Report and Recommendation of the President to the Board of Directors

Sri Lanka Project Number: 40272 November 2007

Proposed Loan Republic of Indonesia: Third Development Policy Support Program

CURRENCY EQUIVALENTS (as of 30 October 2007)

Currency Unit – rupiah (Rp)

Rp1.00 = $0.000110

$1.00 = Rp9,114

ABBREVIATIONS ADB – Asian Development Bank ASEAN Association of Southeast Asian Nations AusAID – Australian Agency for International Development BAPPENAS – Badan Perencanaan Pembangunan Nasional

(National Development Planning Agency) BAWASDA – Badan Pengawas Daerah (Regional Supervision Agency) BI – Bank Indonesia BNI – Bank Negara Indonesia BOS – Bantuan Operasional Sekolah (Operational Aid to Schools) BPK – Badan Pemeriksa Keuangan (State Audit Agency) BPKP – Badan Pengawasan Keuangan Pemerintah

(government-wide internal auditor) BSNP – National Education Standard Agency CAS – country assistance strategy CCT – conditional cash transfer CDD – community designed development CPA – core policy area CSP – country strategy and program DG – Directorate General DIPA – Daftar Isian Proyek Anggaran (spending warrants) DPL – Development Policy Loan DPR – Dewan Perwakilan Rakyat (House of Representatives) DPSP – Development Policy Support Program e-GP – e-government procurement GDP – gross domestic product GFMRAP – Government Financial Management and Revenue

Administration Project IG – Inspector General IMF – International Monetary Fund KPK – Komisi Pemberantasan Korupsi (Anti-Corruption Commission) KPPN – Kantor Pelayanan Perbendaharan Negara (State Treasury

Office) LIBOR – London interbank offered rate LPKPP – Lembaga Pengembangan Kebijakan Pengadaan Pemerintah

(Goods/Services Procurement Policy Development Institute) LPND – Lembaga Pemerintah Non Department (Non-governmental

government institute) MDG – Millennium Development Goal MOF – Ministry of Finance MPW Ministry of Public Works MTEF – medium-term expenditure framework NBFI – nonbank financial institution NPPO – National Public Procurement Office

NPRS – National Poverty Reduction Strategy NSW – National Single Window PEPI – Tim Nasional Peningkatan Ekspor dan Peningkatan Investasi

National Team on Accelerating Investment and Exports PFM – public financial management PMK – Peraturan Menteri Keuangan (Ministry of Finance regulation) PNPM – Program Nasional Pemberdayaan Masyarakat (National

Community Empowerment Program) PP – government regulation PPP – public-private partnership RAN-PK – Rencana Aksi Nasional Pemberantasan Korupsi (an

anticorruption package) RDA – Regional Development Account) RDI – Rekening Dana Investasi (central government investment

funding) RENSTRA – rencana strategis (strategic plan) RKP – Rencana Kerja Pemerintah (Government’s Annual Work Plan) RPJM – Rencana Pembangunan Jangka Menengah (Government’s

Medium-Term National Development Plan) SME – small and medium-sized enterprise SOE – state-owned enterprise TSA – treasury single account UCT – unconditional cash transfer UNDP – United Nations Development Programme UNESCAP – United Nations Economic and Social Commission for Asia and

the Pacific USAID – United States Agency for International Development VAT – value added tax

NOTE

In this report, "$" refers to US dollars.

Vice President C. Lawrence Greenwood, Jr., Operations Group 2 Director General A. Thapan, Southeast Asia Department (SERD) Country Director J. A. Nugent, Indonesia Resident Mission (IRM), SERD Team leader P. Rajapakse, Principal Country Specialist, IRM, SERD Team members T. Niazi, Public Sector Management Specialist, SERD R. O’Sullivan, Senior Counsel, Office of the General Counsel H. Purnomo, Project Officer (Finance/Small and Medium

Enterprises), IRM, SERD V. Subramanian, Senior Financial Sector Specialist, SERD

S. Synnerstrom, Governance Advisor, IRM, SERD The proposed third phase of the Development Policy Support Program cofinances the Fourth Development Policy Loan (DPL-4), which is being coordinated by the World Bank. The ADB team has worked closely with the World Bank (W. Fengler, task team leader; W. Wallace, lead economist; S. Eckardt, J. Factora; and other sector experts) and the Government of Japan (T. Yasui).

CONTENTS

Page

LOAN AND PROGRAM SUMMARY i

I. THE PROPOSAL 1 II. THE SECTOR AND MACROECONOMIC CONTEXT 1

A. Sector Performance, Issues, and Opportunities 1 B. Program Structure and the Government’s Strategy 5 C. Lessons 8

III. THE PROPOSED PROGRAM 11 A. Impact and Outcome 11 B. Policy Framework and Actions 11 C. Monitoring the Impact of DPSP-3 21 D. Triggers for Future DPLs/DPSPs 21 E. Financing Plan 24 F. Implementation Arrangements 25

IV. PROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS 26 A. Expected Impacts 26 B. Risks and Mitigating Measures 27

V. ASSURANCES 28 VI. RECOMMENDATION 28

APPENDIXES 1. Design and Monitoring Framework and DPL Results Framework 29 2. Accomplishments under the DPL/DPSP Series and Remaining Challenges 38 3. Background Information on the Triggers for the Third Development Policy Support 45 Program (DPSP-3) 4. Development Policy Letter and Policy Matrix for the Third 52 Development Policy Support Program 5. Macroeconomic Assessment Letter form the International Monetary Fund 69 6. Development Partners Coordination Matrix 72 7. Ineligible Items 74 8. Fiduciary Assessment 75 9. Summary Poverty Reduction and Social Strategy 87

LOAN AND PROGRAM SUMMARY Borrower Republic of Indonesia Classification Targeting Classification: General intervention

Sector: Law, economic management, and public policy Subsector: National government administration Themes: Governance, sustainable economic growth, capacity development Subthemes: Financial and economic governance, promoting macroeconomic stability, institutional development

Environment Assessment Category C Program Description The proposal comprises the third phase of the Development Policy

Support Program (DPSP-3), which is subprogram 2 of a program cluster building on the support provided through subprogram 1 of the cluster approved by the Asian Development Bank (ADB) in December 2006 and the first DPSP which was approved in December 2005. The DPSP series—cofinancing the Development Policy Loan (DPL) series supported by the World Bank and the Government of Japan—is embedded in the Government’s Medium-Term National Development Plan (RPJM) for 2004–2009. It supports the RPJM’s broad goals of stimulating higher and sustainable economic growth (up to 7% average annual growth by 2009 from levels of around 4% prior to 2004) and halving poverty (to 8.2% by 2009 from 16.6% in 2004). To achieve these goals, DPSP-3 supports wide-ranging reforms in three core areas to (i) improve the investment climate, (ii) strengthen public financial management and anticorruption, and (iii) improve public service delivery. DPSP-3 is proposed as a single-tranche operation based on completed actions demonstrating satisfactory progress. While building on reforms undertaken during past DPSPs, DPSP-3 sets the groundwork for an expanded policy dialogue for future operations.

Rationale The DPL series aims to harmonize policy reform support from key

development partners. ADB’s involvement in the DPL process effectively builds on and deepens sector-specific reforms supported by ADB through its past, ongoing, and planned operations under the Country Strategy and Program 2006–2009. ADB’s participation in the DPL stems from its endeavors to reduce transaction costs for its developing member countries. The approach is consistent with ADB’s reform agenda, as outlined in the Long-Term Strategic Framework and the Middle-Income Country Initiative. Participation in DPL helps implement and fulfill ADB’s obligations to the Rome Declaration on harmonizing procedures of multilateral development banks (February 2003) and the Paris Declaration on Aid Effectiveness (March 2005).

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Impact and Outcome The impact of DPSP-3 will be in the form of higher economic growth that is sustained over the medium term and lower levels of poverty and unemployment. Its principal outcomes include (i) improved macroeconomic stability, (ii) better investment climate, (iii) good governance in public administration, and (iv) improved delivery of public services. DPSP-3 consists of reforms in the latter three core policy areas.

Financing Plan For DPSP-3, the Government has requested ADB to provide a

loan of $200 million. DPSP-3 provides parallel cofinancing for the World Bank supported Fourth DPL (DPL-4), for which the Government has requested $600 million. The Government has also requested $200 million from the Government of Japan to cofinance DPL-4.

Loan Amount and Terms A single-tranche program loan of $200 million from ADB’s ordinary

capital resources will be provided under ADB’s London interbank offered rate (LIBOR) based lending facility. The loan will have a 15-year term, including a grace period of 3 years; an interest rate determined in accordance with ADB’s LIBOR-based lending facility; a commitment charge of 0.75% per annum; conversion options that may be exercised in accordance with the draft loan agreement, the loan regulations, and ADB’s conversion guidelines; and such other terms and conditions as are set forth in the draft program loan agreement.

Disbursement The loan will be disbursed in a single tranche upon declaration of

loan effectiveness. Program Period The Program implementation period for DPSP-3 is from January to

December 2007 and the loan amount will be disbursed in a single tranche upon declaration of loan effectiveness. DPSP-3 covers progress made in general macroeconomic and key high-level sector reforms during the course of 2007. All actions included in the policy matrix have been implemented within the year. DPSP-3 fits within the overall reform agenda supported under the DPLs, which cover 2003–2008.

Executing Agency Coordinating Ministry of Economic Affairs Procurement The loan proceeds will be used to finance the full foreign exchange

costs (excluding local duties and taxes) of items produced and procured in ADB member countries, excluding ineligible items and imports financed by other bilateral and multilateral sources. In accordance with the provisions of ADB’s Simplification of Disbursement Procedures and Related Requirements for Program Loans, the loan proceeds will be disbursed to the Republic of Indonesia as the Borrower. No supporting import documentation will be required if, during each year when loan proceeds are expected to be disbursed, the value of Indonesia’s total imports minus imports from nonmember countries, ineligible imports, and

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imports financed under other official development assistance is equal to or greater than the amount of the loan expected to be disbursed during such year. The Government will certify its compliance with this formula with each withdrawal request. Otherwise, import documentation under existing procedures will be required. ADB reserves the right to audit the use of loan proceeds and verify the accuracy of the Government’s certification.

Program Benefits and Beneficiaries

The key benefits expected from the DPSP series are: (i) Progress toward the Government’s medium-term objectives of

macroeconomic stability and creditworthiness, improved investment climate, reduced corruption, and improved governance.

(ii) Raising the profile of key issues at the ministerial level, accelerating the timetable for policy actions to be taken, addressing administrative and bureaucratic bottlenecks, and providing an impetus for decision makers to further coordinate across economic and line ministries.

(iii) Institutional development within government institutions, Bank Indonesia, and banks.

(iv) Greater public confidence in the banking system stemming from implementation of the deposit protection scheme.

(v) Sustained ADB engagement in policy dialogue with the Government on the direction and content of, and strategies for, its economic, structural, and institutional reform agenda—with DPSP-3 providing for policy continuity and consistency in sectors where ADB has been actively involved.

(vi) Facilitation, through crosscutting reforms, of sector-specific reforms in areas where ADB is providing or planning support.

(vii) Harmonization and parallel financing by the key development partners (ADB, World Bank, and Government of Japan) around a common policy framework and dialogue, and the resulting endorsement of the Government’s sound policy implementation and macroeconomic management.

Risks and Safeguards Implementation of the DPSP series is subject to the following risks:

(i) External vulnerabilities. With its increased integration into

global capital markets, Indonesia remains vulnerable to such external shocks as a capital account shock or a global economic slowdown. With improvements in its macroeconomic indicators, however, the economy’s resilience to external shocks has increased. Factors limiting the potential impact of external shocks include diversity of exports, limited external debt exposure, and an adequate level of reserves. While significant subsidies continue in fuel and electricity, by more than doubling domestic fuel prices in 2005 Indonesia has significantly reduced its vulnerability to volatile global petroleum prices. The banking sector is also now sufficiently strong to weather a moderate external shock. The maintenance of a financial sector safety net supported by the DPL/DPSP series will help to improve the resilience of the banking sector.

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(ii) Policy Coordination risks. Economic volatility could worsen if the Government does not sustain the reform momentum to follow up on the reduction in fuel subsidies. Lack of progress in structural reforms or investment in infrastructure could soon lead to bottlenecks which would limit investment and potential growth. Following the volatility of the October 2005 fuel price hike, however, the need for rapid policy adjustment on the domestic front in line with key global developments is clearly recognized. The Government and Bank Indonesia have also considerably enhanced their coordination, which will be reinforced by the measures under DPSP-3. (iii) Fiduciary constraints. Notwithstanding the improvements underway, there are continuing concerns on the utilization of public resources. The overall fiduciary assessments undertaken since 2001 (with the Country Financial Accountability Assessment) have indicated considerable improvements in the overall fiduciary environment in Indonesia. Ongoing programs supported by several development partners provide significant technical assistance support to strengthen fiduciary governance. The DPSP focus on treasury single account implementation will significantly enhance transparency. (iv) Public opposition to reforms. Tariff reforms and some aspects of investment climate reforms, such as relate to labor, are generally opposed by the public as well as special interest groups. The Government managed the fuel subsidy reduction well, but labor reforms have slowed. DPSP allows for flexibility, enabling the Government to build consensus for reforms to ensure their acceptance. (v) Heightened security risks. Alerts stemming from sectarian and regional conflicts and terrorism could slow foreign direct investment and set back the recovering tourism industry. The Government and law enforcement authorities have taken a range of measures aimed at rebuilding public and investor confidence.

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on a proposed loan to the Republic of Indonesia for the Third Development Policy Support Program (DPSP-3), which constitutes the second of two subprograms of a program cluster for the DPSP. The design and monitoring framework is in Appendix 1.

II. THE SECTOR AND MACROECONOMIC CONTEXT

A. Sector Performance, Issues, and Opportunities

2. Ten years after the East Asia financial crisis, Indonesia has transitioned into a very different country, becoming in the process more stable, more democratic, and increasingly resilient to both internal and external shocks. The concern is no longer one of economic stabilization and recovery, but is one of achieving and sustaining higher rates of growth to reduce unemployment, poverty, and overall levels of vulnerability. To achieve these objectives, the Government is pursuing a pro-growth agenda while pushing forward on broad structural and institutional reforms. Progress has been made on all fronts, albeit unevenly in some areas. Despite recent improvements, there is a continued need to improve the investment climate, public financial management, and service delivery mechanisms to the poor. The DPSP series has allowed the Government to work with development partners in a flexible manner to implement critical high-level macroeconomic and crosscutting sector reforms that address constraints to growth and poverty reduction while providing predictability of financial support. As such, its coverage is fairly broad. Governance is a recurring theme throughout the DPSP series, as it aims to promote transparency in all its core policy areas. The proposed DPSP-3 is anchored in the country strategy and program,1 which in turn provides for deeper sector-level interventions to complement the macroeconomic and governance reforms supported through DPSP-3. DPSP-3 builds on past DPSP operations to further support the Government on key reform measures in the core areas of investment climate, public financial management and anticorruption, and service delivery to the poor. 3. Sustained Macroeconomic Performance. Economic growth has picked up in 2007 following a mild slowdown in 2005 and the first half of 2006 caused by a sharp spike in administered fuel prices and a subsequent hike in interest rates. Year-on-year growth rates dipped to 5% through mid-2006, but then recovered to 6% in the second half of 2006 and edged up to 6.1% during the first half of 2007. The main drivers in recent growth were private consumption, a recovery in private investment, and solid expansion of net exports. These developments have been underpinned by a pickup in domestic credit and falling inflation and interest rates. Year-on-year inflation eased to 6.9% in October 2007, from a peak of 18.4% in November 2005, as the impact of the 126% rise in fuel prices in October 2005 faded. Inflation is now within the Bank Indonesia (BI) inflation target range of 5–7%. With the easing of inflationary pressures, BI, which had earlier lifted its policy rate (SBI 1 month) by 450 basis points in response to the rise in prices, has lowered interest rates from 12.8% in May 2006 to 8.25% in July 2007. In recent months BI has maintained this rate in view of the rising volatility in international markets, and inflationary developments. 4. The lowering of the BI rate has led to a corresponding reduction in commercial bank lending and deposit rates and a recovery in credit growth. Notwithstanding an easing of deposit

1 ADB. 2006. Country Strategy and Program (2006–2009): Indonesia. Manila.

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rates, deposit mobilization has continued to gather pace and reflect growing public confidence in the banking sector. The stronger growth in lending led to increased profitability for banks, as lending rates are less elastic than deposit rates with respect to BI’s policy rate. At the end of July 2007, banks’ nonperforming loans amounted to 6.5% (gross) and 3.o% (net). Banks remained well capitalized, with a capital adequacy ratio of 20.5%. Indonesia’s strengthened fundamentals and yield differentials have attracted significant foreign portfolio inflows and helped propel the Jakarta Composite Index up by 46.4% between end-2006 and end-October 2007. The portfolio inflows, in turn, helped to support the rupiah, which has remained broadly stable amidst some volatility in recent months. The overall favorable external developments also led to a fall in the external debt-GDP ratio (one of the main external risk indicators) to 33% in 2006 from around 82% in 2001. Citing the improved policy environment, Standard & Poor’s raised Indonesia’s sovereign rating from B+ in 2006 to BB- in 2007. 5. Fiscal policy remains geared towards accelerating development spending2 while at the same time reducing public debt. Higher social spending has been made possible by the fiscal space of about $10 billion a year generated as a result of reduction in the fuel subsidy, as well as by increased revenues of about $5 billion from more effective tax administration and declining debt service payments. As a result, expenditures on education as a proportion of total national expenditures have gone up from 14.2% in 2004 to an estimated 17.1% in 2007 while expenditures on health have increased from 3.8% to 4.5% during the same period. The overall budget deficit has been gradually increasing in recent years from 0.5% of GDP in 2005, to 0.9% in 2006, and a projected 1.5% of GDP in 2007 (versus a budgeted 1.1%). This reflects expenditures to mitigate the effects of natural disasters and recognition of the need to ramp up much-needed development expenditures, which have been lagging behind those of other countries in the region. Before the crisis, development expenditures had been generally around 7–8% of GDP. These dropped considerably at the time of the financial crisis and have been fairly stagnant at around 2–3% of GDP since then. Although good progress has been made over the past 2 years in reallocating spending from inefficient subsidies towards pro-poor programs, there are concerns over the quality of such spending. That is especially true regarding health, where more resources appear to be going to services predominantly used by richer income quintiles (secondary care). Moreover, spending on health, at below 1% of GDP, is low by most international standards while total investment on infrastructure (public, private, and state-owned enterprises), at around 3% of GDP, is still substantially below pre-crisis levels of 5–6% of GDP. As a result, the road network, port facilities, water supply and sewerage facilities, and electricity supply are all in need of substantial new investments. The proposed budget for 2008 indicates a significant increase in resources for the infrastructure and social sectors and a small increase in the overall deficit to 1.7% of GDP. 6. Indonesia’s move to decentralization in 2001, when significant authority was devolved to district governments, has significantly altered the fiscal fundamentals of the country. In 2006, with the greater fiscal space provided by reduction in the fuel subsidy, transfers to the regions increased from Rp150.5 trillion in 2005 to Rp226.4 trillion in 2006. These are projected to rise further to Rp252.5 trillion in 2007. Here again there are issues relating to the overall effectiveness of expenditure orientation, as increased fiscal transfers to the regions having been offset to some extent by the accumulation of regional government bank deposits, reflecting limited implementation capacity at the regional level. As of March 2007, the regions were estimated to hold the equivalent of 2.5% of GDP in cash deposits with commercial banks. The central Government is encouraging local governments to use these large deposits to increase priority spending, notably on education, health, and infrastructure. The central Government is 2 Development spending comprises capital and social assistance spending.

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also currently rolling out a community-designed National Community Empowerment Program (PNPM) that could become a vehicle for lifting development spending by local governments. The program will provide resources to communities to undertake locally executed small-scale public works projects. 7. The Government aims to meet the additional financing for the fiscal deficit through issuing government securities and through higher concessional borrowing from development banks. In this context, the Government has requested Asian Development Bank (ADB) to increase its program lending from $600 million to $900 million. Notwithstanding increased budgetary financing requirements, given the sources of financing and steady economic growth, the total Government debt-GDP ratio is projected to decline to around 35% at the end of 2007 from 39% at the end of 2006.

Table 1: Indonesia Key – Macroeconomic Indicators Indicator 2002 2003 2004 2005 2006 Real GDP growth (%) 4.5 4.8 5.0 5.7 5.5 Inflation (%; average of period) 11.8 6.8 6.1 10.5 13.1 M2 growth (% annual growth) 7.9 9.8 10.0 13.0 18.1 External debt (as % of GDP) 67.2 57.7 53.5 46.6 36.6 Debt service ratio (as % of exports of goods and services) 32.1 29.8 31.2 38.6 37.5 Overall fiscal balance (as % of GDP) (1.6) (2.0) (1.4) (0.3) (0.9) Current account balance (as % of GDP) 4.0 3.5 0.6 0.1 2.6 Gross official reserves ($ billion) 32 36.3 36.3 34.7 42.6 in months of imports 6.8 6.1 4.8 4.4 4.8 ( ) = negative. GDP = gross domestic product; M2 = broad money. Sources: Bank Indonesia, Central Bureau of Statistics, IMF Article IV 2007. 8. Translating Growth into Poverty Reduction and Human Development—Poverty Profile and Prospects for Attaining the Millennium Development Goals. Indonesia has had a good track record in poverty reduction and social development. The proportion of people living below the national poverty line declined consistently from about 40% in the mid-1970s to just above 17% in 1996. It subsequently had a sharp spike during the Asian financial crisis—increasing to 23.4% in 1999—before declining to the precrisis levels of 16% in 2005. By March 2006, however, the poverty incidence had risen once again to 17.8% (translating into an additional 4 million people falling into poverty). The rise in poverty is largely attributed to higher rice prices, due in part to drought conditions that delayed the planting season, a ban on rice imports, and the inflationary impact of the fuel subsidy reduction. More recent data, however, suggest that the pickup in growth since the latter half of 2006 has led to a decline in the incidence of poverty to around 16.7% as of March 2007. These levels of poverty, however, translate to 37.2 million poor people and remain far from the Millennium Development Goal (MDG) target of 7.6% by 2015, and the Government’s own target of 8.2% by 2009. While the level of extreme poverty (those living on less than $1 per day) remains relatively low at 8.5%, the proportion living below $2 per day is 49.6%, or about 10 percentage points higher than the comparable average for East Asia (including People’s Republic of China). These figures suggest that there is a very large group of near-poor in Indonesia who are highly vulnerable to shocks at all levels. The poverty profile in Indonesia also indicates vast regional differences in

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poverty, with four provinces having poverty rates of less than 10% (with Jakarta at 3.4%) even as at least 14 provinces have poverty rates of more than 20% (with Papua at about 50%). A challenge for the Government is that while the poverty incidence is far higher in eastern regions, most of Indonesia’s poor actually live in the densely populated and relatively more prosperous western regions. 9. Indonesia’s progress toward meeting other MDG targets is somewhat mixed (Table 2). Malnutrition remains a significant public health problem, with the percentage of children under 5 years who are underweight (MDG1, Target 2) rising from 24.6% in 2000 to 28% in 2005. This has been attributed in part to decentralization in 2000, since the responsibilities for the previous highly centralized family nutrition programs were devolved to more than 400 districts. This created difficulties in planning, financing, and supervising these programs. On the second MDG goal relating to education, Indonesia is well on track to achieve the target in primary net enrollment, but it is falling behind in achieving net enrollment in junior secondary education. In relation to the third MDG on gender equality, Indonesia is on track to achieve gender equality in education. The gender gaps in terms of net enrollment rates in primary and lower secondary education have already been closed. Measured in terms of labor market participation in the nonagricultural sector and seats in parliament, however, female participation continues to lag behind that of men. Indonesia is also on track to achieve the MDG target of reducing the under-5 mortality rate by two thirds by 2015, but progress in reducing the maternal mortality ratio has not been sufficient to meet the levels targeted in the MDGs. While the country remains on track for achieving the targets for improved drinking water, it is off track with regard to attaining the target on access to improved sanitation facilities. The country is severely off track in achieving the targets of reversing forestry loss. In most of the MDG-related indicators, sharp regional and socioeconomic differentials remain and progress in many instances remains less than has been achieved by the relatively more advanced regional economies. ADB’s proposed Poverty Reduction and MDG Acceleration Program will help Indonesia meet these challenges.

Table 2: MDGs: Indonesia and Comparator Countries (selected indicators) Goal 1 Goal 2 Goal 3 Goal 4 Goal 5 Goal 7

Eradicate extreme

poverty Universal primary

education Gender equality

Reduce child

mortality

Improve maternal

health

Ensure environmental sustainability

Poverty ($1/day

headcount ratio, %)

Prevalence of

Malnutrition (% under

age 5 under- weight)

Primary Enrollment Ratio (net

%)

Primary Completion Rate

(%)

Girl-Boy Ratio in Primary Schools,

(%)

Under-5 Child

Mortality (per

1,000)

Maternal Mortality

Ratio (per 100,000

live births)

Access to Improved

Water Source, (% rural

pop.)

Access to Improved Sanitation Facilities (% rural

pop.)

