Financial reform: Achievements, problems (2)

Financial reform: Achievements, problems (2)

This is the second of a three-part article based on a keynote
address given by presidential advisor Ali Wardhana at the
Indonesia Update 1994 seminar at the Australian National
University in Canberra, on Aug. 19.

CANBERRA: Initially the financial reform measures in Indonesia
were focused on removal of credit and interest rate controls on
the banking system, while developing indirect, market-oriented,
instruments of monetary policy to replace the ineffective credit
ceilings. These first steps resulted in a significant increase in
the deposit mobilization and lending activities, especially of
private banks. Also, Bank Indonesia introduced new money market
instruments, such as SBIs and SBPUs. But Bank Indonesia did not
succeed in developing sufficient depth and breadth in the markets
for these instruments to permit effective open market operations.
When a sudden loss of foreign exchange reserves occurred in 1987,
the government had to resort to directed transfers of state-owned
enterprise deposits from commercial banks to the central bank to
achieve its monetary policy objectives.

Since 1988 there has been a deliberate attempt to stimulate
the development and growth of the various financial sectors in
addition to banking -- what Shaw labeled "financial deepening."
Banking still had priority, simply because it was, by a
significant margin, the largest financial service sector and
because it was dominated by very large, but highly inefficient,
state-owned banks. Far reaching decontrol measures were taken to
increase competition in the banking sector. Moreover, in the
years 1989-1990, the capital market sprang to life. This was
partly the result of special factors -- an active chairman of the
Capital Market Executive Agency, the stimulus of foreign demand
for Indonesian securities, and relatively low interest rates
resulting in low returns on deposits -- but also as a result of a
series of measures that removed many bureaucratic controls over
the fledgling capital market.

During this period there was increasing recognition of the
important role prudential regulations had to play in a market-
oriented system. As a result much time and effort has been spent
on formulating the principles and the drafting of three financial
laws: The Banking Law, the Insurance Law, and the Pension Funds
Law -- finally passed in 1992 -- and the comprehensive Capital
Market Decree of December 1990. As you may be aware, the so-
called "deregulation packages" provided many of the guidelines
for the banking and insurance laws; the capital market decrees
serve the same purpose to a large extent for the drafting of the
capital markets law, which is currently underway. The Pension
Funds Law provided the first set of rules in the important area
since the 1984 Income Tax Law granted tax exemption for pension
fund deposits. Measures addressing licensing of non-deposit
financial institutions such as venture capital, factoring and
leasing were also enacted in 1988.

Looking back from our current vantage point, one can identify
a number of specific components of the financial reform measures
that might well have been done differently. Hindsight is, as we
all know, a powerful analytic tool. But at the time the
Indonesian government implemented the various financial reform
measures, it did not have the benefit of hindsight, or even of
any approximate models or good examples from other, similarly
positioned, countries. In many ways, Indonesia was a pioneer in
implementing financial reforms. Moreover, it has pushed them
further than most other countries in the region, despite the fact
that Indonesia is one of the poor countries in the region.

Before attempting to review some of the main issues raised by
the reforms and discuss whether they were handled in the best
possible manner, let me first raise, and give my answer, to what
I consider to be the basic question: "Is Indonesia better off now
in terms of both economic growth and improvement in the general
welfare of the people than it would have been if the broad set of
financial reforms introduced over roughly the past decade had not
been implemented?" And, perhaps equally important, "does the
existing partially reformed financial system provide a better
foundation for future economic development than would have been
provided by a system still functioning along the general lines
that existed in 1982?"

My answer to both of those questions is an unqualified "Yes".
I believe that the size and diversity of the present financial
system is much greater than it would have been; that the array of
instruments offered is much broader and much better suited to
meet the more varied needs of the economy; that the financial
system meets the needs of the economy more efficiently; that the
system is, and will continue to be, able to meet a much greater
share of the country's demands for financial services than it
would have been without the reforms; and, finally, that the
levels of human skills and knowledge, as well as the intellectual
and organizational infrastructure now found in the financial
sector, are much higher than they might have been.

