in Table VI.2.

Source: World Bank staff estimates.

6/ A very Important part of the December 1987 reform package was thereduction in the number of items in the machinery and heavy equipmentsubsectors under the AT (sole agent) license from 278 to 70.

- 46 - ANMEX VIPage 5 of 11

Table VI.4s STRUCTURE OF NOMINAL AND EFCTIVE PROTECTION /a

Output Nominal protection Effectivt RateIndustry Sector Rp trillion on Output of Protection

(X) (Z)

Agriculture and agroprocessingFood crops 16.5 15 19Estate and other crops 6.9 6 11Livestock 4.9 23 23Forestry 1.6 -17 -25Fishing 2.1 25 22Food, beverages andtobacco 18.0 23 37

ManufacturingTextiles, clothing andfootwear 3.8 35 49

wood products 3.9 3 14Paper products 1.1 22 14Chemicals 2.9 21 45Non-metallic products 4.3 29 43Basic metals 1.9 8 31Engineering 6.4 37 48Other manufacturing 0.5 38 40

Mining and petroleumMining and quarrying 1.2 6 4Oil and gas 24.2 0 -1

_ As of mid-1987, i.e. prior to recent reforms.

Sourcet World Bank Consultant Study, December 1987.

8. Import Tariffs and Surcharges. In addition to reducing importlicense restrictions, all of the recent trade reform packages have includeddecrees which changed import tariff rates. The changing pattern ofIndonesia's overall tariff structure is illustrated by the frequencydistribution of tariff rates in Table VI.5. As shown, the major correctivetariff reform occurred in 1985, and the net impact of the subsequent tradereform packages has been small. Recent changes were of two types. First,tariffs were increased on 154 items in October 1986 and on 121 items inDecember 1987. The objective of these increases was to approximate theprotection provided by the license restrictions, within the reduced tariffceilings set in 1985. 71

7/ In only three instances were tariffs raised above the 602 ceilings setin the comprehensive 1985 tariff reform, and these three items havesubsequently been reduced to below the ceiling.

- 47 - ANNEX VIPage 6 of 11

Table VI.5s RECENT CHANGES IN THE TAR!?? SCHEDULE La

1980 Schedule 1985 Schedule end-1987 scheduleNo. of I of CCCN No. of S of CCCN No. of I of CCCN

Tariff tariff items tariff items tariff ItemsRates lb categories covered categories covered categories covered

0X 1 6.5 1 6.3 1 9.1Up to 52 4 29.2 2 32.0 2 35.4Up to 10 6 39.5 3 44.9 3 47.8Up to 15! 7 41.9 4 50.3 4 52.5Up to 20! 8 47.8 5 64.0 5 62.5Up to 301 10 58.7 6 81.8 6 80.5Up to 402 12 70.6 7 91.5 7 90.2Up to 50 14 77.9 8 96.2 8 95.4Up to 60a 15 90.1 9 99.6 9 99.5up to 80S 17 95.1 9 99.6 9 99.5Up to 1OOY 19 99.6 10 99.9 10 99.9Up to 2002 24 99.9 11 100.0 11 100.0Up to 2252 25 100.0

/a Table shows cumulative number of tariff categories and percent of CCCNitems covered at various tariff rates. Specific tariffs are excluded.

lb As of December 24, 1987.

Sourcet Ministry of Finance and World Bank staff estimates.

9. Second. tariffs were lowered on 152 items in October 1986. on 55items in January 1987 and 124 items in December 1987. In the first twopackages, the reductions focussed on imported inputs which are not producedlocally, so as to offset the cost-raising effects of the September 1986devaluation.81 The December reductions went beyond this limited objective inthat some were for domestically produced items that were removed from licenseprotection under an earlier decree but provided a high tariff (e.g.. paperproducts). This is an important next step in the reform process of reducingthe level and disparity of protection through tariff rationalization.

8I For those items that are inputs into export or lightly protected importsubstitution activities and for highly protected end-products, thereduced tariffs have improved the structure of as.istance by raisinglow levels of effective protection. But for those items that areinputs into license-protected, import substituting activities, thereduced cost of imported inputs vill increase protection in alreadyhighly protected activities. In cases where tariffs were raisedfollowing the removal of import licensing restrictions, the analysisundertaken indicates that new tariffs (excluding surcharges)approximate the protection afforded by license restrictionv.

