Survey of recent developments

Macroeconomic conditions have been improving slowly but steadily since the beginning of the year. The exchange rate had strengthened to below Rp 8,700/$ by mid June. Stock prices have also rebounded. Inflation has been declining since February after increasing steadily for almost two years. Real interest rates are now below pre-crisis levels. These developments have been supported by a combination of positive moves on the policy front and an improvement in relations with the international community. After several months of indifferent performance the Megawati government has made some progress in several key areas of the reform program, as evidenced by the long delayed divestment of Bank Central Asia, a flicker of life in the stalled privatisation program, some significant taxation reform, and the abolition of costly subsidies. In April 2002 the International Monetary Fund (IMF) approved the disbursement of a further $347 million loan, and the Paris Club of creditor nations agreed to reschedule $5.4 billion of Indonesia's debt service payments. Output grew by 2.5% in the year to Q1 2002. While this was lower than forecast, there is consensus among analysts that growth of 3.5-4% in calendar 2002 is within reach. Weak first quarter growth can be attributed partly to factors outside the government's control: severe floods in February and continuation of the global economic slump that began in 2001. Nevertheless there is no room for complacency. The recovery has been fuelled mainly by consumer demand. Improvements in investor confidence have been reflected so far only in portfolio investment flows, while the net foreign direct investment outflow has continued unabated. Investment spending is still contracting, and the banking system remains fragile. There is little room for manoeuvre on the fiscal front because of the huge domestic debt service burden resulting from the government guarantee of bank deposits, and the planned budget deficit for 2002 may be exceeded unless more rapid progress with privatisation and divestment of bank sector assets can be achieved. Corruption in the customs service is creating a drag on recovery especially for exporters and other producers dependent on imported inputs-while there seems to be an increasing tendency for the courts to be used as instruments of extortion, especially in relation to foreign companies. Much remains to be done in Setting up a viable set of arrangements in relation to decentralisation, especially in delineating the boundaries of authority for different levels of government.