Reform of the financial sector

This is the second of two articles based on a paper presented by Dr. J. Soedradjad Djiwandono, the Governor of Bank of Indonesia in the 29th Asian Development Bank Annual Meeting Seminar on Financial Sector in Transition held on April 29, 1996 in Manila.

MANILA: The entire deregulation or adjustment measures adopted by Indonesia have been very fruitful as shown by many economic indicators. For more than two decades, the Indonesian economy had registered relatively high growth levels that averaged 6.9 percent per annum. The strong economic growth has enabled income to rise considerably and resulted in our being categorized as a lower middle income country. The favorable figures were substantiated by other factors.

Firstly, the increasing importance of the manufacturing sector in supporting economic growth. Secondly, the dominating role of non-oil/gas exports in our exports. Its value jumped from 25 percent to more than 75 percent of total export earnings over the past decade. Thirdly, within the government budget, the proportion of non-oil revenue surged as compared to total domestic revenue, namely from less than 30 percent to around 76 percent.

Most of the non-oil government revenue came from taxes, indicating our country's greater financial independence. This also established the growing prominence of the private sector that matched the diminishing role of the government.

In line with the positive results of adjustment measures, the outcomes of the specific financial reformation were impressive. Our banking industry has recorded a dynamic advancement, both in terms of the amount of banks or offices and in terms of mobilization of financial sources.

As of the end of 1995, we have a total of 240 banks with more than 6,000 bank offices, compared to 124 banks with about 1,900 banks offices in October 1988. In the same period, funds mobilized by banks reached US$87 billion with total bank loans of US$97 billion, as compared to US$22 billion and US$25 billion respectively previously.

Meanwhile, the capital market has grown rapidly as illustrated by the dramatic increase in the number of companies listed in the Jakarta Stock Exchange, from 24 in December 1988 to 236 in September 1995 with the volume of stocks rising from 72 million shares to 45 billion shares and the value of market capitalization rising from $275 million to $62,5 billion.

Foreign investors have played a part in the development of the capital market. All of these developments have linked the domestic market to the international market.

More importantly, financial reforms have fostered more effective market mechanism within the banking system, thus enhancing its function as a financial intermediary. Efforts toward deregulating our banking industry, for example, have led to increased competition among banks, prompting in turn greater efficiency.

Banks are now more independent in terms of being able to set their own business strategies. They have become more market- oriented, as reflected in the price banks have established for deposits and loans as well as in the variety of new financial products they have introduced for their consumers.

Bank financing to the business community, for instance, has now gone beyond traditional bank loans to other forms of financing, such as the introduction of their commercial paper. We believe that grater dependence on market forces have allowed, and will allow, our financial markets to operate more effectively in terms of mobilizing and allocating the nation's financial resources.

The initial conditions in an economy determine the forms and scope of adjustments policies. Steps that are pursued in one country may not necessarily be applicable for other countries, and likewise, the causes and objectives that will be attained from adjustment policies.

Therefore, the terms that are used to exemplify adjustment copies often vary from one country to another: "structural adjustments" in developed countries, "economic reforms" in previously socialist and communist countries, or "deregulations/debureacratizations" in developing countries, including Indonesia.

Even in a country or an economy, the form of adjustment policies may vary from time to time due to various changes that occur. In Indonesia, for instance, because of the high economic cost due to bureaucracy and relatively widespread government regulations in various sectors of the economy and constituted the initial conditions, the form of adjustment policies pursued thus far have been deregulations and debureaucratizations.

But this does not mean that re-regulations is out of question in the future, considering especially structural changes that may occur with the advancement of the economy and modernization of the financial sector.

Regarding the sequencing of adjustment policies, numerous arguments have been advanced in literature. The debate is still going as to which sector should be liberalized first: real versus monetary sector, monetary versus fiscal, as well as money market versus capital market in the monetary sector.

Various models have been advanced in literature: trade liberalization is either preceding, simultaneously adopted with, or following financial reforms. Regarding this, McKinnon argued that adjustments should not be undertaken simultaneously. Certainly it will depend on the initial conditions. It is difficult to make generalization since the economic conditions of a country differ from those in other countries.

Theories on sequencing often disregard existing conditions in a country and rarely provide sufficient alternatives for policy makers to decide on the optimal course of adjustment policies.

One may say that Indonesia's reform was set of responsive actions taken by the authority. This is undeniable. I would also add, however, that every situation and condition is different so that particular situation never properly matches a set of necessary conditions for a particular policy to be taken.

