Introduction

The discussion in the previous chapter shows that Indonesian manufacturing establishments seem to have different access to credit according to their characteristics. Evidence also exists that the elimination of administered interest rates and credit ceilings has changed previously negative real interest rates to relatively high positive rates. Relying on recent theoretical and empirical studies on the link between financial market imperfections and real activity, this chapter will examine whether the deregulation of the banking system has resulted in any relaxation of financial constraints that firms face in their investment behaviour. In particular, this chapter will analyse whether different types of firms have different financing behaviour before and after the financial reform.

In order to analyse cross-sectional variations in financing and investment behaviour before and after the financial reform, establishment data for the manufacturing sector that are currently available in suitable form for the period 1981–88 only will be used. The 1981–84 period will be referred to as the “prederegulation” period on the assumption that changes instituted late in 1983 had insufficient time to affect real investment decisions until well into 1984, while 1985–88 will be referred to as the “post-deregulation” period. This dichotomization suggests a once-for-all regime shift that considerably exaggerates the reality. Rather, there was a fairly continuous process of deregulation of various aspects of the economy after mid-1983. Furthermore, the response of economic agents to these reforms took place fairly gradually. Nevertheless, for our purposes, the 1983 reforms were extremely significant for increasing levels of real interest rates, and reducing credit controls on individual banks. Dominant state banks were forced to act more autonomously and to base their lending decisions more on commercial criteria than had been the case before the reform.

Review of the Literature on Investment and Financial Constraints

Over the last decade, studies that link financial structure and investment behaviour have been put on firmer theoretical ground, borrowing heavily from the economics of information and incentives.

Introduction

During the 1980s, Indonesia undertook a series of structural reforms in response to its deteriorating economic situation especially in the market for Indonesia's primary export, petroleum products. It was recognized that high economic growth could not be sustained by export earnings alone, and that diversification from oil-related export was needed. The deregulation of the banking system removed control on interest rates and administratively determined credit ceilings were abolished. The devaluation of the rupiah and trade deregulation were part of the programme to stimulate economic growth and improve resource mobilization.

This chapter gives an overview of the Indonesian economy and discusses the process and effects of the financial liberalization. The reform in the financial sector should be examined in the context of the whole economic reform. Macro-economic and financial-sector indicators of 1981–88, which reflect the economic growth, capital accumulation, and financial deepening will be presented, as well as the behaviour of interest rates, and a brief review of the financial system in relation to the industrial policy. There is also an assessment on whether the dramatic switch in the regulatory regime generated any efficiency and growth benefits as predicted by financial repression literature (McKinnon 1973; Shaw 1973).

Macro-Economic Review and Economic Background to Deregulation

Since 1968 Indonesia has been having a high rate of growth, facilitated considerably by high oil prices in the 1970s and early 1980s. As an oil exporter, Indonesia experienced two major booms, in 1974–77 and 1979–82. The period of oil boom, which began with a quadrupling of oil prices in 1973 and continued with high prices until 1982, had profound effects on the Indonesian economy. Table 1.1 shows the growth of its gross domestic product (GDP) since the beginning of 1970. During the first period of the oil boom (1972–81), the average annual change was 8.1 per cent, a very high figure compared with other developing countries.

APPENDIX I: DATA CONSTRUCTION

This appendix describes the procedure used to construct my data set, including the method used to construct annual capital stocks and stocks of debt that are not available in the original survey data.

Data Construction

The data has been taken from the annual surveys on manufacturing establishments conducted by the Central Bureau of Statistics since 1975. An additional data set, which proves to be very useful because it contains data on capital stocks and exports, is the 1986 Census of Manufacturing Establishments. The number of establishments in the annual survey varies from 8,300 establishments in 1975 to around 14,000 in 1988, and the 1986 census has 5,830 establishments with complete capital stock data.

