Banking expected to improve, but slowly

Fauzi Ichsan

International investors and donors like to point out that although Indonesia's economic growth is rising, investment in the real sector of the economy, and therefore economic growth, are a lot lower than their full potential. There are two reasons why real investment is so low. First is legal uncertainty, which hampers long-term investment like infrastructure and mining.

Second is a "malfunctioning" banking sector. Still traumatized by corporate debt defaults in 1998/99, the banking sector prefers to keep its assets in the form of government bonds, central bank discount bills (SBI) and consumer loans to individuals, who are better at repaying debt than corporations. But real sector investment, the kind that accelerates economic growth and creates employment by the millions, is driven by corporations, not individuals.

The role of the banking sector remains smaller than before the financial crisis. Bank lending now generates less than 25% of the economy, compared to 60 percent in 1997. Bank loans now cover only 38% of the total banking sector assets, compared to 71 percent in 1997. Banks' reluctance to lend to the real sector is ironic since they have too much cash. In a recent parliamentary hearing, Bank Indonesia (BI) Governor Burhanudin Abdullah even said, "Indonesia is still in an economic crisis", as "excess banking liquidity" has reached Rp 180 trillion - Rp 190 trillion or around 10 percent of the economy. The banks spend around 85 percent of this excess liquidity to buy SBI notes and place the rest in the overnight BI facility, which is annually costing the central bank about Rp 14 trillion to 16 trillion in interest expense and eating up its capital. Overall, the banking sector is still dependent on the government, as almost 40 percent of their interest income comes from government bonds and SBI. Given a weak legal system, banks remain reluctant to lend to the real sector, particularly the corporate sector. In addition to its "generic problems", the banking sector has also been affected by "high- profile" fraud cases at state-owned Bank Negara Indonesia (BNI) and Bank Rakyat Indonesia (BRI). Given all these problems, it is not surprising that bank lending for corporate investment remains low.

Looking over the medium term, however, the banking sector is now healthier than during the peak of the crisis. Between 1998 and 2003, non-performing loans (NPL) as a percentage of total bank loans have sharply declined from 49 percent to about 7 percent. Over the same period, banks' net interest income has increased from minus Rp 61.2 trillion to around Rp 27.8 trillion and banks' capital adequacy ratio (CAR) has improved from minus 15.7 percent to around 23 percent. The Indonesian Bank Restructuring Agency (IBRA) has sold most of the troubled banks that it took over during the crisis, Including BCA, Danamon, Niaga and BII, to strategic investors. The government has also partially sold its non-IBRA banks, including Bank Mandiri, Indonesia's largest, and BRI, a solid rural credit bank, through successful initial public offerings (IPO). Meanwhile, the international rating agencies, like Standard and Poor's and Moody's, have been upgrading the risk rating of several banks. So, there are good stories to tell about the banking sector and further progress is expected, slowly but surely because of the inherent problems the sector is facing.

Banking sector in 2003

In 2003 the banking sector experienced three major developments. The first of these has been a continually falling interest rate. BI has been willing to reduce SBI rates (the benchmark for banking rates) because of falling inflation and because of excess liquidity in the banking sector. The immediate effect of falling interest rates is falling profitability, given banks' dependence on government re-capitalization bonds and SBI. Many banks hence try to protect their profits by maintaining high interest rates on loans, inviting criticism from BI and the business community. But the positive effect of a falling interest rate is that banks are increasingly forced to look for alternative sources of income, either through increased lending or service fees, to reduce their dependence on the government and BI debts.

The second development is domestic consumption growth. A falling interest rate, stronger rupiah exchange rate and falling inflation have all supported domestic consumption, which generates 80 percent of the economy. If banks are reluctant to lend to corporations, they are more than happy to lend to retail consumers to buy cars, motorcycles and residential houses. While this may not be a healthy strategy in the long run, the banks at least are lending to the real sector of the economy.

And the third development is the emergence of the mutual fund industry. The tax-free mutual fund industry has grown rapidly from Rp 46.6 trillion at the end of 2002 to Rp 85.8 trillion by September 2003. The growth of the industry has simply exceeded the growth of the bank deposit market. Many banks used the opportunity to rapidly sell their re-capitalization bonds to mutual funds, both to book trading profits (because of rising bond prices due to falling interest rates) and to reduce their debts by persuading bank depositors to move their money from deposits to mutual funds. The emergence of the mutual fund industry allows the banking sector to slowly reduce its dependence on government bonds.

All in all, in spite of the highly publicized bank fraud cases, the banking sector in 2003 has become healthier, judged on basic banking indicators, such as NPLs, CAR and loan-to-deposit ratio (LDR). Falling interest rates are squeezing profits but that has also reduces the government's interest expense (and taxpayers' burden) on re-capitalization bonds while slowly forcing banks to resume their capital intermediary role in the economy.

Banking sector in 2004

In 2004, the banking sector can also expect three developments. The first of these is the general election. The elections will mean two things. First, that real investment is likely to remain flat. And second, that political parties will be spending money on their campaigns at the grass-roots level, which will help consumer spending. This will support the bank consumer lending business, as households will have more cash to repay their loans and credit cards. Businesses, which "profit" from the "spillover" of money politics, will also need working capital financing from banks. All in all, unless it descends into a political disaster, which is unlikely, the general election is likely to be positive for the economy, including the banking sector.

The second likely development is higher interest rates. Interest rates are expected to rise, albeit slightly, because of the general election, due to likely rupiah volatility during the election and possible U.S. interest rate hikes. This would prevent banks' interest income from falling further. Because banks' are unlikely to raise their deposit rates (unless interest rate goes up sharply - which is unlikely), the "spread" between SBI rates and deposit rates could widen, improving banks' profitability.

And the third likely major development is further bank privatization and consolidation. The government is already planning to sell Bank Permata and Bank Lippo to strategic investors in 2004. The fraud cases at Bank BNI and BRI, as well as the likelihood of higher non-performing loans at Bank Mandiri, could increase public pressure on the government to divest state- owned banks. This could both insulate the government from future financial liabilities while improving the management and capital base of the banks. On the regulatory side, further progress is expected but mainly after the election. This would include the removal of the blanket deposit guarantee scheme and the gradual introduction of the financial services authority (FSA) that could take over supervision and regulatory powers from BI.

All in all, 2004 is likely to be a year of further privatization and consolidation for the banking sector. In spite of all the structural problems it faces, the banking sector is likely to continue to progress, surely albeit slowly. In the long run, progress in the banking sector could only be accelerated by a combination of factors. First, continual political stability. Second, a better investment climate for investors. Third, a stronger legal system, particularly in the bankruptcy court and its legal enforcement. Fourth, improved bank internal risk management, particularly on credit risks. And fifth, prudent supervision by the government, particularly strong coordination between the Ministry of Finance, Bank Indonesia and the Capital Markets Supervisory Board - BAPEPAM.