Indonesia's history of finance

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...