I select a sample of firms from those two sources as follows. As there is no data available on financial sources prior to 1981, a sample period which runs from 1981 to 1988 is used. The 1981–88 survey data include 4,400 firms with complete data for at least three sequential years of output. The census data include 5,430 firms. Merging the 1981–88 survey with the 1986 census set brings the total number of firms to 3,192. I then construct a capital stock estimate by back-casting and forecasting the capital stocks, using the capital stock from the 1986 census data as a benchmark (see below for details). Leaving out establishments that have negative and zero capital stock and outliers, and keeping firms that have at least one year of positive investments, leaves us with 2,970 establishments (data set I). The frequency of each category of firms is given in Table 1 of this appendix. This data set is used to calculate the tables in Chapter 2 and the summary statistics in Chapter 4, section 4.

A very large number of firms report zero investment for many years. I am unable at this time to determine whether reporting of zero investment is in fact a non-response or represents a real observation of very low investment. I run a logit estimation of investment where it takes a value of 1 if investment is positive, and zero otherwise, the results of which are given in Table 2 of this appendix.

Introduction

The issue of whether the shift towards market-based credit policy has helped in directing credit to technically more efficient firms have been investigated in numerous studies. Do financial resources flow to more efficient firms after the removal of administrative controls in the financial market? Other things being equal, do more efficient firms receive more debt after liberalization that affect their capital structure? Is a higher proportion of investment carried out by firms that are more efficient, that is, firms with higher productivity?

This chapter investigates whether financial reform in Indonesia has indeed redirected credit towards more efficient firms, as suggested in financial repression literature. Firm-level efficiency is an interesting tool to compare market-based and government-directed allocation of credit. To explore this issue, an attempt is made to incorporate different measures of efficiency in explaining the distribution of credit and investment, before and after the reform. In particular, taking into account market structure issues, this chapter will explore a physical measure of efficiency derived from different specifications of frontier production functions. Whether a firm's technical efficiency plays a role in the allocation of credit, and whether its role changes before and after liberalization will be tested. It will also investigate whether there are specific characteristics of firms that can be identified as being potentially related to efficiency. The performance of measures of efficiency derived from the production function will also be compared with less structured measures of efficiency.

Literature Overview and the Measurement of Efficiency

How is efficiency measured? There are various concepts of efficiency available in the economic literature. The focus here will be on firm-specific technical efficiency, defined as how close a firm is to the production possibility frontier, given its quantity of capital and labour.

Farrell (1957) develops a method of measuring efficiency and characterizes the ways in which a production unit can be technically and allocatively inefficient.

Is there econometric evidence that liberalization has succeeded in relaxing financial constraints faced by individual establishments? This chapter investigates the issue by estimating a simple form of the investment function for the panel of individual establishments.

Introduction

Our basic theoretical view is that Indonesian manufacturing establishments increase their capital stock through investment in response to potential profitearning opportunities. Desired investment can be financed in a number of ways, the two most important being borrowing from the credit market and retention of cash flow (internal finance). If capital markets are perfect and taxes are absent, firms will be indifferent between various sources of funds. They will finance their investment at a constant marginal cost that is closely related to the risk-free market interest rate, and they will invest until the latter is equated with the expected marginal return to investment. In such a world, only the constant marginal cost of funds and rate of return to investment are important for the investment decision and the former should be closely related to the risk-free market interest rate.

However, even in perfect markets there will be constraints to borrowing because of asymmetric information, monitoring costs, and other factors, which make fixed-interest-rate lenders willing to lend a higher proportion of the costs of proposed investments only at increasing interest in order to compensate for the increased risk. The premium charged will depend on the value of the firm's assets that can be used as collateral. This is referred to in the literature as agency costs. Therefore, a negative association is expected between increasing divergence between average and marginal interest rates for individual borrower firms as the degree of financial leverage increases.

If markets are segmented so that some classes of firms have limited access to borrowing, they will be forced to rely on internally generated funds and may have to forego some desired investment because of financial constraints.

The general atmosphere at the Seattle meetings was very positive. Even the weather, unpredictable in that part of the country at best, co-operated and there was sunshine almost all of the time. Seattle is a mid-sized city in the American northwest. It is famous for its salmon, intellectual life and a damp and rainy climate. It is also a major U.S. gateway for trade with Asia. Its importance to Pacific trade, and the fact that Seattle is home to such international giants as Boeing, Microsoft, and Weyerhauser, made it an appropriate U.S. city to host the 1993 APEC Ministerial Meeting.

