Reform of the financial sector

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.