Asian Development Bank Support to Indonesia s Capital Market Development, : A Background Paper

Transcription

1 March 2018 Asian Development Bank Support to Indonesia s Capital Market Development, : A Background Paper Director General M. Taylor, Independent Evaluation Department (IED) Deputy Director General V. Salze-Lozac h, IED Director W. Kolkma, Independent Evaluation Thematic and Country Division (IETC), IED Team leaders B. Graham, Senior Evaluation Specialist, IETC (until July 2017) L. Ocenar, Evaluation Officer, IETC Team members G. Castillo, Associate Evaluation Analyst, IETC V. Melo-Cabuang, Senior Evaluation Assistant, IETC A. Martinez, International Consultant NOTE In this report, $ refers to US dollars.

2 ASIAN DEVELOPMENT BANK SUPPORT TO INDONESIA S CAPITAL MARKET DEVELOPMENT, : A BACKGROUND PAPER Table of Contents A. Scope, Approach, and Overall Context 3 B. Financial System..6 C. ADB Support to Capital Market Development, D. Assessment of Relevance and Results 18 E. Issues and Suggestions 34 Appendixes 1. Asian Development Bank Support to Finance Sector in Indonesia, Capital Markets, Financial Development, Economic Growth, and Poverty Alleviation List of Tables Table 1: Finance Sector Development, Table 2: Southeast Asian Capital Markets Development Index Table 3: Banking System Soundness Indicators (%), Table 4: Summary of Key Strategic Focus Areas of ADB Support to Financial Sector in Indonesia, Table 5: ADB Finance Sector Loans, Table 6: Ratings for Finance Sector Lending Operations, Table 7: ADB Finance Sector Technical Assistance, Table 8: Ratings for Finance Sector Technical Assistance Projects, Table 9: Distribution of Policy Actions of ADB Policy-based Loans, Table 10: Distribution of Market Infrastructure Policy Actions, Table 11: Distribution of Issuer Policy Actions, Table 12: Local Currency Government Securities Yield Curve, December 2017 Table 13: Government Bond Market Indicators, Table 14: Capital Market Health Scorecard: Indonesia Table 15: Comparative Data of Peer Countries Table 16: Corporate Bond Market Indicators, Table 17: Stock Market Indicators, Table 18: Distribution of Investor Policy Actions, List of Figures Figure 1. Framework for the Capital Market Development Review Figure 2. Theory of Change: ADB Support to Capital Market Development in Indonesia Figure 3. Funding Sources to Fill the Infrastructure Investment Gap Figure 4: Indonesia Corporate Governance Scores, Figure 5: Growth of Government Local Currency Sukuk, Figure 6: Number of Articles on "Financial Deepening in Indonesia", List of Boxes Box 1: Weathering the 2008 Global Financial and Economic Crisis Box 2: Designing Program Clusters Box 3: Inflation Performance and Development of Bond Markets Box 4: World Bank Group Support for Viet Nam Bond Market Development 2

3 A. Scope, Approach, and Overall Context 1. During , Asian Development Bank (ADB) supported Indonesia s capital market development with six policy-based loans (PBLs) amounting to $1.95 billion. While the PBLs covered several aspects of the financial sector, support to capital market development was a significant component in all of them. The other main areas covered by the PBLs were financial sector governance, specifically the transformation towards an integrated supervisory system, and in the latter part the of period, financial inclusion. PBLs represented about 95% of ADB s lending to the financial sector in Indonesia during the past 16 years. In addition, the PBLs were supported or accompanied by technical assistance (TA) focusing on various aspects of capital market development. 2. This paper reviews ADB s support to capital market development in Indonesia during with the objective of identifying issues which may have to be addressed in developing ADB s future strategy in this area. This review was undertaken in connection with the program performance evaluation report (PPER) for the Capital Market Development Program Cluster (CMDPC) Subprograms 1 and 2. 1 The review will serve as an input to the next Independent Evaluation Department s (IED) country assistance program evaluation (CAPE) for Indonesia and the sector assistance and program evaluation (SAPE) for Indonesia s finance sector both set to commence in The review methodology was based on document and file study; data analysis; and interviews and consultations with ADB staff, government officials, and other stakeholders. The interviews and consultations took place in ADB headquarters and during the PPER mission to Jakarta in April Limitations of this background paper include the lack of validations/full evaluations of many programs/projects as well as lack of engagement with market participants and the relevant regional department as this is mainly a desk review, with consultations through the PPER. This review is organized into five sections: Scope, Approach, and Overall Context; Financial System; ADB Support to Capital Market Development; Assessment of Relevance and Results; and an Issues and Suggestions section The Asian Financial Crisis and Reforms to Develop Capital Markets 4. There were several weaknesses of the financial systems in the Asian region which were manifested during the Asian financial crisis. 3 There was excess dependence on the banking system economic growth was financed primarily by banks, and the financial system did not have a spare tire. 4 Many financial institutions and corporations in countries most adversely affected by the financial crisis borrowed in foreign currency without adequate hedging. In addition, much of the debt was short term, while assets were longer term banks were not well suited to finance long-term investments on a large scale. 5 This double mismatch was a contributory factor to the crisis. 5. However, policies were also to blame: poor sequencing of capital account liberalization encouraged short-term borrowing, exchange rate policies (supporting local currencies) led borrowers to underestimate currency risk, and monetary policies allowed domestic credit to expand too quickly. 6 There 1 ADB Report and Recommendation of the President to the Board of Directors: Proposed Loan and Technical Assistance Grant to Indonesia for the Capital Market Development Program Cluster (Subprogram 1). Manila; ADB Report and Recommendation of the President to the Board of Directors: Proposed Loan to Indonesia for the Capital Market Development Program Cluster (Subprogram 2). Manila. The key findings and suggestions in this background paper will be validated during the consultations for the forthcoming CAPE for Indonesia and SAPE for Indonesia s finance sector. 2 A documentation of ADB Support to Finance Sector in Indonesia ( ) is provided in Appendix 1. 3 B. Eichengreen and P. Luengnaruemitchai Why Doesn t Asia Have Bigger Bond Markets? National Bureau of Economic Research Working Paper Cambridge, Massachusetts. 4 A. Greenspan Lessons from Global Crises. Remarks Before Program of Seminars. World Bank Group and International Monetary Fund (IMF). Washington, D.C. 5 R. Fabella and S. Madhur Bond Market Development in East Asia: Issues and Challenges. Economics and Research Department Working Paper Series No. 35. ADB. Manila. 6 T. Lane The Asian Financial Crisis: What Have We Learned? Finance and Development 36 (3). Washington, D.C. 3

