Indonesia needs a more diversified financial sector

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.