Bank Indonesia, Financial Stability Review, No 4 - April 2005

The Financial Stability Review (FSR) is one of the avenues through which

Bank Indonesia achieves its mission ≈to safeguard the stability of the Indonesian Rupiah by

maintaining monetary and financial system stability for sustainable national economy

development.∆

Published by:

Bank Indonesia

Jl. MH Thamrin No.2, Jakarta

Indonesia

This edition was launched in March 2006 and is based on data and information available by the end of 2005, except stated

otherwise. With the exception of those stated in graphs and tables, all data sources are from Bank Indonesia.

The pdf format is downloadable at http://www.bi.go.id

Any inquiries, comments and feedback please contact :

Bank Indonesia

Directorate of Banking Research and Regulation

Financial System Stability Bureau

Jl.MH Thamrin No.2, Jakarta, Indonesia

Phone : (+62-21) 381 7353, 7990

Fax : (+62-21) 2311672

E-mail : [email protected]

FSR is published biannually with the objectives:

- To analyze potential risks confronting domestic financial system;

- To recommend policies to relevant authorities for promoting a stable financial system; and

- To foster market discipline and public knowledge on domestic and global financial system stability

issues.

i

fsrFinancial Stability Review

II - 2005

( No. 6, March 2006 )

ii

List of Abbreviation

BCBS : Basel Committee of Banking Supervision

DII : Deposit Insurance Institution

EM : Emerging Market

FDR : Financing to Deposit Ratio

FSN : Financial Safety Net

FtS : Failure to Settle

IRB : Internal Rating Based

JCI : Jakarta Composite Index

JSX : Jakarta Stock Exchange

LDR : Loan to Deposit Ratio

LHS : Left Hand Side

LPS : Lembaga Penjamin Simpanan or Deposit Insurance Institution

MSME : Micro, Small and Medium Enterprise

NCD : Non Core Deposit

NPL : Non Performing Loan

RHS : Right Hand Side

SUN : Surat Utang Negara or government bonds

SBI : Sertifikat Bank Indonesia, short-term open market instrument issued by Bank Indonesia

iii

Foreword vi

Chapter 1 Overview 3

Evaluation 3

Outlook 5

Chapter 2 Macroeconomic Stability 9

Global Economy 9

Domestic Economy 11

Chapter 3 Corporate and Household Sector 17

Corporate Credit Risk 17

Household Credit Risk 20

Chapter 4 Financial Sector 27

Banking 27

Intermediary Function 28

Credit Risk 29

Bad-debt Provision 31

Market Risk 32

Liquidity Risk 34

Profitability 36

Capital 36

Measures to Safeguard Banking Stability 37

Sharia Banking 37

Intermediary Function and Financing Risks 37

Liquidity Risk 38

Profitability and Capital 39

Rural Banks 39

Outlook of Banking Stability 39

Multi-Finance Companies 40

Financing Performance 40

Capital 41

Table of Contents

Business Risks 41

Capital Market 42

Stock Market 42

Stock Market Performance 42

Sectoral Index Performance 44

Mutual Funds 45

Mutual Fund Performance 45

Bond Market 46

Government Bond Market Performance 46

Corporate Bond Market Performance 47

Box IV.1.Stress Test of Fuel Price Increase 32

Box IV.2.Stress Test of Market Risks 33

Chapter 5 Financial Infrastructure 51

Large Value and Retail Payment Systems 51

Box V.1.Improvement of the Efficiency and Integrity of

the Payment System 53

Box V.2.Financial Safety Net (FSN) and the Deposit

Insurance Institution (DII) 54

Box V.3.Financial Stability Forum 55

ARTICLES

1. Crises in the Emerging Markets: A Balance Sheet

Perspective (Endang Kurnia Saputra) 3a

2. Post-Crisis Financing Behaviour In The Property Industry:

Survey Result (Gantiah Wuryandani, Martinus Jony

Hermanto, Reska Prasetya) 29a

3. National Discretion of Retail Banking Risk Exposure: The

Case of Indonesia (Gusti Ayu Indira, Indra Gunawan,

and Minar Iwan Setiawan) 39a

iv

List Graphs and Tables

Tables

2.1. Global Economy Indicators

2.2. Global Equity Index

2.3. Balance of Payment

2.4. GDP Growth

2.5. Forecast of GDP

3.1. Unemployment in Indonesia

4.1. Key Indicators of Banking Sector

4.2. Financing of Sharia Bank

4.3. Deposits of Sharia Bank

4.4. Financial Highlights of Sharia Bank

4.5. Key Indicators of Rural Banks

4.6. Net Asset Value of Mutual Funds (Trillion IDR)

4.7. Volume and Issuance of Corporate Bonds

Table of Box :

IV.1.1. Stress Test of Fuel Price Increase to Credit Risk

IV.2.1. Stress Test Scenario

5.1. Settlements at BI-RTGS

Table of Article :

A1.1. Estimated Cost of Crisis

A1.2. Pre Crisis Key Macro Economy Indicator

A1.3. Key Balance Sheet Vulnerabilities

A1.4. Key Policy Adjustment In Crisis-Hit Countries

A1.5. External Debt Structure and Short-Tem Vulnerabilities

A1.6. NPLs in Asia

A1.7. Prominent Empirical Study of Financial Crisis

A1.8. S&P Sovereign Credit Rating

A2.1. Ratio of Installment to Revenue

A2.2. Production Plan

A3.1. Annual PD Calculation for Performing Retail Exposure

Result

A3.2. Usage Type √ Retail Industry LGD (%)

2.1. Oil Price

2.2. Fed Fund Rate

2.3. Current Account, S-I Gap of US (% of GDP)

2.4. Global Equity Index

2.5. USD/IDR Rate

2.6. Domestic Interest Rate

2.7. Inflation Expectation 6 month to come

(% Respondent)

