h- Indonesia Country Unit October 8, 2003 INDONESIA WORLD BANK GROUP COUNTRY ASSISTANCE STRATEGY ISSUES AND OPTIONS

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INDONESIA

WORLD BANK GROUP

COUNTRY ASSISTANCE STRATEGY ISSUES AND OPTIONS

FY04 - 07

Indonesia Country Unit October 8, 2003

K.I.T.L.V LEIDEN

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EXECUTIVE SUMMARY

i. Indonesia has regained macroeconomic and political stability, but growth is stuck below 4 percent and poverty reduction remains a challenge. Indonesia continues its transition from an autocratic, centralized state to a democratic, decentralized one. Recent constitutional changes will further strengthen democratic accountability, including direct presidential elections in mid- 2004. Macroeconomics have been impressive: public debt to GDP has declined from 100 percent to 72 percent, inflation is below 7 percent, and income poverty has come down from 27 percent in 1999 to 16 percent today. However, over 110 million people are still vulnerable to severe poverty, surviving on less than $2 a day. Indonesia continues to under-perform its neighbors in access to quality health, education and other basic services, as reflected in MDG indicators.

ii. Governance concerns continue to cloud Indonesia's achievements, but it has begun to undertake reforms that could lead to more transparent and accountable government. High hopes that the Reformasi movement would lead to a demonstrative reduction in the corruption of the Soeharto era have not yet been realized. Increased transparency has not been matched by increased accountability. Poor governance continues to weaken the investment climate and undermine the provision of services, especially to the poor. Major reforms to enhance political accountability and enhance ftnancial management have been introduced, but strong implementation is needed to bridge the gap between the promise and the reality of reform.

111. The Government's recent Economic Policy Package represents a major. effort to

enhance the momentum of reforms, while the planned PRSP will address medium-term poverty issues. Following its decision not to renew the IMF program after 2003' the Government prepared a comprehensive package of policy reforms intended as a "letter of intent"

to the Indonesian people. The package provides an agenda of time-bound measures covering macroeconomic management, financial sector reform, and policies to help raise investment, growth and poverty reduction. The package is ambitious, but will serve as a potentially powerful mechanism to monitor the Government's progress in reform on the basis

of

benchmarks. With steady progress on this reform package and an effective PRSP,2 growth over the CAS period is expected to reach 5 percent by 2006.

iv. But with corruption still a significant problem, Bank assistance should be focused on direct measures to enhance transparency and accountability. Indonesia continues to rank near the bottom in surveys of corruption perceptions as the institutions to ensure better accountability are still in their infancy. Corruption poses a triple threat, undermining development, threatening the effectiveness of Bank financed projects, and weakening public support for development assistance. The CAS consultations have shown that Indonesians will judge the success of the Bank program on its contribution to improving transparency and accountability across sectors in which we operate, and by the standards of integrity with which the projects are implemented. The country team aims to integrate governance and corruption issues through the entire Indonesia program, shaping how projects are selected, designed, implemented and monitored, as well as out policy dialogue and partnerships.

'The IMF will engage in post-program monitoring beginning in 2004 at the Govemments request.

2 As a blend country, Indonesia's PRSP preparation is not directly linked to IDA access and was therefore not a pre- requisite for Bank CAS preparation. Indonesia's I-PRSP was circulated to the Board in March 2003.

v. Further progress in reducing poverty is prevented by two major factors - low investment, and weak service provision - which in turn are caused primarily by problems of governance. The Bank Group's entire efforts will be to help address these problems.

• Objective 1: Improving the Investment Climate. At the root of Indonesia's slow growth is lack of investment which declined from 30 percent at the time of the economic crisis to 20 percent, where it has broadly remained since. The Bank Group will focus support in five areas: maintaining macroeconomic stability, building a stronger financial sector, fostering a competitive private sector, building Indonesia's infrastructure, and creating income opportunities for poor households and farmers.

• Objective 2: Making Service Delivery Responsive to the Poor. Weak service delivery is undermining Indonesia's goal of improving lives of millions of poor and slowing attailUnent of MDGs. To accelerate better education and health outcomes, including tlu'ough reduced enviromnental degradation and better access to clean water and sanitation, the Bank will help Indonesia revamp the management and accountability systems for service delivery to make providers more directly accountable to their clients, especiall y the poor.

• The Core Issue of Governance - Defining Selectivity. Advances in governance are needed to make progress under both of these CAS objectives. As a result, selectivity in the Bank's activities will be determined less by sectoral priorities than by opportunities to help improve governance. Four areas will be given priority: making development planning more responsive to constituents; improving public financial management;

strengthening the accountability of local governments under a more coherent decentralization framework; and enhancing the public credibility, impartiality and accessibility of the justice sector.

vi. Business Platforms - How the World Bank Will Deliver. Indonesia's massive decentralization calls for a new approach to the delivery of development assistance. For each level of government mechanisms, a strategy is needed to ensure transparent use of funds, accountability of service providers to clients and the necessary capacity for their effective use.

The Bank will leverage the projects it finances with analytical work, policy advice, technical assistance, strategic partnerships and capacity building to systematically increase standards of governance at each level of govermnent the Bank engages. Four business platforms are envisioned:

• The Community Driven Development Platform: Scaling up a successful program.

