This Selected Issues paper on Indonesia explains through econometric analysis the contribution of different factors to export growth and assesses the prospects for its maintenance in the future. The paper reviews developments in Indonesian export growth since 1970. It develops a model of export demand and export supply, provides empirical estimates from the model, and the implications of the results. The paper also addresses medium-term prospects for export growth on the basis of the estimated model and the possible impact of exchange rate changes.


This Selected Issues paper on Indonesia explains through econometric analysis the contribution of different factors to export growth and assesses the prospects for its maintenance in the future. The paper reviews developments in Indonesian export growth since 1970. It develops a model of export demand and export supply, provides empirical estimates from the model, and the implications of the results. The paper also addresses medium-term prospects for export growth on the basis of the estimated model and the possible impact of exchange rate changes.

IV. Banking Sector Challenges 1

A. Introduction and Summary

1. This paper examines issues related to the soundness and stability of Indonesia’s banking sector. Recent banking and financial sector crises in a number of countries have served as a reminder of the close links between macroeconomic stability and the health and efficiency of the financial sector. In the aftermath of these crises, it has also become clear that financial sector risks are often not visible at the outset, leading to a deepening of the problems as a result of delayed policy response. Such risks can more easily be detected if the standard monetary and credit growth indicators are complemented by regular monitoring of prudential ratios, along with a strengthening of the supervisory framework.

2. Key findings and recommendations of the paper include:

  • The banking sector, while improving overall, continues to show signs of weakness. Symptoms include a high share of nonperforming loans, foreign exchange risk, concentrated bank ownership and connected lending, and large exposure of banks to the property sector.

  • The authorities’ response to earlier banking problems has addressed key prudential areas, although implementation of the new rules has sometimes been uneven.

  • It would be desirable to improve compliance with prudential rules and eliminate unsound banks from the system. Strengthening the banking system along with greater transparency would enable the authorities to reduce reliance on direct measures of credit growth.

3. The plan of the paper is as follows. Section B outlines the present characteristics of the Indonesian banking sector. Section C provides an historical overview of the liberalization process since 1983; and reviews the causes of banking sector problems in recent years, the initial policy responses, and indicators of the current health of the sector. Section D outlines the agenda for the completion of banking sector reform, detailing regulatory, prudential, and jurisdictional actions to build upon earlier efforts.

B. Overview of the Banking Sector

4. Rapid economic growth, a liberal capital account regime and regulatory changes over the past decade have all contributed to fast changes in Indonesia’s banking sector. The main developments in the system and its current state can be summarized as follows:

  • Size and concentration: After liberalizing entry, the number of banks increased rapidly from 111 in 1988 to 240 in 1994.2 Since then, the increase of minimum capital requirements from Rp 10 billion to Rp 50 billion has reduced the number of potential entrants, leaving the number of institutions almost constant over the past four years. The seven state banks still dominate the sector, with their combined assets accounting for about 45 percent of the entire system, although their share of total bank lending has declined markedly in recent years (Table 1). 3

  • Ownership and entry: Liberalization increased the attraction of the financial sector to many commercial and industrial concerns and many of Indonesia’s large business conglomerates now own at least one bank. State-owned enterprises and pension funds have also established banks of their own, thus increasing the potential for connected lending. The ten foreign banks which operate in Indonesia obtained licenses in the late 1960s. Since then, the entry of foreign banks has been limited through the requirement to form either joint ventures (with a maximum of 85 percent foreign ownership) or buy shares of domestic banks on the stock exchange, where the maximum foreign holding is set at 49 percent.

  • Areas of business activities: Domestic banks are required to direct 20 percent of credit to small-scale business projects and foreign banks are required to lend 50 percent to export-oriented businesses, although these requirements are often not met. While overall loans have been growing fast in the past four years, sectoral loan distribution remains difficult to examine. Data published by Bank Indonesia show an apparent shift from lending to the manufacturing sector to service industries (Table 2). They fail, however, to clearly identify the increase in real estate lending that has proven to be an area of special concern in a number of countries. From 1988, Bank Indonesia limited banks’ direct involvement in leasing, venture capital, securities trading and investment management. Banks are, however, permitted to pursue such activities through the formation of subsidiaries operating as nonbank financial institutions, and they have made frequent use of this option.

  • Capital inflows and exposure to foreign currency risk: Foreign currency borrowings show substantial growth between 1988 and 1996. In addition, foreign currency deposits have also grown rapidly, but banks’ foreign currency liabilities are generally higher than their foreign currency assets. Although Bank Indonesia imposes limits on net open foreign exchange positions equivalent to 25 percent of bank capital, a small number of banks do not always comply with this rule.