Economy 2006 2005 2006 2004 2005 2005 2000 2004 2004 Indonesia 8.5 28 94.8 89.0 96.0 36.0 230.0 69.0 40.0 Cambodia 18.5 45.2 98.9 63.0 92.0 143.0 450.0 35.0 8.0 Lao People’s Democratic

28.8 40.0 83.6 63.0 88.0 79.0 650.0 43.0 20.0

Malaysia – 10.6 95.4 98.0 100.0 12.0 41.0 96.0 93.0 Philippines 13.2 27.6 94.4 75.0 99.0 33.0 200.0 82.0 59.0 Thailand – 17.6 93.1 – 96.0 21.0 44.0 100.0 99.0 Viet Nam 8.4 26.6 87.8 87.0 94.0 19.0 130.0 80.0 50.0 Note: Year listed refers to Indonesia, for all other countries it indicates the most recent year available. Sources: ADB. 2007. Key Indicators 2007. Manila; ADB, UNESCAP, and UNDP. 2007. The Millennium Development Goals: Progress in Asian and the Pacific 2007. Bangkok; and National Socioeconomic Survey (Susenas), Nutritional Status Component, 1989–2005.

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10. Translating Growth into Equity and Efficiency—Progress on the Governance Front. Indonesia has made significant progress in improving governance since the crisis, and particularly over the last 2–3 years. Legal reforms on elections and decentralization have resulted in greater transparency and political accountability. There is open public debate on a wide range of issues including, among others, the Government’s performance, quality of public administration, corruption, and government support to the private sector. Noteworthy also has been the Government’s openness and commitment to fighting corruption. The country’s recent experience with democracy has led to a range of institutions dealing with accountability and oversight. All line ministries have inspectorate generals who are entrusted with internal audit functions. The government-wide internal auditor BPKP reports to the President. The State Audit Agency (BPK) is the external auditor and supreme audit institution, reporting to Parliament. The country has also established and strengthened a range of independent oversight and judicial institutions, such as the Anti-Corruption Commission (KPK), the Anticorruption Court, the Judicial Commission, the Police Commission, and the Prosecutorial Commission. The KPK, which has a strong mandate to fight corruption through prevention and law enforcement, has achieved notable success since it became operational in early 2004, and it is the main vehicle for the President’s anticorruption drive. ADB has provided significant support to strengthen the capacity and role of the KPK and such other independent institutions as the Financial Transactions Analysis and Tracking Center and the Attorney General’s Office. 11. Notwithstanding these developments, considerably more needs to be done. While the President has taken anticorruption seriously, there has been no effective bridge to reduce the significant disconnect between the new vision and the old way of doing business in most of the line ministries and other public sector agencies. An anticorruption package (RAN-PK) was adopted through Presidential Instruction No. 5/2005 in February 2005, soon after the new Government took over. With more than 100 action plans, the package was meant to institutionalize preventive measures against corruption. The package is to be updated annually to include the latest anticorruption initiatives. In September 2006, an updated version of RAN-PK was published, introducing new action plans to improve service delivery, reform the budget system, and improve tax services. An elaborate monitoring and evaluation system to track the progress of government agencies towards fulfilling targets set out in RAN-PK has also been created. Implementation of Presidential Instruction No. 5 has been slow, however, and particularly at the decentralized level.

B. Program Structure and the Government’s Strategy

12. The DPSP supports the development policy agenda of the Development Policy Loan (DPL) series prepared by a joint team of the Government of Indonesia, the World Bank, the Government of Japan, and the Asian Development Bank (ADB). 3 Building on the support provided by DPSP-2 (approved in December 2006), the proposed DPSP-3 will provide parallel cofinancing support to the Government to help implement reforms under the fourth Development Policy Loan (DPL-4), which is the fourth in a program of four annual, single-tranche loans to support high level macroeconomic and crosscutting sector reforms to accelerate economic growth and poverty reduction. The DPL series aims to help the Government achieve its medium-term growth and poverty reduction objectives through four core policy areas: (i) supporting macroeconomic stability and creditworthiness, (ii) improved

3 As ADB did not participate in DPL-1, a different title—DPSP—has been adopted for ADB’s operations. Thus, the

equivalence is as follows: DPL-1 = ADB’s participation through policy dialogue; DPL-2 = DPSP-1; DPL-3 = DPSP-2; and DPL-4 = DPSP-3. The proposed program is in line with ADB’s CSP 2006–2009 for Indonesia, which supports continued cofinancing of the DPLs.

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investment climate, (iii) improved public financial management and anticorruption, and (iv) improved public service delivery to the poor. 13. The Government’s Medium-Term National Development Plan, or RPJM, aims to achieve peace and security, justice and democracy, while advancing the welfare of the people within the time frame of 2004–2009. The RPJM includes the main tenets of a previous draft national poverty reduction strategy and incorporates the eight MDGs that provide an overarching framework placing human development and poverty reduction at the center of the development agenda. The RPJM has set a number of social targets, some of which are more ambitious than the MDGs. For example, it aims to halve the 2004 national poverty rate of 16.6% to 8.2% by 2009. The Government’s annual work plan (RKP), approved each year by the Cabinet, guides RPJM implementation. The RKPs set out annual development priorities, including quantitative targets and policy directions, which in turn determine the budgetary allocations.4 The RKP for 2007 has nine priority areas to address the overall theme of “Increasing Employment Opportunities and Reducing Poverty” (Figure 1). Of these, the first, second, fourth, fifth, and eighth priority areas relate to the four core policy areas of DPSP-3, respectively. This linkage is elaborated further in Section III. 14. The RKP for 2008 indicates that the overall development theme for next year is “Accelerated Economic Growth for Job Creation and Poverty Reduction.” To address this overall theme, the RKP for 2008 has the following eight priority areas: (i) increasing investment, exports, and job opportunities; (ii) revitalizing agriculture, fisheries, forestry, and rural development; (iii) accelerating development of infrastructure and improvement of energy management; (iv) improving access and quality of education and health services; (v) improving the effectiveness of poverty reduction measures; (vi) corruption eradication and accelerated bureaucratic reform; (vii) strengthening defense capabilities and improving domestic security; and (viii) disaster response, disaster risk reduction, and improvement of avian influenza control. 15. To help implement the RKP priorities, there are several policy packages from which specific measures are derived to be achieved within a defined period. The June 2007 package on Policies to Accelerate Development and Empower Micro, Small and Medium Enterprises (Presidential Instruction No. 6/2007) builds on last year’s set of policy packages on infrastructure, investment climate, the financial sector, and small and medium enterprises (SMEs). Through these policy packages, the Government has demonstrated a clear willingness to deal with a number of complex, and in some cases politically sensitive, issues that have been on hold for some time. Each policy package has time-bound actions and stipulates a minister to be responsible for each item. ADB has provided advice that underpins some of the actions in these policy packages and has supported the monitoring of progress on implementation.

4 In an apparent recognition of the difficulty of attaining the poverty target, the 2008 RKP sets a target of reducing

the poverty rate to 15–16% in 2008 from 16.7% in March 2007.

7

16. The DPSP Series, ADB’s Other Sector Programs, and Donor Harmonization. Support for the RPJM through parallel cofinancing of the DPL series is a key pillar of ADB’s country strategy and program (CSP) for 2006–2009. Under the CSP, a dual-track approach is adopted to ensure that the high-level macroeconomic and governance reforms supported through the policy dialogue of the DPL series complement, and are reinforced by, ADB’s sector programs. Figure 2 presents the approach, which involves structuring ADB’s support through (i) participation in the DPLs to strengthen the macroeconomic and fiscal framework while addressing crosscutting concerns; and (ii) sector-specific policy interventions in the areas of

Priority 1 Reduction of poverty and disparities

Priority 2 Employment opportunities,

investment, and exports

Priority 3Revitalizing agriculture and rural

development

Priority 4Improving access

and quality of education and health services

Priority 5 Eradication of

corruption, civil service reform, and

law enforcement

Priority 6Strengthening

defense, security and order, and

conflict resolution

Priority 7Disaster mitigation and reconstructing

Aceh, Nias, and Central

Java/Yogyakarta

SPNK

N

ational Strate gy for P

overty Reduction

RKPAnnual Work Plan

(9 priority areas in 2007)

DPSP = Development Policy Support Program, RKP = Rencana Kerja Pemerintah (Government’s Annual Work Plan), RPJM = Rencana Pembangunan Jangka Menengah (Government’s Medium-Term National Development Plan), SNPK = Strategy Nasional Pengentasan Kemiskinan (National Strategy for Poverty Reduction). Note: Dotted boxes denote areas supported by DPSP program. Source: National Development Planning Agency (BAPPENAS).

Priority 8 Accelerating infrastructure development

Priority 9Developing border areas and remote

isolated areas

RPJMMedium-term Strategy

(3 objectives addressing 33 policy areas)

Objective 1 A safe and peaceful

Indonesia

Objective 2A just and democratic

Indonesia

Objective 3A prosperous

Indonesia

Figure 1: Links between RPJM, RKP, and the DPSP cluster

8

infrastructure, financial deepening, local government finance and public financial management, and poverty reduction and accelerated progress towards the MDGs. ADB’s dual-track approach aims to harmonize and align development partner strategies with Indonesia’s country strategy and priorities. The participation of ADB and the Government of Japan in the World Bank coordinated DPL series, and the participation of the Government of Japan and World Bank in ADB’s Infrastructure Reform Sector Development Program have helped reduce the Government’s transaction costs of policy dialogue with three of the country’s most important development partners. Moreover, development partner harmonization around the Government’s own programs has bolstered country ownership of the reform process and helped change the nature of the relationship with the three development partners to one of reliable collaboration. ADB’s active participation in the policy discussions in all areas of the DPL and the parallel policy dialogue on sector reforms have been particularly appreciated by the Government, as these have helped in setting the overall macroeconomic framework for sector-level reforms supported by ADB. ADB’s engagement in these policy discussions and its strength in the areas of infrastructure, financial sector, decentralization, and support for achieving MDGs have helped avoid duplication of effort and improved the monitoring as well as the quality of the triggers.

C. Lessons

17. The proposed DPL is the fourth operation in a program of annual single-tranche loans. The rationale at its inception in 2004 was to support Indonesia’s transition from postcrisis recovery and stabilization to longer-term strategic development. Four years on, the DPL series has succeeded in providing predictable and harmonized budget support from development partners. This reflects the overall good progress that has been made in implementing reforms and achieving development results (see Appendix 1 Table A1). In this context, it should be noted that while the financing terms of ADB and the other two development partners remain attractive, Indonesia can also access domestic and international capital markets. The main reasons for involvement, then, are the reinforcement and policy engagement that the three development partners provide in the focus reform areas. The following broad lessons can be derived from past and ongoing DPL operations. 18. Government Ownership. The effectiveness of the DPL series has been greatly enhanced by strong country ownership. The DPL reform measures have been taken directly from the Government’s policy packages and built on existing legislation. The Government does not therefore regard including policy actions in the DPLs as a conditionality but rather as support for an integral part of its own program. The DPL series has thus provided a means for decision makers to operationalize the RPJM by translating broad objectives into priority actions. In the process, the DPLs have helped raise the profile of key issues at ministerial level, accelerated the timetable for policy actions to be taken, addressed administrative and bureaucratic bottlenecks at lower levels of the Government, and provided an impetus for decision makers to further coordinate across economic and line ministries. The DPL series have also supported champions within the Government to lock in and accelerate key reform measures. 19. Selectivity. Experience suggests that for the program to remain effective and sustainable there is a need to focus on just a few and meaningful triggers that can create additional reform momentum. The DPL series has tried to address this issue by focusing only on a subset of the Government’s broader development program. It does not pretend to capture the totality of reforms being implemented in the core areas of investment climate, public financial management, and public service delivery. Nor does it address issues where the breadth and depth of the required policy dialogue across a number of areas would indicate that they be better addressed under such sector programs as the ADB and World Bank supported

9

infrastructure reform programs and ADB’s program support for financial sector deepening, local government finance, poverty reduction and MDG acceleration. 20. Diversity, Flexibility, and Long-Term Engagement. A number of areas addressed under the DPL series have had relatively short reform histories, as many of the reforms were initiated after the Asian financial crisis (i.e., public financial management, administrative reforms). There is a need to accept that progress in these areas involving significant structural and institutional reforms could be slower than in some other areas. The design of individual DPL programs has to some extent taken this into account by enabling a progressive deepening of reforms. Thereby, each successive DPL operation has built upon the previous one to ensure incremental implementation. While this has led to advances and successful outcomes in a number of areas (such as the consolidation of core government cash operations into a treasury single account and the phased elimination of blanket guarantees on deposits), in some instances the reform initiatives have come up against a number of obstacles, ranging from bureaucratic resistance to serious capacity constraints. Therefore, in formulating each new DPL program, it has been important to allow for flexibility to accommodate the evolving country circumstances and political economy. Experience has also suggested the importance of aligning with reform champions within government to push through reforms, as well as the need to ensure adequate prior buy-in across line ministries and agencies where successful outcomes typically depend on active collaboration across a multiplicity of government institutions. It also underlies the importance of ensuring continuous policy engagement and the provision of capacity building support to underpin the reform efforts.

10

Strategic Framework: Medium-Term Development Plan (RPJM)Outcomes:

(i) Revive economic growth to achieve 7% average annual real GDP growth by 2009. (ii) Halve poverty from 16.6% in 2004 to 8.2% by 2009. (iii) Reduce unemployment by 2009 from the current levels above 10%. (iv) Promote good governance through combating corruption. (v) Ensure peace, safety, security, justice, and democracy for all Indonesians.

Figure 2: Support for the Government’s Medium-Term National Development Plan

DPL Series (Coordinated by the World Bank)

High-level macroeconomic

and cross-sector reforms 2–3 strategic triggers per

core policy area (CPA) Annual program lending

support

Sector Programs under the New CSP (Coordinated by ADB)

Deeper sector-specific

implementation support for policy, institutional, regulatory reforms

Each program designed as a cluster, with subprograms sequenced over 18–24 months

Close seamless coordination moving from

macro-economic to

sector reforms, reinforced by cofinancing

where possible

CPA 1: Macroeconomic Stability and Creditworthiness • Effective fiscal policy • Macro-level support for

decentralization • Fiscal-monetary

coordination • Debt management

CPA 2: Improving Investment Climate • Legal framework • Financial stability • Macro-level support (e.g.,

fiscal incentives, risk-sharing)

CPA 3: Improving Public Financial Management • Transparency and good

governance • Institutional measures (e.g.,

treasury single account)

CPA 4: Improving Public Service Delivery • Establishing and

institutionalizing national-level program evaluation

• Targeted cross-sector reform

Infrastructure Reform Sector Development Program Cluster • Comprehensive sector and cross-sector reforms as

outlined in the Program Cluster over 2005–2010 • Establishment of Project Development Facility • Supporting infrastructure project transactions

Capital Market Development Program Cluster • Enhanced information disclosure and improved price

discovery • Deeper and more liquid financial markets • Improved market surveillance and investor protection • Improved governance and human resource capacity in

market institutions

Local Government Finance and Governance Reform Program Cluster and the State Audit Reform Program • Ex ante planning and budget reforms through Program

Cluster • Streamlining fiscal decentralization • Local government level civil service reforms • Improving public financial management (ex ante aspects

through Program Cluster and internal control and audits through State Audit Reform Program)

Poverty Reduction and Millennium Development Goal (MDG) Acceleration Program Cluster • Improving delivery of health, education, and other

community services in MDG-deficit areas, in a programmatic manner

• Enhancing accountability for service delivery at local government and institutional levels, reinforced by well-defined standards that are based on clear costing

• Facilitating transition towards greater performance-orientation

RPJM = Rencana Pembangunan Jangka Menengah (Government’s Medium-Term National Development Plan); DPL= Development Policy Loan; CSP= Country Strategy and Program; CPA = Core Policy Area; MDG = Millennium Development Goal. Source: ADB.

11

III. THE PROPOSED PROGRAM

A. Impact and Outcome

21. The impact of DPSP-3 will be in the form of higher economic growth that is sustained over the medium term and accompanied by lower levels of unemployment and poverty. Its principal outcomes include (i) improved macroeconomic stability, (ii) better investment climate, (iii) good governance in public administration, and (iv) improved delivery of public services. 22. The design and monitoring framework for DPSP-3 is in Appendix 1. Appendix 2 provides a detailed assessment of achievements under the DPL series and remaining challenges, while Appendix 3 presents some background to the DPSP-3 triggers. The development policy letter and the policy matrix for DPSP-3 are in Appendix 4. A macroeconomic assessment letter from the International Monetary Fund is in Appendix 5. Appendix 6 presents the development partners coordination matrix, outlining support from ADB and other development partners in areas related to the DPSP series.

B. Policy Framework and Actions

23. At its inception in 2004, the DPL series was designed to support Indonesia’s transition from postcrisis stabilization to more long-term development. The DPL was expected to provide the foundation for continued, medium-term policy engagement in the areas of macroeconomic stability, the investment climate, and public financial management and anticorruption. It also provided for a flexible means of taking into account the pace and fluidity of the reform process. Hence, as the program has evolved, the scope of the reform agenda has become broader. The broadening of the agenda has also been accompanied by a deepening of reforms, whereby successive DPL operations have built on previous ones to ensure incremental implementation. Reflecting the Government’s success in recent years in achieving macroeconomic stability and attaining the macroeconomic triggers of the DPL program ahead of time, the Government and development partners have agreed to continue the policy dialogue on macroeconomic stability and, in view of the progress of reforms, to remove the macroeconomic pillar in the proposed DPL-4/DPSP-3. At the same time, the increased fiscal space generated by the reduction in fuel subsidies, declining debt service payments, and increasing revenues has opened up opportunities for a greater focus on public service delivery. Reflecting the ongoing policy focus on decentralized development and education, it was agreed that there should be a trigger on community designed development and education under a new pillar—improved delivery of public services—in DPL-4/DPSP-3. 24. Taken as a whole, the Government is on course to meeting most of the expected outcomes of the DPL program by 2008 (some of which having already been achieved). Table A1 in Appendix 1 presents the DPL Results Framework presented in the World Bank’s program document for a proposed DPL-4. 25. The DPSP-2 program document laid out 20 indicative triggers (prior actions) across 10 policy areas for DPSP-3. 5 Subsequently, it was decided to drop two triggers relating to infrastructure financing and the restructuring of local government debt as these will be covered

5 Table A3.2 in Appendix 3 of the Report and Recommendation of the President to the Board of Directors on the

proposed program cluster and loan to the Republic of Indonesia for the Second Development Policy Support Program (November 2006).

12

more extensively under the ADB-supported Infrastructure Reform Sector Development Program and the World Bank’s proposed Infrastructure Development Policy Loan. DPSP-3 will also not include a trigger relating to the regulatory framework for issuing subnational government bonds, as this will be taken up under ADB’s proposed Capital Market Development Program Cluster. In total DPSP-3 is, therefore, focusing on 17 triggers across 10 policy areas.6 26. In line with the DPL modality, which has been characterized by medium-term engagement, strong country ownership, and continuous policy dialogue with the Government, triggers are used in a more process-oriented and flexible sense with less of a focus on condition compliance. 7 On this basis, satisfactory progress has been made in complying with requirements of the triggers. Of the 17 triggers, Indonesia has met or exceeded the requirements for 13. Satisfactory progress has been made on the remaining four. These four triggers relate to passage of implementing regulations for the investment law, implementation of transparent accountability arrangements for central government investment funding (RDI) and regional development accounts (RDA), setting up of a national procurement office, and introduction of a mechanism to reallocate unused community designed development (CDD) funds into subsequent budget. In the case of implementing regulations for the investment law, the relevant decrees have been drafted and are expected to be issued before the end of 2007. In the case of RDI and RDA accounts, the regulatory framework for RDA accounts is being set up and IT needs are being met. These actions will be monitored in the next DPL/DPSP round. Delays in the case of establishing the procurement office and CDD carryover are mainly procedural, requiring the signature of the President for the former, and the issuance of a ministerial regulation for the latter. Both these actions are expected to occur before the end of 2007.

1. Core Policy Area I: Improved Investment Climate

27. Indonesia invested the equivalent of over 30% of its GDP prior to the crisis. This has since averaged around 19–24%. Such low levels of investment have impeded Indonesia from competing effectively with People’s Republic of China and Vietnam, which benefit from considerably higher investment-GDP ratios. Weaknesses in the investment climate were clearly identified at the outset of the current administration. The Indonesian Chamber of Commerce provided a road map for improving the business environment, and the Government and development partners outlined five high priority policy areas, including (i) taxation, (ii) customs clearance and tariff system, (iii) labor regulation, (iv) infrastructure, and (v) investment policy and SME promotion. Although businesses continue to face significant constraints, there has been steady progress. The gross investment rate rose from 19% of GDP immediately after the crisis to 23.5% in 2005 before declining to 22.6% in 2006 due to high interest rates and inflation prevailing at that time. Inflow of foreign direct investment increased from $1.9 billion in 2004 to $8.3 billion in 2005 and was $7.5 in 2006. Both gross investment and foreign direct investment are projected to come in at considerably higher levels in 2007. Business confidence has strengthened over the past few years, with the rupiah among the top six best-performing currencies tracked by Bloomberg. 6 The following section on triggers should be read along with the background information presented in Appendix 3 on

the DPSP-3 triggers. 7 International experience with policy based lending and recent literature on the subject suggests that a focus on

traditional conditionality could undermine country ownership and sustainability of the reform process (see World Bank. 2005. Conditionality Revisited. Washington DC, and ADB. 2007. Policy-Based Lending: Emerging Practices in Supporting Reforms in Developing Member Countries (draft). Manila.

13

28. Nonetheless, Indonesia’s investment climate continues to rank poorly in international comparisons. Transparency International’s 2007 Corruption Perceptions Index ranked Indonesia 143rd out of 180 countries, while the World Bank’s Doing Business 2007 report ranked Indonesia 135th out of 175 economies on ease of doing business. These comparisons are, however, based mainly on information from 2005 and hence do not reflect recent reforms. More recent surveys of businesses perceptions about the investment climate indicate significant improvements between 2005 and 2007, with the biggest improvement in perceptions of macroeconomic instability and economic policy uncertainty (Figure 3). Macroeconomic instability is still viewed as the biggest obstacle, however, followed by transportation, corruption, electricity, the legal system and conflict resolution, tax issues, and labor issues. To address these issues, the Government has undertaken a good deal of planning and preparation for its policy packages relating to investment reform.

`

29. The investment climate policy package issued in March 2006 listed 85 individual action items assigned to a minister for follow-up responsibility. Fifty-four of these items specified target completion dates, ranging from March to December 2006. Forty-two of the 54 (or 78%) were completed by the end of 2006 and several others reached completion in early 2007. The most notable development is approval of the Investment Law in March 2007, the implementing decrees of which are included as triggers for DPSP-3. Other key achievements include (i) passage by Parliament of revisions to the draft tax laws by the Ministry of Finance (MOF) incorporating proposals from the business community; (ii) creation of new investment tax incentives for certain sectors and regions (Government Regulation No. 1/2007 specifies three types of tax incentive: loss carry forward, accelerated depreciation, and investment tax credits); (iii) establishment of a team to evaluate draft regional regulations, leading to cancellation of 70 regulations; (iv) improvement of the electronic data interchange system at customs to reduce customs clearance time to 30 minutes in the green lane and 3 days in the red lane; (v) cancellation of regional regulations imposing taxes and fees on the movement of goods,

Figure 3: Constraints to Investment(% of firms reporting constraint to be moderate to very severe)

20

21

28

28

29

29

32

3335

35

37

37

38

38

39

39

42

43

43

48

49

53

16

21

23

28

29

27

36

36

36

34

37

37

39

39

38

41

36

47

59

52

42

66

0 10 20 30 40 50 60 70 80 Land Procurement

TelecommunicationFinancial Access

Monopoly PracticesLicense & Permits Central Government

CrimeCustoms&Trade Regulation-NationalCustoms&Trade Regulation-RegionalLicense & Permits Local Government

Labor Regulation Central GovernmentCost of Finance

Labor Regulation Local GovernmentTax Administration

Labor skill & EducationTax rate

Legal System&Conflict ResolutionElectricity

Corruption Central GovernmentEconomic Policy Uncertainty

Corruption Local GovernmentTransportation

Macroeconomic Instability

end-2005

mid-2007

Source: Institute of Economic Research/Faculty of Economics of the University of Indonesia. 2007. Investment Climate Monetary Survey. Jakarta (June).