I ndonesia has implemented a set of world-class CDD projects, including the Kecamalan Development Program and urban poverty projects that direct resources to small-scale investments identified by empowered communities to improve their livelihoods. In addition to high economic returns, transparency, inclusive participatory approaches, and accountability are the hallmarks of these programs. CDD projects will make up nearly 25 percent of our new commitments, emphasizing stronger links with the private sector and local govermnents, the development of a stronger legal basis for the model and more 1 comprehensive monitoring and evaluation efforts.

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• The Local Services Platform: Creating Accountability at the District Level.

Decentralization has put district-level governments in charge of service delivery and given them authority to regulate their local investment climate. The local services platform will be built on four principles: 1) define selection criteria based on clear standards of governance reform; 2) maximize complementarities across activities to promote a critical mass of reforms; 3) integrate capacity-building into project designs; 4) encourage cross-district networks and demonstration effects through stepped-up monitoring and dissemination. As more districts are willing and able to reform, access to Bank funds will increase so that up to 40 percent of our new commitments could be administered at this level of government.

• The Public Utility Platform: Demanding Good Corporate Governance and Efficiency.

Under this platform the Bank would support growing recognition of the need to apply sound governance and financial sustainability procedures to the public utilities. Funds would be provided on a competitive basis to reforming utilities, especially in the water sector, where needs are huge. As reform takes hold, around 15 percent of new commitments would go here.

• The National Lending Platform: Addressing Central Problems. The Bank will continue to engage strongly with the central government. However, the volume of direct financing for central government execution will be relatively modest since the imperatives and opportunities are currently greater at sub-national levels. About 15 percent of new commitments will be provided for national level governance reforms, infrastructure and areas requiring central government management.

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I. COUNTRY CONTEXT AND DEVELOPMENT CHALLENGES A. POLITICAL, SOCIAL AND ECONOMIC CONTEXT AND CHALLENGES

Indonesia continues its transition from an autocratic, centralized state to a democratic, decentralized one. In the five years since President Soeharto's resignation and the fall of tbe New Order regime, Indonesia's democracy has gained much ground. A multiplicity of voices is being heard from civil society, political parties, and the academic community, and communicated through a burgeoning and relatively free local media. Indonesia's Parliament has seen its role increase dramatically, and is now actively engaged in the policy debate and providing an institutional check on the executive branch. After a rocky start, the political arena has stabilized over the past two years. Recent constitutional and legal changes bave been passed that should further strengthen democratic accountability by paving the way for the first direct election of a President next year and phasing out of the military from Parliament. The successful implementation of the Big Bang decentralization as of 2001 has transferred considerable authority over public expenditures and public service delivery to over 400 local governments in the hopes of improving responsiveness to client needs. There are clear signs that decentralization is enhancing participation in decision-making in the most reform-minded regIOns.

1. Macroeconomic stability has been restored, and poverty has been reduced to near pre-crisis levels (Figure 1). The Rupiah has strengthened from over 10,000 per dollar at the start of the previous CAS period to 8,500 now, inflation has been brought down to below 7 percent, interest rates have fallen accordingly, and the stock market has risen sharply over the past year. Fiscal consolidation has been impressive, as the budget deficit has been reduced by two-thirds to an expected 1.9 percent of GDP in 2003, and 1.3 percent in 2004. Government debt to GDP has fallen from almost lOO percent in 1999 to some 72 percent now, and total external debt has shown similar trends. Progress in structural reforms, notably bank sales and asset recoveries by IBRA, the bank restructuring agency, have supported the macroeconomic gains. This stabilization ofthe economy supported a strong reduction in income poverty/ which fell from over 27 percent of the population in 1999 to 16 percent in 2002, in part because a stronger Rupiah made key staples, including rice, more affordable after the crisis spike.

2. Nevertheless, the reduction of poverty remains a critical challenge for Indonesia.

Despite progress since the crisis, the number of poor in Indonesia continues to be high: currently double that of the entire population of Australia. Moreover, while 6.7 percent of the population live below $1 per day, over 110 million people (53 percent of the population) live on less than $2 per day, and about that many remain highly vulnerable to falling under Indonesia's poverty line.

Eastern Indonesia continues to lag far behind the rest of the country, but there are also pockets of poverty within all regions, and the high population density of Java and Sumatra means that most of the poor in fact live on these islands. Looking beyond income poverty, Indonesians continue to suffer in many ways. Progress in ensuring access to basic health, education, water, and sanitation services (e.g. as measured by births attended by traditional healers, child enrollment, household access to sanitation and to water), improvements have been slow. These are also reflected in poor MDG outcomes, particularly in health (see Table I), relative to countries within the region. Women in particular suffer problems of access to quality services and bear the consequences: Indonesia's maternal mortality rate is two times greater than the Philippines and five times greater than Vietnam. Where public services are available -- in education and health,

3 As measured through expenditures.

i

..

"

I •

•

•

Ilo\erl)' incitlenct. (-/.)

JO~/.

2(J(1O 200' 1002

DP, and Investment

10,000

0,000

,- 8,500

lOOl 200.

ll-t.

