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Spreads Out in the Sky

Gathers the Wind

Grandiose and brave challenge the sky. Gathering the power from the universe to across the ocean. It seems no fear to be blown by the wind. Synergized in motion and time to lead the way where the ark goes.

THE ROLE OF FINANCIAL SYSTEM STABILITY IN SUPPORTING ECONOMIC ACTIVITIES

CHAPTER

IV

108

The dynamics of the global and domestic economies over the past two years have demonstrated that financial system stability has played a more strategic role in supporting economic activities. This was illustrated by the fact that disruptions to financial system stability during the global financial crisis in 2008 precipitated a catastrophic economic collapse in developed countries. In contrast, countries that has successfully maintained financial system stability were able to minimize the negative fallout from the global financial crisis. In the context of the ongoing global crisis, one factor among others that has supported the resilence of Indonesian economy is the robust financial system, particularly the banks, which is now better equipped to deal with external shocks compared to circumstances during the 1997/1998 crisis.

Awareness regarding the importance of financial system stability and economic activities is not a new found concern, particularly since the 1997/1998 monetary and financial crisis that had propagated a severe economic contraction.80 Such awareness

80 The correlation between financial system stability and macroeconomic performance is in line with empirical evidence and experience over the past several decades. Abundant literature empirically proves the positive relationship between financial system growth and economic growth. See Levine, Ross (1997), “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature, Vol. 35(2). See Olivier J. Blanchard, Giovanni Dell Ariccia, Paulo Mauro (2010) ”Rethinking Macroeconomic Policy”, IMF Staff Position Notes SPN/10/03 on the importance of regulation policy as part of macroeconomic policy.

The Role of Financial System Stability in Supporting Economic Activities

The Role of Financial System Stability in Supporting Economic Activities | CHAPTER IV 109

encouraged Bank Indonesia to strengthen financial system stability, ad infinitum, through reforms in the banking system.

Policies instated in 2009 were extensions of the various policies applied intensively at yearend 2008. In quarter IV 2008, Bank Indonesia in cooperation with the Government implemented several measures to alleviate pressures on domestic financial system stability. In conjunction with easing the liquidity pressures at several banks due to counterparty risk, Bank Indonesia broadened the definition of collateral for utilizing its long-term funding facility, extended the maturity profile of FTO and forex swap transactions as well as reduced the overnight repo rate.81 In addition, Bank Indonesia and the Government also provide funding facilities under crisis condition. This is legislated by the second amendment to Act No. 23/1999 regarding Bank Indonesia and Act No. 6/2009. These regulations represent the legal foundations for Bank Indonesia to extend credit or financing to banks suffering from short-term liquidity problems and the provision of an emergency liquidity assistance for banks with systemic impact. Furthermore, in an effort to strengthen financial system resilience several supplementary policies were instated concerning the implementation of risk management and prudential principles for activities associated with structured

81 These policy steps are presented in the Indonesian Economic Report of 2008 and Financial Stability Review No. 12, March 2009.

products. Meanwhile, in line with the reduction of BI rate, Bank Indonesia reduced the risk weight for MSMEs in order to expand bank intermediation.

After experiencing escalating pressures up to quarter I 2009, the array of policies instated managed to achieve domestic financial system stability82. This was reflected in the easing of risk and the improvements in a number of financial sector indicators, principally since quarter II 2009. The Jakarta Composite Index (JCI) rallied on the back of propitious economic growth, low domestic inflation, and a rebound on global and regional markets. Moreover, the price of government bonds (SUN) strengthened in harmony with the improved domestic economic outlook supported by a decline in Indonesia’s risk premium. Credit risk, which was initially projected to intensify, was managed well by the banks and, therefore, did not trigger any significant financial market shocks. Liquidity risk was more controlled and market risk tended to ease in accordance with a stronger exchange rate, lower BI rate and restored international confidence in Indonesia’s financial market. Rupiah denominated credit to the real sector grew favorably on the strength of preserved banking system stability, whereas foreign currency credit contracted due to a decline in export-import activities. The various improvements in the financial system were generally

82 A detailed assessment is presented in Box 1.1. – Policy Response to Global Financial Market Volatility

110 CHAPTER IV | The Role of Financial System Stability in Supporting Economic Activities

the market’s ability to absorb risks; therefore, it has the potential to disrupt financial system stability.

Further discussions on these issues are presented in the five sections that follow. The first section outlines financial sector stability and financial system resilience in 2009. The second describes the self-financing phenomenon that contributed to financial system resilience. The third section details the relationship between financial system stability and macroeconomic stability amid vast capital inflows, including the phenomenon of asset price bubble. The fourth section illustrates financial shallowness in Indonesia’s financial system and several challenges that need to be resolved in order to improve performance and stability. The chapter is closed with conclusion and several related policy implications.

reflected in the improvement of the Financial Stability Index (FSI).

Amid the efforts to maintain financial system stability and improve the bank intermediation function, several challenges remain that require vigilance. The first challenge is associated with a potential asset price bubble on the stock market. Congruous to greater market player optimism regarding the prospects of Indonesia’s economy, financial market performance has improved. It is important to note that excessive optimism can generate backpressure on the financial market. The second challenge is associated with financial market shallowness. Consequently, the financial market has played a limited role in accelerating the economic growth. Besides, financial market shallowness has restricted


4.1

Financial System Stability in a Dynamic Economic Environment

Financial system stability in Indonesia was affected by the dynamics of the global and domestic financial markets. The turbulence in the global financial markets from quarter IV 2008 until quarter I 2009 affected the performance of Indonesia’s financial market. Sluggish stock market and SUN market performance, mounting rupiah volatility and liquidity shortfalls on the rupiah money market placed additional pressures on financial system stability. As mentioned earlier, in quarter IV 2008, Bank Indonesia and the Government took several measures designed to loosen rupiah and foreign currency liquidity, as well as restore confidence in the financial system. Such measures were in accordance with those taken by various countries around the world, but at a relatively lower intensity.83 In the banking sector, these steps successfully provided breathing space for banks to overcome their liquidity problems during that period, as well as an opportunity to consolidate. In the capital market, rising optimism surrounding a domestic economic recovery, underpinned by a global economic recovery in quarter II 2009 restored the risk appetite of global investors, therefore, foreign capital inflows returned to emerging markets, including Indonesia. This further reduced market risk and improved the performance of Indonesia’s financial market. Against such an auspicious backdrop, financial system stability in Indonesia was sustained.

83 For instance, to alleviate pressures on large bank deposit withdrawals, several countries applied full deposit guarantees, including guarantee for inter-bank claims. Indonesia only increased the total value of deposits that is guaranteed by the Deposit Insurance Corporation from Rp100 million to Rp2 billion.


g Risk Mitigation in the Financial Sector

Conditions on the global financial market affected the performance of the domestic financial market and the banking sector. Pressures on the financial system that emerged in quarter IV 2008 until quarter I 2009, stemming from global financial market volatility, undermined the financial market and banking sector performance. Tight liquidity on the global financial market spurred investors to adjust their investment portfolio in emerging countries, including Indonesia, which hastened a foreign capital flow reversal and intensified pressures on the domestic financial market. This was reflected in a sharp depreciation of the rupiah exchange rate, coupled with tumbling share prices and a slump in the price of SUN. In the banking sector, tight liquidity was also found in the interbank money market as a result of the banks’ preference to hoard liquidity and limit interbank transactions.

Improving financial sector performance and strong domestic bank resilience reinforced financial system stability. In line with momentum on the global financial market since quarter II 2009, market confidence in the domestic financial market began to recover. Growing optimism concerning an economic and global financial recovery encouraged foreign investors to again seek investment portfolio that provided higher returns through increased investment in emerging markets. This triggered a surge in inflows of foreign capital to the domestic financial market, which caused equity and government bond price indices to soar. Meanwhile, banking sector resilience improved due to reduced market risk, improved liquidity conditions on the money market and internal consolidation. Consequently, FSI dropped below the maximum indicative limit of 2.00.84

The stability of Indonesia’s financial system was primarily attributable to financial system solvency and supported by the panoply of Bank Indonesia’s banking policies. In 2009, Bank Indonesia policy was directed towards stimulating credit extension by emphasizing risk mitigation and bank resilience. To encourage credit allocation, Bank Indonesia lowered its BI rate and loosened the regulation on risk-weighted assets to MSMEs. To ameliorate risk

84 FSI is an indicator of financial system stability based on three blocks: the banking system, stock market and bond market. The psychological threshold of FSI is 2. An FSI value in excess of 2 implies a disruption to financial system stability. Comprehensive details on FSI are available in the Bank Indonesia’s Financial Stability Review No. 8, March 2007 and No. 9, September 2007.

mitigation by bank and maintain banking sector stability, Bank Indonesia promulgated Bank Indonesia Regulation (Peraturan Bank Indonesia or PBI) No. 11/25/PBI/2009 dated July 1, 2009 regarding a bank’s obligation to effectively apply risk management, both individually and also by consolidating with subsidiary companies. This regulation aimed to improve the quality of risk control by banks; therefore, banks were systemically resilient to the variety of emerging risks. Bank Indonesia also issued PBI No. 11/26/PBI/2009 to regulate activities related to structured products in order to maintain public confidence in the banking system as well as mitigate the market risks associated with structured product transactions.