14

telecommunication towers, and roadside weigh stations; (vi) elimination of VAT on certain primary agricultural commodities to increase competitiveness; and (vii) simplification of procedures for granting visas and residence permits to foreign investors and expatriate employees. 30. Labor reform is one of the most sensitive areas critical to improving the investment climate. Revisions to the Labor Law 13/2003 were proposed for April 2006 as part of the investment policy package. However, following a strong negative reaction from organized labor, the April target could not be met. This represented a setback for investors, as the 2003 law significantly raised hiring costs. For example, severance pay rates are now far higher than in other regional economies, discouraging employers from hiring new workers on a permanent basis. The proposed changes would have addressed this bias against employers and brought labor regulations into line with those of such neighboring countries as Thailand and Malaysia. While the Government has indicated that there will be no comprehensive reforms, it is nevertheless exploring various options such as linking unemployment benefits to pension funds. 31. Triggers under Core Policy Area I. DPSP-3 supports reform measures to improve tax and customs administration, trade policy, and investment procedures; reduce business start-up times; strengthen small businesses; and strengthen the financial sector. 32. Trigger 1: Improve VAT by, among others, reducing the time for VAT refunds through implementation of the DG Tax Regulation No. 122/2006. (Status: Exceeded) Directorate General (DG) Tax Regulation No. 122/2006 is being implemented. Substantial progress has been achieved in VAT administration. Manufacturing exporters surveyed in June 2007 reported that the average VAT refund time had fallen to 5.1 months compared with an average processing time of 12–18 months in 2003. During the past 12 months, the Government has also settled 7,878 VAT refund claims from previous fiscal years amounting to Rp10.4 trillion. This amounted to more than 99% of the backlog. The Government has signaled its intention of further reducing the processing times for VAT refund claims by stating in Presidential Instruction No. 6/2007 that the maximum time to process VAT refunds for compliant (“Golden”) taxpayers will be cut from 1 month to 7 days, for low-risk exporters from 12 months to 2 months, and for medium-risk exporters from 12 months to 4 months. Issuance of a DG tax circular letter on accelerating the settlement process for VAT refunds in July 2007 has further strengthened implementation of Tax Regulation No 122/2006. 33. Trigger 2: Issue MOF Decree on tax audit procedures that allows taxpayers to request details of audit findings and a review in case of disputes after closing conference but before completion of audit. (Status: Exceeded) In late 2006, the MOF and the Directorate General for Taxes issued a number of regulations that affected tax audit procedures. Ministerial Decree 123/PMK.03/2006 revised previous provisions related to tax audit procedures and taxpayer rights. The decree was intended to strike a better balance between the rights and obligations of taxpayers and the powers of tax officials. The regulations allow taxpayers to appeal tax assessments or audits without having to pay 100% of the disputed amount in advance. Taxpayers are also given the right to be present during audit hearings and to receive copies of the results. Article 15 of the decree supports transparent tax audit procedures and strengthened taxpayer rights in disputing audit findings. It requires the tax auditor to inform taxpayers in writing about the results of the audit and closing conference, including details on the audit findings and the legal basis for audit decisions. In addition, the DG tax regulation on desk audit and field audit procedures stipulates taxpayer

15

rights to bring an audit decision to—and request a review by—a higher level authority in case of disputes. Extended taxpayer rights are also embedded in the Tax Law Package passed by Parliament in March 2007. 34. Trigger 3: Roll out a National Single Window with online clearance of merchandise. (Status: Achieved) The Government has signed two international agreements with the Association of Southeast Asian Nations (ASEAN) to establish an ASEAN Single Window by 2008. A blueprint for a National Single Window (NSW) was launched on 7 August 2007. A pilot project for Tanjung Priok, which handles around 60% of Indonesia’s trade, is currently under preparation with a launch date of end-2007. Thus far, DG Customs at Ministry of Finance, the Ministry of Trade, the Food and Drugs Supervisory Board, the Quarantine of Animals Department at the Ministry of Agriculture, and the Quarantine of Fish Department at the Ministry of Fisheries have committed their readiness for implementing the NSW at Tanjung Priok. These five agencies handle around 70% of total import activity. A pilot for food, beverage, and drugs related products commenced in early October 2007. A nationwide launch and integration into the ASEAN Single Window is scheduled by end-2008. 35. Trigger 4: Enhance procedure for tariff setting through implementing better methodology, improved research capability, and better information technology. (Status: Achieved) The technical team supporting Team Tariff (the interministerial team responsible for tariff setting) has been reconstituted by a decree issued by the Finance Minister and its leadership, and coordinating functions have been transferred from MOF to the Ministry of Trade. The World Bank is currently providing assistance to improve the capacity of the technical team. 36. Trigger 5: Implement the Investment Law, its supporting regulations, and new operating procedures. (Status: Satisfactory) Of the four implementing regulations to be issued in 2007, two decrees on negative lists (the criteria for negative lists and the negative list itself) were issued in July 2007. To further support implementing the law, a new investment policy unit was established by decree of the Coordinating Ministry of the Economy in July 2007 as a professional secretariat for the National Team on Accelerating Investment and Exports (PEPI). A second ministerial decree created three working groups under PEPI (each chaired by a minister) for policy formulation; policy implementation; and integrated trade, tourism, and investment promotion. The other implementation regulations on investment procedures and one-stop shops will replace the current investment approval system with a simpler registration system and will support establishing one-stop shops for business licenses. These regulations have been drafted and are likely to be issued before the end of 2007. 37. Trigger 6: Simplify or eliminate unnecessary and/or redundant business licenses, procedures, and multiple registration requirements. (Status: Achieved) In September 2007, the Government announced significant reforms designed to simplify business licenses and the time to establish a company. The Minister of Trade issued two new decrees dated 4 September 2007. The first, on the business trading license, eliminates the need for an on-site inspection prior to issuing the license, reduces the number of prerequisites, simplifies reporting requirements, and allows foreign businesses to hold a trading license. It also

16

established a 3-day ceiling on the time to issue a license (from the previous 14 days). The second decree, on business registration certification, also establishes a 3-day time limit (again from the existing 14 days). On 21 September 2007, the Minister of Justice issued a decree simplifying the procedures to legalize a limited liability company. The decree eliminated the requirement to open a bank account in the name of the new company prior to legalization. This effectively removes several preceding steps, such as the need for a Certificate of Domicile issued by a local government official, a letter from a building manager, and a lease agreement. It also allows tax registration to take place towards the end of the business start-up process, thereby enabling parallel processing in place of sequential processing. At the same time, the Minister of Justice issued a decree rescinding a previous decree that transferred the authority to legalize limited liability companies from its central office to its provincial offices, resolving a problem that had added at least 1 week to business start-up times. The combined impact of these changes—if fully implemented by local governments—should cut business start-up times by potentially more than a month. 38. Trigger 7: Issue a comprehensive SME policy package (including supporting industries) that, among others, increases access to finance and implements the Warehouse Receipts Law. (Status: Achieved) The SME policy package was issued as part of Presidential Instruction No. 6/2007 covering a number of areas pertaining to SMEs. In particular, it highlights several actions related to improving SMEs’ access to finance. This includes recapitalizing credit guarantee firms through a reallocation from existing SME finance programs of line ministries, thereby reducing the credit risk borne by commercial banks. Implementing regulations for the Warehouse Receipts Law have been issued (PP 36/2007). 39. Trigger 8: Implement good corporate governance and risk management standards, particularly in state-owned banks, and continue implementation of financial sector safety net. (Status: Achieved) To promote good corporate governance in the banking industry, Bank Indonesia (BI) issued Regulation No. 8/4/PBI/2006 and followed up with a circular letter on 30 August 2006 to the managements of commercial banks on Preparations for Implementation of Good Corporate Governance Self-Assessment. This circular letter presents guidelines to banks on corporate governance self-assessment, with self-assessment coming into effect from January 2007. The self-assessment is expected to help banks assess their own compliance with the principles of good corporate governance at the individual bank level and take corrective actions. A recent BI survey concluded that nearly all banks had carried out individual self-assessments in accordance with the circular and that approximately 98% of banks in Indonesia have applied a minimum 50% of the good corporate governance principles, as mandated by the BI Regulation. Further, steps to improve governance and combat money laundering have been taken by BI through measures for enhanced cooperation with various law enforcement agencies such as the Indonesian Police, Attorney General, Indonesian Financial Transaction Reports and Analysis Centre, and, most recently, the Anti-Corruption Commission (KPK). BI has also clarified the roles and responsibilities of boards of commissioners and directors and addressed areas with potential for conflicts of interest. Regulations now stipulate that key board committees should have substantial representation of independent commissioners and that there is to be more disclosure of key developments that could affect shareholder rights. With specific reference to state-owned banks, a joint decree on special supervision of these banks to improve performance and corporate governance was issued in February 2007.

17

Implementation of the financial sector safety net program continues, with coverage on deposits having been reduced to Rp100 million in March 2007, as scheduled. Concern about the possible flight to safety and flight to quality of deposits consequent to changing the blanket guarantee scheme to a limited guarantee scheme proved to be unfounded, as the banking system seems to have gone through the transition with little impact.

2. Core Policy Area II: Improved Public Financial Management and Anticorruption

40. Indonesia has made significant progress in strengthening public financial management (PFM), and its efforts have sparked a genuine momentum in the fight against corruption. Taken with the RPJM agenda and overall governance reforms outlined earlier, the PFM measures are beginning to have an impact on the way business is done within the Government. At the national level, the Government aims to have a state-of-the-art PFM system in place by 2008, with support from the World Bank through the Government Financial Management and Revenue Administration Project (GFMRAP) for ex ante aspects of PFM, and with ADB support through the State Audit Reform Program for the ex post aspects focused on internal and external audits. Presidential Decree 80/2003 on procurement set out the basic principles of procurement: transparency, open and fair competition, economy, and efficiency. It covers all areas of procurement that use public funds and is supposed to cover contracting entities at all levels of government. Notable progress has also been achieved in making the national budget compatible with the international standard Government Financial Statistics classification and establishing a treasury single account (TSA). These reforms are making important contributions to increasing efficiency and transparency while reducing corruption in PFM. 41. However, key indicators of government budget performance have not improved, most importantly the pattern of disbursement. Indonesia still makes 50% of its capital expenditures in the last quarter of the year. For the last 5 years, spending has started very slowly and then accelerated. This unhealthy pattern raises concern. Economic activity is disrupted by an unnatural cycle; project implementation starts late or, as in the case of multiyear projects, is interrupted at the beginning of each year. 42. With respect to tax administration, despite progress on extending the modern tax office system, the tax system is still characterized by relatively low revenue generation, poorly defined and overly complicated taxes (i.e., creating excessive compliance costs), and poor and inconsistent enforcement (i.e., creating uncertainty and abuse). In part, the problem requires better oversight of tax officials, and in part it stems from a systematic lack of information and capacity for tax and customs analysis outside of the respective tax and customs offices. The lack of capacity has led to an inability to accurately assess and forecast implications of the proposed tax and customs changes, has reduced checks and balances, and has not permitted balancing taxpayer and government requirements. 43. Triggers under Core Policy Area II. There are six triggers under this area, focused on strengthening budgeting, controls, and transparency in financial management; improving procurement processes and outcomes; and initiating civil service reforms. 44. Trigger 9: Implement a medium-term expenditure framework (MTEF) with a system of clear forward estimates for the 2008 budget. (Status: Achieved)

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The 2008 budget submitted to Parliament in August 2007 included for the first time aggregate revenue and expenditure forward estimates based on macroeconomic forecasts (in the past budget submissions were strictly annual). Progress has also been demonstrated in moving toward a policy-based budget by further integrating the planning and budgeting processes in the 2008 budget preparation cycle. This has resulted in significant budget reallocations to priority sectors—particularly infrastructure, education, and health—while more closely reflecting government policy priorities as outlined in the government work plan (RKP). These developments constitute an important step forward in implementing a full MTEF. 45. Trigger 10: Continue to consolidate core government bank accounts. (Status: Achieved) Zero-balance banking arrangements with commercial banks were successfully piloted in 50 selected regional treasury offices. The tender for administration of operational accounts to commercial banks has been completed in all regions. Rollout of zero-balance arrangements to expenditure accounts in all 178 regional treasury offices occurred on 1 October 2007. This consolidates more than 1,000 balance-bearing treasury accounts into one balance-bearing TSA and associated zero-balance accounts. Revenue accounts are scheduled to become zero-balanced by the end of 2007. Meanwhile, substantial state funds continue to be kept in commercial banks that are not recorded in the treasury system. Adoption of Government Regulation (PP) No. 36/2007 on Cash Management, enacted in July 2007, provides the legal basis for a census of all government accounts and enhances the power of the Minister of Finance to close unauthorized bank accounts. Identification and closure of unauthorized bank accounts is underway with 30 (out of 73) line ministries and agencies having completed the process by August 2007. 46. Trigger 11: Implement transparent accountability arrangements for RDI and RDA accounts. (Status: Satisfactory) Regulation No. 8/2007 has been issued, which prescribes the principles for improved management and transparent accountability in the management of central government investment funding (RDI). In addition, detailed procedures have been issued through ministerial decrees covering a wide range of operational matters, such as execution of investments, administration and supervision of investments, management of the Infrastructure Guarantee Fund, the minimum service standards for investment funds, administrative requirements for financial management of public service agencies, supervisory boards for public service agencies, and establishing an investment committee for the central government. However, while the regulatory framework for RDI accounts has been put in place, the regulatory framework for regional development accounts (RDAs) is not yet complete. While the MOF has also gradually computerized records of subsidiary loan accounts (onlending), which contain amounts due from ministries, using a modified debt management information system, accounting for RDI and RDA accounts continues to be manual and both banking and record keeping are currently segregated from the MOF accounting system. Computerization is, however, in progress. A complete and reliable listing of individual loan accounts is under preparation but has not yet been issued. 47. Trigger 12: Operationalize the National Public Procurement Office (NPPO) and issue a draft procurement law. (Status: Satisfactory) A new presidential decree has been drafted to establish an independent NPPO or a Goods/Services Procurement Policy Development Institute (LPKPP). That would exceed the expectations of the original trigger that had aimed at strengthening the existing National Procurement Office in the National Development Planning Agency (BAPPENAS). The planned

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institution will report directly to the President with deputies heading three main departments for Strategy and Policy Development, Monitoring and Evaluation, and Information Systems. The decree has been finalized and endorsed by the Minister of Planning, Minister of Economic Affairs, Minister of State Apparatus, and Coordinating Minister for Economic Affairs, and it now awaits the final signature of the President. The decree is set to be issued in November 2007. An independent procurement agency with adequate resources, authorities, and strong political backing is likely to drive public procurement reform in the future and inject new momentum into such critical initiatives as finalization of a new procurement law, adoption of standard bidding documents, e-procurement, and certification programs. A procurement law has been drafted but has not been finalized in part because there was no institutional focal point to propel the lawmaking process. 48. Trigger 13: Establish a remuneration commission or interdepartmental team to recommend pay policy and pay levels for high level state officials. (Status: Achieved) A new job evaluation and grading system for high-ranking state officials has been completed by an interministerial team from the Ministry of Finance, Ministry of Administrative Reform, and the Civil Service Agency. New methods for job evaluation, including new grading standards, have been developed, and nearly 200 job descriptions intended to cover some 7,000 high-ranking state official positions have been prepared. For the first time in Indonesia, an appropriate pay grade structure has been developed for state officials based on a comprehensive assessment of relevant job factors in a coherent structure of comparative job grades. However, the plans to establish an independent pay commission have been abandoned due to the administrative difficulties and lengthy procedures implied in such an establishment. Instead, and to keep up the reform pace, a different and possibly more ad hoc structure (e.g., an interministerial team) would be established to oversee implementing the new grading system and pay scales. 49. Trigger 14: Develop a comprehensive civil service reform plan for the Ministry of Finance as a pilot for civil service reforms on a larger scale. (Status: Achieved) MOF is implementing a comprehensive strategy of reforms related to business process and human resource management, including remuneration, service standards, and internal ethics. The reforms, targeting the whole ministry including DG Customs and DG Tax, are coordinated by a high-level reform team that reports to the Secretary General. Specifically, the following areas are addressed:

(i) strengthening the human resource management capacity of the Secretary General’s office;

(ii) systematic review of business processes in every department to ensure more effective service delivery based on new standard operating procedures, including workload analysis;

(iii) improved overall human resource management in the Ministry through (a) reformed job classification for every department, including new job descriptions; (b) establishment of a Personnel Information Management System; (c) establishment of an assessment center; (d) formulation of new guidelines for staff recruitment; and (e) a new approach to career paths for the various departments; and

(iv) creation of a remuneration scheme based on new job evaluations and pay grades to link pay to responsibilities, complexity, and workload. In the absence of a national civil service reform effort, a working group consisting of the Supreme Court, Supreme Audit Board, State Ministry of Administrative Reform, and KPK are considering how to roll out the MOF pilot more widely.

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3. Core Policy Area III: Improved Delivery of Public Services

50. As noted earlier, large numbers of poor remain vulnerable, while education and health outcomes are not at desired levels. In the context of increased availability of public resources, the challenges in delivering such services include how to (i) improve efficiency of public spending, (ii) improve services quality, and (iii) reduce inequalities in access and outcomes. 51. The Government remains committed to improving public service delivery. This is exemplified by the decision it took in 2005 to reallocate savings from the fuel subsidy reductions in favor of programs targeting the poor. While monitoring the effectiveness of these various compensation programs has led to improvements in their design and better beneficiary targeting, lessons learnt have also been used to improve the design of such new programs as an individual conditional cash transfer (CCT) program and a community-based alternative that will together cover close to one million households. The CCT program is modeled on similar successful programs in other countries, notably in Latin America, and is intended to improve health and education outcomes. In addition to piloting CCTs, the Government has also built on Indonesia’s extensive experience with community-driven development projects by introducing a National Community Empowerment Program (PNPM). This program focuses on improving local governance and service delivery at the sub-district and village level by encouraging participatory planning and providing block grants. Funds are generally used for rural infrastructure, or education- and health-related projects. Set up to be implemented in 2,000 subdistricts in 2007, the program will be expanded to cover the entire country by 2009. Detailed design of the two approaches is currently underway and a communications strategy and social mobilization strategy will assist in ensuring household beneficiaries understand the programs and expected results. Plans also include participatory monitoring and complaints resolution mechanisms. 52. Triggers under Core Policy Area III. There are three triggers under this area consisting of institutionalized assessments of service delivery mechanisms, competency standards for teacher certification, and community spending over multiyear periods. 53. Trigger 15: Develop an enhanced assessment framework for selected service delivery programs. (Status: Achieved) Guidelines are being prepared for BAPPENAS to develop an enhanced assessment framework for selected service delivery programs with assistance from the World Bank. In addition, a new position of Deputy, Monitoring and Evaluation is being created in BAPPENAS. Other initiatives in this area include technical assistance from ADB that supports the Ministry of Home Affairs DG for Regional Autonomy in developing a performance measurement system for local governments. 54. Trigger 16: Establish competency standards for teacher certification and the instruments for measuring compliance with those standards. (Status: Achieved) The Teacher Law issued in December 2005 requires teachers to be proficient in four competency domains: pedagogical, professional, personal, and social. The National Education Standard Agency has formalized standards for teachers for each subject within the school curriculum (Ministerial Decree No. 16/2007). Ministerial Decree No. 18/2007 formalized these standards for teacher certification and the mechanism and instruments for certification. The Ministry of National Education began the certification process for approximately 190,000 teachers in July 2007. The Decree is sufficient for meeting the trigger, but a government

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regulation on the Teacher Law is expected to be passed in the near future and will supersede the Ministerial Decree. 55. Trigger 17: Permit community spending over multiyear periods and clarify procurement procedures for national budget funded CDD programs. (Status: Satisfactory) The Government has agreed upon a mechanism that will reallocate unspent CDD funds of one year into subsequent budgets through a revised budget process. However, a Finance Minister’s regulation on this is still pending. The Government has clarified the rules governing procurement procedures in the guidelines for the PNPM, which is due to be released in November (see also the description of this trigger in Appendix 3).

C. Monitoring the Impact of DPSP-3

56. As part of the policy matrix for DPL-1 (prior to ADB’s direct cofinancing involvement), outcome indicators were introduced to highlight the expected key results of the support. These indicators were taken mainly from government planning documents. Additional outcome indicators have been added during the past 4 years reflecting the expanded scope of the reform agenda and number of triggers under the DPL’s core policy areas. As the original program was extended by 1 year (from DPL-3 to DPL-4), the targets for each outcome indicator have correspondingly been updated to reflect the expected outcomes by 2008.8 These indicators are expected to provide the basis for an evaluation by the World Bank and ADB of the program after DPL-4 (DPSP-3). Other indicators, such as the standardized Public Expenditure and Financial Accountability used to assess PFM, would also supplement such an evaluation.

D. Triggers for Future DPLs/DPSPs

57. The current DPL series ends in 2008, in line with a 1-year extension of the World Bank’s Indonesia country assistance strategy (CAS) time frame. However, the Government has indicated strong support for continuing the DPLs in the near future. In anticipation of a continued DPL engagement under the next CAS (covering fiscal years 2009–2012), a policy program for future operations has been discussed between the Government and development partners. In deciding on the indicative triggers for the next DPL/DPSP series, there was agreement that, given the considerable challenges remaining in the existing core policy areas of investment climate, public financial management, and public service delivery (see Appendix 2), the triggers will remain within these broad areas. However, the policy and reform focus will be shifting more toward reforms designed to improve regulations, increase transparency, and deepen institutions as required to sustain medium-term growth and social development. In moving forward, the Government has also articulated its interest in aligning the policy matrix as closely as possible to the existing government reform agenda. The Government has asked ADB to support the next DPL series and the current CSP contains provision for such support. 58. Within this reform program, a core set of 19 policy actions were selected to anchor the policy engagement of a future DPL-5/DPSP-4 operation.9 The selection of policy actions was guided by the Government’s ability to continue the reform momentum in given areas and, in

8 The DPL program originally envisioned three single-tranche operations. However the program was extended by 1

year to DPL-4 in line with a 1-year extension of the World Bank’s country assistance strategy for Indonesia. 9 ADB will only focus on 17 triggers under its next DPSP operation, as a policy action relating to operationalizing the

Financial Sector Stability Forum and establishing a uniform database for poverty targeting are already covered under the proposed Capital Markets Development Program Cluster and Poverty Reduction and Millennium Development Goals Acceleration Program.

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some cases, expand into new but related areas where there was increased reform momentum. In certain areas, the indicative policy actions for DPL-5/DPSP-4 deepen policy actions already supported under previous DPL operations (i.e., moving beyond the National Single Window pilot towards choosing the operator and moving the Treasury Single Account beyond expenditures to revenues). In other areas, policy actions aim to strategically broaden the focus of the policy dialogue into new areas in response to openings in the Government’s evolving agenda, such as by working with the Central Statistics Agency to begin improving targeting of the poor. Consequently, while some areas are well-advanced and beginning to affect desired outcomes, others are focused on inputs (such as action plans, laws, or organizational changes) and may take longer to translate into progress on outputs and outcomes. 59. Under the pillar of investment climate, the economic policy package (Presidential Instruction No. 6/2007) provides a source of specific policy measures. In particular, DPL-5/DPSP-4 triggers will focus on improving entry conditions for businesses by following up on the Investment Law and negative investment list, and improving the ability of the private sector to voice concerns. Improving private sector operations will focus on actions to follow up on the new Tax Administration Law, the National Single Window, and tariff harmonization. In addition, in the next DPL/DPSP series there will be a focus on improving financial markets by strengthening the operations of insurance markets, a key nonbank market. That will complement the work under ADB’s proposed Capital Markets Development Program Cluster. Finally, the Government attaches great importance to the economic health and vitality of small and medium enterprises, and the focus will be on continuing to improve their access to credit. 60. Financial management and governance are becoming ever more important in light of increased fiscal space. The next DPL will focus on actions designed to maintain momentum on financial management. In particular, this should include a focus on the Treasury Single Account (underpinning the new budget and treasury system that should roll out in 2009), extending budgeting reforms to improving performance measures, improving the profile of disbursements through measures designed to anticipate multiyear spending, and improving overall feedback through support for improved accounting by the line ministries. In addition, procurement remains a critical area where improvements are needed, and it would be important to assist the development and institutionalization of the NPPO while simplifying procedures that have also been delaying disbursements. Finally, civil service reform will be furthered by extending the pilot at the Ministry of Finance to additional agencies. 61. The next DPL/DPSP series will also continue to promote improvements in public service delivery that are critical to poverty reduction and other MDG goals. This will complement the Government’s efforts under the ADB-supported Poverty Reduction and Millennium Development Goals Acceleration Program. Three broad areas will be considered: improving the effectiveness and targeting of pro-poor programs, the operations of the PNPM program, and reinforcing the teacher-based education reforms introduced in DPL-4.

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Table 3: Indicative Triggers for DPL-5 A. DPL Core Policy Area I: Investment Climate 1. Regulatory Reform

a. Empower PEPI to coordinate the development of implementing regulations and technical guidelines for effective implementation of the Investment Law to undertake a review of the negative list (Perpres Nol. 77/2007), and to oversee compilation of a mapping of business licenses in key economic sectors with recommendations for specific licenses to be streamlined or eliminated.

b. Monitor the investment climate by publishing monthly data on: (i) VAT refund processing time using Directorate General Tax data; (ii) time to establish a company from reserving the name to issuing the legalization decree (using Ministry of Justice data). Design a system to monitor and report on import clearance time from unloading to gate-out, combining data from the Port Operator and Customs.

2. Tax and Customs Reform a. Determine the operational model for the National Single Window and select the operator.

Establish the governance structure for the National Single Window with participation from the private sector.

b. Issue implementing regulations for the Tax Administration Law and instructions to tax offices. Establish a system to monitor and report on response time for tax audit objections and appeals.

c. Team Tariff: Continue the tariff harmonization program and implement effective and transparent operating procedures, including public disclosure.