29%

11""

!S",I.

U";' 21%

to GDP

\row1

h

'99' '99' ^{,999 l(J(lO 200' 2001}

I (,'Y.

14'1".

12%

10*1.

S"/.

6"/.

""f.

2·;.

0'-..

-Z·.r., ^{GDI' Priva}le consumption Inn,lme:nl

2000 2001 2002 2000 20012002 2000 2001 Z002

The Government of lndonesia is in the process of preparing a Millennium Development Goals report. In this table we have made an effort to present the indicators as they are likely to feature in the Gol's report, There are however

likely to be differences and this table should not be considered the Ool's view with respect the progress toward the MDOs.

Poorest Progress towards

1990 2002 quintile Goal

I. Halve between 1990 and 2015 the proportion of people who suffer from poverty and hunger

Population below I dollar a day (%)' 20.6 6.7 33.6 Achieved

IShare of poorest quintile in National consumption 0.086 .0843 o.a. No change Prevalence of underweight children

37 26 ".a. On track, but slipping

under 5 years of age, %)'

Proportion of population below minimum level of

nergy consumption 70 65 20 slow progress

less than 2100 Calories per person per day, %) b

•. Achieve universal primaiyeducanon

Ensure that by 2015 everywhere, boys and girls alike will be able to complete a full course of primary education

Net enrollment rate in primary school' 93.2" 92.5 88.3 No change

Proportion of children aged 16 that have completed

88.4 ' 94.2 88.1 Improvement

primary school. b

3. Promote Gender Equality and Empower Women

Primary 1.06" 1.08 1.06

Ratio of boys to girls b Junior secondary 1.13 " 1.04 0.99 On track Senior secondary 1.21 " 1.12 1.14

Share of women in wa~e employment in non-

gricultural sector (%) ^{30' 32 31 No change}

Proportion of seats held by women in national

13 8.8 n.a. Deterioration parliament (%)'

4. Reduce Child mortality

Under 5 mortality rate r 99 60 n.a. On track

Proportion of children ot I year ImmuOlzeO against

neasles (%)b ^{74 ' 68 60 Worsening}

5. Improve maternal health

Maternal mortality ratioC: ^{420 •} 334 ' n.3. Improving slowly

Proportion of births attended by skilled health

39.6' 67 46 Improving but low

personnel b

b. Combat HIV aids, malaria and other diseases Lontraceptive prevalence

80.8' 73 73 worsening

% among married women)

7. Ensure Environmental Sustainability

Proportion of land covered by forest' 63" 57' ".3. ^worsening

Percel~t of population that has access to improved

63 ' 78 65 Improving but low

~aterJ

I World Bank. April 2003. East Asia Update - Looking Beyond Short-term Shocks, Regional Overview. East Asia and Pacific Region. Washington D.e.

I World Bank Staff calculations based on Susenas.

, BPS stafT calculations based on Susenas.

d t993 dal •.

International Institute for Democracy and Electoral Assistance. 2000. Democratization in Indonesia: An Assessment.

r BPS publications, using population census, International Demographic and Health Survey and intercensal surveys.

1:1 J Jolmcs. Dcrck A. 2002. "Indonesia: Where have all the forests gone?" Discussion Paper. Environmental and Social Development, East Asia and Pacific Region. World Bank., Washington D.C.

k t985 dat •. 1997 data.

J Improved water is derived from bottled, piped or pumped water, protected well or spring and rainwater. Not improved water is rrom unprotected well or spring, river, etc.

L 1991 data.

I 1997 d., •.

i

for example -- they are often of poor quality as evidenced by student scores and the high prevalence of cOrnn1unicable diseases such as TB.

3. The achievements of the past few years continue to be clouded by widespread concerns about governance and corruption across Indonesian society. The high hopes that the Reformasi movement would break the hold of the vested interests and the corruption, collusion, and nepotism that characterized the later years of the Soeharto era have not been realized. Few have been held to account for the theft of public resources, and there are signs that

"money politics" is at work allowing old elites to reacquire their previous assets, and new elites

to consolidate their positions. While corruption captures headlines, the issues created by Indonesia's weak institutions have wider implications. The "please your boss", upward-looking accountability and reward system of Indonesia's centralized New Order civil service lingers on at the expense of citizen participation and accountability for results. The perception that corruption is still entrenched in the political system has damaged Indonesia's investment climate and generated popular resentment and resignation. The uneven burden that corruption and poor governance place on poor families raises serious issues of equity and fairness. Indeed,

addressing governance was identified in the Bank's 2001 Poverty Report⁴ as the single-most

important agenda for reducing poverty in all its dimensions. Many senior Indonesians recognize that that the "crisis of governance" is becoming a "crisis of development", and that a whole new mindset is needed, including tools, instruments and capabilities of modern, responsive government.

