Study on the

The Indonesian Monetary Policy

1. 
   Basic Principle
   

The Indonesian economy has been oriented to a more market-based monetary system. Among other things, the entrance barrier against the financial industry was lowered, many capital controls were removed and a more flexible exchange rate system was adopted. As a result, the competition level increased in the financial market and the domestic financial market became more integrated with the international market. Such changes show that the stability of the financial structure has been shaken by the emergence of the countless financial institutes including unstable ones and that the independence of the monetary policy has been disturbed to a considerable extent, to the effect that the magnitude of the risk on the Indonesian economy has increased.

The financial authorities adopted a more restrictive CAMEL(Capital adequacy, Asset quality, Management, Earnings, Liquidity) system to regulate and to supervise banks. The capital adequacy ratio of 8 percent was imposed on the banks. The authorities also introduced new standard accounting and reporting system for banks.

2. 
   Reforms in the Financial System
   

Table 8
Reform in the Banking Industry in Indonesia, 1983-1995

Policy Measures	Before reform	After reform			Date
I. Competitive Measure
1. Entry of new banks
(a)Private banks	Closed since 1970		Permitted	1988.10
(b)Foreign banks	Closed since 1970		Permitted	1988.10

Branching power Private banks Foreign banks	Restricted 1) Restricted to Jakarta	Permitted to Sound banks Permitted to Seven cities	1988.10 1998.10
3. Foreign exchange License	Restricted 1)	Eligible for Sound banks	1988.10
4. Type of loans
(a) State banks	Mainly the extended	The scope and	1983. 6
	subsidized credit	coverage of the
	programs, as set and	subsidized credit
	refinanced by Bank	program reduced
	Indonesia
(a)Private banks	Free to set	20% total credit	1988.10
		must be extended
		to small business
		2)
(b)Foreign banks	Free to set	50% total credit	1988.10
		must be extended
		to export related
		active
5. Types of loans
(a) State banks	Set by Bank Indonesia	Free to set	1983. 6
(a)Private banks	Free to set	Free to set
(b)Foreign banks	Free to set	Free to set
6. Deposits of public sector	Restricted to state Banks	Restricted to state Banks	1988.10
7. deposits of state enterprise	Restricted to state Banks	Up to 50% with Private banks	1988.10

8. deposit rate
(a) State banks	Set by Bank Indonesia	Free to set	1983. 6
(a)Private banks	Free to set	Free to set
(b)Foreign banks	Free to set	Free to set
9. Loan rate (a) State banks	Controlled by Bank Indonesia Free to set Free to set	Free to set	1983. 6
Private banks Foreign banks		Free to set Free to set
10. credit ceiling
(a) State banks	Set by Bank Indonesia	Eliminated	1983. 6
(a)Private banks	Set by Bank Indonesia	Eliminated	1983. 6
(b)Foreign banks	Set by Bank Indonesia	Eliminated	1983. 6
11. Foreign exchange power(limited to licensed banks)	Subjected to ceilings set by Bank Indonesia	Net open position 3)	1989.11
12. reserve requirements	15% of deposits (differentiated between banks)	2% of deposits	1988.10

13. entry to new activity (a)Leasing (b)Venture capital (c)Securities trading Factoring (e)Consumer finance (f)Credit cards (g)Underwriting shares) 5) (h)Custodian Trustee and guarantor Securities administrative agency Investment Manager	Not regulated Not regulated Not regulated Not regulated Not regulated Not regulated - Not regulated Not regulated Not regulated Not regulated	Subsidiary Subsidiary Not for own Account, not as Broker/dealer Directly Directly Directly Prohibited Approval required for capital market Approval required for capital market Prohibited Subsidiaries	1988.12 4)
II. Prudential Measures
1. Capital requirements
a)Private banks	-	Rp. 10bn	1988.10
		Rp. 50bn	1992.10
(b)Foreign banks	-	Rp. 50bn	1988.10
(min. 15% domestic		Rp.100bn	1992.10
ownership)
(c)Bank Perkreditan	-	Rp. 50bn	1988.10
Rayat