3. Financial Sector a. Design a policyholder protection scheme for insurance sector policyholders.

4. Small and Medium Enterprise (SME) Development a. Rationalize SME financing and/microfinance schemes across line ministries and state-owned

enterprises, including to issue a presidential decree on credit guarantee institutions and its implementing regulations.

B. DPL Core Policy Area II: Public Financial Management and Governance

5. Strengthen Budgeting, Controls, and Transparency in Financial Management a. Establishment of a comprehensive TSA regime, including revenue accounts. Counterpart

team for implementation of the new automated treasury system is in place and is beginning preliminary work, including mapping and reviewing of business processes, to increase readiness for system rollout in 2009. Modernization of 30 provincial treasury offices (KPPNs).

b. Enhance performance-based budgeting by revising budget templates (for PKA-KL) and accompanying budget preparation manuals, as well as the introduction of key performance indicators for selected programs in the 2009 draft budget.

c. All DIPAs are issued and teams assigned at the beginning of the fiscal year by eliminating annual SK requirement (for project managers) for multiyear projects and allowing for parallel processing of procurement. An action plan has been drafted to continue leveling out disbursement of capital and material expenditure over the fiscal year.

d. Complete a midterm review to assess application of accounting standards and accounting procedure manuals by line ministries.

6. Procurement a. Fully operational LPKPP (staffing and budget allocation for operational costs). Simplification

of Presidential Decree (Keppres) No. 80/2003 to, among others, accommodate a new set of standard bidding documents.

7. Civil Service Reform and Governance a. Expand civil service reform pilot to five additional agencies in 2008. Update Ministry of

Finance organizational road map and implement next phase of Ministry’s human resource

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management reform strategy.

C. DPL Core Policy Area III: Public Service Delivery

8. Strengthened Effectiveness and Pro-Poor Targeting of Public Programs a. Institutionalize government system for program evaluation/assessment and use results in

budget allocation, program design, and targeting (Government's annual work plan, state budget).

b. Improve effectiveness in subnational spending in issuing guidelines for pro-poor budgeting and planning for local governments.

9. Community-Driven Development

a. Subject to satisfactory performance, adjust community block grant of PNPM to maximize employment and poverty impacts.

10. Education a. Require teachers (other than head teachers) to be assigned a minimum 24 teaching hours

per week in order to receive either the professional allowance (for certified teachers) or the special area allowance (for teachers working in hardship areas), or a combination of both.

E. Financing Plan

62. The Government has requested a loan of $200 million from ADB’s ordinary capital resources to help finance DPSP-3. DPSP-3 provides parallel cofinancing for the World Bank supported DPL-4, for which the Government has requested $600 million. The Government has also requested $200 million from the Government of Japan to cofinance the DPL-4. The loan will have a 15-year term, including a grace period of 3 years; an interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR) based lending facility; a commitment charge of 0.75% per annum; 10 conversion options that may be exercised in accordance with the draft loan agreement, the loan regulations, and ADB’s conversion guidelines; and such other terms and conditions as set forth in the draft program loan agreement. The Government has made its own independent decision to borrow under ADB’s LIBOR-based lending facility, and it has given an undertaking that this choice was not made on the basis of any advice from ADB. Responding favorably to the Government’s request will signal ADB’s relevance in an emerging, confident, and well-performing middle-income country 63. Gross financing needs of the Government have increased from $11.6 billion in 2006 to $15.4 billion in 2007. This reflects a higher fiscal deficit on account of increased development spending and increased expenditures relating to natural disasters, as well as higher loan amortization payments. The Government has sought $2.1 billion in program loan financing from ADB ($900 million), Japan ($400 million), and the World Bank ($800 million). For the proposed DPL-4, the World Bank envisages providing a $600 million program loan on International Bank for Reconstruction and Development terms. ADB’s proposed support is based on the strengths of the policy package, its development impact, the importance of the sectors covered, and the investment needs. Besides the overall financing needs stemming from a greater focus on development spending, the Government will incur cash outlays in excess of $200 million to implement many of the institutional strengthening measures supported under DPSP-3, such as rolling out the National Single Window for clearance of merchandise and setting up the proposed national procurement office.

10 There will be no commitment charge for the single-tranche loan if it is declared effective and disbursed within 60

days after signing of the Loan Agreement. Currently the waiver on the commitment charge of 0.50% is applicable to all interest periods commencing from 1 January 2007 up to and including 30 June 2008.

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F. Implementation Arrangements

1. Program Management 64. The Coordinating Ministry of Economic Affairs will be the Executing Agency, collaborating closely with MOF. Implementation of the DPL-4/DPSP-3 actions is coordinated with a number of other ministries and agencies, including BAPPENAS, Ministry of Trade, Ministry of Cooperatives and SMEs, and BI.

2. Implementation Period 65. The program implementation period for DPSP-3 is from January to December 2007. The Government and the development partners will prepare a program completion report by mid-2008.

3. Procurement and Disbursement Arrangements 66. The program loan of $200 million will be released in a single tranche upon effectiveness. The loan proceeds will be used to finance the full foreign exchange costs (excluding local duties and taxes) of items produced and procured in ADB member countries, excluding the items specified in the negative list of ineligible items (Appendix 7) and imports financed by other bilateral and multilateral sources. In accordance with ADB provisions for simplifying disbursement of program loans,11 the proceeds of the program loan will be disbursed to the Republic of Indonesia as the Borrower. No supporting import documentation will be required if during each year that loan proceeds are expected to be disbursed the value of Indonesia’s total imports minus imports from nonmember countries, ineligible imports, and imports financed under other official development assistance is equal to or greater than the amount of the loan expected to be disbursed during such year. The Government will certify its compliance with this formula with each withdrawal request. Otherwise, import documentation under existing procedures will be required.

4. Anticorruption 67. ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the Government. Consistent with its commitment to good governance, accountability and transparency, ADB reserves the right to investigate, directly or through its agents, any alleged corrupt, fraudulent, collusive, or coercive practices relating to the Program. To support these efforts, relevant provisions of ADB’s Anticorruption Policy are included in the loan regulations and the bidding documents for the Program. In particular, all contracts financed by ADB in connection with the Program shall include provisions specifying the right of ADB in connection with the Program shall include provisions specifying the right of ADB to audit and examine the records and accounts of the Executing Agency and all contractors, suppliers, consultants, and other service providers as they relate to the Program. In addition, DPSP-3 has a core focus on improving governance and anticorruption. It promotes transparency in PFM. Noteworthy progress has been achieved through the TSA system and in the implementation of transparent accountability arrangements for RDI and RDA accounts, which will help the Government in its anticorruption efforts. The programs’ focus on tax audit procedures, simplifying and/or eliminating unnecessary business licenses, and implementing good corporate governance in state-owned banks will also further the Government’s anticorruption agenda and improve the investment climate. 68. The Government places significant emphasis on strengthening internal control systems and overall PFM, with support from the World Bank through the GFMRAP and from ADB 11 ADB. 1998. Simplification of Disbursement Procedures and Related Requirements for Program Loans. Manila.

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through the State Audit Reform Sector Development Program. Reforms and capacity building initiatives supported under both these programs have led to initial progress in strengthening PFM (see the fiduciary assessment presented in Appendix 8).

5. Accounting, Auditing, and Reporting 69. ADB retains the right to audit the use of loan proceeds and to verify the accuracy of the Government’s certification for the withdrawal applications. Prior to withdrawal, the Government will nominate a deposit account at BI to receive all loan proceeds. The account will be managed, operated, and liquidated in accordance with terms satisfactory to ADB.

6. Performance Monitoring, Evaluation, and Program Review 70. The Coordinating Ministry of Economic Affairs, MOF, and BAPPENAS will continuously monitor implementation of the DPL-related reforms and their impacts, in line with the overall program framework and outcome indicators agreed upon with the Government. An overall evaluation of the program cluster will take place in 2008.

IV. PROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS

A. Expected Impacts

71. The key benefits expected from implementation of the DPSP cluster are (i) progress in meeting the Government’s medium-term objectives through improved

(a) investment climate, (b) public financial management and governance, and (c) service delivery to the poor;

(ii) raising the profile of key issues at the ministerial level, accelerating the timetable for policy actions to be taken, addressing administrative and bureaucratic bottlenecks, and providing an impetus for decision makers to further coordinate across economic and line ministries;

(iii) sustained ADB engagement in policy dialogue with the Government on the direction and content of, and strategies for, its economic, structural, and institutional reform agenda (with DPSP-3 providing for policy continuity and consistency in sectors where ADB has been actively involved);

(iv) aid harmonization and cofinancing by the key development partners (ADB, World Bank, and Government of Japan) around a common policy framework and dialogue, and the resulting endorsement of the Government’s sound policy implementation and macroeconomic management; and

(v) facilitation, through crosscutting reforms, of sector-specific reforms in areas where ADB is providing or planning support.

72. Institutional. Significant benefits stem from the engagement of Indonesia’s three principal development partners. Participation in the DPL series has helped in overall institutional coordination amongst the partners as well as between the Government and the partners. Provision of advisory support through technical assistance has also been significantly streamlined and coordinated to best meet the Government’s needs. The measures supported under the DPSP cluster will result in sustained institutional capacity in such key areas of policy formulation as fiscal policy, debt and treasury management, and public expenditure and financial management. 73. Social. The main contribution of support being leveraged through DPSPs is in the forms of improved public administration, sustaining effective public expenditure reorientation towards productive needs, and continuously supporting government measures to effectively align its

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resources with its medium-term objectives of economic growth and poverty reduction. By focusing on supporting strategic reforms aimed at improving public service delivery, the program will have direct beneficial social impact. Appendix 9 presents a summary poverty reduction and social impact mitigation strategy. 74. Economic. The nature of the DPSP series does not allow for quantitative financial and economic analysis. However, significant general economic benefits will accrue to the entire country from the policy initiatives within the three core areas under the present phase. 75. Resettlement, Indigenous People, and Environment. Implementation of the DPSP-3 measures will cause no direct or indirect involuntary resettlement, nor will it lead to any issues affecting indigenous peoples. Based on desk review, the measures supported under DPSP-3 are unlikely to have any adverse environmental impacts.

B. Risks and Mitigating Measures

76. Implementation of the DPSP cluster is subject to the following risks: (i) External vulnerabilities. With its increased integration into global capital

markets, Indonesia remains vulnerable to such external shocks as capital account shocks or a global economic slowdown. With improvements in its macroeconomic indicators, however, the economy’s resilience to external shocks has increased. Factors limiting the potential impacts of external shocks include diversity of exports, limited external debt exposure, and an adequate level of reserves. While significant subsidies continue in fuel and electricity, by more than doubling domestic fuel prices in 2005, Indonesia has significantly reduced its vulnerability to volatile global petroleum prices. The banking sector is also now sufficiently strong to weather a moderate external shock. The maintenance of a financial sector safety net supported by the DPL/DPSP program will help to improve the resilience of the banking sector.

(ii) Policy coordination risks. Economic volatility could worsen if the Government does not sustain the reform momentum to follow up on the reduction in fuel subsidies. Lack of progress in structural reforms or investment in infrastructure could soon lead to bottlenecks, which would limit investment and potential growth. However, following the volatility of the October 2005 fuel price hike, the need for rapid policy adjustment on the domestic front in line with key global developments is clearly recognized. The Government and BI have also considerably enhanced their coordination, which will be reinforced by the measures under DPSP-3.

(iii) Fiduciary constraints. Notwithstanding the improvements underway, there are continuing concerns regarding utilization of public resources. The overall fiduciary assessments undertaken since 2001 (with the Country Financial Accountability Assessment) have indicated considerable improvements in the overall fiduciary environment in Indonesia. Ongoing programs supported by several development partners provide significant technical assistance support to strengthen fiduciary governance. The DPSP focus on TSA implementation will significantly enhance transparency.

(iv) Public opposition to reforms. Tariff and some aspects of investment climate reforms, such as relating to labor, are generally opposed by the public as well as special interest groups. The Government managed the fuel subsidy reduction well, but labor market reforms have slowed. DPSP allows for flexibility, enabling the Government to build consensus for reforms to ensure their acceptance.

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(v) Heightened security risks. Alerts stemming from sectarian and regional conflicts and terrorism could slow foreign direct investment and set back the recovering tourism industry. The Government and law enforcement authorities have taken a range of measures aimed at rebuilding public and investor confidence.

V. ASSURANCES

77. In addition to the standard assurances, the Government has given the following assurances, which are incorporated in the legal documents:

(i) Counterpart funds will be used to finance the development needs as outlined under DPSP-3 implementation arrangements.

(ii) The policies and actions taken prior to the date of the DPSP-3 loan agreement, as described in the development policy letter (including the policy matrix), will continue to be in effect for the duration of ADB’s engagement in the DPL series, and subsequently.

VI. RECOMMENDATION

78. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve a loan of $200,000,000 to the Republic of Indonesia for the Third Development Policy Support Program from ADB’s ordinary capital resources, with interest to be determined in accordance with ADB's London Interbank Offered Rate (LIBOR)-based lending facility; a term of 15 years, including a grace period of 3 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Program Loan Agreement presented to the Board.

Haruhiko Kuroda President

23 November 2007

Appendix 1 29

DESIGN AND MONITORING FRAMEWORK AND DPL RESULTS FRAMEWORK

Design Summary

Performance Targets/Indicators Data Sources/ Reporting

Mechanisms

Assumptions and Risks

Impact Higher economic growth that is sustained over the medium term and lower levels of unemployment and poverty.

By 2009, progress made towards the following goals of the Medium-Term National Development Plan: (i) real gross domestic product (GDP)

growth at 7% (ii) poverty reduced from 16.6% in

September 2007 to 15–16% by end-2008 (Government work plan 2008 target)

(iii) unemployment reduced to 8-9% by end-2008 from 9.7% in February 2007 (Government work plan 2008 target)

(iv) corruption reduced (to be monitored through corruption perception surveys and cases handled by the Corruption Eradication Commission (KPK))

Development spending increased from the 1996 level of 2.8% of GDP to 4% of GDP by end-2008

Central Bureau of Statistics data Ministry of Finance data Data from KPK Data on Millennium Development Goals from Central Bureau of Statistics, line ministry surveys, and other development partners

Assumption • Macroeconomic

and political stability

Risks • Lack of effective

coordination between national government ministries

• Slow pace of reforms

• Public opposition to reforms

Outcome Improved overall economic management anchored on good governance

Sustained macroeconomic stability, improved investment climate, better public financial management, and improved service delivery achieved by 2008. These achievements will be demonstrated by, among other things: • Reduction of government debt-GDP

ratio from 59% in 2003 to below 38% (38.6% at end-in December 2006, and projected to fall below 35% by the end of 2007).

• Mobilize additional domestic non-oil and gas tax revenues as a share of GDP from 10.4% of GDP in 2003 to 12–13% in 2008 (11.4% in 2006).

• Significant budgetary allocations made for poverty reduction programs ($2.6 billion allocated for social assistance spending in 2005, $4.4 billion allocated in 2006, and a projected $7.4 billion allocated in 2008).

Ministry of Finance reports Consolidated government-wide financial reports submitted to Parliament Directorate General (DG) of Treasury reports on budget outturns Debt outcome reports produced on a quarterly basis by DG Treasury Audit reports of the Supreme Audit Institution on Government Financial Accountability

Assumption • Economy able to

withstand external or domestic shocks

Risk • Legal and

regulatory uncertainties continue to prevail

Outputs (i) Improved investment climate • Improved VAT by

reducing time for VAT

By end-2008 as compared with 2003 (with a current assessment, where appropriate, presented in brackets) S&P sovereign rating upgraded from CCC+ in 2003 to BB in 2008 (BB- in 2007) Reduce time to obtain VAT refunds from 12–18 months in 2003 (average

Assessments done by external credit rating agencies Doing Business Surveys

Assumption • Government stays

fully on course with key policy reform measures and is effectively able to liaise with Parliament and explain its policy

Appendix 1

30

Design Summary

Performance Targets/Indicators Data Sources/ Reporting

Mechanisms

Assumptions and Risks

refunds

• Improve transparency of

tax audit procedures

• Roll out National Single Window with online clearance of merchandise

• Enhance procedures for tariff setting

• Implement Investment Law

• Reduce the time to set up a business

• Increase SME access to finance, including to implement Warehouse Receipts Law

• Implement good corporate governance and risk management standards, particularly in state-owned banks, and implement the financial sector safety net in a sustained manner

(ii) Improved public financial management and anticorruption • Medium-term

expenditure framework implemented with

time to obtain VAT refunds was 5.1 months in September 2007) Reduce proportion of respondents who identify tax administration as a moderate, severe, or very severe constraint to doing business from 57% of respondents in 2003 (down to 38% by September 2007) Reduce average import clearance time from 8 days in red lane in 2004 (average import clearance time was 6 days in the red lane by September 2007) Increase investment-GDP ratio from 18.9% in 2003 to 23–25% (it was 22.6% in 2006 and projected to rise to 24% in 2007) Reduce start-up times for a new business to 30 days from 168 days in 2003 (start-up time for a new business takes 105 days in 2007) Progressively increase loans to SMEs from 47% of total loans in 2003 (was 52% of total loans in June 2007) Reduce the share of state banks in the overall banking system from 46% in 2003 (down to 36% by September 2007) Implement Basel II standards by end-2008 Reduce the blanket guarantee on all bank deposits that was introduced in response to the financial crisis in 1997 to Rp100 million from 22 March 2007 (coverage on deposits reduced to Rp100 million as per schedule) Improve budget disbursement pattern on capital and material expenditures from average of 54% disbursed in the last quarter of the fiscal year in 2001–2004 (In 2006, 52% of these expenditures were made in the final quarter. By July 2007, 32% of budgeted amounts for these expenditure items had been made, compared with 26% by July 2006.) Incorporate a macro-fiscal framework in the 2008 budget with projections of aggregate revenue and expenditure for

Investment Climate Surveys Data on financial markets Central Bureau of Statistics data Directorate General of Treasury reports on budget outturn

and regulatory stance to judicial authorities

• Social tensions

relating to key policy changes effectively contained

Risks • Unanticipated

global or regional macroeconomic shocks may affect Indonesia’s economy

• Weak interagency

coordination • Capacity

constraints slowing policy reforms and reducing the quality of outputs

• Delays in enacting

laws, which in turn would lead to delays in regulations

Appendix 1 31

Design Summary

Performance Targets/Indicators Data Sources/ Reporting

Mechanisms

Assumptions and Risks

forward estimates for 2008 budget

• Continue to consolidate

core government revenue and expenditure bank accounts

• Implement transparent

accountability arrangements for RDI and RDA accounts

• Fully operationalize

NPPO • Establish body to

recommend pay policy and pay levels for high-level state officials

• Develop civil service

reform plan for Ministry of Finance as pilot for civil service reform on a larger scale

(iii) Improved public service delivery • Develop enhanced

assessment framework for post-fuel subsidy compensation programs

• Establish competency standards for teacher certification

• Permit community

spending over multiyear periods

2009 and 2010 Improved management of state finances by consolidating more than 18,000 commercial bank accounts handling government funds (situation in 2003) into a treasury single account (TSA) (Pilots started in Jakarta and extended to 50 regional treasury offices by 2006. Pilot to be extended to all 178 regional treasury offices by end-2007.) Complete the computerization of RDI and RDA balances, a listing of debtors and amounts due classified into amounts collectible or not collectible, and formalize standard operating procedures for authorizing and recording of such investments or loan transactions. Issue a Presidential decree creating an independent NPPO by end-2007 and commence implementation in 2008 Develop a new job evaluation and grading system for 200 job descriptions intended to cover some 7000 high-ranking state official positions MOF to implement a comprehensive strategy of reforms related to business process and human resource management including remuneration, service standards and internal ethics. Greater allocation to health and education needs in the 2007–2008 budgets, with education budget being increased by at least 15% and health spending increased by at least 4–5% each year Lessons learned from assessments of post-fuel subsidy compensation programs used to design and pilot a better targeted, publicized, and managed conditional cash transfer program for the poor in seven regions benefiting 500,000 households Increase proportion of teachers with 4-year university degree from 36% in 2004 (By 2006, this proportion had increased to 40%.) The Government to introduce a mechanism to reallocate unspent funds of one year into subsequent budgets

Daily balance reporting system under the TSA (including the treasury office jurisdictions that go through the TSA pilots) Directorate General of Treasury reports on budget outturn National and regional assessment reports on the poverty reduction programs launched after the fuel subsidy reduction in 2005

Appendix 1

32

Activities with Milestones (during the program period) • DG tax regulation 122/2006 is being implemented (strengthened by DG tax

circular letter in July 2007). • Ministry of Finance Decree 123/PMK 03/2006 issued. • Complete a pilot for the National Single Window by December 2007. • Technical team supporting team tariff reconstituted and receiving technical

assistance from World Bank to improve capacity. • Government regulations 76/2007 and 77/2007 on negative lists issued.

Decrees pertaining to investment procedures and one-stop integrated services to be issued by December 2007.

• Ministry of Justice decree simplifying the procedure to legalize a limited liability company has been issued. Ministry of Trade decrees to reduce the time to obtain the business trading license, and the business registration certificate issued.

• Presidential Instruction 6/2007 issued. Also implementation regulations for Warehouse Receipts Law (PP/36/2007) issued.

• Implementation of the financial sector safety net continues, and coverage of deposits has been reduced to Rp100 million.

• Projections for expenditure and revenue for two out-years included in the Medium-Term Expenditure Framework.

• Roll out zero-balancing banking arrangement for all regional treasury officers by end 2007

• Complete computerization of subsidiary loan account, RDI, and RDA balances currently outstanding and listing of debtors and amounts due and collectible; and formalize Standard Operating Procedures for the authorization and recording of such loan transactions by end 2008.

• Issue decree to create an independent NPPO by end 2007. • Interdepartmental team to recommend pay levels and policy established

and has completed a pay proposal for high state officials. • A comprehensive civil service reform plan for Ministry of Finance

developed. • Enhanced assessment framework for selected service delivery programs

have been developed in National Development Planning Agency. • Regulations to establish competency standards for teacher certification

approved. • Minister of Finance to approve arrangements for carryover of unspent

community budgets from one year to the next by end 2007.

Inputs • ADB program loan ($200

million) for DPSP-3 • World Bank support of $600

million for DPL-4 • Parallel cofinancing support

from the Government of Japan envisaged at $200 million

ADB = Asian Development Bank, DG = directorate general, GDP = gross domestic product, KPK = Corruption Eradication Commission, NPPO = National Procurement Policy Office, RDA = regional development account, RDI = central government investment funding, S&P = Standard and Poor’s, SME = small and medium-sized enterprise, TSA = treasury single account, VAT = value added tax.

Appendix 1 33

Table A1: Development Policy Loan Results Framework Outcome Indicators Policy Area / Target*

Baseline Latest Available Assessment

OVERALL GOAL OF THE DPL PROGRAM Goal: Achieve sustained growth and poverty reduction

Sustain Economic Growth Achieve growth of at least 5% [CAS].

GDP growth was 4.9% (2003). GDP growth reached 5.5% in 2006 and is projected to reach 6.3% in 2007 (Oct. 2007).

Highly Satisfactory

Poverty Reduction Reduce the percentage of people living below the national poverty line [RPJM].

17.4% of people live below the national poverty line (2003).

16.6% of people live below the national poverty line (Sep. 2007).

Moderately Satisfactory

DPL Core Policy Area I: Macroeconomic Stability and Creditworthiness Objective: Maintain macroeconomic stability as precondition for sustainable growth

Overall Outcome S&P sovereign rating upgraded to BB.

S&P sovereign rating at CCC+ and Moody’s rating at B3 (2003).

S&P raised sovereign ratings to BB- and Moody’s raised bond ratings to B1 (Oct. 2007).

Highly Satisfactory

Debt Management Reduce debt-GDP ratio to below 38%.

Debt-GDP ratio at 59% (2003). Debt-GDP ratio projected to fall below 35% in 2007 (Oct. 2007).

Highly Satisfactory

Fiscal Policy and Management Mobilize domestic non-oil and gas tax revenues to 12–13% of GDP.

Domestic non-oil and gas tax revenues at 10.4% of GDP (2003).j

Domestic non-oil and gas tax revenues reached 12.0% in 2006.j Satisfactory

DPL Core Policy Area II: Improved Investment Climate Objective: Attract quality investments through a supportive business environment

Objective: Strengthen, diversify, and increase equitable access to the financial sector Financial Sector

Stability: Reduce state bank share of overall banking system [CAS].

State bank share of overall banking system is 46%.

State bank share of overall banking system is 36%. Satisfactory

Eliminate economic distortions and moral hazard in the financial sector stemming from unsustainable blanket deposit guarantees [CAS].

Government maintained a policy of providing blanket guarantees on all bank liabilities in response to the 1997 financial crisis (2003).

Coverage on deposits was reduced from Rp5 billion in March 2006 to Rp100 million in March 2007 as per schedule (2007).

Highly Satisfactory

Diversification: Increase NBFI assets as a share of total financial assets by 5–10 percentage points.

NBFI assets estimated to comprise 15–20% of total financial assets (2003).

NBFI assets comprise 22.3% of total financial sector assets (2006). Satisfactory

34 Appendix 1

Outcome Indicators Policy Area / Target* Baseline Latest Available

Assessment

Access: Create a fair business environment in which SMEs benefit from market-based services [CAS].