When President Clinton decided to host the APEC Leaders' Meeting there as well, the logistics became a little sticky. But the people of Seattle rose to the occasion, and their hospitality and warm welcome reflected the very best American qualities. Fortunately, two friends from the state Department, Chris Runkel and Pat O'Brien (who had helped me set up the secretariat in the early days) were in charge of a major part of the logistics and they did an incredible job. They also ensured that the secretariat was set up so that it could function efficiently.

Everywhere you looked, including the Space Needle, there were posters and “WELCOME APEC” signs. Even the local adult movie house joined in the act with a risque marquee welcoming the delegates. The local citizens endured the intrusive security measures, the VIP motorcades that tied up traffic and the overtaxed facilities with good cheer and humour. It seemed perfectly appropriate that the theatres in the city were showing “Sleepless in Seattle”.

In addition to the official APEC meetings, there was a customs fair, an international business forum, meetings of PBEC and PECC, and numerous bilateral diplomatic meetings, including the first high-level meeting between China and the United States since 1989. The three official APEC meetings were the SOM, the Ministerial Meeting, and the Informal Leaders' Meeting on Blake Island in Puget Sound, with President Clinton as host.

Summary

Thailand has been a latecomer to industrialization in general, and to clothing and textiles in particular, largely as a result of the free trade policies that followed the Browring Treaty (1850–26) and subsequent attempts at public investment in industry. The policy served the country well in developing agricultural and raw material exports in the 1950s and 1960s. Thailand concentrated on exporting agricultural products such as rice and teak, while it imported manufactured products. A change in policy in favour of promoting private investment in the 1960s was inaugurated with the introduction of tariffs, an Investment Promotion Act and subsidized credit for industry. Clothing and textiles were among the first industries to be affected by these policies. Initially, manufacturing was largely for import substitution.

Clothing and textiles have become increasingly important since the mid 1980s because of their successful export performance. They have become the highest foreign exchange earners and the major source of employment in manufacturing.

Government intervention in clothing and textiles has been considerable, but often confusing. There has been both promotion and protection, as well as attempts to restrict the industry's capacity.

Although tariff protection has been high, especially at the more capital intensive end of the industry (notably for man-made fibres), the level has been moderate when compared with many other developing countries. Promotion granted to the industry has been intermittent. The government has also tried to control the supply of textiles by prohibiting capacity expansion from 1978–86.

Fluctuations in clothing and textile policies reflect the effectiveness of lobby groups within the industry. From time to time interest groups have lobbied: for the prohibition of expansion, against the establishment of new textile capacity, for protection, for an export quota allocation system that favours large firms, and for other forms of public assistance.

The prohibition of expansion of textile capacity has a major impact on the organization of the industry and on the effectiveness of protection policy.

It gives me great pleasure to be here today and to have this opportunity to discuss Indonesia's financial development and prospects. At the outset, let me note that I have taken the liberty of changing the title that was suggested for my presentation, namely: ‘Financial Deregulation Too Much? Not Enough?’. The original title seemed to suggest a simple either/or answer to what is really a complicated set of questions. Although we often use the term ourselves, I felt that it was inappropriate to label what has happened in Indonesia, or in a number of other countries for that matter, simply as ‘deregulation’. A more accurate label might be ‘regulatory reform’.

Some of the early writers in the field of finance and development, such as Edward Shaw (1973) and Ron McKinnon (1973), emphasised almost exclusively the elimination of certain controls as the key to the development of the financial system. They called this process financial liberalisation. Today, we would call it deregulation. But as the experience of several Latin American countries in the late 1970s and the United States’ savings and loan industry in the 1980s have made clear, reforming a financial system is fundamentally a two-pronged process. On the one hand, it involves the removal of direct controls over prices, quantities and activities, combined with an easing of the process that governs the entry of new firms. The result should be that economic choices will be determined mainly through the interaction of market forces. On the other hand, it requires the imposition of prudential regulations that ensure that clear and sufficient information is available to all, reducing excessive risk and minimising opportunities for fraud and manipulation at the expense of the general public.

