Indonesia-Financial Reform

The president's technocratic advisers on financial policy, who had unsuccessfully resisted growing government regulations during the 1970s, spearheaded the return to market-led development in the 1980s. The financial sector is often the most heavily regulated sector in developing countries; by controlling the activities of relatively few financial institutions, governments can determine the direction and cost of investment in all sectors of the economy. From the 1950s to the early 1980s, the Indonesian government frequently resorted to controls on bank lending and special credit programs at subsidized interest rates to promote favored groups. Toward the end of this period, the large state banks that administered government programs were often criticized as corrupt and inefficient. Sweeping reforms began in 1983 to transform Indonesia's government-controlled financial sector into a competitive source of credit at market-determined interest rates, with a much greater role for private banks and a growing stock exchange. By the early 1990s, critics were more likely to complain that deregulation had gone too far, introducing excessive risk taking among highly competitive private banks.

Like many developing countries, the Indonesian financial sector historically was dominated by commercial banks rather than by bond and equity markets, which require a mature system of accounting and financial information. Several established Dutch banks were nationalized during the 1950s, including de Javasche Bank, or Bank of Java, which became the central bank, Bank Indonesia, in 1953. Under Sukarno's Guided Economy, the five state banks were merged into a single conglomerate, and private banking virtually ceased. One of the first acts of the New Order was to revive the legal foundation for commercial banking, restoring separate state banks and permitting the reestablishment of private commercial banks and a limited number of foreign banks.

During the 1970s, state banks benefited from supportive government policies, such as the requirement that the growing state enterprise sector bank solely with state banks. State banks were viewed as agents of development rather than profitable enterprises, and most state bank lending was in fulfillment of governmentmandated and subsidized programs designed to promote various economic activities, including state enterprises and small-scale pribumi businesses. State bank lending was subsidized through Bank Indonesia, which extended "liquidity credits" at very low interest rates to finance various programs. By 1983 such liquidity credits represented over 50 percent of total state bank credit. Total state bank lending in turn represented about 75 percent of all commercial bank lending. The nonstate banks--which by 1983 numbered seventy domestic banks and eleven foreign or joint-venture banks--had been curtailed during the 1970s by licensing restrictions, even though they offered competitive interest rates on deposits and service superior to that offered by the large bureaucratic state banks. Bank Indonesia also imposed credit quotas on all banks to reduce inflationary pressures generated by the oil boom (see Monetary and Exchange Rate Policy , this ch.)

The first major economic reform of the 1980s permitted a greater degree of competition between state and private banks. In June 1983, credit quotas were lifted and state banks were permitted to offer market-determined interest rates on deposits. Many of the subsidized lending programs were phased out, although certain priority lending continued to receive subsidized refinancing from Bank Indonesia. Also, important restrictions remained, including the requirement that state enterprises bank at state banks and limitations on the number of private banks. By 1988 state banks still accounted for almost 70 percent of total bank credit, and liquidity credit still accounted for about 33 percent of total state bank credit.

In October 1988, further financial deregulation essentially eliminated the remaining restrictions on bank competition. Limitations on licenses for private and foreign joint-venture banks were lifted. By 1990 there were ninety-one private banks--an increase of twenty-eight in a single year--and twelve new foreign joint-venture banks, bringing the total foreign and joint-venture banks to twenty-three. State enterprises were permitted to hold up to 50 percent of their total deposits in private banks. Later, in January 1990, many of the remaining subsidized credit programs were eliminated.

The extensive bank deregulations promoted a rapid growth in rupiah-denominated bank deposits, reaching 35 percent per year when controlled for inflation in the two years following the October 1988 reforms (for value of the rupiah--Rp--see Glossary). This rapid growth led to concerns that competition had become excessive; concern was heightened by the near failure of the nation's second largest private bank, Bank Duta. The bank announced in October 1990 that it had lost more than US$400 million, twice the amount of its shareholders' capital, in foreign exchange dealings. The bank was saved by an infusion of capital from its shareholders, which included several charitable foundations chaired by Suharto himself. The spectacular crash of Bank Summa in November 1992 was not protected by Bank Indonesia. Its owner, a highly respected wealthy businessman, was forced to liquidate other assets to cover depositors' losses.

Unrestricted transactions in foreign exchange by Indonesian residents had been a unique feature of the financial sector since the early 1970s. While many developing countries attempt to outlaw such so-called capital flight, the New Order continued to permit Indonesian residents to invest in foreign financial assets and to acquire the foreign exchange necessary for investments through Bank Indonesia without limit. Commercial banks in Indonesia, including state banks, were also permitted since the late 1960s to offer foreign currency--usually United States dollar--deposits, giving rise to the so-called Jakarta dollar market. By 1990 20 percent of total bank deposits were denominated in foreign currency. This freedom to invest in foreign exchange served the financial institutions well. During the 1970s, when banks' domestic credit activities were heavily restricted, most banks found it profitable to hold assets abroad, often well in excess of their foreign exchange deposits. When demand for domestic credit was high, banks resorted to international borrowing to finance expanding domestic loans. To control the domestic supply of credit by plugging the offshore leak, in March 1990, Bank Indonesia issued a new regulation that limited the net foreign position of a bank (the difference between foreign assets and liabilities) to 25 percent of the bank's capital.

Prior to bank reforms in October 1988, some private banks were essentially the financial arm of large business conglomerates and consequently did not make loans to businesses outside those connected with the bank's owners. The 1988 bank reforms limited loans to businesses owned by bank shareholders. When many of the government-subsidized credit programs targeted to small businesses were eliminated in January 1990, the government required banks to lend a 20 percent share of their loan portfolio to small businesses, defined as those businesses with assets, excluding land, worth less than Rp600 million (about US$300,000). This aspect of financial reform ran counter to the overall effort to improve bank efficiency, since the rule applied to all banks regardless of their expertise in small-scale lending. However, the policy reflected the government's persistent concern that the public might perceive the benefits of economic growth as limited to the wealthy few.

One of the most striking outcomes of financial reform was the revival of the Jakarta stock market in the late 1980s. Established in 1977, the stock market had become lifeless during the early 1980s because of extensive regulation of stock issues and price movements. In conjunction with substantial bank reforms, many restrictions on the Jakarta Stock Exchange were lifted in the mid1980s , broadening the range of firms that could issue equity and permitting stock prices to reflect market supply and demand. To tap the growing international interest in Asian investments, foreign ownership was permitted for up to 49 percent of an Indonesian firm's issued capital. The market's response to these reforms was dramatic. The number of firms listed on the exchange rose from 24 in 1988 to 125 in January 1991, and the market capitalization--the total market value of issued stocks--reached more than Rp12 billion. Although this amount of market capitalization was less than 15 percent of the volume of bank credit to private firms, the stock market promised to become an increasingly important source of finance.

Data as of November 1992