Completion Report. Project Number: Loan Number: 1866 November Indonesia: State-Owned Enterprise Governance and Privatization Program

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1 Completion Report Project Number: Loan Number: 1866 November 2008 Indonesia: State-Owned Enterprise Governance and Privatization Program

2 CURRENCY EQUIVALENTS Currency Unit rupiah (Rp) At Appraisal At Program Completion (28 February 2000) (7 October 2005) Rp1.00 = $ $ $1.00 = Rp7,305 Rp10,305 ABBREVIATIONS ADB Asian Development Bank MOF Ministry of Finance MSOE Ministry of State-Owned Enterprises OECD Organisation for Economic Co-operation and Development PPP public-private partnership PSO public service obligation SCI statement of corporate intent SOE state-owned enterprise TA technical assistance NOTES (i) (ii) The fiscal year (FY) of the Government ends on 31 December. FY before a calendar year denotes the year in which the fiscal year ends. In this report, $ refers to US dollars. Vice President C. Lawrence Greenwood, Jr., Operations Group 2 Director General A. Thapan, Southeast Asia Department (SERD) Director J. Ahmed, Governance, Finance, and Trade Division, SERD Team leader K.-P. Kriegsmann, Senior Financial Sector Specialist, SERD

3 CONTENTS Page BASIC DATA i I. PROGRAM DESCRIPTION 1 II. EVALUATION OF DESIGN AND IMPLEMENTATION 2 A. Relevance of Design and Formulation 2 B. Program Outputs 3 C. Program Costs and Disbursements 10 D. Program Schedule 10 E. Implementation Arrangements 10 F. Conditions and Covenants 11 G. Related Technical Assistance 11 H. Consultant Recruitment and Procurement 12 I. Performance of Consultants, Contractors, and Suppliers 12 J. Performance of the Borrower and the Executing Agency 12 K. Performance of the Asian Development Bank 12 III. EVALUATION OF PERFORMANCE 13 A. Relevance 13 B. Effectiveness in Achieving Outcome 13 C. Efficiency in Achieving Outcome and Outputs 14 D. Preliminary Assessment of Sustainability 14 E. Impact 14 IV. OVERALL ASSESSMENT AND RECOMMENDATIONS 15 A. Overall Assessment 15 B. Lessons 15 C. Recommendations 15 APPENDIXES 1. Program Framework Compliance with First-Tranche Release Conditions Financial Performance of State-Owned Enterprises in Indonesia Privatization Indicators Compliance with Second- and Third-Tranche Release Conditions Compliance with Monitorable Actions under the Second and Third Tranches Recommendations for Future Corporate Governance Reform Compliance with Assurances 38

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5 BASIC DATA A. Loan Identification 1. Country 2. Loan Number 3. Program Title 4. Borrower 5. Executing Agency 6. Amount of Loan 7. Program Completion Report Number B. Loan Data 1. Appraisal Date Started Date Completed 2. Loan Negotiations Date Started Date Completed 3. Date of Board Approval 4. Date of Loan Agreement 5. Date of Loan Effectiveness In Loan Agreement Actual Number of Extensions 6. Closing Date In Loan Agreement Actual Number of Extensions 7. Terms of Loan Interest Rate Maturity (number of years) Grace Period (number of years) Indonesia 1866 State-Owned Enterprise Governance and Privatization Program Republic of Indonesia Ministry of Finance $400,000,000 PCR: INO February February October November December December March December December October London interbank offered rate (LIBOR) based Disbursements a. Dates Initial Disbursement 21 December 2001 Effective Date 18 December 2001 Final Disbursement 07 October 2005 Original Closing Date 31 December 2004 Time Interval 45 months Time Interval 36 months b. Amount ($ million) Original Allocation Amount Disbursed Undisbursed Balance 400,000, ,000,000 0

6 ii C. Program Data Ratings Implementation Period Development Objectives Implementation Progress From December 2001 to September 2004 S S From October 2004 to March 2005 S PS D. Data on Asian Development Bank Missions Name of Mission Date No. of Persons No. of Person-Days Specialization of Members a Reconnaissance 19 Mar 10 Apr a, b, c Fact Finding May a, d, e Sr. Policy Consultation Jul a, d, f Sr. Policy Consultation Feb c, f, g Appraisal Feb a, b, d, h, i, j Inception Dec a Loan Review Jan a Loan Review Feb a Loan Review Mar a Loan Review Apr a Loan Review 5 30-May 1 Jun a Loan Review 6 11 Jul a Loan Review 7 26 Aug 7 Sep a Loan Review Oct a Loan Review Feb a Loan Review May a Loan Review Jul a Loan Review Sep a Special Loan 4 6 Sep f Administration 1 Loan Review Nov a Special Loan Administration 2 28 May f Loan Review Jun c Loan Review 15 Project Completion Review 14 Mar Jul to 05 Aug a, f c a a = financial economist; b = social sector development specialist; c = senior financial sector specialist; d = senior programs officer; e = young professional; f = manager; g = lead financial sector specialist; h = senior counsel; i = senior environment specialist; j = senior social development specialist.

