Million persons Percentage Indonesia: Financial Market Development and Integration Program (FMDIP) Summary Poverty Impact Assessment A. Introduction 1. This Poverty Impact Assessment (PovIA) describes, in general, how financial sector development reduces poverty, as well as how FMDIP is expected to contribute to poverty reduction in Indonesia. The assessment starts with a brief review of the international evidence on the nexus between financial sector development, financial stability and poverty reduction. The assessment then describes the transmission channels through which FMDIP will contribute to poverty reduction in the medium to long term, including i) indirectly through economic growth and financial stability and ii) the more direct channel of access to finance for the poor. The direct role played by Islamic finance is also discussed. B. Background 2. Indonesia s national development plan is anchored on the National Long-term Development Plan (RPJPN) 2005 2025. Within this framework, the government rolls out medium-term development plans (MTDP) every five years. Poverty reduction has always been a primary focus of these medium-term development plans with the previous plan covering the period 2004-2009. During this period, the average economic growth rate of 6% was sufficient to reduce the poverty rate from 16.7% (36.1 million persons) in 2004 to 14.1% (32.5 million persons) in March 2009. 3. These results are impressive given that the poverty rate in Indonesia was as high as 17.8% in 2006. However, these figures are still above the targeted rate of 8-10% which is to be achieved by year-end 2014. A number of factors continue to hamper the government s efforts, including increasing global inflation, the large percentage of the population considered to be near poor and limited coordination between sectors and between the central and local governments. 1 The government also acknowledged that the average growth of 6% that was achieved during the previous MTDP was insufficient to achieve the 8-10% targeted poverty rate. Hence the new MTDP (2010 2014) sharpens the Graph 1: Poverty in Indonesia Poverty in Indonesia government s focus on poverty alleviation by building on the lessons learned over the previous planning period and emphasizes the institutionalization and mainstreaming of social protection in all developmental sectors. As a basis for these programs, the government has determined that the Indonesian economy will need to grow an average of 6.3% to 6.8% which would boost GDP per capita from $2,555 in 2010 to $3,811 by end-2014. To attain these targets, total cumulative investment of between Rp11.9 billion and Rp12.5 trillion will be needed. 45 40 35 30 25 20 15 10 5 0 Source: 2004 2005 2006 2007 2008 2009 Year 20 18 16 14 12 10 8 6 4 2 0 Total of poor population (million persons) Poverty Rate (%) 1 October 2010. SEMRU Research Institute, Review of Government s Poverty Reduction Strategies, Policies, and Programs in Indonesia.
2 The government has identified the financial markets as the source of a majority of this investment, reflecting the government s commitment to, and belief that financial sector development helps to reduce poverty. C. Impact of Financial Sector Development on Poverty 4. Financial sector development helps reduce poverty through three primary channels; higher economic growth, financial sector stability and access to finance for the poor, the first two are indirect and the last is direct. The link between financial sector development and poverty reduction is summarized in table 1 below: Table 1: Links between financial sector development and poverty reduction Financial Sector Development Economic Growth Pooling of savings Reduce information cost monitoring system and corporate governance risk diversification facilitates trading of goods and services Financial Sector Stability Access to Finance for the poor Jobs for the poor Higher taxes for social reforms Higher capital accumulation Financial instability affects the poor the most Poverty reduction Source: ADB staff 5. First, there is general consensus that economic growth reduces poverty reduction through i) job creation, ii) increasing tax revenues which can be used for social welfare programs and reform such as education and health which typically benefits the poor, and iii) higher capital accumulation even amongst the poor which can be used for investment to get higher returns and income. 2 2 ADB s working paper 173 on Financial Sector Development, Economic Growth, and Poverty Reduction: A Literature Review, October 2009.