3.1. Growth of Working Capital and Investment Loans

3.2. Real and Nominal Interest Rates

3.3. Working Capital and Investment Loans to GDP

3.4. NPL of Working Capital and Investment Loans

3.5. Sales and Rent of Industrial Property

3.6. Financial Indicators of Publidy Listed Companies

3.7. Sectoral Corporate Loss Ratio

3.8. Growth of Earning Before Tax and Net Income

3.9. Corporate Liquidity

3.10. Cash Flow for Financing Activities

3.11. Corporate Leverage

3.12. Business Activities

3.13. Business Plan for the Next 6 Months

3.14. Investment Plan

3.15. Growth of Consumer Loans

3.16. NPL of Consumer Loans

3.17. Ratio of Consumer Loans to GDP Consumption

3.18. Interest Rate of Consumer Loans

3.19. Residential Property Inflation

3.20. Credit Card

3.21. NPL of Credit Card

3.22. Consumption Plan

3.23. Consumer Expectation Index

3.24. Consumer Confidence Index

4.1. Loan Growth

4.2. Loan to Deposit Ratio

4.3. Loan Growth per Type of Industry 2005

4.4. Loan per Business Sector

4.5. Earning Assets

4.6. Ratio of Loan to Earning Asset and Total Assets

4.7. Growth and Share of MSME Loans to Total LoansΩ

Graphs

v

4.8. NPL and Loans

4.9. NPL per Type of Loans

4.10. NPL of Consumption Loans

4.11. NPL of Property (in value)

4.12. NPL of Property (in percentage)

4.13. NPL of MSME

4.14. Loans, NPL and Provision for Loan Losses

4.15. Ratio of Liquid Assets to NCD

4.16. Trend of Inter-Bank Money Market Rates

4.17. Trend of FX and IDR Deposits

4.18. Allotment of Deposits (in IDR)

4.19. Structure of Deposits

4.20. Deposits Structure as per Maturity Profile

4.21. Deposit Structure as per Ownership

4.22. Net Interest Income and Interest Rate

4.23. CAR of Commercial Banks

4.24. Assets, Deposits and Financing of Sharia Banks and

Sharia Business Unit of Commercial Bank

4.25. Non Performing Financing

4.26. Key Balance Sheet Items of Multi-Finance Companies

4.27. Source of Funds of Multi-Finance Companies

4.28. Financing Structure of Multi-Finance Companies

4.29. Capital of Multi-Finance Companies

4.30. JCI and Transaction Volume

4.31. Volatility of Jakarta Composite Index

4.32. Prominent Events and JCI

4.33. Trading Value and Volume at the JSX

4.34. Foreign Investor Transaction

4.35. Market Capitalization

4.36. Number of Transactions at the JSX

4.37. JCI and Financial Sector Index

4.38. Development of Infrastructure Sector index,

Mining and Agribusiness

4.39. Redemption and Subscription of Mutual Funds 2005

4.40. Government Bond Prices

4.41. Yield Curve

4.42. Country Yield Spread 2005

4.43. Value and Volume of Corporate Bonds

4.44. Interest Rate Rise and Its Impact on Bond Yield

Graph of Box :

IV.2.1. Stress Test of Price Risk

IV.2.2. Stress Test of FX Risk

IV.2.3. Stress Test of Interest Rate Risk

5.1. Settlements of BI-RTGS

5.2. Settlements of BI-RTGS as of Financial Institutions

5.3. Volume and Value of Clearing Settlements

Graph of Article :

A1.1. Private Capital Inflows in Asia and Latin America

A1.2. Domestic Financial Liberalization Index, 1973 - 2002

A1.3. Average Debt to Equity Ratio (1988-1996) (%)

A1.5. Short and Long-term Leverage of Corporations in

Asia

A2.1. Production of Property Industry

A2.2. Growth of Property Industry

A2.3. Marketing System of Property Product

A2.4. Method of Payment

A2.5. Purchase of Property

A2.6. Purchase Through Credit

A2.7. Cash Payment

A2.8. Source of Financing of Property Customers

A2.9. Credit Tenor

A2.10. Ratio of Collateral to Income

A2.11. Type of Loans in Property Financing

A2.12. Ratio of Installment to Income

A2.13. Cycle of Property Industry (Perception of Producer)

A2.14. Net Balance of Developer Perception

A2.15. Property Buying Plan

A2.16. Property Financing Plan

A2.17. Cycle of Property Industry (Perception of Banks)

A2.18. Net Balance of Bank Perception

A3.1. Illustration of the Main Principal Framework to

Calculate the Number of Default Accounts.

Appendices

A3.1. Example of Default Calculation for Bank A

A3.2. Example of LGD Calculation for Credit Consumption

of Bank A

vi

Efforts to safeguard financial stability are the focal role of central banks in light of their objectives to achieve

monetary stability. Financial crises as well as the increasingly integrated global financial system remind us how important

it is that financial system stability be preserved to promote sustainable economic growth and employment. A stable and

robust financial system will have natural capabilities to allocate funds, carry out payments, maintain the value of assets

and diversify risks. The Financial Stability Review (FSR) is one avenue through which Bank Indonesia strives to safeguard

financial system stability. This sixth edition attempts to comprehensively discuss the risks and potential risks which have

confronted the Indonesian financial system recently.

The second half of 2005 was an extremely challenging period, as the stability of the domestic financial sector was

under serious pressures. As a result, the economy is becoming increasingly sensitive to externalities, predominantly due to

the rocketing oil price that precipitated sharp rises in domestic fuel prices and interest rates. These factors had undesirable

impacts on both the corporate and household sectors, as they face escalating costs while their incomes are tightening.

However, these huge obstacles can be absorbed by the corporate sector as production remains stable despite shrinking

profit margins. To survive, many manufacturing firms have sought greater efficiency through downsizing, reducing costs

and improving corporate structure. As a result, investments continued to decelerate at the end of 2005 after rebounding

in the previous periods. The shrinking investment value is also a result of the remaining sub-optimal domestic investment

climate.

Nevertheless, the Indonesian financial system can withstand these shocks, as various components of the financial

system, including financial institutions, financial markets, clearing and settlement systems remain solid amid external

pressures.

• The intermediary role of banking continues to show positive results despite growing pressures in the real economy

and sharp rises in domestic interest rates. Notwithstanding, credit risk has followed a slightly upward trend as

indicated by growing distressed loans (NPLs). However, banks have ample capital to absorb unexpected defaults as

a result of shocks.

• Financial markets were bullish and investors remained buoyant. In bond markets, investors have recently searched

for yield by investing in government bonds and other low-risk assets. The yield of government bonds, nevertheless,

has been more sensitive to the rise in domestic interest rates. This has spilled over to the fixed-income mutual funds,

which remain subjected to downward pressure as a consequence of the decreasing value of underlying assets. The

inter-bank money market remained liquid and showed resiliency in light of our more stringent reserve requirement.

• Financial infrastructure remains in good shape. Clearing and settlement systems remain robust despite the mounting

settlement value and frequency. This has been supported by the establishment of the National Clearing System,

Foreword

vii

which began in July 2005. Bank Indonesia, in coordination with the government, has also supported limited deposit

insurance and financial safety net schemes in an endeavor to promote stability in the banking sector. Moreover, a

risk-management certification program has been conducted as one of the means to enhance the quality of bank

risk-management.

Bank Indonesia responded to the recent potential vulnerability by three pre-emptive measures. First, we tightened

monetary policy via interest rate and reserve requirement increases, the latter being directly linked to the loan deposit

ratio. Secondly, we improved the availability of standby foreign exchange liquidity reserves by arranging Bilateral Swap

Agreements with the Bank of Japan, Bank of Korea and Peoples» Bank of China. In addition, we are also providing short-

term swap facilities for hedging. Third, we prohibit margin trading transactions of rupiah.

Given the recent developments, Indonesian financial stability in the near term is projected to be stable despite the

remaining challenges. The second-round effect of the recent external shocks will continue to pose threats to the real and

financial sectors. Household and corporate real income will be tightened while financial institutions -predominantly banks-

will intensely mitigate credit risk pressures. However, considering the positive outlook of the macro-economy, business

and consumer confidence, as well as stimuli from the government, the near-term outlook for Indonesian financial stability

is likely to be positive.

This has been a brief conjuncture and outlook of recent financial stability in Indonesia that is comprehensively

outlined in this edition. This review is expected to build the awareness of stakeholders on the importance of financial

stability and its potential threats. Finally, we look forward to receiving constructive comments regarding any improvements

for this review in the future.

