Report and Recommendation of the President to the Board of Directors

Transcription

1 Report and Recommendation of the President to the Board of Directors Sri Lanka Project Number: August 2012 Proposed Policy-Based Loan Republic of Indonesia: Financial Market Development and Integration Program

2 CURRENCY EQUIVALENTS (as of 8 August 2012) Currency unit rupiah (Rp) Rp1.00 = $ $1.00 = Rp9,468 ABBREVIATIONS ADB Asian Development Bank CMNMP Capital Market and Nonbank Financial Industry Master Plan DGDM Directorate General of Debt Management FPO GDP Fiscal Policy Office gross domestic product NMTDP National Medium-Term Development Plan OJK TA Otoritas Jasa Keuangan (Integrated Financial Services Authority) technical assistance GLOSSARY sukuk a financial document or certificate that represents the value of an asset evidencing an undivided pro rata ownership of an underlying asset takaful a form of Islamic insurance based on the principle of mutual assistance, which provides mutual protection of assets and property and offers joint risk sharing in the event of loss incurred by one of its members NOTE In this report, "$" refers to US dollars

3 Vice-President S. Groff, Operations 2 Director General K. Senga, Southeast Asia Department (SERD) Director S. Hattori, Public Management Financial Sector and Trade Division, SERD Team leader Team members Peer reviewers S. Schuster, Senior Financial Sector Specialist, SERD F. Barot, Senior Operations Assistant, SERD R. Hattari, Public Management Economist, SERD S. Ismail, Financial Sector Specialist, SERD L. Jovellanos, Senior Economics Officer, SERD B. Konysbayev, Senior Counsel, Office of the General Counsel S.M. Lee, Capital Markets Specialist, Office of Regional Economic Integration L. Schou-Zibell, Senior Economist, Central and West Asia Department In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

4 CONTENTS Page I. THE PROPOSAL 1 II. THE PROGRAM 1 A. Rationale 1 B. Impact and Outcome 4 C. Outputs 4 D. Proposed Technical Assistance 6 E. Medium-Term Reform Framework 6 F. Development Financing Needs 7 G. Implementation Arrangements 7 III. DUE DILIGENCE 8 A. Governance 8 B. Poverty and Social 9 C. Safeguards 9 D. Risks and Mitigating Measures 9 IV. ASSURANCES 10 V. RECOMMENDATION 10 APPENDIXES 1. Design and Monitoring Framework List of Linked Documents Development Policy Letter Policy Matrix 21

5 PROGRAM AT A GLANCE 1. Program Name: Financial Market Development and Integration Program 2. Project Number: Country: Indonesia 4. Department/Division: Southeast Asia Department/ Public Management, Financial Sector, and Trade Division 5. Sector Classification: Sectors Primary Subsectors Finance Money and capital markets 6. Thematic Classification: 6a. Climate Change Impact No Climate Change Indicator available. Themes Primary Subthemes Economic growth Promoting economic efficiency and enabling business environment Promoting macroeconomic stability Governance Economic and financial governance Capacity Development Organizational development 6b. Gender Mainstreaming Gender equity theme (GEN) Effective gender mainstreaming (EGM) Some gender benefits (SGB) No gender elements (NGE) 7. Targeting Classification: General Intervention Geographic dimensions of inclusive growth 9. Project Risk Categorization: Complex Targeted Intervention Millennium development goals Income poverty at household level 8. Location Impact: National High 10. Safeguards Categorization: Environment Involuntary resettlement Indigenous peoples C C C 11. ADB Financing: Sovereign/Nonsovereign Modality Source Amount ($ Million) Sovereign Program loan Ordinary capital resources Total Cofinancing: 13. Counterpart Financing: No Cofinancing available. No Counterpart Financing available. 14. Aid Effectiveness: Parallel project implementation unit Program-based approach No Yes