It is probably correct to characterise the very first steps taken by the Indonesian Government in June 1983 as deregulation. These initial steps consisted of the removal of direct central bank control over the state banks’ interest rates, and over credit allocation by all banks.

Overview

The prospects for peace and stability in the overall East Asian/ Western Pacific region for 1994-95 remain largely positive. A credible U.S. military presence will remain, Japan will still be anchored in the security alliance with the United States, and Russia preoccupied with domestic problems. China is likely to experience more domestic stresses but there will be no reversal of the policies of economic reform. North Korea remains the biggest uncertainty. In a much changed world, will change in North Korea, which is inevitable, be managed peacefully? And will North Korea be nuclear-armed?

While in the short term the strategic landscape will thus remain largely unchanged, with many familiar sign posts still in place, over the longer term a new balance of power will be shaping. It is clear that China wants to be a powerful military player and would want to acquire the necessary power projection capabilities. Japan sees this coming. Despite the reassurance provided by the Clinton Administration's new five-year defence plan, doubts remain as to whether the United States will retain credible military power or the will to carry the burdens of international security by the turn of this decade. If the economic sums do not work out as planned by a president elected to solve the country's domestic problems, the defence budget can easily become politically the least unpalatable target for more cuts. The anxieties of many countries in the Asia- Pacific region over such longer-term concerns were reflected in the establishment in 1993 of the ASEAN Regional Forum (ARF), an Asia- Pacific-wide forum for security discussions. Its purpose is to foster better understandings and confidence.

Yet such anxieties should not be unduly exaggerated for there are also positive longer-term trends. First, there is the economic dynamism and growing interdependence of the Asia-Pacific region. Secondly, the very establishment of the ARF in such a short time indicates that there is a will among the various countries to build a climate of confidence. Thirdly, there are indications that America sees its economic destiny increasingly linked to Asia.

It is a great pleasure to share the platform with such a distinguished economist and, could I say, valued friend. But it is with some trepidation that I comment on this paper, because not only was Pak Ali present at the creation of the Indonesian financial sector as we now know it, but he was mid-wife at its birth and its guardian as it grew up.

While on this subject of the Good Old Days, let me say that I resist the idea that the development of the Indonesian financial sector started with the regulatory reform of June 1983, because I believe its true origins go back further and can be found in the early days of the New Order.

Some highlights of the process of financial reform

The 1960s: early reform

The main achievement of this period, of course, was the halting of hyperinflation. Without this achievement, the financial sector could not have been built. McKinnon (1973:3) captures the essence of this when he says ‘[O]nce the monetary linchpin is put in place, appropriate strategies for liberalizing foreign trade and rationalizing domestic tax and expenditure policy follow naturally’. In this early period, also, came the removal of controls on foreign capital flows and the introduction of what, for its day, was a high- tech financial instrument—high interest rate time deposits.

Innovations in exchange rate policy

Also going back to this early period, Indonesia had a brief flirtation with floating exchange rates, long before they became fashionable. Just as others, in a later era, recognised the problems of a floating exchange rate, Indonesia moved to a greater degree of fixity during the 1970s. Then came the three bold devaluations. Not all commentators were quick to see the underlying logic of these changes, but many now see them as a great success in that they reoriented the economy towards export growth, driven by very favourable international competitiveness.

Parameter Lists and Data Sources

Demand and supply parameters are required for the model. The demand parameters are income elasticity of demand, price elasticity of demand, elasticity of demand for domestically produced products, elasticity of total demand for imports, elasticity of demand for imports from restricted and unrestricted products, and substitution demand for imports by source in restricted and unrestricted markets. The parameters have been gathered from this study's estimates as well as from several other studies. These include: Houthakker and Taylor (1970); Moshin (1974); Stern, Francis and Schumacher (1976); Tan (1978); Stone (1979); Lee and others (1980); Grossman (1982); Kirmani, Milajoni and Mayer (1984); Hufbauer, Berliner and Elliott (1986); Koekkoek and Mennies (1986); Cline (1987); and Erzan and Karsenty (1987). Where the elasticity of demand for a particular country is not available, a formula has been derived from the data available and market shares. Estimate of the elasticity of substitution is not available by source. It is assumed to be low (0.5) in developing countries, as there is limited access to these markets and thus low degree of substitution is allowed, and higher (2.5) for developed countries in both restricted and unrestricted markets, where a higher degree of substitution is allowed from different sources because these markets are more open despite the MFA.