7 I. PROGRAM DESCRIPTION 1. With the overall objective of improving resource allocation in the public sector and promoting private sector participation in economic activities that have traditionally been controlled by the state, the Asian Development Bank (ADB) approved the State-Owned Enterprise Governance and Privatization Program (the Program) for $400 million on 4 December ADB also approved two technical assistance (TA) grants the first, for the privatization and restructuring of state-owned enterprises (SOEs), 2 and the second, for the commercialization of public service obligations (PSOs) 3 to help the Ministry of State-Owned Enterprises (MSOE) implement the Program. 2. The Program was aimed at reforming the SOE sector by (i) subjecting SOEs to sound corporate governance practices, (ii) separating SOEs commercial activities from their PSOs to improve resource allocation, (iii) restructuring and privatizing SOEs to increase their profitability and revenue flows to the Government, (iv) establishing fair and transparent labor practices, and (v) strengthening and effectively enforcing procurement guidelines for SOEs The Program comprised policy actions in these five areas supported by the $400 million loan, which was disbursed in three tranches. The first tranche of $150 million was released in December 2001 when the loan took effect and after the 26 conditions for its release were met (see Appendix 1). The second tranche ($150 million) was originally scheduled for disbursement in July 2003, and the third tranche ($100 million) in July 2004; both were released in October 2005, after the Government had substantively complied with the 7 tranche release conditions and 17 monitorable actions for the second tranche and the 7 tranche release conditions and 14 monitorable actions for the third tranche (see Appendix 2 for the tranche release conditions and Appendix 3 for the monitorable actions). The Program met its development objectives. With the help of the improvements it made in corporate governance and operational efficiency, the overall profitability of the SOE sector increased in The SOE reforms under the Program involved transferring ownership and management to the private sector. The Government took a strategic approach to implementing the Program. First, it identified more than 30 enterprises for restructuring and privatization. Second, it gave priority to divesting state shares in high-value enterprises to mobilize revenues that financed part of the fiscal costs associated with the economic restructuring in the post-crisis period. This move in turn facilitated fiscal consolidation and contributed to macroeconomic stability. Third, the Government leveraged the restructuring of state-owned banks and successfully divested shares in several large and medium-sized banks under the Program. 5. SOEs remain significant in the Indonesian economy. At the end of 2007, 139 SOEs (versus 152 at the end of 2005) and 21 enterprises with minority state shareholdings (compared with 17 at the end of 2005) together contributed about 40% to gross domestic product (GDP). This contribution is partly due to the rise in business activity over the last few years in key segments of the economy with SOE concentration, and also to the reclassification of the 1 ADB Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Republic of Indonesia for the State-Owned Enterprise Governance and Privatization Program. Manila. 2 ADB Technical Assistance to the Republic of Indonesia for the Privatization and Restructuring of State-Owned Enterprises. Manila (TA 3714-INO, for $2.6 million, approved on 5 September 2001). 3 ADB Technical Assistance to the Republic of Indonesia for the Commercialization of Public Service Obligations. Manila (TA 3728-INO, for $1 million, approved on 25 September 2001). 4 The Program Framework can be found in Appendix 1.

8 2 national energy company, PT Pertamina, and the national basic food distributor and price control agency, Badan Urusan Logistik (BULOG), as SOEs. Further, the transfer of 13 large SOEs to private sector ownership through the capital markets means that SOEs now make up a sizable portion about 35% of the value of all listed securities of the capital markets. Indonesian equity market capitalization grew from $32.6 billion at the start of the Program to $72.3 billion at the end of 2004, and to $192.3 billion by the end of June II. EVALUATION OF DESIGN AND IMPLEMENTATION A. Relevance of Design and Formulation 6. Indonesia, among the Southeast Asian economies, was hit hardest by the Asian financial crisis. In 1998, GDP contracted by 14% after three decades of high growth. The economy was vulnerable, as the crisis showed, largely because of inherent structural weaknesses in key sectors. In the corporate sector, the complex structures of holding companies that also owned banks encouraged the growth of an opaque web of highly leveraged conglomerates. These conglomerates indulged in lending to related parties, expanded their operations without regard for economic or prudential considerations, exploited depositors of their banks, and dispossessed minority shareholders of their listed subsidiaries. Amid the excessive leveraging, and without adequate prudential regulation and supervision, the fragile domestic banking sector was overexposed. A currency and maturity mismatch on the banks balance sheets heightened the impact of the reckless lending and borrowing. After the currency devaluation, a large segment of the corporate sector mostly enterprises with foreign currency borrowings became insolvent. Corporate losses and debtors unable or unwilling to repay their obligations wiped out the equity of many banks that were overly exposed to the commercial and speculative adventures of their majority owners. Although less leveraged and not so severely affected as private enterprises, SOEs also suffered from growing operational and financial inefficiencies, and many needed restructuring. 7. ADB s support for the Government of Indonesia (the Government) was an integral part of a multidonor rescue package led by the International Monetary Fund to help the country overcome the financial crisis. In 1998, ADB approved the Financial Governance Reforms: Sector Development Program for $1.2 billion. That program was centered on helping restructure the banking sector, strengthening financial governance, and reinforcing the legal and regulatory framework of the financial sector. The intent was to help Indonesia respond to the immediate demands of the crisis, as well as to make the country less vulnerable to adversity. While the failure of the financial sector was the major cause of the economic crisis, the notoriously under-perfoming SOEs were the major obstacle to economic recovery. 8. The Government requested the ADB Policy Consultation Mission in September 1998 to support the MSOE in dealing with the issues facing the SOE sector. In December 1998, ADB approved an advisory TA to address the corporate governance and privatization of SOEs. 5 But the processing of the loan was delayed between August 2000 and September 2001 by problems related to the transfer of MSOE functions to the Ministry of Finance (MOF), political changes stemming from President Wahid s impeachment, and delays in the resolution of issues surrounding the macroeconomic stabilization program and structural reforms. When these 5 ADB Technical Assistance to the Republic of Indonesia for Corporate Governance and Enterprise Restructuring. Manila (TA 3149-INO, for $2.47 million, approved on 29 December 1998).