To mitigate liquidity problems, the second amendment to Act No. 23/1999 regarding Bank Indonesia, superseded by Act No. 6/2009 was applied. This law forms the legal basis for Bank Indonesia to extend credit and financing to banks with short-term funding difficulties, as well as an emergency liquidity assistance for banks with systemic impact. To ensure more caution regarding potential imbalances in the financial system, which was one of several commitments made as a G-20 member, Indonesia implemented the Financial Sector Assessment Program (FSAP). FSAP includes a series of activities to diagnose vulnerabilities in the domestic financial sector, compatibility to international standards including legal aspects, as well as development aspects of the sub-sectors of the financial system, including banks, the capital market, insurance, the payment system and monetary policy, which all correlate to Indonesia’s financial system. The results of FSAP becomes a feedback for improvements of structure and various domestic financial system policies, as well as contribute to improve the architecture of the global financial system.

Solid domestic financial system resilience was inseparable from the robust financial system fundamentals that were put in place after the 1997/1998 crisis. Bank Indonesia regulations to prohibit banks from purchasing shares on the capital market helped mitigate the loss risk in the banking sector originating from a decline in share prices during the global financial crisis in 2008. The domestic banking sector remained sound and managed to continue its intermediation function to fund economic activities. In addition, Bank Indonesia also introduced policies that allowed banks to perform other valuation techniques to determine a fair values of bonds, specifically by applying discounted cash flow other than the market price for ‘tradable’ and ‘available-for-sale’ bonds in order to


minimize the market risk exposure to banks due to weak asset prices on the bond market. These improvements, among others, contributed to financial system resilience in Indonesia.

In terms of the capital market, price volatility was offset by the relatively high appeal of Indonesia’s capital market products to foreign investors as well as the paucity of external shocks that could significantly disrupt the domestic stock market. Indonesia’s bonds market, consisting purely of traditional products due to the relatively thin market, did not trigger any noteworthy disturbances in the financial market as a whole. Bank Indonesia noted that the banking system maintained a 79.5% share of the total financial system.85 Banking system performance also has a significant impact on the financial system due to the concentration of capitalization within the financial sector. Therefore, for the case of Indonesia, stable banks also create a stable financial system. Conversely, unstable banks will lead to financial market instability through negative market sentiments toward shares and obligation from financial companies and declining market confidence. Looking ahead, the nascent global economic recovery requires close attention and Indonesia’s financial system must maintain sound fundamentals in order to avoid any negative impacts stemming from a recurrence of global financial or economic turbulence.

85 See Financial System Review No. 13, September 2009, Bank Indonesia.

g Financial System Stability and Development in the Financial Sector

Banking Sector Adjustments

Fluctuations in the global financial market that dried up liquidity on the global money market also impacted domestic liquidity and bank performance. Several banks were unable to fulfill their short-term liquidity requirement due to tight bank liquidity in quarter IV 2008. Interbank market segmentation problem was compounded by a lower supply of funds from the banks that actually maintained a liquidity surplus but tended to avoid risks, and therefore, preferred to hoard their liquidity.

Liquidity shortfalls had a major impact on the behavior of banks, which were initially aggressive in seeking credit expansion in 2008 but became more prudent. The prudent stance of banks coupled with apprehension concerning a potential rise in NPL encouraged banks to place their funds in BI Certificates and FASBI, which is evidenced by expanding shares of BI Certificates and FASBI to earning assets, whereas the share of credit diminished (Chart 4.1). This trend is a reflection of the banks’ efforts to mitigate liquidity risk by maintaining adequate liquidity. One of the numerous indicators of banks liquidity is the liquid assets to deposit ratio. The higher this ratio, the more capable a bank is in dealing with deposit withdrawal risk that exceeds the daily average. In 2009, banks successfully mitigated their liquidity risk and maintained their liquid assets to deposit ratio in the range of 20% (Chart 4.2).

Chart 4.1 Share of Credit and SBI plus FASBI to Productive Assets

Chart 4.2 Liquid Assets (LA) to Deposit Ratio

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As liquidity risk dispersed, market risk also improved, thus shoring up bank performance. Better stock market and bond market performance together with rupiah appreciation eased market risk. The 6.98% increase in the SUN price index lowered the risk of a decline in the SUN price on the trading portfolio of the banks’ balance sheets. From the perspective of the banks’ portfolio maturity profile, bank liabilities were dominated by short-term liabilities, whereas banks assets tended to be longer term, both on the rupiah and foreign currency portfolios (Chart 4.3 and 4.4). Consequently, banks had the opportunity to re-price, where the downward interest rate trend in the first semester of 2009 was favorable due to the lower cost of funds. Furthermore, this form of short-term bank liquidity was placed in assets with a longer maturity profile. In terms of foreign currency, the short-term liabilities of banks decreased in line with rupiah depreciation and a lower foreign currency deposit interest rate level in quarter IV 2008 and quarter I 2009. Meanwhile, bank aversion to extend foreign-currency-denominated credit was demonstrated by declining long-term foreign currency assets in quarter I through quarter III 2009. This was necessary to reduce exposure on the foreign currency portfolio as banks awaited confirmation of the global economic recovery.

Credit risk, which escalated in early 2009, began to recover as reflected by a lower NPL ratio at yearend 2009. The bank gross NPL ratio was 3.79% at the end of 2009, declining from its peak in 2009 at 4.71% in May. The highest nominal NPL increase occured in trade and miscellaneous sectors, which concomitantly experienced the most expansive credit growth compared to other sectors. The growing ratio of loan loss provisions to NPL persisted from early 2008

until yearend 2009 (Chart 4.5), which highlights the banks’ endeavors to alleviate their credit risk.

Bank consolidation also contributed to the improvement in bank performance. Banks began to lower their interest rates on time deposits in line with the reductions in the BI rate. However, the perception of a high-risk real sector inevitably resulted in a slower decline in lending rates compared to saving rates, therefore, interest rate spread increased. Earnings accrued from the interest rate spread, when added to the fee-based income, helped maintain bank profitability. This was reflected by the relatively high Return on Assets (ROA), averaging 2.67% in 2009. Despite the contribution of an increase in bank profitability to maintain banking system stability as a whole, regretfully it somewhat undermined the intermediation function.

Improved banking sector performance was also reflected by relatively sound bank solvency, which manifested in

Chart 4.3 Rupiah Portfolio Maturity Profile Chart 4.4 Forex Maturity Profile

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Chart 4.5 NPL and Loan Loss Provision

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a Capital Adequacy Ratio (CAR) that was jumped 117 bps to 17.37% in 2009, compared to a 310 bps decline in 2008 (Table 4.1). Such conditions were a reflection of bank efforts to consolidate internally in order to reinforce solvency by accumulating more capital, which cushions economic turbulence and provides clear signals regarding the soundness of the bank. The conservative stance of banks was further evidenced by significantly slower asset expansion in 2009 as a result of sluggish credit growth in response to economic conditions and the wait-and-see attitude when dealing with growing uncertainties on the global financial market. The slowdown in global and domestic economic activities in 2009 also reduced the expansion of bank deposits. Deposits only grew by 12.53% compared to 16.06% in 2008.

Stock Market Development

Stock market performance in 2009 recovered after the initial blip in quarter I 2009. The drastic decline in the Jakarta Composite Index (JCI) that began in quarter IV 2008 reached its nadir at a level of 1,256 in March 2009, its lowest level since 2006. Trading volume also contracted significantly to Rp1.57 trillion per day, compared to the annual average of Rp3.99 trillion per day (Chart 4.6).

