Budi Mulya: The need to strengthen Indonesian financial market
Keynote speech by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at Japan
International Cooperation Agency's (JICA) seminar on "The Challenge in Developing
Indonesia's Financial Market", Jakarta, 11 December 2009.
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Distinguished speakers, ladies and gentlemen,
It is such a great pleasure to join in today's seminar, which will address Indonesia's financial
market and its further development. This particular topic, I believe, become more relevant
and crucial for Indonesian economy. In the last couple of decades, we all have been
witnessing on the role of the financial market in many economies. Yet, within the last two
years, we also have observed on how financial market malfunction has severely impacted
the real economy, a very hard lesson to learn. Many aspects of this phenomenon have been
written and discussed, both from policy makers' perspective as well as analysts'. All of these
analyses are intended to search for the most possible cause of the crisis, in order to prevent
a repeating occurrence in the future.
On that respect, I would like to highlight one important aspect from the most recent global
financial turmoil, as background of my speech today and as one alternative reference of the
approach in discussing the future development of Indonesia's financial market, that most fit
with Indonesian economic characteristic.
In general, if we look back to the mid 2007, it can be reasonably seen that the crisis emerged
in the debt market, particularly with regard to its derivative product, which reached its peak in
September 2008 when Lehman Brothers collapsed. The financial market transaction and
instrument development moved too far, beyond the need to serve the economic financing in
a healthy way. The value of financial market instruments have been much higher, compared
to their fundamentals value and their inherent risk. This is also closely related to the fact that
the financial institution involved has also not been supported by adequate resource buffer to
absorb potential capital loss. They tended to operate with very high leverage, depending their
funding from money market, as well as debt market. On this regard, the liquidity of those
markets is a crucial key, since in high leverage circumstance, counterparty risk could easily
jump. As a consequence, when there is a serious disruption in money market, as we
observed during financial crisis, funding becomes more difficult for those institutions. They
had to undertake force sale of their assets, experienced big losses, and some of them even
collapsed or had to be bailed-out by the government.
Some argued that those behaviors were closely related, or as consequences of the low
interest rate policy, particularly in early 2000s, as well as the relatively loose financial
institution regulation and supervision by authorities in major countries. Now, we are also
again witnessing low interest rate environment in major countries, as one of the main parts of
the crisis policy respond. However, there is now an increasing discussion on how to enhance
the effectiveness of the financial regulation and supervision, to prevent, that what happened
in the past will not be repeated. In addition, there is also an increasing attention, put in the
risk taking behaviors of financial market players, such as we find in the Leaders' Statement
of the G20 Summit in Pittsburgh last September. This risk taking behavior is believed,
affecting monetary policy transmission through their significant distortion in financial stability.
Hence, in turn it reduces the effectiveness of monetary policy. This issue, known as risk
taking channel, is also relevant to today's discussion, but I will not discuss further this aspect
in my speech this morning.
With the above background, I would like to emphasize my speech on the liquidity aspect of
the banking and money market, as well as in the financial market. This liquidity aspect, along
with the availability of related "infrastructure" is a crucial foundation, to ensure the soundness
of financial institutions and to develop healthy financial market.
The Indonesian banking, money market and financial market
In contrast to those observed in major financial market, the Indonesian financial market can
be considered as still in an early stage of its development, despite significant progresses
achieved in the last couple of years. Also, from the type of transaction and instrument variety,
as well as from their funding type of financial institution, the Indonesian financial market
could be viewed as too traditional or too conventional. Yet, these facts became such a
"blessing in disguise" and help sheltered the domestic financial market and the economy
from the adverse impact of the recent global crisis.
Before I elaborate on the aspects that need to be improved in our domestic financial market,
I would like to briefly discuss the characteristics of the Indonesian banking, money market
and financial market as a background.
Banking
The Indonesia's banking industry is actually operating in a new stage in post 1997/98 crisis
and 1999 banks recapitalization era, as compared to the previous period. There are two
factors that characterized the current Indonesian banking sector in general.
First, they are operating in structural excess liquidity in the inter-bank money market. In this
regard, I refer the term liquidity as central bank's reserve money. This is also reflected in the
volume of Bank Indonesia's open market operation - banks' liquidity that Bank Indonesia
absorb, as part of Bank Indonesia's monetary policy implementation to maintain short-term
money market (overnight PUAB) stable around BI Rate. This is cash alike in banks' assets.
This is actually a rather common phenomenon in countries that experienced financial crisis
and had to bail-out the financial industry. For example, in the US, the central bank balance
sheet has ballooned from around USD 800 billion before crises into around USD 2.2 trillion
recently. This data also reflected in the US commercial banks or other financial institutions'
placement - usually in overnight basis as excess reserve and now remunerated at 25 bps -
in the Federal Reserve. Thus, in essence similar to bank placement in Bank Indonesia's
OMO instrument (SBIs. FASBI, FTK).
The situation I just described was needed to facilitate the domestic banking sector
consolidation process in the post 1997/98 crisis. However, if this continue to exist too long,
will lead to a mislead incentives. It will not encourage banks to have a more efficient asset
and liabilities management. Also, banks will tend to be less aware to liquidity risk, as there
will be a perception that there will always be a huge supply of liquidity in inter-bank money
market. This can be seen during the peak of global financial turmoil at the end quarter of last
year, where our domestic money market also experienced a significant "perception" of
tightening liquidity, despite that there was a large number of liquidity stock in the money
market. There was more than Rp. 150 trillion of banks' cash, placed into Bank Indonesia's
OMO instruments. Yet, the inter-bank money market indicators showed that the flow of
liquidity in inter-bank money market has squeezed. The volume of inter-bank money market
has declined from its normal level of around Rp. 10 trillion to below Rp. 5 trillion. The interest
rate spread has also widened significantly. The JIBOR 1 month spread over BI Rate jumped
from its normal level of around 50 bps to around 220 bps. Further, there was also indication
of unhealthy competition among banks, to maintain third party's fund by offering higher
deposit rate.
