FROM THE OFFICE OF PUBLIC AFFAIRS

Introduction:

Thank you for giving me the opportunity today to offer the perspective of the Treasury Department on U.S. policy toward Indonesia.

Indonesia's future is critical to the stability and prosperity of Southeast Asia and the region as a whole. The United States has a major stake in the success of the political transition now underway and in seeing the foundation laid for a strong and durable economic recovery.

I will focus my remarks on three subjects:

• The sources of the economic recovery underway in the region and what lessons this holds for policy makers in Indonesia.

• A review of the major economic policy challenges facing the new Indonesian government.

• The broad strategy we have adopted to support recovery in Indonesia.

Your hearing takes place in the context of a remarkable improvement in economic and financial prospects for emerging Asia as a whole.

• Growth across the region has recovered more rapidly than expected, with most economies in the region estimated to have expanded at a rate of 4 to 9 percent in 1999.

• With the restoration of investor confidence, currencies have stabilized, and interest rate spreads over U.S. securities have approached pre-crisis levels (and in some cases fallen below).

• The process of repairing financial systems has begun, and corporate restructuring is underway.

These improvements came from a complex and varied mix of factors across countries. But the dominant lesson of the financial crises of the last several years is that countries that react rapidly with strong, credible stabilization and reform programs are likely to fare better than those that find it difficult to do so.

In Asia, the common elements of success were:

• The development and implementation of a sound framework for monetary and fiscal policies that gave investors the confidence necessary to stabilize exchange rates.

• Rapid implementation of a credible plan to restructure the financial and corporate sectors so that the overhang of debt could be lifted and private sector lending and growth could resume.

• Early progress toward creating the right legal and regulatory infrastructure for private investment and growth (especially a functioning and credible legal system that protects property rights and a working insolvency regime), and improved transparency by regulatory agencies, corporations and financial institutions.

• Commitment to openness to trade and foreign capital.

• Political leadership that inspires confidence, at home and in global financial markets, in its commitment and its capacity to get things done.

Where these conditions were satisfied, the financial support and advice provided by the international institutions were remarkably effective in generating positive economic results. Where they were not, or where a positive commitment on paper was overwhelmed by political uncertainty or undermined by political constraints on implementation, the crisis was much deeper and more protracted and recovery much more difficult to establish. This is, in a sense, the story of Indonesia since the fall of 1997.

Indonesia has taken some important steps to lay the foundation for economic recovery.

The macroeconomic environment has stabilized, and output has begun to expand again. After the deep declines of 1998 and early 1999, the economy is expected to expand at an estimated 1.8% annual rate in FY1999 (ends March 31), and the government expects it to grow 3 - 4% in FY2000. Inflation has been reduced sharply to near zero, from a high of more than 75% in late 1998. Nominal interest rates have fallen dramatically, with the yield on one-month central bank certificates now only 11% (down from around 65% in late 1998). Real interest rates have also declined from their peak in mid 1999. The rupiah has strengthened significantly from the depths of the crisis, though it is still estimated to be about 25% below the pre-crisis level in real trade-weighted terms.

The new government has adopted a new framework for economic policy, with the support of the IMF, World Bank and Asian Development Bank, which holds the prospect of maintaining macroeconomic stability and creating greater confidence among domestic and foreign investors. On February 4, the IMF Board of Directors, with U.S. support, approved a new three-year program for Indonesia. Now, Indonesia must focus on implementation of its policy agenda.

In our view, Indonesia faces four main economic challenges.

1. The Macroeconomic Dimensions of Growth

Indonesia can take considerable comfort in the progress achieved in stabilizing inflation, the recovery in the exchange rate, and the fall in interest rates.

Going forward, Indonesia faces a difficult balance between the near-term need to stimulate the economy, invest in social programs and recapitalize the banking system, and the longer term challenge of reducing public debt and reducing dependence on foreign official assistance.

In the economic program outlined in the agreement with the IMF, the government decided to avoid a further expansion in the fiscal deficit (targeted in the program at nearly five- percent of GDP for FY2000). With ambitious targets for government asset sales and privatization of state-owned enterprises, the government hopes to begin to reduce the large public debt burden.

