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

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.