3 6. Financial sector development and economic growth. The link between financial sector development and economic growth has seen extensive debate. Economists, backed by empirical evidence have recently agreed that the nexus between financial sector and economic growth is real and countries with better functioning banks and financial markets grow faster. More crucially, some studies have gone to prove that the reverse is not necessarily true, thus disproving the reverse causality. 3 7. Financial sector development leads to economic growth in five distinct ways. First, developed financial systems are more effective at pooling the savings of individuals, exploiting economies of scale, and overcoming investment indivisibilities. As a consequence, rates of private investment and household consumption increase over time leading to higher economic growth and poverty reduction. Financial sector development also produces intermediaries that reduce information costs through specialization and economies of scale and thereby improve resource allocation and accelerate growth. Third, a developed financial sector with adequate monitoring systems and corporate governance standards encourages those with surplus finance to invest for production, innovation and Greenfield projects. Fourth, a developed financial system will provide risk diversification benefits which encourage long-run economic growth by improving resource allocation. Finally, the financial sector facilitates trading of goods and services, and promotes specialization and technological innovation. Specifically the role of capital market development is also important as public listings provide an avenue for small investors to participate in privatizations and stock markets provide complementary risk diversification that facilitates the efficient allocation of credit. 8. The second channel or link between financial sector development and poverty reduction is that financial sector development generally increases financial sector stability. Poor households are much more vulnerable than the rich to instability in the financial sector as the poor have fewer and less diversified financial assets than the rich. For example, rich households are more likely than the poor to have assets indexed to inflation. 4 Often times, instability in the financial sector arises during the earlier stages of financial sector development as the financial regulatory and enforcement architecture is not fully effective. The resulting policy responses such as large scale bank closures tend to hurt the poor the most by exacerbating problems with the payments system and through a loss of deposits. Furthermore financial sector instability is often accompanied by a credit crunch wherein banks often require higher pricing and more conservative collateralization which disproportionately affects the poor. Thus, financial sector reforms that aim to enhance financial sector stability also help reduce the vulnerability of the poor or near poor falling into poverty arising from financial sector crises. 9. The third channel of financial sector development that directly reduces poverty is through access to finance, particularly for the poor. Financial sector development reduces informational asymmetries which produce credit constraints. These constraints typically hurt the poor who do not have the resources to fund their own projects, nor the collateral to access bank credit. Through better access to credit, the poor are given the opportunity to participate in meaningful economic activity and undertake investments which increases their incomes. Furthermore, by expanding the access of the poor to financial services, they can increase their lifetime income through the use of basic savings products such as bank accounts, and special purpose savings products such as pre-need plans and pensions. Islamic finance plays a crucial and distinct role 3 For a more through discussion and literature review of this, please see ADB s working paper 173 above. 4 G. Jeannwney, S. and K Kpodar (2008), Financial Development and Poverty Reduction: Can there be a benefit without a cost?. IMF Working Paper #62. Washington DC. The authors estimated quite large coefficients on the financial sector development variable a 10% increase in the broad money (M3) to GDP ratio raises the incomes of the 20% poorest households by between 3 and 5%.