We may agree that any policy is suitable for a particular circumstance, but in the real world the circumstances would never be appropriate for the underlying policies. In fact, given the dynamics of the problem, any authority has to move expeditiously to address the challenges adequately. It is even said that a difficult situation produced a good policy. When everything is fine and in order, there would be no urgency to consider new measures.

The basic principle in this sequencing approach, therefore, is not on how to justify the political decision to reform the financial sector or the real sector, but on what the underlying circumstances of the overall economy are. The determination to reform is persisted in order to remedy the economy that was not able to keep up with the eventual domestic as well as international progress.

Another lesson that we have learned from the financial reformation was very significant. The removal of barriers to entry into the banking industry in a very abrupt manner, as stipulated in the 1988 decree, produced quite an astonishing impact as the banking industry advanced significantly.

Accordingly, banks were induced to discover new methods to mobilize funds and at the same time to extend new loans intensively which, to a large extent, contributed to the upswing in the economy, leading to the problem of economic overheating.

On the side of micro management, the growing credit extended by banks partly due to the over supply of funds, produced another symptom in the years after, that is, the bad debt problem.

It seems that the reformation was somewhat too fast and too soon because the tremendous expansion in the banking industry in the period 1989-1991 was not accompanied by an appropriate level of compliance to prudent banking principles. In dealing with this problem, correction measures were taken in 1991 to prevent further deterioration in the industry.

This experience suggested that the financial reformation has been very instrumental in promoting the banking industry, nonetheless, the timing of implementation proved to be crucial and critical in ensuring the expected outcome. Prudent banking principles should be established prior to financial reformation, or at least established in tandem.

It also meant that prudential aspects of banking operation is a necessary condition to cope with increasing competition in the globalization era. This is partly the reason that since 1991, we have been doing our best to maintain prudential principles not only in the banking industry but in economic management as a whole. There is a saying that it takes two to dance.

In the case of financial reformation, we may add that it takes everything to achieve success. Prudent macro management would need concerted efforts in fiscal and monetary policies that are directly related to financial reformation. Apart from that, financial reformations must also be supported impartially by overall structural adjustments in all the elements of the economy.

As we deregulate many facets of the economy, one common phenomenon arose. Before deregulation, the government possessed a set of comprehensive tools and regulations to control economic activity. Similarly, the monetary authority had a complete set of "dos and don'ts" to manage and influence the banking sector and monetary behavior.

Since financial adjustment measures were basically designed to deregulate most element of monetary and banking activities, the ownership of instruments and regulations by the authority had diminished. Therefore, the importance of a particular monetary instrument, namely moral suasion.

For money management to be successful, we have to go beyond managing the growth of reserve money through normal open market operations to include steps to contain the growth of factors affecting the growth of monetary aggregates. Since bank credit expansion was the main factor that contributed toward the growth of monetary aggregates, we persisted in moral suasion programs to influence banks in their lending activities.

One of the important measures that we have found for moral suasion is as follows: through regular monthly meetings with the banking sector, we provided a macro picture of our economy and raised some critical issues that banks should take into consideration, especially signs of emerging economic overheating.

Next, we shared with banks selected data showing the currently vulnerable sectors so as to persuade banks to readjust their lending activities to those sectors. We asked banks to submit their credit plans and discussed with them the consequences of their credit expansion plans and on both macroeconomic stability and their financial condition.

Through these steps, we tried to achieve better and prudent macroeconomic management through implementation of prudential principles by banks, a program that linked macro and micro management that relied on better coordination between the central bank and the banking community.

The deregulation measures adopted in Indonesia were aimed at streamlining regulations. However, it does not necessarily mean that we are going to set up a free system. In fact at certain stages, if necessary, we may impose new regulations as we have done so far, for a sound and efficient banking system.

However, we have also learned that the regulations themselves are not enough to ensure sound bank operations. The effectiveness of regulations depends on the management of banks themselves. Regardless of how well the regulations were designed, a regulation may still contain loopholes that can be exploited to evade compliance.

Therefore, we require banks to adopt a stricter self- regulation principles by taking into account the risks that may arise in the course of business. By applying self-regulatory principles, banks would not conduct their operations solely on the basis of what is allowed in general regulations, but more importantly, banks would apply internal regulations that specify detailed application of general regulations.

Window: Prudent banking principles should be established prior to financial reformation, or at least established in tandem.