Information about Asia and the Pacific Asia y el Pacífico

10 Indonesian Financial System: Its Contribution to Economic Performance and Key Policy Issues

John Hicklin, David Robinson, and Anoop Singh
Published Date:
July 1997
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This paper examines the structure of the financial system in Indonesia and considers its past and prospective contribution to the country’s economic performance. The focus is on the banking system and securities markets, which are the primary mechanisms for mobilizing savings and allocating investment funds. It also examines the performance of the financial system through the analytical lens of its contribution to growth, stability, and efficiency, using where possible the theory of financial markets. It considers a wide variety of data, although the unavailability of sufficiently detailed, published material for the most part precludes formal econometric tests.

Structure of the Financial System

The Indonesian financial system relies heavily on bank finance and internal finance. The role of securities markets has been small, although the stock market is growing rapidly.

Data on Indonesian Financial Structure

Indonesian finance has historically been dominated by banks. Flow of funds accounts show that approximately 40 percent of savings by the private sector flow into bank deposits (Table 1). Most of the rest of these savings remain within the private nonbanking sector, on which data exist only in aggregate form. It seems probable that much of the residual savings is retained by the original savers and a substantial part of capital formation is self-financed. The flow of funds accounts indicate that 30–45 percent of private capital formation is financed by bank credit and most of the rest is financed within the domestic private nonbanking sector. According to these accounts, finance provided directly by the government and foreigners declined during 1991-94.

Table 1.Indonesia: Role of Banks in Private Finance
(In trillions of rupiah)
Domestic private nonbank sector
Gross savings39.149.058.867.5
Gross capital formation51.253.267.586.2
Bank deposits and currency14.520.226.329.5
Credit from domestic banks19.315.731.037.5
Credit from Bank Indonesia and central government7.
Credit from foreign sources8.
(In percent)
Private nonbank savings intermediated by banks37.141.244.843.7
Private nonbank investment
Intermediated by banks37.729.545.943.6
Financed by government15.
Financed abroad16.916.01.83.2
Financed within sector30.045.348.351.7
Source: Bank Indonesia, Indonesia’s Flow of Funds Account Matrix, 1991-94.
Source: Bank Indonesia, Indonesia’s Flow of Funds Account Matrix, 1991-94.

Available data indicate that the bond market provides a very small part of commercial finance, while the stock market provides just over one-third and banks provide just under two-thirds of the total (Table 2). However, these figures substantially overstate the role of the stock market, because capitalization includes shares that have never been sold on the stock market. A reported 70 percent of total shares are held by company founders, including those held by the government after partial privatizations. If a rough adjustment is made for these unissued shares, the stock market has provided about one-seventh of total business finance, and banks have provided a little under six-sevenths.

Table 2.Indonesia: Role of Bank and Securities Finance
19941995In percent of total business finance
In trillions of rupiah
Bank credit (commercial credits only)142.2176.465.762.4
Total securities market capitalization74.2106.134.337.6
Stock market67.798.831.335.0
Bond market6.
Source: Bank Indonesia (1995).Note: Data are for end-March.
Source: Bank Indonesia (1995).Note: Data are for end-March.

The role of financial intermediaries, including insurance companies and nonbank finance companies in Indonesian markets, is small compared with that of banks. Banks own over 85 percent of the total assets of this group of intermediaries, which excludes pension funds because of a lack of consistent data (Table 3). The first domestic mutual fund in Indonesia began operations only in late 1995.

Table 3.Indonesia: Size of Selected Financial Intermediaries
(In trillions of rupiah)
Commercial banks (total credit)115.7124.2153.9
Of which:
State banks61.869.173.7
Private national banks42.342.564.6
Local government-owned banks2.62.93.5
Foreign and joint banks9.19.712.1
Insurance companies (assets)
Of which:
Life insurance1.61.95.6
Social insurance3.64.32.3
Indemnity insurance and reinsurance2.62.83.3
Finance companies (assets)8.410.111.9
(In percent of bank credit and assets of other companies)
Commercial banks87.786.786.9
State banks46.848.241.6
Private national banks32.029.636.5
Insurance companies6.06.36.4
Finance companies6.37.16.7
Source: Bank Indonesia (1994, 1995).Note: Bank data as of end-March; insurance and finance company data as of end-December of preceding year. Pension funds are excluded because of a lack of consistent data; Leechor (1996) indicates these controlled assets totaled Rp 18.6 trillion at end-1994.
Source: Bank Indonesia (1994, 1995).Note: Bank data as of end-March; insurance and finance company data as of end-December of preceding year. Pension funds are excluded because of a lack of consistent data; Leechor (1996) indicates these controlled assets totaled Rp 18.6 trillion at end-1994.

Economic Implications of Structure

The key link between the financial system and economic growth is mobilizing savings and channeling them into productive investment. Indonesia has high saving and investment rates relative to most other countries in the world, although not relative to some of its neighbors. Prima facie, this suggests that the financial system, by intermediating a large share of savings and investment, has successfully fostered growth. However, it is possible that with a different financial structure, Indonesian growth could be higher and the saving and investment rates could be larger.