9 3 issues were resolved after the inauguration of the new government under Megawati Sukarnoputi, and the MSOE was reestablished, a follow-up mission in September 2001 updated the State-Owned Enterprise Governance and Privatization Program in light of the developments and firmed up understandings on the Program. B. Program Outputs 9. Outputs under the Program can be grouped into five broad areas. 1. Sound Corporate Governance 10. To comply with the requirements of the Program, MSOE (i) issued appointment agreements for all newly appointed directors and commissioners; 5 (ii) received statements of corporate intent (SCIs) 6 for 86 SOEs; and (iii) made certain that all 125 SOEs under its jurisdiction at the end of 2005 submitted audited annual financial reports for to shareholders at the annual general meeting, according to the Company Law. MSOE introduced sound corporate governance norms through measures outlined in Appendix 2, particularly to improve transparency in SOEs not listed on the stock exchange. It also required listed SOEs to comply fully with the listing rules of the Jakarta Stock Exchange. 11. The Program introduced substantial improvements in the corporate governance regime for SOEs, after an almost complete absence of rules before A 2004 evaluation 7 of the Indonesian corporate governance framework against international best practice for SOEs developed by the Organisation for Economic Co-operation and Development (OECD) 8 found only minor deviations from the international benchmarks. 12. The SOE Law and associated regulations set out the requirements for SOEs regarding (i) conflicts of interest on the part of directors, commissioners, and other officers; (ii) mandatory internal supervisory units and audit committees; (iii) compulsory audits of financial statements; (iv) adherence to the principles of good corporate governance issued by MSOE; and (v) special circumstances, such as privatization and restructuring. 13. In addition, the Ministerial Decree on Corporate Governance of August 2002, which was adopted by the Program, emphasizes the following principles: (i) Transparency openness in decision making and in the disclosure of material and relevant information about enterprises. 6 Going beyond the financial and corporate information required in the annual report of a listed company, the SCI provides specific and strategic directions to the board of directors. It defines (i) the objectives and scope of SOE activities; (ii) the business and corporate restructuring plan and an assessment of cost and savings; (iii) accounting policies; (iv) performance targets against prescribed objectives; (v) the information requirements of the shareholding ministry; (vi) compliance with environmental legislation to be certified by the accredited agency (e.g., ISO 14000); (vii) the employment status of staff and compliance with labor laws and regulations; (viii) procedures for the acquisition or sale of shares and divestment of subsidiaries; (ix) compensation for SOE activities from the public sector, if any; and (x) procedures for the financial valuation of SOEs. 7 ADB Technical Assistance to the Republic of Indonesia for State-Owned Enterprise Restructuring. Manila (TA 4280-INO, for $600,000, approved on 18 December 2003). 8 The OECD Steering Group on Corporate Governance in June 2002 mandated the Working Group on Privatisation and Corporate Governance of State-Owned Assets to develop a set of nonbinding principles and best practices in the corporate governance of state-owned assets. TA 4280 analyzed the Indonesian SOE framework against these.

10 4 (ii) (iii) (iv) (v) Independence professional management of enterprises without influence from any party contrary to applicable laws and regulations and good corporate principles. Accountability clarity of functions and responsibilities of corporate organs, to allow effective enterprise management. Responsibility management compliance with applicable laws and regulations and adherence to good corporate principles. Fairness equity in upholding the rights of shareholders under agreements and applicable laws and regulations. 14. Within the SOEs the key outcomes were (i) improved corporate governance practices in unlisted SOEs, including qualitative changes in the composition of boards of commissioners and directors; (ii) an appropriate number of independent commissioners appointed in proportion to the number of shares held by noncontrolling shareholders in listed SOEs; (iii) a performance incentive system for SOE managers; 9 (iv) audit committees established in listed SOEs; (v) audit committees, comprising one commissioner and two outside experts, established in 26 unlisted large SOEs; (vi) a corporate secretary appointed in each listed SOE and in those that were to be listed within the next 12 months; and (vii) independently audited annual reports submitted by unlisted SOEs. The implementation of these measures was facilitated by an ADB TA that was approved before the Program Improvements in the corporate governance of SOEs are reflected in their improved financial performance (Appendix 3, Table A.3.1). SOE profits grew almost 2.5 times in to Rp18 trillion ($2.0 billion). Receipts in the form of dividends and corporate income taxes to the Government as a shareholder also grew by more than 140%, to more than $2.6 billion in The financial turnaround is significant, as several SOEs reported losses in from mismanagement and the impact of the Asian financial crisis. 16. The SOE balance sheet strengthened in (Appendix 4, Table A.4.2). Total assets grew by 32%, largely because of higher retained earnings but also because of revaluations, and current assets grew faster than current liabilities. This trend was reflected in a 140% increase in total equity in the selected SOEs, to Rp277 trillion ($30.5 billion). 2. Separation of Commercial Activities from PSOs 17. Traditionally, the Government often used SOEs to provide public goods and services. 11 Frequent political interference in the pricing of such services and inadequate accountability of SOEs resulted in inefficient delivery of goods and services, with profitable business units within the SOEs cross-subsidizing PSO delivery. The Government usually provided no compensation 9 MSOE is now working to improve the incentive system for SOE management and give it a broader base of value-added indicators rather than just profits and the timely submission of reports. 10 ADB Technical Assistance to the Republic of Indonesia for Corporate Governance Reform. Manila (TA 3484-INO, for $300,000, approved on 28 August 2000). 11 PSOs (i) goods and services produced and supplied below cost, (ii) public sector infrastructure projects contracted at prices below cost, (iii) services provided without compensation, and (iv) social services such as education and health for nonemployees are the noncommercial programs and activities of SOEs designed to meet community and social objectives determined by the Government. Their provision is the result of specific government directives to SOEs regarding the conditions (e.g., price) of their supply. PSOs would not be supplied by SOEs, or at least not on the same terms, if they were acting primarily in their own commercial interest. Instances of good corporate citizenship such as sponsorship are not PSOs.