4. Unlike many other countries facing similar governance problems, Indonesia has begun to undertake important structural reforms tbat could ultimately lead to more transparent and accountable government. An ambitious program of electoral reforms has been introduced that will, over the coming few years make policymakers at all levels of government directly beholden to voters. The mid-2004 national elections will be an important first test. Will "money politics" rule the day? Or will direct election of the President and parliamentarians spark greater responsiveness to public demands for integrity and good

6. Finally, Indonesia is not yet free from risks to political and social stability, against which democracy, growth and poverty reduction remain the best weapons. The recent resumption of military action in Aceh demonstrates that so far, decentralization and special autonomy, have not resolved separatist tensions. At the same time, extremist Islamic movements bOoth within Indonesia and across the region, though representing a small minority, continue to pose a heavy burden of terrorism threats. The twin threats of separatism and terrorism raise concerns about security and uncertainty that impose high costs on the population and dampen the response of investors to Indonesia's strong macroeconomic achievements. At the same time, these twin threats underlie a continued powerful political role for the military which weakens some of the recent gains in establishing greater transparency and accountability in the political system.

B. INDONESIA'S NEW ECONOMIC POLICY PACKAGE: THE CRITICAL SHORT-TERM AGENDA

7. The Government has decided not to renew the IMF program when it expires at the end of 2003, and in its place has announced a package of policy actions for the next eighteen months. Following much discussion among politicians, cabinet members, academic economists and civil society groups, President Megawati Soekarnoputri announced the Government's decision in her budget speech to the nation on August 15, 2003s In place of th~

IMF LOT, the Government has prepared its own time-bound package of economic policies, that will guide policy direction through 2004, covering the period ofthe elections and installation of a new administration. The package, signed by the President on September 15, covers three areas- macroeconomic management, financial sector reform, and policies to restore investment and growth.

8. Further Macroeconomic Consolidation. The Government's aim is to reduce the fiscal deficit to zero by 2006, and the public debt to GDP to "safe levels" (the State Finances law specifies a level below 60 percent of GDP -- equal to the so-called "Maastricht" norms prevalent in the European Union). Measures to modernize the tax system include revisions of taxation laws, expanding the large tax payers' office, and reforms of the customs office. Measures to increase efficiency in spending include revised procedures on government procurement, establislunent of a separate treasury and a treasury single account, and implementing regulations for budget preparation and government accounting standards. The plan calls for further reductions in untargeted fuel subsidies -- and limiting these to household kerosene, a fuel mainly used by the poor. The program includes privatization of 10 state enterprises -- an ambitious target for an election year --and a revamp of intergovernmental fiscal relations.

' The IMF will continue to be strongly engaged through its "Post Program Monitoring" missions,

9. Deeper Financial Sector Reform. Government plans include polices to solidify a financial sector safety net, continue bank restructuring, strengthen state bank governance, and improve capital market supervision. A "white paper" on the financial safety net would be prepared, a deposit insurance law submitted to Parliament, and the "lender of last resort" role of Bank Indonesia would be amended. Specific actions on bank restructuring include further sales of IBRA banks and assets, and introduction of risk-adjusted capital adequacy rules. State banks would be strengthened by appointment of independent commissioners, and by improving credit and risk management systems, and by launching an IPO for Bank BRI. Capital markets would be placed on a firmer footing by enforcement of capital adequacy standards, regulation of the mutual funds business, and consolidation and improved regulation in the insurance and pension sector. The anti-money laundering law has been revised to abide by FA TF guidelines, and an anti-money laundering task force will be created.

10. An Improved Investment Climate. Actions promised by the Government draw from consultations with the business community, and seek to begin to address deep seated constraints, such as corruption, the lack of a trusted legal system, the lack of access to land tenure, and the lack of adequate physical infrastructure as well as more immediate regulatory and labor issues.

The Government will set up an Investment and Trade Team to identify and address constraints, and monitor progress. Specific actions include a revision of the investment law, a review the negative list of sectors barred for foreign investors, and acceleration of tax refunds for exporters.

The Anti-Corruption Commission will begin operation, a judiciary commission in charge of the appointment of judges will be established, and the law on the attorney general's office will be revised. The bankruptcy law will be revised, and the commercial court in charge of application of that law will be strengthened. To improve investment and management of physical infrastructure, additional public funds will be allocated; and private investment will be facilitated through revisions to the Transport Law, and the creation of an independent supervisor for the electricity market. The Government commits to improving service delivery to investors by improving tax and customs administration, and by requiring all agencies with services to the public to publish service delivery standards.

11. The Economic Policy Package has been received domestically and internationally as ambitious but welcomed. By announcing actions and dates, the Government has opened itself to publ ic scrutiny and made itself accountable in an unprecedented manner. Existing planning documents, such as the five year plan (PROPENAS) and annual plan (REPET A), discuss development objectives and list loosely related development spending programs, but do not include concrete time-bound actions, with allocated responsibilities. The new package can be criticized as containing too many items and being unfocused, and its success will only become evident over the coming months. Monitoring units are being established within Government and outside, and the Bank will support the Government's efforts to refine the program, and will provide support for its implementation.

C. THE EMERGI G PRSP: A MEDIUM-TERM FRAMEWORK FOR POVERTY REDUCTION 12. A Poverty Reduction Strategy Paper (PRSP), scheduled for completion in May 2004, is expected to build on the Economic Package, and layout a comprehensive medium- term development program for poverty reduction. In early 2003 Indonesia finalized its Interim PRSP, which provided a broad road-map and timetable for developing the full PRSP.