At least two aspects of Indonesian financial structure have potential effects on macroeconomic stability. First, the dominance of bank debt over other forms of finance can facilitate the operation of monetary policy by raising the importance of the banking system relative to other parts of the financial system. This makes the transmission of Bank Indonesia’s monetary policy to economic activity more direct and potentially more precise and predictable. Second, the dominance of banks also has negative implications in that enterprises have fewer alternative sources of finance than in some other countries. Recent efforts to tighten regulation of the commercial paper market may exacerbate this effect, although the close links between that market and banks or bank affiliates reduce the degree to which it truly represents an alternative source of finance. The dependence of firms on bank finance increases the risk of a credit crunch, which could magnify the effects of an economic downturn.

The financing of investment projects by internal corporate funds, or at least by funds internal to a conglomerate group, appears to play a major role in Indonesia. The literature suggests that this is an effective way to finance capital formation, because there tend to be fewer informational asymmetries in such arrangements than in more arm’s-length transactions. Nonetheless, the prevalence of self-finance may indicate that other channels of finance are not working well, which may inhibit growth. There is also the agency-theoretic concern that heavy use of self-finance indicates a high level of free cash flow that is being inefficiently deployed. More data would be needed to evaluate these questions. However, evidence on the effects of the 1983 liberalization of interest rates and bank credit on enterprise finance (Goeltom, 1995) shows that enterprise borrowing costs increased, but that reliance on internal finance by smaller firms and by firms not connected to a conglomerate decreased. Goeltom also finds that after the interest rate increase that accompanied liberalization, firms that were not entirely self-financed were more efficient, suggesting that the liberalization increased the efficiency of the allocation of investment.

The development of the stock market has positive implications for growth in Indonesia. A stock market is a necessary component of the development of sources of finance for risky investments in growing sectors of the economy. While venture capital so far plays a small role, the development of a larger venture capital sector could help channel initial finance to small firms, which could access the stock market later in their life cycle. Without venture capital, self-finance augmented by bank loans is likely to be the primary source of finance for risky firms.

The financial structure has other effects on economic efficiency. For example, Indonesian residents benefit as the set of available savings and financing vehicles becomes larger. The benefits result from financial markets’ becoming more complete, which, according to standard microeconomic theory, increases welfare. There has been much progress in recent years on expanding the range of financial products, with the development of the stock market and pension funds, as well as money market instruments and, most recently, stock warrants. Indonesia lacks an exchange for financial futures and options. Although such derivative products could enhance efficiency, it will be argued later in this paper that the supervision of the financial system should be improved before such an innovation is contemplated.

While positive real interest rates have helped encourage short-term personal savings, there is a dearth of vehicles for long-term savings. Reform of the pension system, including efforts to make employer-sponsored plans more attractive (Leechor, 1996), could help attract more savings and also channel the savings more to long-term investments such as stocks and bonds. Development of the life insurance industry could make a similar contribution.

Growth depends on the efficiency of investment, particularly the extent to which funds are allocated to high-return projects. One factor that influences efficiency is the enforceability of investment contracts and related agreements. The World Bank (1996) recently examined this issue and concluded that there are substantial legal impediments to financial contracting. Action to alleviate these impediments, which hinder both bank lending and bond finance, would ensure that intermediaries allocate funds more according to the criteria of economic risk and return than to the availability of other means to enforce contracts, such as social relations between counterparties.

Banking System

The number of commercial banks grew rapidly, from 111 in 1989 to approximately 240 in 1994, when the authorities placed stricter limits on the issuance of new bank licenses. Large state-owned banks and regional government-owned development banks coexist with a rapidly growing sector of privately owned banks and partly or fully foreign-owned banks (Table 4). The large state-owned banks and the private national banks together accounted for 87 percent of total banking assets at the end of 1995. Although distinctions have diminished in recent years, the seven state-owned banks consist of five that began as sectoral lending banks, a former development bank, and a former savings bank. During 1991-95, the assets of the private national sector grew at an annual rate of 26 percent, while the state bank sector grew at a 12 percent annual rate. By 1994, the assets of the private national sector had surpassed those of the state bank sector. Foreign-owned banks consist of joint ventures between foreign banks and domestic investors as well as branches of foreign banks. Indonesia does not permit wholly owned subsidiaries of foreign banks in Indonesia, and only foreign banks with existing branches may open new branches. Foreign banks without a preexisting presence must enter through a joint venture.

Table 4.Indonesia: Composition of the Banking Sector
Number of banks
State commercial banks77777
Local government-owned banks2727272727
Private national banks129144161166165
Joint banks1920293031
Foreign banks1010101010
Number of offices
State commercial banks1,3951,4341,4551,4901,635
Local government-owned banks580613639645705
Private national banks3,2603,3853,6013,8064,160
Joint banks2431455052
Foreign banks999498100103
Assets (in trillions of rupiah)
State commercial banks78.093.3100.6104.5122.6
Local government-owned banks4.
Private national banks58.566.388.2113.8147.5
Joint banks5.67.511.814.317.9
Foreign banks7.
Sources: Bank Indonesia (1994, 1995, 1996).
Sources: Bank Indonesia (1994, 1995, 1996).