DEPUTY GOVERNOR

BANK INDONESIA

Maman H. Somantri Maman H. Somantri Maman H. Somantri Maman H. Somantri Maman H. Somantri

viii

1

Chapter I Overview

Chapter 1Overview

2

Chapter I Overview

3

Chapter I Overview

Financial system stability in Indonesia remained positiveFinancial system stability in Indonesia remained positiveFinancial system stability in Indonesia remained positiveFinancial system stability in Indonesia remained positiveFinancial system stability in Indonesia remained positive

despite facing significant pressure emanating fromdespite facing significant pressure emanating fromdespite facing significant pressure emanating fromdespite facing significant pressure emanating fromdespite facing significant pressure emanating from

externalities, in particular increases in oil prices and interestexternalities, in particular increases in oil prices and interestexternalities, in particular increases in oil prices and interestexternalities, in particular increases in oil prices and interestexternalities, in particular increases in oil prices and interest

ratesratesratesratesrates

In general, financial stability in Indonesia during the

second semester of 2005 remained positive despite being

confronted by significant external pressure, in particular

due to the ongoing impact of global oil price increases

that lead to sharp hikes in domestic fuel prices. In addition,

the ongoing global tight-biased monetary policy and global

imbalances brought their own impacts on domestic

financial stability. Subsequently, there were three major

factors which intensified risks to domestic financial system

stability. Firstly, financial system stability was more sensitive

to externalities; secondly, real economy performance

remained slow, exacerbated by domestic distortions

impeding sustainable economic development; and finally,

the intensified potential risks in the financial system, in

particular the banking sector, hindered the intermediary

function.

Against this backdrop, near-term risks still confront

domestic financial stability. There were signs,

notwithstanding, that domestic financial system will be

able to absorb the negative impacts of the near-term risks

and consequently, remain stable. To mitigate potential

instability, Bank Indonesia and the government imposed

various policies to encourage financial institutions to

manage their risks prudently and thus, bolster more

favorable economic conditions. The main priority is to

create a robust balance of payments, which remains a

serious challenge considering prevalent economic

conditions. A solid balance of payments is pre-requisite

to diminish the negative impacts of future externalities,

and subsequently support domestic financial system

stability.

EVALUATION

Domestic fuel price hikes and soaring interest ratesDomestic fuel price hikes and soaring interest ratesDomestic fuel price hikes and soaring interest ratesDomestic fuel price hikes and soaring interest ratesDomestic fuel price hikes and soaring interest rates

hampered financial system performancehampered financial system performancehampered financial system performancehampered financial system performancehampered financial system performance

Reviewing the first semester of 2005, the soaring

global oil prices since mid 2004 forced the government to

increase domestic fuel prices in early 2005. The negative

spill-over, however, was contained in such a way that it

did not trigger financial instability. The second semester

of 2005 was extremely challenging for the Indonesian

economy. Indonesia has gradually achieved financial

stability momentum; however, this was constrained by

externalities during the second semester. Global oil prices,

which soared to US$70 per barrel, coupled with ongoing

global imbalances intensified the risks in the domestic

economy and subsequently aggravated potential instability

in the domestic financial system. This forced the

government to raise fuel prices for a second time by as

much as 127% in October 2005; a decision that

heightened pressure on macroeconomic conditions and

financial system stability. The consequences were reflected

by soaring inflation, which reached 17.11% in December

2005; significant increases in exchange rate volatility; and

a drop in the performance of the balance of payments.

In response to the potential of instability, Bank

Indonesia launched several pre-emptive measures: (i)

tightening monetary policy by raising the BI Rate to

12.75%; (ii) tightening banking liquidity by raising the

reserve requirement pegged to the loan to deposit ratio

Chapter 1Overview

4

Chapter I Overview

(LDR); (iii) strengthening commitment to provide stand-

by foreign exchange liquidity via the Bilateral Swap

Agreement between Bank Indonesia and the Bank of

Japan, Bank of Korea and People»s Bank of China; (iv)

providing investment swap facilities for 3-6 month terms

for hedging purposes; (v) requiring banks to maintain

mid-day and end of day net open position; and (vi)

banning banks from transacting margin trading of foreign

currencies against the rupiah.

Previously, Bank Indonesia also took pre-emptive

measures to eliminate exchange rate volatility by enforcing

the following policies: (i) limiting short-term capital flows

by restricting non-resident rupiah transactions; and (ii)

managing the demand and supply of foreign currencies

at state-owned companies, including encouraging

repatriation of their foreign exchange reserves to the

domestic market. These measures were able to reduce

subsequent vulnerabilities and stabilize the rupiah, hence,

alleviating macroeconomic conditions.

Furthermore, the various obstacles confronting the

real economy were adequately mitigated by the corporate

sector. Albeit slower, the corporate sector has continued

to record positive growth and profitability by boosting

efficiency, amongst others through downsizing and energy

diversification. Increases in the magnitude of the lay-offs

have reduced household income and, therefore, the

repayment capacity of the household sector has

deteriorated.

The developments of the macroeconomic and real

economies spilled over to the financial system. The banking

industry confronted intensified credit risks, reflected by a

higher rate of non-performing loans (NPLs). Despite this

pressure, however, banks continued to expand their

intermediary function, particularly for consumer financing.

On the other hand, market and liquidity risks were

adequately managed and have not yet appeared to trigger

any potential instability. Overall, the stability of the

domestic banking sector remained positive, despite

intensifying risks, due to ample capital held at banks.

Sharia banking remained buoyant with regard to its

intermediary role and performance. Financing to the real

economy increased, prompting the financing to deposit

ratio to peak at 97.8%. However, compared to the rapid-

growth period of 2004, growth in sharia banking slowed

as a consequence of the adverse macro-economy during

the course of 2005.

Moreover, the performance of multi-finance

institutions remained satisfactory but sluggish due to rises

in domestic interest rates. Their credit risk, however, tended

to rise, as a result of less prudent financing assessment.

This may trigger a rise in the credit risk exposure of banks

as the vast majority of funding sources originate from

banks.

The Indonesian Stock Market, in general, continued

a bullish trend, peaking at 1192.20, despite external and

internal pressures, primarily from fuel price hikes. This was

partly due to buoyant investor confidence -essentially

foreign investors- towards social, political and economic

conditions in Indonesia. However, this trend requires close

supervision to prevent a sudden reversal of short-term

foreign capital.

The bond market recorded a positive trend, although

growth was slower than the previous period. Significant

rises in interest rates put downward pressure on bond

prices and, therefore, increased potential market and credit

risks. Interest rate sensitivity was higher in the government

bond market, which is more liquid and active compared

to corporate bonds. This momentum benefited corporate

and government issuers through buy-back. Successive spill-

over effects from the fall of bond prices induced panic

redemption in mutual funds, leading to a dramatic drop

in Net Asset Value (NAV) to Rp28 trillion in December 2005.

Regarding financial system infrastructure, the

payment system was robust and supportive of domestic

5

Chapter I Overview

financial stability. Although the value of settlements

significantly increased, the payment system has continued

to remain sound. The Real-time Gross Settlement (RTGS)

system functioned successfully despite an increasing

number of settlements. On the other hand, no significant

disruptions occurred in the implementation of the National

Clearing System (NCS) in several cities, which boosted the

efficiency of the payment system. In addition, the Failure-

to-Settle (FtS) scheme was introduced in conjunction with

the NCS. This scheme will eliminate counterparty risks and

handle the increasing volume of RTGS as well as clearing

systems, and therefore, enhance the robustness of the

payment system.

