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.