2. Legal lending limit	None	1.Old credit(% of			1993. 5
		bank capital)
		Indivi.	Group
		20%	50%
		20%	50%		1993. 5
		20%	50%		1995.12
					1997. 3
		2. New credit 20% of for indivi. & group
3. Loan to deposit ratio	None	110%			1991. 2 6)
4. Capital adequacy Ratio	None	(% of risk weighted assets) 5% by Mar.1992 7% by Mar. 1993 8% by Dec. 1993 7)			1991. 2
5. Net open position	None	25% of capital			1989. 3
6. Accounting standard	None	Standardized		8)		1993. 1
III. Money market
Reintroduced in February 1984, SBI is the most important money market instrument at present. On June 1, 1993, the auction system of SBI changed from “cut-off rate”(COR) to “stop-out”(SOR). The private sector commercial paper(SBPU) introduced in January, 1985. Until now, the government has not floated treasury bonds in domestic market.
IV. Transparency and accountability of reporting and management

Notes:

1. 
   Permitted in principal, but economic and social requirements made it prohibited in practice.
   
2. 
   Since May 29, can be channeled through other banks and BRPs.
   
3. 
   Overseas borrowing for public sector is subject to ceilings set by TKPLLN(Coordinating Team for Management of Commercial Offshore Loans) since October 1991.
   
4. 
   Item (g) to (j) are subject to Ministry of Finance’s Decisions No. 1548 of 4 December 1990.
   
5. 
   Can underwrite bonds and other debt instruments.
   
6. 
   Since May 29, 1993, own capital included in the denominator.
   
7. 
   In May 29, 1993, this schedule was extended to December 1994.
   
8. 
   Standardized - Standar Khusus Akuntansi
   

SKAPI(Perbankan Indonesia) – Accounting Standard for Indonesian Banks


Sources.:

1. 
   Pakto 1988, Pakmar 1988, Pakjan 1990, Pakfeb 1991, Banking Law Number 7,
   

1992: Banking Regulation, May 29,1993

2. 
   Nasution, Anwar, “Financial Institution and Policies in Indonesia” Singapore: ISEAS(1983)
   
3. 
   David Cole and Betty F. Slade, “ Development of Money Markets in Indonesia”, Development Discussion Paper No.371, Cambridge, MA: Harvard University, HIID, in January 1991.
   
4. 
   John Chant and Mari Pangestu, “An Assessment of Financial Reform in Indonesia: 1983-90” in G.Caprio, Jr. et. Al., Financial Reform: Theory and Experience, mimeo, 1992.
   

3. 
   Liberalization of Foreign Capital Inflow
   

The Indonesian government has implemented two controversial policies regarding foreign capital inflow.

First, the Indonesian government has pursued a balance budget policy. As a result, the government did not wish to bring a budget deficit or to offset the government budget deficit by borrowing foreign capital. Instead, the government tried to offset the budget deficit by way of concessionaire foreign aid and loans from the Western official creditors. It was not difficult for the Indonesian government to draw an official proceed because Indonesia had held a substantial political and diplomatic power for a long time. The Indonesian government has strictly regulated the public sectors from obtaining foreign loans (including local government, quasi-government and state-owned enterprises) and required approvals from the Ministry of Finance as well as the Planning Agency (Bappenas-Badan Perencaan Pembangunan Nasional). The Bappenas controls the allocation of the expenditures for development in the state budget and the Ministry of Finance governs the allocation of the routine budget.

Second, the Indonesian government has attempted to attract more foreign capital, especially from direct investment by foreign entities. Although the saving rate of Indonesia has been maintained at a relatively high level for the past several decades, the investment rate has always surpassed the saving rate due to the fact that the Indonesian government had pursued and achieved high economic growth during the period. Thus, Indonesia has always maintained a current account deficit. The Indonesian government had hoped for a foreign capital inflow, which would offset the current account deficit, as well as augment and

stimulate economic growth. Foreign capital inflow in the private sector was regulated in a relatively less severe manner for the purpose of inducing foreign capital. The government had in fact helped the private sector borrow foreign proceeds at a special exchange rate and with the exchange rate swap facility assisted by the government, which provided a forward cover.

Furthermore, the Indonesian government lifted a number of restrictions on foreign capital inflow in order to attract more foreign capital. The reforms eased the requirements on the foreign exchange transaction for domestic banks and opened in considerable scope the domestic economy to foreign banks.