  • Profitability: Return on assets in 1996 averaged 1.2 percent and return on equity around 16.5 percent, which exceeds those in a number of other countries. However, these mask a wide dispersion, with several loss-making banks remaining in the system. In addition, bank profitability is, in some cases, adversely affected by credit guidelines and other measures used to control liquidity.

Table IV.1.

Indonesia: Banking Sector Statistics, 1993-96

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Sources: Bank Indonesia; and Fund staff estimates.
Table IV.2.

Indonesia: Composition of Bank Lending, 1993-96

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Sources: Bank Indonesia; and Fund staff estimates.

C. Progress in Banking Sector Liberalization and Outstanding Issues

Evolution of the banking environment

5. Over the past 15 years, the Indonesian banking environment has undergone fundamental changes (Table 3). Following the liberalization of most interest rates in 1983, a second round of reforms started in 1988. The role of private banks relative to state banks was greatly enhanced and the scope and coverage of directed credit schemes was drastically reduced. At the same time, some limits were put on banks’ other financial business activities, and—in part to compensate for the decline in directed credit—lending requirements to small businesses (domestic banks) and the export sector (foreign and joint venture banks) were introduced. The reforms were codified in the banking law of 1992, which unified and replaced the 1967-68 banking acts; previously there had been a separate law for each state bank and the central bank. In addition to describing the more liberal framework, the new banking law officially removed the traditional functional specialization between various types of banks and the major areas of specialization for state-owned banks.

Table IV.3.

Indonesia: Evolution of the Regulatory Framework

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Source: Bank Indonesia.

6. The relatively fast pace of banking sector liberalization was not matched initially by increased prudential oversight, contributing to several episodes of distress in the banking system.4 As liberalization progressed, the problems became deeper, because of the growing number of banks and the increased complexity and depth of their business activities. In response, Bank Indonesia formulated stronger prudential regulations, spearheaded by the introduction of minimum capital requirements in 1988 and net open position limits in 1989. With input from the IMF, the prudential framework was strengthened substantially in the first-half of the 1990s. A loan to deposit ratio (1991) and legal lending limits (1993) were added, and capital adequacy ratios phased in over a period of two years. Mandatory accounting standards were formulated (1993), followed by standards for internal auditing and information technology (1995). Bank Indonesia designed a program to tighten requirements for bank owners and managers, and required banks to submit annual business plans for approval (1995). In addition, Bank Indonesia limited banks’ permitted access to derivatives business and started to closely monitor problem loans, even in banks that were folly provisioned and did not have other sizable problems. Banks with nonperforming loans above a certain threshold (7.5 percent of total loans) were required to present a credit recovery plan.

7. In contrast to the redesign of the prudential framework, attempts to deal with the identified problem banks have been slower. Violations of prudential regulations have sometimes been met with regulatory forbearance and few banks have been closed or merged. However, measures taken do include an attempt at restructuring state banks, assisted through support from the World Bank; one of the major banks was 25 percent privatized in late 1996. For private banks, Bank Indonesia has relied on a strategy that emphasizes negotiated solutions between banks’ largest borrowers and owners, and financial incentives to assist mergers and sales of problem banks. A welcome additional step was the issuance of a directive in December 1996 to provide a firmer basis for Bank Indonesia to close insolvent banks. Bank Indonesia intends to further strengthen the prudential and regulatory framework by a phased increase of capital asset requirements from 8 to 12 percent, to be achieved by 2001.

8. Regarding the overall environment in which banks operate, there have also been concerns about the security and efficiency of clearing and settlement arrangements. A substantial share of payments take place across commercial banks’ correspondent accounts, which may involve large interbank exposures and could cause systemic risk. In its discussions on payments issues, the IMF has stressed the need for Indonesia to stay abreast of the growing sophistication of the operational and risk management frameworks which support payments systems in other countries in the region.

Current situation

Problem loans

9. Data on classified loans based on bank reports indicate that loan quality has improved over the last three years (Table 4). Nevertheless, the overall level of classified loans—around 10 percent—remains high and approaches levels witnessed in other countries before and during banking crises. A matter of concern is also the worse outlook for state-owned banks, and the notable deterioration of the portfolio of private foreign exchange banks, albeit from a much sounder base. The high level of problem loans may increase cash flow problems if asset growth slows; in addition, there is the possibility that the actual situation is worse than indicated by these data.

Table IV.4.

Indonesia: Classified Loans of Commercial Banks, 1993-96

(In percent of total loans)

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Sources: Bank Indonesia; and Fund staff estimates.

