III. Corporate Financing Patterns in Indonesia: Challenges amid Changing Financial Conditions21
In parallel with a continuous reduction of leverage between 2000 and 2007, Indonesian firms have diversified their sources of funding. The paper finds that corporate leverage in Indonesia is in large part driven by market conditions, such as market-to-book value and profitability, though the legacy of the crisis still persists. Indonesian companies may now face new challenges in light of increased financing needs to support the expansion of their productive capacity, including higher financing costs as a result of volatile global financial conditions and appropriate risk management of emerging vulnerabilities.22
48. The 1997 financial crisis left important lessons regarding corporate financing. Prior to the 1997 financial crisis, large corporate borrowing in Indonesia spurred high growth rates, with corporate groups linked to banks borrowing beyond what was economically justified. Poor risk management in firms and banks explained widespread maturity and currency mismatches. Once the crisis erupted, the impact on the cost of borrowing for the corporate sector was substantial, and serious corporate governance shortcomings compromised firms’ access to bank financing in the years after the crisis (see Morales and Widyastuti, 2006). As a result, private investment and economic activity plummeted, and the ensuing increase in nonperforming loans put the financial sector at risk.
49. Following a period of consolidation, corporate leverage in Indonesia has declined sharply while companies have diversified their sources of financing. The debt to assets ratio has declined by about 30 percentage points since 2000, and bond and equity financing have become more important with the development of securities markets in Indonesia. In addition, the institutional framework for financial intermediation was strengthened, and this has helped improve prudential practices in the allocation of credit. Also, despite sustained de-leveraging by the corporate sector, the ratio of investment to GDP has recovered in the last three years consistent with an increase of capital expenditure to fixed assets by corporates, although it is still below the level observed before the crisis. At the same time, banks have also diversified their loan portfolios, as evidenced by the stabilization of the share of corporate loans in total bank loans (Figure 1).23
Figure 1.Indonesia: Corporate Leverage and Private Investment
Sources: Thompson One; and Indonesian authorities.
1/ 2007 observation only includes 59 listed nonfinancial companies.
50. Corporate financing lies at the heart of macro-financial links. Decisions about the timing and size of investment are influenced by financing conditions, with implications for production and employment. Corporate financing decisions have implications for monetary policy as well, as the transmission mechanism depends on the financing behavior and balance sheet structures of firms. As evidenced by the Asian crisis, the corporate sector can play an important role in transmitting financial shocks to the economy. This is particularly relevant at the current juncture, where turmoil in global financial markets could greatly affect the financing conditions for the Indonesian corporate sector.
51. In this context, this paper provides and overview of recent financing trends of the non-financial corporate sector in Indonesia and highlights main challenges and vulnerabilities going forward. In particular, the paper addresses the following questions: (1) is corporate financing in Indonesia still affected by the legacy of the 1997 crisis?; (2) What will be the main drivers of corporate leverage going forward?; and (3) What are the main challenges arising from the current global and domestic financial conditions, given Indonesia’s corporate financing structure? In attempting to answer these questions, the paper aims to identify the implications of the firms’ capital structure for financial stability, macro-financial policies, and the investment outlook. Information from nonfinancial companies listed in the stock exchange is used to analyze recent trends. Also, in order to identify the determinants of corporate financing decisions, the paper estimates standard models from the corporate finance literature.
52. The paper concludes that balance sheet vulnerabilities of the Indonesian corporate sector have been reduced over the last decade, but increased exposure to external sources of funding makes firms vulnerable to global financial market conditions. The capital structure of Indonesian firms has improved with the sharp decline in indebtedness and increased exposure to non-bank funding sources. Furthermore, firms do not appear to face financing constraints, as evidenced by their increased profitability, and their financing decisions do not seem to differ significantly from those in other emerging market countries. In contrast with the Asian crisis period, current leverage ratios in Indonesia can be largely explained by profitability indicators as well as measures of growth prospects and investment opportunities. Going forward, continued diversification of funding sources and further development of the domestic bond market could help reduce vulnerabilities from increased exposure to foreign financing as well as from spillover from the global financial market turmoil.
