Gradual steps to understanding sound corporate governance

By George S. Tahija

The following article is an excerpt from a paper presented at the APEC Symposium in Sydney on Nov. 3, 1998.

SYDNEY: Indonesia is undergoing many changes. Major transitions are taking place in the sociopolitical and industrial structure. To look at corporate governance in perspective, it is necessary to understand the nature and magnitude of these changes.

First, our society is emerging from a period of feudalistic and paternalistic government. We are desperately searching for some form of democratic government that will allow all Indonesians to feel fairly represented. We must also ensure prosperity, and above all, on-going unity of the nation.

Second, as the technological revolution sweeps the world, we are beginning to depart from being a traditional agricultural and industrial society. Indonesia's public and political institutions find themselves becoming vehicles catering to the past. They are unable to cope with present needs and certainly unable to anticipate future demands.

Indonesia's recent troubles reflect the dire consequences of failure to manage the transition. In the short term, political parties and public institutions responsible for governance of finance and banking will be the focus of attention. In the medium term, education, health and the environment must surely become the focus of reform.

Most companies on the Jakarta Stock Exchange are only one step removed from their origins. Most started as family run businesses or government business units where the owners had free reign. These companies are still grappling with the transition, and the majority probably view corporate governance as a hindrance rather than an important support to corporate development.

Managing these changes is a challenge under any circumstances, let alone during this period of unprecedented and severe economic crisis.

Corporate governance is a relatively recent phenomenon in its current form. Until the late 1980s, and subject to the constraints of Company Law and Stock Exchange Listing Procedures, self-regulation of companies was the norm. This self-regulation, in practice, was limited to the presence of a few nonexecutive directors, probably selected by management. Audit committees and remuneration committees were the exception rather than the rule, certainly in countries such as the UK, Australia and Singapore.

In many developed economies, standards of corporate governance were subjected to scrutiny after the financial scandals of the 1980s. The aftermath of these scandals and the resultant financial turmoil changed attitudes toward corporate governance in virtually every developed economy.

Developed economies have the advantage of being able to build corporate governance on a foundation of political stability, a solid body of law and impartial implementation of that law, professional services, including accountants and lawyers, and a sound banking system. There must also be a cadre of people prepared to accept positions as nonexecutive directors who understand their fiduciary duties, and most importantly, have the courage to meet their obligations. Of course, none of this should be static. Regulatory frameworks and institutions, including those in the banking system, must constantly evolve to meet changing needs.

Until the mid 1980s, economic growth was driven by the government and funded mainly by oil and gas exports. When oil and gas revenues declined in the mid 1980s, the government wisely embarked on a liberalization program to diversify its sources of income. It also began to share its role in development with the private sector.

First, in 1986, the government initiated extensive deregulation of trade and business to boost non-oil and gas exports. It encouraged larger and broader participation of both foreign and local capital in industries that were traditionally government owned, such as powers, telecommunications and transportation.

Second, the deregulation of the banking sector in 1988 was initiated to increase the availability of credit to fuel further growth.

These efforts were successful. Non-oil exports grew from 30 percent to 70 percent of total export revenues. In less than eight years, the private sector replaced the government as the main engine of growth and employment. This in itself was a major achievement. Unfortunately, much of this impressive growth by the private sector was supported by equally impressive amounts of debt, which would eventually put the entire country in a vulnerable position.

Strategically, the government had taken the right steps. What remained unaddressed were a weak legal system, a weak audit regime and breaches of the banking regulations on a massive scale. This was a major mistake because it encouraged unsustainable business practices to flourish unabatedly.

It was commonly known that we had a high-cost economy caused by collusion, corruption and favoritism. Political and economic observers had for years warned of the dangers of these practices and urged reform.

Few in the government and private sector paid attention to those warnings while economic growth continued. Frankly, the international investment and financial community continued to provide financing to the private sector in increasingly large amounts. International investment banks competed with each other for advisory and lead underwriting roles to the very cronies they are now complaining about. The World Bank and the IMF, until 1996, gave rave reviews on Indonesia's economic achievements and portrayed us as a model developing country.

So it is not surprising that there was little, if any, incentive for reform. Greed, arrogance and complacency on all sides (from within and without) overruled ethics and good judgment.

Globalization and liberalization were the trigger rather than the cause of Indonesia's financial collapse. Internal weakness and irresponsible capitalism were the root cause.

What can we do to achieve better corporate governance?

The stage needs to be set before corporate governance can happen. Above all else, we must have a political system with transparent checks and balances. Until there is a more democratic political system, concentrations of power and influence will occur in society. This concentration of influence will inevitably encourage collusion and corruption. Regulation and enforcement cannot function equitably in this environment. In the past, this has led to directed lending to preferred parties, rigged stock markets, politically favored companies and many regulatory "exceptions".

In Indonesia, the salary of civil servants must be increased for two reasons. First, it is unfair and unrealistic to expect regulators and enforcers to act impartially when their salaries don't even cover basic needs. Second, we must improve salaries in order to attract capable young people into government service.

Business leaders must set the example for responsible capitalism. We are part of a much larger society, without which we will not survive. When the interests of a few outweigh the interest of many, sustainable development becomes impossible. Every one looses. This has become painfully apparent in Indonesia. Business leaders need to focus on:

* improving productivity and quality of assets rather than just going for asset growth

* building competitive businesses rather than just trading assets

* viewing good corporate governance as a competitive advantage rather than a regulatory burden

* rethinking the viability of the so-called diversified conglomerate.

Until the financial crisis began last year, international financial institutions such as banks, securities companies and fund managers were actively raising money for Asian corporates that were clearly engaged in less than transparent practices. In pursuit of fee income, financial institutions have basically been rewarding the very type of behavior that erodes the fabric of society and the foundation on which good corporate governance is built. I believe these financial institutions have behaved irresponsibly, and in so doing have contributed to the crisis. They need to take a good hard look at the kind of people they were supporting and why they were supporting them.

The task ahead is a difficult one but certainly not insurmountable. This is not a time for gimmicks or short-term solutions. We must put the long-term economic development of the country ahead of short-term political interest. Progress toward better governance is actually being made, particularly in the financial sector. We must remember that it is a process rather than an event and it will take time to get there but I am confident that we will.

Indonesia is still a country with an abundance of natural and human resources and a huge potential market. If we do the right things, local and foreign investment will return to Indonesia and develop these resources.