Financial reform: Achievements, problems (3)

Financial reform: Achievements, problems (3)

This is the last of a three-part article in a series 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: The most important banking reform, adopted in
October 1988, reduced the barriers to the entry of new banks, to
the establishment of new bank branches and to the carrying out of
foreign exchange operations by banks. New prudential requirements
for minimum bank capital and lending limits to individual
borrowers or affiliated groups of borrowers, based on the bank's
capital, were also adopted. Applicants wishing to establish new
banks still had to meet both minimum capital and experience
requirements, but the flood of new applicants indicated that
these requirements were too low. They were later raised.

Another regulatory change reduced the legal reserve
requirements from a mixture of rates that averaged about 11
percent, to a uniform rate of 2 percent for all bank liabilities.
A major reason for this large reduction was to reduce the
intermediation costs to bank's to make them more efficient and to
partially offset the effects of the withholding tax on interest
paid on bank deposits that was imposed.

The 1992 banking law also changed the status of the state
banks to that of commercial banks, in the expectation that this
move would force the banks to become more efficient and more
market responsive. Until recently the state banks continued to be
treated as conduits for government programs and other goals, as
is suggested by the recent Bapindo case. Finance Minister Mar'ie
Muhammad, in response to the Bapindo crisis, has stated
emphatically and clearly that state banks must act efficiently
and professionally, analyzing carefully their customers' projects
and ability to repay loans while rejecting loans where repayment
is questionable.

It has been argued that the Indonesian government has been
slow in fostering the development of money markets. In part this
resulted from the conservative approach that was followed in
developing more flexibility in the SBI market and in related
interest rates. This reflected Bank Indonesia's concerns about
control over foreign exchange reserves and the feeling by Bank
Indonesia management that it lacked an effective tool to counter
speculative capital movements. Developments since mid-1993 have
demonstrated that Bank Indonesia can effectively influence
interest rates through its management of indirect money market
instruments, thus effecting foreign capital movements.

Finally, let me mention the remaining direct controls
affecting the assets and liabilities of banks, such as the
requirement on the loan portfolio of domestic banks that 20
percent of loans be allocated to "small business", and the rule
that 50 percent of loans of foreign and joint venture banks be
allocated to foreign exchange generating activities. In January
1990, the long-standing system of liquidity credits, i.e.
subsidized credits from Bank Indonesia to priority sectors, was
severely curtailed. This was a major step towards a market-
oriented system, but it was also a controversial step. It was
judged necessary to be sure that credit would be provided to
small business and the 20 percent rule was the policy adopted.
This requirement was made more flexible in May 1993, and in the
future, if there is adequate evidence that the financial system
is meeting the needs of small businesses fairly and effectively,
it may be possible to eliminate it altogether.

Similarly, the requirement that joint venture banks allocate a
minimum share of their loans to foreign exchange-earning
activities was an effort to ensure that these new largely
foreign-owned banks not just engage in currency speculation, or
lend primarily for import-absorbing projects of investors from
their home countries. Given current concerns about the growth of
non-oil exports, it is unlikely that this rule will be changed
soon, but if exports resume their recent growth rates, then this
rule, too, might be relaxed.

After PAKTO there were predictions of imminent and numerous
bank failures, especially among the many newly licensed banks. In
fact there have been only two notable private bank insolvencies
and these have occurred in old established banks. The first
instance, in August 1990, involved Bank Duta, and was
precipitated by excessive, and unwise, foreign exchange
speculation that violated the net open position rules imposed by
Bank Indonesia in May 1989. The losses incurred were covered by
additional capital contributions at no cost to the depositors or
the central bank. The second instance, which led to the collapse
and liquidation of Bank Summa, resulted from the continued
provision of credit to affiliated companies contrary to the new
PAKTO rules. The liquidation process is still underway and it is
expected that all deposit liabilities will ultimately be honored.

The state banks, which are seen as stolid but safe, continue
to have troubles. Lending by some state banks has in the past
been influenced by outside pressures, which has led to a large
number of problem loans. A joint Ministry of Finance -- Bank
Indonesia committee was established last year to deal with non-
performing loans of the state banks, and this is leading to a
thorough examination of the kinds of steps that need to be taken
to improve the performance of the entire banking system.

An outgrowth of the government's efforts in this area has been
the ongoing Bapindo case, where, as you are undoubtedly aware, it
came to light that the state-owned industrial development bank
Bapindo suffered losses amounting to perhaps US$430 million, an
amount in excess of the bank's total capital base. While I wish
that this problem had never occurred, I believe that the public
airing of the bank's problem has been good for the banking
system. It has put bankers and borrowers on notice that the
government is serious about improving the banking sector.

One continuing criticism of the deregulation process in
general, and the financial sector is no exception, is that the
major beneficiaries have been the so-called "conglomerates". What
impact the deregulation measures have had on the growth of
enterprises by size, let alone on income distribution, is still
uncertain. International studies have consistently shown that
reducing regulations and protective measures is an important
means of improving income distribution. We also know that the
measured Gini-coefficient for Indonesia improved from 0.34 in
1976, to 0.319 in 1990. A recently published study, based however
on data only through 1988, reaches the conclusion that "...
financial ... liberalization has helped to reallocate domestic
credit toward small establishments." Prior to the financial
sector reforms, small-scale establishments were faced with
capital market imperfections in the form of liquidity constraints
or a schedule of rising costs for external funds. Such
constraints, the study concludes, were relaxed after the
financial sectors reforms. However, the authors correctly note
that not all of the changes in profitability of assets,
borrowing, and investment rates that they observe can be
attributed solely to the financial deregulation measures.

Despite concerns about the potential for concentration of
financial activity in the large urban centers, there has been a
major increase in banking services for the rural population.
Although the Unit Desa program carried out by Bank Rakyat
Indonesia was not conceived as a part of the financial sector
reforms, the decision to provide banking services to people
residing in rural areas, to pay positive real interest rates for
rural savings, and to charge loan rates sufficient to cover all
costs and earn a reasonable profit for the bank, were consistent
with the reform agenda. Research suggests that major benefits of
improving the operation of the rural credit system benefited low
income households. The Unit Desa program has a single loan
product, KUPEDES, which carries an effective annual interest
rate, if payments are made on time, of about 32 percent. The
average size of loan made through the Unit Desa is about $750,
with about 70 percent falling below this figure. Most important,
loan performance has been excellent, with losses running a little
over 3 percent, an amount easily covered by the interest spread.

Finally, concerns about general financial instability or even
the capacity to manage monetary policy effectively have been
largely unrealized. There has been no serious instance of capital
flight, despite occasional political disturbances and, at times,
unfavorable economic developments. When stability problems have
arisen, the government has not hesitated to take corrective
action quickly when that seemed required. I would submit that the
overall record of price, and exchange rate stability has been
quite good when compared with other countries.

Window 1: Lending by some state banks has in the past been
influenced by outside pressures, which has led to a large number
of problem loans.

Window 2: Concerns about general financial instability or even the
capacity to manage monetary policy effectively have been largely
unrealized.