B. Corporate Financing in Indonesia
Evolution of Capital Structure
53. The nonfinancial corporate sector in Indonesia has diversified its sources of financing over time. Total identified sources of corporate financing (including foreign loans, bank loans, corporate bonds issued onshore and offshore, and public equity issuance) were equivalent to about 30 percent of GDP in 2007. Corporate debt—i.e., total financing minus cumulative equity financing—reached about US$110 billion in 2007 or 28 percent of GDP.24Figure 2 shows corporate debt growing at a slower pace than total corporate financing, especially in the last two years, consistent with de-leveraging. Additional attributes of the nonfinancial corporate capital structure in Indonesia are the following:
- Foreign financing is a significant source of corporate financing. Although foreign loans to nonfinancial firms reported to Bank Indonesia have increased at an average growth rate of just 1 percent between 2003 and 2007, once corporate bonds issued offshore (not included in BI’s data) are incorporated into the total, the share of foreign financing exceeds 47 percent in 2007.
- Domestic bank loans to the corporate sector have accelerated in recent years. In US$ terms, the value of bank loans reported by Bank Indonesia increased by 17 percent annually on average between 2003 and 2007, after having declined drastically following the Asian crisis. Specifically, banks reluctance to lend to some segments of the corporate sector led to a reduction of 60 percent of bank loans to the corporate sector between 1997 and 2003. In 2007, bank lending to the corporate sector reached 40 percent of total corporate financing, up from 34 percent in 2003.
- Equity issuance has been encouraged by rising stock prices. Cumulative equity issuance since 2000 has reached an equivalent of 10 percent of total financing in 2007, increasing more than twofold in the last four years. In the same period, the Jakarta Stock Price Index (IHSG) increased four times, with stock market capitalization reaching 50 percent of GDP in 2007, compared with 23 percent in 2003.
- Nonfinancial corporations show a strong preference for issuing corporate bonds offshore. Corporate groups with access to foreign financing find that offshore bond issuance allows them to benefit from access to a larger pool of investors, lower intermediation costs and tax advantages relative to bonds issued domestically.25 In 2007, offshore bonds were equivalent to 10 percent of total corporate financing, five times more than the share of onshore bonds. However, onshore bond issuance reached record levels in 2007, showing a substantial growth relative to preceding years (Figure 3).
Figure 2.Indonesia: Composition of Financing - Nonfinancial Corporate Sector
Sources: Indonesia Stock Exchange; Bank Indonesia; and Dealogic.
1/ Nonfinancial corporate sector financing, excluding retained earnings and companies to companies borrowing.
2/ Includes financial corporations.
Figure 3.Indonesia: Offshore and Onshore Corporate Bond Issuance
Sources: Indonesia Stock Exchange; Dealogic; Bank Indonesia; and CEIC Data Co., Ltd.
C. Debt Financing vs. Equity Financing
54. In general, borrowing seems to complement, rather than substitute for, increases in equity. This is consistent with the simultaneous process of de-leveraging and asset expansion reported above. After the crisis, reductions in leverage resulted from debt-equity conversion operations associated with corporate debt restructuring up to 2001. After that period, additional corporate borrowing has been accompanied first by resort to retained earnings and later by increasing equity issuance.26
55. Equity issuance remains moderate and concentrated in a small number of firms. Annual issuance was equivalent to just 4.4 percent of annual trading value in 2007 compared to 11.2 percent in 2003 (also because trading has increased in line with higher expected profitability). Dominant shareholders usually resort to “rights issuance” when issuing equity, by which existing shareholders keep the first preference to buy additional shares or sell the right to third parties. Rights issuance has been equivalent to around 60 percent of total equity issuance in the last four years (Figure 4).
Figure 4.Indonesia: Corporate Sector's Retained Earnings & Equity Issuance
Sources: Indonesia Stock Exchange; and Thomson One.
1/ Includes financial corporations.
56. Several large corporate groups remain unlisted in the stock exchange. Based on information for the largest 20 corporate groups, non-listed companies held 32 percent of total assets in 2006. Excluding Astra, the largest conglomerate operating in a number of sectors in Indonesia, the share of listed companies is only 44 percent.27 Reasons for this include reluctance to release information and concerns regarding control. To reduce the scope for regulatory arbitrage the government has introduced new reporting requirements to large firms whether they are listed or not in the stock exchange.
D. Determinants of Corporate Leverage
57. Investment decisions are affected by firms’ capital structure. Modigliani and Miller (1958) identified a set of strict conditions that make a firm’s value independent of its capital structure, namely the absence of transaction costs, taxation, inflation, and bankruptcy costs as well as independence of financing and investment decisions. A substantial body of literature has found that the relaxation of one or more of these conditions is sufficient to reach the opposite conclusion. Because the valuation of firms has implications for investment decisions, it is important to identify the drivers of corporate leverage going forward.
