II. Corporate Sector in Indonesia: Financial Performance and Underlying Vulnerabilities1
1. The corporate sector in Indonesia has been recovering in recent years from the financial crisis of 1997–98. Prior to the crisis, high growth rates were spurred by rapid corporate borrowing, in many cases by groups with ownership links to banks providing financial resources. Poor risk management in banks and firms explained sizable and largely unhedged bank financing (uncovered maturity and currency risk). Once the crisis hit, the sharp rupiah depreciation and accompanying high interest rates led to severe and prolonged financial instability. In recent years, progress toward macroeconomic stability and the gradual recovery of economic growth have contributed to improved corporate sector performance.
2. This paper analyzes the performance of the Indonesian nonfinancial corporate sector in recent years and discusses remaining challenges and vulnerabilities. The analysis looks at the overall financial condition of firms, as well as relevant changes in the regulatory framework that are likely to have contributed to the improved performance of the corporate sector. The paper also assesses lingering vulnerabilities, which may become more evident in the face of the recent slowdown in economic activity.
3. Based on data from nonfinancial companies listed in the Jakarta Stock Exchange (JSX), the main findings of the paper are:2
- Financial indicators of nonfinancial firms show stronger balance sheets. Leverage is now in line with pre-crisis levels and similar to other countries in the region. Firms show strengthened capacity to repay obligations and improved profitability. Currency mismatches on bank loans have declined substantially. Corporate bond financing, although still moderate, has doubled in the last four years to $6 billion in 2005.
- Regulations aimed at enhancing governance have been incorporated into the institutional environment. Partly as a result of this, risks of over-borrowing, misreporting, and abusing related-party lending, have diminished. However, there are many areas for improvement: courts are reportedly still ineffective, adequate provisions for corporate debt restructuring are lacking, and minority shareholders are not adequately protected.
- Remaining corporate vulnerabilities explain the lingering reluctance of banks to lend to riskier corporate borrowers. The share of short-term borrowing is higher for domestic corporations relative to foreign; coverage of interest payments is relatively low for Indonesian corporations, partly explained by higher interest rates in recent years; and the profitability of the top 100 largest firms is still weak.
4. The decline in corporate leverage may have resulted to a large extent from supply-side constraints. Because of the gap between the regulatory environment for banks and firms, banks have been reluctant to lend to avoid risks associated with eventual difficulties in loan recovery and execution of collateral. Thus, at least in part, declining leverage reflects reduced availability of financing to an important segment of the corporate sector. Foreign creditors, the main source of financing to the corporate sector until 2004, also seem to have been more reluctant to lend directly to firms recently, so that in 2005 banks were once again the main source of corporate financing. To the extent that the financing needs of the corporate sector are partially unattended in an environment of increased caution, this means that the level of investment and economic activity may be running below potential.
5. This chapter is organized as follows: in the next section, background is provided on the financial evolution of the corporate sector since the crisis, as well as on the corporate governance environment. Next, indicators on leverage, liquidity, solvency, and profitability are discussed, with an emphasis on latest developments, trying to differentiate the evolution for different types of corporations. Finally, the paper discusses conclusions and policy implications. Four types of data are used for the analysis of financial indicators (see Section C): information from an IMF database drawing on financial statements of firms listed in the JSX, information on individual firms from Thompson Watch to obtain the distribution around the mean, information from Worldscope updated to September 2005 for the same sample of firms to analyze recent trends of selected financial ratios, and information from Worldscope and the JSX for the top 100 firms to differentiate financial indicators based on the ownership structure.
Financial Evolution of the Corporate Sector
6. Indonesia was the country most severely affected by the Asian financial crisis, with GDP declining by 13 percent in 1998. The financial system suffered severe simultaneous shocks.3 The impact on the cost of borrowing for the corporate sector was substantial, unmasking the low quality of the bank portfolios in the context of widespread currency and maturity mismatches. Massive defaults caused the banking system to collapse. The subsequent recovery of financial intermediation has also been slower than in the rest of the region. Bank intermediation, defined as the credit-to-GDP ratio, has declined from a peak of 61 percent of GDP in 1997 to 18 percent in 2001, to recover to just 25 percent of GDP in 2005 (the lowest ratio in emerging Asia).