The l-PRSP (circulated to the Boards of the Bank and Fund in March 2003) was consulted

broadly with civil society and across the country. Consensus was developed on four fundamental themes for the national PRSP: (i) creating opportunities; (ii) empowerment; (iii) human capital and capacity development; and (iv) social protection. Four multi-stakeholder Task Forces are charged with putting substance behind these areas through a program of analytics and policy development. A Core PRSP Team, under the leadership of the Coordinating Minister for Social Development, is responsible for the overall strategy, and for seeking to link to the strategy to the medium term plan and budgetary framework. A series of district level poverty reduction strategies, based on participatory poverty assessments (PPAs), are also being prepared. The CAS has been designed to be fully consistent with the emerging PRSP, and has been prepared in consultation with the PRSP Core Team. The CAS Progress Report, to be prepared at the end of 2004, will propose fine tuning of the CAS, in light of the full PRSP and the concerns of the new Government.

D. ECONOMIC OUTLOOK, EXTERNAL ENVIRONMENT AND FINANCING NEEDS

13. A gradual increase in growth characterizes the Base case economic outlook.

Supported by a recovering international economy, and a slow but steady improvement in the investment climate, Indonesia's GDP growth rate is expected to reach 5 percent by 2006, up from the 3.5 percent in 2003, and broadly similar rates over the last CAS period. Inflation is expected to drop further to some 5 percent per annum and domestic interest rates to drop in line.

Under this scenario, the poverty rate would fall from 16 percent in 2002 to 11 percent in 2007, less than half the 27 percent it was in 1999. The external environment is likely to be slightly more supportive of Indonesia's growth than over the past years: the most recent World Bank projections envision a pick-up in the rate of global GDP growth and of world trade.⁶ Indonesia will face increasing competition on traditional markets, particularly from China, and that competition will intensify after expiry of the MF A agreement in 2005. At the same time, China will be a rapidly growing export market for Indonesia in the years ahead and, on balance, we therefore expect continued export growth. Imports will grow faster, as a result of recovering investment, and the current account surplus is thus expected to gradually decline from the record

$7.5 billion, or 4.3 percent of GDP in 2002.

14. Our Base case projections include gradual increases in investment rates and factor productivity, which in turn are predicated on continued sound macroeconomic performance and a moderate improvement in the investment climate. We expect the Government to continue fiscal consolidation, although at a more moderate pace than the Government itself projects. We assume a balanced budget by 2007, down from 1.9 percent projected for 2003. Consolidation will not only come from further cuts in fuel subsidies - already down from over 5 percent of GDP in 2001 to 1.4 percent of GDP projected for 2003- but also from an increase in non-oil tax revenues on the back of accelerated revenue administration reforms. The government debt to GDP ratio will continue to fall through 2007 from 67 percent by the end of this year to below 50 percent by 2007 given the debt repayment schedule, exchange rate assumptions, and nominal GDP growth. Likewise, the total external debt to GDP ratio, which had dropped to 76 percent in 2002 is projected to continue to decline to about 40 percent in 2007. We expect investments as a share of GDP to gradually rise from 20 percent now to 22 percent in 2007.

6 The World Bank's Global Development Prospects 2004 publication envisages world GDP growth climbing from 2 percent in 2003 to 3 percent in 2004-2005, and regional (East Asia and Pacific) growth rates rising to 6.6-6.7 percent in 2004-2005. World trade volume is expected to increase from 4.6 percent in 2003 to 8 percent in 2004-2005.

15. Despite further fiscal consolidation, financing needs will be particularly high in the first two years of the CAS period. With the expiration of the IMF EFF arrangement, Paris Club rescheduling ceases at the end of 2003, adding some $3 billion in additional financing needs. In addition, an increasing share of bank re-capitalization bonds will fall due over the coming years, while IBRA asset recoveries are tailing off, as are privatization receipts. As a result, higher financing is required to support a public investment program that complements private investment. With respect to domestic financing, the government will look to the domestic bond market and a draw-down in deposits. However, increased foreign-financed disbursement will also be required as one important element in bringing about enhanced investment levels and growth. Foreign financed disbursements on the order of US$3 billion will be required annually over this period, relative to a level of $2.3 billion per annum over the last three years, excluding Paris Club.

11. THE WORLD BANK IN INDONESIA: LEARNING FROM RECENT EXPERIENCE

A. LESSONS FROM THE TRANSITION PERIOD

16. In the aftermath of the economic crisis, the World Bank was seen by many as part of the problem rather than the solution. To many Indonesians the Bank was associated with the Soeharto Government, which it had supported through loans and policy advice for 32 years.

The Bank was a contributor to Indonesia's external debt, perhaps the country's most visible economic problem in the post crisis years, without being able to contribute to debt rescheduling or debt reduction. And the Bank's reputation was damaged as it was perceived to have failed to takc a stand against corruption, wh.ile lending large sums of money in support of the Soeharto regime. As of mid-2000, the Bank had $11.8 billion of IBRD funds outstanding to Indonesia.

To many NGOs this was a millstone around Indonesia's neck. And to the Bank's risk managers, this posed one of the most dangerous parts of the overall portfolio.

