Indonesia needs a more diversified financial sector

P.S. Srinivas, Jakarta

Having put the crisis of eight years ago firmly behind it, Indonesia is now looking ahead -- to a more promising economic future for its people. The government is targeting a gross domestic product (GDP) growth rate of 6 percent or more from 2006. The private sector will be the engine of this growth and it needs financing. In addition, infrastructure development, small and medium enterprises (SMEs), and housing have also been identified as key priorities.

The achievement of all these objectives calls for substantial financial resources. Indonesia would clearly do well to mobilize as much of these resources domestically as possible. A strong, vibrant, and diversified financial sector -- that consists not only of banks, but also capital markets and non-bank financial institutions such as pension funds and insurance companies, mutual funds, leasing and factoring companies, and venture capital firms -- can efficiently mobilize and effectively allocate finance.

Banks dominate the Indonesian financial landscape at present holding over eighty percent of financial assets. After the costly crisis, in which over 50 percent of GDP was spent to put the banking sector back in order, the good news is that Indonesia's banking sector is much healthier now. It has been restructured, is now much stronger, with fewer non-performing loans, higher capital-adequacy ratios, and higher profitability.

While some concerns remain, especially on the role of state owned banks, the time is now right to broaden the policy agenda beyond banks. Capital markets and non-bank financial institutions need to be further developed so that the financial sector can play a better role in supporting Indonesia's development.

A dynamic economy needs access to different types of capital. Banks typically provide relatively short term credit to borrowers. This is line with the structure of their liabilities. Nearly all deposits at Indonesian commercial banks are less than one year in maturity.

It is therefore not surprising that the majority of the lending growth in bank is coming from short-term consumer credit and working capital lending. While banks claim to be targeting SMEs for their new lending, SMEs themselves complain of facing credit constraints from banks.

The key point is that, even if attractive investment opportunities were available, banks would not necessarily be a source of long-term capital. Neither would they invest in financing entrepreneurship. While entrepreneurs are what drive SMEs and job creation-- financing them is often too risky for banks. For long-term capital and for equity and risk capital, we need well functioning capital markets, non-bank financial institutions, and institutional investors.

Housing, infrastructure, and government's own financing requirements -- all call for long-term financing. Pension funds, insurance firms, and other institutional investors typically have access to long-term funds that can be used to finance long-term needs. These institutions also provide financial products that can help individuals and institutions better manage risks.

Venture capital funds can finance entrepreneurship at early stages -- when the ventures are risky but financing is critical, so that new and dynamic firms can be established. Capital markets can mobilize debt and equity financing and offer products that offer higher returns than bank deposits.

Indonesia's non-bank financial institutions are small for a country of its size. For example, Indonesia's insurance firms have assets of 5 percent of GDP -- compared to 20 percent of GDP for Malaysia. Pension funds assets in Indonesia are 3 percent of GDP compared to Malaysia's 56 percent. Mutual funds are 5 percent of GDP Indonesia compared to 12 percent in Thailand. Not only that, the investments are also sub-optimal. Pension funds and insurance firms in Indonesia invest nearly 60 percent of their resources in short-term bank deposits -- in essence transforming scarce long-term resources into short-term assets.

But there is significant potential. Pensions and life insurance firms are estimated to have assets of more than Rp 130 trillion (US$13.6 billion) and these are growing. Going forward, given the demographics of Indonesia -- a country with a large and relatively young population -- these assets in these institutions are likely to grow significantly. A small fraction of these -- if invested in sound long-term investments -- could begin to make a difference. Mutual funds have another Rp 100 trillion.

This market needs careful nurturing and sound regulations to ensure that past growth is sustained. Equity markets have been booming and the Jakarta Stock exchange was the fifth best performing market in world (in local currency) last year. However, there are less than 75,000 domestic individual investors in a country of 220 million people and equity raised in 2004 was Rp 7 trillion (less than 3 percent of all private capital formation.

What needs to be done? A concrete first step would be the clear recognition and articulation by the government that the development of the non-bank financial sector is key to Indonesia's future development. Based on this recognition, a vision for the future of this sector can be developed, in consultation with key stakeholders, including industry. Second, there needs to be a focus on assessing and improving the "market infrastructure" that underlies the sound functioning of financial institutions.

Examples include strengthening creditor rights; developing sound credit bureau; enforcing sound accounting and auditing procedures; improving corporate governance; and strengthening regulation and supervision. This is a big agenda, but it can be sequenced and implemented in a phased manner over time. Finally, detailed reform agendas for each segment of institution need to be developed and implemented.

Indonesia's financial sector is at a crossroads. It has been rescued from a debilitating banking crisis at a huge cost to the tax payer. Much of the crisis management work is behind the Government. However, the economy continues to be too dependent on banks and less emphasis has been placed on other financial institutions.

Therefore, the focus of policy now needs to shift to ensuring the development of a diversified financial sector that is able to finance economic growth in future on a sustainable basis. Indonesia needs to develop a well functioning "spare tire" in its financial system -- one that can mobilize and allocate long-term resources, reduce vulnerability, and provide additional products for savings and risk management.

Well developed capital markets and non bank financial institutions are an integral part of the solution to the needs of Indonesia. How best to do this: The upcoming NBFI conference on April 11-12 in Jakarta will try to address the challenge.

The writer is Sector Coordinator, Finance & Private Sector Development, at the World Bank Office in Jakarta. The views expressed here are his own.