Financial system reform

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Didin S. Damanhuri Professor, Department of Economics, Faculty of Economics and Management, Bogor Agricultural University

IO – One of the most important acts following the 1997/98 monetary crisis was the reform of the Bank of Indonesia (BI) and the banking sector. Thus, BI became an independent institution, upholding macro and microprudential principles in banking management in Indonesia. 

That way the Rupiah is stable, inflation is controlled and economic growth picks up. After more than a decade and a half, BI and banking reforms have succeeded in being an actor in achieving macroeconomic stability. 

However, that is not enough, because the state has not yet succeeded in creating decent “work opportunities” for every citizen (Article 27 paragraph 2 of the 1945 Constitution) and economic development for the greatest prosperity of the people (Article 33 paragraph 2 of the 1945 Constitution). 

Since the reform era, welcoming an independent BI and a banking system that has succeeded in creating macroeconomic stability, it has not been able to promote better welfare distribution. 

This can be seen from the very large proportion of the informal sector, around 60 percent, while economic development should further reduce the informal sector because large numbers of the workforce should have been absorbed into the formal sector. 

Besides, there is an increase in total, open unemployment plus hidden underemployment, which now accounts for more than 40 percent of the workforce. It also fails to address inequalities between income groups, across sectors, and between regions. Among other things, the Gini ratio for consumption in 2014 was 0.413; in 2018 it improved to 0.39. Citizens surviving on an expenditure of 2 US dollars per day still comprises 46 percent of the total population, from the impact of the 2008 crisis to the COVID-19 pandemic; at the moment it is even above 50 percent. 

This means that the progress of the poor group is stagnant, if not even degenerating. So in terms of the 1945 Constitution, BI has not fully realized its constitutional obligations. 

A more basic substance is related to empirical factors: the placement of monetary policy is not sufficient to encourage general welfare through increased equity, employment opportunities, and support for Micro-Small-Medium-Enterprises (MSMEs). 

This phenomenon in Indonesia confirms various cases of the role of central banks in developing countries. The role of the central bank is not sufficient to maintain macroeconomic stability. Thus, revising the Banking Law becomes an urgent matter. The urgency lies in efforts, on the one hand, to play as an agent of development, while on the other hand, to uphold the financial sector in Indonesia. 

As the banking sector recovered from the 1997/1998 crisis, the Indonesian government opened up space for foreign capital ownership in banks, up to 99 percent. However, when the crisis passed, the prior limits on foreign capital ownership were no longer imposed. 

Real interest rates in Indonesia are much higher than those in comparable countries, and the massive influx of foreign capital into the banking sector is inevitable. Without strict regulation of foreign capital, the vulnerability of the economy to crises will rise. This is because, along with the opening of the foreign ownership portion, Indonesia adopts a free foreign exchange system, in which capital can enter and exit easily.

During a crisis, foreigners easily divert their capital from a subsidiary (in Indonesia) to a parent company or bank (abroad), which could exacerbate the situation, even though a stated function of banks is to create job opportunities and help people prosper. 

As an agent of development, it is difficult when national banks are controlled by foreigners, on the one hand, and there is the freedom to save export proceeds on the other. 

Meanwhile, the revision of the BI Law must explicitly emphasize its independent position, namely, that the direction of BI independence is from the financial instrument side. In terms of national goals, BI cannot be independent. From here it is necessary to balance the function of BI as a stabilizing agent and agent of development, by strengthening the BI Law, in line with national objectives. 

Meanwhile, the revision of the Banking Law should aim at creating financial sector sovereignty, forming domestic capital, increasing access to credit for MSMEs, and distributing liquidity (credit) more evenly to the regions. 

If we look back upon the economy after the 1997/1998 monetary crisis, in fact in the long run the macroeconomy was quite stable. However, it was not directly proportional to efforts to improve people’s welfare, especially the provision of meaningful employment opportunities, reducing poverty and inequality significantly. 

The distribution of the economic ratio is increasingly flowing to sectors that do not cover the lives of many people, such as agriculture and industry, so that the impact is to widen the level of inequality. 

Apart from being agents of economic stabilization, BI and the national banking function need to be added as agents of development, especially in creating employment opportunities and equitable economic growth. These two functions in the practice of managing the monetary sector in Indonesia cannot be separated, considering that factors are originating from the monetary sector, and also from the real sector, such as inflation that comes from food and energy. 

Thus, economic stabilization function by BI will only run effectively if it is supported by its function as an agent of development, namely, creating jobs, increasing access to credit for MSMEs, and equalizing access to credit to the regions. 

The challenges of national development in an increasingly globalized world economy require synergy and the role of the banking system that is contributive to the development and stability of the economic system. 

Revisions to the BI Law and the Banking Law, which aim at and return to national goals, can be the starting point for development that makes the people prosperous. 

Financial reform 

That is the substance that must be included in the revision of the BI Law and the Banking Law in the framework of financial system reform. There is also an urgency to revise the Foreign Exchange Traffic Act, which requires that at least six months of export proceeds be kept in the national banking system. 

 Then, the need for a revision of the Capital Market Law, making capital markets accessible to MSME actors. At present they are only controlled by large national and foreign corporations. 

However, the draft Financial System Reform Bill proposed by the Government and the Parliament will eliminate the independence of BI which has been successful in upholding macro and microprudential principles. 

This is the performance that creates macroeconomic stability with low inflation, controlling the Rupiah so that economic growth can be boosted. However, Article 9A and B of the Bill state that there is a Monetary Board chaired by the minister of finance. This subordinated BI to ministerial levels, such as during the New Order era, which in turn the President could intervene in the narrow interest of the government. 

However, this is at the expense of the macro and microprudential aspects of the monetary considerations, namely, the consideration of the amount and speed of money circulation, the reference interest rate, inflation, and the health of banks. Therefore, the reform of the financial system should be limited so that BI can maintain its independence, as it is now. On the other hand, it should include the main points of reform, as described above. 

Then, there is a clause that the president, as head of state, can negotiate with the BI governor so that national goals can be achieved, outside of any applicable law. For example, specifically in dealing with the current COVID-19 pandemic. 

As well as the revision of the Capital Market Law and the revision of the Foreign Exchange Traffic Law, it is estimated that there is cumulative foreign exchange from exports abroad of around US $ 150 billion, which could strengthen fiscal capacity in handling COVID-19 and economic recovery.