To bolster the financial system stability, the

government and Bank Indonesia are formulating a

comprehensive Financial Safety Net (FSN) framework. The

components of FSN include prudential regulation for

financial stability, Emergency Liquidity Assistance (ELA), and

the Deposit Insurance Scheme (DIS). DIS in Indonesia has

two primary features: to provide an explicit limited deposit

insurance scheme up to a particular amount; and to carry

out the resolution of failing banks. Under the auspices of

FSN, in September 2005 the Indonesian Deposit Insurance

Institution (DII), was established. DII has the authority to

implement a limited deposit insurance scheme,

commencing in March 2007, for deposits of up to Rp100

million per customer per bank.

In addition, Bank Indonesia is dedicated to the

implementation of Indonesian Banking Architecture (IBA)

and progress during 2005 continued unabated. The

implementation of IBA is directly aimed at efforts to bolster

financial system stability. As part of the IBA initiative, Bank

Indonesia is steadfast in its commitment to expedite

national banking consolidation by 2010. Within this

roadmap, it is expected that banks will become well-

performing and well-managed by 2007 as pre-requisite

to become an anchor bank. In addition, the

implementation of a certification program to improve the

quality of risk-management for risk-managers will

contribute to financial stability. By the end of 2005, 529

directors and commissioners had been certified as well as

1,700 bank officials. Moreover, Bank Indonesia will

promote banking infrastructure through the establishment

of the Credit Bureau.

OUTLOOK

Despite continued exposure to internal and external risks,Despite continued exposure to internal and external risks,Despite continued exposure to internal and external risks,Despite continued exposure to internal and external risks,Despite continued exposure to internal and external risks,

financial system stability will remain solidfinancial system stability will remain solidfinancial system stability will remain solidfinancial system stability will remain solidfinancial system stability will remain solid

The domestic financial system is projected to remain

stable in spite of exposure to internal and external

pressures, considering the second-round effects which will

linger early in the first semester of 2006. This is

predominantly supported by banking system stability,

improved risk-management and bullish financial markets.

Externalities, driven by surging international oil prices,

tightening monetary policy and unsettled global

imbalances, are predicted to distort macroeconomic

stability. Internally, plans to raise the electricity tariffs, civil

servant remuneration and the minimum provincial wage

rates will lift inflation expectations. Hence, monetary policy

will remain tight to maintain inflation within the target.

The macroeconomic forecast remains unfavorable for

the real economy; however, the real economy is resilient to

shocks even in the face of prevalent escalating production

costs and the cost of funds. Efforts of business players to

achieve greater efficiency for survival, in turn, will exacerbate

the potential for lay-offs and, thus, diminish the purchasing

power of household sectors. Such conditions are detrimental

to the repayment capacity of both the corporate and

household sectors in servicing their liabilities.

As a result, the credit risk of financial institutions,

particularly banks, will remain high but the performance

of banks will be positive despite the pressures. These

conditions will force banks to become more conservative

6

Chapter I Overview

in allocating credit and expand their portfolio in low risk-

weighted assets. The pressure from the escalating cost of

funds and overhead costs will shrink their profit margin.

However, banking capital adequacy is far above the

minimum required threshold and, therefore, sufficient to

absorb any shocks and potential instability. Furthermore,

long-term stability in the banking system will be supported

by a certification program to improve the quality of risk-

management.

In light of promoting the intermediary function and

banking system stability, Bank Indonesia introduced a

prudential banking package in early 2006. This package

includes adjustments to the quality of earning assets of

commercial banks; expansion of public access to sharia

banking services through office channeling; extension of

the banking service network to micro, small and medium-

sized enterprises (MSME); adjustment of risk-weighted

assets for mortgages and pensioners loans; a customer

protection scheme through the enforcement of banking

mediation program; and the implementation of Good

Corporate Governance (GCG) for commercial banks.

Due to the growing external and internal

uncertainties, Indonesian stock markets will remain bullish

despite facing downward pressures caused by deterioration

in the performance of issuers and market sentiment. The

mining industry, especially oil and natural gas, is expected

to be upbeat, in correlation with persistently high energy

prices. In addition, the telecommunications sector will

retain its position as the «blue-chips», and will continue to

drive the Jakarta Composite Index upward. Foreign

investors will remain the largest players in the stock

markets, and their decisions will be largely influenced by

their expectations of upcoming Indonesian GDP growth,

global oil prices and the Fed Fund Rate.

The bond markets, particularly government bonds,

will remain buoyant despite a flattening yield curve due to

the rise in short-term bond yields. Unlike in government

bond markets, corporate bonds will appear to be sluggish

due to growing uncertainty in the performance of issuers.

This condition is neither conducive for liquidity

improvements nor attracting more investment funding

through corporate bond markets.

7

Chapter II Macroeconomic Stability

Chapter 2Macroeconomic Stability

8


9


Macroeconomic stability was hampered by continuousMacroeconomic stability was hampered by continuousMacroeconomic stability was hampered by continuousMacroeconomic stability was hampered by continuousMacroeconomic stability was hampered by continuous

hikes in the global oil price, persistent global imbalanceshikes in the global oil price, persistent global imbalanceshikes in the global oil price, persistent global imbalanceshikes in the global oil price, persistent global imbalanceshikes in the global oil price, persistent global imbalances

and the tight monetary policyand the tight monetary policyand the tight monetary policyand the tight monetary policyand the tight monetary policy

Macroeconomic stability was confronted by external

pressures stemming from soaring oil prices, persistent

global imbalances and tightening monetary policy. Disparity

in supply and demand pushed the global oil price up to

US$70 per barrel at its peak. These externalities sparked

domestic fuel price and interest rate hikes, as well as raised

liquidity risk in the balance of payments. However,

countermeasures taken by the government and Bank

Indonesia dampened the subsequent negative impacts

stemming from the aforementioned externalities. In the

future, pressures from global risks are predicted to continue

attributable to high oil prices and interest rates, as well as

global imbalances. Internal pressures have also emerged

due to plans to raise the electricity tariff, civil servants»

salaries and minimum provincial wages.

GLOBAL ECONOMY

Risks emanating from global economic uncertainty areRisks emanating from global economic uncertainty areRisks emanating from global economic uncertainty areRisks emanating from global economic uncertainty areRisks emanating from global economic uncertainty are

predicted to remain high over the near-termpredicted to remain high over the near-termpredicted to remain high over the near-termpredicted to remain high over the near-termpredicted to remain high over the near-term

External risks to financial system stability primarily

stemmed from three precipitating factors, which

significantly impinged on Indonesian economic

performance. These are: (i) persistent oil price hikes

recorded their highest level for three decades; (ii) recurrent

tight-biased monetary policy, which directly suppresses

inflation; and (iii) incessant global imbalances propagated

by capital flows to the US to finance their twin deficits.