10. Quantification of the extent of problem loans remains complicated, given the large number of banks and the complex pattern of cross holdings of equity and loans which tends to impair transparency of reports. Even where problem loans are clearly identified, there is a concern that loan classification standards in Indonesia are inadequate, especially because of the granting of liberal options for loan restructuring as a way to reduce the size of portfolio problems. Moreover, a classified loan reverts to performing status as soon as one payment is made, irrespective of the anticipated future payments stream on the loan. Banking supervisors, while recognizing the drawbacks of these practices, have not focused thoroughly on the extent of loan restructuring as an additional indicator of banking sector soundness. On-site inspections apparently yield limited additional insight into the actual number of problem loans, in contrast with experience in other countries where on-site inspections usually find a higher number of nonperforming loans than reported by banks.

Insolvent banks

11. Data on nonperforming loans can be complemented by analysis of banking sector capitalization. According to a recent MAE study, the overall negative net worth of insolvent banks remains relatively small at the equivalent of about 0.5 percent of GDP. However, several banks with negative capital continue to operate, a situation that could create moral hazard and add to the overall problems of the banking sector.

Regulatory noncompliance

12. Over the past five years, Indonesia has introduced an arsenal of prudential rules. Given banking sector problems at the time of the introduction of these rules, it was expected that these could only be applied over time, but compliance levels are still relatively low (Table 5). Another concern is that some banks, especially privately owned foreign exchange banks, show increasing violations of loan-to-deposit-ratio requirements and legal lending limits. Compliance with small scale business credit and export credit requirements, while not exclusively a prudential matter, is low.

Table IV.5.

Indonesia: Noncompliance with Prudential Regulations and Lending Directives, 1993-96

(In percent of all banks)

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Sources: Bank Indonesia; and Fund staff estimates.
Property loans

13. Lending to the property sector accounted for 20 percent of total outstanding loans in February 1997, compared with 12 percent in December 1993 (Table 6). One concern with this level of exposure is that declines in property values can have a substantial negative income effect on banking system profitability if borrowers are unable to repay debt. In addition, there may be a wealth effect because of a shortfall between the collateral value and the market price obtained when selling the property. Finally, legal difficulties and the high costs associated with seizing and selling collateral could heighten the dangers.

Table IV.6.

Indonesia: Trends in Property Lending, 1993-97

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Sources: Bank Indonesia; and Fund staff estimates.

D. Agenda for Further Strengthening the Banking Sector

14. On the basis of the above review, the main problems of the Indonesian banking sector manifest themselves in the continuing high share of nonperforming loans, incomplete compliance with prudential requirements by some banks, a large exposure of banks to property loans, concentrated bank ownership and connected lending, and the continued operation of problem banks. These issues would be best resolved through a systematic and comprehensive resolution effort in several areas:

Measures to restore banking sector soundness

15. The presence of undercapitalized and possibly insolvent banks can reduce the overall efficiency of the system, distort incentives, and create the potential for systemic instability. Specific policy actions in the area could include:

  • Memoranda of understanding with undercapitalized banks: All banks below 8 percent capital adequacy—with capital measured after provisioning—should be subject to heightened supervision by Bank Indonesia, including the development of an action plan to increase capital to the required level.5 Bank Indonesia could require that, in the case of private banks, capital increases include injections from owners. Violations should trigger supervisory action, including license suspension.

  • Amending bank closure regulations: From an operational point of view, the December 1996 regulations are a welcome step, although they fall short in a few areas. First, shareholders and managers continue to be allowed a role in the closure process, even in assigning the liquidator, which may make it difficult to effectively close a bank. In addition, the time frame foreseen of five years is too long for effective asset disposal.6 To be effective, the regulations might be amended by assigning all decision rights in bank liquidations to the central bank, stating clearly the loss of all shareholder rights and limiting the liquidation process to two years.

  • Preparing an operational plan for bank closures: Bank Indonesia should be prepared to implement bank closures quickly without notification, if necessary. This requires a smooth technical closure process, as well as steps to minimize the effects of closures on the rest of the banking system. Given that both Bank Indonesia (through its supervisory role) and the Ministry of Finance (through its power to issue and withdraw licenses) are involved in the closure process, coordination is essential. More specifically, to avoid a situation where implementation issues become a bottleneck, a blueprint detailing all relevant technical, logistical, and legal questions would be useful. The most pertinent issues for consideration in this regard include setting up a coordinating team between Bank Indonesia and the Ministry of Finance to design the framework and decide on the relative responsibilities; forming a subcommittee of a wider group of concerned agencies to work out the logistics of bank closures; and, within Bank Indonesia, clarifying necessary operational measures in the payments and clearing system associated with closures.