Notwithstanding, stock market performance gradually recovered in line with improvements in global financial market conditions during quarter II 2009, which sparked a resurgence in foreign capital inflows. An increase in transaction activities by foreign players, closely mirrored by domestic players, instigated an impressive 86.98% upswing in the JCI closing at 2,534 in 2009. This upswing was the highest experienced by any index in the Asian region (Chart 4.7). In addition to the resurgence in capital inflows, the rally on the JCI was also due to the improved fundamentals of companies issuing shares, therefore restoring the confidence of market players. In accordance with increasing trading activities, average trading volume in 2009 achieved Rp3.99 trillion per day, with the net foreign purchases valued at Rp13.92 trillion.

JCI momentum was also supported by sectoral price index increases. Optimism regarding the end of the global recession sparked commodity price hikes on the international market. This encouraged investors to seek stocks in primary commodities such as mining, hence, the significant upturn (Chart 4.8). The rapid upsurge in the mining sector was also buoyed by investor preference towards commodity-based sectors rather than the financial sector. Meanwhile, share price index volatility also gradually dissipated in accordance with the improvement in stock market performance despite the domestic political situation that tended to heat up at yearend 2009, which intensified volatility (Chart 4.9).

Amid improving stock market performance, financing through the issuance of shares, through Initial Public Offerings (IPO) or rights issues, decreased. Total shares issued in 2009 achieved just Rp13.0 trillion as follows: IPOs amounted to Rp3.7 trillion and right issues Rp9.3

YearGrowth (%)

CAR Asset Deposits

2007 -117 bps 14.75 17.39

2008 -310 bps 16.32 16.06

2009 117 bps 9.68 12.53

Table 4.1 Growth of Capital, Asset and Third Party Fund

Chart 4.6 JCI and Average of Stock Trading Value Chart 4.7 Global Stock Market 2009

Source: IDX

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trillion (Chart 4.10). Total issuances declined by 83.5% compared to the previous year that reached Rp79.2 trillion (IPOs Rp23.7 trillion and right issues Rp55.5 trillion). The number of companies issuing shares nearly halved from 42 in 2008 to 25 in the reporting year. Most companies issuing shares were from the financial and trading sectors. Cumulatively, shares issued by companies in the financial sector accounted for 46.2% of the total, whereas the trading, services and investment sector made up 21.0%.

A precipitous drop in share prices heavily affected the decline in issuances during quarter IV 2008 and quarter I 2009. Due to the slump in share prices, several companies that had previously obtained permits to issue shares postponed issuances as it was deemed unprofitable. Issuances usually gain momentum during periods of share price hikes because the capital investment cost becomes relatively cheaper, which further boosts the

asset valuation ratio (Q ratio).86 However, the opportunity provided by the increase in Q ratio was underutilized by companies issuing shares to finance their investment activities. The impressive rally on JCI in 2009, which approached its peak during a boom period, was not followed by a corresponding rise in issuances (Chart 4.11).

Bond Market Development

In line with conditions prevalent on the financial market, SUN market performance also experienced pressures from quarter IV 2008 until quarter I 2009, before subsequently recovering. Pressures on the SUN market stemmed from

86 When share prices increase, the Q ratio value, which is the ratio of share market value against asset value, will increase (Tobin, James (1969), “A General Equilibrium Approach to Monetary Policy”, Journal of Money, Credit and Banking Vol. 1 No. 1). When Q>1, the replacement cost of capital is cheaper, therefore motivating companies to increase investment by issuing shares.

Chart 4.8 Sectoral Price Index Chart 4.9 The Volatility of Asian Stock Indices

Source: Bloomberg

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Chart 4.10 Share Issuance, IPO, and Right Issue Chart 4.11 JCI and Share Issuance Volume

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widespread selling by foreign investors, which depressed the SUN price index to 81.32 in March 2009 (Chart 4.12 and Chart 4.13). Along with the decline in SUN price, the yields of SUN for all tenures increased. Yield average for all tenures was 12.4% in February 2009. However, with the return of foreign capital flows to the SUN market and Indonesia’s improved sovereign rating, the SUN market began to rebound. The risk appetite of foreign investors returned in quarter II 2009, which brought vast inflows of foreign capital to the SUN market. Besides, relatively sound macroeconomic fundamentals in Indonesia and improved debt risk helped restore market player confidence in SUN instruments. The upgraded sovereign rating of Indonesia awarded by Moody’s to Ba2 spurred positive sentiment that strengthened the average price of FR series SUN for all tenures. This led to a 6.98% increase in the SUN price index (IDMA), climbing from 88.21 at the end of 2008 to 94.37 by the end of 2009 (Chart 4.13).

SUN of all tenures improved on their respective markets (Chart 4.13). In 2009, the monthly average price of medium-tenure and long-tenure SUN strengthened most significantly, by 1,361 bps (increase of 13.98%) and 1,632 bps (18.83%) respectively. Meanwhile, short-tenure SUN increased by just 407 bps (4.03%). Even though long-tenure SUN experienced the most significant price hikes, the decline in long-tenure SUN yield was relatively slow, dropping by just 129 bps, compared to 379 bps and 236 bps for short and medium-tenure SUN respectively. This was associated with the lack of liquidity for long-tenure SUN market. Meanwhile, in accordance with improved SUN performance, foreign SUN ownership increased by Rp20.1 trillion. However, the trading volume of SUN, on average, declined to Rp3.39 trillion per day compared to Rp4.49 trillion per day in 2008.

Corporations exploited the SUN market to obtain cheaper financing through the issuance of bonds. Lower SUN yield, which is often applied as a reference point for the issuance of bonds, encouraged companies to issue bonds in order to finance their business activities. That was reflected by the growing value of corporate bonds issued, which even exceeded the value of shares issued. Corporate bonds issued in 2009 were valued at Rp27.2 trillion, which was a 128.7% increase compared to the previous year (Chart 4.14). Of the total bonds issued, sharia bonds accounted for Rp1.3 trillion (4.9%); dominated by bonds based on leasing principles (ijarah). Meanwhile, the value of corporate bonds that matured in 2009 totaled Rp12.3 trillion, thus giving a net increase in financing from corporate bonds of Rp14.9 trillion. This net increase boosted outstanding corporate bonds by the end of reporting year to Rp88.3 trillion. In addition to the lower SUN yield, two other factors indicated the high value of corporate bonds issued during the reporting year, namely the large value

Chart 4.12 Foreign Investment Chart 4.13 SUN Average Price Indices

Source: CEIC Data

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of bonds reaching maturity that required refinancing and the banks’ reluctance to extend credit, as reflected by the phenomenon of credit interest rate rigidity. Consequently, companies seek alternative financing sources.

By sector, companies in the financial sector dominated those using bonds as a source of financing. The cumulative share of bonds issued by companies in the financial sector by the end of 2009 reached 47.9% (Chart 4.15). The relatively high share of the infrastructure and transportation sector was particularly noteworthy, amounting to 22.7%. Cumulatively, the value of bonds issued by the infrastructure and transportation sector exceeded the value of shares issued. This was an indication that companies in the infrastructure and transportation sector were more likely to issue bonds rather than shares to finance their investments. However, the concentration of share and bonds issuances on the financial sector highlights an important risk potential that requires further observation. In the event of a shock befalling a financial institution, the high concentration will significantly disrupt stability on the bonds market.

The combination of lower risks in banking, improved profitability and solvency at banks, as well as improved

stock market performance contributed to improve the stability of Indonesia’s financial sector. FSI (financial stability index) declined from 2.43 during the height of the global crisis to 1.91 in December 2009 (Chart 4.16). The favorable characteristics of low market risk and sound bank solvency in Indonesia’s financial system were in stark contrast to conditions in more developed countries. Currently, developed countries are still struggling to improve their solvency conditions. The relatively solid foundation that is Indonesia’s banking system, as a result of a restructuring program implemented in conjunction with the 1997/1998 economic crisis recovery, has bolstered bank resilience in terms of dealing with liquidity issues. Therefore, banks can continue to perform their function, primarily supporting the payment system, and can drive economic growth. In this context, financial system resilience is associated with the availability of reliable payment system infrastructure. Bank Indonesia maintained payment system infrastructure reliability through the development and implementation of the Bank Indonesia - RTGS system and Bank Indonesia - 2nd Generation SSSS in 2008. The more reliable, secure and efficient infrastructure, as well as the improved risk-mitigation capabilities of BI-RTGS support financial system stability.

