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“The banking system is now more resilient”

Interview - May 7, 2014
Bank Indonesia – the central bank of the country – has one single overarching objective: to establish and maintain rupiah stability. In an interview with United World, Senior Deputy Governor of the bank Mr. Mirza Adityaswara discusses how the bank is working to achieve its objective, and talks about the transformation of the banking industry through the continuation of financial sector reforms
In the last decade Indonesia has been transformed almost beyond recognition, please, share your insights into Indonesia’s financial and economic accomplishments?

The real change started in 1998, with the Asian Financial Crisis. The rupiah depreciated from Rp2,500 per USD in July 1997 to Rp16,000 per USD in June 1998, and during that time interest rates increased from 12% to 70%. The government was forced to step down as a result of the crisis.

This was when we saw a major transformation in the financial sector. Before the crisis there were around 240 banks in Indonesia; the crisis reduced this number to 120 banks. In 1999 Indonesia needed to recapitalize many banks, we merged the four large state owned banks into one, known as Bank Mandiri, we also recapitalized the smaller banks through either Government or foreign investment. After this recapitalization we cleaned up the non-performing loans (NPLs) and transferred them to Indonesia’s Bank Restructuring Agency. Around 3 years after the recapitalization we divested the banks that were recapitalized to foreign investors. This was in an effort to improve governance, capital positions, and risk management. The Government is still the owner of the major banks, when Bank Mandiri went public the government retained 65% of the shares.

Bank Indonesia was also reformed; before 1999 it was part of the Government, after, it became independent based on Central Bank Law. The supervisions department was restructured and significantly reformed.

What were the effects of these reforms?

The banking system is now more resilient. Capital requirements for new entrants was raised to Rp3 trillion. In 2004, we also established the Deposit Insurance Corporation (LPS) so that the widespread panic of 1998 can still be avoided, while the Government does not need to directly guarantee the banking sector.

There have been other major improvements in the banking sector. The capital adequacy ratio is much higher now (19%), and well above the Basel II requirement of 8%. Another improvement has been the banks’ increased profitability. Before 1998, net interest margin was only 2-3% because many banks were owned by conglomerates that tend to lend money to their own groups at very low margins; this was unsustainable. Additionally, before 1998 foreign exchange loans were 40% of total loans and the interest rate was lower compared to that of domestic currency loans. However, after the reforms the banks moved away from corporate loans and into Indonesian consumer loans and micro loans, which provided higher margins than foreign exchange and corporate loans. So currently, the net interest margin is around 5%. Additionally, the return on equity of Indonesian banks is above 20% and return on asset is higher than 2.5%, some banks even have a ROA of around 4%, which is very high. Analysts usually say that achieving a ROA of above 1.5% is very difficult, so banking in Indonesia is now a very profitable business, which is why investors continue to invest in this sector.

As I mentioned foreign exchange loans were 40% of total loans, now they are only 15%, so if there was a shock in the currency market it would not have the sort of effect it had 16 years ago. We are much more disciplined than before. In those days companies borrowed foreign exchange loans even if they earned revenue in rupiah. So when the rupiah weakened the debtor could not pay.
Another effect of the reforms has been Bank Indonesia’s enhanced regulations and supervision. The gross NPL ratio is only around 1.8-1.9%. Many of the major listed banks have provision coverage above 150%- 200%, as to buffer any unexpected occurrence.

What are the main areas that reforms should be focused on in the future?

After the 2014 election we will keep reforming. Legal reforms are the priority. It is very important for business efficiency, which in turn is important for keeping the costs of doing business under control. It is also imperative to restructure our export products. If we look at the structure of the economy, we are facing a situation where China has slowed its economic growth to around 7% and changed the formula for economic growth. China is now focusing more on domestic demands; there is less demand for our main export commodities, such as coal. We must counter the declining proportion of commodity exports with an increase in manufacturing exports.