58. More than 10 years after the crisis, are the determinants of corporate leverage in Indonesia consistent with experience in comparable countries? This paper uses annual data from nonfinancial companies listed on the stock exchange to analyze recent trends and estimate standard models from the corporate finance literature in order to identify the drivers of corporate leverage decisions across firms and over time. Some other specific questions are:
- Are the determinants of corporate leverage and their coefficients comparable with other countries? Or do the lingering effects of the crisis period still play a role?
- What explains the process of de-leveraging since the crisis? Have Indonesian firms faced financial constraints when making decisions related to leverage?
- Is there evidence of appetite for control that may have led shareholders to bypass investment opportunities?
59. The approach used in the paper to identify the determinants of corporate leverage is consistent with conventional empirical work. Following Rajan-Zingales (R–Z), the paper uses as explanatory variables measures of tangibility of assets (the ratio of fixed to total assets); the market-to-book value of equity (usually used as a proxy for investment opportunities); firm size (measured by the logarithm of sales) and profitability (return on assets).28 The summary charts below show the evolution of the variables used for the regression analysis in this section (Figure 5). The justification for the use of these variables in the case of Indonesia is as follows:
- The greater the proportion of tangible assets on the balance sheet of firms, the more willing are lenders to supply loans, and leverage is higher.
- Firms expecting high future growth (measured by the ratio of market capitalization to the book value of assets, MtB) should use greater equity finance to benefit from the higher market valuation of shares (lower leverage).
- Larger firms tend to be more diversified and less prone to failure, therefore size may be used as an inverse proxy for the probability of bankruptcy perceived by creditors (allowing for higher leverage).
- In line with Myers and Majluf (1984), a negative relationship between profitability and leverage would be explained by a preference to finance firms’ activities with internal funds rather than debt. Thus, a negative sign would reveal the absence of financial constraints.29
Figure 5.Indonesia: Evolution of Main Variables Used in Regressions
Source: Thomson One and Companies' Annual Reports.
60. Profitability and equity valuation are quite significant in explaining corporate leverage. The paper uses the R–Z model as a benchmark to identify the determinants of corporate leverage. First, an OLS cross-section regression is run with the Debt-Capital ratio as the dependent variable, defined as debt divided by debt plus equity, as in R–Z. Two other regressions using the Debt-Asset ratio (D/A) instead of the Debt-Capital ratio are also estimated. The lag structure used in this section is consistent with R–Z: the data for leverage ratios correspond to the year 2006 while the data for explanatory variables correspond to the period to the average for 2002–05.30Table 1 shows that, using the pure R–Z approach (equation 1), tangibility and profitability are found significant and show the expected sign. By contrast, MtB is strongly significant but with the opposite sign. Size does not appear to be very significant. Using the more conventional D/A ratio (equations 2 and 3), significance improves, but the overall results remain the same. In the rest of the paper, the D/A ratio is therefore used as the dependent variable, consistent with many other empirical applications of the R–Z framework.31
|Debt to Capital 1/||Debt to Asset 1/|
|United States||Canada||Japan||(1) Indonesia||(2) Indonesia||(3) Indonesia (no constant)|
|Tangibility||0.50 ***||0.26 ***||1.41 ***||0.81 *||0.28 ***||0.27 ***|
|Market-to-book||–0.17 ***||–0.11 ***||–0.04||–0.27 **||0.16 ***||0.15 ***|
|Sale||0.06 ***||0.08 ***||0.11 ***||3.78||2.06||1.3 **|
|Profitability||–0.41 ***||–0.46 **||–4.26 ***||–1.98 ***||–1.04 ***||–1.01 ***|
For R–Z equations, the dependent variable corresponds to 1991, and for Indonesia to 2006.
For R–Z equations, the dependent variable corresponds to 1991, and for Indonesia to 2006.
61. A positive response of leverage to increases in MtB is not an uncommon finding in empirical applications of the R–Z framework in emerging markets. Three possible explanations are: (i) issuance may not increase more rapidly than borrowing when stock prices go up because of shareholders’ concerns regarding control; (ii) stock prices are too volatile to be relied upon for issuance decisions; and (iii) creditors may be ready to finance firms showing high MtB at better terms—encouraged by potential growth opportunities—inducing firms to increase borrowing. However, it is important to assess whether there are idiosyncratic effects regarding firm and sector-specific factors; and/or specification problems, with important explanatory variables being left out from the equation.
