Monetary Policy and the Financial Sector

task is to conduct monetary policy to stabilize macroeco-nomic environment, issue the national currency, the rupiah (IDR), handle foreign exchange assets and debt servicing, as well as exercise control over national banking and financial system. To this end, BI monitors broad money, credit aggre-gates and reserve money. In addition, the authorities moni-tor the real value of the rupiah against an undisclosed basket of currencies. The main instrument in BI actions are open market operations involving Bank Indonesia papers (intro-duced in 1984) and commercial bank papers (from 1985), as well as reserve requirements and foreign exchange inter-ventions. In the 1990s, BI has succeeded in limiting inflation only to rather moderate level of 7–11%, however, in a peri-od leading to the crisis inflation was steadily falling and reached about 5% in mid-1997.

Foreign reserves, together with reserve money, have been rising largely due to capital inflows, while domestic credit accelerated, triggered by financial liberalization. In the 1990s, BI had permanent problems with rapidly growing

[1] In 1995: 41/41 (41 place out of 41 reviewed countries), 1996: 47/54, 1997: 46/51, 1998 80/95.

Figure 5-2. Indonesia: GDP by sector

Agriculture, mining, etc.

25%

Manufact.

and costruction 34%

Services (and other)

41%

Source: IMF

Figure 5-3. Indonesia: Employment by sector

Agriculture, mining, etc.

42%

Manufact.

and costruction 20%

Services (and other)

38%

Source: IMF

credit (over 20% a year in the period preceding crisis).

Because of that, BI has conducted a relatively restrictive pol-icy of high interest rates. Reserve requirements have been raised in accordance with BI plan to reduce credit growth to 17% in 1997 [2]. Bank lending rates in the 1990s have been usually 10% or more above inflation. The exchange rate policy can be described as real exchange rate targeting – with the rupiah gradually and predictably depreciating with respect to the USD about 4% year, i.e. from around 1900

IDR/USD in 1990 to around 2400 IDR/USD in mid-1997.

Such a policy combined with capital account liberalization created incentives to borrow abroad to take advantage of interest rate differentials and prepare the ground for large capital inflows. BI tried to counteract excessive inflows by widening the rupiah's trading bands from 2% to 3% around daily mid-rate in 1995, and further to 5% in June 1996, and to 8% in September 1996, adding therefore some risk to foreign exchange market.

Before the crisis, the size of the Indonesian financial sec-tor amounted to some 60% of GDP [3]. The leading finan-cial institutions in Indonesia were commerfinan-cial banks, accounting for 87% of total assets, out of which the biggest seven state-owned banks accounted for around half of that figure, the other half being distributed among around 170 private banks (1995). Other financial institutions like insur-ance companies, pension funds, stock brokerages or other financial intermediaries played only a minor part in the sys-tem and had no impact on the overall picture.

The process of liberalization of the banking system began in 1983 with interest rates liberalization and the elim-ination of credit ceilings. But ever since the government opened up the system to new entrants in 1988–89, the sec-tor started to thrive. In 1988, reserve requirements were reduced from 15% to 2%, licenses for new private and joint-venture banks issued, and state-owned firms were allowed to put 50% of their funds with private banks. The following year, the requirement of BI license in long-term loans granting and offshore loans ceiling was removed. The number of banks soared from 112 to around 240 as anyone Figure 5-4. Indonesia: Size of Indonesian banking system, assets of

banks in 1996

Joint 6%

Foreign 4%

Local state 3%

State commercial 40%

Private national 47%

Source: IMF

Figure 5-5. Indonesia: Trading volume on forex market (bln USD/day)

0 2 4 6 8 10

forward&swap spot

1997M1 1997M2 1997M3 1997M4 1998M1 1998M2 1998M3

Source: IMF

[2] The plan failed to large extent and eventually credit growth reached 23%.

[3] Data for 1994. Compare Malaysia 100% of GDP and Thailand 110% of GDP.

with access to around 3 mln USD minimum capital could set up shop. So did bank credit that rose by 350% from 1988 till 1995. In 1994, new private banks overtook state banks with lending activity. Without a proper supervision frame-work, and in combination with a severe shortage of trained and experienced bankers, this quickly led to a problem with prudent asset management and bad debts. To counteract this problem, BI introduced a minimum capital adequacy ratio of 8% and gradually increased minimum capital need-ed to open a bank to around 30 mln USD. In 1992, state owned banks were converted into limited liabilities compa-nies. However, the Ministry of Finance announced in 1994 that it would not permit a state bank to default on its oblig-ations.