During the last two years, international oil prices have

continued to increase reaching a peak in August 2005 at

Chapter 2Macroeconomic Stability

Graph 2.1Oil Price

2003 2004 2005

0

10

20

30

40

50

60

70

80

Source: Bloomberg

$/barrel

Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec

WTI Future Price (6 mth)WTI Future Price (3 mth)WTI Spot Price

US$70 per barrel. This was mainly influenced by strong

demand, especially from China and India; countries still

experiencing booming economies. In terms of supply, oil

production capacity was insufficient to satisfy the

increasingly high demand. In addition, distortions such as

hurricane Katrina, which destroyed oil and gas

infrastructure in the Gulf of Mexico, restricted further the

already inadequate supply of world oil.

Persistent strong consumption and limited supply,

particularly from non-OPEC countries and Russia, provoked

upward expectations that the oil price would continue to

rise. Higher volatility in the spot and futures oil markets

was indicative of the greater control speculators have in

determining oil prices. High demand from emerging

economies, inadequate supply from non-OPEC countries

and no significant investment in oil exploration drive

expectations of the futures prices. This is expected to spur

extremely tight supply and demand of global oil.

The oil price remains the key determinant of global

economic growth. High prices drive capital flows from

10


importing to exporting countries that usually have low

marginal propensity to consume. Higher production costs

and a fall in profit margins, but with the declining intensity

of oil usage over the last three decades, particularly in

industrialized countries, has helped lessen the impacts of

oil price hikes. Monetary measures have also dampened

the negative pass-through effects of rising inflation on

corporate revenues and household purchasing power. This

significantly alleviated the impact of high oil prices on the

global economy. Unlike today, the energy crises during

the 1970s and 1980s were predominantly triggered by

distortions in oil supply, while increases in the oil price

over the last two years have mostly been precipitated by

high demand. This was evidenced by strong economic

growth of 5.1% in 2004, albeit slowing to 4.3% in 2005

and 2006. Also, inflationary pressures were considered low

with a delta of 0.2% in developed countries and 0.1% in

developing countries.

Against high inflationary pressures, central banks

exercised tight biased monetary policy, while the European

Central Bank (ECB) and the Bank of Japan (BoJ) maintained

loose monetary policy to encourage investment. The Fed

Fund rate (US) rose to 4.25% and, consequently, attracted

Table 2.1Global Economy Indicators

Indicators 2003 2004

World Output 4.0 5.1 4.3 4.3

Advanced Economies 1.9 3.3 2.5 2.7

Emerging & Developing Countries 6.5 7.3 6.4 6.1

Consumer Price

Advanced Economies 1.8 2 2.2 2

Emerging & Developing Countries 6 5.8 5.9 5.7

LIBOR

US Dollar Deposit 1.2 1.8 3.6 4.5

Euro Deposit 2.3 2.1 2.1 2.4

Yen Deposit 0.1 0.1 0.1 0.2

Oil Price (US $) - average 15.8 30.7 43.6 13.9

Forecast

2005 2006

Source: World Economic Outlook

%%%%%

more capital flows to the country, spurring bullish asset

prices and USD appreciation amidst the growing twin

deficits. These capital flows were used to finance deficits

in the current account.

Graph 2.2Fed Fund Rate

4.25

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

%


2003 2004 2005

Source: Bloomberg

Graph 2.3Current Account, S-I Gap of US (% of GDP)

-7

-6

-5

-4

-3

-2

-1

0

Current Account

S-I gap

1999 2000 2001 2002 2003 2004 2005

Source: World Economic Outlook

Globally, stock market indices fluctuated as a

consequence of movements in international interest rates

and oil prices. In Asia, the KOSPI index of South Korea

performed best during 2005. Factors such as favorable

macroeconomic conditions, strong issuer fundamentals

and unremitting positive growth in the industrial sector

bolstered the stock index. These alleviated the negative

impacts emanating from increases in global interest rates

11


and oil prices. In South Korea, local investors were the

major buyers in the stock market while foreign investors

were mostly net sellers. The outlook for South Korean stock

market performance is positive until 2006 as a result of

bullish economic recovery and buoyant local investor

optimism.

of potential capital reversals due to the predominantly

short-term nature of these capital flows.

High pressure from global risks are likely to continue

due to expectations that the oil price will persistently rise;

distortions caused by the geo-political problems in Iran;

expected inflation remaining high; rising interest rates; and

persistent global imbalances. These developments are

expected to trigger risks in economic growth and global

financial system stability.

DOMESTIC ECONOMY

Higher volatility in the exchange rate, soaring fuel pricesHigher volatility in the exchange rate, soaring fuel pricesHigher volatility in the exchange rate, soaring fuel pricesHigher volatility in the exchange rate, soaring fuel pricesHigher volatility in the exchange rate, soaring fuel prices

and rising domestic interest rates hampered the domesticand rising domestic interest rates hampered the domesticand rising domestic interest rates hampered the domesticand rising domestic interest rates hampered the domesticand rising domestic interest rates hampered the domestic

real economyreal economyreal economyreal economyreal economy

The Indonesian economy faced great challenges

during the second semester of 2005. Macroeconomic

stability was confronted by serious pressures due to

several factors; (i) rising volatility in the exchange rate

attributable to increasing demand for the US dollar; (ii)

hikes in fuel prices up to 127%; and (iii) significant

increases in the domestic interest rates. The rupiah

depreciated against the hard currencies after rebounding

in the preceding period as a consequence of both external

and internal vulnerabilities. The gradual and steady

STI

FTSE

PCOMP

JCI

SET

KOSPI

KLCI

Source : Bloomberg

1,000

2,000

3,000

4,000

5,000

6,000

600

700

800

900

1,000

1,100

1,200

1,300

1,400

3 18 5 20 4 19 4 19 3 18 3 18 2 17 1 16 1 16 31 15 30 15 30

2005

FTSE, STI & PCOMP JCI, SET, KLSE & KOSPI

Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Graph 2.4Global Equity Index

The Japanese stock market, the Nikkei, also

recorded high growth. The relatively solid recovery of the

Japanese economy buttressed capital market

performance and the Nikkei index passed the 16,000

point, the highest for 5 years. Foreign investment in

prospective domestic stocks strengthened the Nikkei

further. In 2006, investors expect the Nikkei to perform

well due to investor confidence in the protuberance of

the Japanese economy.

Upward risk pressures in the international markets

did not provoke negative expectations of global economic

growth. Conversely, developments in financial markets

were indicative of continued global economic growth,

particularly in Southeast Asia and East Asia. These

expectations drove the perpetual capital inflows into these

regions resulting in appreciation of the respective

currencies. This has also contributed to financial stability

in the Asian region. Notwithstanding, signs are apparent

Table 2.2Global Equity Index

Index

KLCI 907.43 899.79 (0.84)Dow Jones 10,783.01 10,717.50 (0.61)Hang Seng 14,230.14 14,876.43 4.54SET 668.10 713.73 6.83NYSE 7,250.06 7,753.95 6.95STI 2,066.14 2,347.34 13.61PCOMP 1,822.83 2,096.04 14.99JCI 1,000.23 1,162.64 16.24FTSE 4,814.30 5,618.80 16.71Nikkei 11,488.76 16,111.43 40.24KOSPI 895.92 1,379.37 53.96

Source: Bloomberg

December 31, 2004 December 30, 2005 %

12


increase in the Fed Fund Rate attracted capital flows into

the US, induced USD appreciation and consequently,

intensified capital outflows from Indonesia. This pushed

the Jakarta Composite Index to its lowest level for two

years. Internally, the soaring oil price, up to US$70 per

barrel, spurred high foreign currency demand for oil

imports, predominantly from the large players such as

Pertamina, a state-owned oil company. Additionally, the

fiscal burden was perceived as unsustainable on account

of the large fuel subsidies and the inappropriate interest

rate level, which seemed lower than the inflation

expectations of market participants. This contributed to

higher volatility in the foreign exchange market.