11 5 or made only inadequate subsidy payments to meet the SOEs costs of delivery. Given the adverse impact of such practices on the commercial viability of several SOEs, the Program supported the reform of PSOs in selected enterprises. 18. With support from an ADB TA (footnote 3), MSOE (i) identified PSOs in 15 SOEs, and (ii) quantified the costs and environmental impact of PSOs. It received substantial cooperation in this exercise from the SOEs involved, which are now requesting the commercialization or other alternative treatment of PSOs. The treatment of PSOs will become increasingly important, as it may increase the costs, and complicate the design and the delivery, of the massive infrastructure investments in Indonesia over the next 5 10 years. So far, all efforts of SOEs, with MSOE support, to be paid for the supply of PSOs, have been rejected by MOF for budgetary reasons. MSOE has nonetheless set up a division under a deputy minister to resolve the matter. Its importance is clearly recognized by MSOE. 3. Corporate Restructuring and Privatization 19. MSOE strengthened the legal and regulatory framework for corporate restructuring and privatization reform through the SOE Law of June 2003 and through presidential and ministerial decrees outlining the various privatization procedures. a. Financial Assessment, Restructuring, and Liquidation 20. To prepare for the Program, MSOE assessed the financial and operational viability of 60 SOEs, with ADB TA support (see footnote 4). Then, as a first step toward implementation, MSOE developed policies and procedures for privatization and issued a ministerial decree to guide employee buyouts, strategic sale, free share transfers, initial public offerings, joint ventures, lease of operating assets, concessions, and cash auctions. 21. A condition for the release of the second and third tranches was the comprehensive financial audit of at least 30 SOEs, covering remuneration and all expenses of the members of the board of commissioners and directors, and the submission of the audited accounts. The number of SOEs that complied far exceeded this requirement: 111 submitted audited financial reports for the 2001 audit cycle, 99 for 2002, and 100 for Corporate restructuring, as defined under the Program, involved operational and financial restructuring. Operational restructuring dealt with changes in at least one of the following: management information systems, production and logistics planning, distribution network, marketing strategy, workforce strength and composition, and organizational structure. Financial restructuring involved one or more of the following: sale of subsidiaries or surplus assets, equity injection from third parties, merger or acquisition, debt restructuring, and liquidation. Under the Program and with support from ADB TA (footnote 2), 36 SOEs submitted restructuring plans at their annual shareholders meetings; all were approved. 23. The preparatory actions and the operational and financial assessment of 60 SOEs enabled MSOE to identify 12 SOEs for liquidation and to prepare and initiate a time-bound liquidation plan for 11 of these. Of the 11 SOEs, 4 had been fully liquidated by the end of the 12 SOEs are now required to submit their audited statements to both MSOE and the Ministry of Industry and Trade. The numbers given here include only those SOEs that complied fully with this requirement.