7. The condition of the corporate sector has been made more difficult by the modest development of capital markets. Stock market capitalization for the nonfinancial corporate sector declined from 35 percent of GDP in 1996 (40 percent for all listed companies) to about 11 percent in 2002. The increase in the number of listed companies has been meager, from 269 to 279 between 2001 and 2005. The recent recovery in stock market capitalization to 22 percent of GDP in 2005 was driven mainly by higher stock prices.4 Also, the lack of long-term liquidity in the financial market has constrained the development of the corporate bond market. Although issuance of corporate bonds increased from $3 billion to $6 billion between 2001 and 2005, it is equivalent to just 10 percent of stock market capitalization.
8. Despite modest bank intermediation, bank financing has regained prominence as a source of corporate financing in recent years. Corporate borrowing from domestic banks in 2005 surpassed external borrowing as the main source of corporate financing. This has contributed to a reduction of currency mismatches, since bank intermediation is chiefly conducted in domestic currency. However, this development has contributed to a shortening of the maturity profile of corporate borrowing, since bank loans are typically concentrated in short-term loans (equivalent to 72.6 percent of the total loans in 2005, against 19.4 percent for external loans) (Figure 1).
Figure 1.Indonesia: Composition of Corporate Financing
Sources: CEIC database; IMF, International Financial Statistics; and Bank Indonesia.
Evolution of the corporate governance environment
9. Severe governance problems had to be addressed following the crisis. During the 1990s, corporate groups linked to banks, operating in a weak institutional environment, were able to borrow beyond what was economically justified at a low cost of funds. In this period, concentration of ownership was highest in the region, with ten families controlling more than half of the corporate sector.5 Firms were able to disguise their actual financial position, overstate profitability, and continue to operate even after they were no longer financially viable.6
10. Corporate governance regulations and practices have been upgraded since the crisis. Widespread bank-corporate ownership ties were broken as a result of bank restructuring, facilitated by the removal of restrictions on ownership structure of firms. Financial reporting has become more transparent following the adoption of basic international financial reporting standards. The excessive degree of ownership concentration observed prior to the crisis has moderated significantly. A Code of Good Corporate Governance was published in March 2001 by the National Committee on Corporate Governance (founded in 1999). The upgrade of corporate governance has also found support in the ongoing anti-corruption drive by the government, as well as from better banking regulation and supervision.
11. Despite gains in the quality of the institutional framework, corporate governance could still be significantly improved. According to indicators compiled by the World Bank up to 2004,7 there is a trend toward improved regulatory quality, compliance with the rule of law, and control of corruption. However, governance indicators still compare unfavorably with neighboring countries (Figure 2). Priority areas for improvement include legal and judicial reform, the full adoption of international financial reporting standards, the introduction of adequate mechanisms for corporate debt restructuring; and further improvements in capital market surveillance.
Figure 2.Indonesia: Governance Indicators Relative to the Region
Source: World Bank.
12. More specifically, a World Bank Report on the Observance of Standards and Codes (ROSC) in the corporate sector, completed in 2004, found the following problems:
- Insufficient disclosure of cross-ownership. Pyramidal structures remain and family-based groups are still significant, despite some dismantling of widespread bank-corporate groups. Disclosure is required by the Capital Market Supervisory Authority (Bapepam) for shares in ownership of 5 percent or more for listed companies, but detection of cross-ownership is difficult because of deficient reporting procedures. In an environment where separation of shareholders and management is not clear, this may result in the abuse of power by controlling shareholders to pursue group/family interests above those of the firms.
- Quality of financial statements not fully consistent with international standards and practices. Despite significant progress since the crisis, inconsistencies between the Indonesian accounting standards and International Financial Reporting Standards (IFRS) remain, particularly as some standards have been modified to suit local requirements. However, one of the main reasons why the number of firms listed in the JSX has increased only slowly, according to stock exchange analysts, is because of the reluctance of firms to comply with more stringent disclosure and financial reporting standards.