6

7 I. THE PROPOSAL 1. I submit for your approval the following report and recommendation for the proposed policy-based loan to the Republic of Indonesia for the Financial Market Development and Integration Program The program will be the culmination of a long-standing engagement by the Asian Development Bank (ADB) with Bapepam-LK, which will be the program s executing agency. The program will support the combination of Bapepam-LK, the supervisory agency of the country s capital markets and nonbank financial institutions, and the bank supervision division of Bank Indonesia (BI), into a unified, independent financial sector regulator. Because Bapepam-LK will no longer be able to serve as executing agency for ADB programs or technical assistance (TA) after 1 January 2013, the program will also expand ADB s engagement in support of broader financial sector development with the government s Fiscal Policy Office (FPO), which will succeed Bapepam-LK as executing agency. The program is fully consistent with and supports the government s medium-term reform priorities set out by the National Medium-Term Development Plan (NMTDP) which is being implemented through the Capital Market and Nonbank Financial Industry Master Plan (CMNMP) for These reform priorities have been incorporated into the first strategic pillar of ADB s country partnership strategy for Indonesia for , which is inclusive growth. The program and proposed capacity development TA 2 which is being processed to support it are included in the country operations business plan for The program is also consistent with ADB s Financial Sector Operational Plan because it will improve access to capital markets, increase financial stability and integrity, and foster regional cooperation and integration. 3 II. THE PROGRAM A. Rationale 3. Encouraging progress to date. ADB has successfully supported financial sector development in Indonesia since Over the first ten years of the engagement, ADB programs helped develop the sector s basic legal, regulatory, and supervisory frameworks while encouraging competition between financial institutions. During the Asian Financial Crisis, ADB supported bank restructuring to restore financial sector health and initiated efforts to strengthen financial sector supervision. In addition to providing capacity building, ADB sought to reduce regulatory arbitrage by supporting the merger of the capital market regulator and the nonbank financial sector regulator, which led to the formation of Bapepam-LK. ADB s more recent initiatives, covering the period , have promoted deeper and more liquid financial markets, strengthened market surveillance and investor protections, and have helped steadily build capacity. A primary dealer system was established and the country s stock exchanges were merged and placed under professional management. Governance of mutual funds was strengthened and price discovery and transparency were enhanced at the same time by the creation of an independent bond pricing agency. Initiatives were undertaken to develop an independent anti-money laundering capability in the Financial Transaction Reports and Analysis Center, which was followed by the development of anti-money laundering protocols within Bapepam-LK. Training budgets were increased and independent training centers were established through partnerships between Bapepam-LK and the private sector. The CMNMP itself, which will focus and coordinate the efforts of stakeholders as Indonesia continues to 1 The design and monitoring framework is in Appendix 1. 2 This TA is being processed separately and the funding source is yet to be determined. 3 ADB Financial Sector Operational Plan. Manila.

8 2 develop and expand its nonbank financial sector, was initiated under ADB s Capital Markets Development Program Cluster and was drafted with TA provided by ADB The impact of ADB-sponsored reforms is reflected in the improving fundamentals of the country s capital markets. The Directorate General of Debt Management (DGDM) of the Ministry of Finance now issues an annual schedule of auctions and reopens issues instead of issuing new series of government securities. As a result, the sum of amount traded for five recognized benchmark issues increased by a factor of 25 during The DGDM has smoothed out the government s debt profile through debt swaps and buybacks. Because of this, Indonesia now has the most long-dated maturity structure of any government bond market in emerging East Asia with around 40% of its government bonds issued with tenors greater than 10 years. 5 Prudent fiscal management and sound debt management led to an upgrade of Indonesia s credit rating in 2011 to investment grade. The upgrade provided additional support to the local bond market as the volume of corporate issues doubled in 2010 over Bond market returns were also impressive, with Indonesia outperforming its peers with a return of 24%. These trends continued into 2011 when Indonesia registered year-on-year growth in corporate issuance of 28%, the fastest in Southeast Asia. 6 Indonesian bonds also outperformed their Southeast Asian regional peers for the second consecutive year, yielding a return of 20% on an unhedged local currency basis. 5. The pension and insurance subsectors have also exhibited promising trends with total aggregate assets increasing from Rp192 trillion in 2006 to Rp618 trillion in During this period, insurance density more than doubled and the number of individuals covered by a private pension fund increased to 2.7 million. Insurance premiums relative to gross domestic product (GDP) have been growing and now approximate the level of insurance penetration in Thailand. As of 2011, the aggregate net asset value of the mutual fund sector exceeded Rp172 trillion, compared with Rp153 trillion in 2010 and Rp114 trillion in The sukok market has also grown remarkably. It has increased by an average of more than 100% every year since 2006, reaching Rp92 trillion in The work done to strengthen Bapepam-LK has improved standards and made supervision of the financial markets more effective. CLSA Asia-Pacific Markets Corporate Governance Watch for 2010 noted that market participants and regulators are genuinely becoming more serious about enforcement. 7 The report, which provides an independent assessment of corporate governance practices in Asia, noted a substantial increase in the number of enforcement actions initiated by Bapepam-LK as well as strengthened disclosure for public companies, including improved nonfinancial reporting standards, and more active audit committees. 7. Achieving Indonesia s full potential. The overarching goal of the government s NMTDP is to make Indonesia a prosperous, self-reliant, and democratic country. To improve the welfare of the population through sustainable economic growth and to achieve the associated goal of reducing the poverty rate to below 10%, the government has established a cumulative investment target of Rp12,000 trillion Rp12,500 trillion during this time period. A significant proportion of this investment is targeted to come from banks, nonbank financial 4 ADB Report and Recommendation of the President to the Board of Directors: Proposed Loan to the Republic of Indonesia for Subprogram 2 of the Capital Market Development Program Cluster. Manila; and ADB Technical Assistance to the Republic of Indonesia for Strengthening Indonesia s Capital Market. Manila. 5 ADB Asia Bond Monitor: September Manila. 6 ADB Asia Bond Monitor: March Manila. 7 CLSA Asia Pacific Markets, Corporate Governance Watch. Hong Kong, China.

