Indonesia's economic malaise: Fix the banks, quick!

Christopher Lingle, Global Strategist, eConoLytics.com

Indonesia's economy remains plagued by structural inefficiencies and the banking system is near collapse. A first step toward escaping from these economic doldrums is for the government to change policies that inhibit long-term investment.

That requires fixing the financial system whereby ailing banks are recapitalized so they can increase the supply of credit. Only when there is sustainable growth on the back of long-term investments can durable employment opportunities be provided.

According to Standard & Poor's, when measured on a fiscal cost-to-gross-GDP basis Indonesia is in the grips of the worst banking crisis of any country in the world since the 1970s. Estimates put the funds provided by the government to initially recapitalize or pay out creditors of distressed banks to be about $87 billion or 82 percent of gross domestic product.

This figure is 24 percent higher than the Indonesian government's own estimate. With the proportion of non-performing loans to outstanding debt as high as 75 percent, economic problems cannot be resolved without serious attempts at bank reform.

It is not that nothing has been done to sort out the banks. It is just too little has been done right and more progress must be made before it is too late. Steps taken after 1988 included making public funds available to the largest surviving banks to replenish their capital-adequacy ratios. At the same time, Jakarta topped up the deposit insurance fund and forced smaller lenders to shut down or merge.

What can be shown for the Rp 600 trillion (US$65 billion) of public funds used for restructuring the banks? According to official sources, the average nonperforming loans (NPLs) rate of recapitalized banks has improved to 15 percent from more than 20 percent last year. While this is an improvement, it is a wide miss of Bank Indonesia's target of 5 percent by the end of the year.

So it seems that much of what has been spent has gone astray. According to the Finance Ministry, there is evidence of malfeasance by the Bank Indonesia concerning disbursement of almost Rp 145 trillion ($14 billion) earmarked for use as emergency funds to restore liquidity to distressed banks.

And the Supreme Audit Agency has discredited the central bank's financial reports. An investigative audit revealed that nearly Rp 138 trillion of total loans were extended in violation of prudential rules relating to BI's role as lender of last resort.

The rule was violated in that some insolvent banks received liquidity support when such funds were only to be given to illiquid banks, and these loans were not always adequately collateralized. Many of the recipient banks used the funds for currency speculation and to finance affiliated businesses. And some banks received credits that exceeded their total assets.

The burden of nonperforming loans hangs like an albatross around the neck of the economy. Bad debt and real estate held as collateral must be removed from the banks to be resolved outside the system. For example, debt-equity swaps can be used to convert nonperforming loans into shares of stock from the debtor. Since borrowers no longer have to pay interest, they have a more manageable financial burden.

However, disposal of bad debts can cut sharply into the capital base of the banks. Unless insolvent institutions are recapitalized with sufficient real capital, the stock of bad loans will continue to rise. If the key to economic recovery is effective bank reform, then it all hinges upon recapitalization.

These amounts would consume most the current capital of the banking system and would surely exceed the proportion of GDP that was required to clean up the U.S. savings and loan problems of the 1980s. At that time, the Resolution Trust Corporation (RTC) took over massive amounts of bad loans in the U.S. financial sector from failing financial institutions using Treasury funds of about $60 billion. Bad loans and real estate holdings were disposed of quickly by turning them into securities and then sold on the open market.

If the government commits more public funds, it would lead to an insupportable increase in public-sector debt. Expenses for banking recapitalization are a large item contributing to the current budget deficit and account for around 24 percent of routine expenses and about 18 percent of total expenses. In the coming fiscal year, about $4.5 billion are allocated to repay principal on foreign debt while interest payments on domestic and foreign debt account for 26 percent of total expenditure, an amount equal to over 5 percent of GDP.

It appears that the best solution is to encourage greater involvement of foreign financial institutions. A first step would be to dispose of BCA as quickly as possible to the highest bidder. This would make fresh capital available to the economy and would allow in new lending and risk-management practices. They would also transfer new technology and introduce best corporate governance practices.

As long as the bad investments remain on the books, they will continue crowding out potentially good investments that could create more jobs and wealth. Policymakers in Jakarta need to focus their minds on what must and can be done, and do it quickly while being sure it is done correctly.