Banking developments in 1996 and policy directions for 1997

The following article is an excerpt from a paper presented by Bank Indonesia Governor J. Soedradjad Djiwandono at an annual bankers' meeting on Jan. 9. This is the second of two articles.

JAKARTA: The following are several key issues faced by our economy and banking system this year and the years to come.

First, as the domestic economy become more integrated into the world economy, consequently our economy will become more sensitive to any disruption in the world economy. Any event, either economic or non economic by origin, whether in Indonesia or other countries, will impact the financial sector and hence also economic stability. It is important to bear in mind the increasing risk of contagion effect, namely that one nation's economic disruption, can quickly spread out to other countries even though their economic fundamentals are strong. Indonesia, Thailand, Hong Kong and Malaysia experienced this contagion effect in the wake of the Mexican crisis.

Furthermore, Indonesia's financial markets were also shocked by the issue concerning the President's health in early July 1996 as well as the outbreak of the July 27 riots. We are fortunate that none of these have produced major disturbances in the economy. Our economic fundamentals are definitely strong, but neither can we rule out the possibility of even stronger shocks, and therefore we must remain cautious.

Second, inflation is still running high. Although this year's inflation is well under control, the average inflation rate during this current Repelita VI has reached 8.2 percent, far above the target established at the beginning of the Repelita. We must remind ourselves that the inflation target is 5 percent, this does not imply targeting inflation only within the single- digit range.

Therefore, despite lower inflation over the past two years, more efforts need to be done to bring inflation down to its target. This is especially important given that our inflation rate is relatively high, compared to those of neighboring countries and our major trading partners.

The high inflation is borne disproportionately by fixed income and low income groups in society. In addition, if our future efforts to bring down inflation succeed in reducing expected inflation, there will be greater possibilities towards lower nominal interest rates. In turn, this will relieve the interest burden borne by the business entities while the associated reduction in the interest rate differential will be less attractive to capital inflows and consequently relieve upward pressures on the value of the rupiah. All these will strengthen the competitiveness of our exports on the international market.

Third, non-oil/gas export growth is still weak and on the decline, making its average below the Repelita VI target. Although we know that slower export growth is common feature across Asia, we still have to improve our national competitiveness, which deteriorated during the past year. Surveys by some international agencies downgraded Indonesia's competitiveness, which was previously already at the lower part of the scale, to an even lower rank. The survey findings should alarm us to improve our competitiveness as a nation.

The government and the private sector must therefore reduce or even eliminate high costs economy while also diversifying export commodities. At this point, I should mention that the growing integration of Indonesia's financial sector into international financial markets gives us less flexibilities in using exchange rate policy to promote the competitiveness of non-oil/gas exports.

Fourth, there is an anxiety regarding capital inflows. Given its saving-investment gap and current account deficit as a developing country, Indonesia needs foreign funds. Nevertheless, we also recognize that the more domestic investment financed by foreign sources, the greater the potential risks for the national economy.

These risks become particularly acute when the capital inflows take form of short term and speculative funds. We must therefore endeavor to attract more long term capital inflows, by consistently improving the fundamentals of the economy. We have to ensure that the allocation is used as efficiently as possible for productive activities.

Fifth concerns the readiness of our banking system for the coming era of ASEAN free trade. This era will be marked by faster growth in non-credit banking services, and therefore Indonesian banks need to do their utmost to improve competitive advantage in this area. In this regard, our banks will make substantial improvement in their competitiveness if they are able to overcome non-performing loans and we resolve the problem of troubled banks that still afflicts the banking system. This includes, the efforts to improve in the quality of human resources will also enhance.

Sixth, banks are being encouraged to employ risk management more effectively and efficiently. Through the implementation of self-regulatory banking. Bank Indonesia is assessing various regulations concerning bank appraisal, particularly on managerial aspect with more weight to management quality and performance.

The assessment of bank management encompasses two key areas: general management and risk management. Analysis of general management is aimed at assessing the quality of bank management covering strategy, structures, systems, human resources, leadership, and corporate culture. All of these are essential to bank performance. Analysis of risk management is aimed at finding the extent to which the bank has hedged itself against risk bearing activities. Important aspects in this area include credit risk, liquidity risk, and market risk.