17. Over the last few years, the Bank has sought to actively confront these issues, making progress and learning important lessons. First, our debt exposure to Indonesia has been lowered. In agreement with the Goverrunent, lending was reduced dramatically from an average of $ 1.3 billion per year before the crisis, to about $4~0 million over the last three years. As a result the Bank's exposure to Indonesia has dropped by some $1.5 billion, and will fall by a further $700 million in FY04. Second, as the Bank's portfolio has shrunk, portfolio performance has picked up. Consolidation, project restructuring and intensive supervision has helped portfolio performance recover from its FY02 post-decentralization dip. Commitments at risk, which reached 39 percent in FY02, dropped to 12 percent by end FY03. Third, the Bank shifted its focus (and its reputation) towards a major expansion of our work on community-driven development programs, governance and anti-corruption (see Section B), and engagement with civil society.

18. Recent portfolio performance has been mixed. Recent OED ratings largely apply to projects that began before the crisis, and thus teach lessons about the need to be flexible at times of stress. Of the 30 projects closing in FYOI-03, 60 percent were rated satisfactory or highly satisfactory, while 37 percent were rated moderately unsatisfactory or unsatisfactory. Problems identified understandably included lack of counterpart funding and more generally a lack of ownership on the part of Government during the transition period. Lack of supervision from

central Govenunent and from the Bank was identified in several situations, as was more generally the break-down of traditional top-down project design and administration. During the past CAS period, therefore, an effort has been made to introduce a new generation of projects, giving much greater emphasis to participatory approaches, being sensitive to the capacities at local and central levels of government, and introducing mechanisms for local level accountability. Some of the lessons from the past CAS period are summarized in Box I.

Box 1: Several lessons from the last CAS inform this one

• Aligning the CAS and t~e High case triggers to the Government's program is essential for ownership and effectiveness in implementation.

• Recognizing poor governance and corruption and dealing with it head-on in our strategy and our own operations. even if it means identification and increased investigations of alleged corruption within World Bank projects, enhances our legitimacy and effectiveness in addressing and speaking out on these issues.

• Close partnerships with donor partners and civil society, such as through the CGI process and Partnership for Governance Reform, enhances our effectiveness, as does current exemplary collaboration with the Fund.

• Decentralization is now for real and affects everything we do. It poses real opportunities and real challenges which, going forward, we must address centrally in our strategy.

• Our community driven development efforts, central to our last CAS, are bearing results and are appreciated by the client. We must learn and build on this.

• \I1ore systematic monitoring and evaluation of the impacts of our interventions is essential to an innovative program such as ours. This requires priority going forward.

• Strong analytical work continues to be a strength of the Bank and is appreciated by the client and our partners. Increasing its leverage to better inform the design of operational interventions and affect policy change is key.

19. Indonesia remained in the Base case throughout the last CAS period, but has now broadly achieved the High case. Triggers for the High case gave emphasis to the continuation of the post-crisis reforms. Table 2 summarizes progress made over the past three years on both the triggers and related measures in which the Bank Group provided technical support. By the end of FY03 only one High case trigger - the issuance of a new Procurement decree -- remained unmet. This progress, however, must be tempered by the fact that much still remains to be done on the reform agenda, and implementation of policies and laws remains a serious issue.

Table 2: Government policy performance under last CAS

Action Area GOI Action and Progress To Date (Higit case trigger cOllditiolls itigitligl,ted ill bold) /lank and • ^IBRA sold $45 billion in distressed banking system debt.

CO/parale

•

Restructuring

•

•

A1acroeconomic

•

Stabilily

•

•

•

Pro-Poor

•

• ^Land policy management clarified through Presidential Decree 3412003, but implementation regulations yet to be prepared and adopted.

•

•

•

Private Sec/or

•

Development

I,?fros/ructure

•

BOlllenecks

•

•

•

Legal and

•

.ludicial Reforms

•

•

Civil Service

•

Public

•

Procurement and

•

Management

Management of

•

Process

•

Box 2: CAS consultations highlight Indonesia's development challenges

As part of the preparation of this CAS, consultations with various civil society representatives, both in Jakarta and in the regions, highlighted priority development issues that participants thought the Bank should address. They closely mirror and valid'ate the key challenges posed above. First, participants saw "KKN" (corruption, collusion and nepotism) as the country's core problem. As it was put by one participant, "corruption is the real root of poverty in this country". Many called for particular attention to legal reform as a related development priority. Second, participants stressed the need to alleviate poverty, especially through job creation and economic growth. Third, consultations raised the need to improve public services - especially in education and health - as a key development priority. With regard to service delivery, concerns were raised about corruption and quality. Fourth, related to both growth and governance, Indonesians felt there was a need to pay more attention (0 improving agriculture and environmental management.

B. THE SPECIAL PROBLEM OF CORRUPTION

20. More than 5 years after the fall of Soeharto, the salience of the issue of corruption has not diminished. Though it is nearly impossible to compare the actual levels of corruption under the New Order and Reformasi regimes, it is clear that corruption has become less predictable in this more competitive and uncertain environment. Moreover, the unfulfilled expcclalions that Reformasi would quickly bring a new integrity to public life has generated resentment, fuelling perceptions that corruption has become endemic in the new system. For the Bank, corruption has become a triple threat: it undermines progress on the country's broad development objectives, it remains a serious risk to the effectiveness of our projects and it continues to weaken public credibility in development assistance overall which is still too often portrayed within segments of the community as contributing to the problem.