We must also diversify our export destinations. The US is steadily recovering, so it is time to refocus on the United States as an export destination. We also need to put a greater focus on our agricultural products; Indonesia has a large unrealized potential. We need to reduce imports of products where we have the comparative advantage. Reforms should focus on moving to the next stage of development; adding value.

Explain some of the recent challenges the banking sector and the wider Indonesian economy have faced lately.

Indonesia enjoyed very good loan growth, especially during the Chinese economic boom. Commodity prices were very strong and banks loaned extensively to new commodity companies. Problems arose when China changed the direction of its economic policy, intentionally lowering growth from 12% to 7%, which coupled with the US crisis in 2008, the European crisis 2009-10, and the later, shale gas revolution in the US, meant that the coal price was coming down, as were commodity prices in general, hence our exports started to decline.

However, because of the emergence of the middle class in Indonesia, loan growth continued to be very strong. We had loan growth of 26-27%, and very low interest rates because of the quantitative easing programs in the US and Europe, and this led to higher imports. We managed to keep inflation low, but our balance of trade was in deficit and fuel imports went up.

In May 2013, the Federal Reserve made a statement that quantitative easing would be tapered. So money began leaving many emerging markets. Anticipating this, we knew we had some problems to solve, especially balance of trade and current-account deficit. We started seeing a deficit from the fourth quarter of 2011, widening throughout 2012-13. We needed to reduce imports and encourage exports, so we increased the BI interest rate by 175 basis points and tightened loan to deposit ratio to 92%. We advised banks not to grow loans above 20% and not above 17% for the period 2013-2014.

Obviously a big challenge has been the currency. Mantaining the exchange rate at Rp9600 per USD could not be sustained would only create further demand for imports and discourage export. Hence we decided to let the currency float and save our foreign exchange reserves.

With these strategies in place we started to see results very quickly, in October, the balance of trade improved and closed with a US$80 million surplus. By November the surplus increased to US$800 million, and in December it was US$1.5 billion. The general opinion is that we have recovered from any balance of payments issues, but the US monetary policy will still affect us, as interests rates in the US are set to go from 0.25% to 2-3% in the next 2 to 3 years. We will continue to adjust our polices to face the challenges ahead.

How can the financial sector be strengthened in Indonesia?

I think that there should be more banking consolidation. In partnership with OJK (Indonesia Financial Services Authority), we issued regulations whereby if a bank fails to maintain top ratings in terms of soundness and good corporate governance (within the top two of the five ratings categories), the owner must divest ownership to 40%. This means that they must divest to a stronger investor. This would certainly create a stronger banking system.

I also think the financial market needs to be deepened; in Indonesia the value of trade transactions is around US$30 billion a month while our spot FX transactions is only US$1 to 2 billion a month, so our financial system is still too small. We want to deepen both the money market and foreign exchange. We started last year with what we call a mini repo agreement; we encourage big banks to do transactions with mid size and small size banks using the repo mechanisms. Before the current repo agreement, most banks placed their excess liquidity in Bank Indonesia and the big banks were reluctant to lend to smaller banks. However, under the new system the smaller banks could use their securities as collateral for the bigger banks to lend them money, ensuring liquidity, and deepening the money market.

The foreign exchange transactions and interbank swap market also needs to be developed. In other countries the swap market is actually larger than the spot market. During the second semester of last year spot market transactions were only around US$300-500 million a day. That is why Bank Indonesia must try to improve the market liquidity for the foreign exchange market. The situation is already improving and the market is now around US$1 billion a day, but it could still be improved.

What effect will the ASEAN economic community have when it comes into force?

I think it is a big opportunity. Indonesia’s banks, insurance companies, manufacturing companies, as well as the population can benefit from a more open market. In the financial sector specifically, we are already very open, there are many foreign banks, and local banks owned by foreign banks, and yet, we have no banks in Malaysia or Singapore. This is because we have such a big market, for Indonesian banks and insurance companies, this market still has many opportunities. However, Indonesian banks should look for opportunities in other ASEAN countries, not just for short-term investment but also for long-term business opportunities over the next 30 years.