Indonesia's modern financial system

Indonesia's modern financial system

By David C. Cole and Betty F. Slade

CAMBRIDGE, Massachusetts, U.S. (JP): Building a modern
financial system was not even mentioned in early literature on
the elements critical for achieving economic development.
Although Schumpeter recognized that banks were important sources
of funds for entrepreneurs, he considered the entrepreneurs as
critical, and banking institutions were largely accommodating
suppliers of credit.

Modern economic growth, the concept used by Kuznets to
describe the rapid growth and structural change of relatively
poor countries in the 20th century, so well exemplified by the
recent experience of the countries of East and Southeast Asia,
focused on the physical and human dimensions of growth and
structural change, essentially ignoring the financial aspects.

Gurley and Shaw were the first writers to insist that
"Development involves finance as well as goods", that "the rise
of (financial) intermediaries -- of institutional savers and
investors -- quickens the growth rate of debt relative to the
growth rates of income and wealth".

Recently King and Levine have provided strong support for this
proposition. Using data from 80 countries for the period 1960-
1989, they found that many indicators of the level of financial
development were significantly correlated with (real) growth,
with the rate of physical capital accumulation, and with
improvements in the efficiency of capital allocation.

Shaw and McKinnon suggested that efforts to promote real
growth by making finance supply-leading could lead instead to
excessive credit expansion, inflation and financial repression
rather than genuine financial and general development. To avoid
these consequences they recommended measures to reform, or
liberate, repressed finance so that it could play its appropriate
role in supporting economic development.

Influenced by the Shaw-McKinnon writings, financial reform
became a common theme of policymakers in developed countries and
policy advisors to developing countries in the 1980s. Reform was
defined as a reduction in direct government controls over finance
and a shift to greater reliance on market forces to determine the
prices and flows of financial services.

There was a naive belief that once financial systems were
liberated they would evolve in a healthy and efficient manner to
serve the needs of the developing economy. Early advocates of
financial reform essentially ignored the issues of prudential
regulation of financial institutions and markets. Subsequent
crises and failures of financial institutions in both developed
and developing countries that had recently implemented financial
reforms, have led to much greater emphasis on this aspect in
recent years.

The Indonesian experience with building a modern financial
system is of considerable interest in light of both the problems
encountered in other countries that have attempted such reforms,
and, more importantly, the choices being faced by those countries
that are, or may be, undertaking such reforms now, or in the
future.

The approach applied in Indonesia has gone well beyond
reduction of repression and distortions arising from direct
controls and inflation. It has encompassed a much broader process
of structural change of the financial system, of extending and
improving financial services and institutional capacity, of
strengthening prudential regulation, and of seeking to lessen the
potential risks of crises, instability and institutional failure.

The Indonesian government initiated some financial reform
measures in the late 1960s and early 1970s, well before the
notions had become fashionable, and it has followed a sequence of
reforms that was the reverse of recently prescribed patterns
based on problems experienced by several Latin American
countries.

The reform and modernization process in Indonesia has been
spread over an extended time period. This article traces the
process of financial reform and modernization in Indonesia over
nearly three decades. It identifies the problems that were faced
at different stages of the process, what policies were considered
for addressing those problems, which were adopted, and what were
their consequences.

Three macroeconomic features of Indonesia have had a
significant influence on the development of the financial system.
The first was the open capital account for financial flows out of
Indonesia and for most inflows which was adopted in 1970 and
maintained more or less continually ever since.

Both Indonesians and foreigners have generally been free to
move their funds as desired thus opening up opportunities for
both borrowing and investing abroad. Second, the Indonesian
government did not issue debt instruments to borrow from the
domestic public. Any shortfalls in the budget were met through
concessional loans from bilateral donors and international
institutions and were allocated to developmental expenditures
only.

Third, Indonesian authorities had a strong aversion to
inflation, having suffered the consequences of the severe
hyperinflation of the mid-1960s. There was determination at the
highest political levels to keep inflation under control.

The decade of rapid financial growth and structural change
beginning in 1983 was precipitated by a sharp drop in world
market oil prices and Indonesia's oil revenues in 1982, which
adversely impacted on Indonesia's balance of payments and fiscal
revenues. These external events led to a number of basic policy
actions in 1983 affecting government expenditures and revenues,
exchange rate and trade incentives, as well as the financial
system.

In the financial sphere the policy changes in 1983 consisted
of removal of direct controls over credit ceilings and interest
rates for all banks. These measures were followed by efforts to
encourage the development of new short-term money markets mainly
to support use of indirect instruments of monetary policy.

In late 1987, the first steps toward rejuvenating a moribund
stock market were made. In 1988 further major policy and
regulatory changes reduced barriers to entry and increased
competition in practically all aspects of the financial system.
These measures led to a burst of new activity in the capital
markets and rapid expansion of the banking system.

New regulations covering the operations of securities markets
were enacted in December 1990, followed by new prudential rules
for banks in February 1991. The legal foundations for a modern
financial system were greatly strengthened in 1992 with enactment
of a set of new laws relating to banking, insurance, and
pensions, which clarified the roles of various institutions
within the financial system and provided the guidelines and
authority for strengthening prudential regulation of banks,
insurance companies and pension funds. A new capital markets law
was enacted in 1995.

Since the reforms of 1983, the financial system has expanded
rapidly and became much more diversified and sophisticated. The
number of enterprises engaged primarily in financial business
quadrupled. The ratio of total financial assets to the gross
national product nearly tripled. Interaction with the global
financial system increased, while the degree of dependence on
foreign providers of financial capital remained high. Demands on
other professions, such as accountants, lawyers, appraisers and
actuaries, to meet the needs of the financial system expanded
rapidly.

The share of the government-owned banks in total bank assets
dropped from 80 percent to less than 40 percent in one decade.
This was not due to the sale of any of the state banks, but
simply to different rates of growth of the state and private
banks. The central bank reduced its direct controls over credit
allocation and increased its emphasis on prudential regulation.
Other financial services such as insurance, pensions and capital
markets, which, at the beginning of the decade, were largely
provided by government-owned and subsidized institutions, were,
by the end of the decade, increasingly in the hands of the
private sector, and the new laws called for more effective
governmental supervision of those private institutions.

Fraud and mismanagement led to two major private bank
insolvencies in 1991 and 1992, and political influence
contributed to high levels of non-performing loans in most of the
government-owned banks. None of these developments caused serious
loss of confidence in the financial system, or systemic crisis,
mainly because the owner of the government banks, the Ministry of
Finance, and the regulator, Bank Indonesia, cooperated
effectively to contain the damage and work toward resolution of
the problems.

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