12 6 Program, 1 was at an advanced stage of liquidation, the closure of 5 SOEs had been finalized, and a merger partner had been identified for the remaining SOE. 24. To improve the performance and viability of SOEs, MSOE prepared and adopted corporate restructuring plans for 45 SOEs (36 of these with ADB support; footnote 2). The restructuring program covered these key industry segments: (i) fertilizer (7 SOEs); (ii) plantation (14); (iii) construction (2); (iv) financial institutions (1); (v) airlines (2); (vi) electricity (1); (vii) fisheries (5); (viii) trading (3); and (ix) forestry (6). 25. From a review of annual reports 13 and discussions with MSOE and SOE officials, it is clear that a large number of SOEs have been restructured, both during and after the Program. PPPs are increasingly being used to bring the private sector into SOE restructuring, thereby circumventing parliamentary proceedings. Appendix 4, Table 4.1 shows that several PPPs had already been established in large SOEs 14 before the Program, and even before the Asian crisis struck. Besides the PPPs listed in the table, 15 plantation SOEs have set up more than 50 PPPs since 2002, following on analytical and advisory support under ADB TA for the restructuring of plantations (footnote 6). b. Privatization 26. Recognizing that its various roles as owner, regulator, supervisor, and manager of SOEs have led to serious conflicts of interest, and constraints on potential growth, the Government has made privatization a key strategy to increase economic efficiency, promote growth, and generate revenues for debt repayments and bank recapitalization. The Program acted as a catalyst, leveraging the Government s commitment to achieve reforms in a systematic manner. The Government took a number of strategic steps in with ADB support to prepare for the divestment of its shares in SOEs. It (i) (ii) (iii) (iv) (v) assessed the operational and financial viability of 60 SOEs, finalized and implemented liquidation plans for 12 SOEs, and adopted corporate restructuring plans for 36 SOEs; strengthened the legal and regulatory framework for privatization, first through presidential and ministerial decrees on privatization procedures and then through the Law on State Finances of March 2003 (Law 17/2003), which regulates revenue generation for the state budget, including SOE privatization; passed the Law on SOEs in June 2003 (Law 19/2003) to empower SOE management and to elaborate on the implementation of corporate governance and privatization procedures; formulated privatization options for 42 of the 60 SOEs assessed, prioritized the privatization of 28 SOEs, and submitted a program for parliamentary consideration in early 2003; and sequenced the privatization of larger and strategic SOEs to (a) restructure and privatize commercial banks, and recover the liquidity support given to such institutions during the Asian financial crisis, and (b) meet budgetary needs in and sustain macroeconomic stability. 13 Under TA 4280-INO (see footnote 6). 14 This list is not complete. Among others, it excludes PT Pertamina, which is known to have PPP arrangements.

13 7 27. With regard to the actual divestment of state shares, the Program required MSOE to make satisfactory progress in privatizing at least seven SOEs for the release of the second tranche) and at least eight SOEs for the release of the third tranche. 15 In satisfactory compliance with these conditions, MSOE obtained parliamentary approvals and completed all government actions for the privatization of at least 15 SOEs. Table 4.2 in Appendix 4 gives details on the privatization transactions. 28. The Government has taken a strategic approach and concentrated on privatizing large institutions to provide adequate support for the state budget. This approach has been backed by (i) significant investor interest in financial institutions and other large SOEs whose viability or value was not affected by security concerns stemming from events in , and (ii) continuing momentum for banking sector restructuring and reforms. The sale of shares in Bank Mandiri, Bank Rakyat Indonesia, PT Persuhaan Gas Negara, PT Indosat, PT Telcom, and PT Indocement fall into this category. The Government has also privatized state assets to improve economic efficiency, while mobilizing the required resources to support the budget. The privatization initiatives in the banking sector have increased competition and improved financial services. Table 4.3 in Appendix 4 presents the outcomes of the sale of large and strategically important SOEs during the Program. 16 c. Sale of Government s Minority Shareholdings 29. In addition to the divestment of majority positions, the Program required MSOE to achieve satisfactory progress in selling all state shares in at least 12 companies in which the Government was a minority shareholder. In preparation for the Program, the Government had drafted plans for divesting its minority ownership shares in 20 enterprises. The 2004 privatization program presented to Parliament covered the Government s minority shareholdings in 12 enterprises 5 for the release of the second tranche and 7 for the release of the third. 30. Given the Government s strategic focus on larger SOEs and budgetary needs, lower-value transactions related to the divestment of minority shareholdings and smaller enterprises have not progressed as quickly. Labor sensitivities in some enterprises and uncertainty surrounding elections and the government transition in have complicated privatization in these cases. The Government hadtherefore taken significant steps to fully comply with the conditions of the Program, with the following results: (i) All of the remaining holdings in PT Wisma Nusantara (42.0%) were divested in December 2002, and those in PT Indocement (16.9%) in October (ii) All valuations and assessments needed to facilitate immediate sale upon approval by Parliament have been completed by end (iii) The President of Indonesia approved Government Regulation 33/2005 (PP 33/2005) on SOE privatization procedures, authorizing the Government to divest its shareholdings once approved by Parliament as part of the annual budget deliberations. 15 For the purposes of the Program, satisfactory progress in the privatization of SOEs was defined as (i) the transfer of more than 50% of the voting shares of an SOE to private investors, or (ii) the transfer of up to 50% of the voting shares of an SOE combined with the transfer of a majority of the seats on the boards of commissioners and directors of an SOE to private investors, or (iii) the formulation of an action plan for implementing either of these transfers if adverse economic or other circumstances do not allow the transfer to take place. 16 Since the end of the Program three more SOEs have been partially privatized through initial public offerings: PT Jasa Marga, a toll road operator; PT PGN, the national gas reticulation company; and PT BNI, a bank.