Liberalization of the banking system began in 1983 (Binhadi, 1995; and IBCA, 1995) with a liberalization of interest rates, the elimination of credit ceilings, and the introduction of indirect monetary instruments. As part of a package of deregulatory measures passed in 1988, reserve requirements were reduced from 15 percent to 2 percent, licensing for new private banks and foreign joint-venture banks was re-opened, and permission was granted to state-owned firms to deposit 50 percent of their short-term funds with private banks instead of only with state-owned banks. The number of privately owned banks exploded after this measure. Further deregulation the following year eliminated the need for Bank Indonesia approval for medium- and long-term loans and removed ceilings on offshore loans. Regulators also enacted a restriction on bank lending to related parties and a limit on net foreign exchange open positions and limits on equity activities of banks.

The authorities have strengthened the regulation of the banking system in the 1990s. They introduced a risk-weighted capital adequacy ratio, effective end-1993, which mirrored the one adopted by the Group of Ten countries through the Basle Committee on Banking Supervision, and enacted minimum loan-loss provisions. In the face of slowing activity in 1993, the authorities relaxed regulations somewhat, although they tightened the legal lending limit, which governs bank exposures to single borrowers and to parties affiliated with the bank.1 Banking Act No. 7 of 1992 converted state banks to limited-liability companies and permitted them to lend to nonpriority sectors. Despite the imposition of limited liability, which in principle limits the amount of state support available, the Ministry of Finance announced in 1994 that it would not permit a state bank to default on its obligations (Chan, 1995a). In 1995, reserve requirements were raised to 3 percent from 2 percent, effective February 1996. In addition, the minimum capital required for banks with foreign exchange licenses was tripled, and the capital adequacy ratio for these banks was raised from the 8 percent that currently applies to all banks to 12 percent, with both of these measures to be phased in over a five-year period ending in 2001. Bank Indonesia has developed a supervisory system patterned on the U.S. CAMEL system (capital, asset quality, management, earnings, and liquidity) and undertakes annual on-site examinations of banks. It remains responsible for bank supervision and regulation, while the Ministry of Finance has authority to grant and revoke bank licenses.

The substantial asset quality problems banks experienced in the early 1990s were part of the impetus for the tightening of supervision and regulation. These problems appear to have been due to lax lending controls, exacerbated by the effects of a tightening in monetary policy in 1991. The problems of state banks culminated in the rescue in 1995 of Bapindo, which had built up an overwhelming percentage of nonperforming loans. Earlier, a government program had been set up with the support of the World Bank to recapitalize and restructure the five state commercial banks. Problems among private banks led to the first bank failure in Indonesia in over twenty years, that of Bank Summa in 1992.

Some Indonesian banks continue to be adversely affected by problem loans and reported asset quality continues to be worse at state banks than at private banks. Official figures indicate that classified credits for the banking system as a whole declined from a peak of 14 percent of total loans at the end of 1993 to 10 percent at the end of 1995. However, the improving trend of this ratio appears to be largely due to the continued fast expansion of bank credit. Nonperforming loans comprised about 17 percent of total credits extended by state banks at the end of 1995, but only 5 percent of private bank credits (Table 5). Private foreign exchange banks (which tend to be the larger private banks) had substantially better asset quality than the smaller, private nonforeign exchange banks (Chan, 1995b; and World Bank, 1996).

Table 5.Indonesia: Commercial Bank Nonperforming Loans
(In percent of total credits)
All banks
State banks2
Private banks
(In trillions of rupiah)
Memorandum items:
Total credits177.5217.0267.8
State banks99.1104.1120.9
Private banks79.8108.5141.3
Source: World Bank (1996).Note: Data are for end-December.

Bad loans are the lowest quality of three categories of nonperforming loans.

Includes the five state commercial banks, Bapindo, and Bank Tabungan Negara.

Source: World Bank (1996).Note: Data are for end-December.

Bad loans are the lowest quality of three categories of nonperforming loans.

Includes the five state commercial banks, Bapindo, and Bank Tabungan Negara.

There are indications that a significant number of banks are under-capitalized and have not yet complied with some important prudential rules, although compliance appears to be improving. According to Bank Indonesia, 15 banks did not meet the required 8 percent capital adequacy ratio in April 1996, down from 21 banks in December 1995, while 41 banks did not comply with the legal lending limit; this was an improvement from the 70 banks in December 1995. Twelve of the 77 licensed foreign exchange banks did not meet the rules on net open foreign exchange exposure. Private banks have accounted for most violations (Table 6).

Table 6.Indonesia: Number of Banks Not in Compliance with Prudential Rules, 1995
Total Number in Category1Capital Adequacy Ratio2Legal Lending Limit2Loan-Deposit Ratio2
State banks7021
Private banks166185611
Local development banks27230
Foreign and joint-venture banks40196
Sources: Bank Indonesia (1995) and Indonesia Observer, “Banks Suffer US$4.5 Billion in Bad Loans,” January 26, 1996.