9 3 institutions, and the capital markets. Despite progress in capital markets development, the local currency government and corporate bond markets in Indonesia represent, in the aggregate, less than 15% of GDP and remain very small compared with those in regional peers Malaysia and Thailand, where bond markets exceed 65% of GDP. The contractual savings sector also remains small, with insurance premiums representing less than 2% of GDP. If Indonesia is to meet its internal investment targets, more needs to be done to deepen the financial sector and to establish vibrant nonbank financial institutions. 8. Boosting the role of the contractual savings subsector as a source of potential demand for capital markets products is particularly important and needs to be encouraged. For example, the interconnections between contractual savings, capital market development, and economic growth are not deeply understood by the public or even segments of the government and the private sector. The government and stakeholders in the private sector need to jointly encourage growth in long-term savings by providing tax incentives, improving the governance of the sector, and adopting more effective asset allocation methodologies. Other constraints on Indonesia s capital markets are a lack of risk management tools, burdensome regulatory requirements, and limited transparency. Low domestic investor confidence and high volatility brought about by dominant levels of foreign participation have limited domestic participation in the capital markets. The need to address these issues and to modernize the regulatory structure has become even more urgent due to an increase in inward capital flows associated with the country s credit rating upgrade and the need for infrastructure funding The cost to Indonesia of limited financial sector development can be measured in terms of forgone economic benefits. The link between economic growth, private credit and stock market liquidity is well known and is empirically supported. Studies indicate that contractual savings also play a large role in fostering economic development By increasing the links between contractual savings and the other financial subsectors, Indonesia s economy can benefit from lower information and transaction costs, pooling of risk, increasing efficiency of capital allocation, and enhanced intermediation. This same research indicates that the boost to economic growth achieved by increasing the penetration of life insurance will be even more pronounced given higher levels of bank credit to GDP and stock market liquidity. Using studies by Levine and Zervos done in 1998 and Marco Arena in 2008, and the World Bank s Financial Development and Structure Database, ADB staff estimated that Indonesia s real GDP per capita would have been $1,300 in 2010, or 14% higher than the actual $1,144, if the level of bank credit intermediation had been equal to the average of the data base in each year over the period Similarly, real GDP per capita in 2010 would have risen to $1,335, or 17% higher than the actual if the level of bank credit intermediation and stock market liquidity 11 had been equal to the average of the data base in each year over the period Finally, combining an increase in bank credit intermediation and stock market liquidity with an increase Asia Wall Street Journal A Bridge to the Next Asian Boom. 30 January. Ross Levine, Sara Zervos Stock Markets, Banks, and Economic Growth.The American Economic Review. 88 (3). pp The Levine-Zervos study estimated that an increase by one standard deviation in stock market liquidity at inception would have resulted in an 18% increase in GDP over the 18-year period of study. If this was combined with a one-standard-deviation increase in bank credit to the private sector, GDP growth would have been 31% higher. Marco Arena Does Insurance Market Activity Promote Economic Growth? A Cross-Country Study for Industrialized and Developing Countries. The Journal of Risk and Insurance, volume 75 (Number 4), pp Research indicates that a one-standard-deviation increase in total insurance premiums to GDP would increase real GDP per capita growth by 0.47% with even greater effects in countries at low to middle levels of development. Liquidity here is defined not by the number of companies listed but by the ease with which the shares of listed companies are traded.

10 4 in insurance penetration during this same period would have increased real per capita GDP in 2010 to $1,700, representing an increase of almost 50% over the actual. 10. The proposed program. The government s medium-term reform priorities focus on the identified development constraints. First, the government seeks, in particular, to foster economic development by strengthening regulatory oversight. This in turn will increase stability and investor confidence. Also, the CMNMP aims to deepen the capital market, expand access to nonbank financing, and broaden the investor base. To attain these objectives and build momentum for capital market development, the CMNMP provides a functional focus on increasing the linkages between the contractual savings subsector, the subsector dealing in funding arrangements that are compliant with Islamic sharia law, and the traditional capital markets. To support these reforms, the government has requested ADB assistance in the form of a policy-based program loan. The program will build on the government s accomplishments under the post-program partnership framework (P3F) of Subprogram 2 of ADB s Capital Market Development Program Cluster (footnote 4). Guided by this program, the government has completed 45 of the total 54 actions within the post-program partnership framework, including 9 of the 11 actions that were identified as required actions. 12 B. Impact and Outcome 11. The impact of the program will be an expanded nonbank financial sector supporting increased intermediation. The outcome will be increased domestic participation in the nonbank financial sector. The program s three outputs will reflect the primary objectives of the CMNMP. C. Outputs 12. Output 1: Regulatory oversight strengthened. Indonesia s credit rating upgrade in 2011 has led to an influx of foreign investment. This will increase the country s exposure to the risk of global contagion through capital flows and exposure to sophisticated and interlinked international investment schemes. In light of this, the government has recognized the need to continue strengthening the regulatory infrastructure to ensure investors of stability and proper governance of the financial sector. Under output 1, the creation of the Integrated Financial Services Authority (OJK) was authorized in law in 2011 and the agency will be operational by the end of This initiative will provide for independent, harmonized, and comprehensive regulation and supervision of the financial markets. ADB has been a consistent supporter of this effort since In addition, Bapepam-LK has further enhanced its supervisory capabilities and those of the successor OJK by processing the revision of three primary financial sector laws on capital markets, insurance, and pensions to include resolution powers over problematic institutions and qualified supervisor immunity. Drafts of all three laws have been completed, socialized and entered into the national legislative agenda. Bapepam-LK has introduced riskbased supervisory practices to the contractual savings subsector and has continued to pursue regional integration initiatives that include the harmonization of standards. As part of these efforts, Bapepam-LK has participated in an initiative to introduce a common set of corporate 12 The actions not completed related primarily to reform of domestic taxation applied to financial products and financial markets in general. The Directorate General of Taxation, which is responsible for such taxes, is a peer agency of Bapepam-LK under the Ministry of Finance and therefore not subject to its control. Bapepam-LK has not become a signatory of Schedule A of the International Organization of Securities Commissions because this will be possible only after passage of the revised capital markets law. Several actions were dropped as they had become obsolete or responsibility for performance was transferred to another party. 13 ADB Report and Recommendation of the President to the Board of Directors: Proposed Loan to the Republic of Indonesia for the Financial Governance and Social Security Reform Program. Manila.

