Indonesia's history of finance

By David C. Cole and Betty F. Slade

Following is the last of two articles dealing with Indonesia's success in building a modern financial system. The first appeared yesterday under the heading Indonesia's modern financial system.

CAMBRIDGE, Massachusetts, U.S. (JP): Indonesian experience provides evidence on a number of propositions concerning financial development. Perhaps of greatest significance, this experience demonstrates that it is possible to develop a relatively modern financial system in a large, highly dispersed country that has a per capita income even now of less than US$1,000.

The process of financial development has not been linear or based upon some "grand design." It has instead progressed rapidly in some sectors during some periods and then stagnated or even retrogressed in those or other sectors in other periods.

Banks have been the dominant element of the financial system throughout this developmental process, and the pace of banking growth has dominated that of the whole system. Banking growth in turn has been most rapid when bank deposit and loan interest rates have been positive in real terms, and when restrictions on licensing and branching have been relaxed.

Banking growth was slowed by increased inflation, by imposition of credit ceilings and, in the short run, by tightening prudential regulations that were expected to contribute to healthier growth in the long run.

Attempts to promote new types of financial institutions or instruments prematurely, before the demand for them was sufficient or market conditions appropriate, were generally unsuccessful. This was especially true when government agencies were assigned responsibility for promotion, such as with development banks, the capital market, investment funds, venture capital funds and even insurance companies. On the other hand, when circumstances were more favorable and private financial enterprises were permitted to play a significant role under reasonable prudential regulations, then the new sectors and services expanded rapidly.

Similarly, the provision of financial services to rural areas and small-scale enterprises, when comprised mainly of subsidized credit programs designed and implemented by government institutions, was largely ineffective and wasteful. But when such services were focused on safe savings facilities and flexible credit at interest rates that reflected full operating costs, then both government and private institutions were able to expand their services rapidly and successfully.

The macroeconomic environment in Indonesia has had a strong influence on the pattern and pace of financial development. The balanced fiscal budget (including foreign aid receipts) has provided room for the financial system by not forcing the central bank, commercial banks, other financial institutions and the general public to fund the government's deficit.

This has permitted the financial system to channel its funds predominantly to enterprises, both government and private, that were engaged in directly productive activities. Clearly, not all such funds have been invested wisely, but they have by and large contributed more to economic growth than comparable additions to government expenditure would have.

The open capital account has, over the longer run, probably kept real interest rates in Indonesia somewhat higher than they might have been under capital account restrictions. This may have increased the costs for investors, but probably not by very much. More importantly, it kept open the possibility of saving and borrowing offshore and helped to integrate Indonesian financial markets closely with the international financial centers of Southeast Asia.

In addition, the open capital account compelled the Indonesian government to maintain sensible macroeconomic policies, to take quick corrective action when external changes impinged on the balance of payments, or internal problems threatened to do so.

When combined with the fixed, or crawling peg, exchange rate policy, the open capital account sometimes necessitated very forceful monetary policy actions to reverse undesirable capital movements. These shocks were clearly disruptive for the financial system, but it seems unlikely that these short-run costs exceeded the longer-term benefits of keeping macroeconomic policies in order.

The combination of no fiscal deficits, an open capital account and avoiding excessive inflation has rendered the issue of central bank "independence" largely irrelevant in the Indonesian context. It has been the coalition of the central bank, the Ministries of Finance and of Planning, and the President, which supported macroeconomic stability and pushed for the measures needed to bring it about.

Without those combined forces the central bank would have been isolated, or coopted, and rendered impotent, as it was under the Sukarno government. Recently, the weakening of the coalition has raised concern about the directions of economic policy at both the macro and micro levels.

Powerful political and economic interests have repeatedly sought to gain control of financial institutions or financial resources in Indonesia, as in most other countries. One of the important contributions of the economist technocrats in the Indonesian government, often with support from the international financial institutions, has been their ability to contain these special interests.