Sources: Bank Indonesia (1995) and Indonesia Observer, “Banks Suffer US$4.5 Billion in Bad Loans,” January 26, 1996.



Impact of the Structure of the Banking System on Growth and Efficiency

Poorly capitalized banks tend to make economically suboptimal lending decisions. In the theory of banking, a poorly capitalized bank has an incentive to make riskier loans if depositors and shareholders expect to get bailed out if the bank fails. Bank shareholders in essence own a put option. If the loan portfolio does well, they gain the proceeds, but if the portfolio does poorly, their losses are limited by the willingness of the authorities to bail out the bank. Without the possibility of a bailout, creditors would demand a higher payout, and market pressure would operate on bank owners to reduce risks. However, if creditors expect to get bailed out, bank owners do not face this market pressure. Bank owners maximize the expected value in their put option by choosing a portfolio with high risk. In a system where a number of banks operate with low capital, the economy will end up selecting production technologies that are riskier than optimal, given the expected returns of those projects, and tax-payers consequently bear more risk than is optimal.

The level of problem loans suggests that not only undercapitalized banks have been making poor lending decisions. The ownership structure of Indonesian banks also influences the efficiency of asset allocation. State banks may not be required to make lending decisions on a commercial basis and, although direct information on this does not seem to be available, it is clear that problem loan ratios are much higher at state banks. In addition, many private banks are owned by affiliates of large corporate groups. There is a risk that they will make lending decisions in the interest of the owners of these groups—rather than ones that maximize returns for the banks—and that the legal lending limit will not be observed.

Problems in the legal system may also influence bank lending and steer lending to areas with fewer legal risks rather than toward the highest economic return. The World Bank (1996) has cited difficulties in the use of collateral in Indonesia. Lenders have limited recourse if a borrower fails to make payments. The bankruptcy law is said to be inadequate, and there is also no adequate framework for restructuring corporations (IBCA, 1995).

A second, broader efficiency question is whether banks are operating as competitive entities. Competition induces marginal cost pricing in both lending and deposit markets, as well as efficient use of resources to produce banking services. Direct evidence on this issue is absent in Indonesia. In general, however, the authorities do not appear to focus on ensuring a level of competition among banks adequate to produce competitive pricing on loans and deposits. The often-expressed concern that Indonesia is overbanked presumes that the entire country can be considered a single and frictionless market, but this is not correct for many banking services. For small and medium-sized business lending and for some consumer finance, the local municipal market is the relevant market. These markets often have a small number of players and relatively high informational barriers to entry on the lending side. For other products, the relevant geographic market is larger, perhaps national or even international, and the likely level of competition is higher. In addition, the current policy curtailing the issue of new banking licenses probably reduces efficiency by restraining entry by new banks that may have more efficient means of producing services. This is especially true of the restrictions on banks with foreign ties. These barriers to entry reduce incentives for existing banks to improve the efficiency of their operations.

Impact of the Structure of the Banking System on Stability

Two types of actual or potential events may affect stability. First, destabilizing shocks can originate within the banking system, such as from a bank failure or a credit crunch. Second, the banking system can be part of the propagation mechanism for macroeconomic effects that originate elsewhere, such as aggregate demand or supply shocks, or changes in the exchange rate or international interest rates.

Problems Originating Within the Banking System

The insolvency and subsequent failure of an individual bank can have implications both for other banks and for the economy more widely. The systemic risk is that the failure of an insolvent bank could put pressure on solvent banks, leading to liquidity problems as deposits are withdrawn. In many countries, such generalized problems do not occur because of the presumption that the central bank will act decisively as a lender of last resort to supply liquidity to banks under pressure. This presumption exists in Indonesia. Nonetheless, it is useful to analyze three different factors that contribute to such an event: first, the likelihood of banks becoming insolvent; second, the likelihood of a bank, insolvent or not, defaulting on its liabilities; third, the possibility that a bank default would cause other banks to default on their liabilities. In the Indonesian context, there is also the risk that the current measures of bank solvency may be inaccurate owing to inaccurate accounting or reporting of asset quality.

One particular area of recent concern has been the extent of property lending, which grew at an annual rate of 37 percent during 1992-95, compared with 22 percent for total bank credit. According to Bank Indonesia, bank credits to property developers had reached 17 percent of total credit by September 1995, when the property market in Jakarta was reported to be facing a glut of unoccupied apartments and, to a lesser extent, hotels and offices. The risk of banks’ indirect exposure—through loans to industries related to the property sector, such as those producing construction materials, or through loans to other borrowers whose creditworthiness depends on assets that include real estate—has also been cited (Chan, 1995b; and Marriott, 1996). Risk is further created by problems in the legal system that make it difficult for banks to enforce loan contracts, so that borrowers who purchase real estate or other assets may walk away from the loan if their equity value turns negative (Sinclair, 1996).

Another concern is the lack of transparency of balance sheets, which means that the value of bank assets may actually be lower than stated. International credit agencies have raised this issue, stating that the adequacy of bank loan-loss provisioning is difficult to assess (Chan, 1995b). It is also possible that some nonperforming loans have been restructured into performing loans, but that these technical restructurings may hide poor-quality assets.

