Fuel, utility price hikes keep banks `risk averse'

Fajar Hidayat, Financial Market Analyst, Jakarta, fajarhidayat@lycos.co.uk

The banking sector is a major player in the Indonesian financial market worth Rp 1.145 trillion with 91.6 percent of all shares. This means that financing for the real sector to boost economic growth is heavily dependent on the ability of banks to act properly and optimally as financial intermediaries, simply in terms of moving funds from surplus fund units (lenders) to shortage fund units (borrowers) in the nature of loans.

Unfortunately, most Indonesian banks presently are "risk averse", avoiding lending to the real sector and hence unable to perform optimally as financial intermediaries. In October 2002, total bank loans outstanding to the real sector (investment and working capital loans) accounted for Rp 279.4 trillion, or only 34 percent of banks' total liquidity of Rp 821.5 trillion.

Bank Indonesia (BI), as the monetary authority, has made some effort to improve the banks' performance as financial intermediaries, such as gradually reducing interest rates. During 2002, the benchmark interest rate (BI promissory note) fell significantly from 17.62 percent to 12.93 percent.

However, according to BI governor Sjahril Sabirin, the benchmark rate cut was not followed by a comparable reduction in bank lending rates. He said that the intermediary role of the banking industry was not being performed as expected because banks continued to face internal problems, and because lending to the real sector was still considered too risky (The Jakarta Post, Jan. 11)

In 2003 it can be expected that banks will stay risk averse. The fuel and utility (electricity and telephone) price hike announced on Jan. 2 is an additional factor heightening the risk of lending to the real sector.

The fuel and utility price hike will increase production costs in the real sector, forcing producers to raise the prices of their products. The hike will also cut domestic consumers' purchasing power, leaving them unable to absorb domestic products. Increases in the price of products also will reduce the competitiveness on the global market of export-oriented businesses. Inevitably, many producers might face income reductions or even suffer losses.

Many industrial sectors will feel the negative effect of the fuel and utility price hike. For example, in the textile and garment industry, the hike is predicted to affect 18 percent of the total production costs. Sales in the domestic market might decrease by 20 percent due to the diminishing purchasing power of consumers. Exports could also plunge, as it will be impossible for products to maintain their price competitiveness.

This condition will lead banks to perceive that the real sector is not eligible to receive loans. The banks will worry that borrowers from the real sector would face difficulties paying the loan interest and the principal, due to the possibility of significant income reductions. The banks would judge that the lending risk to the real sector is heightened because the borrowers' cash flow, i.e. cash inflow (sources) weighed against cash outflow (uses), has become more volatile.

If credit is, as the English philosopher John Locke (1773) defined, "nothing but the expectation of a sum of money within some limited time", then a bank's credit decision is a process that places cash flow analysis as a crucial step. The purpose of cash flow analysis is to examine the actual and predicted movements of cash in terms of its sources and uses.

Once past sources and uses have been examined, a reasonable estimate can be made as to future sources and uses. Based on cash flow analysis, combined with a bank's deep understanding of a borrower's business quality, an authorized judgment can be made to decide the borrower's credit worthiness.

Consequently, if a rise in production costs due to the fuel and utility price hike leaves the predicted cash inflow of borrowers unable to bear the increasing cash outflow, banks would certainly reject credit proposals.

Banks also are becoming more anxious about the quality of their existing loan portfolios because of the rise of production costs in the real sector. A deterioration in the business performance of borrowers because of rising cash outflow that might not be covered by cash inflow could decrease the ability of existing debtors to pay loan obligations. This would possibly increase non-performing loans (NPL). Meanwhile, BI, as the banking supervisor, insists on imposing NPL regulations requiring banks to reduce their NPL ratio to a maximum of 5 percent by June 2003.

For that reason, it is understandable that many banks would stay risk averse by avoiding lending to the real sector. Instead, some of them prefer to play it safe by investing their liquidity in safer financial instruments such as mutual funds and T-bonds.

On the other side, it is also understandable why businesspeople in the real sector reacted negatively and criticized the government decision to increase fuel and utility prices.

This reaction reflects their struggle to survive in the country's unsound business and investment climate. Even before the fuel and utility price hike, they were tired of dealing with the high-cost economy, such as the extensive tax policy, long process of tax restitution, mushrooming illegal levies, rampant corruption by the bureaucracy, legal uncertainty, etc. The government treats the real sector as a cash cow through its extensive taxes, but acts slowly to resolve the other sources of the high-cost economy.

The implication is, in order to encourage banks to act optimally as financial intermediaries to boost economic growth, the government must take care of the real sector. If the policy of increasing fuel and utility prices is unavoidable, the government must provide some stimulus to the real sector as compensation for the unfavorable effects of the policy.

The first fiscal stimulus package, worth Rp 6 trillion and issued on Jan. 9, is an appropriate policy to help the real sector cope with the effects of the fuel and utility price hike. Subsequently, the government must work very hard to resolve the other sources of the high-cost economy by taking comprehensive action as soon as possible.

Once the effects of the fuel and utility price hike are minimized and the high-cost economy eliminated, the real sector will reach recover and be ready to run on the fast track. If a real sector recovery can be supported by a stable monetary situation and proper banking regulations, there would no longer be a reason for banks to stay risk averse.