Guest Author: Milan Zavadjil, IMF Indonesia

By now it is well known that Indonesia is weathering the global financial crisis (GFC) better than most countries. This is usually explained by lower dependence on exports, as well as the stimulus provided through fiscal and monetary policies.

Nonetheless, there is another reason behind Indonesia’s strong performance. Cautious policies by Indonesia’s government, banks, corporations and households over the past decade have resulted in low debt levels and limited refinancing needs. This served the country especially well in late 2008 and early 2009, when liquidity tightened around the world.

To begin with, careful fiscal management reduced the public debt ratio to 33 per cent by the end of 2008, which was amongst the lowest in the G20, and had the prospect of further decline. Consequently, the government was in a position to increase the deficit from roughly 0.1 per cent of GDP in 2008 to as much as 2.5 per cent in 2009, raising the growth rate by 0.5-1.0 percentage points according to IMF estimates. This is very different from many other emerging markets, especially in Eastern Europe which, because of high debt burdens, were not as free to provide fiscal stimulus. Moreover, if global economic conditions deteriorate again, Indonesia has the option of pursuing more stimulus.

Secondly, Bank Indonesia had built-up adequate foreign exchange reserves, currently equivalent to almost 200 per cent of short term debt on a remaining maturity basis, which provided a good cushion against capital outflows in the second half of 2008. While not as large as in some other emerging markets, reserves were sufficient to allow Bank Indonesia to intervene in the market to limit the fluctuation of the rupiah, and thus prevent a major decline in confidence. The key, however, was allowing the rupiah to fluctuate freely and absorb the impact of the capital outflows.

Thirdly, Indonesia’s banks have maintained ample liquidity and capital buffers. The capital adequacy ratio is around 17 per cent, compared with the Basel requirement of 8 percent. Also, banks hold about 23 per cent of their assets in Bank Indonesia paper or government bonds, considerably above international norms. Thus, the overall loan to deposit ratio is about 75 per cent, i.e. banks are mainly financed by deposits rather than the interbank market and/or foreign loans which proved much more unstable sources of funds during the crisis. The loan to deposit ratio is above 100 per cent in most of the East European countries which have been most affected by the global financial crisis. The large, systemic banks in Indonesia are in especially good shape. Thus, although bank lending growth has been reduced in line with the slowing economy, it has stayed positive, unlike many other countries where banks have had to rebuild their capital.

And what about the corporate sector? Currency and maturity mismatches were one of the key causes of crises in 1997-99. Many analysts thought that Indonesian corporations would be unable to refinance their debts in late 2008, perhaps triggering a balance of payments crisis. There was little confidence in data that suggested only moderate indebtedness. These sentiments were amplified when one conglomerate had problems in meeting some obligations in October 2008. In fact, the bulk of Indonesia’s corporations were in relatively good shape, in line with the rest of emerging Asia. There were very few bankruptcies and/or defaults during the crisis, unlike in mature economies.

Last but not least, Indonesia’s consumers, at about 13 per cent of GDP, carry a much lighter debt burden than in other countries. Thus, when banks around the world, including Indonesia, tightened credit standards in late 2008, the Indonesian consumer could continue spending. Nevertheless, the sharp fall in car and motor cycle sales probably could be explained by caution on the part of banks to provide credit.

Of course, the low level of debt in the economy only partly results from choices by the public and private sectors. The lack of intermediation in Indonesia to a large extent reflects the traumas of the Asian crisis: many high wealth individuals keep their fortunes abroad. Banks are very cautious in extending credit—loan recovery, especially in the case of large corporations, remains difficult because of problems in the judicial system. Access to finance, including credit, remains beyond the reach of much of the population. Had more credit been available to companies and households, the economy would have grown faster and Indonesia would have been a richer country. Scholars have found evidence from a variety of perspectives that suggests financial development, typically measured in terms of either credit or broad money relative to GDP, raises economic growth.

Nevertheless, looking ahead, strong balance sheets represent an enormous growth opportunity for Indonesia. While consumers with huge debt ratios, such as in the US and UK, will likely have to limit their purchases for years to reduce debt levels and ensure adequate pensions, Indonesian households have room to take on some more debt which should boost economic growth. At the same time, many corporations are cash rich and debt free, and will be able to finance investments including in infrastructure if attractive opportunities arise. Moreover, with their relatively low loan to deposit ratios, banks are in a position to support both consumption and investment. Additionally, Indonesia’s government has room to finance the building of infrastructure as well as to raise social spending. Deficits of 2 per cent of GDP over the next few years would not increase the government’s debt burden significantly. Thus, the current cautious government fiscal strategy is especially wise given the expected increases in private sector debt.

Of course, it is not sufficient for investors and consumers to have the capacity to take on more debt, the government has to offer a better legal and regulatory environment. To translate its strong fiscal position into roads and ports, Indonesia’s government must implement investment projects more effectively. This is the most difficult part, but not the subject of this article.

In sum, the Indonesian private sector has room to take on more debt and this could be an important driver of growth in the period ahead. However, the bodies supervising banks and other financial institutions will need to monitor the increase in the debt of households and companies closely to avoid a rapid and excessive rise. One of the lessons from the global financial crisis is that it is not sufficient to supervise individual institutions but to look for vulnerabilities in the system as a whole. Excessive credit growth in the system is usually an excellent predictor of future asset bubbles which could ultimately threaten the financial system as a whole. The challenge for policymakers therefore is to ensure that rapid credit growth is not accompanied by a relaxation of loan origination and risk assessment standards. Hence, there is a need for continued improvement in bank regulation and supervision.

Milan Zavadjil is a senior representative at IMF Indonesia.

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