Over the medium term, once the recovery is more firmly established, the government will have to put in place a credible program for reducing the public debt burden further, and as it moves toward fiscal decentralization, will have to ensure that the transfer of fiscal resources to the regions is accompanied by a commensurate transfer of responsibilities and capacity.

In this context, it is critically important that the government commit to preserve the independence of the central bank, whose policies have been responsible for much of the return to stability.

The government's macroeconomic framework is designed so that, by the end of the IMF program, Indonesia would no longer need exceptional balance of payments support or further debt rescheduling.

Economic growth will not recover with any strength in Indonesia without a recovery in private sector activity. A recovery in private investment now depends critically on progress toward repairing the financial sector and restructuring insolvent banks and corporations.

The Indonesian government's efforts to restructure, recapitalize, and privatize both the state-owned and nationalized banks (which together now account for about 70% of banking system liabilities) have been painfully slow and inadequate. The Indonesian Bank Restructuring Agency (IBRA), which now holds assets amounting to roughly 50% of GDP, has made alarmingly little progress in recovering non-performing loans and disposing of the assets that it now holds. Restructuring has been hampered by private debtors' belief that they ultimately will not be forced to pay, foreign banks' reluctance to invest due to concerns about transparency and governance, and political pressure on IBRA not to write down or collect on claims. Restructuring delays have severely impeded the growth of bank credit and added to the government's fiscal costs and already high debt burden.

Financial and corporate sector restructuring is the central focus of the government's program with the IMF. The program outlines several priorities for the financial sector: first, restructuring and privatization of state-controlled banks, which the Indonesian government committed to begin before the end of March; second, improving supervision and governance in the banking sector; third, minimizing the public cost of the remaining recapitalization; and fourth, deepening bond and equity markets, which will provide alternatives to bank finance.

On the corporate debt restructuring side, the IMF program calls for: stronger powers for IBRA, able to restructure debt without political interference, and mandated to send recalcitrant debtors to bankruptcy court; better implementation of the bankruptcy law, so that the threat of bankruptcy proceedings provides troubled debtors with a real incentive to restructure debt with creditors; and measures to combat corruption in the judiciary, including stepped-up investigation of bankruptcy judges suspected of corruption.

3. Bolstering Transparency and the Rule of Law

The challenge of creating a legal system that allows creditors to enforce their rights, permits the bankruptcy regime to work, and provides a mechanism to begin to unravel the legacy of corruption this government inherited is essential to recovery in Indonesia.

This is why the work of the newly appointed Indonesian Attorney General is so important to the success of the economic program. This is why the U.S. and other countries, working with the international financial institutions, made judicial reform a centerpiece of the recent consultative group meeting of donors.

Foreign investment and domestic flight capital are unlikely to return to Indonesia in the amount necessary to finance future growth until investors are more confident that they will be treated fairly by the legal system, that they will be protected from discrimination, and that they will be safe from the selective assignment of privileged economic rights that prevailed under the Suharto regime. This confidence is critical to an effective process of unwinding the complex interests tied up in the claims now held by the government.

The IMF program outlines measures for greater transparency in many areas, including fiscal management (both in central and regional governments), the operations of the central bank, the judicial system, and commercial bank and corporate governance (including accountability and disclosure standards).

The IMF LOI includes a strong commitment to audit the Indonesian military, including extra-budgetary sources of income, and to report findings to civilian authorities. The Indonesian Coordinating Minister for Economics and Industry, Kwik Kian Gie, has assured us that the audit has begun and will be completed by August 31.

The LOI also contains commitments to speed up the resolution of disputes with independent power producers (IPPs). The new government has committed to become directly involved in accelerating negotiations between the state power company and the IPPs and has already taken the step of replacing the state power company's management, and ensuring that various lawsuits against several IPPs were dropped.

The new government has moved to address one of the most conspicuous recent examples of public corruption in the Bank Bali case. An independent investigation of the scandal by was undertaken by PriceWaterhouseCoopers (PWC) and released publicly by the Indonesian government in October. The Indonesian attorney general took up the investigation where PWC left off and has committed to follow through on the investigation. The attorney general has named several suspects, including a former cabinet minister.