The second bank stability issue is the likelihood that banks will default, which depends, in part, on government policy and on the legal system. The support given Bank Lippo suggests that the possibility of default also depends on the decisions made by other participants in the financial system to maintain stability.2 To help prevent bank failures, the authorities encourage mergers of weak banks with strong ones, offering a variety of inducements, including favorable tax treatments and foreign exchange licenses. Although this policy helps prevent defaults, it implies that some undercapitalized banks remain in business. When coupled with the unreliability of financial reports, this policy decreases the certainty among creditors that they are dealing with a solvent bank. If confidence in the system were to fall for some exogenous reason, this uncertainty would make the impact greater on financial stability. In such an event, the authorities would face the decision of whether to aid a larger number of banks than would otherwise be the case.

The third risk, that a bank failure could prove contagious and induce runs on other banks, remains hypothetical for Indonesia. Bank failures so far, including that of Bank Summa, have not resulted in runs on other banks. The response to the risk of such a situation, which could have damaging economic consequences, is to maintain confidence in banks through strong capitalization and a high level of transparency of bank balance sheets. In addition, one of Bank Indonesia’s justifications for its policy of merging troubled banks has been the potential effect of a bank failure on other banks.

Problems Originating Outside the Banking System

Macroeconomic shocks, including exchange rate or interest rate shocks, can increase the instability of the banking system, and initial problems can magnify their effects. In principle, Bank Indonesia regulations control bank sensitivity to exchange rate fluctuations by limiting bank net foreign exchange exposure to 25 percent of bank capital. This rule is applied to net on and off-balance-sheet exposures combined and to net off-balance-sheet exposures separately. The exposure level specified by the regulation would appear to be low enough to prevent bank insolvency from occurring, but two concerns remain. First, it can be difficult to value bank exposures, especially those related to exchange rate options written by banks. There is little information available on how these derivatives are valued, so exposure may be larger than stated. Second, low net exposures may mask large gross exposures. Many banks have made substantial foreign currency loans, financed by foreign currency deposits. If the rupiah were to depreciate substantially, the rupiah-equivalent obligations of borrowers from the banks could soar, and if this were not offset by an increase in the foreign currency resources available to these borrowers, defaults could occur.

Aggregate foreign exchange liabilities of Indonesian banks have grown rapidly in recent years and comprised 271 percent of total commercial bank equity capital by the end of 1994/95 (Table 7). Although total regulatory capital includes debt-based capital in addition to equity capital, the amount of equity capital alone determines a bank’s solvency level. Foreign exchange credits of banks were 169 percent of equity capital, so that net on-balance-sheet foreign exchange liabilities were 102 percent of equity capital. Any large default on foreign currency loans could therefore quickly begin to erode equity capital. In addition, the separate net open exposure rule for off-balance-sheet instruments prevents banks from hedging these exposures through forwards and options.

Table 7.Indonesia: On-Balance-Sheet Bank Foreign Exchange Exposure
(In trillions of rupiah)
Current foreign exchange liabilities129.231.444.757.362.5
Outstanding foreign exchange credits12.319.323.230.438.9
Equity capital11.910.913.419.823.0
(In parent)
Foreign exchange liabilities-equity capital246288334289271
Foreign exchange credits-equity capital104177173153169
Net foreign exchange liabilities-equity capital143111161136102
Source: Calculations by author using data from Bank IndonesiaNote: Data are for end-March.

Current liabilities comprised 88 percent of total commercial bank liabililities at end-March 1995.

Source: Calculations by author using data from Bank IndonesiaNote: Data are for end-March.

Current liabilities comprised 88 percent of total commercial bank liabililities at end-March 1995.

The degree to which interest rate shocks can harm banks depends on several factors. First, a typical bank borrows on a shorter-term basis than it lends on, so that an increase in interest rates squeezes bank margins. Bank Indonesia statistics suggest that a substantial part of bank liabilities are extremely short term. Second, the degree to which longer-term loans are extended at variable rates affects bank exposure. It is not clear, however, to what extent interest rates on loans are variable in Indonesia. Finally, an increase in interest rates tends to increase nonperforming loans, which creates a negative bank exposure to interest rate increases. Borrowers at variable rates face higher interest payments, while interest rate increases also slow aggregate demand, reducing business profitability and the ability of borrowers—at both fixed and variable rates—to repay loans.

Bank’s sensitivity to exchange rate and interest rate shocks can be greater than their assets and liabilities indicate if they have significant off-balance-sheet derivative exposures. (It can also be less if derivatives are used to hedge balance sheet exposures.) Bank Indonesia recently recognized off-balance-sheet risks and enacted a regulation that limits bank derivative exposures to interest rate and exchange rate derivatives, except for case-by-case exceptions granted for equity derivatives, and requires that potential losses from derivatives not exceed 10 percent of bank capital. Such a modest limit would appear appropriate for a banking system that is still developing a reliable supervisory infrastructure. A potential weakness of the rule, however, is that it appears to offer little guidance on how these exposures should be computed. The valuation of derivatives, particularly options, can be difficult, and this process requires careful supervision.