21. A central lesson of the Bank Group's experience in Indonesia is that our entire success will be judged by the contribution that our programs are seen to make towards greater transparency and accountability and by the standards of integrity with which we implement these programs. This has consistently been one of the main messages of our enhanced CAS consultations with civil society (see Box 2) and the Indonesia Country Team's own self-assessment of the Bank's objectives over the next several years. Since the crisis, the Bank has responded to the triple threat of corruption by scaling back our lending, while seeking to build a capacity to act as a catalyst for anti-corruption reforms, cultivating partnerships to promote good governance, and strengthening the team's own capacity for mitigating corruption risks to our projects. Much has been achieved in each of these areas, providing a stronger foundation for the Bank to respond to Indonesia's increasedJleed for development assistance.

22. Going forward, the Bank Group will integrate four key anti-corruption principles across its entire program in Indonesia:

• A clear and consistent voice raising corruption concerns and promoting feasible policy responses across all sectors of our operations. In the past three years the Bank invested considerable efforts in assisting the development of the Partnership for Governance Reform - an indonesian-led, multi-donor supported effort to raise awareness of and devise solutions to governance problems. The Bank is complementing this work by raising its own voice on corruption through analytical and advisory work. In October 2003 a multi-sector Bank report dissecting "how corruption works" in a wide range of areas will be launched. This will be followed up by expenditure reviews and expenditure tracking targeted at key breeding grounds of corruption, more core diagnostic reports, and detailed studies of the effects of participation and transparency on corruption outcomes in

community level programs. At the same time, the Bank has supported national-level reforms in procurement and financial management (see Table 2). The Bank will help the Government persevere in fending-off special interests to create a national procurement function and modernize its procurement law. We will also support the Government to implement the agenda that has been codified in the recent State Finance Law (and soon to be passed Treasury and Audit laws).

• Project selection and design to open multiple entry points in the fight against corruption. Instead of relying on the development of an overarching anti-corruption program or anti-corruption institution, the Bank's projects described in the pages ahead have been chosen to open up multiple anti-corruption entry points at different levels of government and across different sectors. CDD projects promote participatory planning and monitoring to reduce corruption in village level governments. District level projects will seek to select kabupaten and kota with a demonstrated commitment to greater accountability and transparency and work with them to improve their financial management and pro-poor planning capacity. Justice sector work wi II target both enhancing access to justice for the poor as well providing technical assistance to the new central institutions designed to fight corruption. The Bank will respond in particular to partners with a demonstrated track record of commitment to anti-corruption reforms.

• Mechanisms to mitigate corruption risks for all projects through empowerment, participation and transparency. The lessons of our successful CDD projects in Indonesia demonstrate the impact of smart project design for reducing corruption risks and getting more development impact for less. Direct client participation in the selection and implementation of projects engages citizens as monitors with a direct incentive to reveal corruption problems. Public disclosure requirements at key stages of the project make asset diversion more difficult and build public credibility behind the project.

Enhanced supervision through project facilitators in the community linked to national networks has been particularly successful in revealing corruption allegations. To ensure smart project designs, all projects are required to devise an Anti-Corruption Plan, assessing risks of corruption inherent in the project and proposing design and supervision mechanisms to mitigate those risks.

• Pre-emptive audits, vigorous investigation and follow-up to allegations of corruption in Bank projects, and public disclosure of the results. Having created better mechanisms to detect and handle corruption allegations in our projects, the Bank is now receiving and investigating considerably more corruption complaints. It is also proactively uncovering the methods and systems that allow corruption to flourish, notably the Fiduciary Audit of the Second Sulawesi Urban Development Project. Professionals from the Department of Institutional Integrity (INT) were brought in to investigate high profile corruption allegations such as Books and Reading, and Kerinci Seblat ICD. In these and other examples, the investigations have been coupled with the development of corrective and preventive action plans by the relevant government agencies, blacklisting of contractors and full public disclosure of the findings and remedial actions.

24. The Country Team has invested unprecedented resources into mainstrcaming anti- corruption throughout our program. The Indonesia Country Office is the only mission worldwide with a Senior Governance Adviser to coordinate our anti-corruption dialogue, oversee governance-related operations, advise projects on governance and anti-corruption strategies, and

develop a comprehensive research agenda and monitoring framework on governance. A strong field-based OSU team has been put in place to lead the movement towards a systematic and effective supervision of fiduciary practices during project implementation. An in-house Anti- Corruption Committee has been established with representation across the sectors to serve as a focal point for integrating anti-corruption mechanisms into project design, review procurement and corruption allegations and liase with our internal investigations unit. Full-time staff members are now being assigned to assist task teams in the design of anti-corruption strategies, and in the investigation of possible corruption within our portfolio.