11 5 governance standards in the Association of Southeast Asian Nations and has strengthened corporate governance standards in Indonesia in line with this effort. Programs to develop the capacity of the industry and financial regulators have been completed and will continue. 13. Output 2: Deepened capital market provides expanded access to nonbank financing. To deepen the capital markets and facilitate the formation of a risk-free yield curve, the government s efforts were focused on coordinated, ongoing activities to strengthen the primary and secondary government debt market, including the market for sukok. The DGDM has continued to consolidate government debt issuance around recognized benchmarks. To support the secondary market and to strengthen the conduct of monetary policy, Bank Indonesia discontinued issuance of Bank Indonesia bills, which were supplanted by Treasury bills beginning in Concurrently, Bank Indonesia began implementing monetary policy through open market operations with its own inventory of securities and repos/reverse repos with maturities of 1 week to 6 months. This reform includes measures to increase the proportion of tradable securities within the government s debt stock by beginning a process through which non-tradable bank recapitalization bonds will be converted to tradable status. To improve market efficiency, increase trading volumes, and strengthen risk management, a draft global master repurchase agreement, with applicable annexes, has been completed and will be introduced into Indonesia. To provide a greater number and variety of instruments to investors, measures were implemented to ease the securities issuance process and to encourage the use of municipal bonds by rationalizing existing regulations and harmonizing them with those governing the issuance of corporate debt. To improve the quality and transparency of financial information, Bapepam-LK has continued to progress towards full convergence with the International Accounting Standards and International Financial Reporting Standards. To strengthen investor protections, Bapepam-LK has launched an initiative to create a securities market investor protection fund and has increased participation in the investor area facility to provide investors with the ability to independently self-monitor their investment portfolios. Bapepam-LK has introduced a code of conduct for market intermediaries. 14. Output 3: Increased mobilization of long-term savings through a broadened investor base. The resilience of the capital market is also dependent on the strength and depth of the domestic investor base and the accumulation of long-term savings. To capture the benefits of coordinated financial market development, Bapepam-LK has simultaneously increased the contractual savings sector s demand for capital market products. Specifically, Bapepam-LK has encouraged participation in retirement planning by easing the rights issuance process, which benefits employee stock ownership plans, and by exempting investment income earned by pension funds from taxation. Bapepam-LK has also provided an enabling environment for the growth of takaful, a form of Islamic insurance, by issuing guidelines on the governance of takaful undertakings. 14 Bapepam-LK has adopted and implemented basic principles and standards of financial soundness for shariah compliant insurance and reinsurance. To strengthen the conventional insurance industry, Bapepam-LK raised the minimum capital standards for insurance and reinsurance companies and has worked with the industry to improve pricing and risk management in the life and nonlife insurance subsectors. This included collaboration to develop updated mortality tables based on Indonesian data as well as minimum tariffs for auto insurance. To broaden the investor base, the government has encouraged the development of the Islamic finance sector by giving it the same tax treatment as conventional finance. Bapepam-LK revised the criteria for giving stocks sharia-compliant status. 14 Feyen, Lester, and Rocha What Drives the Development of the Insurance Sector? Washington, DC: World Bank. This article cites empirical evidence that Sharia compliance must be assured to build the insurance sector in Islamic countries.