- Weak legal basis for related-party transactions. Regulations have been introduced to limit related-party transactions (transactions with firms and individuals belonging to shareholders), but their full implementation is still pending. Bapepam requires the approval of independent shareholders for any related-party transactions. However, the Capital Market Law apparently does not provide adequate powers to officials, beyond some administrative sanctions, to enforce the regulations.
13. A classification of firms by ownership type shows that changes in the governance framework have had a moderate impact on the corporate ownership structure (Figure 3). In this paper, a classification by ownership type is made following Sato’s (2000) methodology for the 100 largest nonfinancial corporations. The top 100 companies were determined based on the value of assets of nonfinancial companies listed in the JSX as of December 2000 and September 2005. Private domestic corporations were divided between “Indonesian corporations” (those for which a single shareholder or group held more than 40 percent of equity) and corporations with “widely-held” shares (the largest shareholder holding 40 percent or less of equity). Additional categories comprise foreign corporations and state-owned corporations, using the same criterion. Borderline cases were classified as “mixed” companies. A clear trend is observed away from family-based structures to more widely-held ownership following the crisis. Nevertheless, “Indonesian corporations” remain predominant, in many cases using ownership structures that are not fully transparent.
Figure 3.Indonesia: Top 100 Corporate Ownership Pattern, 2000 and October 2005
Source: Jakarta Stock Exchange.
C. Recent Corporate Financial Performance
14. Most indicators on leverage, liquidity, solvency, and profitability show significant improvement since the crisis. For the overall analysis of financial performance, financial ratios are calculated using data from nonfinancial companies listed in the JSX. However, it should be noted that the sample is less representative than for other countries, since market capitalization is low. Two kinds of ratios are calculated: the capital-weighted mean and the median. While the former gives more weight to larger firms, the latter serves as a proxy to assess the behavior of medium-size firms. Although only information up to 2004 was available for this exercise for the whole sample of firms, some indicators were updated up to the third quarter of 2005 for the same sub-sample of firms using information from Worldscope.
15. Leverage has returned to pre-crisis levels. A decline in leverage is observed relative to assets, equity, and sales. The more even distribution of leverage around the value of equity rather than assets seems to suggest that supply rather than demand factors shape the leverage structure (Figure 4). The decline in leverage relative to equity is influenced by the recent increase in stock valuation (Figure 5). A change in the sectoral composition of firms listed in the JSX, including the de-listing of a few highly-leveraged nonfinancial firms following the crisis (10 out of about 100)8 could also have played a role in the observed reduction of leverage, since highly-indebted firms belonging to the basic industries sector experienced a reduction in their share in market capitalization relative to services and manufacturing of consumer goods.
Figure 4.Distribution of Corporate Leverage, 2000 and 2004
Source: Thompson Watch.
Figure 5.Indonesia: Corporate Leverage Indicators, 1994-2004
Source: IMF database (sample of firms from an IMF database using information from companies listed in the Jakarta Stock Exchange).
16. Some differences in leverage patterns between large and medium-sized firms are revealing (Figure 5). Large firms resort more intensively to financing through retained earnings. Leverage relative to assets seem to be higher for less asset-intensive medium-sized firms compared to larger firms, while the opposite is true for the debt-to-equity ratio. The share of short-term debt does not show a significant decline, especially for smaller firms as they are likely to have had more difficulties in obtaining long-term financing.
Liquidity, profitability, and solvency
17. Liquidity ratios have improved, especially for larger firms. The ratio of working capital over assets has steadily increased (Figure 6). Inventories appear to have contributed significantly to the improvement in liquidity, since the liquidity ratio excluding inventories (Quick ratio) has risen at a more measured pace. Interest payments are covered comfortably by earnings (interest coverage ratio), although less for medium-size than large firms, the former having been more adversely affected by higher interest rates.