Chart 4.15 Cumulative Share of Bond Issuance by Issuer Business Sector

Chart 4.16 Financial Stability Index (FSI)


Agriculture, 2%Mining,

2%Basic Industry &

Chemical, 5%

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08

M0

7

20

09

M0

1

20

09

M0

7

Mini crisis 2005: 2.33

Crisis 1997-1998March 1997: 3.23

Global Crisis November 2008: 2,43


4.2

Financing Economic Activity: The Internal Financing Phenomenon

Amid limited credit extension by banks, economic players sought alternative financing sources, which include the capital market, non-bank financial institutions and internal financing. Based on the identification of economic financing sources, internal financing was the main economic source of financing compared to other sources like banks, capital market, government and foreign sources. In this regard, the corporate sector tended to optimize financing sources from retained earnings and asset structure adjustments, particularly on inventory and other current assets. Analysis using the Flow of Funds approach also demonstrated that when economic activities wane, the business sector adjusts portfolio asset placements to obtain alternative financing sources. Such conditions imply that business players maintain a financing buffer amid limited bank credit and financing through the capital market.

Prior to the 1997/1998 economic crisis, financing was dominated by bank loans. However, in the post-crisis period the allocation of credit by banks has decreased significantly with the prevailing share replaced by internal financing. Less financing by banks during the recent crisis was due to: (i) the greater tendency of banks to hold low-risk liquid assets, such as SBI and SUN; (ii) higher risk in the real sector that undermined the banks’ willingness to extend loans; and (iii) the ongoing internal consolidation process to meet CAR and NPL requirements that had resulted in more prudent behavior. Consequently, these factors triggered a credit crunch in Indonesia, where the banks tended to apply loan rationing. These symptoms caused many companies to suffer difficulties in financing


their investments, thus encouraging the utilization of internal sources.

To analyze economic sources of financing, several approaches have been taken, namely survey, the Gross Fixed Capital Formation approach, Flow of Funds approach and Listed Company Balance Sheet approach. In general, these approaches all confirmed the dominant use of internal funds in company financing.

g Financing Source Survey

The survey approach was conducted to reveal the dominant role of internal financing during the post-crisis period. The survey was performed in 200187 and showed that the share of internal sources reached 56%, whereas financing from bank loans was just 24%, foreign borrowing 5%, equity 6% and bonds 3%. The 2002 survey, however, indicated an increasing share of internal financing to 60.7%, whereas the share of financing from bank loans shrank to 20.7%.88 The dominance of internal financing, hitherto, continued, which was confirmed by the 2009 Bank Indonesia survey that revealed the share of internal financing remained in the range of 60%,

87 Agung, Juda, Bambang Kusmiarso, Erwin G. Hutapea, Bambang Pramono, Andry Prasmuko, Nugroho Joko Prastowo (2001), “Credit Crunch in Indonesia in the Aftermath of the Crisis: Facts, Causes and Policy Implications”. Directorate of Economic Research and Monetary Policy, Bank Indonesia, p.48

88 Kusmiarso, Bambang, Elisabeth Sukawati, Sudiro Pambudi, Dadal Angkoro, Andry Prasmuko, Iss Savitri Hafidz (2002), “Interest Rate Channel of Monetary Transmission in Indonesia,” Transmission Mechanism of Monetary Policy in Indonesia. Directorate of Economic Research and Monetary Policy, Bank Indonesia, p. 60

whereas the share of domestic bank loans was in the 21% range (Chart 4.17).89

g Gross Fixed Capital Formation

The above changes in the structure of economic financing sources was also confirmed by the Gross Fixed Capital Formation approach that clearly indicated a decreasing share of bank loan financing and an increasing share of internal financing. Prior to the crisis, the share of bank loans reached 31.8%, whereas internal financing was just 12.4%. The composition changed to 16.1% for bank loans and 46.0% for internal financing in 2008 (Table 4.2). Despite the improvement in the intermediation function in line with the post-crisis economic recovery, the share of bank loans remains well below that prior to the crisis. Companies did not optimally exploit the period of rising share prices from 2005 to mid 2008; therefore, the portion of share issuances remains relatively small.

g Flow of Funds

The relatively minor share of bank loans in economic financing was also evidenced by data analysis using the flow of funds, which showed the correlation between financial transactions of various economic sectors, both in the domestic sector and foreign sector, in financing their economic activities. Flow of funds statistics detailed the financial transactions of eight categories of economic

89 Bank Indonesia (2009), The 2009 Adhoc Survey “ The Conditions of Companies’ Employment, Finance and Financing,” Directorate of Economic and Monetary Statistics, Bank Indonesia.

Chart 4.18 Share of Non-Financial Investment, Flow of Funds Balance 2005-2007

Chart 4.17 Source of Financing of Corporate Investment

Source: BPS-Statistic Indonesia (processed)

73% 73%

63%

10% 9% 8 %

12% 13 % 13%

5% 4%

16%

1% 1 % 0%0%

10%

20%

30%

40%

50%

60%

70%

80%

2005 2006 2007

Private CompanyState-Owned Enterprise

GovermentHousehold

Financial Sector (monetaryauthority, bank & non-bank)

* corporate projection

59%

10%

20%

3%

1%

7%

61%

9%

21%

3%

2%

4%

59%

8%

21%

2%

2%

8%

-10% 0% 10% 20% 30 % 40% 50% 60% 70%

Internal Funds

Affiliated Funds

Domestic Bank

Overseas Bank

Stock Market

Others

2009* 2008 2007


agents, namely the monetary authority, banks, non-bank financial institutions, households, the Government, state-owned enterprises, businesses and foreign. Flow of funds data for 2005-2007 demonstrated that non-financial investment in the Indonesian economy was dominated by the business sector (private companies) with an average share of 69.7%, followed by the Government with 12.7%, state-owned enterprises with 8.8% and 8.2% for households (Chart 4.18). In terms of the source of funds, financing to the business sector and state-owned enterprises (including non-investment activities) in 2007 was dominated by equity and ownership investment, as well as saving. Meanwhile, financing from bank loans accounted for just only 18% for the business sector, 7% for state-owned enterprises and 15% for households (Chart 4.19).

Table 4.2 Sources of Investment Financing in Indonesia

*government investment data (processed from State Budget) **the difference between investment credit and working capital credit ***FDI withdrawal realisation and external debt, balance of payment (BoP) ****internal fund is residual which included retained earning and additional capital, etc

trillions of rupiah

Chart 4.19 Source of Financing for Firm and Household Activities, Flow of Funds Balance 2007

Source:BPS-Statistic Indonesia (processed)

33%

22%

37%

18 %

7%

15%

42%

56 %

0%0%

10%

20%

30%

40%

50%

60%

Gross DepositShare and Participation Certificate

SecuritiesCredit

Commercial CreditOthers

Private Company State-OwnedEnterprise

Household

Description 1995 2000 2005 2007 2008

Gross Fixed Capital Formation (Nominal

Investment) 129.2 275.9 655.9 983.8 1,369.6

Sources of financing:

1. Government* 33.6 29.2 77.3 133.7 181.3

2. Banking Loans** 41.1 27.9 80.7 151.8 220.7

3. Foreign Financing*** 27.5 84.7 170.4 203.6 244.1

FDI, equity capital & RE 6.2 8.1 76.2 69.2 67.9

FDI, loan disbursement 7.4 17.8 16.0 50.0 81.4

Other, loan disbursement 13.9 58.9 78.3 84.4 94.8

4. Stock Issuance 8.9 19.4 10.2 47.3 78.9

5. Bond Issuance 2.0 5.6 8.2 31.3 14.2

6. Internal Fund**** 16.1 109.1 309.2 416.1 630.4

Total 129.2 275.9 655.9 983.8 1,369.6

Portion of Source of Financing

1. Government* 26.0% 10.6% 11.8% 13.6% 13.2%

2. Banking Loans** 31.8% 10.1% 12.3% 15.4% 16.1%

3. Foreign Financing*** 21.3% 30.7% 26.0% 20.7% 17.8%

FDI, equity capital & RE 4.8% 2.9% 11.6% 7.0% 5.0%

FDI, loan disbursement 5.7% 6.4% 2.4% 5.1% 5.9%

Other, loan disbursement 10.8% 21.3% 11.9% 8.6% 6.9%

4. Stock Issuance 6.9% 7.0% 1.5% 4.8% 5.8%

5. Bond Issuance 1.6% 2.0% 1.2% 3.2% 1.0%

6. Internal Fund**** 12.4% 39.5% 47.1% 42.3% 46.0%

Total 100.0% 100.0% 100.0% 100.0% 100.0%


Data analysis using the flow of funds revealed an interesting behavioral trait. The business sector adjusted its portfolio to fund business activities when the economy was in a crisis. Portfolio adjustment was performed by: (i) reducing deposits in forex and rupiah, (ii) reducing placements in short-term securities, and (iii) reducing the capital accumulation. Reducing portfolio placements by the business sector was one source of funding during a period of sluggish economic growth and limited alternative sources of financing.

g Balance Sheet of Listed Companies

Analysis of the balance sheets of listed companies90 also revealed the use of liquid assets and retained earnings as sources of financing, as reflected by the decreasing share of inventory to total assets and increasing share of retained earnings to total assets. Among the 170 companies sampled under the categories of manufacturing, infrastructure, agriculture and mining, inventory shares declined during the period of January 2007 to June 2009 (Chart 4.20). In addition to reducing

90 Analysis was performed on balance sheets of 170 listed companies in the Indonesian Stock Exchange during the period of first quarter of 2007 to second quarter of 2009.

inventory, companies in the manufacturing, mining and agricultural sectors also utilized retained earnings as a source of financing (Chart 4.21). The utilization of inventory and increasing retained earnings are a business survival strategy amid inauspicious economic conditions to overcome the requirement for financing from limited sources. A larger ratio indicates a greater potential to utilize retained earnings for future company financing.

