Despite the recent downturn, Indonesia's medium-term prospects for growth remain strong, the International Monetary Fund says, with economic expansion reaching up to 5 percent this year as long as government policies are consistent with achieving macroeconomic stability and pushing structural reform to attract investment.

In its latest economic review on Indonesia, the Fund commended the government and the central bank for hiking fuel prices and raising interest rates last year to stabilize the rupiah and restore policy credibility in the financial markets.

While the measures had resulted in adverse effects in the near-term, with high inflation and interest rates slowing down last year's economic growth and likely to limit growth in the first half of 2006, medium-term prospects were good.

"The outlook should remain favorable, provided the authorities continue to implement policies consistent with macroeconomic stability and accelerate structural reforms," the IMF said, projecting growth of between 4.5 and 5 percent for 2006. The government's growth target for this year is 6.2 percent.

Indonesia's economy grew by 5.6 percent last year, higher than the 5.05 percent notched up in 2004. The government, however, missed its 6 percent growth target as a result of a slowdown from 6.2 percent in the first quarter to 4.9 percent in the fourth as soaring inflation from a double fuel price hike and increases in Bank Indonesia (BI)'s key rate to 12.75 percent stymied consumer demand and investment.

Looking ahead, the Fund said the priority now for monetary policy was to ensure that inflation was brought down.

The IMF deemed appropriate BI's commitment to maintaining a tight money supply until inflation showed clear signs of abating, and said that BI should be ready to raise rates further if inflation failed to subside.

The Fund noted that "once inflationary pressures subside, interest rates could be reduced."

The IMF sees inflation as possibly easing to 8 percent by year-end, which is in line with the government's budget target. BI is projecting inflation of between 7 and 9 percent.

For the government, the IMF recommended a continued emphasis on limiting the budget deficit, which would help to further reduce the public debt burden.

If the recent economic slowdown continued, however, the government could run a higher budget deficit so as to provide a mild fiscal stimulus.

The government plans to carry over Rp 12.95 trillion in unused funds from last year's budget, which officials said could raise the budget deficit to between 0.9 and 1.1 percent of gross domestic product (GDP) this year, compared to the initial forecast of 0.7 percent. Last year, the deficit came in at 0.5 percent of GDP.

The IMF underscored the importance of structural reform to help boost investor confidence, and welcomed the government's plans to formulate transparent, time-bound schedules for tax and labor market reforms, upgrading the country's woefully deficient infrastructure, and improving legal certainty.

"This will not only provide an important stimulus in the current economic environment but also ensure sustained growth over the medium term," the IMF said.

The IMF also emphasized the need to address vulnerabilities in the banking sector, particularly the recent rise in non-performing loans at state banks. It backed the establishment of an asset management company to restructure the loans, and recommended that the government consider amending the legislative and regulatory provisions that hampered such a development.

Commenting on the IMF review, Coordinating Minister for the Economy Boediono said the government would further intensify policy coordination with BI.

Boediono said he expected that this would result in lower inflation and interest rates, which would enable the economy to kick into gear by the second half of this year. He expressed optimism that the 6.2 percent growth target could be achieved in 2006, while forecasting 6.4 percent growth for 2007.

The economic review, released Wednesday in Washington, is the IMF's fourth semi-annual review as part of its post-program monitoring arrangement with Indonesia following the country's decision to terminate its program with the Fund at the end of 2003.