Inefficient government bureaucracy Policy instability Access to finance Inflation Tax Regulation Restrictive labor regulations Foreign currency regulations G D P p e r C Percentage 4 in reducing poverty by through this channel. Studies have shown that a segment of Muslim populations abstain from holding conventional savings accounts due to the interest-generating feature which is prohibited in Shariah (Islamic law). Similarly, some abstain from conventional investment instruments as they prefer investments which are compliant with Shariah. Islamic finance provides alternatives, in terms of both savings accounts and investment instruments through the profit sharing structure offered by Islamic financial institutions (IFI). 5 10. Empirical studies confirm the relationship between financial sector development and poverty reduction. A recent IMF working paper estimated the quantitative impact of financial sector development on poverty in 65 developing countries. The study found that: (i) financial sector development raises economic growth and reduces poverty; (ii) financial sector development directly reduces poverty by raising the investment and interest incomes of the 20% poorest households; and (iii) financial sector instability directly reduces incomes of the poor thereby raising poverty. 11. Similarly, a study by Beck, Demirgüç-Kunt, and Levine (2004) using data for 58 developing countries over 1980 to 2000 showed that countries with better-developed financial intermediaries (measured as the ratio of private credit to GDP) experience faster declines in both poverty and income inequality by disproportionately boosting the incomes of the poor. In addition, the studies revealed that industries composed of smaller firms grow faster in countries with a better-developed financial sector. This reflects the fact that small firms such as SME s generally face greater barriers to raising funds than large firms, and thus, financial development is particularly important for their growth. Moreover, a recent ADB study on financial development and economic growth in developing Asia (2010) shows that financial depth, using different measures of liquid liabilities, private credit and stock market capitalization all exert significant positive effect on real per capita GDP growth. 6 Graph 2: Ease of financial access and the level of GDP per capita Graph 3: Most problematic factors for doing business 4 5, 0 0 0 4 0, 0 0 0 S i n g a p o r e 3 5, 0 0 0 H o n g K o n g S A R 3 0, 0 0 0 2 5, 0 0 0 2 0, 0 0 0 1 5, 0 0 0 1 0, 0 0 0 M a la y s i a 5, 0 0 0 P h i li p p i n e s T h a i la n d In d o n e s i a 0 0 10 20 30 40 50 60 F i n a n c i a l A c c e s s ( R a n k o u t o f 5 5 ) Source: World Bank 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Figure 5A: Most problematic factors for doing business (2011-2012) 14.30% 7.40% 7.20% Source: World Bank 6.10% 6.00% Factors 3.60% 2.30% Series1 5 Mohieldin, Iqbal, Rostom and Fu, The Role of Islamic Finance in Enhancing Financial Inclusion in OIC Countries, World Bank, December 2011 6 Estrada, Park and Ramayandi, Financial Development and Economic Growth in Developing Asia, ADB Economic Working Paper Series, November 2010, Manila.
5 12. These studies confirm the earlier findings of Li, Squire, and Zou (1998) that financial depth (measured as the ratio of broad money supply [M2] to GDP) is associated with lower inequality and also higher income of the lower 80% of the population. The regression results suggest that a one standard deviation increase in financial depth would result in an increase of US$3,000 in the incomes of the poor but only an increase of US$1,600 in the incomes of the rich. Another study by Honohan (2004) appeared to confirm that a 10 percentage-point increase in the ratio of private credit to GDP would lead to a 2.5 3.0 percentage-point reduction in poverty incidence. C. Contribution of FMDIP to Poverty Reduction in Indonesia 13. Despite the laudable pace of poverty reduction, the incidence of working poor 7 is still high, especially when measured by the $2 poverty line. The distribution of workers with incomes ranging from $1.25 to $2 a day is relatively dense and indicates that large numbers of workers are vulnerable to abject poverty unless current and targeted economic growth rates can be maintained. 14. A deeper capital market and expanded access to non-bank financing will reduce poverty by enabling higher economic growth. As illustrated in Graph 2, GDP per capita is highest in those countries exhibiting ease of financial access. Graph 3 confirms the correlations in Graph 2 in that access to finance is one of the top 5 constraints to doing business in Indonesia. FMDIP includes measures to improve the flow of credit and improve access to finance by supporting the ongoing and coordinated initiatives to strengthen the primary and secondary government debt market, including sukuk. Taken in conjunction with efforts to improve price transparency, and to rationalize the securities issuance process, these reforms will enable and encourage an expansion in corporate bond issuance. Parallel efforts to encourage the issuance of municipal bonds outside of Jakarta will also provide alternatives to local governments to support the improvement of infrastructure and social services. 15. The public and the poor in particular, will also benefit indirectly from FMDIP as a deeper and more liquid finance sector will increase access to finance by providing a greater diversity of financial providers and financial products at a lower cost. Direct benefits will be provided through implementation of the ADB sponsored Capital Market and Nonbank Financial Industry Master Plan (CMNMP) for 2010 2014. Specifically, the state-owned pawn business (Perum Pegadaian) will be privatized to encourage the expansion of guarantee and non-bank finance institutions. These efforts will provide rural areas, which typically report higher poverty rates than urban centers, with wider access to cheaper credit by introducing well-established and effective collateral-based lending techniques to the private sector. 16. Additional reforms under FMDIP will implement an investor protection fund and strengthen governance and risk management in the contractual savings industry. In a country like Indonesia, where financial literacy is still in its infantry, it is important that investors feel secure when investing. A backlash against the market may hamper the government s efforts to encourage broader participation in the financial markets. Conversely, measures to protect investors will encourage them to access the capital market as they are protected from malfeasance by market intermediaries. 7 Defined as people who are employed but do not earn sufficient income to meet the basic necessities of life.
