DOCUMENTS) A Y Letter of Dev. pment Policy. No. S- 108.A /M.EKON/04/2014 Jakarta,April 25, 2014 No. S- 255/MK.08/2014. Dear Mr.

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1 Letter of Dev pment Policy MENTERI KEUANGAN REPUBLIK INDONESIA DOCUMENTS) No. S- 108.A /M.EKON/04/2014 Jakarta,April 25, 2014 No. S- 255/MK.08/2014 Mr. Jim Yong Kim President The World Bank Washington, DC, USA A Y 2014 Dear Mr. Kim, On behalf of the Government of Indonesia, we would like to request World Bank support through the Financial Sector Reform and Modernization Development Policy Loan in the amount of US$ 500 million. This operation aims to promote the development of a stable, efficient and inclusive financial sector and will support the Government in achieving its medium term goal of accelerating economic growth and promoting inclusive development The current Government is now in the last months of its second and final term in office. During this important period, we remain focused on our core reform agenda to maintain macro-financial stability, improve economic growth, generate better employment, and reduce poverty and regional disparities while enhancing governance. The purpose of this Letter of Development Policy is to provide an update on the Government's recent progress towards implementing its reform program and its medium term agenda with regard to strengthening the financial sector. The World Bank's financial support provided through this loan will complement that of the Connectivity DPLs and INSTANSI DPLs, approved in 2013 and build directly in the Financial Sector and Investment Climate Reform and Modernization DPL (FIRM DPL), approved in The loan also builds upon the reforms supported under the Program for Economic Resilience, Investment and Social Assistance (PERISAI) DPL with Deferred Drawdown Option, approved in 2012 and designed to enhance financial crisis preparedness and promote resilience to the potential effects of a financial crisis. The Economic Context In 2013 Indonesia faced a number of external challenges. Capital flows receded on the announcement of the tapering of quantitative easing (QE) by the US Federal Reserve Bank. Gedung Djuanda 1, Lantai 3 Kementerian Keuangan Republik Indonesia

2 From the end of May 2013 to the end of August, the Jakarta Stock Exchange Index fell by almost 25 percent although it has rebounded significantly in the year-to-date. The 5-year Indonesia Rupiah (IDR) bond yield rose by around 300 bps in the same period and has only recovered marginally. The Credit Default Swap rate for Indonesia has increased more sharply than other countries in the region. While the primary trigger was external and related to the potential QE tapering, Indonesia has been more severely affected because of its relatively open capital account and the significant foreign presence in its stock and bond markets. At the same time, the domestic bond market is still very shallow. To cope with the heightened financial market turbulence, the Government has implemented a set of comprehensive measures. On the macroeconomic side, Bank Indonesia has increased its policy rate 175 bps from June to November 2013 and allowed for the rupiah to depreciate, bringing its depreciation over 2013 to 26 percent against the US Dollar. The Government has also issued structural policy measures targeted to reduce the current account deficit, support investment, and ease inflationary pressure from key commodities. To add a buffer to the country's large reserves, the swap line between Bank Indonesia and Bank of Japan worth US$ 12 billion has been extended for another 2 years, and another line worth US$ 10 billion has just been set up with the Bank of Korea. In addition, as mentioned above, in May 2012 the Government established the PERISAI, a US$ 5 billion contingent financing facility with financial support of the World Bank, Asian Development Bank and the Governments of Australia and Japan. Overall therefore, despite financial market headwind and lower commodity prices since 2011, we expect the country's economic growth will remain resilient, as we have strived to put in place a strong macroeconomic foundation. With a diversified economic base and a growing middle class, consumer spending and investments have good medium to long-term prospects. While we expect lower economic growth in 2014, we will continue to adjust our fiscal and monetary policy to the recent changes in the external and domestic environment. As part of its overall economic development agenda, the Government has made a competitive business climate a top priority in recent years. This is clearly stated both in the Government's medium term development plan for (RPJMN ) and the Masterplan for Acceleration and Expansion of Indonesia's Economic Development (MP3EI). The Masterplan outlines an integrated approach that involves the central government, local governments, state owned enterprises, and private sector working together to achieve Indonesia's development goals and propel its citizens. Under the plan, the Government will not only be a regulator, it will also be a facilitator, and catalyst to support this growth. With regard to regulations, the Government aims to amend or remove regulations that inhibit the implementation of investments. As a facilitator and catalyst, the Government will provide incentives, both fiscal and non fiscal. In support of the above, the Indonesia Investment Coordinating Board (BKPM) has been tasked with coordinating effort to facilitate investment, and in October 2013 it announced a comprehensive policy package to improve the ease of doing business. The 17 actions plans include commitments from the related ministries and institutions such as ministry of trade, ministry of law and human right, ministry of manpower and transmigration, the Supreme Court, and the state-owned enterprises (SOEs) responsible for providing telephone, electricity, and