4 was an overreliance on volatile capital inflows. Because of their reliance on international capital flows to finance investments, Asian economies became vulnerable to shifts in capital flows Various member-countries in the Association of Southeast Asian Nations (ASEAN) pursued reforms to develop capital markets following the Asian financial crisis. Multilateral institutions such as ADB and the World Bank provided support. In 1999, the International Monetary Fund (IMF) and the World Bank established the Financial Sector Assessment Program (FSAP) to conduct comprehensive and in-depth analysis of financial systems of countries, including development of capital markets. 7. After the crisis, the Government of Indonesia made financial development and stability development a high priority. There were sustained efforts at laying the groundwork for the recovery of the banking system and the prevention of a recurrence of a banking crisis. The supervision capacity of Bank Indonesia (BI) was strengthened and the frameworks for debt recovery and bankruptcy were improved. The financial sector safety net was strengthened with the establishment of a deposit insurance scheme and clear procedures for lender of last resort support. The banks taken over by the Indonesian Bank Restructuring Agency (IBRA) were returned to private ownership with IBRA closing in However, state-owned commercial banks (SOCBs) continued to account for a large share of banking assets and lagged private banks in terms of financial performance. 8. In 2000, the Government issued the Indonesian Capital Market Blueprint , which included initiatives to improve trading systems and enhance information disclosure in public offering. This was followed up by the Capital Market Master Plan which served as a strategic plan. From , the Government implemented several reforms focusing on strengthening the institutional foundation to support capital market development resulting in an increase in the share of the nonbank financial sector in total financial system assets during , from 17.9% in 2005 to 23.9% in Indonesia s financial markets quickly rebounded from the 2008 global financial and economic crisis (Box 1). Box 1: Weathering the 2008 Global Financial and Economic Crisis The banking sector proved to be resilient to the effects of the global financial turmoil in With a strong capital position, the banks weathered the difficult operating environment in late 2008 and early The Government and the Bank Indonesia were able to respond with a series of mitigating measures including injecting liquidity and expanding deposit insurance. Financial markets recovered in 2009 after an initial shock. The 2010 International Monetary Fund-World Bank Financial Sector Assessment found that a decade of sound policies and structural reform helped Indonesia recover quickly from the 2008 global economic crisis. Source: IMF-World Bank Financial Sector Assessment While noting the reforms since the crisis, the 2010 FSAP found continuing challenges in preserving financial stability and developing the financial system. The FSAP pointed to weaknesses in the legal and governance framework as a major constraint to further development of the financial system, which lagged comparable countries in terms of depth and contribution to the economy. Specifically, there were gaps in the legal mandate and powers of supervisors, poor governance of financial institutions, and concerns about creditor rights. The FSAP included a set of recommendations in various areas including the development of capital markets. 8 In 2010, the Government issued the Capital Market and Nonbank Financial Industry Master Plan , which addressed many of the concerns raised by the 2010 FSAP. Following the establishment of a single supervision authority in 2011, the Government issued the Indonesian Financial Services Sector Master Plan , which emphasized support to 7 The statements in paras. 3 and 4 were sourced from IED Performance Evaluation Report of Technical Assistance Grants to Support Development of Cross-Border Bond Markets in the ASEAN+3 Countries. Manila: ADB. 8 IMF and World Bank Financial Sector Assessment: Republic of Indonesia. Washington, D.C. 4

