V Indonesia

Tomás Baliño, Charles Enoch, and William Alexander
Published Date:
July 1995
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Indonesia moved toward indirect monetary control in the 1980s in the context of a market-oriented adjustment program that included reforms of the financial sector, government finance, trade, and industry. Contrary to the cases of many other countries undergoing similar transitions, the move took place in an environment of generally favorable macroeconomic and fiscal conditions and an exchange rate system virtually free of restrictions. Because of continuous pressure on the exchange rate, significant capital outflows, and related liquidity crunches in the banking system. Bank Indonesia (BI) was forced partially to redesign some of the initial reform measures; however, the broad direction of the reform was maintained.

Also contrary to many other countries’ experiences, improvements in banking supervision and measures to enhance competition in the banking system, which is dominated by state-owned banks, lagged behind the reorientation of monetary policy and somewhat delayed the full benefits from the introduction of indirect monetary policy instruments. These delays also contributed to the banking crises in the early 1990s, which included severe difficulties for, and even the failure of, several financial institutions.

Motivation for Reform

Until the beginning of the 1980s, the financial sector in Indonesia was highly regulated and barely competitive, and monetary policy relied heavily on direct instruments. BI used credit ceilings and interest rate controls to conduct its monetary policy with the objective of curtailing expansion of domestic credit in a booming economy and accumulating foreign exchange reserves. It also intervened extensively in credit allocation. Aggregate credit ceilings, which were translated into credit ceilings for each bank, were the main monetary policy instrument. Nonbank financial institutions were exempt from those ceilings.

Interest rate ceilings were imposed on both domestic currency deposits and credits and rarely changed, but they did not apply to nonbank financial institutions or to foreign and domestic private banks. As a consequence, these unregulated sectors could increase their combined market share to more than 20 percent of the gross assets of the total financial sector. Under this policy, from 1981 to 1983 state banks’ deposit rates were negative in real terms, while their private and foreign competitors were in a position to offer highly positive real interest rates. The rigid structure of the banking system and of interest rates distorted financial intermediation, reduced the banking system’s international competitiveness, and—together with uncertainties about the future exchange rate—contributed to currency substitution. Foreign currency deposits within the domestic banking system accounted for roughly one-fourth of total bank deposits in 1982, and Indonesian residents increasingly built up deposits abroad.

The effectiveness of monetary policy was also impaired by the quasi-automatic access of banks to so-called central bank liquidity credits at subsidized interest rates. These credits were used to refinance priority sector loans, representing a heavy involvement of BI in credit allocation. A fast expansion of liquidity credit in the presence of binding credit ceilings raised banks’ excess reserves, which averaged 7 percent of deposits in 1978-82, and boosted banks’ holdings of foreign assets at the expense of the central bank.

Overall, the prereform system of monetary control was effective in controlling credit expansion, but un-desired side effects occurred, such as excess liquidity, financial repression, distortions in financial intermediation, currency substitution, and a reduced competitiveness vis-à-vis other Asian financial centers. In addition, the interbank market as well as money and capital markets were underdeveloped and segmented, and banking supervision was inadequate. However, given the abundance of oil revenues, the government’s balanced budgets, and the relatively open access to foreign financial markets, the negative side effects of the monetary control system did not become fully apparent.

This changed drastically when, in the early 1980s, monetary policy was unable to react to the slowdown of the economy and to the deterioration in the balance of payments resulting from falling oil prices. The government began to focus its attention on the reform and expansion of the non-oil sector and recognized the importance of improving both the growth prospects and the efficiency of the financial system.

Process of Reform

Indonesia relied on a gradual approach to reform its financial sector and move toward indirect monetary control. During the entire reform process, BI had to react to speculative capital movements and pressure on the exchange rate, the impact of a major devaluation, and rapidly changing liquidity situations in the banking sector and in certain bank groups. This complicated and slowed the reform process and made the domestic money market vulnerable to sharp contractions and expansions. Nevertheless, Indonesia maintained a largely unrestricted capital account and focused instead on improving the functioning of its domestic financial markets. Macroeconomic and fiscal conditions were largely favorable during the reform years.

In June 1983, credit ceilings and most interest rate controls were removed, and liquidity credit refinancing was sharply reduced. Eight months later, BI introduced open market operations as the main monetary policy instrument, complemented by new rediscount facilities. BI maintained foreign currency swaps and, to a lesser degree, reserve requirements.4

Open market type operations took the form of regular auctions of central bank certificates (SBIs). No government debt instruments were available, given the prohibition against government borrowing.5 SBIs were offered competitively in a multiple-price auction and issued in bearer form in three different denominations with maturities of 30 and 90 days; a 15-day maturity was offered only between October 1984 and May 1985; and a 180-day maturity was added in 1988. The frequency of auctions was increased from once a week initially, to three times a week (October 1984), then to five times a week (July 1985), but then scaled back again to a weekly schedule in August 1986. Auction participation was open to banks and nonbank financial institutions, but the public was allowed to purchase SBIs in the secondary market.

