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.