5 financing priority economic sectors such as infrastructure, financial inclusion including micro, small, and medium enterprise (MSME) finance, and ASEAN financial market integration. 2. Framework of the Capital Market Development Program Review 10. This review follows the World Bank Independent Evaluation Group s (IEG) framework for the evaluation of World Bank Group s support to capital market development (Figure 1). The elements in the framework are presented below 9 : (i) (ii) (iii) (iv) Capital markets are financial markets for the buying and selling of long-term securities instruments. Capital markets provide an interface for allocating capital according to market-based pricing of risk and returns. They channel savings toward long-term productive investments, helping issuers companies or governments to raise long term capital, and long-term investors, such as insurance and pension funds, to hold long-term assets and earn returns. Key securities instruments are: (a) bonds or debt instruments that earn investors a regular coupon, allowing them to become creditors to the issuer; (b) equity instruments or stocks and shares that permit investors to acquire ownership of companies and thereby share risk; and (c) bundles of claims, such as asset-backed securities mortgage-backed securities are an example. Capital market instruments are generally deemed to have maturities of at least a year; instruments of shorter maturity, known as money market instruments, provide the liquidity to support secondary market development, also supported by repos and derivatives. On primary markets, issuers of new stocks or bonds sell them to investors via an underwriting process. In secondary markets, existing securities are sold and bought among investors or traders, on an exchange, or on over-the-counter markets, sometimes intermediated by brokers or primary dealers. Liquid secondary markets increase investors willingness to buy. Stable macroeconomic conditions (low inflation; stable interest rates) are critical for capital market development. Investors in securities instruments include institutions such as insurance and pension funds. These institutions accumulate large sums of money through insurance premia (especially life insurance) and pension deposits. Such investors hold long term assets such as capital market instruments to match their long-term payouts. While institutional investors have been major players in capital markets in advanced countries, their role has been more modest in many developing countries due to several factors that include shortage of liquid assets on the supply side and restrictive regulatory regimes such as those mandating certain levels of holdings in government or state-owned enterprise (SOE) securities. Requisites for capital market development. Capital market development needs the right infrastructure to develop, including soft aspects such as: a solid legal and institutional environment; good corporate governance that protects investor rights, especially those of minority shareholders; and hard aspects of sound financial infrastructure including the physical underpinnings of trading systems and securities clearance and settlement arrangements. 9 IEG The World Bank Group s Support for Capital Market Development. Washington, D.C. 5

6 ADB Support for the Use of Capital Market Instruments in its own operations Intermediaries IED Review ADB Support for Developing Member Countries Capital Markets Figure 1: Framework for the Capital Market Development Review Capital Market Infrastructure Regulation Corporate governance Securities clearance and settlement Soft infrastructure Hard infrastructure Other: Creditor Rights, Rating Agencies Returns Instruments/Issuers Bonds: Sovereign/Treasury (Government) Corporate bonds (Companies) Equities/Stocks (Firms/Businesses) Asset-backed/Mortgage-backed securities Other: Repos, Derivatives Intermediaries Investors Insurance companies Pension funds Other funds: mutual funds, sovereign wealth funds, individuals Investments Financing the Real Sector through Capital Market Instruments Government budgets/public borrowing Corporations: Risk capital (equity) Long-term debt Project finance (infrastructure) Mortgage finance: housing Other real sectors ADB = Asian Development Bank, IED = Independent Evaluation Department. Adapted from: Independent Evaluation Group The World Bank Group s Support to Capital Market Development. Washington, D.C. 3. Theory of Change 11. This review is anchored on the theory of change for ADB programs and projects for capital market development in Indonesia supported mainly by loans approved during , with expected development impacts, outcomes, and outputs (Figure 2). B. Financial System 1. Macro Context 12. Since 2002, the Indonesian economy has performed relatively well and weathered a challenging external environment. Because of macroeconomic fundamentals that were put in place since the Asian financial crisis, the country s economic growth has remained strong: gross domestic product (GDP, in $) growth averaged 5.1% in , 5.9% in , and 5.3% during The increase in global commodity prices during contributed to economic growth and poverty reduction. However, since 2012, weaker global commodity prices resulted in a slowing of the growth momentum and exposed structural weaknesses that need to be addressed to revert to higher levels of growth. The rate of poverty reduction also slowed since