The new rules and regulations replaced the ceiling on the offshore borrowing by commercial banks through a system of net open position, and also abolished the limit for the inflow of FDI in November 1988. The NOP regulation requires commercial banks to maintain long and short positions of foreign currencies with 20 percent of their equities. The short-term foreign capital inflow in the private sector (especially commercial banks) increased very rapidly because the commercial banks generally take portfolio with short-term borrowing and long- term lending. The large-scale foreign capital inflow in the short-term-private sector as a result of the reforms played a role in bringing about the rapid credit extension and inflation. The increase in the short-term foreign currency liabilities lowered the mobility and vitality of the economy.

The authorities imposed a special quantitative ceiling on offshore borrowing by the public sector (including state-owned enterprises) to decrease the short-term foreign capital inflow in October 1991. The ceiling is also imposed on offshore borrowing by the private sector which rely on public institutes for raising their funds. But the quantitative ceilings on foreign capital inflow were not considered adequate in terms of efficiency because the system inevitably brought the rationing of the limited quantity based on a method irrelevant to price. (e.g., political favors)

The Bank Indonesia eliminated the exchange rate swap, which is perceived as an implicit subsidy of short-term foreign capital inflow.

Despite the reforms to restrict short-term foreign capital inflow and to control external borrowing, there are substantial loopholes. The exceptions in the restrictions are long-term economic infrastructure projects (including electric generating plants, telecommunications, toll roads) and industries substituting import (including strategic industries), which are designated by the Ministry of Research and Technology. The designated strategic industries are aircraft (PT IPTN), steel mills (PT Krakatau Steel), shipyard (PT PAC), diesel engines (PT oma Bisma Indra), heavy equipment (PT Barata), electronics (PT LEN), telecommunication equipment (PT INTI), light armaments (PT Pindard), locomotive and railway tracks and wagons (PT INKA). Such industries represent an ambitious plan by the Indonesian government that fosters strategically industries that are considered that necessary for Indonesia to become a developed country by sacrificing an important monetary policy. Unfortunately, the Indonesian economy was not equipped with basic fundamentals to comply with the policy.

First, there was no incentive for strategic industries to promote quality, efficiency, marketability, or etc., because of the government’s protection or guarantee for monopoly or oligopoly status.

Second, the pilot companies taken strategic industries were not competitive companies but politically involved private enterprises. Basically, these kinds of firms are not capable of producing high quality commodities or service.

Lastly, the development in the Indonesian economy did not reach the level high enough to be on track with the high technology industries and there was no domestic market capable of upholding the industries

The Indonesian monetary authorities were not able to succeed in controlling

foreign debts or in decreasing short-term foreign capital inflow due to the unreasonable exception policies. The total amount of Indonesian foreign debts surpassed US$130 billion, which contributed, to the foreign exchange crisis in 1997. Such exceptions, which had deviated from the basic principle, became one of the main causes of the national disaster.

4. 
   Interest Rate Policies
   

The interest rate, which consists of the deposit interest rate and the lending interest rate, is one of the most important factors that affect the bank’s profit level. The gap between the deposit interest rate and the lending interest rate is the deciding factor for the bank’s profits. The interest rate is decided by the conditions of the money market, e.g., demand and supply of money or the inflation rate since the interest rate is the opportunity cost for holding the money in addition to being the expectation money value of the future. The liberalization of the interest rate may be regarded as the first step to the liberalization of financial sectors.

The reforms in 1983 endowed the Indonesian banks with full autonomy in deciding the interest rate according to the money market condition from the complicated ceiling as a result of a selective credit policy and from the repressed credit system involving subsidized interest rates. The following serial financial reforms also removed the external barrier in the financial market. The external deregulation increased the capital mobility and sensitivity for the international interest rate.

These reforms caused serious problems:

First, the monetary policy of the government was limited and became complicated because of the close correlation between the interest rate and exchange rate. As a result, the authorities had to intervene in the foreign exchange market in order to control the interest rate.

Second, the Indonesian financial authorities adopted the CAMEL system to regulate and to supervise the banking system. Generally, undercapitalized Indonesian banks faced serious problems because the banks could not take high risk and high return assets due to CAR.

2.