62. Idiosyncratic effects associated with individual firms improve the results of the regression. The results are compared with a similar exercise performed by Booth and others (2001) for other countries in the region.32 Consistent with Booth and others, the analysis finds that idiosyncratic effects are important (generally consistent with a high R square). For Indonesia, the sign and significance of MtB and profitability remain high. By contrast, although tangibility shows a positive sign, the results are not significant, while size is not significant and shows the wrong sign. A limitation of using panel regressions to assess the R–approach is that the impact of variables such as size and tangibility (which is the reason why the R–prefer a cross-section regression) is assumed not to change over time. However, for some countries for the period 1980–1990 size shows the right sign and is significant, which suggests that the low significance of size in the regressions for Indonesia may be related to the lingering effects from the crisis—i.e., creditors mistrust large firms following the bad experience at the time of the crisis.
|Debt to Asset|
|Tangibility||–0.261 ***||0.013||0.062||0.326 ***||0.01|
|Market-to-book||0.015 ***||0.014 **||0.014 ***||0.019 ***||0.1 ***|
|Sale||1.186||1.801 ***||6.64 ***||3.855||–3.41|
|Profitability||–0.664 ***||–0.934 ***||–0.52 ***||–0.539 **||–0.16 ***|
Fixed-effects estimation results shown in BADM (2001).
Fixed-effects estimation results shown in BADM (2001).
63. Changes in leverage are significantly explained by relative indebtedness at the beginning of the period. An alternative specification is used to explore the post-crisis process of de-leveraging while introducing sector-specific effects. This specification is still consistent with the R–Z framework, while incorporating idiosyncratic effects at the industry level, which are likely to contain information that may have been left out in the original regression. The dependent variable is now the change in D/A between 2000–05 (change in leverage), and the additional explanatory variable measures the deviation of D/A from the sectoral mean for each firm at the beginning of the sample period. Firms showing high leverage relative to the sectoral mean at the beginning of the period would be expected to reduce leverage over time regardless of the evolution of other variables. Table 3 shows that the results from this exercise are highly significant, with the coefficients for size and tangibility showing the right sign and being significant at the 85 percent confidence level.
|Change in Debt to Asset |
Ratio Between 2000 and
2005 Indonesia 2001–05
|D/A initial deviation||0.83 ***|
64. In conclusion the empirical assessment of the determinants of corporate leverage in Indonesia suggests the following:33
- Determinants of corporate leverage in Indonesia are broadly consistent with comparable countries, but some lingering effects from the crisis persist. High leverage after the crisis contributes significantly to explain de-leveraging. For every percentage point that D/A was above the corresponding sectoral average in 2000, firms reduced their D/A ratio by 0.8 percentage points in the following five years.
- Overall, Indonesian firms do not seem to face financial constraints. The high significance and the high absolute value of the coefficient of the profitability variable suggest a strong preference by firms to use their funding before resorting to borrowing. However, at the beginning of the sample period, both creditors and borrowers may have been discouraged to contract loans in light of high debt levels inherited from the crisis.
- Shareholders of Indonesian firms attach substantial importance to control. The significance and the value of the MtB coefficient are relatively high by regional standards, showing that firms are quite sensitive to changes in stock valuation in making borrowing decisions (i.e., increasing leverage when the market valuation of their equity increases).
E. Corporate Financing and Global Financial Conditions
65. The nonfinancial corporate sector in Indonesia seems financially strong, but will face new challenges in coming months. Tighter liquidity conditions in global markets and increased risk aversion has resulted in a sharp rise in corporate bond spreads in recent months, affecting emerging markets, including Indonesia. However, abundant liquidity in domestic financial markets has allowed for a shift toward domestic sources of financing.
66. Under these circumstances, the following new potential vulnerabilities need to be closely monitored (Figure 6):
- Offshore corporate bond issuance has been greatly reduced since September 2007. Reportedly, some other sources of offshore financing such as private placements have also dried up, though external bank loans and equity issuance seem to be holding up.
- High market volatility and uncertainty may affect equity issuance plans in the future. However, issuance remains high compared to historical levels, and expansion plans associated with announced initial public offerings are expected to continue, although some delays have been reported.
- Bank loans to the corporate sector have exceeded average loan growth in recent months. Also, lending in foreign currency to nonfinancial corporate groups has at times grown more rapidly than lending in domestic currency, which may result in borrowers’ currency mismatches, though many of these loans are reported to be to the export orientated commodity sector.
- Banks may eventually face constraints on raising funds abroad that so far have affected only the nonfinancial corporate sector. Given that the loan-deposit ratio is much higher than for foreign than for domestic currency intermediation, banks may eventually need to borrow abroad to satisfy increasing corporate demand for foreign currency loans.
- If global liquidity tightens further, the corporate sector may face a trade-off between borrowing at higher costs or postponing investment projects. If tight liquidity globally and domestically lead to financial constraints, only firms that maintain high profitability and high market stock valuation would continue enjoying access to borrowing from foreign and domestic sources.