It is generally agreed that the reform measures have had a
profound impact on the growth and structure of the banking system
as well as on the services provided by the banking sector. The
relaxation of ownership requirements for new banks, combined with
the relatively small capital base required to establish a bank,
led to a dramatic increase in the number of Indonesian banks. The
number of private domestic commercial banks grew from 63 in 1988
to 158 at the end of 1993 and the number of foreign joint venture
banks from eleven in 1988 to 39 at the end of 1993. The total
number of bank offices grew from 9,434 in 1988 to 13,330,
including many new branches of small rural banks, serving people
previously excluded from the financial system. Private bank
growth outpaced that of state banks, with a rapid increase in
domestic private bank market shares.

Following PAKTO, as the measures introduced in October 1988
are commonly called, the Indonesian banking sector also
experienced extraordinary credit and deposit growth. In 1989,
credit to private enterprises and individuals grew by 56 percent,
and in the following year by 58.1 percent. Over the same two year
period, deposits grew 43.4 percent and 47.3 percent. Given the
rapid credit growth, it was not surprising that the economy began
to show signs of imbalance, evidenced by rising inflation and a
surge in imports. Moreover, the aggressive growth that occurred
eventually resulted in declining asset quality and system
uncertainty, forcing Bank Indonesia to take steps to limit credit
growth and enforce stronger prudential standards. These measures,
commonly referred to as the "TMP" or "Tight Money Policy,"
reduced monetary growth and resulted in a rise in interest rates.
As a result of the TMP measures, credit growth slowed and a
measure of macroeconomic stability was regained.

Financial reform should also lead to improvements in the
"cost" and the "allocative efficiencies" of the banking system.
There is evidence that the "cost" efficiency of the banking
system has improved, despite an expansion in the branch network
of private banks and the increase in salaries for banking
professionals. Since the freeing of domestic interest rates in
1983, competition has tended to force down bank margins across
all banks.

Improvements in "allocative efficiency," that is the lending
to projects with high returns, have been slower to materialize.
Although the removal of the interest ceiling gave banks an
opportunity to price and size loans in accordance with perceived
risks, steps which should have improved efficiency, this is
evidence that the loan portfolio quality has deteriorated in some
banks. Non-performing loans constituted nearly 16 percent of all
bank loans in October 1993, up from an estimated six percent
three years earlier. The problem of non-performing loans is
especially serious at the state banks, where some 21 percent of
all loans may be classified as non-performing. Though some of
these problems may be due to the unwillingness, rather than
inability, of the borrowers to repay, the evidence suggests that
a substantial portion of total bank credit has not been used
productively.

To deal with the issue of asset quality deterioration,
stronger prudential guidelines have been implemented. A major
package, announced in February 1991, aimed at improving bank
supervision and at encouraging banks to strengthen their internal
controls. The Bank for International Settlement capital-to-risk-
asset standards were also adopted. To ensure full compliance with
these rules, Bank Indonesia is putting high priority on upgrading
its regulatory capacity. And in order to provide more accurate
statistics, Bank Indonesia, in cooperation with the Indonesian
Accountants Association, has developed new accounting standards
for banks.

We have also seen major strides in the Indonesian capital
markets, despite occasional concerns that progress was too slow.
As a result of the various reform measures, the market has
experienced significant growth with the number of shares traded
rising from 6.9 million shares in all of 1988 to 513 million
shares being traded in only one month in 1993. Between 1988 and
the end of June of this year, the number of listed companies has
risen from 24 to 186 and market capitalization has increased from
Rp 481 billion to Rp 70 trillion.

Moreover, the Jakarta Stock Exchange has been privatized and a
clearing, settlement and depository institution has been set up.
It is working, along with the Surabaya Exchange, to computerize
their activities with compatible systems. Finally, a
comprehensive set of regulations, the Capital Market Decree of
December 1990, has served to improve disclosure, reporting, and
overall transparency of market operations. This decree deals with
the legal issues of: fungibility, immobilization, self-regulatory
bodies, as well as providing more enforcement capacity to
BAPEPAM. An inter-ministerial team has been set up to translate
these and other necessary regulations into law.

Window 1: The reform measures have had a profound impact on the growth
and structure of the banking system.

Window 2: Financial reform should also lead to improvements in the
"cost" and the "allocative efficiency" of the banking system.