Data on supply parameters were difficult to obtain. The elasticity of transformation between clothing and other products was close to 1 for industrial countries and the ROW, and lower in other developing countries. Other elasticities have been assumed to be equal to 1 in all countries/country groups following Cline (1987).

The Myanmar economy, according to official sources, grew by an impressive 10.9 per cent during the period 1992-93. As this rate I is derived from provisional data, it is more likely that real growth was between 7 and 8 per cent. Much of this good performance can be attributed to a 15 per cent growth in the agricultural sector brought about by increases in cultivated area and good weather. This is also partly explained by mobilization of the public sector for more efficient operations. Furthermore, the high growth rate is also partly a function of the low base from which economic growth has been moving forth. Although a recovery is under way, the gross domestic product (GDP) in real terms is still smaller (54,170 million kyats) in 1992-93 than it was (55,989 million kyats) in 1985-86.

Most of the economic sectors, with the exception of services, have achieved double-digit growth. The power sector grew by 17.2 per cent, mining by 15.5 per cent, and processing and manufacturing by 13.7 per cent. Nonetheless, this recovery was marred by high inflation and a continuing government deficit. Both these trends have been fuelled by a rapid rise in money supply of around 40 per cent each year since 1990. This has been accompanied by an overvalued exchange rate, which pegs the kyat at over twenty times the market rate. Prices for consumer goods rose significantly and confidence in the currency has been waning. While official consumer price index (CPI) figures indicate a 22 per cent rise in 1992-93, unofficial sources peg the increase at around 70 per cent. More unsettling has been the disclosure that some cities in Upper Myanmar have begun to import lowprice rice from China especially since Myanmar used to be the rice bowl of Asia. While 1992-93 appears to have been a period of unprecedented high growth it remains to be seen whether this can be sustained.

The history of the Indonesian capital market dates back to the period of Dutch colonisation. A stock exchange was established on December 14, 1912 in Batavia—or Jakarta, as the city is called today. It was considered sufficiently successful that two additional exchanges were set up in 1925—in Surabaya on January 11, and in Semarang on August 1. During this period, there were thirteen exchange members, and the number of listed securities totalled 250 (Usman 1990:186).

After the Proclamation of Independence in 1945, the Indonesian government attempted to re-activate the capital market through the issue of its own bonds in the 1950s. This activity was governed by the Emergency Law on the Bourse No. 13 of 1951, which was superseded by the Law on Bourse No. 15 of 1952 (Usman 1990:3). This law is still in effect, and governs the activities of all capital market practitioners, although a new law on capital markets is now being drafted, and is expected to be introduced to the Parliament before the end of the fiscal year in March, 1995 (Ruru 1994b). According to Article 3 of the existing law, the Minister of Finance is responsible for supervising the activities of the Jakarta Stock Exchange (JSX), while Article 5 delegates responsibility for organising its activities from the Minister to the Association of Money and Securities Traders (Perserikatan Perdagangan Uang dan Efek-Efek, or PPUE), with the assistance of the central bank (Bank Indonesia).

A sluggish revival: 1977-1988

After independence, the law and the association proved unable successfully to promote the further development of the capital market, which fell into decline—for reasons which included the nationalisation of Dutch and other foreign companies, political instability, and chaotic economic conditions in which inflation peaked at 650 per cent in the mid-1960s. In an attempt to revive the Jakarta Stock Exchange, the New Order government set up a Capital Market Executive Agency (Badan Pelaksana Pasar Modal, Bapepam) through a Presidential Decree (Government of Indonesia, 1976). Bapepam was established as a unit within the Ministry of Finance, with a mandate to organise the stock exchange and to act as the capital market supervisory agency.