Two new rediscount facilities were established in February 1984, eligible only to banks that were classified as “sound” or “sufficiently sound.” One was designed mainly to help banks to overcome temporary liquidity shortages in their day-to-day reserve management, the other to promote long-term lending and assist banks facing significant maturity mismatches. Limits existed on the use of each facility, and they were used initially only with reluctance, as the discount rate was kept at a penalty level and borrowing was thought to damage banks’ prestige.

The central bank also used foreign currency swaps to control liquidity and stabilize exchange rate expectations. The swap premium was set administratively by BI and altered several times during the first years of the reform process. In contrast, reserve requirements were kept unchanged until 1988.

The ultimate objectives of the central bank’s monetary policy remained unchanged under the new regime. After introducing SBI auctions, BI began using the auction cutoff interest rate as its main operational target, basically pegging it at a level considered consistent with the exchange rate policy and letting market forces determine the quantity. This reflected the authorities’ concerns that money targeting in the face of financial reform would lead to un-acceptably high levels of real interest rates, which might hamper the economic recovery. As a consequence, though, monetary and credit aggregates expanded rapidly and were highly variable, while interest rates throughout the financial system were sticky. Excess reserves persisted, particularly among state-owned banks.

Soon after the beginning of the reform, the money market expanded considerably. However, by mid-1984 it still lacked sufficient depth and liquidity to cope with the sizable capital outflows that resulted from devaluation expectations, thus contributing further to the pressure on the exchange rate. Overnight, interbank interest rates reached 90 percent in September 1984. The liquidity crunch also led to the full use of the existing refinancing facilities. BI relieved the liquidity crunch by directing liquidity-searching banks to a new emergency credit facility and imposing limits on interbank borrowing. Repayment of the special credit facility was due within one year according to a staggered schedule. This central bank assistance eased speculative pressures and lowered interest rates.

To strengthen the money market, facilitate the injection of liquidity, reduce the market’s segmentation, and expand the transaction maturity profile, BI introduced a standardized form of banker’s acceptances (SBPUs) to the money market in February 1985. In general, SBPU rates closely followed the prevailing SBI rates. An investment company (FICORINVEST) was designated as a market maker in SBPUs. Banks were granted individual ceilings to rediscount SBPUs with BI. While private banks relied heavily on the SBPU rediscount facility, state-owned banks still had large excess reserves, which BI tried to mop up through its open market operations in SBIs. Given the role of BI as partner for transactions with both bank groups, regular interbank trading diminished further, making interbank rates more volatile and somewhat delinked from the prevailing SBI and SBPU rates.

While sales of SBIs were modest initially, they picked up in mid-1985 because of efforts by BI to increase their liquidity. For example, in August 1985, FICORINVEST began to rediscount SBIs before maturity.

After renewed pressure on the exchange rate, the authorities devalued the rupiah by 31 percent in September 1986 but continued their efforts to maintain stable interest rates. However, the speculative surges against the rupiah continued, fueled by the availability of excess funds to state-owned banks, which further depleted the central bank’s foreign reserves. At the same time, though, many private and foreign banks had reached their rediscount ceilings and had to borrow short term in the money market, which increased interest rates.

The central bank introduced measures in 1987 to end the speculative attacks on the exchange rate, reverse capital outflows, and eliminate the excess reserves in the banking system. It shifted toward targeting international reserves and allowed the exchange rate and the interest rate to become more market determined. In addition, SBPU rediscount ceilings were eliminated; state-owned companies were forced to transfer some of their deposits from state-owned banks to BI; and the discount rate was raised significantly to induce liquidity-searching banks to sell their foreign exchange to the central bank. Furthermore, the central bank introduced competitive daily auctions of one-week repurchase agreements in SBIs or SBPUs to regain the initiative in transactions with the banking system.

The above measures made the excess liquidity among state-owned banks disappear rapidly, and the liquidity positions of the different bank groups began to converge, while the central bank’s foreign assets began to increase. BI regained the initiative in dealing with the banking system, devaluation pressures disappeared, and interbank interest rates became less volatile and finally began to drop.