14 8 (iv) Plans for the sale of the Government s remaining minority positions in various banks and other enterprises in which it earlier planned to retain some ownership had been finalized. 31. Among these measures, item (iii) relating to the adoption of Government Regulation 33/2005 by the President marked a significant milestone, breaking the deadlock between Parliament and the executive over procedures for the privatization of SOEs. In particular, the two key relevant laws in this area the Law on State Finances and the Law on SOEs both passed in 2003 within 4 months, were inconsistent with regard to the approval authorities of the two branches of government. The regulation, adopted after consultation with commissions of Parliament, reinforced the authority of Parliament to approve in principle the Government s privatization plan and the annual value of privatization proceeds in the budget, while vesting the executive with adequate authority to decide on the mode as well as the timing of the privatization once the foregoing approvals were obtained. 32. However, the privatization and sale of minority shareholdings was again excluded from the parliamentary debate on the 2006 budget, and therefore had to be deliberated separately. Only in May 2008 did Parliament give the executive a free hand in the sale of minority shareholdings, which can now be processed on the basis of cabinet approval alone. 4. Fair and Transparent Procedures for Managing Labor Redundancy 33. With assistance from an ADB TA (footnote 2), MSOE drew up a labor rationalization policy for (i) severance payments and gratuity based on length of service; (ii) early retirement; (iii) re-employment, training, or retraining of employees, and financing of entrepreneurial initiatives; and (iv) employee rights in assessing claims against pension funds. A monitoring mechanism was also developed to oversee the implementation of the policy by the SOEs and improve it. 34. But by 2003, midway through the implementation period, Parliament had introduced new labor legislation that went far beyond the Program s prescriptions and is now considered by many analysts as a major obstacle to Indonesia s economic growth. According to the OECD, job creation has slowed in recent years, unemployment is high, particularly among youths, and the informal economy is widespread. Important contributory factors are a tightening of employment protection legislation (EPL), especially with the passage of the Manpower Law of 2003, and sharp increases in the real value of the minimum wage. Strict EPL does not provide effective social protection for the needy, because it is not binding in the informal sector. It is also affecting Indonesia s trade competitiveness, because the country has a comparative advantage in labor-intensive manufacturing, whose former dynamism has waned. 5. Strengthened and Effectively Enforced Guidelines for Procurement 35. A condition for the release of the second and third tranches was the submission of independent procurement audit reports by at least 40 SOEs. Twenty SOEs submitted such reports for FY2001 and 20 others submitted reports for FY2002. They were audited by audit companies against (then) current procurement regulations outlined in Presidential Decree 18/2000, which applied to SOEs and all public sector projects (and were consistent with ADB s Procurement Guidelines [2007, as amended from time to time]). The findings were assessed by MSOE, in line with the three monitorable actions under the Program.

15 9 36. Although the independent audits uncovered no corruption, they identified inefficient practices that could provide fertile ground for corrupt activity and the waste of resources. Standard operating procedures for procurement by individual SOEs were also found to deviate from global best practices. MSOE appointed a committee to improve the standard operating procedures for procurement (Decree 80/2003 of 3 November 2003, replacing Decree 18/2000), and consultants to assist in the process. But the procedures drafted by the committee were never issued, apparently because they were incongruent with regulations for the public sector. 6. Summary 37. For compliance with (i) release conditions see Appendix 5, and (ii) monitorable actions see Appendix 6. The basic premise of the Program was that reforms that transferred SOE ownership and management and confined the Government s role to policy making and regulation would release scarce resources for poverty reduction and social programs. In this regard, the Program satisfactorily (i) (ii) (iii) (iv) (v) (vi) (vii) established sound policy, legal, regulatory, and operational frameworks for corporate governance in the SOE sector; increased awareness of international norms and practices in corporate and financial governance; improved the financial performance of the SOE sector in , partly through good governance measures introduced under the Program; promoted transparency and disclosure by stipulating the regular submission of financial, operational, and procurement audits of financial outcomes, board compensation, and compliance with legislation (labor, environmental, and procurement); initiated a robust restructuring program for SOEs (for instance, supporting the liquidation of 8 nonperforming SOEs and the restructuring of 36 others) that the Government could use as a model as it moves forward with SOE management and reforms; catalyzed the gradual divestment of state control in 15 large SOEs, including several important financial institutions, and initiated the privatization of 13 other SOEs as part of the Government s privatization program, thereby contributing significantly toward meeting budgetary needs a crucial factor in Indonesia s macroeconomic recovery; and addressed efficiency issues in the SOE sector by facilitating the divestment of shares held by the Government in sectors like construction, where the state has no sound basis for involvement; 38. The Program has had clear and significant development impact, resulting in better corporate governance and a focused and strategic approach to privatization. There is demonstrable evidence of greater awareness of corporate governance norms in SOEs during the implementation of the Program. The Program has also succeeded in facilitating the privatization of several large SOEs. As reported in Table 3 above, the divestment of the Government s shareholdings in SOEs in the real sector contributed Rp6.7 trillion ($652 million) to the budget during the Program, and the sale of government ownership in the banking sector contributed Rp30.3 trillion ($2.9 billion). 39. With the first phase of divestment of state shares in larger and more strategic SOEs completed, the Government plans to concentrate on improving efficiency in its management of