Securities Markets

Indonesian securities markets have developed rapidly in recent years as alternatives to bank finance. The bond market remains relatively small. The main issues in the development of a securities market are the deepening of the markets—including the continued development of market infrastructure—the expansion of the domestic investor base, and the ongoing improvement of regulation and supervision of securities markets.

Continued Development of the Stock Market

Continued progress in the development of market infrastructure and of supervision and regulation will probably contribute to the creation of a vigorous equity market in Indonesia. This is particularly likely if the supply of funds to the market also increases, through the development of institutional investors and mutual funds, and if demand from growing enterprises for equity finance persists. In June 1994, the Jakarta Stock Exchange introduced a centralized settlement system for all listed securities (International Finance Corporation, 1995). It introduced the computerized Jakarta Automated Trading System in May 1995, which has already led to much larger trading volumes.

Recent years have seen great progress in stock market regulation, with a new capital markets law and a set of implementing regulations promulgated by Bapepam, the capital market supervisory agency. The key area for further efforts appears to be in enforcement of these regulations, particularly in areas that promote transparency and fairness, such as insider trading. A transparent and fair market can make a far larger contribution to market liquidity than even large investments in infrastructure. If traders can be assured that their counterparties do not possess privileged information on the value of the security traded, these traders will more readily supply the counterparties with bids or offers at a narrow spread.

Better disclosure by corporations of their financial condition also promotes market transparency. In an important move, Bapepam and the Indonesian Accounting Institute implemented new accounting standards at the end of 1994. This move brought financial accounting close to international standards, which helps international investors evaluate their Indonesian exposures. Nonetheless, an article in the Financial Times Survey of Indonesia notes that concerns remain among investors about the fairness of corporate disclosure, with poor auditing controls and with information leaking out to some parties before it reaches others (Montagnon, 1996). Continued monitoring of enterprises’ production and release of financial information is important to ensure that it is compiled promptly and accurately and disclosed publicly and fairly.

A deeper and more transparent stock market is also likely, other things being equal, to be a less volatile stock market. However, to the extent that a deeper market depends on international investors, volatility may actually increase as spillovers from other markets intensify. Volatility of stock prices on the Jakarta Stock Exchange (Table 8) was low until December 1988, when the market was opened to international investors, who soon dominated trading.3 The market was also less volatile relative to the U.S. market, chiefly because the crash in U.S. stock prices in October 1987 did not spill over into Indonesia. Since the Indonesian market opened in December 1988, it has been somewhat more volatile than the U.S. market. However, the growing liquidity of the Indonesian market in recent years helps explain why its absolute and relative volatility fell in 1993-96.

Table 8.Indonesia and the United States: Daily Market Index Return Volatility
PeriodAbsolute Volatility1Relative Volatility2
April 1986-December 19882.581.77
April 1986-November 19880.720.49
December 198813.1123.41
January 1989-July 19961.301.78
January 1989-December 19921.581.86
January 1993-July 19960.841.47
Source: Bloomberg Financial Markets

Standard deviation of daily returns of Jakarta Composite Index (in rupiah).

Absolute volatility divided by standard deviations of daily returns of Standard & Poor’s 500 Index (in dollars).

Source: Bloomberg Financial Markets

Standard deviation of daily returns of Jakarta Composite Index (in rupiah).

Absolute volatility divided by standard deviations of daily returns of Standard & Poor’s 500 Index (in dollars).

The flow of foreign investment in the stock market has expanded over time. For example, available data on net investment by U.S.-based investors in the Indonesian stock market show that there was almost no foreign investment before 1990. Investment then increased rapidly and reached a peak in 1994. Thus, foreign portfolio investment was associated with an increase in stock price volatility in the early 1990s, and with a fall in volatility from 1993 onward. The finding that volatility fell from 1993 on calls into question the finding by Roll (1995), based on data running only through 1992, that foreign investment contributed to an increase in Indonesian stock market volatility.

To examine the linkages between international and Indonesian stock market volatility, following Folkerts-Landau and others (1995), squared Indonesian daily stock returns were regressed on the previous day’s squared U.S. stock return (Table 9). The results of this analysis are striking. U.S. volatility had no effect on Indonesian volatility before 1993. During 1993-96, there was a strong linkage. Taken together, these results suggest that, although internationalization has had mixed effects on the volatility of the stock market, foreign portfolio investment has increased the linkages in price movements between Indonesian and foreign stock markets.

Table 9.Indonesia and the United States: Volatility Spillover Analysis
PeriodSpillover Coefficient1
April 1986-December 1988-0.04
April 1986-November 19880.00
January 1989-July 19960.17
January 1989-December 19920.02
January 1993-July 19960.71*
Source: Bloomberg Financial Markets.

Coefficient represents regression coefficient of squared daily return of Jakarta Composite Index (in rupiah) on squared daily return on the preceding day of the Standard & Poor’s 500 Index (in dollars). A constant was also included in the regression. The * denotes significance at the 1 percent level. Other coefficients are insignificant at the 10 percent level.