The sustaining role of internal financing up until now, on one hand, could indicate that the corporate sector was resilient to the crisis due to favorable profitability and, therefore, can afford the financing requirement. Yet on the other hand, it could indicate constraints to accessing external sources of financing, either from banks or the capital market. Constraints to external financing sources were primarily suffered by MSMEs, which were mainly due to administrative factors, such as the feasibility of financial statements and insufficient collateral. Nevertheless, internal financing was a reliable alternative to finance economic activity, particularly during a crisis, which enabled the economy to continue expanding.

Chart 4.20 Inventory to Total Assets Ratio Chart 4.21 Retained Earnings to Total Assets Ratio

0.00

0.00

0.00

0.01

0.01

0.01

0.01

0.01

0.02

0.10

0.15

0.20

0.25

0.30

III -07 IV - 07 I- 08 II - 08 III - 08 IV - 08 I- 09 II - 09

Manufacture Mining

Plantation Infrastructure (rhs)

Source: IDX (processed)

0.00

0.10

0.20

0.30

0.40

I-07 II -07 III -07 IV -07 I-08 II -08 III -08 IV -08 I-09 II -09

Plantation Mining

Manufacture Infrastructure

Source: IDX (processed)


4.3

Financial System and Macroeconomic Stability amid Surging Foreign Capital Inflows

The dynamics of the global and domestic economies indicated a close correlation between the performance of the financial sector and macroeconomic conditions. Developments in the global economic environment over the past decade, closely followed by rapid changes in the financial system, have created a stronger feedback loop between financial system stability and macroeconomic stability. This was undoubtedly evidenced during the global financial crisis in 2008. Financial market instability brought with it relatively significant negative impacts on macroeconomic performance. Despite extensive financial product innovation that enriched investment choices and broadened access to financing for households and the corporate sector, financial system instability had a strong impact on macroeconomic stability due to existing market imperfections. Such a weakness could prolong the impacts of the crisis on the financial sector and undermine economic performance in general.

The relatively tight correlation between financial system stability and macroeconomic stability confirmed the importance of monitoring various financial sector indicators that can affect the performance of various macroeconomic indicators. Accordingly, one financial market indicator that influenced macroeconomic performance was a shift in global investors’ capital. Greater financial market integration and abundant global liquidity initiated a surge in capital flows to developing countries. This phenomenon was further encouraged by the low policy rates applied by several central banks, including the Federal Reserve, for extended periods of time. Indonesia constitutes one of several investment


destinations favored by global investors due to maintained macroeconomic stability, positive economic growth and relatively high yields compared to other emerging markets. On the one hand, capital inflows shore up financial system stability. However, on the other hand, capital inflows have the potential to trigger financial system instability in the event of a sudden capital reversal, therefore disrupting macroeconomic stability.

In Indonesia’s case, vast foreign capital inflows to Indonesia affected financial sector and macroeconomic performance. For the financial sector, a rapid upsurge in foreign capital inflows significantly contributed to an increase in performance and lead to rupiah appreciation.91 Eventually, such growth dissipate market risk and maintained the bank intermediation function, therefore, preserving financial system stability. Rupiah appreciation due the surging capital inflows also contributed to macroeconomic stability in the short run.

Amid various positive effects brought about by foreign capital inflows on financial system stability and macroeconomic stability, one phenomenon that requires closer observation is soaring asset prices, in particular share prices. As described previously, the strong upsurge in foreign capital inflows to Indonesia improved financial market performance, especially the stock market (Chart 4.22 and Chart 4.23). Vast foreign capital inflows to the domestic financial market were also attributable to propitious domestic economic conditions. Furthermore, favorable social and political conditions as well as sound

91 Detailed explanations on the influence of foreign capital flows on exchange rate growth and monetary stability are presented in Chapter 3, Monetary Policy Response during the Global Crisis.

economic fundamentals raised the perception of foreign investors. Indonesia represents one of the few countries that recorded positive economic growth amid the threats of global recession in 2008. In addition, inflationary pressures subsided; therefore, Bank Indonesia had the opportunity to reduce its policy rate to 6.50%. Bank Indonesia’s policy to trim its BI rate was responded to favorably by market players.92

Surging capital inflows and auspicious macroeconomic conditions were the primary factors driving positive stock market growth. Indonesia’s stock market rallied 86.98% in 2009. Meanwhile, over the past four years, JCI had skyrocketed by 153.38%93. Market capitalization also expanded exponentially by 189.49% from Rp676.66 trillion in 2004 to Rp1,958.83 trillion at yearend 2009. By sector, the performance of the mining and agricultural sectors improved tremendously (Chart 4.24) on the back of soaring commodity prices on international markets. Market players expect that such growth on the international market will positively impact company performance.

Regrettably, the impact of vast capital inflows on stock market indices was occasionally excessive. The purchase of shares by foreign investors was frequently mirrored by domestic market players, therefore, the impact on prices was multiplied and the index increased sharply. Despite the positive impact of foreign investors on share price index growth, often times the price hikes were not supported by macroeconomic or microeconomic

92 Test results by BI demonstrate that a BI rate reduction is one factor that affects share prices and SUN yield.

93 Position at yearend 2004 compared to position at yearend 2009.

Chart 4.22 Capital Inflow and JCI Chart 4.23 Daily Capital Inflows and JCI 2009

Source: CEIC Data

I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV2004 2005 2006 2007 2008 2009

JCI (rhs)

millions of USD index

Foreign by Net Inflow

500

1,000

1,500

2,000

2,500

3,000

-5,000

-4,000

-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

5,000

Net inflow

Net outflow

JCI (rhs)

millions of USD index

Net Foreign Inflow/Outflow

1,000

1,300

1,600

1,900

2,200

2,500

2,800

-800

-600

-400

-200

0

200

400

600

05 J

an14

Jan

23 J

an04

Feb

12 F

eb24

Feb

05 M

ar17

Mar

27 M

ar07

Apr

20 A

pr29

Apr

08 M

ay19

May

29 M

ay09

Jun

18 J

un29

Jun

09 J

ul21

Jul

30 J

ul10

Aug

20 A

ug31

Aug

09 S

ept

18 S

ept

02 O

ct13

Oct

22 O

ct02

Nov

11 N

ov20

Nov

02 D

ec11

Dec

23 D

ec

Inflow

Outflow

Souce: CEIC Data


fundamentals. This was considered as the case in 2009. JCI growth far exceeded that of macroeconomic fundamentals, which was reflected by growth in M1 and currency (Chart 4.25 and 4.26). From a micro perspective, the strong rally on the price index was not supported by a corresponding improvement in company fundamentals, as reflected by Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA), which all grew negatively for several sectors that experienced expansive growth (Table 4.3). Sharp hikes in the prices of financial market instruments without strong fundamentals were an alarming signal of a potential asset price bubble that could trigger a new crisis when the bubble bursts.

Signs of a share price bubble emerged in several periods. Over the past five years, price bubbles had been in evidence since mid 2003. Observations during the period of 2003-2006 indicated relatively persistent

yet not explosive price bubbles94. This continued until 2007 but subsequently burst at the beginning of 2008, plummeting to its nadir in October 2008 following the bankruptcy of Lehman Brothers. Test results empirical prove the existence of such conditions95 (Chart 4.27). Concerns of an asset price bubble reemerged mid 2009 after the Indonesian stock market experienced a very sharp upswing. Notwithstanding, indications of an asset price bubble faded away by yearend 2009. Market players exploited the strong JCI through profit taking, which occurred several times in 2009, therefore necessitating corrections to alleviate the risks associated with an asset price bubble burst.