7 Inputs/Activities Outputs/Intermediate Outcomes Outcomes Figure 2: Theory of Change: ADB Support to Capital Market Development in Indonesia Development Impacts Greater financial sector resilience and diversification; An expanded nonbank finance subsector; Increased annual growth rate of financial sector supporting increased intermediation; Strengthened financial sector governance and social security system to facilitate broad -based economic growth and reduced vulnerability to crises; Improved and equitable access to infrastructure for economic growth and poverty reduction Supporting the establishment and strengthening of a unified regulatory oversight for banks and nonbank financial institutions Strengthening of the institutional foundation supporting capital market development Promoting issuance of new instruments, and increasing mobilization of long-term savings by broadening the investor base Promoting social security reforms Infrastructure financing Promoting financial inclusion (microfinance, branchless banking initiatives, financial literacy, consumer protection) Strengthened regulatory oversight for banks and nonbank financial institutions Enhanced information disclosure and improved price discovery Deeper and more liquid financial markets Improved market surveillance and investor protection Stronger governance and human resource capacity Increased mobilization of long-term savings through a broadened investor base Improved legislative frameworks and enacted laws for social security governance Financially viable infrastructure finance institution Improved long-term debt market Increased equity investments in infrastructure projects Growth of viable institutions and financial markets development Developed PPP projects Enhanced access to financial services Strengthened financial services regulation and supervision and efficiency Strengthened investor confidence through improved governance Improved national social security Greater contribution by the capital market to domestic financing Increased domestic participation in the nonbank finance subsector Developed and inclusive finance sector Efficient allocation of financing to economically viable infrastructure projects Assumptions: Macroeconomic stability, Political commitment, Effective collaboration among stakeholders Source: Asian Development Bank Independent Evaluation Department. 13. A World Bank report 10 identified three pathways to reducing poverty and increasing shared prosperity: strong economic and jobs growth, improved access to key services, and better national resource management. It also identified infrastructure bottlenecks and underdeveloped financial markets as major impediments to economic and employment growth. To address the infrastructure gap, the Government is embarking on a largescale infrastructure development program. The plan comprises investments of roughly $450 billion (about 50% of GDP) during with significant role of private investment and capital markets (Figure 3). The financing of infrastructure investment, which declined (as % of GDP) since the Asian financial crisis, has been a major motivation of various plans to develop capital markets and the financial system World Bank Group Indonesia Systematic Country Diagnostic: Connecting the Bottom 40 percent to the Prosperity Generation. Washington D.C. 11 Appendix 2 presents a review by the IEG on available literature in terms of the relation between financial sector development and economic growth as well as poverty reduction and inequality reduction. This review also provides a summary information on the recent evolution of capital market development of countries at different income levels. 7

8 Figure 3: Funding Sources to Fill the Existing Infrastructure Investment Gap 70 In $ billion F 2016F 2017F 2018F 2019F 2020F Source: World Bank Group Indonesia Systematic Country Diagnostic: Connecting the Bottom 40 percent to the Prosperity Generation. Washington D.C. 2. Financial System Structure and Oversight 14. Indonesia s financial system continues to be relatively shallow and bank-centered, with a substantial presence of the State and a narrow domestic institutional investor base. At end-2015, total financial sector assets amounted to 72% of GDP, three quarters of which represents banking assets. The insurance sector has been the fastest growing segment and drove the expansion of total system assets by 8 percentage points of GDP during Despite substantial progress since the 2010 FSAP, the 2017 FSAP found that the financial sector was not yet sufficiently able to fund development needs, and that capital markets did not provide sufficient funding nor represented a competitive alternative to banks The financial system is composed of banks, nonbanks and financial conglomerates, with the Government planning to establish a state holding company. Banks are the largest segment, with commercial banks assets at 55% of GDP and 77% of financial system assets as of end Holdings of state-owned commercial and regional development banks were close to 40% of the banking sector s assets and dominating certain credit segments such as microloans. Insurance companies and pension funds accounted for 13% of financial system assets, with other nonbank financial institutions (NBFIs) accounting for 10% as of end-2015 (Table 1). The 44 identified financial conglomerates accounted for about 66% of financial sector assets, including 84% of banking sector assets and majority of insurers. The Government is expected to create a holding company for state-owned financial institutions before end-2017, bringing together the state-owned banks, a financial entity specializing in small and medium enterprise (SME) lending, and a payment switch provider. 12 IMF and World Bank Financial Sector Assessment: Republic of Indonesia. Washington, D.C. 8

9 Table 1: Finance Sector Development, Percent of Percent of GDP Total Financial System Assets Financial System Structure Total Assets Deposit-taking Institutions o/w state-owned banks NBFIs Insurance Companies Pension Funds Other NBFIs Financial System Performance Domestic Credit to Private Sector Credit to Government and SOEs Stock Market Capitalization Local Currency Bond Market Government Bonds Corporate Bonds Financial Inclusion Account (% age 15+) Account, female (% age 15+) Account, poorest 40% (% age 15+) = not available, GDP = gross domestic product, NBFI = nonbank financial institution, o/w = of which, SOE = state-owned enterprises. Sources: IMF-World Bank Financial Sector Assessments 2010 and 2017; World Bank Group Global Financial Database; Global Partnership for Financial Inclusion, and Asian Development Bank AsianBondsOnline. 16. The 2017 FSAP reports that the financial sector lags peer countries in several areas although it is not systematically out of line with countries at a similar level of economic development. Bank credit in Indonesia is about 40% of GDP, thus, credit intermediation is low but roughly in line with other countries with comparable GDP per capita. Equity markets are not at par with other countries, with stock market capitalization at 41% of GDP, and underperform the median of peers by about 30 percentage points of GDP. The fixed income market is underdeveloped relative to peer countries, with private debt securities at about 2.5% of GDP and tradeable government securities just at 13% of GDP. Domestic institutional investors assets are low relative to peer countries, with assets under pension funds at just below 2% of GDP. Foreign investors play a significant role given the absence of domestic investor base, holding almost 40% of government securities and 54% of equities. Financial inclusion indicator is also below peer countries, with 36% of adults holding transactional account which is far below the 69% regional average. A McKinsey study performed a comparative review of capital market development in selected Southeast Asian countries and found that Indonesia lagged most peer countries overall, but performed better in certain areas (Table 2). Table 2: Southeast Asian Capital Markets Development Index Capital Market Development Index and Components SIN MAL THA PHI INO VIE Capital Markets Development Index (Composite) (i) Funding at Scale Financial Depth of Primary Market Availability of Long Term Debt Availability and Stability of Foreign Investment Competitiveness of Cost of Capital Real Cost of Equity Real Cost of Debt (ii) Investment Opportunities 9