Delivering a more substantial and broad-based improvement in the economic welfare of Indonesians is a fourth important challenge for the new government. A broad majority of Indonesians will not support the economic reform program unless they believe that it will bring about a tangible improvement in their welfare. In an increasingly constrained budgetary environment, given the costs of resuscitating the banking sector, it will be vital to ensure that social investments are better targeted to the people who need them most. This means:

• Building on past successes in community-based provision of basic social services, with greater decentralization and transparency and wider participation to command credibility and popular trust.

• Maintaining and extending the impressive efforts that have been made to keep children in school through the crisis -- an investment that will pay off many times over in faster growth and greater social cohesion in the years to come.

• Focussing on greater and more effective provision of critical health services -- particularly basic preventive care.

In the area of labor conditions, Indonesia has made considerable progress during the past year in affording its workers rights of association and collective bargaining. Partly in response to the urging of the United States and the IMF, Indonesia ratified ILO Convention 87 (Freedom of Association) in 1998. During 1999 Indonesia ratified ILO Conventions 105 (abolition of forced labor), 111 (employment discrimination), and 138 (child labor), becoming the first East Asian country to ratify all seven of the core ILO conventions. We have been informed that Indonesia intends to introduce new labor legislation by October of this year, which would bring its laws into conformance with the ILO conventions.

Our hope is that the new Indonesian government will move quickly to take advantage of its electoral mandate, and the broad political support in favor of economic reform, to move quickly to implement the new program. Among the most important steps the new government could take to establish its credibility with its citizens and with investors are:

• Demonstrating that officials of IBRA, Bank Indonesia, and other economic agencies can carry out their official duties without fear of inordinate political interference or constraints.

• Indicating the government intends to get out of the banking business, by transferring controlling shares of government-owned banks to the private sector. An important step will be IBRA's sale of shares in Bank Central Asia (BCA), which is expected before end-March.

• Replacing management responsible for the large losses of state-owned banks.

• Demonstrating progress on disposal of assets by IBRA, even where this means writing down debt. An important indicator will be the planned sale of IBRA's stake in the leading Indonesian vehicle maker Astra International. This would be a significant step toward meeting IBRA's key end-March asset sales target.

• Sending a clear signal to large debtors that unless they cooperate, they will be prosecuted and their assets seized. Specifically, IBRA needs to pursue high-profile recalcitrant debtors through the insolvency system.

• Demonstrating a willingness to see foreign investors as part of the solution to Indonesia's corporate and financial sector debt problems -- and not part of the problem -- through the sale of a substantial stake in a large Indonesian corporation or bank to foreign investors. As is has been true elsewhere in Asia, foreign banks could be an important source of support for financial sector modernization in Indonesia, not only as sources of needed capital but greater financial resilience in the future.

• Investigating and prosecuting judges who have engaged in corrupt practices. The word must go out that in a new Indonesia, no one is above the law and the laws will be fairly enforced.

The United States and the international community should be prepared to help Indonesia with its ambitious reform agenda. On the economic and financial front, we can be most effective in the following areas:

- Supporting an adequate scale of official finance in this period of economic distress and transition. The new IMF supported program approved earlier this month will provide approximately $5 billion in financing -- dependent on continued and forceful implementation of conditions -- over the next three years. The World Bank and Asian Development Bank together have about $7.8 billion in already-approved loans in the pipeline that have yet to be disbursed.

- Focusing the international financial institutions on the core challenges facing the new government, with reforms concentrated on those steps necessary to restore an environment conducive to private enterprise and new investment, an adequate safety net with important investments in health and education, and growth oriented macroeconomic policies.

- Supporting an appropriate breathing space on external debt service, including a rescheduling of Paris Club obligations. We have signaled that we are ready to work with other Paris Club creditors to achieve a further rescheduling of Indonesia's obligations. This would provide another two years of relief to strengthen the government's capacity to carry through with its economic policy agenda.

- Providing an expanded program of technical assistance, in cooperation with State, AID and other agencies, targeted toward public debt management, fiscal decentralization, financial and corporate restructuring, and law enforcement.

Indonesia's most pressing economic challenges are in many ways more political than economic. Progress depends critically on the political capacity of the government to act.

The new government has outlined a credible program of political change and economic reform. Combined with the general improvement in the economic environment in Asia and the world economy as a whole, this creates the potential for substantial and enduring improvement in economic conditions for the people of this important nation.