Loans to SMEs comprised 47% of total loans (2003).

Loans to SMEs comprised 52% of total loanse (Jun 2007). Satisfactory

Regulatory and Institutional Framework for Trade and Investment

Increase investment-GDP ratio to 23–25%.

Investment-GDP ratio at 18.9% (2003). Investment-GDP ratio projected to be 24% by end-2007 (Sep. 2007). Satisfactory

Reduce start-up time for new businesses to 30 days.

Start-up time for new businesses takes 168 daysh (2003).

Start-up time for new businesses takes 105 daysh (2007).

Satisfactory

Tax services: Improved perception by users [CAS].

57% of respondents identify tax administration as a moderate, severe, or very severe constraint to doing business (2003).a

38% of respondents identify tax administration as a moderate, severe, or very severe constraint to doing business (2007).b

Satisfactory

Reduce time to obtain VAT refunds [CAS].

Average time to obtain VAT refunds is 12–18 months (2003).c

Average time to obtain VAT refunds is 5.1 months (2007).b Satisfactory

Customs services: Improved perception by users [CAS].

51% of respondents identify customs and trade regulations as moderate, severe, or very severe constraints to doing business (2003).d

32% of respondents identify customs and trade regulations as moderate, severe, or very severe constraints to doing business (July 2007).b

Satisfactory

Improve average import clearance time [CAS]. Average import clearance time is 8 days in the

red lane (2004).d

Average import clearance time is 6 days in the red lane (preliminary 2007 data).b

Satisfactory

Public-Private Partnerships in Infrastructure

Improve the regulatory and institutional framework for public-private partnerships (PPPs) [CAS].

Regulatory initiatives in several infrastructure sectors were adopted, but with limited impact given the lack of overall coherent sectoral strategy, central coordination, and follow-through (2003).f

The PPP framework has improved. A decree was issued (Perpres No. 67) requiring open and transparent competitive bidding for PPPs. The National Committee on Policy for Accelerating Infrastructure Provision and a Risk Management Unit were created within the Ministry of Finance to determine public funding for PPPs. These initiatives have been successful in stopping noncompliant projects but have so far failed to initiate model PPP transactions.

Partially Satisfactory

Appendix 1 35

Outcome Indicators Policy Area / Target* Baseline Latest Available

Assessment

DPL Core Policy Area III: Improved Public Financial Management and Governance Objective: Improve transparency, accountability, efficiency, and effectiveness in the use of public resources

Objective: Improve the institutional framework for addressing corruption

Accountability and Tansparency in Public Financial Management

Increase accountability and transparency in government financial management through availability of complete, reliable, and timely budget information and financial statements.

Budgets supported with limited fiscal information and incomplete budget documentation. No government accounting standards developed or applied, nor aggregate financial statements prepared.

Comprehensive fiscal information now included in budget documentation. Government accounting standards developed and applied nationally. Aggregate government financial statements prepared in a timely manner and made widely available, although reliability of these statements needs to be improved.

Satisfactory

Improve budget disbursement pattern on capital and material expenditures.

Budget authorization documents to line ministries invariably issued around mid-year, resulting in expenditure being skewed during the second half of the fiscal year. 54% of disbursement on capital and material expenditures was disbursed in the last quarter of the fiscal year (average 2001–2004).

Government spends 52% of its total capital expenditure in the final quarter of the year (2006).

Unsatisfac-tory

Improve cash management through a treasury single account regime [CAS/PEFA].

More than 18,000 commercial bank accounts handled government funds, with no standards for efficient authorization and management of balances (2003).

Pilots for TSA were successfully implemented, and the national regulatory framework for efficient management of bank balances has been established. Government projected to complete consolidation of all government bank balances into a TSA by end-2007 (Sep. 2007).

Satisfactory

Improve procurement regime that promotes greater transparency, open and fair competition, economy, and efficiency as evidenced by (i) 100% of government agencies following presidential decree on procurement, (ii) prices of public procurement are within market prices, and (iii) bidders from outside the districts or provinces of the procuring agencies are free and encouraged to participate.

No national standards in procurement policies and processes exist.

Procurement reforms have received a major boost with the impending and long-awaited establishment of an Independent National Procurement Office at the end of 2007. The public procurement system still has significant deficiencies at regulatory and implementation levels due to slow progress in establishing a regulatory body, passing regulations, and developing standard tools such as bidding documents and user manuals.

Partially Satisfactory

36 Appendix 1

Outcome Indicators Policy Area / Target* Baseline Latest Available

Assessment

Decentralization Framework Clarify and improve decentralization framework in respect to fiscal affairs [CAS].

Law No. 33/44 needed to be clarified and extended through the issuance of government regulations before it could be implemented. The design of mechanisms for donor finance was particularly inadequate (unclear, not facilitative), constraining financial flows to the subnational level. Furthermore, alternative financing mechanisms were insufficiently developed (i.e., no framework for bonds) (2003).

Major regulations based on Law No. 33/04 were issued. KMK 35 was replaced by regulations on blue book, onlending, and on-granting resulting in a clearer and (slightly) improved system. Regulatory framework for bonds was developed. Insufficient time has elapsed to see any real improvements in terms of subnational borrowing through onlending mechanisms and through bonds (Sep. 2007).

Partially

Satisfactory

Institutional Framework for Addressing Corruption

Strengthen institutional framework for addressing corruption as evidenced by continued positive trend in the number of corruption cases investigated and successfully prosecuted.

No special institutions or agencies to investigate and prosecute corruption cases and few corruption prosecutions (2003). 1,367 cases investigated and 617 cases prosecuted (2004).

The following institutions have been established: the Corruption Eradication Commission, the Anticorruption Court, the Judicial Commission, the Police Commission, and the Prosecutorial Commission (2007). 1,758 cases investigated and 807 cases prosecuted (2006).

Satisfactory

DPL Core Policy Area IV: Making Services Work for the Poor Objective: Improve quality, coverage, and utilization of basic services, especially for the poor

Objective: Make stronger progress toward achieving MDG goals

Pro-Poor Expenditure Reduce costly, inefficient, and regressive spending and reorient public spending toward pro-poor programs.

Spending on subsidies accounted for 4% of GDP (2004). Combined spending on health and education accounts for 3.5% of GDP.j

Spending on subsidies accounts for 2.7% of GDP (2006). Spending on health and education accounts for 4.9% of GDP (2006).j

Satisfactory

Social Protection Improve impact of social assistance programs on the welfare of the poor through better targeted, publicized, and managed social protection and human development programs for the poor in 7 regions benefiting at least 500,000 households.

System of public social assistance characterized primarily by crisis-era safety net programs and large universal commodity price subsidies, particularly through fuel products that benefited primarily the nonpoor (2003).

Social assistance is now delivered in the form of cash transfers systematically targeted to poor households and communities. This represents a more focused approach to identifying and protecting the poor than the series of ad hoc subsidies instituted in the aftermath of the economic crisis. In addition, evaluation has been given more attention in the design of the current programs.

Satisfactory

Appendix 1 37

Outcome Indicators Policy Area / Target* Baseline Latest Available

Assessment

Education Improve the professional competency and performance incentives of teachers through compliance with 2005 Teacher Law.

36% of teachers had 4-year university (S1) degrees (2004).g

42% of teachers had 4-year university (S1) degrees (2006).g Satisfactory

CAS = country assistance strategy, DPL = Development Policy Loan, GDP = gross domestic product, NBFI = nonbank financial institution, PPP = public-private partnership, RPJM = Government’s Medium-Term National Development Plan, S&P = Standard and Poor’s, SME = small or medium enterprise, TSA = treasury single account Notes: a Investment Climate and Productivity Study, Asian Development Bank, 2003. b Monitoring Investment Climate in Indonesia – Round 3 (draft), The World Bank, 2007. c Study of Implementing VAT Refunds in Indonesia, LPEM, Faculty of Economics, University of Indonesia, 2003. d The Study on Trade Related Systems and Procedures in the Republic of Indonesia, Japan International Cooperation Agency, 2005. e Total credit realization by SMEs from commercial banks, as measured by Bank Indonesia. f Averting an Infrastructure Crisis: A Framework for Policy and Action, The World Bank, 2004. g Ministry of Education statistics. Data reflects end-Indonesian school year and includes all primary, junior, and secondary public schools (religious schools not included). h Doing Business Report, The World Bank, 2004. ji Spending for Development, Making the Most of Indonesia’s New Opportunities, The World Bank, 2007.

Source: World Bank, Program Document for a Proposed Fourth Development Policy Loan (DPL-4), 31 October 2007.

38 Appendix 2

ACCOMPLISHMENTS UNDER THE DEVELOPMENT POLICY LOAN/DEVELOPMENT POLICY SUPPORT PROGRAM (DPL/DPSP) SERIES AND REMAINING CHALLENGES

A. Macroeconomic Stability and Creditworthiness

1. In early 2004, at the inception of this DPL series, the economy was growing less than 5% annually, government debt-GDP ratio was over 60%, investment was less than 20% of GDP, and the markets remained wary of the country’s long climb back to a precrisis environment of sustained high levels of investment and growth. Given continued sound economic management and progress on structural reforms on several fronts since that time, momentum has shifted and has led to improved market confidence. Despite occasional bouts of volatility, the economy is now on a much stronger footing. Recent growth rates (5.6% in 2005, 5.5% in 2006, and a projected 6.3% for 2007) are among the highest in the region. Indonesia’s international credit ratings have seen dramatic improvements over the past 4 years, with S&P upgrading Indonesia’s credit rating from CCC+ in 2003 to BB- in 2007―reflecting a five notch improvement in 5 years.

2. Smaller budget deficits, along with steady economic growth, have also led to a rapid decline in the debt-GDP ratio. By end-2005, debt-to-GDP had dropped to 47% from 55% in 2004 and 100% in 1999. That is well below the 60% target specified in the State Finance Law. For 2007, the debt-GDP ratio is expected to fall to approximately 35%, thus achieving the expected outcome on debt reduction envisioned at the outset of the DPL program. Even with expected increases in public investment in the education, health, and infrastructure sectors, fiscal sustainability is expected to continue, and the debt-GDP ratio is projected to fall below 30% in 2010. To bolster the Government’s efforts, the World Bank and Australian Agency for International Development are supporting the development of debt management practices, including risk management, staff capacity building, and the provision of policy guidance.

3. The Government has also achieved improvements in non-oil and gas tax revenues, mainly through the modernization of tax offices. While the increase in revenues over the past 4 years is mostly attributable to higher oil and gas revenues, non-oil and gas revenues have also increased, from 10.4% of GDP in 2003 to a projected 11.4% for 2007. The Government’s overriding objective in its tax agenda is to encourage greater and more predictable revenues through improved compliance and a broader tax base while reducing rates to improve investment sentiment. Over the past few years, the Government has increased taxpayer registration and tax return filings by new and existing taxpayers, and it has improved recovery of tax arrears and expanded audit coverage. In December 2004, e-registration of taxpayers was introduced, as was e-filing in January 2005. This was accomplished, in part, through the establishment and expansion of modern tax offices, including, in 2006 and 2007, those targeting medium and smaller taxpayers that are now responsible for by far the largest share of Indonesian taxes. The World Bank’s Government Financial Management and Revenue Administration Project (GFMRAP) is supporting modernization of these offices, including the upgrading of facilities and IT systems, staff reorganization by function, increased remuneration, and the institution of a taxpayer bill of rights and a tax official code of conduct. In 2007, the Government continued its program of extending modern tax offices with a major expansion to medium-sized tax offices and through the beginning of a reorganization of the central tax office to support the longer-term tax reform agenda.

4. Despite progress on extending the modern tax office system, many problems remain. The tax system is still characterized by relatively low revenue generation, poorly defined and overly complicated taxes (thus creating excessive compliance costs), and poor and inconsistent

Appendix 2

39

enforcement (giving rise to uncertainty and abuse). In part, the problem requires better oversight of tax officials, and in part it stems from a systematic lack of information and capacity for tax and customs analysis outside of the respective tax and customs offices. The lack of capacity has led to an inability to accurately assess and forecast the implications of the proposed tax and customs changes, reduced checks and balances, and diminished the ability to balance taxpayer and government requirements. As part of its second phase of institutional reorganization in 2006–2007, the Ministry of Finance established a Fiscal Policy Office. This office replaces the Agency for Economic and Financial Sector Research and International Cooperation, which had itself become operational only in 2005 with the aim of separating fiscal policy formulation and implementation within the Ministry of Finance and to address the weaknesses described above.

5. One of the most defining reforms supported by the DPL/DPSP program was the dramatic reduction in fuel subsidies under DPSP-1, which overall reduced the level of subsidies from 4% of GDP in 2004 to 2.7% in 2007. The result was a substantial reduction in regressive fuel subsidies, which was accompanied by a stable exchange rate, inflation, and interest rates. More broadly speaking, with lower subsidies, the central and regional governments were able to use the additional $10 billion a year in reallocated funds for social protection programs that helped to mitigate the social impacts of the fuel price hike on the poor and to focus more effectively on human development and such other priorities as increased infrastructure. Overall, consolidated government investment is estimated to be close to precrisis levels as a share of GDP in 2007.

6. Despite these successes, there is scope for more reduction of subsidies. While the 2005 fuel price hikes were a bold move, Indonesia’s retail prices for gasoline and kerosene still remain well below international prices and are not market-based. The Government also faces a critical choice on electricity subsidies. The increases in fuel prices have raised the subsidies required by Indonesia’s state-owned electricity company as they pass into production costs. In 2006, the central government spent Rp35 trillion ($3.8 billion) for electricity subsidies, which have been increasing significantly after the fuel price hikes and result in an additional subsidy of Rp20 trillion. As was the case of fuel subsidies, those for electricity distort consumer and producer incentives and constrain higher value spending. Most of the electricity subsidy is absorbed through a regressive subsidy to consumers (66%), followed by industry (29%), and business (5%) in 2006. Reducing inefficient spending with due consideration for growth outcomes and the impact on the poor will continue to be an important topic of analytical work and policy engagement between development partners and the Government.

B. The Investment Climate

7. After the crisis, investment fell from 30% to 20% of GDP. Such low levels of investment have prevented Indonesia from growing at such rates as do People's Republic of China and Vietnam, which benefit from high investment ratios of 45% and 32% of GDP, respectively. The weaknesses in the investment climate were clearly identified at the outset of the current administration, with the new Government’s medium-term plan detailing the major constraints and proposed solutions. In this context, a major focus has been placed on financial sector reforms. Three economic policy packages were issued in 2006, including one on the investment climate, one on infrastructure, and one on financial sector reform. A comprehensive follow-up package was issued in June 2007 detailing 168 specific reform measures to be carried out over the next 12–18 months. Many of the key reform areas spearheaded by the Government have been supported by the DPL/DPSP programs. The DPL/DPSP has been an effective instrument for promoting interministerial agreement to push for difficult reforms that may encounter bottlenecks at lower levels of the bureaucracy.

40 Appendix 2

8. In general, these reforms, along with the favorable macroeconomic environment described above, have shown good results in improving the environment for investments. This is evident in the strong contribution by investments to economic expansion, which is projected to account for about one quarter of total GDP growth in 2007. Business confidence has strengthened over the past few years. The rupiah has been among the top six best-performing currencies tracked by Bloomberg this year, and the equity market is one of the best performers in 2007. Business perceptions about the investment climate have also improved significantly between 2003 and 2007.

9. Financial sector indicators also show evidence of solid outcomes in terms of stability, access, and diversification. Capital adequacy ratios remain over 20%, nonperforming loans continue to decline, and Indonesian banks continue to be among the most profitable in the region with net interest margins of nearly 6%. Loan-deposit ratios continue to show a gradual increase, although there is concern over sluggish loan growth. The proportion of state-owned banks in the overall banking system stands at 36%, which represents a 10 percentage point decrease since 2003 and indicates the increasing role of private banks. Bank Mandiri―the largest state-owned bank―was removed from Bank Indonesia’s intensive supervision as from September 2007. Its nonperforming loans had dropped to 3.9%, below the 5% threshold. In sectoral terms, small and medium-sized enterprise (SME) lending has been rising rapidly. As of December 2006, loans to SMEs were 52% of total loans, compared with 47% in 2003, and loans to SMEs had grown at nearly 16% over the year. That was higher than the 11% growth of non-SME lending. The deposit insurance scheme was fully implemented in March 2007, and so far without any signs of flight to quality. Minimum paid-up capital for banks has been raised and will be Rp80 billion by December 2007. Thus far, Bank Indonesia (BI) has indicated most banks would be able to comply with this regulation, whereby shareholders are injecting new capital. BI also indicated that only a few small-sized banks would be unable to meet the capital requirement, and mergers and acquisitions of small banks by larger banks are ongoing.

10. In the area of the regulatory and institutional framework for trade and investment, much of the focus up until this year has been on tax and customs reforms. Specific actions have included efforts to restrict the creation of nuisance and/or economically harmful charges and levies, to challenge tax assessments stemming from disputed audit findings, and to speed up value added tax (VAT) refunds in order to free up working capital for export-oriented manufacturing firms. The latter has shown recent progress, as according to manufacturing firms surveyed in July 2007 the average time to obtain a VAT refund fell from 6.3 months in 2006 to 5.1 months in 2007. The same survey revealed improved perceptions of tax administration, as 38% of respondents believed that tax administration represented a moderate, severe, or very severe constraint to doing business in 2007 while 57% of respondents had thought so in 2003.

11. While the investment law, trade reforms, and business procedures were added to DPSP-3 this year, these have all benefited from the Government’s commitment to make improvements in these areas. According to manufacturing firms surveyed in July 2007, average import clearance time dropped to 6 days in the red lane compared with 8 days in 2003. Indicators also show an improvement in perceptions regarding customs and trade regulations as constraints to doing business, that figure falling from 51% of respondents in 2003 to 32% in 2007. Despite improved perceptions and reforms undertaken in recent years, businesses and investors continue to suffer from an overall poor business climate. While import clearance has improved, for example, 30% of all import shipments in the main port (Tanjung Priok) are still sent through the red lane (physical inspection). This is triple the Government’s target of 10% set out in last year’s investment climate policy package.

12. Regarding many other aspects of the investment climate, Indonesia also continues to rank poorly in international comparisons. The World Bank’s Doing Business 2007 report ranked

Appendix 2

41

Indonesia 135th out of 175 economies on ease of doing business, and IMD’s World Competitiveness Yearbook ranked Indonesia 54th out of 55 countries—putting it well behind the Philippines, India, and Thailand. These comparisons are based mainly on information from 2005, and hence they do not reflect more recent reforms. Despite progress, businesses in Indonesia still face a difficult legal and regulatory environment. Strict labor regulations continue to create a disincentive to employment expansion, and infrastructure weaknesses raise the costs and uncertainty of doing business. The Government is attempting to address this issue by forging partnerships with the private sector. To support Government efforts in this area, ADB is providing technical assistance to strengthen institutions promoting public-private partnerships (PPPs) in infrastructure provision, and it is providing a loan to fund a project development facility that will assist in preparing PPP projects at national and local levels for tendering to the private sector on a transparent and competitive basis.1 Businesses also face a complex regulatory system consisting of numerous overlapping, redundant, and unnecessary licenses, each with its own prerequisites, and often involving multiple reporting requirements and inspections. The result is a slow, costly business start-up process and a difficult operating environment in which arbitrary decisions from officials create great risk and uncertainty. While President Yudhoyono had committed publicly to reducing the number of days to start a business to 30 days (adopted as an outcome indicator for DPSP-3), current Government estimates suggest the number of days remains high, at 105, although that at least is lower than the 168 days estimated in 2003.

C. Public Financial Management and Anticorruption

13. Public financial management (PFM) systems in Indonesia were left essentially untouched by reforms and modernization until the beginning of 2000. The systems were heavily centralized, input-based, and largely reliant on manual processing of transactions. PFM was based on an outdated chart of accounts and regulatory framework. Founded on recommendations provided in the Country Financial Accountability Assessment and the Government White Paper on Reform of Public Financial Management Systems―both issued in 2001―there has been ongoing reform to modernize the regulatory framework, reorganize the Ministry of Finance, improve budget documentation, and streamline the budget preparation process. These reforms have taken place in the context of Indonesia’s massive decentralization effort, which has devolved up to 50% of public expenditures to lower levels of government.

14. The seminal changes to the legal and regulatory framework on PFM came with the approval by Parliament of a troika of laws on State Finance, State Treasury, and State Audit in 2003 and 2004. A presidential decree on procurement in 2003 set out the basic principles of procurement: transparency, open and fair competition, economy, and efficiency. It covers all areas of procurement that use public funds and is supposed to cover contracting entities at all levels of government. These laws provide the framework for PFM modernization in line with good international practice.

15. The DPL program has supported a subset of the ambitious PFM modernization agenda. It has supported many of the implementing regulations to put in force the new legal and regulatory framework. The DPL program has also helped move forward reforms to reengineer business process across the budget cycle, including to make the national budget compatible with the international standard Government Finance Statistics classification, consolidate government accounts into a treasury single account (TSA), improve fiscal reporting, and establish forward-looking budgeting. The DPL has also supported institutional reforms aimed at 1 ADB. 2006. Technical Assistance to the Republic of Indonesia to Enhance Private Sector Participation. Manila (TA

4872-INO, approved on 21 November, for $2.0 million); ADB. 2006. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Republic of Indonesia for the Infrastructure Reform Sector Development Program. Manila (Loan 2264-INO (SF), approved in November, for the equivalent of $26.5 million).

42 Appendix 2

modernizing the Ministry of Finance. Overall, Indonesia has taken impressive steps in recent years to establish a sound legal and administrative framework for modern financial management. Changes in the legal and regulatory architecture are now largely complete, and the momentum has shifted towards implementation of new financial management practices.

16. In terms of budget reforms, the DPL has supported implementing regulations under the finance law that define fiscal relationships between various parts of government. Provision of the new regulations is ongoing. The budget classification is largely consistent with contemporary international standards. The Ministry of Finance has taken first steps in developing a medium-term expenditure framework (MTEF) to guide budget policy. The 2008 budget includes for the first time a Medium-Term Budget Framework based on aggregate macro-fiscal forecasts of both revenues and expenditures for two out-years. Nevertheless, budget plans continue to be prepared on a strictly annual basis, and medium-term public investment needs are not yet addressed in a systematic framework that reconciles medium-term budgetary costs with aggregate resources. Integration of planning and budgeting processes—a critical element in the move towards performance-based budgeting—is also progressing. Despite this progress, ministries and agencies still lack a good understanding of the objectives of the work plan and the budget document. Implementation of a more performance-oriented budget will take more time and a clearer strategy.

17. On budget execution, Indonesia still makes 50% of its total capital expenditure in the final quarter of the year.2 For the past 5 years, spending has always started slowly and then accelerated at the end of each year. This spending pattern means that project implementation is disrupted by an adverse cycle. Moreover, underspending on capital investments constrains increases in infrastructure investments. Slow and back-loaded disbursements are symptoms of more severe challenges that are encountered at each stage of the public expenditure management cycle. With expanding fiscal space, public investment is increasing, putting additional pressure on the PFM systems. Planning and executing public investment is inherently more demanding than current or mandatory expenditure.

18. Treasury and cash management reforms have largely focused on converting operational bank accounts into zero-balance transit accounts and installing a treasury single account. Pilot runs for testing zero-balance arrangements with commercial banks have been successful. It is planned to complete consolidation of all government cash balances into the TSA by end-2007. The cash-based accounting system generates timely records of revenue and expenditure transactions, but it does not track monthly arrears. Transaction records are electronically transmitted to the Directorate of Accounts at treasury headquarters for consolidation and generating periodic reports on budget execution. The cash-based treasury system does not track payment arrears on a monthly basis, although Directorate General Treasury’s plan to move towards an accrual recording system would make this possible. Treasury cash management and payment modernization will be supported by the planned computerized Treasury Information Management System under the World Bank GFMRAP project that is under implementation.

19. The past few years have witnessed incremental improvements in the public procurement environment. Presidential Decree No. 80/2003 provided a national public procurement regulation that corresponds with most of what is generally regarded as accepted international practice, including the basic principles of transparency, open and fair competition, economy, and efficiency. This decree also requires that a national procurement policy office (NPPO) be established as a regulatory body for public procurement. With the introduction of Presidential

2 World Bank. 2007. Indonesia Public Expenditure Review 2007: Spending for Development: Making the Most of

Indonesia’s New Opportunities. Jakarta/Washington, DC.

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Decree No. 80/2003, key provisions that had limited competition, such as certification procedures and market segmentation, were deleted. Presidential Decree No. 80/2003 also established a basis for sanctions, complaints handling, and requirements for certification of users. ADB has supported the Government through technical assistance to revise an earlier presidential decree on procurement and to prepare Presidential Decree No. 80/2003. Nevertheless, the public procurement system still has deficiencies in its regulatory and, more importantly, implementation aspects. These are mainly the delays in establishing a strong regulatory body; slow progress in developing procurement regulation anchored by law; weakness in implementing agencies’ procurement capacities, and especially at the provincial and district levels; collusive and corrupt practices in the bidding process; and concerns over the efficiency of anticorruption measures and sanctions.