3 drinking water services, as well as the Jakarta local government consist of legal basis, socialization to stakeholder and monitoring of implementation of regulation/legal basis. Implementation of the reforms in the policy package is expected to improve key aspects of the business environment particularly for small and medium-sized enterprises. A joint monitoring team for implementation of regulation/legal basis that includes the Presidential Working Unit for Control and Supervision on Development (UKP4) has been tasked to monitor and support implementation of the reforms. Reinforcing Financial Sector Stability For the past decade, the Indonesian financial sector authorities have focused steadily on improving banking sector regulation and supervision and bolstering the soundness of the financial sector overall through a broad reform program. As part of this reform since 2007, Bank Indonesia has progressively implemented a number of measures to meet the Basel II and Basel III capital adequacy standards. This prudence has bolstered the ability of the Indonesian banks to withstand shocks whilst continuing to finance the economy. This stability has paved the way for sound and steady growth of the banking sector in recent years. The establishment of an integrated financial services authority, the OJK, also represents a major step designed to lay the basis for enhanced financial sector supervision and development in Indonesia. To that end, in January 2013 the OJK assumed responsibility for capital markets and non-bank financial sector regulation and supervision, and in 2014 responsibility for banking sector supervision and regulation. The financial sector authorities have been working since the passage of the OJK Law in October 2011 to prepare for the smooth establishment of the new institution and ensure the maintenance of regulatory capacity during this important transition period. In recent years, Indonesia also has been implementing an ongoing reform effort to enhance financial sector stability through improved crisis prevention, management and resolution. The establishment of the Financial System Stability Coordination Forum (FKSSK) was a key milestone in this endeavor. The FKSSK is responsible for maintaining financial stability, and members of the committee include the Governor of Bank Indonesia, the Minister of Finance, the Chairman of OJK, and the Chairman of the Deposit Insurance Corporation. Since its establishment, FKSSK has conducted a valuable series of crises simulation exercises and led ongoing systemic monitoring work. Broadly, the Indonesia financial sector authorities are strongly committed to continuing these reform efforts. In the coming years, in line with recommendations of the joint IMF-World Bank 2010 FSAP, Indonesia will also seek to continue to upgrade the financial sector legal and regulatory framework to further strengthen the overall bank resolution framework. In addition, as part of Indonesia's commitment to increase adherence to international financial sector standards, we have participated in the Financial Stability Board (FSB) Peer Review of the Indonesia FSAP. The review focused in depth on two topics that are relevant for financial stability and important for Indonesia: the evolving financial sector regulatory structure and crisis management

4 arrangements. The report pointed to good progress in addressing recommendations on the two topics, although the reforms are still ongoing. some of the FSAP Promoting Financial Sector Diversification Financial sector diversification is a central element of Indonesia's financial sector development reform agenda, given that a deeper and more diversified financial sector can play an important role accelerating growth and promoting inclusive development. Indonesia's financial sector has grown rapidly over the last decade. Despite this, however, the level of diversification in the financial sector in Indonesia is still very low, with the banks playing a highly dominant role compared to finance companies, pension funds, mutual funds, insurance companies, etc., which together account for only 20 percent of the financial sector. The challenge going forward is to make it less bank-focused and more diversified to make available a wide range of products and services to meet the finance and investment demands of the economy. Product diversification also plays an important role in reducing vulnerabilities through products like health insurance, catastrophic insurance, etc. Given the challenges above, in 2010 the Ministry of Finance launched its vision for development of the sector with the Indonesia Capital Markets and Non-bank Financial Industry Masterplan The plan was designed to set forth a clear agenda for regulation of the industry regulation as well outline future development initiatives that will assist market players in developing their business plans. Many of the key elements of the plan are being utilized by OJK in its new role as the capital market and NBFI regulator. Notably, last year, Indonesia has also implemented a number of reforms related to the microfinance sector, which is crucial for the development of micro, small and medium sized enterprises. In this area, reforms have focused on progressively strengthening the legal and regulatory framework as well as implementing reform to improve governance and operations. Enhancing this sector is considered important to reaching many households and businesses particularly given Indonesia's geography and number of people living in rural areas. Insurance sector development also remains a priority area of development. As part of this reform, OJK has established a micro-insurance task force mandated to develop a strategy for the sector's development. The task force recently launched a "Grand Design" strategy which encompasses the regulatory framework, and the approaches to support stakeholder capacity building, consumer education (particularly for the poor and vulnerable), and market promotion. Enhancing Financial Inclusion An efficient and inclusive financial system empowers individuals, facilitates the exchange of goods and services, integrates people into the economy and offers protection against economic shocks. Inclusive finance-through access to financial services such as savings, bank accounts, credit, insurance products, payment services and pensions-helps vulnerable, low income groups to increase their incomes, acquire capital, manage risk and work their way out of poverty.

5 In Indonesia only about half of all households have access to formal financial services. This lack of access constrains the ability of many to cope with unexpected expenditures, take advantage of economic and educational opportunities, participate in business, and send and receive remittances. Firms, particularly, small and medium-sized enterprises are also disproportionally excluded from the financial sector. Given this, a key challenge for the economy as a whole is how to substantially increase access to financial services for particularly for the poor an underserved. To this end, in 2012 Indonesia launched its National Financial Inclusion Strategy. NFIS highlights financial inclusion as a national priority, and represents a first step toward improving policy coordination across key institutions. The strategy involves the Vice President's Office (TNP2K), Bank Indonesia, OJK, CMEA, the MOF, Bappenas, among others. Specific efforts since that time have focused on encouraging access and the culture of savings, strengthening existing credit guarantee and community empowerment schemes, improving the financial infrastructure and payment systems, supporting consumer protection initiatives and enhancing financial literacy. A noteworthy example is OJK's National Strategy on Financial Literacy which was launched by the President in November Conclusion Despite the many challenges, the Government of Indonesia has continued to implement measures to ensure that the country sustains its solid economic growth and poverty reduction. We are committed to maintaining macroeconomic stability while enhancing our preparedness for meeting any global economic shocks or potential financial market turbulence. At the same time, we are pushing ahead with our medium- and long-term financial sector reforms to meet our development priorities. The Government values the support provided by the World Bank in helping to address Indonesia's constraints related to its financial sector reforms. In closing, we would like to reiterate the Government's strong ownership of and commitment to the reform program. We look forward to your continued engagement and support for Indonesia's economic development agenda in the coming years. Minister of Finance Republic of Indonesia Coordinating Minister for Economic Affairs Republic of Indonesia M. ha ib Basri M. Hatta Rajasa 4.