Indonesia’s need for bank reform

Author: Anwar Nasution, University of Indonesia

The collapse of the much-anticipated deal between the Development Bank of Singapore (DBS) and Bank Danamon on 30 June, due to Indonesia’s new bank ownership rules, is further evidence of Indonesia’s nationalistic approach to the banking sector. 

DBS had intended to take over a 99 per cent equity share in Bank Danamon, including a 67 per cent stake from Temasek’s Fullerton Financial Holdings for Rp66.4 trillion (US$6.5 billion). But the deal fell apart as Indonesia’s new bank ownership rules, which were introduced in 2012 as part of Indonesia’s inward-looking strategy, only allowed DBS to acquire a 40 per cent stake in Danamon.

The collapse of the Danamon deal comes at a bad time. Indonesia’s national budget and balance of payments have continuously shown a deficit since 2012 due to falling export prices of primary products and shortfalls in government revenue. While investment is slowing, particularly in mining and agriculture, short-term capital flows from raw materials and primary products — coal, nickel, tin and palm oil — are on the rise due to growing demand from China and India.

Additionally, the Rupiah has been rapidly eroding since June this year due to a combination of factors, namely the receding export values, slowing long-term foreign direct investment and increases in short-term capital. To protect the Rupiah from falling even further, Bank Indonesia has heavily intervened in the foreign exchange market by drawing from its foreign exchange reserves, which have eroded from US$116.4 billion in March 2012 to US$100 billion since June.

Foreign direct investment in Indonesia is mainly confined to mining and agriculture. Indeed, the rapid growth in export and foreign investment in mining and agriculture had been the main engine of economic growth in Indonesia since the 1997 Asian Financial Crisis. But because of Indonesia’s inward-looking strategy, the country is not an attractive place to invest in other sectors of the economy — particularly in Indonesia’s banking sector, as evidenced by the collapse of the DBS–Bank Danamon deal.

Bank Indonesia’s restrictive ownership policy is part of this inward-looking growth strategy that seeks to protect Indonesia’s domestically owned banks. This growth strategy is nothing new — Indonesia consistently ranks as one of the most restrictive countries against foreign direct investment. The restrictive ownership policy preserves the market segmentation and blocks competition in Indonesia’s relatively under-developed banking sector. The market is segmented so that the central government gives exclusive rights to its four state-owned banks — Bank Mandiri, Bank Rakyat Indonesia, Bank Negara Indonesia and Bank BTN — to deposit financial resources from the central government’s institutions and state-owned enterprises, while the 26 regional development banks owned by provincial and district governments are designed to only benefit its owners. Together, these two groups of state-owned banks control about 50 per cent of the Indonesia’s banking market. Meanwhile, the domestic private banks are mainly interested in mobilising financial resources to finance their affiliated companies in the same group of business as the state-owned banks.

To make matters worse, the financial intermediation system in Indonesia is one of the least developed in Asia. Bank loan penetration (the ratio of bank loans to annual GDP), at 30 per cent in 2010, is the lowest compared to its neighbours in Southeast Asia. This indicates that a large proportion of the population do not have access to banking services.

The high cost of intermediation and the inefficiency of Indonesia’s banking system are also evidenced by the fact that Indonesia’s net interest rate margin (NIM) — the margin between lending and deposit rates — is now the highest of all ASEAN countries. In 2009, Indonesia’s NIM margin was 5.9 per cent as compared to 3.9 per cent in the Philippines, 3.4 per cent in both Vietnam and Thailand, 3 per cent in Malaysia and 1.8 per cent in Singapore. In 2010, the NIM of Indonesia’s state-owned banks (at 6.11 per cent) was the third-highest in the market after the small non-foreign exchange banks (at 9.10 per cent) and regional development banks (at 8.74 per cent).

Bank Indonesia has tried a variety of measures to lower bank lending rates, but without much success. The first measure was to set an upper limit for deposit rates at 50 basis points above Bank Indonesia’s policy rate. The second measure was to set prime lending rates as reference for interest rates on loans. Both measures, however, failed to deliver on their terms.

Indonesia’s banking system is in serious need of reform. Indonesia should remove market segmentation and push for greater competition in the banking and finance sectors. This would encourage greater banking penetration and financial inclusion, facilitate the modernisation of Indonesia’s banking system, improve efficiency and reduce interest rates.

Anwar Nasution is Professor of Economics at the University of Indonesia, Jakarta.

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