The pre-emptive policies of Bank Indonesia and the

government were able to dampen macroeconomic

instability. Against the persistent rupiah depreciation

due to externalities, Bank Indonesia took several

measures as follows: (i) raised the BI Rate; (ii) lifted the

minimum statutory reserves ratio linked to the loan to

deposit ratio (LDR); (iii) provide an investment swap

facility for 3-6 month terms for hedging purposes; (iv)

enforced banks to maintain mid-day and end-day net

open position (NOP); (v) expanded the availability of

standby foreign exchange liquidity reserves by arranging

Bilateral Swap Agreements with the Bank of Japan, Bank

of Korea and Peoples» Bank of China; and (vi) prohibited

margin trading transactions.

Formerly, Bank Indonesia took various policy

measures to prevent exchange rate volatility and reduce

speculative pressures by: (i) limiting non-resident

transactions in rupiah; and (ii) managing the demand

and supply of foreign currencies at state-owned

companies, as well as promoting repatriation of their

international reserves into the domestic market.

To reduce the fiscal burden of fuel subsidies, the

government raised fuel prices in October 2005. The

subsidies were reallocated in the form of a direct

compensation package to low-income earners. This

policy sparked positive expectations regarding the

sustainability of fiscal conditions and effectively purged

any social fall-out; a condition that has encouraged

positive sentiment towards the Indonesian economy and

dampened volatility in the exchange rate. On the other

hand, this policy raised production costs, reduced

corporate profits, and weakened the purchasing power

of the household sector. However, a cabinet reshuffle

at the end of 2005 boosted optimism towards the

economy and the performance of the government,

which, in turn, lead to a more bullish stock market and

stable exchange rate.

Graph 2.6Domestic Interest Rate

0

2

4

6

8

10

12

14

16

18

20

Jan Apr Jul OctJan Apr Jul OctJan Apr Jul Oct

2003 2004 2005

Dec

%

Inflation (yoy)BI rateSBI

Graph 2.5USD/IDR Rate

Rp/IDR

Tsunami inAceh and Nias(Dec 26, 2004)

PresidentialElection

(Oct 20, 2004)

Fed Fund Rate Hiketo 4.25% (Dec 13, 2005)

BI-Rate Inauguration(July 5, 2005)

Bali Bomb IIand Domestic Fuel

Price Hike(Oct 1, 2005)

11000

8000

8300

8600

8900

9200

9500

9800

10100

10400

10700

2004 2005

1 31 1 31 30 30 29 29 28 27 27 26 26 25 24 26 25 25 24 24 23 22 22 21 21

-- Hurricane Katrina,Global Oil Price hikeUSD 69.81/barrel

Apr May Jun Jul Aug Sep Oct Nov DecJan Mar Jan Mar May Jun Jul Aug Sep Oct Nov DecFeb Apr

13


priority of the authorities is to bolster a resilient balance

of payments.

Various upward risk pressures hampered economic

growth, particularly in the fourth quarter of 2005.

Notwithstanding, overall annual economic growth in

2005 was satisfactory; achieving 5.6% compared to the

previous year which only achieved 5.13% and

government expenditure supported GDP growth.

The outlook for the domestic economy will remain

positive despite the near-term risks. Distortions in

domestic macroeconomic conditions are expected to

continue, particularly in line with the plans to increase

the electricity tariff (TDL) both for household and

industrial consumers, increase the minimum provincial

Table 2.3Balance of Payment

Indicator

Current Account (% GDP) 1.5 1

Reserves 36,03 33,81

Trade Balance 21,55 23,17

Export 72,17 86,91

Total Debt 137 133,5

ST Debt 3,134 6

ST Debt/Reserves (%) 8.70 17.75

ST Debt/Total Debt (%) 2.29 4.49

2004 2005

(Billion US $)(Billion US $)(Billion US $)(Billion US $)(Billion US $)

The balance of payments remained solid in spite of

pressures emanating from prevalent externalities. Trade and

current account balances recorded surpluses and export

performance was positive. The magnitude of fuel price

and interest rate hikes were insignificant to the

performance of the balance of payments. However, despite

foreign debt decreasing, liquidity risks appeared to escalate;

visible by the growing international short-term liabilities.

The ratio of short-term foreign debt to international

reserves increased dramatically as a result of a considerable

drop in international reserves. Consequently, Bank

Indonesia exercised tight vigilance over the rapid

increments in short-term liabilities to prevent liquidity

pressures in foreign exchange markets that could have

triggered subsequent instability. Against this backdrop, the

Table 2.4GDP Growth

Description2004

Household Consumption 4.94 3.22 3.59 4.43 4.18 3.95

Government Consumption 1.95 -8.63 -5.70 16.15 29.98 8.06

Investment 15.71 13.68 14.54 9.18 1.78 9.93

Export 8.47 13.30 12.69 3.39 7.41 8.60

Import 24.95 15.58 17.86 9.29 3.74 12.35

GROSS DOMESTICGROSS DOMESTICGROSS DOMESTICGROSS DOMESTICGROSS DOMESTIC 5.135.135.135.135.13 6.126.126.126.126.12 5.845.845.845.845.84 5.345.345.345.345.34 4.904.904.904.904.90 5.605.605.605.605.60

PRODUCTPRODUCTPRODUCTPRODUCTPRODUCT

Source: Centre of Statistic Bureau

%%%%%

2005

Total I II III IV Total

Graph 2.7Inflation Expectation 6 month to come (% Respondent)

80

70

60

50

40

30

20

10

0Q III Q IV Q I Q II Q III Q IV

2004 2005

=< 9 %

10% - 15%

>= 16%

Table 2.5Forecast of GDP

Items 2005 2006

Private Consumption 3.95 3.5 3.1 3.8Government Consumption 8.06 13.31 0.91 4.42Total Consumption 9.9 34.6 4.0 5.0Total Investment 9.93 8.9 7.0 10.01Export of Goods and Services 8.6 7.8 6.9 7.88Import of Goods and Services 12.35 9.5 8.6 10.19

GDPGDPGDPGDPGDP 5.65.65.65.65.6 5.425.425.425.425.42 4.94.94.94.94.9 5.75.75.75.75.7Scenario

Government Expenditure 40 50 40 60IDR/USDIDR/USDIDR/USDIDR/USDIDR/USD 97009700970097009700 1010010100101001010010100 1060010600106001060010600 98009800980098009800

(%, yoy)(%, yoy)(%, yoy)(%, yoy)(%, yoy)

2006*

Pessimistic Optimistic

Source: Centre of Statistic Bareau

14


daily wage and raise the salary rates of civil servants. The

second-round effect of this policy appeared to adversely

impact economic growth, inflation and the domestic

interest rate, which, in turn, put pressure on financial

system stability. On one hand, this policy will increase

production costs, inflation and put upward pressures on

domestic interest rates. On the other hand, however,

higher household income will maintain the household

consumption level and thus, prevent consumer repayment

capacity from falling further. Overall, the outlook for the

domestic economy for the first semester of 2006 appears

to be more positive compared to those of previous periods.