94 Test used the autoregressive and unobserved component methods.95 Asset price bubble potential was measured using an Autoregressive

Distributed Lag /ADL(1,1) Dynamic Structural Model with an observation period from January 2003 – November 2009.

Chart 4.24 Sectoral Price Index Chart 4.25 The Growth of JCI and M1

2005 2006 2007 2008 2009I II III IV I II III IV I II III IV I II III IV I II III IV

index

0

500

1,000

1,500

2,000

2,500

3,000

3,500

InfrastructureMining

FinanceConsumer Goods

Plantation

Souce: CEIC Data Source: IDX

JCI M1 (rhs)

yoy yoy

0.0

0.1

0.1

0.2

0.2

0.3

0.3

-0.9

-0.6

-0.3

0.0

0.3

0.6

0.9

1.2

Jan-

03

Jun-

03

Nov

-03

Apr-

04

Sep-

04

Feb-

05

Jul-0

5

Dec

-05

May

-06

Oct

-06

Mar

-07

Aug-

07

Jan-

08

Jun-

08

Nov

-08

Apr-

09

Sep-

09

Table 4.3 Growth of Sectoral Indices and EBITDA

Sectors

2009 - 2008 2008 - 2007

Growth of EBITDA

Growth of Index

Growth of EBITDA

Growth of Index

Miscellaneous Industry

6.46 179.84 67.26 -54.34

Mining -32.79 151.06 49.11 -72.85

Consumer Goods 25.77 105.39 39.34 -26.04

Basic Industry -11.38 102.93 73.65 -43.89

Plantation -78.95 90.81 -87.76 -64.75

Trade 5.49 85.91 25.29 -62.32

Finance 0.00 70.94 0.00 -33.85

Infrastructure 10.42 48.57 -7.32 -46.79

Property -20.27 41.85 30.59 -59.17

Source: Indonesia Stock Exchange (processed)


Chart 4.26 The Growth of JCI and Currency Chart 4.27 JCI, Fundamental JCI, Spread

JCI Currency (rhs)

yoy yoy

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

-0.9

-0.6

-0.3

0.0

0.3

0.6

0.9

1.2Ja

n-0

3

Jul-

03

Jan

-04

Jul-

04

Jan

-05

Jul-

05

Jan

-06

Jul-

06

Jan

-07

Jul-

07

Jan

-08

Jul-

08

Jan

-09

Jul-

09

Source: IDX Source: IDX (processed)

index spread

I II III IV I II III IV I II III IV I II III IV I II III IV2004 2005 2007 2008 2009

-20

-10

0

10

20

30

40

50

60

-50

0

50

100

150

200

250

300

350

400

Spread (rhs) JCI Fundamental JCI

Indications of a share price bubble in 2009 were also noted from the technical indicator Price Earnings Ratio (PER) of the Indonesian stock market. PER at the end of 2009 reached 28.1, which exceeded the annual average for 2009 of 23.3 and easily surpassed the historical average for the last five years of 17.00. Indonesian PER was the highest in the region, with the exception of China. When observed in more detail, indications of a price bubble were found on the share prices of the mining sector and financial sector in line with optimism surrounding a global economic recovery and rising global commodity prices.

Financial asset price bubbles also affected other countries. A more rapid pace of financial market recovery compared to real sector recovery demonstrated excessive asset price increases. However, the 2009 phenomenon of financial sector asset price increases in developed countries involved limited risk if the bubble bursts because the ongoing hikes in financial asset prices in developed countries were not accompanied by a credit boom bubble. Therefore, when the bubble bursts its impact on the financial sector will be insignificant.96 Such conditions would be different in emerging markets, such as China and India. Soaring asset prices in emerging markets were among several factors triggered by government fiscal stimuli and increasing credit allocation, as occurred in

96 Mishkin mentioned that a credit boom bubble is a condition where over expections of economic prospects or structural changes in the financial market would generate excessive credit allocation. Credit funds used to purchase credit assets will trigger soaring asset prices and strong credit demand will encourage banks to lower their requirements for credit extension, as happened prior to 2007 (Mishkin, Frederic (2009), “Not all bubbles present a risk to the economy”, Financial Times, November 29).

China. Therefore, the risk of an asset price bubble burst could bring negative impacts to the financial sector. Due to close integration among financial markets in Asia an asset price bubble burst in China would precipitate a capital flow reversal from emerging markets in the region to developed countries such as the U.S.

Amid indications of a share price bubble, the negative impacts on the domestic financial sector are predicted to be minimal if a sharp correction takes place as occurred in quarter IV 2008. Skyrocketing share prices on the domestic stock market were principally triggered by the upsurge in foreign capital flows, whereas banking sector involvement in stock trading remained limited. Systemic risk in the financial sector tends to intensify if asset price hikes are financed by bank loans and assets are used as collateral. Under such circumstances, asset price increases tend to spur credit growth, as happened in developed countries prior to the subprime mortgage debacle. A sharp decline in asset prices has the potential to increase bank’s balance sheet exposure to credit extended for the purchase of such assets. In Indonesia, asset prices that indicated a price bubble only affected share prices, for which the increase was not financed by bank loans. The impact of share price movements on banking sector performance was relatively minimal due to Bank Indonesia regulations to prohibit banks from purchasing shares on the capital market.

Even though signs of a share price bubble faded at yearend 2009 and the impact of a price bubble burst on financial sector stability is predicted to be relatively minimal, this phenomenon requires careful vigilance. The stock price bubble has increased the complexity of


maintaining financial system stability and macro stability in general. Besides, asset price increases that stem from short-term foreign capital are vulnerable to corrections if a capital flow reversal occurs. Stock market instability is easily observed by foreign investors, which could lead to negative sentiment on the capital market in Indonesia and could trigger panic. Any significant correction on the financial market due to a foreign capital reversal will affect the banking system and exchange rate movement, thus undermining financial system stability and economic performance.


4.4

Financial Sector Deepening and Instrument Development

Financial sector deepening is a crucial aspect of financial market development in a country. Relating to the business community, a deep financial market can facilitate an increase in economic activities by availing various financing alternatives. In terms of investors, a deep financial market provides more investment options, therefore allowing the optimization of investment yield. Nonetheless, financial sector deepening should be performed measurably and prudently. Experience garnered from the 2008 financial crisis provided many valuable lessons that financial market deepening without clear regulations can disrupt financial system stability.

In the case of Indonesia, efforts to deepen the financial sector are currently ongoing. Indonesia’s financial sector is considered shallow compared to several neighboring countries in the Asian region. Financial sector shallowness in Indonesia is attributable to limited investment and financing alternatives, hedging facilities and risk reduction (insurance) facilities. On the one hand, the shallow financial sector enabled Indonesia to minimize the impact of the global financial crisis in 2008. Indonesia’s financial sector has limited exposure to structured products, including subprime mortgages, and is somewhat isolated from asset value depreciation on structured products. On the other hand, limited investment alternatives, which often nurtures herding behavior from market players, frequently leaves assets prices exposed to shocks, therefore, investment uncertainties in the financial sector become widespread. High uncertainties coupled with a shallow financial sector can easily precipitate an exodus of market players.


Chart 4.30 Financial Sector Assets to GDP Ratio

Source: CEIC Data

percent

80.5%

351.9%

152.0%183.7%

553.2%

200.1%

0

100

200

300

400

500

600

Indonesia Malaysia Philippines Thailand Singapore South Korea

2007 2008 2009

Limited investment alternatives in the financial sector also affect bank liquidity management. Consequently, the banks are more likely to place any excess liquidity at Bank Indonesia. However, learning from experience gleaned during the 2008 financial crisis, prudential regulations must be prepared beforehand and market deepening should be measurable and prudent to enable Indonesia’s financial sector to benefit from financial sector deepening and minimize the risk of moral hazard behavior of the market participants.

Several indicators reflect the relatively shallow financial market of Indonesia. The M2/GDP ratio, one of several financial sector deepening indicators, has followed a downward trend since the 1997/1998 crisis.97 The global financial crisis, which affected the domestic financial sector, was revealed to continuously lower this ratio (Chart 4.28). This signifies that the financial sector in Indonesia has become shallower compared to the financial sectors of other countries in the Asian region. At the end of 2009, the M2/GDP ratio of Indonesia was 38.0%, which was below that of the Philippines. This shallowness opened up gaps in financial sector deepening in the region, such as Malaysia, Thailand, Singapore and South Korea (Chart 4.29). Meanwhile, the financial sector assets to GDP ratio also evidenced a shallow financial sector in Indonesia compared to other countries in the region (Chart 4.30). To simplify the comparison, financial sector assets comprised

97 The most common indicator used to assess financial sector depth is the ratio of liquid liabilities in financial system against gross domestic product, in this case M2/GDP (King and Levine, 1993). Such liquid liabilities consist of currency in circulation which is added to deposits (interest bearing liabilities) collected by banks and non-bank financial institutions, that statistically are reported as broad money (M2 or M3).

of total bank assets and the capitalization value of the capital market.