10 Capital Market Development Index and Components SIN MAL THA PHI INO VIE Availability of Investment Opportunities Across Asset Classes Appropriate Risk-Adjusted Returns Market Information Quality of Pricing Information INO = Indonesia, MAL = Malaysia, PHI = Philippines, SIN = Singapore, THA = Thailand, VIE = Viet Nam. Scoring for each component: Financial Depth of Primary Market: 1=very shallow; 2=shallow; 3=moderate; 4=deep; 5=very deep Availability of Long Term Debt: 1=very shallow; 2=shallow, short term oriented; 3=shallow, long term oriented; 4=deep, short term oriented; 5=deep, long term oriented Availability and Stability of Foreign Investment: 1=closed; 2=local investor oriented, unpredictable; 3=local investor oriented, predictable; 4=foreign investor oriented, unpredictable; 5=foreign investor oriented, predictable Competitiveness of Cost of Capital: (i) Real Cost of Equity: 1=high; 5=low; and (ii) Real Cost of Debt (1=high; 5=low) Availability of Investment Opportunities Across Asset Classes: 1=very shallow; 2=shallow; 3=moderate; 4=deep; 5=very deep; (>0) = weak; <0.0 = very weak Appropriate Risk-Adjusted Returns: >2 = excellent (not applicable for any markets analyzed; >1.20 = very strong; >0.80 = strong Quality of Pricing Information: <0.090 = highly efficient; <0.130 = efficient; (<0.170) = moderate; <0.210 = inefficient; >0.210 = highly inefficient Total score out of 5 (5 as the highest, meaning very deep capital market, 1 as very shallow). Source: McKinsey & Company Deepening Capital Markets in Emerging Economies. 17. A unified regulator for banks and nonbanks was established. In 2011, the Indonesia Financial Services Authority Law was enacted establishing a new integrated regulator (Otoritas Jasa Keuangan or OJK). OJK assumed responsibility for banking supervision from BI effective January 2014 and for nonbank financial institution supervision effective January There are transitional and operational challenges for OJK, including: need for capacity building for staff supervisory skills and experience; potential overlap of supervisory activities between OJK, BI, and the Indonesian Deposit Insurance Corporation (LPS); and need for change in governance structure within OJK which is sector-based resulting in operational silos. There is a call for the amendment of OJK Law to place priority on financial stability objectives and make legal protection in accordance with international best practice. 18. While the establishment of OJK presented transitional and operational risks, the financial system has been stable financial soundness indicators for the banking system continued to improve after 2010 (Table 3). The FSAP 2017 concluded that the financial system has been stable and has weathered a simultaneous economic and credit deceleration. The framework for crisis management and resolution and safety nets was revamped in 2016 with the enactment of the Prevention and Resolution of System Financial Crisis Law and the establishment of the Financial System Stability Committee (Komite Stabilitas Sistem Keuangan or KSSK) composed of the Finance Minister and the heads of BI, OJK, and the LPS which is responsible for dealing with distress or failure of systematically important banks. 3. Development Challenges in the Finance Sector 19. The authorities have undertaken several measures to boost credit growth and improve intermediation efficiency in banks. These measures included enforcing deposit rate caps for the largest banks, using moral suasion by OJK to induce lower lending rates, and use of guarantees and credit subsidies to boost MSME and micro lending. However, the 2017 FSAP raised concerns about the lack of effectiveness and unintended consequences of many of the policy measures. The FSAP recommended that the authorities focus on addressing cross-cutting financial system fundamentals such as strengthening insolvency and credit rights regimes, improving quality of accounting and auditing for banks, and enhancing the impact of digital financial services. 10