12 6 As a result, the number of sharia-based contracts expanded and the number of shariahcompliant securities increased. Bapepam-LK has strengthened governance in the contractual savings industry and increased investor confidence by strengthening the role of pension fund controllers committees. 15 D. Proposed Technical Assistance 15. A capacity development TA is being processed separately from the program to provide key risk mitigation and to ensure that reforms continue. The FPO will be named as the executing agency to reflect the next phase of ADB s engagement with the government in support of financial sector development. 16 The program was not preceded by project preparation TA but preparatory work for the loan was supported by TA which funded activities that included the development of a plan to launch of an investor protection fund and the introduction of the global master repurchase agreement 17 In addition, a regional TA is supporting the introduction of a regional corporate governance scorecard. 18 E. Medium-Term Reform Framework 16. The new board of commissioners of OJK was selected on 31 July Bapepam-LK will subsequently relinquish its supervisory mandate over the nonbank financial sector on 31 December This means that Bapepam-LK will no longer be able to serve as an executing agency for ADB program loans or TA projects. However, ADB will ensure continuity of the reform agenda under the program by confirming the FPO as the successor executing agency and will at the same time broaden its engagement with the government. This arrangement is both appropriate and timely because the FPO will assume responsibility for financial sector stability and for establishing and coordinating broad financial sector development strategies across government agencies. This will allow ADB and the government, through FPO, to address select development constraints, such as taxation, that were outside of Bapepam-LK s control but will now fall under the responsibility of the FPO. 17. In recognition of this transition, the need to continue with financial sector reforms, and the government s request that ADB remain engaged in the sector, ADB and the government have developed a non-binding medium-term reform framework to guide the reform agenda from 1 January December Under this framework, the government will provide continuing fiscal and operational support to OJK through the start-up phase and will assist the FPO as it begins building the broad oversight mechanisms, such as a crisis management protocol, that are necessary to assure financial sector stability. ADB will continue to support the FPO and other stakeholders with capacity development and technical advice as coordinated efforts to further develop Indonesia s financial markets continue. These efforts include capacity development and measures to continue deepening the primary and secondary government debt markets, encouraging Islamic finance, and supporting the introduction of hedging instruments. 15 The outputs to provide an enabling environment are supported by initiatives to strengthen the technical capacity of the insurance and pension regulators undertaken by the World Bank and the United States Agency for International Development. 16 The proposed TA will provide assistance to strengthen operations in the newly created OJK to ensure that supervision of the financial system is independent, harmonized, and free of political interference. The TA will also strengthen the government s high-level oversight and financial sector development activities by supporting the emergence of the FPO as an economy-wide policy formulation and coordination body. It will also ensure the continuation of reforms undertaken under the FMDIP by providing support to select activities within the CMNMP. 17 ADB Technical Assistance to the Republic of Indonesia for Strengthening Indonesia s Capital Market. Manila. 18 ADB Technical Assistance for Promoting an Interlinked ASEAN Capital Market. Manila.

13 7 F. Development Financing Needs 18. Indonesia s budget deficit was $16.8 billion in 2011, or 1.3% of GDP, and is expected to be 2.2% of GDP, in The associated government expenditure plan for 2012 includes costs associated with the reforms accomplished under the program that are estimated very conservatively at $304 million. This estimate includes costs that must be absorbed by the government to strengthen the supervisory framework. For example, the absorption of the supervision function of Bank Indonesia into the newly created unified regulatory will require comprehensive support to ensure a smooth integration of people and cultures. The estimate also includes information system upgrades within the supervisory agencies and the selfregulatory organizations to provide for a more efficient and secure financial infrastructure. These upgrades have and will further increase investor confidence and reduce the costs associated with financial transactions. Finally, the estimate includes a one-time lump sum estimate of foregone tax revenue associated with tax reforms under the program but excludes the increased legal, administrative, and compliance expenses associated with strengthening the regulatory posture of OJK. These costs remain modest, however, when compared with the opportunity costs to Indonesia of not enhancing financial sector development. 19. To support these reforms, the government has requested a loan of $300,000,000 from ADB s ordinary capital resources. The loan will have a 15-year term, including a grace period of 3 years, an annual interest rate determined in accordance with ADB s London interbank offered rate-based lending facility, a commitment charge of 0.15% per year, and such other terms and conditions as set forth in the draft loan agreement. The Republic of Indonesia has provided ADB with (i) the reasons for its decision to borrow under ADB s London interbank offered rate-based lending facility based on these terms and conditions, and (ii) an undertaking that these choices were its own independent decision and not made in reliance on any communication or advice from ADB. The financing plan is described in Table 1 below. Table 1: Financing Plan Share of Source Amount ($ million) Total (%) Asian Development Bank Total Source: Asian Development Bank estimates. G. Implementation Arrangements 20. The implementation period will be from 1 Sept 2009 to 31 December The executing agencies for the program will be Bapepam-LK and the FPO. Bapepam-LK will be responsible for carrying out all policy actions and will remain executing agency through 31 December The FPO will assume sole responsibility as executing agency on 1 January The FPO will be responsible for continuing policy dialogue and for any reforms initiated under the nonbinding medium-term reform framework. The implementing agencies for the program will be (i) Bapepam-LK, the DGDM, and the Directorate General of Taxation, all three under the Ministry of Finance; (ii) Bank Indonesia; (iii) the Indonesian Stock Exchange; (iv) the Indonesian Clearing and Guarantee Corporation; (v) the Indonesian Central Securities Depository; and (vi) the Indonesian Financial Transaction Reports and Analysis Center. The proceeds of the loan will be disbursed in accordance with the provisions of ADB s Simplification of Disbursement Procedures and Related Requirements for Program Loans ADB Simplification of Disbursement Procedures and Related Requirements for Program Loans. Manila.

