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.