They have been particularly skillful over the years in sticking to certain basic principles, such as avoidance of a fiscal deficit and maintenance of the open capital account, and in using them in creative ways to frustrate many of the attempts to circumvent the financial controls and manipulate the financial system.

Indonesia has managed to remove many direct controls over financial institutions and shift them to increasingly market- oriented operations without precipitating financial crises. It has also managed to transform a predominantly government owned and operated financial system into a predominantly private system, not by closing down or selling off government institutions, but by opening up opportunities for entry and expansion of private institutions.

Prudential regulations for private market-oriented financial enterprises and markets, and the capacity to implement them, often lagged behind the opening of new opportunities, but the responsible government agencies have generally been quick to appreciate the deficiency and initiate remedial action.

Opening the door to private initiatives, in Indonesia as in so many developing countries, has meant opening opportunities for ethnic minorities to expand their economic activities, their incomes and their wealth. The continuing tension over whether, and how much, to permit such minorities to employ their often more highly developed commercial and entrepreneurial skills has had an important influence on economic and especially financial policies in Indonesia.

Most new market-opening opportunities in the financial sector have been first initiated without significant biases. Then when the minority groups have proven more skillful at exploiting those opportunities, modifications have been made to the policies to try to limit minority access and provide greater benefits for the pribumi (indigenous) majority.

Such shifts from market orientation to direct interference has generated criticism from some quarters over the inconsistency and lack of clear commitment to market-based systems. On the other hand, they have helped to reduce the nationalist pribumi resistance to the broad trends of financial deregulation.

Special financial programs targeted on helping the pribumi groups such as farmers, small merchants or enterprises through subsidized interest rates and restrictive credit allocation, have generally not been successful. The more generalized financial programs, such as encouraging expansion of the rural banking institutions, removing interest rate and credit controls, as well as the broad social programs for improving education and health, have probably done more to improve the competitive position of the pribumi vis-a-vis the ethnic minorities.

The sequencing of macroeconomic policy reforms in Indonesia was somewhat atypical, starting with fiscal stabilization followed soon by removal of foreign capital controls then, after more than a decade, by removal of credit and interest rate controls, and finally, after a few more years, by reduction of trade controls and distortions.

Foreign borrowing has not only been an important means of avoiding domestic fiscal deficits but also of financial domestic investment undertaken directly by the government, and also by government and private enterprises. Recently, the rise in foreign debt obligations has become more of a concern and has led to imposition of some direct restrictions on foreign capital inflow.

The sequencing of structural changes in the financial system itself was more consistent with conventional wisdom. First the central bank expanded as price stability engendered greater demand for domestic money rather than foreign money or commodities; then the commercial banking institutions were able to grow rapidly by attracting time deposits through payment of positive real interest rates, and by providing new and improved services.

After the removal of credit ceilings and interest rate controls, the interbank and other money markets became increasingly active. Then a shift of policies and promotional efforts precipitated rapid expansion of the equity markets, building on the already existing capabilities of the banking system and money markets. Finally, the enactment of new legislation and regulations opened the way for other types of financial institutions, including the longer-term instruments of insurance, pension funds, investment funds and venture capital funds.

Indonesian financial development has now proceeded, albeit somewhat erratically, over a period of almost three decades. Some attempts to accelerate the process have been ineffective, others costly. Some attempts to coopt institutions or circumvent regulations have resulted in collapse of individual institutions, but so far have not lead to systemic panics or crises.

Increasing politicization of major investment and financial decisions has recently raised the level of risk. Most financial systems do experience crises sooner or later, and Indonesia is not likely to be an exception. If and when such a crisis arises, its handling will provide an important test of how sound a structure has been created.

The writers were long-time consultants to the Indonesian Ministry of Finance from the Harvard Institute for International Development. They are the authors of Building a Modern Financial System, The Indonesian Experience, Melbourne: Cambridge University, 1996.

Window A: The macroeconomic environment in Indonesia has had a strong influence on the patern and pace of financial development.

Window B: Indonesia has managed to remove many direct controls over financial institutions and shift them to increasingly market-oriented operations without...