Ill. THE BANK GROUP'S ASSISTANCE PROGRAM

THE WORLD BANK GROUP'S STRATEGIC Focus

25. For the coming CAS period the Bank Group will continue to focus its program on those areas most crucial to poverty reduction. At present these are two primary constraints to further reductions in poverty. These are: first, inadequate productive employment opportunities, which result from low investment and a weak investment climate, and second, the lack of quality service delivery to poor people. Progress in these two areas, in turn, is being compromised by the underlying problem of weak governance.

OBJECTIVE I: IMPROVING TilE CLIMATE FOR HIGH QUALITY INVESTMENT

26. A weak investment climate is undermining Indonesia's future. Indonesia's economy has been growing over the past three years at a rate of less than 4 percent per year - lower than what is needed to absorb the 2.0-2.5 million new entrants in the labor force every year.

Unemployment is rising and wages in the informal sector are stagnant. At root is the lack of investment which at the time of the crisis declined from around 30 percent of GDP to around 20 percent, where it has remained since. The Bank Group's support for reversing this trend will be focused in five areas. Indicators for monitoring success are provided in Table 3.

27. Maintaining macroeconomic stability. In addition to continuing its ongoing macroeconomic monitoring and advice, the Bank will help strengthen the governance of institutions that are criti"cal to underpin macroeconomic stability and growth. Under preparation, jointly with the IMF, is a project to support reform of the Ministry of Finance, including public financial management and tax and customs administration. Public Expenditure Reviews are planned for FY05 and FY07, and support for debt management will be provided through an ASEM grant. Advisory services for the wind-down of !BRA will be provided, and establishment of a sound safety net will be supported.

28. Building a stronger financial sector. Bank Group activities will gradually move from the past emphasis on crisis response and management towards a medium-term focus on overall financial sector development and reform -- including non-bank financial institutions, rural financial intermediation, micro-finance, and improving access to financial services for the poor.

Ongoing financial sector-monitoring, a Non-bank Financial Institutions Strategy and support for implementing the newly revised anti-money laundering law form part of the AAA agenda. The I FC and Bank will work together to assist in the development of financial market infrastructure sllch as credit bureaus, and key market segments sllch as housing finance and securitization.

Micro-fUlance delivery is currently supported through the ongoing COD and rural area development projects. A Micro-finance Project will increase the linkages of these institutions with the formal financial sector, assist in the creation of a sound policy framework for their operation, and work with commercial banks to expand their outreach in rural areas.

29. Fostering a Competitive Private Sector. Bank Group support will include:

• Building the Institutions for a Competitive Economy. A policy-based loan programmed for FY05 linked to significant progress in the Government's Economic Policy Package will support improvements in the regulatory environment that will enhance private sector competition. Support will also be aligned to improve competition in key industries, including support for the regulatory bodies in electricity, telecommunications, oil and gas. Ongoing power projects, as well as a new domestic gas project will promote unbundling and enhanced competition in the power sectors. The Bank will also seek greater clarity and predictability i 11 the enforcement of environmental regulations, through support to the Government's Good El1viromnental Governance (GEG) Program.

• Monitoring the Investment Climate and Promoting Dialogue. A program of national, local and rural business climate surveys is currently being set up, and will be supported by diagnostic work on private sector constraints, including a Diagnostic Trade Integration Study and a Domestic Trade Study. The Private Sector Forum will continue to be organized by the IFC in the context of the Consultative Group meetings to enhance the dialogue between the Government and the private sector. Current topics include, for example, private investment in the power sector, mining, and banking, the role of the commercial courts and corporate governance.

• Strengthening corporate governance and key oversight institutions. Assistance will continue to be provided to institutions such as the Competition Agency, the Corporate Directors' Institute, and auditing and accounting bodies, and a review of corporate governance is being completed.

• Support for SME Development. The IFC's new Program for Eastern Indonesia SME Assistance (PENSA) will be the Bank Group's main vehicle capacity building for SMEs (see Box 3). It will be supported by business climate programs through the Bank's decentralized governance programs (see next section).

Box 3. The Program for Eastern Indonesia SME Assistance (PENSA)

Small and Medium Enterprises (SMEs) account for the vast majority of employment in Indonesia, yet they operate in an uncertain and often unhelpful environment. There are 17 million legally registered enterprises in Indonesia, almost all of which have less than 20 employees each. Those able to produce for a niche market, adapting quality and cost to market demand, have high growth potential, as evident in the rapid growth of exports of SMEs. The growth oPPOItunities for Indonesian SMEs are a critical component to Indonesia's economy, investment climate and political stability. For these reasons, the !FC has initiated PENSA, a five year program funded at approximately US$20 million by Australia, Canada, Japan, the Netherlands and IFC. With offices in Denpasar, Balikpapan, Makassar, Surabaya and Jakarta it aims to stimulate the growth of small scale enterprises in the region. It will pay special attention to promoting sustainable, value-added upstream and downstream product and market relationships between SMEs and larger core businesses, access to finance to SMEs and improving the investment climate. PENSA's five offices concentrate on different aspects of SME development (e.g. extractive industries, handicraft and furniture manufacturing, agribusiness processing, finance, and policy reform and deregulation). Key to PENSA's approach is building the capacity oflocal consultants and institutions.

30. Building Indonesia's Infrastructure. The lack of investment in infrastructure over the past five years is a major threat to Indonesia's economic prospects. Competitiveness is being