This is reflected by emerging optimism from both business

players and consumers. Also, inflation expectations are

positive as market participants expect decelerating inflation

in the near term. Besides, the efforts of business players

to survive by enhancing their efficiency will boost

productivity in the real economy.

15

Chapter III Corporate and Household Sector

Chapter 3Corporate andHousehold Sector

16


17


The real economy grew despite heavy pressuresThe real economy grew despite heavy pressuresThe real economy grew despite heavy pressuresThe real economy grew despite heavy pressuresThe real economy grew despite heavy pressures

As a sector where most funding comes from the

banking system, the real economy is considered a main

determinant of shifts in financial system stability. Despite

heavy pressures, the real economy, in general, grew slightly.

Corporate financial performance, in general, was

satisfactory in terms of profitability and leverage. This

showed that corporations were still able to meet their

obligations, however, rising corporate non-performing

loans indicated high credit risk. In addition, household

credit risk increased as a result of a decline in purchasing

power. The outlook for the real economy is to grow slightly

despite mounting pressure in line with the plan to increase

the electricity tariff (TDL) and provincial minimum wage.

Simultaneously, the expected increases in the salary rates

of civil servants and the provincial minimum wage are

expected to support public consumption and repayment

capacity.

CORPORATE CREDIT RISK

Increases in corporate credit risk, particularly for theIncreases in corporate credit risk, particularly for theIncreases in corporate credit risk, particularly for theIncreases in corporate credit risk, particularly for theIncreases in corporate credit risk, particularly for the

purpose of investment, hampered corporate financingpurpose of investment, hampered corporate financingpurpose of investment, hampered corporate financingpurpose of investment, hampered corporate financingpurpose of investment, hampered corporate financing

Pressures on corporate production costs continued

as administered prices, including the electricity tariff and

fuel prices, continued to rise. In addition, inflation soared

in October as a result of fuel price hikes that lead to rising

domestic interest rates. Although the real interest rate was

negative and hence favorable, high corporate credit risk

hampered investment funding. Sluggish investment

performance was also affected by increases in the leasing

rate of industrial property, which continued to rise.

Furthermore, working capital credit maintained positive

growth with relatively low credit risk.

Chapter 3Corporate and Household Sector

Graph 3.1Growth of Working Capital and Investment Loans

%

5

10

15

20

25

30

35

2003 2004 2005Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec

Working Capital LoansInvestment Loans

Graph 3.2Real and Nominal Interest Rates

InvestmentLoans

Working CapitalLoans

2003 2004 2005

53113579

111315171921

5

311

35

791113

1517

19

Working Capital Loans Nominal (left)Working Capital Loans Real (left)Investment Loans Nominal (right)Investment Loans Real (right)

% %


18


Graph 3.5Sales and Rent of Industrial Property

$/Rp

-

5,000

10,000

15,000

20,000

25,000

30,000

%

66

67

67

68

68

69

69

70

70

71

Q1 Q2 Q3 Q4Q1 Q2 Q3 Q4 Q1 Q2

2003 2004 2005

Sales (%) Rent/m2 ($/Rp)

Graph 3.8Growth of Earning Before Tax and Net Income

0

0

0

1

(1)

(0)

(0)

0

0

0

1

1

1

(1)

(1)

(0)

(0)

2003 2004 2005Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3

EBT (LHS)

Net Income (RHS)

Source: JSX

Graph 3.7Sectoral Corporate Loss Ratio

consumer agriculture miscindustrytradingmining

propertyinfrastructure basicindustry

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3

2003 2004 2005

Source: JSX

Graph 3.4NPL of Working Capital and Investment Loans

%

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

2003 2004 2005

Investment LoansWorking Capital Loans


Graph 3.3Working Capital and Investment Loans to GDP

0

1

2

3

4

5

6

7

8

%

-4

-2

0

2

4

6

8

10

12

2002 2003* 2004** 2005**I II III IV I II III IV I II III IV I II III IV

Working Capital Loans/GDP (LHS)Investment Loans/GDP (RHS)

Source: Centre of Statistic Bareau

Graph 3.6Financial Indicators of Publidy Listed Companies

Base Year 2002=100

Current Ratio

ROA

ROE

Inventory Turn Over Ratio

Collection Period

DER

0

40

80

120

160

200

Q3:2005Q3:2004

Source: JSX

19


Improvements in publicly listed companies indicated

recovery in repayment capacity. There was a significant

rise in corporate profitability and a decline in leverage.

Several sectors, such as property, agro-industry and trading,

showed negative performance but improved compared to

the previous year, as reflected by the declining loss ratio.

Corporate liquidity and profitability improved, which

strengthened repayment capacity. This encouraged

corporations to repay their liabilities before maturity leading

to lower leverage; reflected by the negative cash flow since

2004 and active buy-back in the bonds markets.

Persistent distortion in the real economy post-crisis

created a high-cost economy. The obstacles, among others,

include labor issues, regional regulations, tax, law and

infrastructure. These impediments, coupled with adverse

macroeconomic conditions, caused corporate sector

performance to decelerate up to year end. However, the

production level remained stable; indicated by the capacity

utilization rate at around 72%. Consequently, growth in

2005 was relatively higher than in the previous year.

The plan to raise the electricity tariff and the provincial

minimum daily wage, as well as disturbances in the

distribution system will lift production costs and suppress

corporate financial performance. However, in spite of the

ongoing deceleration in investment, expectations

rebounded optimistically according to the business survey.

Graph 3.10Cash Flow for Financing Activities

2003 2004 2005

Trillion IDR

0

2

4

6

8

(6)

(4)

(2)

Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3

Cash Flow Fr Financing Activities

Source: JSX

Graph 3.11Corporate Leverage

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3

2003 2004 2005

DER Debt/TA

Source: JSX

Graph 3.9Corporate Liquidity

Billion IDR

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3(2)

0

2

4

6

8

10

12CA/CL (LHS)CA-CL (RHS)

2003 2004 2005

Source: JSX

Graph 3.12Business Activities

0

5

10

15

20

25

30

35

40

2003 2004 2005

56

58

60

62

64

66

68

70

72

74

76

Business Situation (LHS)Financial Condition (LHS)Capacity Utilization (RHS)

%Net Balance, in %

Q I Q II Q III Q IV Q I Q II Q III Q IV Q I Q II Q III Q IV

20


Graph 3.13Business Plan for the Next 6 Months

Graph 3.15Growth of Consumer Loans

20

25

30

35

40

45

50

%

2003 2004 2005


This optimism is forecast to dissipate pressures on working

capital credit, however, pressures on investment credit

appear to remain unchanged. As such, expectations are

predicted to drive a bullish rally in the equity and bond

markets; a condition that will foster financial stability.