There were two main contributing factors for the shallowness of Indonesia’s financial sector, namely: (i) limited intermediation performed by institutions in the financial sector, and (ii) low capital market utilization to finance investment. The limited financing capacity of banks led to a relatively low loan-to-GDP ratio in Indonesia compared to other countries (Chart 4.31). Slow loan extension will persist if banks continue their risk-averse behavior and limit loan allocation, therefore, the Loan-to-Deposit Ratio (LDR) will also be low. For banks with high LDR, the availability of non-deposit fund accumulation instruments, such as bonds and derivatives like Asset Backed Securities (ABS) that increase bank liquidity, can improve the intermediation capacity of banks.

Chart 4.28 M2 to GDP Ratio of Indonesia Chart 4.29 M2 to GDP Ratio of Region

Source: CEIC Data

M2

trillions of rupiah

GDP M2/GDP (rhs)

30%

35 %

40%

45 %

50%

55%

60%

65 %

0

1,000

2,000

3,000

4,000

5,000

6,000

Source: CEIC Data

0

20

40

60

80

100

120

140

160

IndonesiaMalaysia

PhilippinesThailand

SingaporeSouth Korea

percent


The lack of interest shown by companies in Indonesia to issue stocks and bonds as a source of financing has restricted the availability of investment instruments for investors. Intense demand pressures for investment instruments that are not followed by a corresponding increase in supply will create a price bubble that could trigger a crisis if the bubble bursts. This is reflected by the correlation between market capitalization value and stock price index, which in this case implies that an increase in stock market capitalization value is attributable more to price hikes than an expansion in volume (Chart 4.32). Meanwhile, on the bonds market the Government issued large quantities of SUN, mainly for the bank recapitalization program, yet the ratio to GDP remained relatively small when compared to the Philippines, Malaysia and Thailand (Chart 4.33). Moreover, the ratio for corporate bonds was a long way behind Malaysia and Thailand.

A shallow financial market also leads to a less liquid financial market. Limited investment instruments cause investors to be less active; therefore, the market is not liquid. Such conditions beset Indonesia’s financial market with thin liquidity that was found not only in the bond market but also in the stock market. The liquidity of Indonesia’s bond market is comparatively lower than other countries in the Asian region, both for government bonds and private bonds. Such conditions are emphasized by two leading liquidity indicators, namely the turnover ratio of bond transactions and bond trading volume. An assessment conducted in September 2009 indicated that the turnover ratio of government bonds in Indonesia was just 0.16, far below that of Malaysia and Thailand, which achieved 0.61 and 0.74 respectively. Meanwhile, the turnover ratio of corporate bonds in Indonesia was similar to that of Malaysia and Thailand (Chart 4.34). The trading volume indicator for the bond market also demonstrated

Chart 4.31 Credit to GDP Ratio Chart 4.32 Stock Market Capitalization and JCI

Source: CEIC Data

percent

2007 2008 2009

26.5%

116.1%

36.3%

88.4%

112.8%

93.2%

0

20

40

60

80

100

120

140

Indonesia Malaysia Philippines Thailand Singapore South Korea

Source: IDX

0

500

1,000

1,500

2,000

2,500

3,000

Jan

-00

Jul-

00

Jan

-01

Jul-

01

Jan

-02

Jul-

02

Jan

-03

Jul-

03

Jan

-04

Jul-

04

Jan

-05

Jul-

05

Jan

-06

Jul-

06

Jan

-07

Jul-

07

Jan

-08

Jul-

08

Jan

-09

Jul-

09

Value of Market Capitalization (trillions of rupiah) JCI (index, point)

Chart 4.33 Bonds Outstanding to GDP Ratio Chart 4.34 Bond Market Turn Over Ratio in Asia

Source: CEIC Data

percent

14.6

52.348,.2

52.3

33.2

1.5

41.7

12.8

61.6

4.1

0

10

20

30

40

50

60

70

Indonesia Malaysia Thailand Korea Philippines

Government Bonds Corporate Bonds

Source: CEIC Data

times


0.16

0.61

0.74

0.85

0.39

0.05 0.05 0.04

0.14

1.0

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0Indonesia Malaysia Thailand South Korea Philippines


relatively low liquidity (Chart 4.35) for both government bonds and private bonds.

Tight market liquidity also shaped the stock market, as reflected by the ratio of stock market capitalization to GDP. Based on observations, liquidity on Indonesia’s stock market over the past three years was the lowest in the Asian region. The ratio of stock market capitalization to GDP was still below 50%, compared to Singapore and Malaysia that are in excess of 100%.

From observing the current portrait of financial sector shallowness, efforts to deepen the financial market in Indonesia are required constantly. A deep financial market can attract more investors to place their funds in the financial market, therefore yielding positive impacts to economic financing. This can be accomplished through the enrichment of investment instruments, such as long-term instruments, structured products and derivative products that can be utilized as hedging instruments or insurance for financial transactions. Financial market deepening can also be done to absorb excess liquidity in

to the economy and minimizing the risk of disruption to financial system stability that emanates from exchange rate volatility as well as fluctuations on the stock or bonds markets. However, to minimize the negative impacts of financial market deepening, microprudential regulations for financial institutions must be applied.

Chart 4.35 Bond Market Trading Volume in Asia

Sumber: CEIC Data

millions of USD


9.3

60.1

98.0

370.9

20.50.4 4.3 1.3

85.7

0

50

100

150

200

250

300

350

400

Indonesia Malaysia Thailand Korea Philippines


4.5

Conclusion

The dynamics of the financial market and banking sector in 2009 demonstrated that financial system stability in Indonesia was maintained, supported by improving financial market performance and strong domestic bank resilience. This relates to fundamental financial system improvements that have taken place since the 1997/1998 financial crisis as well as various policy measures to mitigate the negative impacts of the crisis on the domestic financial system.

However, despite the relatively stable financial system a number of challenges remained, including a shallow domestic financial sector and the vast upsurge in foreign capital flows that have the potential to create a financial asset price bubble.

To overcome these issues, financial deepening and financial broadening are required. These efforts relate to the development of diversified financial market products that avail financial instruments for short-term and medium-term investment, hedging of financial transaction using foreign exchange and risk distribution.

The development of financial market products is expected to minimize the negative impacts of vast foreign capital flows stemming from the availability of more investment alternatives on the financial market. Meanwhile, short-term money market products can be developed to create healthy competition in Indonesia’s financial system in terms of real sector financing. With the availability of a short-term money market, additional alternatives will become available for short-term fund placements that can


be utilized for short-term financing. In this case, the short-term money market can also support short-term liquidity management in the financial system.

The development of these financial products should be directed towards broadening access to financing for business and the general public. Indonesia has a long history of providing special attention to micro, small and medium enterprises. In this context, household participation in the financial sector should be encouraged through increased exposure to financial products. This can be achieved by enhancing financial education to the public regarding appropriate financial products and the potential risk that must be considered. Furthermore, financial education will improve market discipline. Meanwhile, household participation in the financial system will improve the efficient allocation of financial resources in the economy.

The development of financial products should be buttressed by the implementation of prudential regulations. Such regulations should be designed to dissuade the utilization of speculative products and those concerned with excessive profit taking behavior.

Furthermore, the need to anticipate financial system development has necessitated sound macroprudential surveillance and policy coordination regarding financial

system regulation and supervision (See Box: 4.1 Global financial crisis and the structure of financial sector supervision). To this end, the role of Bank Indonesia as a systemic regulator has become imperative. This role is primarily associated with Bank Indonesia’s task of maintaining monetary stability and financial system stability. Utilizing its role as systemic regulator, BI policies on financial system stability will be more effectual. Meanwhile, an effective crisis management protocol should be available to anticipate risk potential in the financial system.

Bank Indonesia implements banking policy based on the provision of incentives and disincentives in order to strike a balance in the intermediation function while maintaining controlled risk conditions in the financial system.98 Incentives is aimed at loan extension, whereas disincentives are instated to minimize excessive risk-taking behavior. Policy design that uses incentives and disincentives must consider the correlation between macroeconomic, macroprudential and microprudential objectives. Such policy design is expected to reduce the procyclical behavior of banks, therefore, leading to a sound banking system that can contribute positively to economic development.