14 8 The loan proceeds will be used to finance the cost (excluding local taxes and duties) of items produced and procured in ADB member countries, excluding ineligible items. III. DUE DILIGENCE A. Governance 21. The program is exposed to the interrelated risks of corruption and weak public financial management. These risks have been mitigated over time by the government s efforts to combat corruption. The government has established targets under the NMTDP to cut down corruption and improve transparency and integrity in the management of public resources. Considerable progress has been made in strengthening the legal and administrative framework of public financial management to support the introduction of international sound practices. 20 Specific reforms have been made in the areas of public procurement, auditing, monitoring, and evaluation. Ongoing reform efforts, including the introduction of a medium-term expenditure framework and performance-based budgeting, emphasize the need for improved transparency in the allocation of fiscal transfers to the regions. In addition, the government has taken important strides toward efficient financial management by establishing public procurement offices at national and subnational levels. Lastly, progress has been achieved in improving the transparency and strengthening the role of the external audit function. Challenges remain, however, including the need to improve internal controls in budget execution by spending agencies and to complete the government financial management information system, which provides information for budget management at all levels of government. 22. ADB is building on this momentum by continuing to support improvements in technical capacity and controls. Building on previous programs, ADB TA 21 is helping improve transparency and efficiency in public procurement processes through institutional development, strengthening the capacity and professionalism of staff, raising public awareness, and improving the e-procurement system. 22 Evidence that the government measures to reduce corruption are having some success can be found in Indonesia s improving score on Transparency International s Corruption Perception Index, which rose to 3.0 in 2011 from 2.8 in The World Bank s country partnership strategy with the country for recognizes that the government has increased the level of electoral accountability, encouraged an independent media, and provided an institutional framework to investigate and prosecute corruption. In the context of capital market development, government anticorruption efforts are evident from a rising number of administrative cases and actions filed and enforced by Bapepam-LK. 23. ADB s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the Bapepam-LK and the Ministry of Finance. The specific policy requirements and supplementary measures are described in the government s development policy letter in Appendix 3 and are further detailed in the policy matrix in Appendix Government regulation (PP) 60/2008 requires that all state institutions implement the government s internal control system. 21 ADB Technical Assistance to the Republic of Indonesia for Strengthening National Public Procurement Processes. Manila. 22 The government has also proposed an investment loan for 2012 to provide training for approximately 20,000 auditors, and their auditees, including public procurement officials.

15 9 B. Poverty and Social 24. The government incorporated the goals and objectives of its Poverty Reduction Strategy Paper (2005) in the NMTDP for In turn, ADB s country partnership strategy for incorporated and supported the goals of the NMTDP, which included achieving higher levels of pro-poor sustainable growth. Five areas of engagement were targeted including deepening of the financial sector. This emphasis has continued into the new NMTDP for and has been incorporated into pillar 1 of the ADB s country partnership strategy for , which is inclusive growth. 23 Under this framework, ADB will continue supporting the government s efforts to achieve more inclusive growth through furthering the development of the nonbank financial sector. 25. A number of empirical studies, including one by the International Monetary Fund have supported the direct relationship between financial sector development and poverty reduction. 24 The link between economic growth and financial sector development as measured by private credit and stock market liquidity is well known, has been empirically supported (para. 9), and serves as the primary basis of the government s focus on financial sector development to reduce poverty. However, financial sector development also improves access to finance by reducing information and transaction costs. This allows more entrepreneurs, especially those less well-off, to obtain external finance. For these reasons, the poor will benefit from the program because a deeper and more liquid finance sector will increase access to finance at a lower cost through a greater number and diversity of financial providers and financial products. Finally, financial sector development reduces financial instability, which has been shown to have a disproportionate impact on the poor. C. Safeguards 26. The program will not trigger ADB s safeguard policies and is categorized C for environment, involuntary resettlement, and indigenous people. ADB and the government have agreed to incorporate the following in the legal agreement. Consistent with its commitment to good governance, accountability, and transparency, ADB reserves the right to investigate, directly or through its agents, any alleged corrupt, fraudulent, collusive, or coercive practices relating to the program. The government agreed to cooperate, and shall cause any and all government offices, organizations, and entities involved in implementing the program to cooperate fully with any such investigation and to extend all necessary assistance, including providing access to all relevant books and records, as may be necessary for the satisfactory completion of any such investigation. D. Risks and Mitigating Measures 27. Several risks can be expected to accompany the significant structural change in the regulatory and policy oversight that the program supports. For example, the government may not achieve its medium-term goals for financial sector development because the broad coordination of financial sector reforms envisioned under the FPO may be limited by a lack of capacity or resources. Continuity of reforms under the CMNMP could be lost during the transfer of executing agency responsibilities from Bapepam-LK to the FPO. The transition of financial sector supervision to OJK could be undermined by political influence and specific reforms 23 ADB Country Partnership Strategy: Indonesia, Manila. 24 G. Jeannwney, S. Kpodar, and K. Kpodar Financial Development and Poverty Reduction: Can there be a benefit without a cost? IMF Working Paper # 62. Washington, DC.