20. Regarding budget reporting, the aggregate Government Annual Financial Statements have been prepared in a timely manner for 3 years now (2004, 2005, and 2006). This is a major achievement. These comply with the new Government Accounting Standards that are described by the authorities as “cash towards accrual basis.” The aggregate annual financial statements present revenues, expenditures and transfers, surplus or deficit, and financing aggregates in comparison with budget provisions. A balance sheet and a cash flow statement are also presented, along with a full statement of government accounting policy. Despite these improvements, there continue to be serious challenges in making the government financial statements reliable, as reported by external auditors in their annual audit report for 2006. This reflects the immense challenges that lay ahead in an environment where accounting capacities at the grassroots are weak and the accounting processes not yet integrated or fully automated.

21. The Government’s internal audit framework is extensive, but scope and organization do not match needs. The internal audit function is carried out at the central government through three institutions: Inspectorates General (IGs) in each spending ministry; the State Financial Control Agency (BPKP), reporting to the President’s office, with government-wide jurisdiction; and the Regional Supervision Agency (BAWASDA) at each local government. To clarify the institutional structure, mandates, and division of labor between the various internal audit institutions, ADB is providing loan support to bring about institutional reform and a changed mandate for BPKP, as well as capacity building support to the BAWASDAs and IGs in spending ministries.3

D. Making Services Work for the Poor

22. After the economic crisis, Indonesia failed to invest sufficiently in its economy, and particularly in public service delivery. With an estimated $10 billion to reallocate from the regressive fuel subsidies and an additional $5 billion available from increased revenues and declining debt service, the Government can start to realize its ambitious poverty reduction agenda linked to achieving the Millennium Development Goals. This agenda was added on to the DPL/DPSP umbrella last year as part of ongoing donor analytic, diagnostic, and policy support to the Government’s fuel compensation schemes. This year, under DPL-4/DPSP-3, education and community-driven development were added on as new policy areas. Because of the recent addition of these policy areas, assessing the expected improvement in service delivery beyond outputs would be difficult at this stage. Hence, the section will be limited to reviewing the results of the fuel compensation programs.

3 ADB. 2004. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the

Republic of Indonesia for the State Audit Reform Sector Development Program. Manila (Loan 2127-INO (SF), approved in December, for the equivalent of $25.0 million).

44 Appendix 2

23. Since the fuel price hike, there has been an evolving change in how social protection programs are administered, implemented, monitored, and evaluated. Prior to 2005, Indonesia’s social protection system was characterized primarily by (i) crisis-era safety net programs; and (ii) large commodity price subsidies and transfers, particularly through fuel products. The crisis-era social safety net programs were temporary, short-term interventions, rather than long-term social protection systems aimed to ensure continued access for the poor to affordable food, health, and education services. While meant to be temporary, many of these programs became entrenched social policy. The continued safety net programs address a diversity of issues, but are low in coverage, institutionally fragmented, and not managed as one umbrella system. In 2003, budgets allocated to the three principal targeted programs, namely subsidized rice for the poor, education scholarships, and health cards, totaled about Rp8.4 trillion, accounting for only 2.2% of total government expenditure. By comparison, in 2005 about Rp103 trillion was spent on fuel subsidies. It is estimated that about Rp5 trillion of this benefited the poorest quintile.

24. The fuel compensation programs enacted shortly after the second wave of fuel price increases in October 2005 represented a break from traditional safety net programs. The Government opted for a cash transfer scheme wherein 19.2 million households would receive Rp300,000 each quarter. This represented the largest ever cash transfer program in terms of coverage and total volume transferred. The unconditional cash transfer (UCT) program was designed as a temporary, 1-year cash transfer program aimed at mitigating the impacts of the fuel subsidy. For poor recipients, the cash transfer more than compensated for the losses incurred due to the fuel price hike. Initial assessments during the first tranche noted several problems, particularly in targeting. That prompted the Government to make adjustments in the UCT’s implementation.

25. Lessons learned from assessments of the UCT program—which was supported by DPL/DPSP—have led to the piloting of conditional cash transfers (CCT). Conditional cash transfers can be used to stimulate demand for services by the poor and give them more of a voice in frontline service provision. Programs that transfer resources directly to poor families have proved effective in several other countries at raising enrolment, attendance, and utilization of health facilities. Community-based approaches that aim at increasing utilization are also relevant in the Indonesian context. The President has announced that the Government will pilot both the “conventional” conditional cash transfer to households and a community-based alternative starting in mid- 2007. Detailed design of the two approaches is currently underway, led by the National Development Planning Agency and involving the Ministries of Social Affairs, Education, Health, Public Works, and Home Affairs.

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BACKGROUND INFORMATION ON THE TRIGGERS FOR THE THIRD DEVELOPMENT POLICY SUPPORT PROGRAM (DPSP-3)

1. Trigger 1: Improve VAT by, among others, reducing the time for VAT refunds through implementation of the DG Tax Regulation No. 122/2006. Exports are zero-rated for value added tax (VAT). Nevertheless, exporters pay VAT on domestic purchases but do not collect any VAT from buyers of their product. Consequently, they are regularly owed VAT refunds by the tax department. Refunds have in the past taken a very long time to process, with the average exporter reporting a 6-month delay between submitting the claim and receiving the refund. This ties up a considerable amount of working capital and makes Indonesian exports less competitive than exports from other countries, where VAT refunds typically take less than 1 month. To remedy this, Directorate General (DG) tax regulation no. 122/2006, issued in August 2006, prescribes reduced time limits for completing the approval of refund claims based on the status of the claimant. Low-risk exporters should see their claims approved in 3 months, medium- and high-risk exporters in 5 months, and other claimants within 13 months. The 2007 package on Policies to Accelerate Development and Empower Micro, Small and Medium Enterprises (Presidential Instruction 6/2007) further states that by July 2007 the maximum time to process VAT refunds for compliant ("Golden") taxpayers will be cut from 1 month to 7 days, for low-risk exporters from 12 months to 2 months, and for medium-risk exporters from 12 months to 4 months. 2. Trigger 2: Issue Ministry of Finance (MOF) Decree on tax audit procedures that allows taxpayers to request details of audit findings and a review in case of disputes after closing conference but before completion of audit. The Indonesian tax system relies on self-assessment, under which taxpayers are trusted to calculate, pay, and report their own taxes in accordance with prevailing tax laws and regulations. However, the DG tax may issue tax assessment letters to a particular taxpayer if it finds that, based on a tax audit or other information, the taxpayer has not fully paid its tax liabilities. Further, DG tax may conduct tax audits in the taxpayer’s premises for some reasons including but not limited to: a tax refund request, an annual income of tax return presenting a tax loss, a tax return not filled within the prescribed time, and other reasons meeting certain (undisclosed) criteria of the DG Tax. At the end of a tax audit, the tax auditors will provide the taxpayer with a written notification of the tax audit findings. The taxpayer will typically have to respond to the notification in writing within 7 to 21 days. After that, a final discussion about the tax audit findings (Closing Conference) is to be held between the tax auditor and the taxpayer. Previously, if the taxpayer disagreed with the result of a closing conference, he or she could file an appeal with the tax court within 3 months but would have to pay 100% of the disputed amount in advance. This created an imbalance between the rights and obligations of the taxpayers and the powers of tax officials. 3. Trigger 3: Roll out a National Single Window with online clearance of merchandise. The National Single Window (NSW) for imports and exports is currently the most important trade facilitation initiative underway in Indonesia. Under a single window, traders (importers and exporters) will no longer be required to apply individually to multiple government agencies—such as Customs, the Port Authority, the Ministry of Trade, the Food and Drug Agency, and Quarantine—to clear cargoes. A single application is instead submitted using a single administrative document, and this application is transmitted to each relevant agency by the operator of the Single Window. Approval is transmitted back to the operator so that the trader

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communicates directly with one authority rather than multiple authorities. Indonesia has signed two international agreements committing to establishing a NSW as a preliminary step toward integrating into an ASEAN-6 Single Window by September 2008. A national team to establish the single window, chaired by the Minister of Finance and led at the working level by a deputy under the Coordinating Minister for the Economy, was created in March 2006. 4. Trigger 4: Enhance procedure for tariff setting through implementing better methodology, improved research capability, and better information technology. A 2004 World Bank report, Making Indonesia Competitive: Promoting Exports and Managing Trade, found that, although import tariffs are generally low in Indonesia, import licenses and nontariff barriers are becoming popular instruments to restrict trade.1 Several high tariffs and a number of nontariff barriers on inputs, and particularly in agriculture, are taxing the further development of agriculture processing industries. The interministerial Team Tariff is responsible for evaluating Indonesia’s tariff regime. With recommendations from the Team, MOF is exercising its authority to change tariff rates. The Team, however, faces weak capacity. There is a consensus that the Team’s secretariat functions should be revamped. A more effective technical team should also enhance Team Tariff’s performance in setting tariff policies. 5. Trigger 5: Implement the Investment Law, its supporting regulations, and new operating procedures. A new Investment Law was passed by Parliament in March 2007 after some delay. The law provides equal treatment to domestic and foreign investors, allows for longer work permits for expatriates, and extends the number of years for which land can be leased. It states explicitly that investors are entitled to repatriate and transfer funds in foreign exchange, and that disputes between government and investors can be settled through international arbitration. One implementing regulation for the law was issued prior to passage of the law: PP1/2007 on fiscal incentives for investment. Four more implementing regulations are to be issued in 2007. Of these, two on the criteria for negative lists and the negative list itself were issued in July 2007. Two more regulations on one-stop shops and investment procedures are pending. 6. Trigger 6: Simplify or eliminate unnecessary and/or redundant business licenses, procedures, and multiple registration requirements. The procedures to set up a business in Indonesia are among the most complex, costly, and time consuming in Asia. Some progress has been made, as the time to establish and register a limited liability company has fallen from 168 days in 2003 to 105 in 2007. This is still well above regional standards (Malaysia and Thailand require only 30 days), however, and after establishing a company, investors still must obtain numerous sectoral and local licenses. The whole process of establishing a new company and obtaining all the required permits and licenses can take six months or more, depending on the sector and activity. A presidential decree in 2006 stated that the time to establish a company would be cut to 30 days. The 2007 package on Policies to Accelerate Development and Empower Micro, Small and Medium Enterprises (Presidential Instruction 6/2007) stipulates that the time to establish a company will be cut to 25 days by simplifying procedures, switching from sequential to parallel processing, and setting maximum time limits for each step.

1 World Bank. 2004. Making Indonesia Competitive: Promoting Exports and Managing Trade, Jakarta/Washington,

DC.

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7. Trigger 7: Issue a comprehensive SME policy package (including supporting industries) that, among others, increases access to finance and implements the Warehouse Receipts Law. The small and medium-sized enterprise (SME) policy package was issued as part of Presidential Instruction 6/2007. One of the package’s main focus areas is improving access of micro enterprises and SMEs to finance, since they face significant constraints in accessing formal sources of finance to meet their working capital and investment needs. Given the collateralized nature of lending, SMEs often have difficulties obtaining competitive loans from banks. In particular, movable property may not be used as collateral, as Bank Indonesia’s loan loss reserve rules prevent the use of such assets. As a result, expanding business has been very hard for many Indonesian SMEs. Presidential Instruction 6/2007 identifies a number of ways for micro enterprises and SMEs to improve access to finance, and one of the key areas is to implement the Warehouse Receipts Law that was enacted by Parliament in June 2006. The Law intends to establish a system of designated warehouses which could provide official receipts for commodities stored by farmers, growers, and traders. This is to provide SMEs in agribusiness and related sectors flexibility in selling their products based on market conditions. The designated warehouses will provide them with certificates against goods held. The receipts can be traded as derivatives, or used to settle maturing futures contracts on a commodities exchange, or as collateral to obtain bank loans. The World Bank Group is currently supporting the Government in developing implementation regulations for the Law. 8. Trigger 8: Implement good corporate governance and risk management standards, particularly in state-owned banks, and continue implementation of financial sector safety net. In the aftermath of the financial crisis in 1997, the Government introduced a blanket guarantee on all bank liabilities to restore public confidence in the banking system and control bank runs. Subsequently, as crisis resolution progressed and the banking sector strengthened, the Government committed itself to lifting the blanket guarantee in a phased manner and introducing a deposit insurance scheme that would cover deposits of up to Rp100 million. The Parliament approved the Law on Deposit Insurance in August 2004, setting out a phased plan to reduce the coverage of the blanket guarantee to commence from September 2005 as per the schedule presented below. The main objectives of the deposit insurance scheme are to reduce the economic distortions and moral hazard created by the blanket guarantee as well as potentially to try and limit the fiscal costs to the Government in the event of future difficulties in the banking sector. It is also an integral part of the overall financial sector safety net being put in place by the Government. Some other elements of that net include BI’s role as a lender of last resort and establishment of institutional processes and mechanisms by which banks facing difficulties would be either aided by BI or their situations would be otherwise resolved.

Table A3.1: Implementation Schedule for the Deposit Insurance Scheme

Implementation Phases Current Status/Milestone 22 September 2005–21 March 2006 Entire amount of deposit was protected. 22 March 2006–21 September 2006 Maximum Rp5 billion was protected. 22 September 2006–21 March 2007 Maximum Rp1 billion was protected. Starting from 22 March 2007 Maximum Rp100 million will be protected. Source: Government of Indonesia. Law on Deposit Insurance.

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9. Trigger 9: Implement a medium-term expenditure framework (MTEF) with a system of clear forward estimates for the 2008 budget. For the 2008 budget preparation process, MOF implemented defined changes in the budget request templates and accompanying budget preparation manuals to strengthen the type and structure of performance information. Progress has also been made in moving towards a policy-based budget by further integrating the planning and budgeting processes into the 2008 budget preparation cycle. The 2008 budget that was submitted to Parliament in August 2007 indicates a substantial reallocation of expenditures towards priority sectors, and particularly infrastructure, that more closely reflect government policy priorities as outlined in the Government’s work plan. Priority programs and activities will also be specifically marked, allowing the Government to monitor alignment of budget allocations to government priorities. At the same time, MOF has made progress in enhancing its macroeconomic forecasting capacity, which is a key prerequisite for implementing the MTEF. The recent reorganization of the MOF, namely establishment of the Fiscal Policy Office, has strengthened its capacity to take the lead role in finalizing the medium-term macro-fiscal projections. Although medium-term macroeconomic and fiscal forecasts are prepared by the Fiscal Policy Office, they are not yet used directly in the budget process and presented in the budget documents that are submitted to the House of Representatives. For 2008, MOF is intending to pilot implementation of programmatic MTEFs in a selected number of line ministries. Finally, to further deepen reforms and to increase readiness for further reforms in the 2009 budget preparation process, MOF is intending to formulate and publish a coherent, phased strategy for budget reform covering the short, medium, and long terms. 10. Trigger 10: Continue to consolidate core government (revenue and expenditure) bank accounts. Effective management of state finances requires minimizing central government idle cash and cash float, reducing the maintenance costs of too many accounts, facilitating cash forecasting and cash management control, as well as enhancing the transparency of central government banking. Support for establishing the treasury single account (TSA) commenced under DPSP-1 (DPL-2), with pilots for zero-balance transitory accounts in Batam, Bekasi, and Jakarta. This has since been extended to 50 state treasury offices (KPPNs). Nevertheless, substantial state funds continue to be held in commercial bank accounts by both spending units and state officials. According to the State Audit Agency’s 2005 audit report, this includes about Rp8.5 trillion in some 1,300 current and savings accounts not recorded in the treasury system. These off-the-books funds not only distort the consolidated government cash balance but also are highly vulnerable to embezzlement and corrupt activities. Recent adoption of government regulation on cash management will enhance the powers of MOF to close unauthorized bank accounts and provide legal backing for a census of all government accounts.

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11. Trigger 11: Implement transparent accountability arrangements for RDI and RDA accounts. The central government investment funding (RDI) and regional development accounts (RDA) are off-budget accounts maintained by MOF to finance loan operations to state-owned enterprises and subnational entities, respectively. As of December 2005, the total amount outstanding as shown by the audited financial statements of the Government was Rp60.4 trillion ($6.5bn), of which nearly Rp29 trillion was the rupiah equivalent of loans made in foreign currency. It is understood that as at end-2006 the total had fallen slightly to Rp59.2 trillion spread across 1,650 loan accounts. Under current practice, RDI and RDA accounts are operated as a revolving off-budget fund. Cash received by MOF by way of repayments of principal, interest, and charges levied is not being deposited into the central treasury account but is retained in separate bank accounts, which may weaken financial accountability. In addition, administrative and accounting records for RDI and RDA transactions have been maintained in a manual recording system, which did not enable appropriate accounting and fiduciary controls to be exercised, given the size, volume, and nature of the transactions 12. Trigger 12: Fully operationalize the National Public Procurement Office (NPPO) and issue a draft procurement law. The Presidential Decree 80/2003 sought to establish an NPPO that was fully staffed and led by a first echelon official with sufficient authority across all levels of government in a decentralized framework. Given political difficulties, an acceptable interim solution was to establish the NPPO as a separate entity reporting to BAPPENAS with subsequent empowerment as an independent entity under the proposed new procurement law. This was agreed upon last year. However, this decision was reversed, and a government committee has now drafted a presidential decree to establish an independent entity. The current draft decree envisages an independent NPPO with a first echelon staff reporting to the President and with deputies heading three main departments for Strategy and Policy Development, Monitoring and Evaluation, and Information Systems. Once this decree is issued by the President, there will still be requirements for staffing, budgeting, and other support to make the NPPO fully functional. The decree represents a major step towards having a fully staffed regulatory body that can improve the public procurement system and monitor its performance. This in itself is a huge task, taking into consideration the degree of centralization in the country. Although a procurement law has been drafted, there is ongoing discussion on the content of a procurement law. The existing Presidential Decree 80/2003 promotes the basic principles of procurement: transparency, open and fair competition, economy, and efficiency. It covers all areas of procurement that use public funds and contracting entities at all levels of government. The decree corresponds with most of what is generally regarded as accepted international practice. However, the pace of Indonesia’s decentralization reforms has had an impact on public sector procurement, as different levels of government—from ministers, to governors, and even mayors—are able to issue their own decrees, regulations, and instructions. The plethora of regulations is often inconsistent and many of these do not correspond to accepted international practice. This is why there is a need for an overall regulatory framework in the form of a procurement law, which will be followed eventually with implementation decrees that would be used at both national and provincial levels.

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13. Trigger 13 and 14: Initiate civil service reform. Recently, the Government has begun to undertake a series of initiatives that constitute one of the most promising openings for civil service reform in years. A key first step has been the effort to design a new job classification and remuneration policy for high-ranking state officials, including ministers, legislators, judges, and heads of special commissions and agencies. MOF has taken leadership and set up a task force to examine the entire compensation package with the goal of creating a more transparent, systematic, and coherent framework of pay and allowances based on a comprehensive job evaluation and pay grading. The task force has proposed the establishment of a body to recommend to the President both the level and structure of the compensation package first for Indonesia’s highest ranking political officials and, once that is established, for the entire civil service. The body will also be tasked with establishing greater consistency and transparency of the overall remuneration package in order to improve governance. The body’s recommendations will be based on such modern techniques as job evaluations and pay comparator surveys. In addition, promising civil service reform pilots are being developed in MOF, which are being rolled out more widely to institutions with reform-minded leadership. 14. Trigger 15: Develop an enhanced assessment framework for selected service delivery programs. The ability to translate public spending into improved services depends, in part, on having better information on what works. It was for this reason that the Government approached donors to support them in assessing the four major fuel subsidy compensation programs (the 1-year unconditional cash transfer program, health insurance for the poor, operational assistance to schools, and village infrastructure) in 2006 (an action supported by DPSP-2/DPL-3). Going forward, the Government would like to take greater ownership and institutionalize the use of program assessments. To do so will require establishing a multiyear plan with appropriate budget and capacity building measures, as well as clearly defined steps to ensure findings are used to inform decisions on whether to expand, modify, or eliminate programs. The implementation of such a plan would likely lead to better understanding of the weaknesses of various program monitoring information systems—hopefully leading to improvements. 15. Trigger 16: Establish competency standards for teacher certification and the instruments for measuring compliance with those standards. Indonesia has identified education as one of the most critical sectors with regard to improving the quality of life of its citizens and the attainment of its Millennium Development Goals. In December 2005, with the passage of the Teacher Law, the Government launched a highly ambitious effort to upgrade the quality of its teachers. Under the new Law, all teachers will have their basic salaries doubled upon being certified as meeting the competency standards mandated by the Law. Those in remote areas will be provided additional incentives, resulting in a near tripling of their basic salaries. The Law presents an unprecedented opportunity to enhance the quality of professional development and training provided to teachers and to create a culture of teaching centered on instructional excellence. While survey data indicate that the quality of teaching in Indonesia compares poorly with those of such neighboring countries as Singapore and Malaysia, the low level of Indonesian teachers’ qualification is itself of concern: some 60% of Indonesia’s teachers do not have the minimum qualifications required by the new Law.

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16. Trigger 17: Permit community spending over multiyear periods and clarify procurement procedures for national budget funded community-designed development (CDD) programs. Implementation of the National Community Empowerment Program in 70,000 villages will depend on public financial management and procurement procedures that are suitable at the subdistrict level. The impact of CDD programs in supporting community groups is reduced, however, by the current annual budget system used by the Government. State budget regulations stipulate that public funds must be spent within the current fiscal (calendar) year even though public funding may be released as late as the second half of the year, and communities’ frequent lack of experience creates further delays. The inability of communities to carry over unspent funds beyond the current fiscal year could potentially lead to major disruptions in spending plans. While the current restrictions on carryover do not affect donor loan and grant funds, it applies to the Government’s rupiah funds. While in the past CDD programs were funded mainly by donor funds, this situation has been rapidly changing, and in 2009 it is expected that the majority of funds will be coming from the Government’s rupiah funds. The Government has been deliberating a number of available options for resolving this issue. The other component of the trigger relates to how funds are to be spent by communities. All public agencies are required to undertake expenditure in compliance with the 2003 Procurement Law. As private entities, community groups are exempt from this requirement. Nevertheless, there is a misunderstanding within central and regional governments that public procurement regulations apply to community groups, thus adding to the problems communities face in completing CDD projects. This has necessitated that the Government raise awareness among public agencies and communities regarding procurement regulations.

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DEVELOPMENT POLICY LETTER AND POLICY MATRIX FOR THE THIRD

DEVELOPMENT POLICY SUPPORT PROGRAM

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Table A4: Policy Matrix for the Third Development Policy Support Program

DPSP-3 Policy Measures Status as of 9 November 2007 A. Core Policy Area I: Improved Investment Climate 1. Improve tax and customs administration a. Improve VAT by, among others, reducing time for VAT refunds through the implementation of the DG Tax Regulation No. 122/2006.

Exceeded. Directorate General (DG) tax regulation No. 122/2006 is being implemented. Substantial progress has been achieved in VAT administration, with the average time taken to settle the VAT refund claims of manufacturing exporters having fallen to 5.1 months in 12-18 months in 2003. The Government has also settled 7,878 VAT refund claims from previous fiscal years amounting to Rp. 10.4 trillion during the past 12 months. The issuance of a DG tax circular letter on accelerating the settlement process of VAT refunds in July 2007, has further strengthen implementation of Tax Regulation No 122/2006.

b. Issue MOF Decree on tax audit procedures that allows taxpayers to request details of audit findings and a review in case of disputes after closing conference but before completion of audit.

Exceeded. In late 2006 the Ministry of Finance and the Directorate General for Taxes issued a number of regulations that affected tax audit procedures. The Ministerial Decree 123/PMK.03/2006 revised previous provisions related to tax audit procedures and taxpayer rights. Article 15 of this decree requires the tax auditor to inform taxpayers in writing about the results of the audit and the closing conference, including details on the audit findings and the legal basis for audit decisions. In addition, the DG Tax regulations PER-173/PJ/2006 on desk audit procedures and PER-176/PJ/2006 on field audit procedures stipulate taxpayer rights to bring an audit decision to and request a review by a higher level of authority in case of disputes. Extended taxpayer rights are also embedded in the Tax Law package passed by Parliament in March 2007

c. Roll out a National Single Window with on-line clearance of merchandise.

Achieved. The blueprint for the National Single Window has been released A pilot project for Tanjung Priok, which handles about 60% of Indonesia's trade, is currently under preparation with a scheduled launch date of December 2007.

2. Improve trade policy a. Enhance procedure for tariff setting through implementing better methodology, improved research capability, and better information technology.

Achieved. The technical team supporting team tariff has been reconstituted by a decree issued by the Finance Minister and its leadership and coordinating functions have been transferred from MOF to the Ministry of Trade. The World Bank is currently providing assistance to improve the capacity of the technical team

3. Improve Investment procedures and reduce business start up time a. Implement the Investment Law, its supporting regulations, and new operating procedures.

Satisfactory. Out of the four outstanding decrees to be issued in 2007, two decrees, PP 76/2007 on the criteria for negative lists, and PP/77/2007 on the negative list itself was issued in July 2007. In addition, two ministerial decrees have been issued creating a professional secretariat for the inter-ministerial National Team on Accelerating Investment and Exports (PEPI), and three working groups under PEPI for policy formulation, policy implementation, and integrated trade, tourism and investment promotion. Two further decrees on investment procedures and one stops shops for business licenses has been rolled into one and its issuance is pending.