.418 .AMNE VIPage 7 of 11

Table VIG6s TARIPP CHANGES UNDER TIE JANUARY AND DECD9MIh REFORMS

Tariff Chan TotalLicense Decrease Increase Other Ja

Off license Jb 106 115 16 2i9Under license 72 6 6 84

Total 178 121 24 323

La Includes those tariffs that had already been changed since the 1985tariff reform to the rate shown in the new decree and those items whereno corresponding CCCN number could be found in the 1985 tariff book.

lb Includes those items moved off license under one of the trade pai-kagessince October 1986.

Sources Ministry of Finance and World Bank staff estimates.

10. The December package also specifies 110 items as potentiallysurchargesble. To date, only 51 of these have had surcharges imposed, vith SOitems having surcharges set at sero.9/ Most of these concern locallyproduced steel products for which license protection was removed. 001'srationale is to use the surcharge as a temporary measure to allow domesticproducers time to adjust and as a mechanism to offset predatory dumping. Aswith the October decree, GOI Intends to impose a surcharge on a temporary andhighly selective basis. These surcharges %,ill be reviewed on a regular basisand extended only if still justified.

11. Exiort Policy Reforms In 1987. The December 1987 package goes beyondthe previous two packages in that it addressed some of the restrictions andInternal licensing requirements that directly affect exports. The Decemberpackage abolishes the need to have an APE (Exporter Identification Number) orAPIS (Provisional Exporter Identification Number) or an AM!? (Limited ExporterIdentification Number). Under the new regulations, both domestic and jointventures will only bave to present their business permit to prove theirexporter Identity.101 This is a significant stop in reducing redundant rulesand regulations. It is anticipated that it will particularly assist smallexporters and help encourage the diversification of exported items. Forexample, smaller handicraft producers no longer have to channel their exporttrade through holders of an APE. In addition, it is no longpr necessary toobtain an export license for textiles if items are exported to non-quotacountries. The December package also redtt ed the items covered by export bansor domestically Imposed export quotas. Zxport bans on 10 items (primarilyprocessed wood products) and export quotas on 24 items (processed meats,

9/ 38 item have been set at SOX, 9 items at 102, and 4 items at 20*,17.5*, 12.5Z and 2.5* respectively.

101 Except those products governed by international trading agreements orwbhre Indonesia is a major world supplier.

- 49 - AEM VIPage 8of 11

refined coconut and palm oil, copra, sugar, asphalt, tires, jewelry nd basiclron) have been abolished. In addition, the export of tobacco Is no longerrestricted to a list of approved exporters. However, the Ministries of Tradeand Agriculture have indicated that exports of certain food products (e.g.,crude palm oil) will still be subject to dmesntic quota restrictions.

12. Finally, the May 6 scheme, which successfully provided exporters vithaccess to their required imported Inputs, has been broadened In a number ofways. First, the December package has Increased access to the mport duty/VATesmWption scheme of P4UM 11/ by lowering the proportion of a firm's totalou at that has to be exported to quali3l. Henceforth, a firm will only haveto export 652 (previously 856) of total production to be granted an exemptionfrom import license restrictions and dutiesVWAT payments on 1002 of the firm'srequired Imported inputs. For the portion sold domestically, firms can payduties and VAT retroactively. Second, PbUM can now exempt from licenserestrictions and Import duty/VAT payments, the mported machinery that non-PMK/WPDM companies need to expand production for exports. It is anticipatedthat this will reduce the time taken for approval from, In some cases, oneyear to a month or less. Third, P43K can now provide import exemptions on theraw material and machinery used by contractors that undertake gove rnmentprojects.121 Lastly, the drawback system for VAT on domestic raw materialsused by exporters has been transferred from the Domestic Tax Inspection Officeto P43M. This consolidates the drawback facility in one department and shouldspeed up processing.

D. Industrial Deregulation

13. External trade policy is just one aspect of the regulatory frameworkthat conditions the business environment In Indonesia. Foreign and domesticentrepreneurs have to contend with a multitude of licensing and reportingrequirements affecting all areas of investment, operations and domestic trade.These regulations are promulgated and implemented by many dlfferent agencieswith generally weak coordination. As a result, a signLficant number ofregulations are redundant and the regulatory system is overburdened withaumerous and contradictory objectives. The complex and restrictive set ofregulations have combined to stifle competition, inhibit flexibility Inresource use and retard productivity improvements, all of which have served toraise production costs. The dense system of regulations, and the uncertaintyit creates in investment decisions, partl? because of discretion in theInterpretation and implemntation of rules, acts as an Impediment both toforeign and domestic private investment. The Government has recognized theconstraints imposed by the industrial regulatory system and has Initiated aseries of reforms focussing on two priority areass (i) Investment andcapacity licensing; and (ii) foreign investment regulations.