16 10 necessary to implement the program fully could be delayed or derailed. To control these risks, the government has adopted a number of mitigation measures, including a consensus driven selection process within the government to choose the initial members of the board of commissioners of OJK and a high-level committee that will manage operational risks arising from the transition. ADB is processing a TA to ensure continuity of reforms by strengthening the capacity of the FPO and ensuring the policy actions initiated under the program are implemented fully (para. 20). Major risks and mitigating measures are summarized in Table 4 and described in detail in the risk assessment and risk management plan. 25 Risks Enhanced coordination of broad-based financial sector reforms is not achieved. Table 4: Summary of Risks and Mitigating Measures Continuity of reforms is lost in the transition as the FPO succeeds Bapepam- LK as the executing agency. The effectiveness of OJK is diminished by political interference and/or a protracted transition process. Program specific risks, including unresolved tax issues and limited financial literacy, interfere with the effectiveness of reforms. Mitigating Measures The proposed ADB TA will help the FPO develop systems and capacity to create financial sector development strategies, conduct macro-prudential supervision, and activate a financial stability forum. The proposed ADB TA will help the FPO take up and continue the implementation of the financial sector reforms. The selection of OJK commissioners has been insulated as far as possible from political considerations by law and a high-level transition planning committee is in place. The TA will mitigate this risk and work to ensure full implementation of policy actions. ADB = Asian Development Bank, FPO = Fiscal Policy Office, OJK = Otoritas Jasa Keuangan, TA = technical assistance Source: Asian Development Bank. IV. ASSURANCES 28. The government and Bapepam-LK have assured ADB that implementation of the program shall conform to all applicable ADB policies, including those concerning anticorruption measures, safeguards, gender, procurement, consulting services, and disbursement as described in detail in the loan documents. V. RECOMMENDATION 29. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve the loan of $300,000,000 to the Republic of Indonesia for the Financial Market Development and Integration Program, from ADB s ordinary capital resources, with interest to be determined in accordance with ADB s London interbank offered rate (LIBOR)-based lending facility; for a term of 15 years, including a grace period of 3 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft loan agreement presented to the Board. 30 August 2012 Haruhiko Kuroda President 25 Risk Assessment and Risk Management Plan (accessible from the list of linked documents in Appendix 2).

17 Appendix 1 11 DESIGN AND MONITORING FRAMEWORK Design Summary Performance Targets and Indicators with Baselines Data Sources and Reporting Mechanisms Impact By 2014: An expanded Increase in nonbank finance Bapepam-LK/OJK nonbank finance subsector assets to 65% of annual report subsector supporting GDP (2010 baseline: 60% of increased GDP) intermediation Assumptions and Risks Assumption Economic conditions remain positive and conducive to business expansion. Outcome By 2012: Increased domestic The level of domestic participation in the ownership of tradable nonbank finance government securities subsector increases to 73% (2010 baseline: 70%) DMO periodic reports Risk Enhanced coordination of broad based financial sector reforms is not achieved. Assumption Market volatility does not reduce risk appetite of investors significantly. Outputs 1. Regulatory oversight strengthened 2. Deepened capital market provides expanded access to nonbank financing. Proportion of government bonds held by the domestic contractual savings subsector increases to 28% (2010 baseline: 26%) By 2012: Board of Commissioners of the Integrated Financial Services Authority (OJK) selected First OJK budget approved By 2012: Total local currency bonds outstanding increase to $105 billion (2009 baseline: $90 billion) Government bond bid ask spreads decline by 15%, (2009 baseline: 26 basis points) Asia Bonds Online website Bapepam-LK annual report, news reports Ministry of Finance budget allocations, press releases Asia Bonds Online website Asia Bonds Online website Risk Continuity of reforms is lost in the transition when the FPO succeeds Bapepam-LK as executing agency. Assumption Proposed reforms are implemented within established timelines. Risk Effectiveness of OJK is diminished by political interference and/or a protracted transition process. Risk Tax issues remain unresolved, preventing the introduction of key financial products and services. Total daily average trading volume of shares on IDX increases to 120,000 (2009 baseline: 87,000) IDX Fact Book

18 12 Appendix 1 Design Summary Performance Targets and Indicators with Baselines Number of companies conducting initial public offerings in a year increases 50% (2009 baseline: 13) Data Sources and Reporting Mechanisms Bapepam-LK annual reports Assumptions and Risks Annual corporate bond issuance increases by 15% each year, from $3.0 billion in 2009 to $5.3 billion. Asia Bonds Online website 3. Increased mobilization of longterm savings through a broadened investor base. By 2012: Life insurance premium volume increases to 2.0% of GDP (2009 baseline: 1.6%) Bapepam-LK annual report Risk Low financial literacy constrains efforts to increase long-term savings. Number of individuals covered by a private pension fund increases to 3 million (2010 baseline: 2.6 million) Bapepam-LK annual report Activities with Milestones 1. Strengthen regulatory oversight and provide credible and reliable infrastructure 1.1 Bapepam-LK introduces risk-based supervision to the pension subsector (December 2010) 1.2 OJK authorized in law (November 2011) 1.3 Three sector laws revised (June 2012) 1.4 Bapepam-LK, Bank Indonesia, and DGDM establish a single government securities registry (March 2012) 1.5 Bapepam-LK and IDX introduce ASEAN corporate governance scorecard to the top 100 listed companies (June 2012) Inputs ADB: $300,000,000 Item Amount ($ million) OCR $ Deepen the capital market and expand access to nonbank financing 2.1 Capital Market and Nonbank Financial Industry Master Plan completed and adopted (December 2010) 2.2 Bond pricing agency launches web-based price discovery (March 2011) 2.3 Bank Indonesia begins open-market operations (September 2011) 2.4 DGDM establishes a range of T-bill issuance at tenors of 3, 6, and 12 months (October 2011) 2.5 Bapepam-LK issues a code of conduct for market intermediaries (December 2011) 2.6 Bapepam-LK launches the capital markets supervisory database (March 2012) 2.7 Draft global master repurchase agreement with Indonesia annexes finalized (June 2012) 2.8 Bapepam-LK harmonizes regulations and facilitate the issuance of municipal bonds (June 2012) 2.9 Bapepam-LK finalizes the concept of the securities investor protection fund (June 2012)