In 1997, the Indonesian economy appears set to perform reasonably well as during the past years. Economic growth is expected to remain above the targeted average for Repelita VI. Although domestic demand is showing signs of abating, it will remain an important element driving economic growth. Investment is expected to be buoyant, particularly when many of last year's investment approvals move forward to implementation. Rising public incomes will lead to higher public consumption.

The improvement in the world economy will also be favorable to the national economy in 1997. Stronger economic performance is expected from Indonesia's major trading partners, particularly Japan and the United States.

The expansion of economic activity in these countries, coupled with increased transparency in international trading regulations, are expected to foster greater volume of world trade and help strengthen prices for both primary commodities and manufactured products. These developments provide Indonesia with opportunities to boost the export. Hence, year 1997 is expected to record a better balance between domestic and foreign demand.

Given the outlook of continued strong domestic demand, we must remain vigilant of upward pressures on prices. For this reason, the government will maintain a prudent fiscal and monetary policy so as to keep domestic demand in check. At the same time, the Government will continue the efforts to eliminate bottlenecks in the supply side by expanding domestic production capacity through productive investment and expediting the production and distribution of goods. These measures are expected to contribute to a lower level of inflation in 1997 than in 1996, bringing it closer to the target for Repelita VI.

The rising current account deficit in recent years demands continued vigilance. The deficit projection for 1997/1998 is US$9.8 billion, equivalent to about 4 percent of the GDP. The main factor responsible for the rising current account deficit includes high non-oil/gas imports growth of 13,5 percent while various internal and external constraints continue to handicap non-oil/gas exports. As I pointed out earlier, non-oil/gas exports are hampered domestically by poor efficiency in production and marketing, while competition in international trade is heightening force. Several countries in Asia, particularly China, India, and Vietnam, now compete closely with Indonesia on the international market. These countries have demonstrated serious, consistent measures to improve their export performance. For these reasons, there is no room for complacency and we must promote non-oil/gas exports with a minimum growth target of 14 percent in 1997/98.

At the same time, strong economic fundamentals and a conducive investment climate have encouraged strong capital inflows, and thus the overall balance may again record a surplus. Therefore, official reserves are expected to reach over US$20 billion, sufficient to finance non-oil/gas imports for about 4.5 months.

In light of this economic forecast and the various issues that I have presented, the monetary authority believes that prudent economic policies in the macro, micro and sectoral level are still necessary to ensure the sustainability of national development. Economic policy formulation will continue to be carefully planned and coordinated, thus ensuring that Indonesia's economic fundamentals remain strong.

In 1997, monetary policy will continue to be focused on the efforts to strengthen both internal and external macro-economic stability. For this purpose, an indicative target of 17 percent has been set for the expansion of claims on business sector during 1997, and this is expected to bring M2 growth down to 18 percent. Monetary policy stance is aimed at maintaining the level of domestic interest rates capable of maintaining internal and external equilibrium.

Real interest rates are expected to ensure that the growth of domestic demand, is consistent with the effort to bring down inflation and the current account deficit. Efforts will also be carried out to reduce the gap between offshore and domestic interest rates to a reasonable level that does not attract large inflows of short term which is speculative in nature.

This will help control the monetary expansion generated by capital inflows, particularly from short term funds attracted mainly by the relatively high differential between domestic and international interest rates. Along with this, the rupiah exchange rate will be maintained at a realistic level without anti-export bias.

The government will continue to strengthen the balance of payments by maintaining sustainable current account deficit, applying prudent debt management and maintaining adequate foreign reserves. Prudent debt management includes the efforts to control private sector borrowings, particularly those incurred by banks and state enterprises, through improved management by the Commercial Offshore Loan Team.

With the ongoing process of globalization of the financial sector, the business community has more opportunity than ever before to benefit from a wide diversity of offshore financing. In this area, the government will continue to place high priority on equity financing and long term foreign loans.

To support the efforts in the monetary sector, the government is also adopting a prudent fiscal policy through a continued stance of balanced, dynamic budget policy. If necessary, the government will not hesitate to apply a fiscal policy that will generate a surplus. At this point, I should emphasize the strong coordination maintained between fiscal and monetary policy has contributed enormously to a more effective monetary control. In light of this achievement, the close cooperation between the monetary and fiscal authorities and other competent agencies will continue to be fostered.