Source: Bloomberg Financial Markets.

Coefficient represents regression coefficient of squared daily return of Jakarta Composite Index (in rupiah) on squared daily return on the preceding day of the Standard & Poor’s 500 Index (in dollars). A constant was also included in the regression. The * denotes significance at the 1 percent level. Other coefficients are insignificant at the 10 percent level.

Two other issues will be important for the Indonesian stock market. First, with the rapid development of Southeast Asian economies, it will remain in competition with other stock markets in the region, including those in Malaysia, Singapore, and Thailand. As the technology and regulatory environment of these markets advance, the role for offshore trading will increase. On economic efficiency grounds, it is not desirable in the medium term to force trading in Indonesian securities to remain solely in Jakarta. Instead, the creation of a market that is appealing to international investors will also benefit domestic investors, whom the authorities wish to attract to the market. Increased supervisory cooperation with financial regulators in neighboring countries will also be necessary.

Second, the development of stock market derivative products, such as futures and options, can help provide liquidity and improve the process by which new information is incorporated into stock prices. However, such markets require assurances that brokerage firms and investors are capable of dealing with the risk inherent in these instruments. Although derivatives merely repackage risk, they make it easier for investors to take leveraged and potentially explosive risk positions. The supervision and regulation of Indonesian financial markets do not appear to have reached the stage where many such products can be handled safely. This applies to the development of both exchange-traded and over-the-counter products, although with Bapepam’s approval of the first warrant issue in mid-1995 (Yu, 1995), one equity derivative market has been initiated.

Development of a Domestic Bond Market

The bond market in Indonesia is small relative to that in other countries in the region (Table 10). Its small size appears to be due to two factors. First, the legal environment for enforcing debt contracts is relatively weak. Second, there is a paucity of institutional investors, which reduces demand.

Table 10.Size of Financial Sectors in Southeast Asia(In percent of GDP)
Bank assets
Bonds outstanding
Equity market capitalization
Sources: International Finance Corporation (1995); International Monetary Fund, International Financial Statistics, various issues; Dalla and others (1995).
Sources: International Finance Corporation (1995); International Monetary Fund, International Financial Statistics, various issues; Dalla and others (1995).

Difficulties with the legal system result in a bond market in which most issues are overcollateralized. Firms cannot issue bonds for general uses, but must earmark them for particular projects. The weakness of laws protecting collateral and governing corporate bankruptcy make even collateralized bonds risky and costly. To the extent that bonds are not collateralized, they are de facto required to have a guarantor, usually a state bank. Bonds are therefore indirectly obligations of a bank as well. Banks are more likely than a diffuse set of bondholders to succeed in collecting problem debts and to be in a position to evaluate the risk, although a new rule requiring bonds to be rated by the domestic credit rating agency Pefindo may reduce this advantage. For the bond market to grow, the legal system must reach the point where the ability of creditors to protect their claims is strengthened.

Inflation also inhibits the issuance of long-term bonds. International evidence suggests that higher inflation tends to accompany more variable inflation, which in turn inhibits the issuance of long-term fixed-rate bonds, because their real value is subject to great uncertainty. In fact, in recent years, almost all bond issues have carried floating interest rates, which reduce exposure to inflation to a level similar to the exposure of short-term debt instruments. The popularity of fixed-rate bonds in some countries suggests that such bonds could be useful in Indonesian finance.

The Indonesian government currently issues no bonds in the domestic market because of its balanced budget rule. For the government to issue bonds that are large enough to serve as liquid benchmarks, the amount of borrowing would have to be relatively large. A large amount of borrowing, however, would raise domestic real interest rates and crowd out private borrowers; the development of a government bond market is therefore probably not a desirable means of fostering a corporate bond market. Instead, state enterprise bonds, which currently dominate the bond market, could be used as benchmarks (as suggested in Dalla and others, 1995). Indonesia could borrow a technique used for government bond markets in other countries (see International Monetary Fund, 1994) and concentrate state enterprise bond issues into a smaller number of large issues, which could help to develop a secondary market.

Current developments are likely to augment the liquidity of the secondary market in bonds, which now suffers from low trading volume (PT Sigma Batara, 1995). The introduction of a centralized clearing and settlement agency for stocks, slated to be extended to listed bonds, may reduce the cost of settling secondary market trades. Bond trades currently require the risky and costly physical delivery of bearer bonds. In addition, the Over-the-Counter Exchange has developed an on-line information system to disseminate bid and offer prices to all market participants. Plans exist to extend this to screen-based trading.

Development of Nonbank Financial Intermediaries

A key contributor to the growth of securities markets is the development of institutional investors—mutual funds, insurance companies, and pension funds—to channel individual savings into markets. These institutions can be efficient mechanisms through which individuals can pool and repackage the risks of securities markets and reduce transaction costs, thereby helping provide equity and long-term debt finance to the economy.