11 Table 3: Banking System Soundness Indicators (%), Capital Adequacy Regulatory Capital to risk weighted assets Regulatory Capital Tier 1 to risk weighted assets Capital to Assets Asset Quality Nonperforming Loans to Total Gross Loans Earning and Profitability Return on Assets Return on Equity Liquidity and Funding Liquid Assets to Short Term Liabilities Non-interbank loans to customer deposits Sources: IMF Financial Soundness Indicator Database; IMF-World Bank Financial Sector Assessments 2010 and Given Indonesia s long-term finance and investment gap, particularly in infrastructure, capital markets can play a larger role in mobilizing longer-term capital from foreign and domestic sources. In addition, deeper local currency markets and a stronger domestic investor base can help reduce the impact of currency shocks and risk of capital outflows posed by the currently large role of foreign investors. However, to date, there is a strong concern that capital markets have not been a significant source of financing infrastructure investments and have not been able to reduce reliance on banking and fiscal finance. To develop the country s shallow capital markets, the 2017 FSAP suggests the following: 13 (i) (ii) (iii) (iv) (v) (vi) Money markets should be developed. This will help spur a robust market for interest rate derivatives and improve market infrastructure, standardization, and liquidity. Government bond markets are relatively developed, but there is a need to enhance the liquidity and the price referencing role of its yield curve. Corporate bond markets are shallow. Companies still prefer bank loans and seem to be the only funding option for many of them while investors seem to prefer SOE instruments. Equity markets have improved yet there are limitations on attracting new listings and increasing the amount of initial public offerings (IPOs). Derivatives is an instrument that is not yet developed, limiting investors ability to manage duration and currency mismatches an impediment to deeper capital markets. Investor base is yet to grow and market participation is yet to improve even if there have been measures to mobilize savings such as social security reform and enhanced regulations of capital market products. 21. The Government has begun to focus attention on financial inclusion with the issuance of the National Financial Inclusion Strategy in According to the 2011 World Bank s Global Findex survey, only about 20% of adults held an account at a formal institution, which is a measly 16% in rural areas, and even less for the poorest 40% of the adult population. This reflects a large number of the population excluded from the formal financial sector and broadly reflects the widening income inequality. Access to financial services in far-flung areas is poor. Aside from geography and lack of physical access, challenges for improving financial inclusion include low levels of financial literacy and education, high transaction costs, income level and socio-economic factors, and lack of identification documents (footnote 10). The Indonesian National Kris Secretariat (Sekretariat Nasional Perkerisan Indonesia or SNKI), which enables coordination and provides guidance to policy initiatives among different stakeholders, has an ambitious goal of 75% of adults having a transaction account by end OJK s National Survey on Financial Literacy and Inclusion in 2016 showed an improvement in two indices compared to the 2013 survey: (i) financial literacy (22% to 30%); and (ii) financial inclusion (60% to 68%). 13 IMF and World Bank Financial Sector Assessment: Republic of Indonesia. Washington, D.C. 11

12 C. ADB Support to Capital Market Development, ADB Sector Programs Strategies 22. ADB s strategies for supporting Indonesia s finance sector during shifted focus compared to prior years. ADB engagement from mainly covered the banking sector (including development banks) (footnote 2). Starting 2002, ADB focused on supporting reforms for transforming governance structures of the financial sector into a single regulatory body and developing capital markets. Towards the end of the period, ADB also begun addressing financial inclusion and access issues. The strategies adopted were in line with the government s strategies and priorities for the sector. Table 4 summarizes ADB s strategies to support Indonesia s finance sector during Table 4: Summary of Key Strategic Focus Areas of ADB Support to Financial Sector in Indonesia, CAP, continue to promote good governance through restructuring and transformation of new regulatory institution for financial markets, and on reforms of nonbank financial sector 2. COS, 2001 encourage formation and strengthening of regulatory institutions and support broader and deeper reforms for the nonbank financial sector 3. CSPU, develop the nonbank financial sector and capital market, including improvement of governance practices 4. CSP, support financial and corporate governance and private sector development 1. CSPU, continue to support efforts for improved governance, environment, and investment climate 2. CSPU, 2005 support microfinance, local government financing, and financing facility intended to promote private sector investments in urban infrastructure 3. CSP deepen the financial sector by focusing on strengthening of nonbank financial institutions and development of capital market 1. COBP a contribute to deeper and broader capital markets to support greater financial sector resilience and diversification 2. CPS support the implementation of finance sector reforms under the government s capital markets and nonbank financial industry master plan 3. I-CPS, 2015 support the development and application of the country s enabling economic policies, which was aimed to (i) deepen and strengthen Indonesia s capital markets, (ii) foster greater financial inclusion, and (iii) reduce impediments to investment and economic growth 1. CPS support capital market and financial inclusion reform to contribute to better economic governance ADB = Asian Development Bank, CAP = country assistance plan, COBP = country operations business plan, COS = country operational strategy, CPS = country partnership strategy, CSP = country strategy and program, CSPU = country strategy and program update, I-CPS = interim country partnership strategy. a The country operations business plans and extended the CSP to 2010 and The COBP updated the CSP results framework reflecting the finance sector as one of the core sectors supporting the government sector objective of greater financial sector resilience and diversification. Supporting this objective, ADB was expected to contribute to deeper and broader and capital markets. ADB s planned interventions were in capital markets development, private sector operations in microfinance, and nonsovereign operations to enhance access of companies to finance. Sources: Asian Development Bank country planning documents for Indonesia; Country Assistance Program Evaluation, ADB s current country partnership strategy (CPS), expects the finance sector to contribute to better economic governance. One of the priority areas under this is capital market and financial inclusion reform. The argument for the support is that a deeper, more broadly-based finance 12