Measures to improve design and enforcement of prudential and regulatory standards

16. Over the past five years, Indonesia has made substantial progress in adapting its prudential framework to international standards. In some areas, such as capital adequacy, Bank Indonesia rightly aims at surpassing international standards to take account of higher risks faced in an emerging market framework. To strengthen the banking sector and to ensure that it operates fully within an appropriately designed framework, the challenges now include:

  • Reduce regulatory forbearance: To date, the violation of prudential rules has not been strictly sanctioned. Bank Indonesia should apply the fuil range of permissible sanctions to increase compliance. However, care should be taken that sanctions are applied in an even-handed and transparent manner.

  • Improve the design of the regulatory framework: Potential vulnerability of the banking system could be reduced through the adoption of smaller limits on net open foreign exchange positions, a reduction in connected lending, and lower exposure to the property sector. Bank Indonesia could also consider the introduction of wider indicators of foreign exchange risk, including the share of foreign exchange loans to domestic sectors; improved supervision of conglomerates by cooperation of all supervisory agencies involved and the appointment of a lead supervisor; and the systematic collection of more detailed information on the property sector.

  • Improve the focus and training of bank supervisors: The restructuring of Bank Indonesia’s supervision department has helped considerably to improve its effectiveness. The remaining challenges require continued training with regard to all forms of foreign exchange exposure and the risks stemming from new financial instruments. In strengthening its authority, it is important to maintain a clear separation of supervision activities and monetary policy management.

Measures to improve transparency and efficiency

17. A range of the problems found in the banking sector stem from insufficient transparency in the application of rules and the legal framework and the need for greater vigor in privatizing state banks. The incentive framework could be strengthened through the following actions:

  • Increase transparency of bank ownership and management: Many banks are part of complex ownership structures, rendering supervision of connected lending and its associated risks difficult. In addition, Bank Indonesia itself holds capital in a number of troubled commercial banks. Remedial action might include limiting cross ownership between banks and companies; limiting the number of nonbank financial institutions owned by banks; and the divestiture of Bank Indonesia from commercial banks.

  • Increase transparency of the regulatory framework: Improvements in this area would include the introduction of a clear distinction between regulatory and prudential rules and the conduct of monetary policy based on market principles. The avoidance of discrimination in setting and applying regulatory rules, and a reduction in the level of lending directives would reduce distortions and improve efficiency.

  • Increase the transparency of banking data. Indonesian accounting standards tend to underestimate the degree of problem loans. This results mainly from the ability of banks to register former problem loans as performing, following restructuring agreements with creditors—where these agreements do not necessarily have to take into account the ability of the borrower to follow the new payments plan. This technique also leads to a reduction in the required amount of provisioning. More problems could arise from an outdated and relatively broad sectoral breakdown of loans, which does not allow for a systematic focus on problem areas, such as property loans or loans in foreign exchange. Therefore, it would be desirable for Bank Indonesia to introduce stricter conditions for loan restructuring and redesign its sectoral loan breakdown to better reflect the needs for optimal risk management.

  • Promote payments system reform: Preferably including the introduction of a real-time gross settlement system to reduce interbank settlement risk.

  • Adapt the legal framework: Legal problems impede the authorities’ ability to fully privatize state banks, enforce loan contracts, and sell loans. A review of the legal framework could include the banking law itself, with a view to allowing full privatization of state banks; the collateral law, with a view to allowing banks faster access to collateral and the automatic right of liquidation; measures to speed up legal disputes between borrowers and creditor, possibly through the formation of special banking courts; and creating the option for banks (and bank liquidators) to sell loans in the secondary market.

  • Examine the possibilities to introduce limited deposit insurance: While the authorities have rightly refrained from introducing deposit insurance during a period of banking sector weakness, the situation should be reviewed once the remaining problem banks have been resolved. Limited deposit insurance could then help to increase confidence in the system, while allowing a faster resolution of any future problems.


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The author of this chapter is Anne-Marie Gulde.


This discussion excludes the 9,300 rural banks which are limited in the geographical area of operations and may only issue time and savings deposits and extend loans. Minimum capital for rural banks is Rp 50 million.


Five state banks are included in a World Bank rehabilitation project, which imposes limits on their asset growth.


The most visible example was the collapse and closure of Bank Summa in 1992.


For state banks, such agreements have been drawn up in connection with the World Bank’s bank restructuring loan. The plans for private banks, especially for banks that are judged not to pose systemic risks, should be less accommodating.


Maximizing the value of assets for the satisfaction of banks’ creditors is best achieved when speed is decisive in the choice of the resolution strategy. Experience in other countries shows that banks under liquidation are often subject to asset stripping.