Reform of the financial sector<\/p>\n
This is the second of two articles based on a paper presented
\nby Dr. J. Soedradjad Djiwandono, the Governor of Bank of
\nIndonesia in the 29th Asian Development Bank Annual Meeting
\nSeminar on Financial Sector in Transition held on April 29, 1996
\nin Manila.<\/p>\n
MANILA: The entire deregulation or adjustment measures adopted
\nby Indonesia have been very fruitful as shown by many economic
\nindicators. For more than two decades, the Indonesian economy had
\nregistered relatively high growth levels that averaged 6.9
\npercent per annum. The strong economic growth has enabled income
\nto rise considerably and resulted in our being categorized as a
\nlower middle income country. The favorable figures were
\nsubstantiated by other factors.<\/p>\n
Firstly, the increasing importance of the manufacturing sector
\nin supporting economic growth. Secondly, the dominating role of
\nnon-oil\/gas exports in our exports. Its value jumped from 25
\npercent to more than 75 percent of total export earnings over the
\npast decade. Thirdly, within the government budget, the
\nproportion of non-oil revenue surged as compared to total
\ndomestic revenue, namely from less than 30 percent to around 76
\npercent.<\/p>\n
Most of the non-oil government revenue came from taxes,
\nindicating our country's greater financial independence. This
\nalso established the growing prominence of the private sector
\nthat matched the diminishing role of the government.<\/p>\n
In line with the positive results of adjustment measures, the
\noutcomes of the specific financial reformation were impressive.
\nOur banking industry has recorded a dynamic advancement, both in
\nterms of the amount of banks or offices and in terms of
\nmobilization of financial sources.<\/p>\n
As of the end of 1995, we have a total of 240 banks with more
\nthan 6,000 bank offices, compared to 124 banks with about 1,900
\nbanks offices in October 1988. In the same period, funds
\nmobilized by banks reached US$87 billion with total bank loans of
\nUS$97 billion, as compared to US$22 billion and US$25 billion
\nrespectively previously.<\/p>\n
Meanwhile, the capital market has grown rapidly as illustrated
\nby the dramatic increase in the number of companies listed in the
\nJakarta Stock Exchange, from 24 in December 1988 to 236 in
\nSeptember 1995 with the volume of stocks rising from 72 million
\nshares to 45 billion shares and the value of market
\ncapitalization rising from $275 million to $62,5 billion.<\/p>\n
Foreign investors have played a part in the development of the
\ncapital market. All of these developments have linked the
\ndomestic market to the international market.<\/p>\n
More importantly, financial reforms have fostered more
\neffective market mechanism within the banking system, thus enhancing
\nits function as a financial intermediary. Efforts toward
\nderegulating our banking industry, for example, have led to
\nincreased competition among banks, prompting in turn greater
\nefficiency.<\/p>\n
Banks are now more independent in terms of being able to set
\ntheir own business strategies. They have become more market-
\noriented, as reflected in the price banks have established for
\ndeposits and loans as well as in the variety of new financial
\nproducts they have introduced for their consumers.<\/p>\n
Bank financing to the business community, for instance, has
\nnow gone beyond traditional bank loans to other forms of
\nfinancing, such as the introduction of their commercial paper. We
\nbelieve that grater dependence on market forces have allowed, and
\nwill allow, our financial markets to operate more effectively in
\nterms of mobilizing and allocating the nation's financial
\nresources.<\/p>\n
The initial conditions in an economy determine the forms and
\nscope of adjustments policies. Steps that are pursued in one
\ncountry may not necessarily be applicable for other countries,
\nand likewise, the causes and objectives that will be attained
\nfrom adjustment policies.<\/p>\n
Therefore, the terms that are used to exemplify adjustment
\ncopies often vary from one country to another: \"structural
\nadjustments\" in developed countries, \"economic reforms\" in
\npreviously socialist and communist countries, or
\n\"deregulations\/debureacratizations\" in developing countries,
\nincluding Indonesia.<\/p>\n
Even in a country or an economy, the form of adjustment
\npolicies may vary from time to time due to various changes that
\noccur. In Indonesia, for instance, because of the high economic
\ncost due to bureaucracy and relatively widespread government
\nregulations in various sectors of the economy and constituted the
\ninitial conditions, the form of adjustment policies pursued thus
\nfar have been deregulations and debureaucratizations.<\/p>\n
But this does not mean that re-regulations is out of question
\nin the future, considering especially structural changes that may
\noccur with the advancement of the economy and modernization of
\nthe financial sector.<\/p>\n
Regarding the sequencing of adjustment policies, numerous
\narguments have been advanced in literature. The debate is still
\ngoing as to which sector should be liberalized first: real versus
\nmonetary sector, monetary versus fiscal, as well as money market
\nversus capital market in the monetary sector.<\/p>\n
Various models have been advanced in literature: trade
\nliberalization is either preceding, simultaneously adopted with,
\nor following financial reforms. Regarding this, McKinnon argued
\nthat adjustments should not be undertaken simultaneously.