The role of domestic institutional investors remains small. Mutual funds have been introduced only very recently, with the first closed-end fund starting operation in October 1995.4 Other closed-end and open-ended funds have applied to Bapepam for approval. A new set of regulations drawn up by Bapepam in May 1996 permits funds to invest a maximum of 85 percent of net assets in the stock market and also specifies procedures for portfolio valuation and financial reporting by funds. Regulations were also changed to eliminate the double taxation of mutual funds. For funds to operate properly and to provide income to investors that is equivalent to income received from direct securities holdings, funds must be able to pass through all income to shareholders on a before-tax basis.

Although Indonesia has made some progress in developing pension funds, existing funds now invest 85 percent of their assets in bank deposits (Yu, 1995). Pension funds can be separated into those sponsored by employers and those linked to the government, including a fund for civil service pensions. A previous regulatory limit on the investment of employer-sponsored plans in securities markets has been lifted, although there continue to be ceilings on property investment, individual exposure limits, and limits on self-investment. A key issue for pension funds is the encouragement of investment in securities markets. The high real returns and relative security available in rupiah-denominated bank deposits have been cited as a reason for the low investment in securities.


This paper has examined policy issues raised by the continued development of Indonesian financial markets. In the banking area, key issues are the resolution of problem banks, continued improvement of supervision and regulation, and maintenance of a competitive and efficient market structure. In securities markets, the main issues are the deepening of markets and the development of a domestic investor base, and the further enhancement of supervision and regulation of markets.

Resolving problem banks remains a crucial priority. The efficiency losses and the risks to stability of permitting undercapitalized banks to continue operation are both clear and potentially large. The present policy of encouraging mergers does not seem to be solving the problem fast enough. Although liquidation carries certain risks, these can be minimized if liquidation is undertaken in an environment of predictability and certainty. To create such an environment, shortcomings in the regulatory framework for closing banks would have to be overcome. A credible liquidation policy could also induce banks to undertake efforts to improve their capital adequacy by making closure a more credible threat.

The second important objective is improving the supervision and regulation of banks. This remains critical despite considerable progress in this area during the 1990s. Notwithstanding the exceptions noted above, bank supervision is now more of a concern than regulation. In other words, it is important to ensure that the regulations are enforced. The rapid expansion of bank real estate exposure brings attention to the need for adequate bank supervision. A related issue is the adequacy of information flowing from banks to bank supervisors and to the public; it is not clear how reliable reported figures are on bank capital adequacy and asset quality.

The third major banking issue is the structure of banking markets. First, it is important that a sufficient degree of competition among banks be encouraged through the identification and analysis of banking markets. Second, the eventual privatization of state banks may reduce inefficiencies, and the authorities have indicated their intention to begin the partial privatization of a state bank in the near future. They have not, however, announced any intent to renounce majority ownership in state banks.

In securities markets, and particularly in the stock market, much progress has been made in a short time. Nevertheless, a clear next step on the agenda should be to deepen these markets. There is both a demand side and a supply side to this deepening. The demand for securities can be expanded most effectively by increasing the size and number of domestic institutional investors and, in the case of insurance companies and pension funds, by creating the conditions under which they shift the allocation of assets more toward securities markets. The supply of securities can be increased if entrepreneurs can be convinced of the benefits, in terms of access to new capital, of surrendering majority control of their firms by selling more of their stock on public issues. The continued privatization of state enterprises would also increase supply. In addition to these measures, the bond market could benefit from improvements in the legal environment for debt contracts.

As a final issue, the improvement of supervision and regulation of securities markets is clearly under way. If securities finance is to provide a reliable alternative to bank and self-finance, it is essential that this process continue. In particular, the development of methods to enforce existing regulations, particularly regarding disclosure and insider trading, will help ensure that markets become more transparent and liquid.


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Note: John Montgomery is an Economist in the IMF’s Research Department. The author thanks David Folkerts-Landau and Garry Schinasi for support and encouragement; Geoff Bascand, Christopher Browne, John Hicklin, and Reza Vaez-Zadeh for helpful comments; Robert Dekle, Olivier Frécaut, Subir Lall, and Michael Spencer for useful information; and Scott Anderson for research assistance.
1The rule currently limits exposure to an individual borrower to 20 percent of capital and exposure to a single company to 35 percent (20 percent by March 1997). The sum of exposures to all affiliated entities must not exceed 12.5 percent of capital (10 percent after March 1997).
2In late 1995, Bank Lippo was hit by rumors of real estate losses in the Lippo corporate group. Although the bank reportedly was well capitalized, investors withdrew deposits and the bank entered technical default for one day. A group of private banks cooperated to inject liquidity into the bank so that it could meet its obligations (Sinclair, 1996).
3This is the same measure Folkerts-Landau and others (1995) used to analyze volatilityin Hong Kong, the Republic of Korea, Mexico, and Thailand.
4A closed-end fund has a fixed number of shares and is funded by a onetime offer of shares to the public. In contrast, an open-ended fund has a variable number of shares and permits new share purchases and redemptions at the current net asset value of the fund, which is normally computed daily. Shares in a closed-end fund are traded on a stock exchange at a price that may be either a premium or a discount to the net asset value of the fund.

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