16 10 SOEs and to continue to transfer assets to the private sector. In particular, it intends to privatize SOEs in infrastructure, natural resources, plantation, and other sectors. The Government is likely to direct its attention to improving macroeconomic growth performance by addressing competitiveness and employment promotion issues. The comprehensive reform agenda that the Program helped formulate should be a good foundation for further reforms in the SOE sector. C. Program Costs and Disbursements 40. The Program was supported by a loan of $400 million from ADB s ordinary capital resources, which was to be released in three tranches. The first tranche ($150 million) was disbursed in December 2001, right after the loan took effect. The second tranche ($150 million) was originally scheduled to be released in July 2003, and the third tranche ($100 million), in July 2004; both were disbursed only in October Despite the Government s active pursuit of the implementation of the Program and its tranche conditions, the complexity of the agenda and the wide-ranging implications across many segments of the economy gave rise to delays in implementation. In particular, the Law on State-Owned Enterprises, introduced after the start of the Program but separately from it, delayed a number of privatizations because of delays in the required parliamentary approval. D. Program Schedule 41. The loan closing date was extended from July 2004 to December 2005 because of parliamentary opposition to privatization. Parliament halted all scheduled privatization in 2002 and asked MSOE to submit a law for SOEs. By the middle of 2002, MSOE and the Cabinet had complied, but then parliamentary committees introduced changes in the law requiring parliamentary approval (after long and extensive deliberations) for every privatization transaction. The parliamentary processing created inconsistencies with the Law on State Finances with respect to the approval authorities of the executive and the legislative. These inconsistencies prolonged deliberations on each privatization transaction, and therefore required an extension of the closing date, but all other areas of the Program were implemented as scheduled. E. Implementation Arrangements 42. MOF, as the Executing Agency, coordinated and monitored the overall implementation of the Program and administered the use of the loan proceeds. MSOE, the Implementing Agency, coordinated with other agencies as required. To monitor progress, the Government created a high-level steering committee with representation from MSOE (chairperson), MOF, the Coordinating Ministry for Economy Affairs, the National Development Planning Agency (Badan Perencanaan Pembangunan Nasional, or BAPPENAS), and the Ministry of Manpower. The committee reviewed SOE restructuring and privatization strategies and endorsed these or recommended changes if required, but the primary authority for approving the strategies remained with MSOE. The steering committee reviewed program implementation every quarter and reported to ADB. It was supported by a corporate governance and privatization working group set up in MSOE to oversee the development and implementation of financial and corporate restructuring, privatization, and corporate governance policy in the targeted SOEs, as well as implementation of the related TA (footnote 2). A separate working group oversaw the implementation of the TA for the commercialization of PSOs (footnote 3). The steering committee was also supported by a consultative working group on labor redundancies.

17 11 F. Conditions and Covenants 43. The policy matrix of the Program covered its three loan tranches and 71 covenants 26 for the first tranche, 24 for the second, and 21 for the third (Appendix 3). All 26 tranche conditions for the first tranche were fully met upon loan effectiveness. The unexpectedly strong involvement of Parliament in the privatization delayed the implementation of some covenants for the release of the second and third tranches; both tranches were deferred and were eventually released together. While loan reviews were conducted regularly, the policy dialogue with senior government officials intensified throughout 2004 and 2005 to gain a better understanding of the delays in privatization. These exchanges led to progress in compliance with outstanding conditions. Privatization eventually proceeded, and the regulations were changed to allow the disposal of minority shareholdings. The Government achieved compliance with all assurances given. These assurances and the status of compliance are summarized in Appendix 8. G. Related Technical Assistance 44. An associated TA (TA 3714-INO in the amount of $2.6 million) was approved to support MSOE in strengthening corporate governance by implementing SCIs and appointment agreements with commissioners and directors. A new performance incentive system for the targeted 30 SOEs was introduced to reward management and staff for improving defined performance indicators. The TA also supported the financial and operational restructuring of at least 10 SOEs, and the privatization of at least five SOEs in line with the privatization options developed under an earlier TA (footnote 4). In addition, TA 3714-INO resulted in restructuring and privatization plans for 30 other SOEs for the next 3 years. Legal advice on privatization transactions and debt restructuring was provided to the Government, which was also assisted in ensuring the fair treatment of redundant employees by using the best international and Indonesian practices and by complying with Presidential Decree 3/1996. The assistance to the Government included the organization and conduct of (i) seminars on SOE reform; (ii) corporate governance workshops for SOE commissioners and directors; (iii) courses in privatization procedures and techniques for MSOE staff; (iv) post-privatization workshops for MSOE staff; and (v) a conference on labor legislation and fair treatment of redundant employees. A TA completion report 17 (TCR) prepared in June 2004 rated this TA a success. 45. Another associated TA (TA 3728-INO in the amount of $1.0 million) was approved to support the identification and measurement of PSOs in SOEs, and the recommendation of more efficient provision mechanisms, including business opportunities in this regard for private sector companies. SOEs were surveyed to identify PSOs, assess their impact on the financial performance of the selected SOEs, and examine whether the accounting systems of SOEs could allocate the general cost components. Alternative ways of separating PSOs from commercially viable activities of SOEs were identified. These included (i) creating separate profit centers, (ii) setting up a subsidiary or an independent company, and (iii) returning the activities to the relevant government department or a provincial authority. Rules and regulations for allowing private companies to supply PSOs were identified, and the financial impact of these 17 ADB Technical Assistance Completion Report for Indonesia for Privatization and Restructuring of State-Owned Enterprises. Manila (TA 3714-INO).