13 sector should help to promote economic growth through productive investments, foster greater economic stability, and support livelihoods and job creation by improving access by households and small businesses to financial services. ADB support aims to improve market infrastructure and encourage product diversification in the bond market. Financial inclusion will be enhanced by addressing regulatory impediments, poor financial literacy, weak consumer protection, and by developing innovative microcredit products to better meet the needs of the poor. TA and financial support to SMEs to enable them to build viable value-chains and integrate into regional and global markets are also planned. 24. IED Program Review Ratings. The CAPE assessed that ADB had a comparative advantage in providing loans in some sectors including in finance and ADB s focus on advisory TA projects for the finance sector improved over the years, with substantial impact on the sector. However, ADB s performance on the development finance loans was marginal (footnote 2). 25. The Country Partnership Strategy Final Review Validation (CPSFRV) 2011 reported that in the area of deepening the finance sector, improved domestic resource mobilization to meet long-term financing needs was expected to help leverage much greater private sector participation. However, targets in the country strategy and program (CSP) results framework were missed, most notably in the failure to stimulate private infrastructure investment and in relation to finance sector deepening. 26. The CPSFRV 2015 highlighted that project performance was better in some sectors including in finance. ADB support for capital market reforms and capacity development has made a positive contribution to: (i) strengthening regulatory and legal structures; (ii) developing the insurance, pension, and Islamic financing markets; and (iii) improving the analysis and design of programs aimed at enhancing financial inclusion. 2. Analytical Work 27. Prior to 2002, ADB had built up a body of knowledge through a series of TA projects. TA projects supported a two-phased study on securities market development (1989 and 1991). There were several TA projects focusing on the development of the pension fund, insurance, and venture capital industries. There was a study on developing the secondary mortgage facility which would enable issuance of capital market instruments. 28. Most of ADB s analytical work during were embedded in the PBLs which included sections describing and identifying the development issues in various aspects of capital markets. In addition, various TA projects produced several studies to further improve design of ADB interventions in various aspects or segments of the capital market. The Financial Governance and Social Security Reform TA, which accompanied the Financial Sector Governance and Social Security Reform Program, included a feasibility study for social security reform and an assessment of the financial condition of the insurance sector. The Strengthening Regulation and Governance TA, which accompanied the CMDPC, included a diagnostic with recommendations on how to harness capital market to support SMEs. As part of ADB Papers on Indonesia quick-disseminating and informal publications maintained by the Resident Mission in Jakarta ADB issued a summary financial sector assessment 15 in Several ADB regional TA programs are supported by analytical work and provide information in Indonesia s capital market. 29. There were several major economic and sector work produced by the World Bank and the IMF during The World Bank issued a major study of NBFIs in 1996 the study was comprehensive and included short and medium-term recommendations for each NBFI segment. There were two joint IMF-World Bank FSAP reports, one in 2010 and a follow-up in Both had substantive coverage of capital markets and included specific recommended actions to be undertaken in the short to mediumterm. The 2017 FSAP also included a scorecard on implementation of recommended actions in the The first CAPE prepared for Indonesia, which covered ADB support during 1990 and ADB Summary of Indonesia s Finance Sector Assessment. Jakarta. 13