19 Appendix 1 13 Activities with Milestones 3. Increase mobilization of long-term savings and broaden the investor base 3.1 Directorate General of Taxation provides pensions with tax-exempt treatment for investment income (December 2009) 3.2 Bapepam-LK requires fund management companies to retain compliance officers (December 2009) 3.3 Bapepam-LK strengthens the role of the pension fund controllers committee and requires a separation between the founder and administrators (September 2011) 3.4 Bapepam-LK introduces basic principles and standards of financial soundness for sharia-compliant insurance and reinsurance (December 2011) 3.5 Directorate General of Taxation provides for tax neutrality between conventional and Islamic finance (December 2011) 3.6 Minimum capital standards for insurance and reinsurance sectors increased (December 2011) 3.7 Bapepam-LK strengthens actuarial calculations of the life and motor vehicle insurance segments (March 2012) 3.8 Bapepam-LK provides legal framework for employee stock ownership plan (June 2012) ADB = Asian Development Bank, ASEAN = Association of Southeast Asian Nations, DGDM = Directorate General of Debt Management, DMO = Debt Management Office, GDP = gross domestic product, IDX = Indonesian Stock Exchange, OJK = Otoritas Jasa Keuangan (Integrated Financial Services Authority). Source: Asian Development Bank.

20 14 Appendix 2 1. Loan Agreement LIST OF LINKED DOCUMENTS 2. Sector Assessment (Summary): Finance 3. Contribution to the ADB Results Framework 4. Development Coordination 5. Country Economic Indicators 6. International Monetary Fund Assessment Letter 7. Summary Poverty Reduction and Social Strategy 8. Risk Assessment and Risk Management Plan 9. List of Ineligible Items Supplementary Documents 10. Macroeconomic Assessment and Debt Sustainability Assessment 11. Summary Poverty Impact Assessment 12. Summary Program Impact Assessment

21 Appendix 3 15

22 16 Appendix 3

23 Appendix 3 17

24 18 Appendix 3

25 Appendix 3 19

26 20 Appendix 3

27 Policy Matrix: INO-Financial Market Development and Integration Program (FMDIP) Completed Policy Actions Program Period September 2009 to September 2012 No. Policy Actions for FMDIP 1 Action Status and Responsible Agency 1. Regulatory Oversight Strengthened. Medium Term Reform Framework 2 1 January 2013 to 31 December Strengthen the Legal Framework and Enhance Capacity to Supervise Financial Markets (i) (ii) (iii) (iv) The Government, through legislation, provides for harmonized, comprehensive and proficient regulation and supervision of the financial markets through the introduction of a unified regulator with financial and operational autonomy. Bapepam-LK will further enhance its supervisory capabilities by initiating the revision of three sector laws (e.g. Capital Markets, Insurance and Pension) to include, among others, resolution powers and supervisor immunity. Bapepam-LK will enhance its supervisory effectiveness by introducing risk-based supervision to the pension industry. PPATK and Bapepam-LK will cooperatively support and strengthen anti-money laundering protocols within the nonbank sector through the issuance of regulations and by providing joint training. Regulation and Legal Counsel Bureau, Bapepam-LK Government to provide fiscal and operational support to OJK throughout the transition phase. a. Regulation and Legal Counsel Bureau, Bapepam-LK; b. Market Institutions and Transactions Bureau, Bapepam-LK c. Insurance Bureau, Bapepam-LK d. Pension Bureau, Bapepam-LK Government to develop Pension Bureau, Bapepam-LK. Insurance Bureau, Pension Bureau, Financing and Guarantee Bureau, Bapepam-LK & PPATK Crisis Management Protocols and continue strengthening policy effectiveness. 1 Policy actions in bold represent triggers for this program as identified in the policy matrix supporting Subprogram 2 of the Indonesia Capital Market Development Program Cluster. 2 ADB s Operations manual (OM Section D4/OP-14 October 2011; Programmatic Approach Concept Paper) specifies that prior actions for subsequent programs will be indicative (nonbinding) and will not represent disbursement conditions. This policy derives from the Review of ADB s Policy Based Lending Guidelines (3 June 2011) which provides guidance that a Post Program Partnership Framework, or in this case, a medium term reform framework, is used to ensure a continuing policy dialogue but is not presumed to lead to a new program cluster. Appendix 4 21