18 12 regulations on the SOEs and their fiscal impact on the budget were estimated for a limited number of SOEs with PSOs. A TCR 18 prepared in June 2004 rated this TA highly successful. H. Consultant Recruitment and Procurement 46. Consultants under both TAs were recruited according to ADB s Guidelines on the Use of Consultants (2007, as amended from time to time) through consulting firms that submitted full technical proposals. No contractors or suppliers were engaged. I. Performance of Consultants, Contractors, and Suppliers 47. The performance of the consultants was evaluated in June 2004 (footnotes 17 and 18). J. Performance of the Borrower and the Executing Agency 48. The Government actively pursued the broad agenda of the Program, which had wide-ranging implications across all segments of the economy and required intensive consultations among stakeholders and the public. The Government advanced a host of new and amended laws and regulations and put in place mechanisms to facilitate their passage and dissemination. After the Program was approved, the Government undertook significant policy measures, including (i) the design and implementation of a corporate governance framework with the associated regulations for SOEs; (ii) the establishment of a directorate general for PSOs and regulations for PSO measurement and treatment in SOE accounts; (iii) the rehabilitation and privatization of SOEs; (iv) fair treatment of SOE employees, active as well as redundant; and (v) ongoing scrutiny of procurement by SOEs. Overall, the performance of the Borrower, the Executing Agency, and the Implementing Agency was satisfactory. K. Performance of the Asian Development Bank 49. The performance of ADB was satisfactory. The original schedule for compliance with the terms of the Program was ambitious, as most of the governance and legislative actions required lengthier consultations than anticipated with stakeholders and with several parliamentary committees, resulting in the delayed release of the second and third tranches. ADB maintained active policy dialogue with the Government on the implementation of the Program throughout its duration and intensified its deliberations with the Government in the area of privatization in 2004 and early In this way ADB elicited renewed assurances from the Government that the momentum of the reforms would be maintained and that the outstanding conditions would be complied with. A mission in July 2008 confirmed the commitment of the Government: reforms in corporate governance, PSOs, and procurement have been sustained, and privatization is regaining momentum. MSOE attributed both developments to ADB s support and the design of the Program. 18 ADB Technical Assistance Completion Report for Indonesia for Commercialization of Public Service Obligations. Manila (TA 3728-INO).

19 13 III. EVALUATION OF PERFORMANCE A. Relevance 50. The Program was highly relevant. The Asian economic crisis hit Indonesia hardest among the Southeast Asian economies. One of the severest consequences of the insolvency of the financial sector was the collapse of public sector finances. The public sector deficit rose rapidly and peaked at 3.5% in 2001, despite the austere fiscal policy prescribed by the International Monetary Fund, which wiped out much of Indonesia s social security network. Public health expenditure for one decreased by 26% in real terms between 1997 and In this dire economic situation, privatization was seen foremost as a means of correcting the fiscal imbalance. In contrast to other countries, which pursued privatization as the centerpiece of SOE reform to strengthen market forces and competition while reducing the state s role to regulation, Indonesia privatized for purely fiscal reasons and enthusiasm for the measure was expected to flag as the fiscal situation improved. The Program therefore took a holistic approach to SOE reform that comprised, besides privatization, corporate governance, fiscal treatment of PSOs, corporate restructuring, social security, and the control of corruption in procurement. This holistic approach ensured the relevance of the Program during implementation and thereafter. B. Effectiveness in Achieving Outcome 51. The Program was effective in achieving its goals. In the area of corporate governance, MSOE (i) negotiated and signed appointment agreements for all newly appointed directors and commissioners, (ii) received SCIs from 37 SOEs in 2002 and from 46 SOEs in 2003, and (iii) achieved the filing of annual reports with the company registrar in the Ministry of Industry and Trade (more than 80% of the SOEs under MSOE s jurisdiction submitted reports for FY2001 and FY2002) and with MSOE (all SOEs submitted reports), in full compliance with the legal requirements. MSOE also implemented a performance incentive system in all profitable SOEs, assessed corporate governance in listed SOEs, and determined the quality and composition of the board of commissioners in about 30 SOEs. All these achievements have been sustained. Public service obligations were identified in 15 SOEs and recommendations developed for their financing and sustained delivery. Ongoing budget constraints, however, held back the MOF from agreeing to an accountable mechanism for financing the PSOs. Under the Program and with support from an ADB TA (footnote 2), 36 SOEs submitted restructuring plans at their annual shareholders meetings, and all of the plans were approved. In satisfactory compliance with the Program s conditions, MSOE obtained parliamentary approvals and completed all government actions for the privatization of at least 15 SOEs. Although privatization lost momentum after the Program, it continued, albeit more slowly. Instead of a labor law, MSOE drafted a labor rationalization policy for (i) severance payments and gratuity based on length of service; (ii) early retirement; (iii) reemployment, training, or retraining of employees and financing of entrepreneurial initiatives; and (iv) employee rights in the assessment of claims against pension funds. A monitoring mechanism was also developed to oversee the implementation of the policy by SOEs and point out needed improvements. But midway through implementation, Parliament passed a restrictive labor law, which went far beyond the Program s recommendations. MSOE conducted procurement audits in 40 SOEs, identified inefficiencies, and required SOEs to improve on their deficiencies.