14 FSAP. The World Bank and IMF also published in 2001 a handbook on how to develop government bond markets The Asian Bond Monitor (ABM) published by ADB three times a year provides detailed information about the condition of local currency bond markets. The ABM covers ten ASEAN membercountries, including Indonesia, plus the People s Republic of China (PRC); Hong Kong, PRC; and the Republic of Korea. In addition to monitoring development in the local currency (LCY) bond markets in these countries, ADB examines outlook, risks, and policy options. ADB also provides an annual bond market liquidity survey and in certain issues produces analytical pieces, such as the examination of empirical evidence on whether LCY bond markets enhance financial stability. 3. Lending and grant operations 31. For , ADB approved 8 loans and a grant amounting to $2.0 billion to support Indonesia s finance sector. The interventions were supported mainly by PBLs ($1.95 billion) except for two project loans and a grant (Table 5). Loan/ Grant No. Table 5: ADB Finance Sector Loans, Modality Sub Approved sector Amount ($ million) Approval Year Title Financial Market Development and Inclusion Program (Subprogram 2) Program FSD Financial Market Development and Inclusion Program (Subprogram 1) Program FSD Financial Market Development and Integration Program Program MCM Capital Market Development Program Cluster (Subprogram 2) Program FSD Capital Market Development Program Cluster (Subprogram 1) Program ICS Indonesian Infrastructure Financing Facility Project FSD Restoration of Microenterprise and Microfinance in Aceh Project MF (L) Microcredit Project MF Financial Governance and Social Security Reform Program (Phase I) Program ICS Total 2,053.0 ADB = Asian Development Bank, FSD = finance sector development, ICS = insurance and contractual savings, MCM = money and capital markets, MF = microfinance. Note: A program is supported by a policy-based loan. Sources: Asian Development Bank Loan, Grant, TA, and Equity Approvals database; Loans and Grants Financial Information System : Financial Sector Regulatory Reform and Development of Contractual Savings Institutions. The 2002 First Finance Governance and Social Security Reform (FGSSR) designed as a program cluster (Box 2) was envisioned to support the establishment of OJK and promote social security reform including governance of pension funds, an important part of the nonbank financial sector. 17 The FGSSR built on the core reforms under the 1998 Financial Governance Reforms: Sector Development Program (FGRSDP) with additional actions in the areas of disclosure, transparency, and enforcement of regulations to support strengthening of the financial sector while reducing vulnerability to crisis. The FGSSR program included TA projects to strengthen the insurance industry and develop the social security system. The second loan in the cluster did not materialize due to the adoption of a phased approach to the establishment of a single regulatory institution. 16 World Bank and IMF Developing Government Bond Markets: A Handbook. Washington D.C. 17 ADB Report and Recommendation of the President to the Board of Directors on the Proposed Loans and Equity Investment to Indonesia for the Financial Governance and Social Security Reform Program. Manila. 14

15 Box 2: Designing Program Clusters One of main lessons in the program completion report (PCR) for the Finance Governance and Social Security Reform (FGSSR) was the usefulness of the program cluster modality in supporting broad-based reforms requiring long-term institutional development. The program cluster combines a long-term approach covering a wide range of policy and institutional reforms with flexibility to adjust in response to changing circumstances. The longterm approach allows for gradual introduction and appropriate sequencing of policies and reforms to result in smooth implementation. The PCR recommended a shift from a multitranche program cluster to a medium-term framework based on single tranche programs to focus on achievement of outcomes prior to disbursement. Subsequent to the FGSSR were program clusters such as the Capital Market Development and Financial Market Development and Inclusion. Source: Program Completion Report for the Finance Governance and Social Security Reform. 33. The project completion report (PCR) assessed the program successful. However, because Parliament found the transition plan towards a single regulatory institution to be ambitious and required the authorities to follow a phased approach, the PCR considered the program less than relevant and less than effective. Nonetheless, the program resulted in the merger of Bapepam and the Directorate General of Financial Institutions to consolidate supervision of capital markets and nonbank financial institutions. The PCR based the overall rating of successful on improvements in the regulatory and supervision system because of the measures supported by the program. 18 While there were attribution issues, there were improvements in several key financial system indicators: total assets of nonbank financial institutions as percentage of GDP increased from 8% in 2000 to 11% in 2005 and stock market capitalization as percentage of GDP increased from 16% in 2000 to 28% in : Comprehensive Support to Capital Market. ADB approved the CMDPC Subprogram 1 in 2007 and the CMDPC Subprogram 2 in 2009 (footnote 1). The CMDPC aimed to promote diversification and resilience of the financial sector by developing capital markets and the nonbank financial sector through: (i) enhancing information disclosure and price discovery, (ii) promoting deeper and more liquid financial markets, (iii) improving market surveillance and investor protection, and (iv) strengthening governance and human resource capacity. In 2009, ADB approved the Indonesian Infrastructure Financing Facility (IIFF) Project which had two components: (i) an ordinary capital resources loan to the Government to be onlent to the Indonesian Infrastructure Financing Facility Company (IIFFC) which is privately-owned; and (ii) a nonsovereign equity investment in IIFFC The PPER for the CMDPC considered the program successful. Notwithstanding the gains in establishing the institutional foundation for capital market development, some critical areas did not meet expectations including corporate bond market growth. The development impact was viewed as less than satisfactory overall because of the nonachievement of the target on increased share of nonbank financial sector assets in total financial system assets In 2009, ADB approved a sovereign loan to and a nonsovereign equity investment in the IIFF. The PCR for the IIFF Project assessed the project successful based on the achievement of outcomes and outputs in the design and monitoring framework (DMF). However, ADB performance was rated less than satisfactory since ADB monitored only the loan agreement and not the project agreement, which was only partially complied with. One of the lessons was the importance of coordination between the Private Sector Operations Department (PSOD) and Southeast Asia Regional Department ADB Project Completion Report: Financial Governance and Social Security Reform Program. Manila. 19 ADB Report and Recommendation of the President to the Board of Directors on the Proposed Loan and Equity Investment to Indonesia for the Indonesian Infrastructure Financing Facility. Manila. 20 IED Program Performance Evaluation Report: Capital Market Development Program Cluster. Manila: ADB. 21 ADB Project Completion Report: Indonesian Infrastructure Financing Facility. Manila. 15