6 17. FMDIP will reduce poverty by mobilizing higher levels of domestic savings through a broader domestic investor base. With an open capital account, Indonesia is vulnerable to swings in economic sentiment towards emerging economies. More importantly, the share of foreign ownership of both government bonds and domestic equities is relatively high. As such, Indonesia remains exposed to sudden reversals in capital flows, and heightened volatility such as occurred in August 2011 which resulted in pressure on the Rupiah and a marked decline Indonesia s stock market. Given the relatively shallow domestic bond market, large capital outflows could significantly reduce the government s ability to fund its social and counter-cyclical programs by deficit financing through the capital markets. The negative impact on the economy would be heightened in a more adverse scenario where there is a concurrent decline in credit availability through the international capital markets and where growth in major emerging economies and commodity prices decline. In this case, economic growth would be expected to slow to around 4% of GDP in 2012 which would cause a significant increase in the poverty rate. 18. The government has recognized the need to increase the size of the domestic investor base and to encourage the accumulation of long term savings and funds. To support this objective, and to achieve the full benefits of coordinated financial market development, FMDIP will simultaneously increase the contractual savings sector s demand for capital market products. To broaden the investor base, the development of Islamic Finance will be encouraged by providing tax neutrality and equivalence with conventional finance. The number of Shariah based contracts will be expanded and the number of Shariah compliant securities will be increased by revising the criteria used to evaluate the eligibility of stocks as Sharia compliant investments. 19. Finally, FMDIP will reduce poverty by contributing to financial sector stability. Research highlights the importance of maintaining sound macroeconomic management and effective financial regulation and supervision. There is a view that financial sector development also increases the opportunities for speculation, increasing volatility and the risk of financial crises. In fact, one study (Arner; 2007) argues that financial crises in emerging economies around the world over the past 20 years highlight the dangers inherent in financial liberalization without first addressing institutional weaknesses in the financial sector such as poor regulation and supervision and weak corporate governance. In the case of Indonesia, the recent credit rating upgrade has lead to an influx of investment, and will further increase Indonesia s exposure to global contagion through capital flows and exposure to sophisticated and interlinked investment schemes. 20. In light of these risks, FMDIP will continue with the ADB sponsored initiative to provide for independent, harmonized and comprehensive regulation and supervision of the financial markets. The creation of an Integrated Financial Services Authority, Otoritas Jasa Keuangan or OJK will largely mitigate these risks and will serve to enhance financial sector stability. First, the creation of OJK will reduce the opportunity for regulatory arbitrage which currently exists within the twin silo regulatory structure. FMDIP will provide for the application of effective and consistent regulation to the delivery of financial services regardless of product or delivery channel. In addition, OJK s operational and fiscal autonomy will provide the agency with much needed insulation from politics while at the same time providing for a significant increase in the technical capabilities which will be necessary to address the increasingly complex nature of the inter-connected global financial system. FMDIP will also support a strengthening of the underlying regulatory framework by initiating the revision of three primary financial sector laws (e.g. Capital Markets, Insurance and Pension) to include, among others, resolution powers over problematic institutions and supervisor immunity.