66 Appendix 4

DPSP-3 Policy Measures Status as of 9 November 2007 b. Simplify or eliminate unnecessary/redundant business licenses, procedures, and multiple registration requirements.

Achieved. The Minister of trade issued two new decrees on 4 September 2007 to reduce the time to obtain the business trading license and the business registration certification. Both decrees eliminate a number of prerequisites and simplify reporting requirements. On 21 September 2007, the Minister of Justice issued a decree simplifying the procedures to legalize a limited liability company, which effectively removed a number of prior actions. At the same time the Minister of Justice also issued a decree rescinding a previous decree that transferred the authority to legalize limited liability companies from its central office to its provincial offices, which had added one-week to business start up times. The combined impact of these changes should cut business start up times by potentially more than one month.

4. Strengthen Small Businesses

a. Issue a comprehensive SME policy package (including supporting industries) that among others, increase-access to finance and implements the Warehouse Receipts Law.

Achieved. The SME policy package was issued as part of Presidential Instruction (Inpres) 6/2007 covering a number of areas pertaining to SMEs - and in particular it highlights several actions related to improving access to finance for SMEs. This includes recapitalizing credit guarantee firms through a reallocation from existing SME finance programs of line ministries into a two step guarantee fund, thereby reducing the credit risk borne by commercial banks. The Government has allocated Rp. 1.4 trillion in the state budget (APBN) for this purpose. Implementing regulations for the Warehouse receipt law has been issued (PP 36/2007).

5. Strengthen the Financial Sector a. Implement good corporate governance and risk management standards, particularly in state-owned banks and continue implementation of financial sector safety net.

Achieved. Bank Indonesia has issued a set of regulations/guidelines on good corporate governance and risk management standards for banks (BI regulation no. 8/4/PBI/2006; and a circular letter dated 30 August 2006). Implementation of the financial sector safety net program continues with coverage on deposits having been reduced to Rp. 100 million as scheduled.

B. Core Policy Area II: Improved Public Financial Management and Anti-Corruption

1. Strengthen budgeting, controls, transparency, in financial management a. Implement medium-term expenditure framework with a system of clear forward estimates for the 2008 budget.

Achieved. Macro Fiscal Framework has been included in the 2008 budget, with projections of aggregate revenue and expenditure for two out-years. A Programmatic MTEF pilot has been prepared for the Ministry of Finance.

b. Continue to consolidate core government bank accounts.

Achieved. Zero-balance banking arrangements with commercial banks have been successfully piloted in 50 selected regional treasury offices (KPPN). The tender for administration of operational accounts to commercial banks has been completed in all regions and the roll-out of zero balance arrangements to expenditure accounts in all 178 KPPNs occurred on 1 October 2007. This consolidates more than 1000 balance-bearing treasury accounts into one balance bearing treasury single account (TSA) and associated zero-balance accounts. Revenue accounts are scheduled to become zero-balanced by the end of 2007. The adoption of Government Regulation (PP) No. 36/2007 on Cash Management enacted in July 2007 provides the legal basis for a census of all government accounts and enhances the power of the Minister of Finance to close unauthorized bank accounts. Identification and closure of unauthorized bank accounts is underway with 30 (out of 73) line ministries/agencies having completed the process by August 2007.

Appendix 4 67

DPSP-3 Policy Measures Status as of 9 November 2007 c. Implement transparent accountability arrangements for RDI and RDA accounts.

Satisfactory. Regulation No. 8/2007 has been issued which prescribes the principals for improved management and transparent accountability in the management of RDI accounts. In addition, detailed procedures have been issued through ministerial decree covering a range of operational matters. The regulatory framework for RDI accounts have also been put in place, while the regulatory framework for RDA accounts is still outstanding. Accounting for RDI and RDA continues to be manual and segregated from the accounting system of Ministry of Finance, though computerization is in progress. A complete and reliable listing of individual loan accounts is under preparation but has not been issued yet

2. Improve procurement processes and outcomes

a. Operationalize NPPO and issue draft procurement law.

Satisfactory. A new presidential decree has been drafted to create an independent NPPO (the Goods/Services Procurement Policy Development Institute, or LPKPP) which is beyond the original expectations of the trigger. The target date for issuance of the decree is November 2007. The draft Procurement Law has yet to be finalized.

3. Initiate civil service reform a. Established a Remuneration Commission or interdepartmental team to recommend pay policy and pay levels for high level State officials.

Achieved. The inter-departmental team that consists of working-level officials from MOF, State Ministry of Administrative Reform and Civil Service Agency was established in 2006. The team has completed a pay proposal of high-state official positions.

b. Develop a comprehensive civil service reform plan for the Ministry of Finance as a pilot for civil service reforms on a larger scale.

Achieved. The Ministry of Finance issued a far-reaching short-term civil service reform program on January 2007 that includes: (i) reorganization within the secretary general office; (ii) improvement of business process; (iii) improvement of the overall human resource management; and (iv) creation of a job-based remuneration system. In the absence of a national civil service reform effort, a working group consisting of the Supreme Court, Supreme Audit Board, State Ministry of Administrative Reform and Corruption Eradication Commission, are considering how to roll out the MOF pilot more widely

C. Core Policy Area III: Improved Public Service Delivery 1. Institutionalize assessments of service delivery mechanisms a. Develop an enhanced assessment framework for selected service delivery programs.

Achieved. Guidelines are being prepared for BAPPENAS (with assistance under a Bank funded consultancy). In addition a new MONEV deputy is being established in BAPPENAS.

68 Appendix 4

DPSP-3 Policy Measures Status as of 9 November 2007 2. Strengthen public service delivery in education and community-based development a. Establish competency standards for teacher certification and the instruments for measuring compliance with those standards.

Achieved. Standards for teachers have been formalized through Ministerial Decree (kepmendiknas) no. 16/2007). The procedure for teacher certification (using a portfolio) was formalized through kepmendiknas no 18/2007.

b. Permit community spending over multi-year periods and clarify procurement procedures for national budget-funded CDD programs.

Satisfactory. The Government has agreed upon a mechanism to re-allocate unspent CDD funds of one year into subsequent budgets as on top budget. However, a Finance Minister’s regulation on this is still pending. The Government has clarified the rules governing procurement procedures in the guidelines for PNPM, which is expected to be issued in November 2007.

BAPPENAS = National Development Planning Agency, BAPEPAM-LK = Non-Bank Financial Institution Supervisory Agency, CCT = Conditional Cash Transfer, DGFI = (former) Directorate General of Financial Institutions, KPPN = state treasury offices. Source: ADB Staff

Appendix 5

69

MACROECONOMIC ASSESSMENT LETTER FROM THE INTERNATIONAL MONETARY FUND

70 Appendix 5

Appendix 5

71

Appendix 6

72

DEVELOPMENT PARTNERS COORDINATION MATRIX

Core Policy Area in the Development Policy Support Program

Components

ADB Support for Policy Reforms

Support from Other Development Partners

1. Improve tax and customs administration

• Local tax reforms (Local Government Finance and Governance Reform Sector Development Program: L2193-INO)

• AusAID: improving government tax revenues through activities undertaken at the Large Taxpayers Office under Technical Assistance Management Facility III

• AusAID/IMF: national level tax reforms

• World Bank: local government tax reforms

• ASEAN Secretariat: facilitating trade with a national single windows

2. Improve trade policy • Enhancing foreign trade tariff competitiveness and improved research capability of trade ministry (L1738)

• The European Union: trade-related cooperation

• JICA: trade-related technical assistance

3. Improve investment procedures and reduce business start-up time

• Enhancing industrial competitiveness; 2002–2004 amendments to the Investment Law (L1738)

• World Bank; USAID; Japan

• IFC: Indonesia SME Assistance

4. Strengthen small business • Industrial Competitiveness

and SME development (L1738) and SME Export Development Project (L1978)

• IFC: Indonesia SME Assistance

A. Improved Investment Climate

5. Strengthen the financial sector

• Financial governance reform focused on strengthening supervisory architecture, and market development (L1965)

• Long-term financing modalities (establishment of Secondary Mortgage Facility)

• Enhancing financial and corporate governance in state-owned enterprises (L1866)

AusAID (financial stability, capital market, and nonbank financial institutions), IMF (restructuring), World Bank (restructuring, product development, mutual funds), USAID (deposit insurance), IMF (mutual funds).

B. Improved Public Financial Management and Anticorruption

6. Strengthen budgeting, controls, transparency in financial management

• Support for state-owned enterprises’ financial management reforms; audits (L1866)

• Policy, institutional, legal, and regulatory reforms in audit sector (L2126)

• World Bank (public financial management and revenue administration reforms)

• World Bank (support to Supreme Audit Agency; crosscutting

Appendix 6

73

Core Policy Area in the Development Policy Support Program

Components

ADB Support for Policy Reforms

Support from Other Development Partners

• Capacity development for State Audit and Inspection Agency (L 2127 and L1620)

work through Country Financial Accountability Assessment)

• CIDA • USAID

7. Improve procurement process and outcomes

• World Bank (procurement assessment report)

8. Initiate civil service reform • UNDP (governance) • GTZ (civil service)

9. Institutionalize assessments of service delivery mechanism

• World Bank (guidelines for monitoring and evaluation work of a new proposed deputy under BAPPENAS)

C. Improved Delivery of Public Services

10. Strengthen public service delivery in education, water, local government, and community-based development

• Sustainable Capacity Building for Decentralization (L1964)

• World Bank (community-driven development programs)

• AusAID (local government bonds)

• USAID (Decentralized Basic Education Program)

ASEAN = Association of Southeast Asian Nations, AusAID = Australian Agency for International Development, BAPPENAS = Badan Perencanaan Pembangunan Nasional National Development Planning Agency), CIDA = Canadian International Development Agency, GTZ = Deutsche Gesellschaft für Technische Zusammenarbeit (German Agency for Technical Cooperation), IMF = International Monetary Fund, JICA = Japan International Cooperation Agency, SME = small and medium-sized enterprise, UNDP = United Nations Development Programme, USAID = United States Agency for International Development Source: Asian Development Bank.

74 Appendix 7

INELIGIBLE ITEMS

1. The proceeds of the loan will be used to finance the foreign currency expenditures for the reasonable cost of imported goods required during implementation of the Program. 2. Notwithstanding the provision of para. 1, no withdrawals shall be made in respect of:

(i) expenditures for goods included in the following group or subgroups of the United Nations Standard International Trade Classification, Revision 3 (SITC, Rev. 3), or any successor groups or subgroups under future revisions to the SITC, as designated by Asian Development Bank (ADB) by notice to the borrower

Table A7: Ineligible Items

Group Subgroup Description of Items

112 Alcoholic beverages 121 Tobacco, unmanufactured tobacco refuse 122 Tobacco, manufactured (whether or not containing tobacco

substitutes) 525 Radioactive and associated materials 667 Pearls, precious and semiprecious stones, unworked or worked 718 718.7 Nuclear reactors and parts thereof, fuel elements (cartridges),

nonirradiated for nuclear reactors 728 728.43 Tobacco processing machinery 897 897.3 Jewelry of gold, silver, or platinum group metals (except

watches and watch cases); goldsmiths’ or silversmiths’ wares (including set gems)

971 Gold, nonmonetary (excluding gold ores and concentrates)

(ii) expenditures in the currency of the Borrower or of goods supplied from the territory of the Borrower;

(iii) expenditures for goods supplied under a contract that any national or international financing institution or agency will have financed or has agreed to finance, including any contract financed under any loan or grant from ADB;

(iv) expenditures for goods intended for a military or paramilitary purpose or for luxury consumption;

(v) expenditures for narcotics; (vi) expenditures for environmentally hazardous goods, the manufacture, use or

import of which is prohibited under the laws of the Borrower or international agreements to which the Borrower is a party; and

(vii) expenditures on account of any payment prohibited by the Borrower in compliance with a decision of the United Nations Security Council taken under Chapter VII of the Charter of the United Nations.

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FIDUCIARY ASSESSMENT A. Background and Analytical Underpinnings 1. Funds from the Development Policy Loan (DPL) operation will provide general budget support to the Government of Indonesia. Management of the Government’s budget is influenced to a large extent by ongoing public financial management (PFM) reforms. This note summarizes the direction and progress of these reforms in order to determine the attendant fiduciary risks with respect to these funds. 2. This assessment of fiduciary aspects of this loan draws upon several studies on PFM and accountability that have been completed over the past 12 months, both internally within the World Bank, Asian Development Bank (ADB), and other development partners. Studies undertaken internally by the World Bank include a Public Expenditure Review completed this year. It also includes a Sector Report on Accountability & Audit in Indonesia (ADB: January 2007), implementation reports on the ongoing State Audit Reform Program being implemented with ADB support, a Statement of Fiscal Risks (IMF: 2006), a Report on Budget Reform Priorities (joint World Bank and IMF: April 2007), and a Report on Observance of Standards and Codes on Fiscal Transparency (IMF: October 2006). This assessment has also taken into account a review of the progress made in implementing actions agreed under the third DPL approved in 2006 and results of recent supervision missions to assess progress in implementing the World Bank financed Government Financial Management and Revenue Administration Project (GFMRAP) that became effective in October 2005. These reports and documents provide the analytical underpinnings for this assessment. An exercise to measure PFM processes based on public expenditure and financial accountability (PEFA) methodology is currently under way and is likely to be completed by November 2007. 3. Deficiencies in Indonesia’s PFM systems have been well documented in recent years, and a reform strategy to address these was formulated by the Government in its White Paper on PFM reforms in 2001. This strategy covered a broad spectrum of public financial management, from budget formulation to budget execution, accounting and reporting, and external oversight. These reforms directly influence the environment in which public expenditure is planned, budgeted, executed, and accounted for across all levels of government. A more detailed commentary on progress in implementing these reforms is given below to help identify the attendant risks arising from the Borrower’s capacity to manage this loan and determine the fiduciary arrangements for this operation. B. Budget Allocations 4. A recent analysis by the World Bank 1 has concluded that prudent macroeconomic policies, particularly the extremely low budget deficits, have been instrumental in Indonesia’s recovery from the last crisis. Over the past 10 years, there has also been a remarkable transformation in the way public resources are managed and allocated. As a result, Indonesia can expect to have significant additional fiscal resources, or “fiscal space,” that is almost of the magnitude of the revenue windfall seen during the oil boom of the mid-1970s. 5. The composition of public investment has changed substantially since decentralization. When Indonesia decentralized, subnational governments increased their shares of resources.

1 World Bank. 2007. Indonesia Public Expenditure Review 2007: Spending for Development: Making the Most of

Indonesia’s New Opportunities. Jakarta/Washington, DC.

76 Appendix 8

Subnational governments now manage about half of total public investment. At the same time, the sectoral composition of expenditures changed as well. The overall shares of education and administrative expenditures have increased substantially, while infrastructure has declined, particularly since 2003. However, some key indicators of Government budget performance have not improved so far, particularly budget outturn indicators. Actual central government expenditure has consistently deviated from initial plans. Subsidies tend to be underestimated, while capital spending has been consistently lower than the budgeted amount. At the same time, other parts of the budget―most notably public investments and central government personnel spending―show underspending. C. Public Financial Management Reform Strategy 6. Some key elements of the reform strategy articulated in the past included the following:

(i) Modernizing an outdated legal environment for PFM, by issuing a modern set of laws and implementing regulations.

(ii) Reforming an opaque and inefficient budget formulation process by discontinuing the separate recurrent and development budgets and introducing performance budgeting systems and forward estimates.

(iii) Reforming budget implementation, in particular the inefficient payments system and weak monitoring and accountability arrangements.

(iv) Modernizing management of the Government Treasury to consolidate fragmented cash management and make government banking arrangements more efficient.

(v) Introducing modern government accounting standards and accounting practices to improve the reliability of government financial reporting.

(vi) Reforming arrangements for government auditing, in particular strengthening the mandate and capacity of the State Audit Agency (BPK), addressing overlaps between external and internal audit agencies, and clarifying their respective roles and responsibilities.

(vii) Modernizing the institutional and regulatory framework for public sector procurement.

D. Summary of Implementation Experience on PFM Reforms 7. The current Government has embarked on a new phase of reforms in the budget and PFM system with support from various development partners. 2 These followed important political reforms that were introduced after 1998, including “big bang” decentralization and the direct election of the President. Key areas of progress so far include the following:

(i) Adopting a new legal framework for planning, budgeting, treasury management, and external audit. New laws were adopted by Parliament in 2003–2004 and many government implementing regulations were issued thereafter.

(ii) Restructuring the Ministry of Finance (MOF). A first restructuring occurred in 2004, when the Directorate General (DG) of Treasury was established, separate from DG Budget. A second restructuring occurred in 2006, when a new Fiscal Policy Office was established with a focus on macro-fiscal policies and projections, and a new DG Debt was created by splitting off two directorates from DG Treasury, with external and domestic debt management consolidated in one DG.

2 The main technical assistance providers are the World Bank, the Asian Development Bank, the International

Monetary Fund, the Government of the Netherlands, the European Community, and the Government of Australia.

Appendix 8 77

(iii) Unifying the previous routine and development budgets. As from the 2005 annual budget, a new economic and functional classification was introduced for budgetary expenditures, based on the International Monetary Fund (IMF) Government Finance Statistics Manual (GFSM 2001) system.3

(iv) Beginning a process of rationalizing government bank accounts and improving cash management.4 A principal objective is to establish a treasury single account (TSA) and to close government accounts outside the DG Treasury’s control.

(v) Government Regulation No. 24/2005 prescribes modified cash government accounting standards as a transition towards full accrual standards at a later date. Templates for accounting statements to be used by central and local governments have also been issued.

(vi) Finalizing plans to introduce a new treasury system. The World Bank’s Government Financial Management and Revenue Administration Project (GFMRAP) focuses particularly on computerization of treasury operations through the treasury system. The GFMRAP also includes components to support change in the budget system—within the MOF and National Development Planning Agency—as well as for improving parliamentary involvement and oversight of the budget approval processes.

(vii) Presidential Decree No. 80/2003 introduces many improvements to the procurement regime and lays out a plan for establishing a national policy formulation and oversight agency. An omnibus procurement law is envisaged for consolidating, clarifying, and simplifying the numerous procurement rules and regulations. This law, currently under preparation, will strengthen the legal foundation for modernizing public procurement.

(viii) Strengthening the mandate of and funding for an external audit institution. The State Audit Law, legislated in 2004, lays out the broad legal framework for the operation of the country’s supreme audit institution, the BPK, to reinforce its position and mandate as an external audit institution reporting to Parliament. A separate law (the State Audit Agency Law) has recently been passed to cover the institutional arrangements for the management and oversight of the BPK. The BPK has seen a significant increase in its budgetary financial resources.

(ix) Enhancing parliamentary oversight of budget processes. Parliamentary commissions have become particularly active in scrutinizing and amending the Government’s draft annual budget. However, this has become more intensive and detailed than is the case in many countries. A more strategic and less instructive approach is needed.

(x) The Government published the IMF fiscal transparency report5 and undertook its socialization throughout Indonesia. The public availability of fiscal information is already improving and the Government has published a fiscal risk statement together with the 2008 budget.

3 IMF. 2005. Indonesia: Treasury Modernization and Related Reforms. Washington, DC.; and IMF. 2006. Report on

the Government Finance Statistics Mission, Jakarta. 4 I. Lienert et. al. 2007. Indonesia: Improving Cash and Debt Management, Washington DC; IMF. 5 IMF. 2006. Indonesia: Report on Observance of Standards and Codes—Fiscal Transparency Module. Country

Report No. 06/330. Washington, DC.

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E. Experience in Implementing Budget Reforms 8. The fiscal roles of the executive and legislative branches are now defined in law and evolving in practice. Fiscal relationships between the executive and legislature are defined in State Finance Law No.17/2003. The House of Representatives (DPR) is the principal legislative body, and it plays a significant role in shaping the budget and fiscal policy. The budget is passed in agreement between the President and DPR. The process involves an examination by the DPR of the macroeconomic framework, macro-fiscal policies, and the detailed budget allocations. The relative roles of the executive and legislative branches in this area are evolving. 9. The laws governing budget management clearly specify the responsibilities of the minister of finance and comprehensive regulations have been developed. While the President, as head of the Government, has overall authority to exercise national fiscal management, Law No. 17/2003 clearly delegates the responsibility of overall fiscal management of central government finances to the minister of finance as chief financial officer. The law also assigns responsibilities to individual ministers, governors, and other local authorities for financial management and accountability in their jurisdictions. 10. Provisions of the new regulations are being implemented. The budget classification is largely consistent with contemporary international standards. The MOF is developing plans for a medium-term expenditure framework (MTEF) to guide budget policy. Forward estimates at the aggregate level have been introduced for 2009 and 2010 with the budget for 2008. However, much more work needs to be done to fully operationalize the MTEF approach. F. Reforming Budget Execution 11. Indonesia still spends 50% of its total capital expenditure in the final quarter of the year.6 For the past 5 years, spending has always started slowly and then accelerated towards the end of each year. This spending pattern is of concern because project implementation is disrupted by an adverse cycle. Moreover, underspending in capital investments constrains increases in infrastructure investments. Slow and back-loaded disbursements are symptoms of more severe challenges that are encountered at each stage of the public expenditure management cycle. 12. The Government maintains a comparatively rigid budget execution process. Detailed input controls aim to ensure that the composition of the budget complies with political priorities and that the budget is not altered during execution. Spending warrants (DIPA), while now issued at the start of the fiscal year, contain excessive detail, leaving little flexibility for adjustments in the composition of inputs needed to carry out a given activity. Reallocations across DIPAs from delayed programs to better performing ones that could enhance satisfactory implementation of the overall expenditure program require lengthy revision, sometimes involving Parliament. Such inflexibility creates practical difficulties and inefficiencies. 13. With expanding fiscal space, public investment is increasing, putting additional pressure on PFM systems. Planning and executing public investment is inherently more demanding than current or mandatory expenditure. 14. Basic internal control procedures are in place to ensure that expenditures across all spending agencies strictly follow approved budgets. Spending units’ DIPAs are the key

6 World Bank. 2007. Indonesia Public Expenditure Review 2007: Spending for Development: Making the Most of

Indonesia’s New Opportunities. Jakarta/Washington, DC.

Appendix 8 79

documents required to authorize government spending and form the basis for expenditure control. These are now issued on a timelier basis than in previous years. MOF regulations have been issued to cover various aspects of budget execution. The Treasury records expenditure transactions at the payment stage. The expenditure control system does not provide for central recording of commitments. Operational control over expenditure stages, such as commitment and verification of delivery of goods and services, is undertaken by budget users. G. Treasury and Cash Management 15. Transparency is clouded by a multitude of bank accounts. The Treasury itself maintains multiple bank accounts, both in rupiah and in foreign currency, at Bank Indonesia (BI). There are also an unknown number of extra-budgetary bank accounts maintained by budget users. External audit reports have placed at over 1,300 the number of bank accounts that have not been reported to the central Treasury. 16. Regulations associated with Law 1/2004 will address this weakness and provide for (i) establishment of a treasury single account (TSA) at Bank Indonesia; (ii) conversion of operational bank accounts at commercial banks into zero-balance transit accounts; and (iii) a mandatory review at MOF of bank accounts of all state agencies outside treasury oversight, with a view to close those that do not serve the public interest. Pilot runs for testing zero-balance arrangements with commercial banks have been successful. It is planned to complete the consolidation of all government cash balances into the TSA by end-2007. 17. The implementing regulation for Law 1/2004, Government Regulation 36/2007 on Cash Management, was issued in July 2007 and details the governance and setup of cash management. In addition, a number of MOF regulations (PMK) have been issued to further the establishment of the TSA:

(i) PMK 57 is the generic PMK to regulate opening of bank accounts by the line ministries.

