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Analysis: Deepen financial system to support infrastructure development
Starting from 2015, the government will focus on four strategic areas: maritime connectivity, infrastructure development, food security and energy security
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Starting from 2015, the government will focus on four strategic areas: maritime connectivity, infrastructure development, food security and energy security. The initiative to build and revamp infrastructure definitely requires lots of funding. The highest proportion of infrastructure funding will go to electricity (19.5 percent), followed by maritime (17.9 percent) and roads (16 percent).
The government has predicted that during the next five years, the need for infrastructure financing will be around Rp 5.5 quadrillion or Rp 1.1 quadrillion per year. With limited government funding ' government budgets (central and regional) will only cover around 50 percent and 19.3 percent will come from state-owned enterprises (SOEs) ' the role of the private sector is significant (30.7 percent).
Fund raising from the private sector both domestically and from abroad can be done through financial systems. However, the financial system in Indonesia is still shallow compared to other ASEAN countries. The M2 money-supply measure to gross domestic product (GDP) ratio in 2013 was 40 percent compared to Malaysia (142 percent), Singapore (133 percent), Thailand (131 percent) and the Philippines (59 percent).
The ratio of total reserve to GDP is also the lowest: 12.9 percent compared to Singapore (92.7 percent), Thailand (49.6 percent), Malaysia (45.8 percent) and the Philippines (33.5 percent). The banking sector dominates the financial system with a contribution of more than 87 percent while bonds and equity contribute the rest.
However there are limitations in the banking sector. A high loan-to-deposit ratio limits the ability to boost more aggressive economic growth. Previously, to obtain a 12-percent nominal economic growth, by rule of thumb, we needed 18 percent of loan growth. The second limitation comes from the capital adequacy ratio (CAR), which will decrease in accordance with aggressive financing.
Meanwhile, the assets of the banking system were around
Rp 5.45 quadrillion in October 2014 compared to Rp 416 trillion for multi finance companies and Rp 235 trillion of mutual funds. Although infrastructure loans from the banking sector have increased by more than four times since 2007 to September 2014 (from Rp 88 trillion to Rp 348 trillion), this only covers 32 percent of national infrastructure financing needs.
The capital market is still shallow as depicted by the average daily trading in the local currency government bond market that only reached US$951 million in 2014 (vs Malaysia and Thailand that reached $2.7 billion and $4.8 billion, respectively) and the corporate bonds that also only reached $54 million (vs Malaysia and Thailand that reached $294 million and $157 billion, respectively). The number of companies listed on the Indonesia Stock Exchange is 501, with daily average transactions of $500 million, which is low compared to Malaysia and Thailand.
Moreover, a shallow financial market increases the vulnerability of the financial system since the dependency on foreign funds is high. High foreign-investor exposure in the Indonesian market leads to a high risk of capital reversal. Percentage of foreign stock transactions and foreign ownership in government bonds in Indonesia is higher than in Malaysia and Thailand (38 percent and 31 percent respectively).
Against this backdrop, financial deepening is really necessary for Indonesia especially with the high need for infrastructure funds. There are four main asset classes that can be developed to deepen the financial market, namely, the money market, bond market, foreign exchange market and equity market. Each market faces different challenges and has different initiatives that can be developed. The primary barrier faced by those markets is the lack of structural investors in Indonesia's economy. Big and long-term domestic investors are lacking as pension funds' involvement in the market is still limited.
In addition there is small history of shares traded and limited product variety for bond markets. Actually the share of wealth that is being managed in Indonesia is relatively small. The major segments are offshore high net-worth individuals and non-resident Indonesian accounts as well as corporations, including export money, which was not repatriated. Offshoring high net-worth individuals are driven by business relationships, variety of products and risk diversifications as tax can be very high in Indonesia.
The second challenge is a lack of instrument variety to accommodate investors' needs. One problem in the money market is limited and uncollateralized instruments; therefore, the development of cross currency swap (CCS) facilities, negotiable certificates of deposit (NCD) and repurchase agreements (REPO) is desirable. Coordination among government agencies is necessary, such as tax treatment for swaps and a clear definition of CCS.
The development of capital-market mortgage securitization instruments such as real-estate investment trusts (REIT) and residential-mortgage backed securities (KIK EBA) will provide alternatives for investors for securitization of assets. Some banks have developed these instruments but government support in terms of regulations and policies is still needed to accelerate the development of the instruments.
Other policies that are expected by investors to further develop the financial system in Indonesia are double taxation exemptions for KIK EBA because until now special purpose vehicles (SPV) are treated as new companies therefore are subject to tax. Policies to relax the restriction on bonds and equity investment including simplifying procedures of equity offerings and expediting processes for share offerings (large domestic investors, such as pension funds and insurance, are limited in investing on bonds and equity).
Others are strengthening the credibility and transparency of the credit rating agency to improve investors' confidence in investing in the Indonesian bonds market and reviving the secondary market for mortgage securitization by establishing a secondary mortgage corporation for Indonesia and providing a supporting regulatory framework.
The above initiatives would create a more stable and reliable financial system in Indonesia and would provide a larger domestic base for infrastructure financing, which is needed to obtain high growth of an average 7 percent per year until 2019.
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The writer is the head of the Mandiri Institute