14. Investment and Capacity Licensing. Industrial investment for new orexpanded capacity is regulated by two agencies, the Investment CoordinatingBoard (BRPM) and the Ministry of Industry (MOI). All firms with any degree of

111 P4BM (the Pusat Pengelolaan Pembebanan dan Pengembalian Bes Masuk ofthe Department of Finance) is the implementing agency for the Kay 6scheme.

121 Previously, the exemptions were limited to those items of machinery andgoods that were on the tender masterlist that would be transferred toGOI when the project was complete.

-50- ANNEX VIPage 9 of 11

foreiga Investment must apply through BXPM. DomestLcally-owned firms, on theother hand, may opt to apply either through BKPM or dLrectly to the MOI.Applications that are approved by BXPM receive limited fiscal incentives inthe form of duty exemptions on tmported capital equipment and, for up to twoyears, on raw materlals.

15. A central element of the investment licensing system is theInvestment Priority Llit (DSP), whlch determines areas of investment open todifferent classes of investors. It is prepared annually by BKPM afterconsultatlon with responsible government agencies, and covers investmentsoutside the oil and gas, and financial sectors. It speclfies fields ofinvestment that ares open to foreign investment (PHA); open to domesticinvestment with limited flscal incentives (PMDN); open to small scaleenterprises and non-PMAIPHDN investment flrms; and, closed to furtherlnvestment.

16. After an investment application is approved by either BKM or the Moland an investment license is lssued, a number of other licenses are requiredprior to project construction and operation. These include: land rights,location permit, nulsance license (including pollution control approval),building permlt, tax registration, domestic trade license, and safety permit.While many of these licenses serve legitimate regulatory concerns, therequirements and steps in obtaining them tend to be cumbersome, and add to thecosts and time of the investment process. Finally, a permanent operatinglicense ls lssued prior to commencement of production. This license speclfiesin detail the operating conditions for the factory, including the type ofactivity and approved plant capacity.

17. Since 1985, a number of steps have been taken by GOI to streamlinethe investment approval and relax iavestment llcensing. First, investmentlLcensing procedures were simplified and streamlined in 1985. The maximumnumber of requirements for an investment application was reduced to 15,compared with 25 ln 1984 and 35 in 1977. Moreover, BUPM's role as a *one-stop* service for foreign and domestic investors was strengthened by giving itexecutive authority to issue most of the major llcenses requlred in additionto the investment license. Second, the 1986 DSP list clearly identified whlchareas were open or closed to PMA and PMDN investment. Previously, the DSPlist was narrowly specified and, in some areas, listed the number of projectsfor which licenses would be given as well as the permitted capacity. Underthe 1986 list, no restrictiens were placed on the number of applications thatwould be approved in open areas; in most cases, investment appllcations lnopen areas are being approved. And thlrd, beginning in 1986, all fields ofinvestment, whether declared open or closed in the DSP, were considered openfor investment if production was intended for export (defined as, at least 85Xof production was exported).13/

18. During 1987, GOI took a serles of further steps to simplify andliberalize the investment licensing system. First, using the improved formatintroduced in 1986, the 1987 DSP list expanded the number of areas open toforeign and domestic private investment; 42 industrial sectors previouslyclosed to foreign investment (e.g., the manufacture of truck tires and severalmetal, chemical, food and paper products) were opened. Domestic lnvestorswere also permitted to invest in several sectors that were previously closeddue to capacity and other considerations (e.g., chemical products). As aresult, of a total of 670 branches of manufacturing (other than those reservedfor small-scale firms), 542 are now open to foreign investment, and 620 are

13/ Under the December 1987 package, the percentage requirement ofproduction which must be exported was lowered from 852 to 65Z.

- 51 - ANNEX VIPage 10 of 11

open to domestic investment. Second, the requirements for investment licensesvere further streamlined. Under the old system, industrial licenses wererequired for establishing new firms, restarting unproductive enterprises,expanding existing capacities and for changing the ownership or location offirms. Moreover, the permanent operating license (ZUT) had to be renewedevery five years. As a result of the June 13, 1987 Presidential Decree, onlytwo licenses ate requireds the TUT, that is now valid for the entire life ofthe plant; and an expansion license for Increases in authorized capacity ofmore than 30S. Also under the June decree, firms are allowed to expandinvestments and operations up to 30S of their licensed capacity without anyinvestment approval.