\nCertainly it will depend on the initial conditions. It is
\ndifficult to make generalization since the economic conditions of
\na country differ from those in other countries.<\/p>\n
Theories on sequencing often disregard existing conditions in
\na country and rarely provide sufficient alternatives for policy
\nmakers to decide on the optimal course of adjustment policies.<\/p>\n
One may say that Indonesia's reform was set of responsive
\nactions taken by the authority. This is undeniable. I would also
\nadd, however, that every situation and condition is different so
\nthat particular situation never properly matches a set of
\nnecessary conditions for a particular policy to be taken.<\/p>\n
We may agree that any policy is suitable for a particular
\ncircumstance, but in the real world the circumstances would never
\nbe appropriate for the underlying policies. In fact, given the
\ndynamics of the problem, any authority has to move expeditiously
\nto address the challenges adequately. It is even said that a
\ndifficult situation produced a good policy. When everything is
\nfine and in order, there would be no urgency to consider new
\nmeasures.<\/p>\n
The basic principle in this sequencing approach, therefore, is
\nnot on how to justify the political decision to reform the
\nfinancial sector or the real sector, but on what the underlying
\ncircumstances of the overall economy are. The determination to
\nreform is persisted in order to remedy the economy that was not
\nable to keep up with the eventual domestic as well as
\ninternational progress.<\/p>\n
Another lesson that we have learned from the financial
\nreformation was very significant. The removal of barriers to
\nentry into the banking industry in a very abrupt manner, as
\nstipulated in the 1988 decree, produced quite an astonishing
\nimpact as the banking industry advanced significantly.<\/p>\n
Accordingly, banks were induced to discover new methods to
\nmobilize funds and at the same time to extend new loans
\nintensively which, to a large extent, contributed to the upswing
\nin the economy, leading to the problem of economic overheating.<\/p>\n
On the side of micro management, the growing credit extended
\nby banks partly due to the over supply of funds, produced another
\nsymptom in the years after, that is, the bad debt problem.<\/p>\n
It seems that the reformation was somewhat too fast and too
\nsoon because the tremendous expansion in the banking industry in
\nthe period 1989-1991 was not accompanied by an appropriate level
\nof compliance to prudent banking principles. In dealing with this
\nproblem, correction measures were taken in 1991 to prevent
\nfurther deterioration in the industry.<\/p>\n
This experience suggested that the financial reformation has
\nbeen very instrumental in promoting the banking industry,
\nnonetheless, the timing of implementation proved to be crucial
\nand critical in ensuring the expected outcome. Prudent banking
\nprinciples should be established prior to financial reformation,
\nor at least established in tandem.<\/p>\n
It also meant that prudential aspects of banking operation is
\na necessary condition to cope with increasing competition in the
\nglobalization era. This is partly the reason that since 1991, we
\nhave been doing our best to maintain prudential principles not
\nonly in the banking industry but in economic management as a
\nwhole. There is a saying that it takes two to dance.<\/p>\n
In the case of financial reformation, we may add that it takes
\neverything to achieve success. Prudent macro management would
\nneed concerted efforts in fiscal and monetary policies that are
\ndirectly related to financial reformation. Apart from that,
\nfinancial reformations must also be supported impartially by
\noverall structural adjustments in all the elements of the
\neconomy.<\/p>\n
As we deregulate many facets of the economy, one common
\nphenomenon arose. Before deregulation, the government possessed a
\nset of comprehensive tools and regulations to control economic
\nactivity. Similarly, the monetary authority had a complete set of
\n\"dos and don'ts\" to manage and influence the banking sector and
\nmonetary behavior.<\/p>\n
Since financial adjustment measures were basically designed to
\nderegulate most element of monetary and banking activities, the
\nownership of instruments and regulations by the authority had
\ndiminished. Therefore, the importance of a particular monetary
\ninstrument, namely moral suasion.<\/p>\n
For money management to be successful, we have to go beyond
\nmanaging the growth of reserve money through normal open market
\noperations to include steps to contain the growth of factors
\naffecting the growth of monetary aggregates. Since bank credit
\nexpansion was the main factor that contributed toward the growth
\nof monetary aggregates, we persisted in moral suasion programs to
\ninfluence banks in their lending activities.<\/p>\n
One of the important measures that we have found for moral
\nsuasion is as follows: through regular monthly meetings with the
\nbanking sector, we provided a macro picture of our economy and
\nraised some critical issues that banks should take into
\nconsideration, especially signs of emerging economic overheating.<\/p>\n
Next, we shared with banks selected data showing the currently
\nvulnerable sectors so as to persuade banks to readjust their
\nlending activities to those sectors. We asked banks to submit
\ntheir credit plans and discussed with them the consequences of
\ntheir credit expansion plans and on both macroeconomic stability
\nand their financial condition.<\/p>\n
Through these steps, we tried to achieve better and prudent
\nmacroeconomic management through implementation of prudential
\nprinciples by banks, a program that linked macro and micro
\nmanagement that relied on better coordination between the central
\nbank and the banking community.<\/p>\n
The deregulation measures adopted in Indonesia were aimed at
\nstreamlining regulations. However, it does not necessarily mean
\nthat we are going to set up a free system. In fact at certain
\nstages, if necessary, we may impose new regulations as we have
\ndone so far, for a sound and efficient banking system.<\/p>\n
However, we have also learned that the regulations themselves
\nare not enough to ensure sound bank operations. The effectiveness
\nof regulations depends on the management of banks themselves.
\nRegardless of how well the regulations were designed, a
\nregulation may still contain loopholes that can be exploited to
\nevade compliance.<\/p>\n
Therefore, we require banks to adopt a stricter self-
\nregulation principles by taking into account the risks that may
\narise in the course of business. By applying self-regulatory
\nprinciples, banks would not conduct their operations solely on
\nthe basis of what is allowed in general regulations, but more
\nimportantly, banks would apply internal regulations that specify
\ndetailed application of general regulations.<\/p>\n
Window: Prudent banking principles should be established prior to
\nfinancial reformation, or at least established in tandem.<\/p>",
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