Figure 6.Indonesia: Recent Developments on Corporate Financing
Sources: Bank Indonesia; Indonesia Stock Exchange; and Dealogic.
NFC: Nonfinancial Corporate Sector.
F. Conclusions and Policy Implications
67. Are Indonesian corporations still affected by the legacy of the 1997 crisis? On the one hand, large firms do not seem to enjoy a clear advantage in access to financing as is the case in comparable countries. Also, high indebtedness inherited from the crisis has induced a process of de-leveraging that has continued until very recently. However, these lingering effects now appear to have largely subsided in light of increasing bank intermediation and low leverage ratios.
68. What will be the main drivers of corporate leverage going forward? Favorable market valuation of equity and possibly some narrowing in profit margins may result in some increase in corporate leverage in the future. However, this may not take place in the event of a slowdown accompanied by financial constraints in credit markets.
69. What are the main challenges arising from the current global and domestic financial conditions, given Indonesia’s corporate financing structure? A shift from foreign sources of financing to domestic bank financing raises the possibility of maturity mismatches because of the short maturity of bank liabilities, and could become a concern if medium-term resources are not widely available to banks. The apparent preference of firms for long-term financing in foreign currency may lead to currency mismatches, including for banks if they have limited access to foreign credit.
70. Regulators and market participants need to be watchful of emerging vulnerabilities to ensure financial stability and a favorable investment outlook. In view of already rapid credit growth, measures to encourage further lending to the corporate sector are not necessary and may be counterproductive. Undue incentives to increase bank lending may result in problems of inadequate monitoring by supervisors, reduced risk aversion by borrowers, and deterioration of credit quality (maturity/currency mismatches, increased credit risk, excessive leveraging by some firms). Surveillance by regulators and financial authorities must be strengthened to monitor corporate financing developments and encourage the preparation of contingency plans by creditors and firms in case financial conditions remain adverse for a prolonged period of time.
71. The authorities should take the necessary steps to preclude eventual financial constraints from becoming an obstacle to investment. In this regard, it seems appropriate to assess differential tax and legal treatment regarding equity issuance against competing jurisdictions. Also, steps to encourage a diversification of ownership, such incentives and elimination of opportunities for regulatory arbitrage, would reduce shareholders’ preference for control over time, reducing the possibility of delayed investment decisions because of control considerations. Consistent with this, recent measures to improve corporate transparency and encourage firms to list in the stock exchange, such as tax incentives and stricter reporting requirements for non-listed firms, are steps in the right direction. Complementary measures should aim at removing obstacles for institutional investors to allocate medium- and long-term resources to the corporate sector.
BoltonPatrick andXavierFreixas2000“Equity, Bonds, and Bank Debt: Capital Structure and Financial Market Equilibrium under Asymmetric Information,”The Journal of Political EconomyVol. 108No. 2 pp. 324–351.
BoothLaurenceVaroujAivazianAsliDemirguc-Kunt andVojislavMaksimovic2001“Capital Structures in Developing Countries,”The Journal of FinanceVol. 56No. 1 pp. 87–130.
HackbarthDirkJianjunMiau andErwanMorellec2006“Capital Structure, Credit Risk, and Macroeconomic Conditions,”Journal of Financial EconomicsVol. 82 pp. 519–550.
HarrisMilton andArturRaviv1991“The Theory of Capital Structure,”The Journal of FinanceVol. 46No. 1 pp. 297–355.
KorajczykRobert andAmnonLevy2002“Capital Structure Choice: Macroeconomic Conditions and Financial Constraints,”Journal of Financial EconomicsVol. 68No. 1 pp. 75–109.
ModiglianiFranco andMerton H.Miller1958“The Cost of Capital, Corporation Finance and the Theory of Investment,”The American Economic ReviewVol. 48N° 3 pp. 261–297.
MyersStewart1976“Determinants of Corporate Borrowing,”Sloan School of Management Massachusetts Institute of Technology Working Paper No. 875–76.
MyersStewart1984“The Capital Structure Puzzle,”The Journal of FinanceVol. 39No. 3 pp. 575–592.
MyersStewart andN.Majluf1984“Corporate Financing and Investment Decisions when Firms have Information that Investors do not have,”Journal of Financial EconomicsVol. 13 pp. 187–221.
RajanRaghuram andLuigiZingales1995“What Do We Know about Capital Structure? Some Evidence from International Data,”The Journal of FinanceVol. 50 N° 5 pp. 1421–1460.