Second, there is large number of government bonds (SUN) in banks' balance sheet, which
mostly originated from banks' recapitalization in 1999. Recently, banks hold around 50% of
outstanding SUN of Rp. 570 trillion. This type of asset is risk free hence no bad debt
provision is needed. It helps banks in maintaining a strong capital, but with result a lower
yield compare to other earning assets. However, on the other side, this result in banks being
more expose into market risk, as has been showed when the SUN prices (IDMA Index)
dropped to their lowest level of 67.11 in 29 October 2008. Under excess liquidity condition,
banks' attention on the liquidness of this type of assets is relatively low. In this regards, I
refer liquidity as an easiness of SUN to be traded, or exchange into cash without significantly
impact their price. Banks tend to practically borrow in unsecured money market, rather than
undertake repo transaction to serve their short-term liquidity need. This could be seen, that
despite Bank Indonesia has actually facilitated market participants to establish a standard
repo agreement (MRA) since June 2005 as one infrastructure to increase the liquidity of SUN
market, but in reality their respond is quite marginal.
Money market and financial market
The Indonesian money market is basically inter-bank money market, as it mostly involves
only banking. So far, the transaction in the inter-bank money market is dominated by
unsecured lending/borrowing (PUAB), and mostly in a very short term maturity. Around 60%
of inter-bank transaction is overnight. There may be some short-term debt instrument in OTC
(over the counter market), but I believe in a very small numbers and not actively traded
amongst bank. There is also perhaps, an interest rate swap (IRS) or overnight index swap
(OIS) in OTC market, as there is sometime a quotation in Bloomberg or Reuters. But, it
seems not quite regular and the transaction is supposed to be in a very small number. Thus,
in general, money market is not yet considered to better serve banks' portfolio management.
Meanwhile, in the foreign exchange market, the transaction is also still dominated by spot
transaction. The daily volume of inter-bank spot transaction is about 1.5 - 2 billion US Dollar
in the last two years. In addition, swap transaction is around 300 million US Dollar in 2009, a
bit lower compare to around 500 million US Dollar last year.
Further, the financial market is dominated by government debt instrument. The development
of Indonesian financial market actually took place from the post 1997/98 period. The SUN
market begun in 2002 when banks were started to be allowed to gradually trade their recap
bond holding. The development in government bond market then triggered the development
of corporate bonds as government bond serve as a risk free benchmark in debt market.
However, the transaction in SUN market is, so far, dominated by outright transaction. The
repo market is not yet active, partly for the reasons as I have previously described, which
lead to a perception of bank that undertake repo is in a desperate liquidity need situation,
hence will be punished with higher interest rate.
The relatively less liquid domestic financial market can be seen from the SUN turnover.
Recently, the daily outright trading volume of SUN is just around Rp 6.5 trillion and
300 transaction within the last two years. Thus, just around 1% of SUN outstanding.
While the repo transaction is much lower, below Rp. 1 trillion daily, but not always
occurring every day.
Why we need to further develop Indonesia's financial market?
From the above description, basically, I have just explained the main reasons, the need to
further develop the Indonesian financial market. First, to increase the resiliency of domestic
financial market, including the banking sector, from possible liquidity shock. Second, to
increase the efficiency of financial portfolio management and to strengthen liquidity risk
management, which in turn it will increase the effectiveness of monetary policy from Bank
Indonesia's perspective. And third, given the increasingly importance of financial market in
the economy, it is crucial to have a strong, efficient and healthy financial market to avoid any
possible distortion, including from inefficient practice that will add more cost in economic
financing. However, the development should be undertaken in gradual manner, and again,
should always be linked closely with the need of the real economy.
I will now highlight some issues that I believe should be firstly considered as a starting point
to develop our domestic financial market.
The development of repo market can be considered as a starting point to increase financial
market liquidity. This will increase efficient banking liquidity and portfolio management, as
well as government financing. In this regard, as financial transaction is mostly in essence a
legal contract, thus having a commonly accepted standard repo agreement is a key. In this
area, Bank Indonesia and the Government Debt Management Office, has again encouraged
market participants to establish a standardized repo agreement that complies with
international standard. In line with this, the progress of the commitment from major market
players in debt market (HIMDASUN) signed in 20 August 2009 has to be monitored closely.
On the other side, Bank Indonesia will also continue to promote the use of repo transaction
by enhancing the strategy adopted in Bank Indonesia's liquidity management operation. In
addition, the need to have a commonly accepted standardized transaction among market
participants is also valid for transaction in foreign exchange market.
It is also important to encourage the establishment of broader self regulatory organization
(SRO) in domestic financial market that covers all segments in the market, to provide
convention for various market transactions, and to assist in monitoring OTC market, as well
as a counterpart for the authorities and regulators.
However, it is important to note that coordination among authorities, and the continued dialog
with market participants, is a key element in developing financial market that most fit with the
need of the economy.
Ladies and Gentlemen,
I hope today's seminar produces fruitful discussion for all of us, as well as exchange
perspectives from expertise speakers to enrich our understanding on developing the
Indonesian financial market.
Thank you.