This was not the end of banking fragility and problems.

Financial scandals and bank failures were quite frequent, with government intervening to bail out bankrupt banks and cover deposits [4]. Noncompliance in lending limits and off-balance sheet operations were widespread. Strong polit-ical dependence of state banks, which were used as a source of cheap capital for government affiliates' enterprises, explains their permanent inferior performance, in terms of both return on assets and bad loans.

After liberalization, the 1990s witnessed a rapid devel-opment of the securities market. In 1988, the market was opened to foreign investors, in 1994 Bapepam (the state supervisory agency) implemented new accounting stan-dards, and in 1995 a new computerized automatic trading

system was introduced allowing for much higher trading vol-ume. Despite these changes, the securities market never became a major source of commercial finance. In 1994, equity market capitalization was only of 30% of GDP [5].

Moreover, its importance is still overestimated because cap-italization includes shares that have never been sold – 70%

of the shares are held by companies' founders [6], while the

Figure 5-7. Indonesia: Equity market size in % of GDP

0 5 10 15 20 25 30 35

1989 1990 1991 1992 1993 1994

Source: IMF Figure 5-6. Jakarta Composite Index

0 100 200 300 400 500 600 700 800

1992M1 1992M5 1992M9 1993M1 1993M5 1993M9 1994M1 1994M5 1994M9 1995M1 1995M5 1995M9 1996M1 1996M5 1996M9 1997M1 1997M5 1997M9 1998M1 1998M5 1998M9 1999M1 1999M5 1999M9

Source: Bloomberg

[4] Examples include looting of Bank Bapindo, or Bank Lippo scandal.

[5] Compared to 280% in Malaysia and 95% in Thailand.

[6] Indonesia has the highest ownership concentration in corporate sector among Southeast Asian countries. As it has been stated above, main Indonesian companies are characterized by the close connections with the authorities, strong family ties, and are monopolized by the small elite of Chi-nese businessmen, and senior government officials.

government holds large stakes in privatized and listed for-mer-state-owned companies. When adjusted for that the stock market has provided about 15% of total business finance. The small size of the market and open access to it are the reasons why the Indonesian stock exchange was 70% dependent on foreign investors and relatively volatile.

International investors complained about small liquidity, poor audit standards, doubtful fairness and quality of com-panies' disclosures as well as notorious insider trading.

Capital account liberalization started with a gradual pro-motion of foreign direct investment in designated sectors and with efforts to restructure and modernize the economy from oil-export dependence [7]. Investment procedures were simplified, certain restricted fields gradually opened, equal treatment with domestic investment sequentially granted, etc. In 1989 so called priority list ("in what fields to invest") was exchanged by so called negative list consisting of domains in which foreign investment was restricted. The number of items on the negative list was decreasing. As a result, foreign direct investment has been steadily pouring into Indonesia, especially from 1995 (in 1996/97 accounting year [8] FDI inflow amounted to 6.5 bln USD). In 1988, Indonesia accepted the obligation of Article VIII [9] – the foreign exchange market was developed and the swap transactions liberalized. The forex market remained rela-tively shallow with a 10 bln daily turnover in mid-1997. In 1989 and 1996 the authorities liberalized portfolio capital inflows by eliminating quantitative limits on banks'

borrow-ing from nonresidents, foreigners were permitted to freely invest in stocks up to 49% of share capital, and the central bank withdrew from its obligatory intermediation in foreign exchange transactions.

High interest rates, a stable rupiah exchange rate, a growth-oriented environment and an expanding stock mar-ket resulted in constant inflows of foreign portfolio and short term capital (7 bln USD in acc. year 1995/96 and 6 bln USD in acc. year 1996/97). As a result, foreign reserves in Bank Indonesia have been steadily increasing. BI attempted to sterilize the resulting increase in base money by sales of central bank papers and through interventions on foreign exchange market. Capital inflows mainly took the form of borrowing of commercial banks, which in turn were con-verted it into local currency and lent to domestic corporate sector.