(ii) PMK 58 mandates a census of the existing line ministry accounts. (iii) PMK 59 mandates echelon I officers of MOF to disclose the bank accounts if any

are being operated. 18. The cash-based accounting system generates timely records of revenue and expenditure transactions, but does not track monthly arrears. Transaction records are electronically transmitted to the directorate of accounts at treasury headquarters for consolidation and generation of periodic reports on budget execution. The cash-based treasury system does not track payment arrears on a monthly basis, although DG Treasury’s plans to move towards an accrual recording system would make that possible. 19. Treasury cash management and payment modernization will be supported by the planned computerized treasury information management system under the World Bank GFMRAP project. Implementation of the treasury component of GFMRAP has been delayed. DG Treasury has not mobilized for project implementation, and the procurement process has been ongoing for more than 18 months. H. Procurement Reforms 20. The past few years have witnessed improvements in the public procurement environment. Presidential Decree No. 80/2003 provided a national public procurement regulation corresponding to most of what is generally regarded as accepted international

80 Appendix 8

practice, including the basic principles: transparency, open and fair competition, economy, and efficiency. This decree also requires that a national public procurement office (NPPO) be established as a regulatory body for public procurement. With Presidential Decree No. 80/2003, a previous certification (“pre-qualification”) process for suppliers of goods and services was, in most instances, abandoned by the Government. This has previously led to segmentation of the market and especially at the provincial levels. Presidential Decree No. 80/2003 also established the basis for sanctions, complaint-handling and requirements for certification of users. 21. Nevertheless, the public procurement system still has significant deficiencies in its regulatory and, more importantly, implementation aspects. These are due mainly to delays in establishing a strong regulatory body; slow progress in developing procurement regulation anchored by a law; slow progress in developing standard tools in terms of bidding documents and users manuals; weakness in procurement capacity in implementing agencies, especially at the provincial and district levels; and collusion and corruption practices in the bidding process, along with concerns over the efficiency of anticorruption and sanction measures. 22. A new presidential decree has been drafted that, when issued, will establish a fully independent Goods/Services Procurement Policy Development Institution (Lembaga Pengembangan Kebijakan Pengadaan Pemerintah, or LPKPP). The planned institution will be chaired by an appointee from the civil service (nonpolitical), who may be assisted by a committee comprised of procurement experts sourced from both inside and outside government. The establishment of the LPKPP, in itself, should not be regarded as reforming public sector procurement. Rather, it should be perceived as the first crucial stepping stone to enable focus on a wider public procurement reform program. 23. Laws enacted since 2000 impacting, or making reference to, public procurement cover construction (governing civil works), state finance, treasury, audit, and small-scale business. The pace of Indonesia’s commendable decentralization reforms has impacted public sector procurement at all levels of government, with ministers, governors, and even mayors able to issue decrees, regulations, and instructions. The plethora of regulations is often inconsistent, and many regulations do not meet accepted international practice. Consequently, national procurement reform and the need for national procurement policies and standards have become urgent. 24. Indonesia’s legal framework for public sector procurement can best be strengthened by anchoring it with an overarching, consolidated, and comprehensive national public sector procurement law at the highest level that (i) establishes the fundamental principles and procedures applicable to all public sector procurement, (ii) allows for the imposition of sanctions where the principles and procedures, and particularly those relating to good governance and ethics, are not met, (iii) amends other laws that refer to public sector procurement, and (iv) ensures that such law has the necessary authority in a decentralized environment. Drafts of a new high-level law and associated subordinate regulations are being finalized and should be ready by the end of 2007. 25. Standard Bidding Documents. Currently, there are no national standard bidding documents in Indonesia. Some implementing agencies (such as the Ministry of Public Works) have developed standard bidding documents for their own use. However, there is no evidence that such documents are consistently used at all levels of government. The NPPO, through the support of ADB, has drafted eight National Model (Standard) Bidding Documents: (i) An Explanatory Guide, (ii) Goods with Pre-qualification, (iii) Goods with Post-qualification, (iv) Works with Pre-qualification, (v) Works with Post-qualification, (vi) Other Services with

Appendix 8 81

Pre-qualification, (vii) Other Services with Post-qualification, and (viii) Consulting Services. These are now available in a draft form in the Indonesian language only. The use of these documents is still not mandatory, and, in fact, there is still no strong push from the NPPO to enforce their use at the national level. The NPPO preference is to try these documents on a pilot basis. While Presidential Decree No. 80/2003 provides the basic requirements to be included in General Conditions of Contract, such a standard has yet to be produced. 26. Capacity Building and Certification. There has been growing concern, both in the Government and the ADB and World Bank, over the pace of project implementation. Significant delays and slow disbursement seem to occur across the entire PFM cycle. Projects reported delays and difficulties in budget preparation and approval, budget execution, and implementation (procurement). Specifically, there are concerns on the implementation (procurement) capacity of government staff and the absence of incentives for project managers and procurement committees. Added to this, fears of prosecution have also affected projects due to the reluctance of officials to take action amid growing worries of being prosecuted under anticorruption legislation, even over minor mistakes. 27. On Capacity Building. Presidential Decree No. 80/2003 required the Government to adopt an examination system and certification for procurement practitioners within Government contracting entities, in order to ensure that their level of competence is consistent with their level of responsibilities. So far, the rate of staff passing the basic procurement certification is very low (12%). It is evident that there is need for a strategic approach to capacity building. The future LPKPP will consider creating a professional procurement training and certification board in order to develop and integrate a cost-effective procurement capacity-building program. 28. Corruption, Sanction and Independent Appeals Mechanism. Despite improvements in the public procurement system, concerns remain over corrupt and collusive practices. Several cases under ADB and World Bank projects have come to light. While addressing this requires an overall governance strategy, there are several important elements in the procurement system that can support such a strategy, such as an independent complaints mechanism, an effective sanctions mechanism, and improving transparency in the procurement process through e-procurement. 29. Presidential Decree No. 80/2003 requires the establishment of a complaints handling mechanism. However, this is not set up independently but within each implementing agency. As part of the ongoing Country Procurement Assessment Report, options to be explored include to have an independent complaints handling mechanism under the “umbrella” but independent of the LPKPP, or possibly to have a totally independent body comprising individuals from private sector professional organizations and civil servants with expertise in public sector procurement and procurement law. 30. E-procurement. The Ministry of Public Works (MPW) and City of Surabaya have both been at the forefront in the development of e-government procurement (e-GP) technology. The NPPO has been taking the lead on behalf of the Government for implementing e-GP in Indonesia at a national level. Currently, the focus is on developing policy and legislation for the validity of e-GP, including electronic documents and signatures. The NPPO has also established an electronic bulletin board for advertising national procurement opportunities. The NPPO is considering to adopt a national e-GP system similar to that adopted by the City of Surabaya and to pilot the e-tendering functionality as a first step. Eventually, MOPW will need to decide whether to adopt the national system in its entirety or ensure that its own system will integrate with it. Currently, the MPW quasi e-system is used for large national road works

82 Appendix 8

contracts in Java and Sumatra. Generally, the MPW system provides most of the online functionalities for e-tendering that would be required by international standards. However, submission of bids is still being done manually due to the absence of legislation to allow the full process as described above. I. Accounting and Reporting on Budget Execution 31. The aggregate Government Annual Financial Statements have been prepared in a timely manner for 3 years now (2004, 2005, and 2006). Although the timeliness is a significant achievement, serious concerns remain over their reliability. The BPK has for 3 years issued a “disclaimer” opinion on these financial statements due, among various factors, to serious shortcomings in the control environment in which these statements were prepared and due to scope limitations. 32. The aggregate annual financial statements present revenues, expenditures and transfers, surpluses or deficits, and financing aggregates in comparison with budget provisions. A balance sheet and a cash flow statement are also presented, along with a full statement of government accounting policy. 33. The recent development of Government Accounting Standards is a step forward in improving financial reporting, although the requirement of the State Treasury Law for the complete introduction of accrual accounting by 2008 is very ambitious and may not be realistic. The Accounting Standards Committee has been in operation for a few years now, and during that time it has put into place a due process for developing government accounting standards that are well aligned with comparable international standards. Technical capacity constraints limit the pace at which these accounting standards can be implemented at all levels of government, including line ministries and subnational governments. 34. Monthly and quarterly reports on budget realization are produced by each ministry on a monthly basis and sent to the MOF for consolidation. A midyear unaudited report on budget realization is presented to the DPR in July and is available to civil society. 35. There are no systematic and publicly available reports of the Government’s contingent liabilities, tax expenditures, or quasi-fiscal activities. Data on central government debt are regularly published, but there are time lags in reporting total debt and concerns over the reliability of the data on external public debt. Information on government financial assets is published annually. 36. Although commendable action has been taken to improve government financial reporting, there continue to be serious challenges in making government financial statements reliable, as reported by the BPK in its annual audit report for 2006. This reflects the immense challenges that lie ahead in an environment where accounting capacity at the grassroots is weak and accounting processes are not yet integrated or fully automated. J. External Audit 37. Indonesia has made significant progress7 in addressing deficiencies in the audit sector over the past few years. The enactment of the State Audit Law in 2004 clarified the BPK’s

7 ADB. 2007. Sector Report on Accountability and Audit in Indonesia. (produced under TA-4473 INO: Support for

Implementation of Program Loan). Manila.

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mandate as the sole external state audit agency, granting it extensive rights of audit over public finance that are generally in line with international standards (Lima Declaration). In practice, however, some restrictions continue to apply. 38. In addition, the State Audit Agency Law was passed by Parliament in 2006, laying down internal and external governance arrangements for the BPK as an organization on matters such as the appointment of BPK Board members and financial and administration independence. The BPK has issued a series of internal implementing regulations for these laws and has also recently issued a new set of Government Auditing Standards that are substantially in line with comparable international standards (International Organization of Supreme Audit Institutions). The BPK has completed a comprehensive study of its organizational structure compared with fully developed audit institutions in other countries and has also prepared a medium-term strategic development plan. Significant increases in budgetary financial resources have been granted to the BPK for its operational needs. 39. A peer review of the BPK was completed in 2004 and revealed serious weaknesses in capacity. Since then, improvements are gradually being made to the organization, with new hires and training. Spending agencies generally respond well to audit findings reported by the BPK. The BPK’s audit reports are submitted semiannually to Parliament within a legally mandated time. These reports certify the financial statements of the audited reporting entities and comment on any irregularities or inefficiencies in budget execution that may have been found. However, there appears to be little systematic follow-up by the DPR on BPK reports and no formal reporting of this. A recent study by ADB8 has highlighted the need for capacity building at the DPR Secretariat in order to handle audit reports and information constructively. Public disclosure of all BPK audit reports is now mandatory. K. Internal Controls and Internal Audit 40. The internal audit framework of the Government is extensive, but scope and organization do not match needs. Ironically, even with (or perhaps because of) multiple internal audit agencies in existence, the internal audit function continues to be a weak link in governance. The internal audit function is carried out at central government by three institutions: the Inspectorate General (IG) in each spending ministry; the government-wide internal auditor (the State Financial Control Agency, or BPKP), reporting to the President’s office, with government-wide jurisdiction; and the Regional Supervision Agency (BAWASDA) at the local government level. 41. This institutional structure is complex, and the mandates and division of labor between the various internal audit institutions are unclear. The IG represents the principal internal audit apparatus of a ministry. The scope of IG audit activities is generally limited to technical compliance audits. The IGs therefore operate as individual institutions corresponding to the number of ministries. Professional backgrounds of IG staff therefore normally include technical qualifications and not accounting or auditing. Audits by IGs are not conducted on a risk-based methodology. Local governments maintain their own internal audit units (BAWASDA). 42. BPKP’s staffing levels do not reflect its reduced mandate. Despite this reduced mandate, it maintains fully staffed decentralized offices in 26 provinces. The BPKP no longer has a formal role in internal audit, except to provide audit services to line ministries upon request.

8 ADB. 2006 Report on Capacity Building Needs of DPR Secretariat on Review of BPK Reports. (produced under TA

4473-INO: Support for Implementation of Program Loan). Manila.

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43. Each line ministry plays the role of program executing agency and is therefore principally responsible for maintaining internal controls. It is responsible for performing and achieving the objectives stated in budget allotment documents. In order to strengthen responsibility and accountability over the appropriated budget by the line ministries, the function of payment order issuance has been transferred to the line ministries. This is resulting in a better segregation of the functions for verifying transactions and issuing payments. While this segregation of duties is well designed, implementation experience has not been entirely satisfactory in the absence of clearly defined standards of accounting evidence, verification procedures, and well-staffed prepayment audit units in the spending agencies. L. Reforming Regional Public Financial Management 44. Decentralization has provided local governments with significant resources and authority. This requires an adequate regulatory framework and PFM capacity at the local level. The PFM reforms stipulated in the decentralization and subsequent finance and treasury legislation aim to modernize the regional PFM system and improve accountability (assuming efficient implementation), but these reforms are vast in scope and the concepts are sophisticated. 45. The regulatory framework for regional PFM reforms is largely in place and includes mechanisms for fiscal transfers to local governments. After decentralization, the central government passed comprehensive legislation for PFM reforms at the regional level to mirror the changes being made at the centre. 46. Most regions lack adequate technical and human resources to implement the reforms, however, and the central government has not yet provided the needed support. The unclear division of tasks between the MOF and Ministry of Home Affairs has resulted in inconsistent and contradictory legislation with regards to regional financial management, and this has caused confusion among most local governments. While subnational governments are obliged by law to report certain fiscal and financial information to the central government, many do not (the data may be missing or simply withheld voluntarily). M. State-Owned Enterprises 47. Indonesia has a sound legal framework for corporate governance and monitoring state-owned enterprise (SOE) operations. First, the SOE Law, No. 19/2003, sets a clear ownership policy, as the state is not allowed to be involved in the day-to-day management of SOEs and must allow them full operational autonomy. Second, a 2002 ministerial decree clearly details corporate governance responsibilities, including the requirements to (i) submit each quarter the SOEs’ financial statements to the Ministry of State-Owned Enterprises and to the appropriate line ministries, (ii) prepare annual financial statements that must be audited internally and by an independent auditor, and (iii) publish SOE annual reports in a timely manner. 48. Existing laws and regulations governing SOEs are not effectively implemented. Long delays still occur in auditing and publishing SOE financial statements. SOE annual reports are usually only regularly and systematically made public in cases where companies have accessed the local capital markets with listed instruments. 49. The planned use of public-private partnerships (PPPs) to accelerate investment will create fiscal risks that merit disclosure. The Government has taken steps to mitigate fiscal risks

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from PPPs. Presidential Regulation No. 67/2005 emphasizes careful project preparation and the selection of bidders in an open, competitive tender. It gives the minister of finance the right to approve or reject requests for government support. N. Debt Management 50. Two major initiatives in debt management have been launched. Despite recent improvements in debt indicators, risks to the Government’s budget remain substantial, and further improvements in debt management are essential to avoid future debt distress. MOF has made good progress in this regard. Two specific examples are the development and publication of a comprehensive debt management strategy in September 2005 and the decision to create a Directorate General for Public Debt Management. The Government is now working on a more formal debt sustainability analysis. O. Governance and Anticorruption 51. The Anti-Corruption Commission (KPK) is fully operational and performs its duties independently, free from any influence. It coordinates with other entities combating corruption, conducts investigations and prosecutions against corrupt acts, performs preventative actions against corruption, and monitors state governance. It has initiated and signed memoranda of understanding with some provincial and local governments to establish and support good governance at the subnational level. As its capacity to carry out prosecutions is limited to a few cases per year, its focus tends to be on high-level, large-scale corruption. P. Key Areas for Future Attention 52. In the period ahead, progress of the following key ongoing PFM reforms will need to be closely monitored:

(i) Ensuring coherence and momentum in public financial management reform. (ii) Deepening the reforms of the central government budgetary sector along the

lines discussed above. (iii) Ensuring greater integrity and more effective management of public funds

through implementing a TSA, automating the treasury payments system, and instituting measures to prevent the proliferation of off-budget bank accounts.

(iv) Strengthening internal audit institutions by establishing synergistic relationships between them and removing overlaps.

(v) Implementing a new treasury system, extending implementation of Government Accounting Standards, and reengineering underlying business processes at spending agencies to ensure reliable financial reporting.

(vi) Widening the reforms throughout government. This means extending modern financial accountability and management processes to subnational governments in a coordinated manner and bringing these fully in line with emerging national standards.

53. Many of these reforms are being actively considered, and prioritized implementation plans are being developed by the Government. The capacity to centrally monitor these and other reforms has recently been established at the Secretary General’s Office of MOF. The ongoing work on Public Expenditure and Financial Accountability indicators will also assist the Government in setting benchmarks and monitoring progress.

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Q. Management of Foreign Exchange 54. The foreign exchange control environment is assessed to be generally satisfactory. The country is no longer subject to the Extended Arrangement from the IMF. Bank Indonesia was last subject to the transitional procedures under the Fund’s safeguards assessment policy in 2002. That assessment recommended remedial action to address a number of vulnerabilities in BI’s audit arrangements. The main recommendations have been implemented, including the establishment of an independent audit committee at BI and the publication of BI’s audited financial statements. BI’s audited financial statements for 2006 have been reviewed, and we note that the audit report issued by the BPK contained an unqualified audit opinion. R. Conclusion 55. Following initial years of analytical work, Indonesia has taken impressive steps in recent years to build upon this work and establish a sound legal and administrative framework for modern PFM. Changes in the legal and regulatory architecture are now largely complete and the momentum has shifted towards implementation of new PFM practices. 56. Known weaknesses in financial management and accountability continue to be gradually addressed through the PFM reform program discussed above. The development partners are actively engaged in this process. Key elements of the reforms are supported by the DPL triggers, as well as by the GFMRAP project and initiatives supported by development partners. Much remains to be done, however. It will clearly take time to realize the full impact of these reforms and to attain high standards in every element of sound PFM. 57. In the meantime, some fiduciary risks will arise for this operation. Although the pace of implementing the planned reforms has been somewhat slow over the past year, the trajectory of reform is in the right direction and the current Government continues to demonstrate a commitment to completing the planned reforms in public financial management. Taking these into consideration, we do not propose putting in place any additional fiduciary arrangements for this operation.

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SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY

Country/Project Title: Indonesia/Third Development Policy Support Program (DPSP-3)

Lending/Financing Modality: Policy-Based Department/

Division:

Southeast Asia Department

(SERD)/Indonesia Resident Mission (IRM)

I. POVERTY ANALYSIS AND STRATEGY

A. Linkages to the National Poverty Reduction Strategy and Country Partnership Strategy Based on the country poverty assessment, the country partnership strategy, and the sector analysis, describe how the project would directly or indirectly contribute to poverty reduction and how it is linked to the poverty reduction strategy of the partner country.

The National Poverty Reduction Strategy (NPRS) has five basic strategies for poverty reduction: (i) broadening opportunities, (ii) empowering community institutions, (iii) increasing capacity, (iv) providing social protection, and (v) promoting global partnerships. The NPRS is to be implemented through macroeconomic strategy and policies for fulfilling basic rights, promoting gender justice and equality, and regional development. The NPRS considers macroeconomic policies as the foundation for reducing poverty through a supportive business environment and broad opportunities for increasing the capability of the poor through four related objectives to (i) create macroeconomic stability, (ii) promote economic growth, (iii) increase opportunities for employment and entrepreneurship, and (iv) reduce inequalities between regions. The Government’s Medium-Term National Development Plan, or RPJM, includes the main tenets of the previous draft NPRS and also incorporates the eight Millennium Development Goals (MDGs). This provides an overarching framework that places human development and poverty reduction at the center of the development agenda. The country poverty assessment 1 and country poverty partnership agreement 2 consider macroeconomic stability as a fundamental underpinning to poverty reduction. Under the agreement, Asian Development Bank (ADB) has agreed to support the Government in promoting macroeconomic stability for inclusive growth and poverty reduction. Highest priority is given to institutional reforms to achieve transparent and accountable institutions. The poverty agreement also calls for expanding and improving such key basic services as health, education, water supply, and sanitation through public-private partnerships, and points out the need to expand the system of social protection.

B. Poverty Analysis Targeting Classification: General intervention 1. Key Issues DPSP-3 supports key areas of the RPJM and NPRS, including the investment climate, public financial management and governance, and service delivery to the poor. The DPSP-3 triggers or policy actions under these core areas are unlikely to harm the poor, while several triggers have the potential to reduce poverty in the medium term. 2. Design Features. Not applicable

C. Poverty Impact Analysis for Policy-Based Lending 1. Discuss the impact channels of the policy reform(s) (direct and indirect, short and medium term) to the country and major

groups affected. The majority of triggers under these core policy areas concern policy areas that do not directly affect the household budgets of the poor. The links between poverty reduction and areas such as tax and customs administration, investment procedures, financial sector improvements, and increased transparency are indirect, through increased economic growth. Bureaucratic barriers to establishing new businesses, increasing access to finance, and strengthening transparency are all areas involving constraints to growth in the medium term. Three triggers in the DPSP-3 policy matrix are, however, likely to affect the poor in a more direct manner: (i) Changes in tariff rates can alter the purchasing power of poor households. Tariff reductions in goods that make up a significant share of poor households’ budgets will benefit the poor by increasing their purchasing power. To mitigate risks of adverse affects in low income groups, the additional research capacity mandated by the trigger should enable policymakers to use empirical estimates of the impact of tariff adjustments on poor household as an input into the policy process. (ii) An effective

1 ADB. 2005: Indonesia: Country Poverty Assessment. Manila. 2 ADB. 2002. ADB-Indonesia Country Poverty Partnership Agreement. Manila.

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assessment framework for selected service delivery can also reduce poverty in the medium to long term. The poor disproportionately suffer from low quality services and low levels of access to health, education, and infrastructure. As a result, 50% of the bottom quintile complete grade 7 compared with 90% of the richest quintile. Similar large inequalities are present in health outcomes and water access. (iii) Teacher certification also has great potential to improve the quality of schools in poor areas, since only 55% and 73% of primary and secondary teachers, respectively, currently meet the minimum qualifications required by the Ministry of National Education. 2. Discuss the impact of the policy reform(s) on vulnerable groups and ways to address it/them (refer to social analysis). The policy reforms of DPSP-3 do not adversely affect vulnerable groups. 3. Discuss how the policy reform(s) contribute(s) to poverty reduction, pro-poor growth, and the MDGs.

The trigger on enhancing procedures for tariff setting (trigger 4) has the potential to increase the purchasing power of poor households. The triggers relating to implementing the investment law (trigger 5) and to simplifying and eliminating unnecessary business licenses (trigger 6) may indirectly improve growth and poverty outcomes by encouraging additional investment and competition, respectively. The trigger relating to increasing access to finance for small and medium enterprises (trigger 7) may indirectly reduce poverty through additional growth, while the trigger relating to consolidation of core government bank accounts (trigger 10) and implementing transparent accountability arrangements for RDI and RDA accounts (trigger 11) has the potential to indirectly improve poverty by increasing local outlays and possibly reducing corruption. The trigger relating to developing an enhanced assessment framework for selected service delivery programs (trigger 15) has the potential to focus attention on service delivery in poor areas to improve poverty outcomes. Finally, the trigger relating to carryover of community-designed development (CDD) budgets over multiyear periods (trigger 17), would allow communities and local governments greater flexibility in determining CDD projects and maintaining existing projects

II. SOCIAL ANALYSIS AND STRATEGY

A. Findings of Social Analysis The policy actions or triggers under DPSP-3 are not likely to harm the poor and, if they affect them at all, they will do more good for the poor. The main impacts, as mentioned above, are indirect.

B. Consultation and Participation

1. Provide a summary of the consultation and participation process during the project preparation. The DPL series has supported actions that have been taken by the Government as part of its own reform agenda. The development of this reform agenda has been done in close consultation with civil society. In particular, the Government undertook extensive consultation with key stakeholders on all four recently issued policy packages for 2006/2007 — in infrastructure, investment climate, SMEs, and the financial sector. The Government has engaged extensively with civil society on tax and investment law reforms. The entire set of DPL-4/DPSP-3 policy actions will, as was done last year, likely be discussed with Parliament. The design and implementation of the unconditional cash transfer anti-poverty program involved substantial participation by development partners and civil society. This extended to the evaluation of these programs, as well. Such a systematic assessment of key government programs, making these findings public, and using these findings to help design future anti-poverty programs is a first in Indonesia.

Moreover, as part of the development policy loan process, consultations were held with a wide range of stakeholders,

including the private sector, labor groups, and enterprises.

2. What level of consultation and participation (C&P) is envisaged during the project implementation and monitoring?

Information sharing Consultation Collaborative decision making Empowerment

3. Was a C&P plan prepared? Yes No If a C&P plan was prepared, describe key features and resources provided to implement the plan (including budget, consultant input, etc.). If no, explain why. The DPL/DPSP process supports the Government’s C&P process

C. Gender and Development 1. Key Issues. The DPL/DPSP series has indirect gender impacts through its emphasis on making services work for the poor. The improved poverty orientation of public spending increases women’s access to essential services for achieving Millennium Development Goal targets, including to reduce child and maternal mortality. Improvement of the financial

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management systems of the Government through increased transparency and accountability will provide the civil society with basic information necessary to monitor government actions and enable it to provide inputs into policy and budget decisions.

A strengthened civil society provides women with a more effective channel for voicing their priorities. An improved investment climate is expected to provide greater opportunities for women, who experience significantly higher rates of unemployment, even when controlling for experience and level of education. 2. Key Actions. Measures included in the design to promote gender equality and women’s empowerment—access to and use of relevant services, resources, assets, or opportunities and participation in decision-making process:

Gender plan Other actions/measures No action/measure

Summarize key design features of the gender plan or other gender-related actions/measures, including performance targets,

monitorable indicators, resource allocation, and implementation arrangements. III. SOCIAL SAFEGUARD ISSUES AND OTHER SOCIAL RISKS

Issue Significant/Limited/

No Impact Strategy to Address

Issue Plan or Other Measures

Included in Design Involuntary Resettlement

No Impact

Full Plan Short Plan Resettlement Framework No Action

Indigenous Peoples

No Impact

Plan Other Action Indigenous Peoples

Framework No Action

Labor

Employment opportunities Labor retrenchment Core labor standards

Limited No impact No Impact

Plan Other Action No Action

Affordability

No impact

Action No Action

Other Risks and/or Vulnerabilities

HIV/AIDS Human trafficking Others(conflict, political

instability, etc), please specify

No Impact

Plan Other Action No Action

IV. MONITORING AND EVALUATION

Are social indicators included in the design and monitoring framework to facilitate monitoring of social development activities and/or social impacts during project implementation? X Yes □ No