Figure 6.Indonesia: Corporate Liquidity, Profitability and Solvency, 1994-2004
Source: IMF database
18. The recovery of profitability ratios is impressive, which contributes to a lower probability of default. However, it should be noted that this result may be influenced by Indonesian accounting standards not being fully in line with IFSR. Both the return-on-assets (ROA) and return-on-equity (ROE) ratios have improved strongly, with the latter exceeding the average levels prevailing before the crisis. The distance-to-default ratio (a reverse measure of the probability of default based on Merton-Scholes valuation of equities as a call option) has recovered to about precrisis levels.
Comparative performance and recent financial trends
19. The financial performance of the Indonesian corporate sector is comparable to that of the other countries in the region for 2000–04 (Figure 7). The average debt-to-assets and debt-to-equity ratios, of about 30 percent and 100 percent, respectively, are similar to most countries in the region except for Thailand. The share of short-term debt, at about 40 percent of total debt, is lower than in Korea and not much higher than other countries in the region. Liquidity, as measured by the Quick ratio, is broadly comparable to other countries in the region, except for the Philippines. Profitability of Indonesian firms is higher than in other countries, with ROE exceeding 27 percent.
Figure 7.Indonesia: Corporate Financial Indicators in Selected Asian Countries, 2000-2004 (In percent)
Source: IMF database.
20. The evolution of key financial indicators through September 2005 shows some weakening. Overall, continuing de-leveraging, higher preference for liquidity, and declining profitability may reflect the fact that the restricted availability of financing is becoming a binding constraint for some firms. Based on information available from Worldscope for listed nonfinancial firms,9 debt-to-asset and debt-to-equity ratios continue to show declines, with a slightly lower share of short-term debt. Firms also continue to increase their “liquidity buffer.” However, such an improvement is not observed for the interest coverage ratio, because of high interest rates. Profitability ratios declined markedly in the period, right at the outset of the recent slowdown of economic activity (Figure 8).
Figure 8.Recent Trends in Selected Corporate Financial Indicators, 2003-2005
21. Financial performance shows marked differences between “Indonesian corporations” and other categories (Figure 9). Although all firms show a decline in leverage, “Indonesian corporations” maintain higher leverage than other types, especially in recent times. Also, the share of short-term debt is higher for “Indonesian corporations,” while their liquidity position and interest coverage ratio are less comfortable. Profitability is higher in foreign firms relative to domestic firms.
Figure 9.Indonesia: Top 100 Corporate Financial Indicators, 2000 and 2005
22. “Indonesian corporations” appear to have more limited access to financing and this is reflected in their weaker financial position. Banks are reluctant to lend to companies that have had a poor track record in terms of loan recovery, especially given the difficulty to execute collateral by resorting to the courts. Also, banks are reluctant to increase loan exposure to “Indonesian corporations” that keep ownership structures that are not transparent (based on pyramidal schemes). Some of these groups still have substantial obligations on earlier loans, which explain their higher leverage ratios, and are therefore reportedly having problems accessing new financing.
D. Conclusions and Policy Implications
23. The financial performance of the corporate sector is promising. The improvement in solvency has helped them to weather the recent slowdown in economic activity and, going forward, should help them to cope with shocks. Firms show improved “financial fundamentals” and their pursuit of nonbank sources of funding has led to some development of corporate bond financing, although this market is still too small to meet their needs. Further improvement of banking supervision would ensure a more appropriate channeling of financial resources from banks to the corporate sector.
24. The development of capital markets is crucial to strengthening corporate capital financing and investment. Bank financing has become dominant in spite of increased caution because alternative sources of financing have not kept pace with the growth in companies assets and equity. Additional investment to support the expansion of the capital base to achieve higher growth can only be possible with decisive progress in capital market development.
25. “Governance imbalance” between the financial and the nonfinancial sector may also be hampering long-run growth. The availability of bank financing to “Indonesian corporations” has remained limited. Bank lending to these groups entails uncertainties regarding the capability of banks to fully exercise their creditor rights in courts in the event of difficulties in loan recovery. To resolve such an imbalance, further progress on legal and judicial reforms, the full adoption of international financial reporting standards, appropriate mechanisms for corporate debt restructuring, and further improvements in market surveillance is needed.
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