In late 1988, a broad package of financial reform (PAKTO) was announced, which also included measures to refine the daily money market operations of BI. A syndicate of 15 private banks and nonbank financial institutions was established to act as dealers and agents for the issuance of SBIs in the weekly auctions and as market makers in the secondary market. BI began to channel all its money market operations through the syndicate. Furthermore, all existing limitations on interbank borrowing were eliminated. PAKTO reduced reserve requirements to a uniform rate of 2 percent on all third-party liabilities. Reserves freed by this decision were absorbed by forced temporary purchases of three- and six-month SBIs by banks. In addition, the premium on foreign currency swaps became market determined.

The PAKTO also included deregulation of financial activities and a strengthening of the supervisory system. Banking deregulation included a relaxation of barriers to entry, to opening branches, and to establishing joint ventures of foreign and domestic institutions; an easing of restrictions on foreign exchange operations; and an expansion of the types of operations that particular banking groups can conduct (for example, allowing public enterprises to deal directly with nonstate banks). As a consequence, competition increased considerably, with a doubling in the number of banks from end-1988 to end-1993, while profit margins, after an initial surge, fell.

BI improved its on-site and off-site surveillance of the banking system and introduced a comprehensive system of capital adequacy and other ratios, provision requirements for bad debt, bank ratings, and standardized accounting principles. Because of increasing difficulties experienced by some banks, including a growing share of nonperforming assets, BI has continued to refine its prudential regulations, without, however, being able to prevent severe banking difficulties, even the failure of some banks, during the past two to three years.

BI has also continued to refine its monetary policy instruments and reserve money management during the 1990s. The 1988 PAKTO reform initiated a rapid growth in bank intermediation. In spite of an increase in interest rates on open market operations and a further reduction in liquidity credits, commercial banks were able to sustain high levels of lending, mainly through increased recourse to offshore borrowing. The increasing demand pressures, led by a rapid growth of investment demand, contributed to an acceleration of inflation.

To contain the growth of money and credit aggregates, BI forced the conversion of state enterprise deposits into SBIs, required the transfer of government deposits to the central bank, limited domestic borrowers’ access to foreign funds, overhauled its swap operations, introduced a limit on banks’ short-term obligations to nonresidents, and further tightened prudential regulations and bank monitoring.


The move toward indirect monetary control, combined with a far-reaching reform of the banking system and financial markets as well as prudent macroeconomic and fiscal policies, led to gains in resource allocation and financial intermediation and improved the international competitiveness of Indonesian banks.

The new system was able to cope with two liquidity crunches, in 1984 and 1986-87, which were caused by speculative capital outflows. The ratios of private sector credit to GDP and of M2 to GDP rose significantly in those years, while the ratios of currency to deposits and of foreign currency deposits to total deposits fell continuously. Private sector credit growth exceeded the growth of deposits during the first years after the abolition of credit and interest rate controls but soon leveled off. The number of financial institutions rose markedly. Competition among banks increased, as shown by the growing market share of private banks from 10 percent in 1982 to 23 percent in 1989, while the share of state-owned banks declined from 80 percent to 69 percent over this period.

Unlike the sequencing pattern in some other countries, the reform of monetary instruments in Indonesia preceded improvements in financial markets and in the structure of the banking system. The segmentation of the banking system between state-owned banks on the one hand and private and foreign banks on the other diminished only after the reorientation in the central bank’s monetary policy in 1987. The recent difficulties and failures of some financial institutions can, to a large degree, be attributed to these delays in reforming the structure of the banking system.

The interest rate targeting of the central bank during the initial phase of the reform slowed down the development of financial markets, as it contributed to a stickiness of interest rates throughout the financial system. Nevertheless, interest rates have been largely positive in real terms since the beginning of the reform. After the 1986-87 crisis, which led to the abandonment of the interest rate targeting. BI actively promoted the development of financial markets and increasingly used them for its monetary policy.

The slow development of financial markets can also be attributed, at least partially, to the incomplete removal of liquidity credits. Central bank refinancing remained high, particularly during the first few years of the reform, and began to decline only after 1988 when the second phase of the financial sector reform improved the structure of the banking system, enhanced the efficiency of the financial markets, and increased competition, and after 1990 when liquidity credits were further curtailed.

Contrary to the usual experience of countries undergoing financial liberalization, Indonesia maintained an open external capital account during the entire reform process. Various shocks forced BI to redesign some features of the new instruments and refocus its operational target; however, the broad direction of the reform toward a more market-oriented approach continued. Overall, the redefinition of the central bank’s operational target in 1987 and the subsequent strengthening of financial markets and the banking system contributed to a reduced vulnerability.

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