These macro-economic policies represent a minimum or necessary condition for macroeconomic stability that is essential for sustainable development. However, macroeconomic policies alone are not adequate. All of this must also be supported at the micro level. Monetary (macro) policy can only be effective if supported by strong, solid financial and banking industry (micro) and a secure, efficient payments system.

In recent years, I have repeatedly stressed the importance of integration in the implementation of these macro, micro, and sectoral policies. The importance of these macro-micro policies were also emphasized by key speakers at the seminar on "Macroeconomic Issues Facing ASEAN Countries" held jointly by Bank Indonesia and the IMF in early November 1996.

In this regard, banking policies will continue to focus on the development of a sound, competitive banking industry. This is essential because banks assume a special function in the process of creating money supply and maintaining the stability of the national financial system, and therefore play a pivotal role in the implementation of monetary policy. A financial sector with sound, efficient institutions is vital to the implementation of monetary policy and the operation of the national payments system. Both are important elements to support development.

A very recent IMF study found that 130 of the 180 member countries in the IMF have experienced banking problems, with various stage that have adversely impacted the effectiveness of monetary policy. This finding emphasizes the need for a sound and competitive banking industry in the economy. Policy measures adopted in this direction are expected to lead to the creation of a financial system capable of supporting and promoting the activities of the real sector. The creation of such a financial system is crucial to sustainable economic growth.

In this regard, Bank Indonesia will consistently pursue banking policies aimed at creating a sound, secure banking industry that will support effective implementation of monetary policy.

It is within this framework that various measures will be continued with the objective of building a strong, secure, and competitive banking system. These measures include the settlement of problem loans and problem banks, as well as more effective and efficient risk management. Also important are mergers and consolidation carried out as part of the restructuring process to create a stronger banking industry. In the case of rural banks, a review will be conducted on the status and supervision, given that the characteristics of these financial institutions differ from those of commercial banks. Furthermore, the various constraints faced in writing off bad debts sought to be solved. This is important, given that some banks have now accumulated adequate reserves for write-off.

For this purpose, closer coordination is needed with related agencies, and the Draft Government Regulation on Banking Secrecy needs to be completed within the near future. Additionally, the introduction of the government regulation on liquidation is expected to facilitate solutions for problem banks, particularly through consortium rescue packages or through acquisitions by other banks.

In a further move to improve the efficiency and effectiveness of risk management, the program undertaken since 1995 for the application of self-regulatory banking principles will be continued while other improvements will be undertaken in management quality, human resources and technological infrastructure. In another measure aimed at improving risk management, the Criteria of Reprehensible Acts Precluding Persons from Holding Position as Bank Shareholders or Bank Management will be intensified, along with a more intensive implementation of Cease and Desist Orders.

To encourage the development of a banking system that is competitive both internally and externally, the process of restructuring will be carried out further until a more optimum banking structure is achieved in a way that is capable to support overall development. For this purpose, greater incentives will be offered for banks to merge and consolidate.

Concerning the payments system, I would like to mention that Bank Indonesia has prepared a blue print to serve as a reference for the future development of an efficient, secure, and reliable national payments system. Many central banks are now devoting greater attention to the importance of a payments system based on these consideration.

First, the payments system supports the creation of a more efficient financial sector while improving the effectiveness of monetary and banking policies.

Second, the payments system involves a considerable potential risk that may affect overall economic stability. This blue print details various matters related to institutional organization, policies, legal provisions, infrastructure, systems, and procedures, as well as some programs to be developed progressively in the short and long term.

Bank Indonesia will soon introduce an electronic clearing system in Jakarta as part of the short term program for the development of national payments system. A study is also under way for a Retail Payments System to be developed soon. Another development program still under intensive study is related to Electronic Funds Transfer, to serve as part of a High Value Payments Systems.

As we all know, main elements in the operation of a national payments system are banks. Therefore at this opportunity, I would like to urge banks to play more active role in the development of this national payments system. The success of the system will tremendously benefit not only the growth of the national economy, but also the operations of the banking community itself.