19. The most significant element of the June 1987 Decree was to *broad-band, product categories for the purposes of investment licensing. A firststep in this direction had already been taken in February 1987, whenelectrical and non-electrical machinery plants were allowed to carry outproduct diversification in relatively broad categories and outside the narrowspecification of their licenses, without requiring approval of the investmentauthorities. Under the June Decree, this principle was extended to allsectors. Consequently, the number of product categories has been reduced from2490 to 387, and firms are now free to change product lines within thesebroader categories. This measure, in combination with the automatic approvalof capacity expansion by 3O0, will not only improve the operationalflexibility of firma, but will also increase considerably domestic competitionby allowing firms to compete within broader product categories.

20. Foreign Investment Regulations. In addition to the investment andcapacity licensing requirements for all firms, there were several importantaspects in which PMA companies were treated differently from domesticcompanies, prior to 1986. First, PMA companies were subject to specificregulations governing minimum initial local ownership and the eventualtransfer of the company from foreign ownership to domestic ownership. Before1986, PMA companies had to be established with a minimum of 201 domesticequity, and by the end of the tenth year of commercial operation, domesticownership had to be raised to 51S. Second, specific restraints were appliedto the business activities of PMA companies: PMA firms were not allowed toengage in domestic trading (this could be undertaken only through authorizeddealers); and PMA companies were issued 'limited' trading licenses thatrestricted the domestic inputs that they could purchase. Third, their accessto domestic capital was regulateds they were not allowed access to exportcredit schemes and had only limited access to foreign exchange swapfacilities; and they were prohibited from borrowing from state banks, whichare the primary source of Rupiah long-term credit finance. GOI has taken aseries of steps to address these impediments to foreign investment. Measureswere introduced in May 1986, October 1986, and more recently, December 1987.

21. Under the May 1986 package, a number of steps were takens (a) inpriority subsectors, the initial domestic ownership requirement was reduced toa minimum of 52, with a transition to 202 by the beginning of the sixth yearof commercial operations. Priority subsectors were defined as companieslocated in specific regional locations, with 85? export orientation,14/ inhigh technology fields, or with a project cost exceeding US$10 million;(b) the validity of investment licenses was extended to 30 years; and (c) PMA

14/ Under the December 1987 package, this requirement was reduced to 65?.

-52 - AN=E VIPage 11 of 11

firms were accorded PNDR status, If ownership vas 751 Indonesian, or 51SIndonesian with 202 of the shares traded on the Jakarta Stock Exchange.Further changes were introduced In October 1986, that continued to equalizetreatment between foreign Investors and domestic investors* (a) in prioritysectors (as identified in (a) above), foreign investors were allowed topurchase local companies, as long as 202 of the equity remained under domesticownership: (b) PMA firms were accorded access to the export credit financescheme on the same terms as domestic investors; (c) ceilings on the swapfacility for foreign exchange coverage have been removed, thereby providingPMA firms with access to the swap facilities; and (d) PMA firms were allowedto obtain a license to act as a marketing channel for export products.

22. Further measures were undertaken in the December 1987 package torelax foreign investment regulations. First, ownership requirements werefurther liberalized. The transition period to majority ownership by domesticinvestors was lengthened from 10 to 15 years, with the possibility of anextension for an additional five years. A new ownership category was alsoestablishedt 951 foreign ownership is allowed with no further divestiture, ifthe firm's production is 1001 for export and it is located in a bonded zone.Second, PKA firms are given PMDN status, if they have 51S domestic ownership(a reduction from 751 in the October 1986 decree), or 451 domestic ownership(a reduction from 512 in the October 1986 decree) with 20t of its shareslisted on the stock exchange. Third, PMAI firms are automatically allowed tomarket export goods; this represents a relaxation of the October 1986 decree,which required PMA firms to acquire a license. Foreign investors are alsoallowed to form joint ventures for export marketing with Indonesian partners.Fourth, the limited purchase license has been eliminated so that PMA firms canpurchase domestic inputs without restriction. This is a significant stepsince it allows PMA firms to take greater advantage of the *broad-banding'measures discussed earlier (see para. 20 above). And finally, the proceduresand regulations regarding the hiring of expatriate personnel for export-oriented activities have been eased.l/

23. These measures have responded to the major concerns expressed byforeign investors and significantly reduced the differences in treatmentbetween PMA and non-PMA firms. By relaxing ownership requirements, allowingimproved access to domestic financial markets, dropping the limited purchaselicense and permltting PMA companies to market Indonesian exports, thesemeasures have significantly improved the operational flexibility of PWA firms,expanded the scope of their activities and enhanced the attractiveness ofIndonesia to foreign investors.

151 Rules governing the hiring of expatriate personnel applied to both PMAand domestic firms, and procedures have been eased for both. Rut, PMAfirms perceive the past rules to be particularly burdensome, as theyhave the greatest demand for expatriate services.

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