98 See again the definition of financial system stability


Box 4.1: Global Financial Crisis and the Structure of Financial Sector Supervision

Since the onset of the global financial crisis in 2008, many countries around the world again considered giving central banks a bigger role in maintaining financial system stability.1 This was based on the increasing number of financial institutions that had defaulted necessitating prompt actions from the respective governments and central banks to restore financial system stability. Based on empirical experience from the United States, United Kingdom, Germany, South Korea and France; bank default was thought to be caused by weak implementation of macroprudential policy and ineffective coordination between the authorities responsible for financial sector regulation and supervision. Against this backdrop, central banks, which generally act as the lender of last resort (LOLR), were late in responding to the crisis situation that required immediate action. This exacerbated the recovery costs to the financial sector.

World Financial Sector Supervision Map

A survey conducted by the IMF (2007)2 showed that 60%3 of respondents, primarily central banks, retained

1 In the late 90s, there was a major tendency to separate the banking supervision function from the central bank. One of the first was Government of England that established the Financial Services Authority (FSA) in October 1997.

2 Survey was conducted involving 140 financial sector regulatory and supervision institutions in 103 countries worldwide from February to April 2007. The sample represented around 56% of IMF member countries and 91% of world GDP, as of World Bank Key Development Data & Statistics in June 2006. Around 68% of the respondents were from developing countries, whereas 32% were from developed countries.

3 A combination of respondents who stated that they supervised

the authority to perform the banking supervision function. Survey results also illustrated that only around 23% of respondents performed a consolidated supervision function of the entire financial sector that includes banks, the capital market and other financial institutions (Table 1). Meanwhile, most of the respondents (58%) acknowledged their independence when performing tasks, either as supervisors or regulators.4 In terms of financial sector supervisors at a central bank, survey results showed that 80% of respondents could set regulations independently.

Financial Sector Regulatory Structure: Empirical Experience from Several Countries

In general, the insistence to form an independent financial supervisory institution is more prevalent in countries beset by a relatively heavy and extended financial crisis. In some cases, the decision to shift the supervisory role from one institution to another can be emotional and is heavily influenced by political pressures during a financial crisis.

Unfavorable developments were experienced by South Korea. After the 1997/1998 Asian financial crisis, the Government of South Korea decided to separate the banking supervisory function from the Bank of Korea (BoK), by forming the Financial Supervisory Services

banks, either unitary (31%), integrated (6%) or consolidated (23%). Around 7% of respondentd performed an integrated supervision function but did not supervise banks.

4 Independence is defined as impartiality in the implementations of policy instruments which are free from politic and business player influences.

No Type of Supervision Number of Respondents Percentage

1 Banking only (unitary supervisor) 44 31

2 Insurance only (unitary supervisor) 16 11

3 Securities only (unitary supervisor) 25 18

4 Integrated (integrated supervisor) 18 13

5 Consolidated (consolidated supervisor) 32 23

6 Others 5 4

Table 1. Type of Financial Sector Supervision*

*) Novoa, Alicia and Seelig, Steven A. “Governance Practices at Financial Regulatory and Supervisory Agencies”, IMF Working Paper No. 09/135 (2009)


(FSS) in 1999. At the outset most of the employees and directors of FSS originated from work units in BoK that handled the banking supervisory function, however, over time the flow of information regarding banks and financial conditions that could be accessed by BoK was restricted. This was because no work mechanism had been put in place to form a strong legal basis for BoK to access various information on banks and financial institutions in South Korea.

Considering the various weaknesses that emerged after the separation of the supervisory function, BoK recently proposed that the Government amend the law giving authority to BoK to access information relating to banks in South Korea. However, so far these efforts by BoK have not yielded a response from Parliament. The unresolved problems contributed to weak anticipation by BoK and FSS in dealing with the 2008 global financial crisis. During that period, BoK as a monetary authority could not obtain the information required in relation to its function of maintaining financial system stability and also in applying monetary policy, therefore, the financial system in South Korea had to endure relatively widespread instability.

In addition, weaknesses stemming from financial sector authorities in anticipating and mitigating the risks inherent with a financial sector failure in the U.S. were also experienced in countries such as UK, Germany and France. Developments in UK demonstrated a tendency to return the bank supervisory function to the Bank of England (BoE). During the 2008 global financial crisis, BoE was deemed inept in performing its task of maintaining financial system stability as it did not have the authority to supervise banks. To prevent a similar failure, the BoE will be provided with macroprudential and microprudential regulatory authority over all banks, building societies (a form of Rural Bank), and other vital financial institutions. The Financial Services Authority will presently be reassigned as the Consumer Protection Agency.

This issue was based on the inability of the financial authority in UK to anticipate potential bank failure, which urged the Government to nationalize Northern Rock Bank and bail out Lloyds TSB and the Royal Bank of Scotland. This experience demonstrated that action to wrestle the bank supervisory authority away from the central bank cannot guarantee financial system stability.

Consequently, the strong correlation between a central bank and the bank supervisory function was conformed by the governments of several countries. The function of a central bank as LOLR can only be optimally employed if the monetary authority has the power to directly access accurate and complete information relating to the condition of an individual bank or the banking industry in general. To this end, a central bank should have the authority for macroprudential supervision (systemic supervision) and microprudential supervision (supervising individual banks).

A similar case was reported in Germany. In May 2002, Germany formed a financial services supervisory institution (consolidated supervision), known as BaFin to supervise banks, securities and insurance. However, during the 2008 crisis the Government of Germany committed to return bank supervision to the central bank, the Bundesbank.5 To this end, three options have been considered. First, bank supervision becomes a separate department in the Bundesbank. Second, BaFin is part of the Bundesbank. Third, adopt the Twin Peaks model where the Bundesbank acts as prudential supervisor. 6

Latest update from France. On 21st January 2010, the Prudential Supervisory Authority (PSA) was established, tasked with supervising the banking and insurance industries. Legally PSA is a separate entity from the central bank, however, several regulations have been designed to ensure a tight relationship between PSA and Banque de France (B de F). The regulations have underlined several salient issues: (i) all PSA employees are also employees of the central bank; (ii) PSA has an autonomous budget within the central bank’s budget, yet it is paid on an activity basis for the evaluation and supervision of the institution it supervises; and (iii) the Governor of the Banque de France is also the Director of the newly founded PSA. 7

In accordance with the trend of developed countries to return the bank supervisory function to the central bank,

5 See the article “German coalition agrees Bundesbank to takeover bank supervision,“ Reuters, 8 October 2009.

6 Seelig, Steven A. “Alternative International Structure of Financial Sector Supervision and Regulation” Monetary and Capital Market Department, International Monetary Fund, March 2009.

7 Ibid


the Federal Reserve (The Fed) has toughened its stance in terms of maintaining the bank supervisory function at the central bank. The Governor of The Fed, Ben S. Bernanke acknowledged to the Committee on Banking, Housing and Urban Affairs that the experience of the 2008 global financial crisis is a valuable lesson about the importance of strengthening the financial regulatory system as a prerequisite for economic stability in the long run.

The various responses from different countries in dealing with the global financial crisis impacts were in line with the research by Nier (2009)8

. Nier concluded that the conditions of countries that mandated their central banks with the authority to supervise banks were relatively robust in response to the 2008 global financial crisis. In addition, the economic costs borne by countries whose central banks have such authority is ultimately less than those without.

Conclusion

Based on the empirical experience of several countries, it can be summarized that generally there is no model or structure of financial sector supervisory organization which is considered the best or fit for all countries. Diverting the banking supervisory function from one institution to another will not automatically resolve

8 Erland Nier, “Financial framework and the Role of Central Bank: Lesson from the Crisis” IMF Working Paper, No. 09/70 (2009)

the problems or improve the supervisory system. Whereas, on the other hand, in the past year there has been a tendency in several countries to return the bank supervision function to central banks in order to maintain financial system stability.

From the various options available in terms of the structure of financial sector supervision, there are generally several salient issues that are prerequisite to an effective financial sector supervisory function. First, whichever supervisory structure is chosen, the central bank must be mandated with the authority of macroprudential supervisors, either on-site or off-site supervision. Second, it is imperative to develop a clear and integrated system and procedure in anticipation of potential systemic risk. Third, strong commitment to coordinate and share information among authorities in the financial sector is crucial. Fourth, the responsibilities and authorities in conducting supervision and monitoring the financial sector must be clearly laid out.

In terms of a central bank conducting its macroprudential as well as microprudential functions, an adequate legal framework and sufficient power are required as references of the tasks, independence as well as the existence of sufficient legal protection for policymakers to achieve monetary and financial system stability.

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