HOUSEHOLD CREDIT RISK

Household credit risk remained moderate but increasingHousehold credit risk remained moderate but increasingHousehold credit risk remained moderate but increasingHousehold credit risk remained moderate but increasingHousehold credit risk remained moderate but increasing

Although the trends continued to decline, the high

growth in consumption credit expanded its share in total

credit. On the other hand, there was an increase in non-

performing loans starting at the beginning of the year,

though the level remained relatively low. Household credit

has lower risk than corporate credit and for this reason

household credit is regarded as a favorable investment for

the banking industry despite weakened purchasing power.

This was indicated by increased competition between

banks to provide better access for customers to

consumption credit. Additionally, low inflation in the

residential property sector accelerated growth in

Graph 3.14Investment Plan

Graph 3.16NPL of Consumer Loans

%

1.00

1.50

2.00

2.50

3.00

3.50

2003 2004 2005


0

5

10

15

20

25

30

35

40

45

50

2003 2004 2005

Net Balance, in %

Q I Q II Q III Q IV Q I Q II Q III Q IV Q I Q II Q III Q IV

20

22

24

26

28

30

32

34

2003 2004 2005 2006

Semester II Semester I Semester II Semester I Semester II Semester I

Net Balance, in %

21


0

2

4

6

8

10

12

14

2003 2004 2005

I II III IV I II III IV I II III IV

%

Graph 3.19Residential Property Inflation

Graph 3.17Ratio of Consumer Loans to GDP Consumption

0

1

2

3

4

5

6

%

2002 2003* 2004** 2005**I II III IV I II III IV I II III IV I II III IV

Graph 3.18Interest Rate of Consumer Loans

%

-5

0

5

10

15

20

25

2003 2004 2005


Consumer Loans (Nominal) Consumer Loans (Real)

consumption credit. Furthermore, unsecured credit risk was

relatively low and tolerable. Growth in unsecured credit

through credit cards rose by 36%, however, the share of

credit cards was relatively low at around 7-8%. The ratio

of credit cards in total credit remained low and also non-

performing loans (NPL) declined, therefore, the risks

associated with this unsecured credit were deemed

insignificant.

Along with rising inflation and unemployment,

household credit risk increased albeit manageable.

Consumer purchasing power was constrained by the hikes

in fuel prices in October 2005 as well as in the interest

rate. This, among others, was reflected by rising

unemployment from 22,355 in June-September 2005 to

55,697 in October-December 2005 triggered by increasing

production costs. Consumer purchasing power will weaken

further in concordance with the proposed plan to raise

the electricity tariff, the high inflation as well as the rising

interest rate. This will inhibit consumer repayment capacity

and put upward pressures on consumption credit risk, yet

Graph 3.20Credit Card

Credit Card(growth)

Credit Card(level)

Trillion IDR

8

9

10

11

12

13

14

15

16

17

18

2004 2005

20

25

30

35

40

45

%

Jan Feb Mar AprMay Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar AprMay Jun Jul Aug Sep Oct Nov Dec

22


remain tolerable. Conversely, the plans to increase the

salary rates of civil servants and the provincial minimum

wage will also counter the pass-through effects of declining

Graph 3.21NPL of Credit Card

5

6

7

8

9

10

11

12

13

2003 2004 2005

%

Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct

Graph 3.22Consumption Plan

Table 3.1Unemployment in Indonesia

Open Underemployment Total Unemployment Workforce Rate of Open Rate ofUnemployment (million) (million) Unemployment Unemployment

1996 4.76 na na 88.19 5.4% na

1997 4.79 10.67 15.46 88.65 5.4% 17.4%

1998 5.71 8.57 14.28 92.13 6.2% 15.5%

1999 8.52 11.98 20.5 96.86 8.8% 21.2%

2000 8.18 10.64 18.83 98.6 8.3% 19.1%

2001 8.01 11.2 19.21 98.84 8.1% 19.4%

2002 9.13 12 21.14 100.35 9.1% 21.1%

2003 9.53 12.42 21.95 100.33 9.5% 21.9%

2004 10.3 13.4 23.7 104.04 9.9% 22.8%

2005 11.2 14.3 25.5 105.83 10.6% 24.1%

2006*) 12.15 28.85 41 109.91 11.1% 37.3%

Year

*) ForecastSource: Department of Workforce

purchasing power and mitigate credit risk. Optimism was

reflected in the consumer survey as consumer confidence

was restored.

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

2003 2004 2005

Net balance in %


Appliances HomeHouse Appliances

Home Improvement/Housing ProcurementMotorbikeCar

Vehicle

23


Graph 3.23Consumer Expectation Index

Graph 3.24Consumer Confidence Index

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

180.00

IncomeEconomyJob Availability

2003 2004 2005Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec

Consumer Confidence Index

Current Economy Condition0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

2003 2004 2005

Consumer Expectation


24


25

Chapter IV Financial Sector

Chapter 4Financial Sector

26


27


Amid interest rate hikes, the financial sector remainedAmid interest rate hikes, the financial sector remainedAmid interest rate hikes, the financial sector remainedAmid interest rate hikes, the financial sector remainedAmid interest rate hikes, the financial sector remained

stable showing positive growth and performance.stable showing positive growth and performance.stable showing positive growth and performance.stable showing positive growth and performance.stable showing positive growth and performance.

Stability of the financial sector was well maintained

despite vulnerabilities in the macro economy as a result of

high inflation and interest rate hikes. The banking sector

remained stable with positive growth and profitability

despite rising credit risk. Non-bank finance companies

showed positive growth but with a flatter trend. Moreover,

stability in the capital market was preserved

notwithstanding the downward price pressures as well as

increasing credit and liquidity risks. The performance of

the equity market at year end was bullish, bolstered by

positive expectations. Conversely, the rising interest rate

drove bond prices down in the bond market. In addition,

redemption of fixed-income mutual funds continued. In

general, the near-term outlook of the financial system in

the first semester of 2006 is upbeat.

BANKING

In spite of intensifying credit risk, banking industry stabilityIn spite of intensifying credit risk, banking industry stabilityIn spite of intensifying credit risk, banking industry stabilityIn spite of intensifying credit risk, banking industry stabilityIn spite of intensifying credit risk, banking industry stability

remained favorableremained favorableremained favorableremained favorableremained favorable

Unfavorable economic conditions during the second

semester of 2005 intensified credit risks in the banking

industry as reflected by the increasing NPLs. Amid growing

pressure, notwithstanding, the domestic banking industry

successfully expanded its intermediary function and

maintained profitability. In addition, banking capital was

adequate to absorb unexpected losses; a condition that is

expected to preserve banking sector resilience in the near

term.

Chapter 4Financial Sector

Table 4.1Key Indicators of Banking Sector

1st Semester 2nd Semester 1st Semester 2nd Semester 1st Semester 2nd Semester

Total Assets (Trillion IDR) 1,111.7 1,196.2 1,185.7 1,272.3 1,344.6 1,469.8

Deposits (Trillion IDR) 846.8 888.6 912.8 963.1 1,011.0 1,127.9

Loans (Trillion IDR) 434.1 477.2 528.7 595.1 664.3 730.2

Earning Assets (Trillion IDR) 1,052.2 1,072.4 1,102.8 1,146.8 1,239.9 1,300.2

Net Interest Income (Trillion IDR) 4.1 3.2 5.4 6.3 6.1 6.2

Loan to Deposit Ratio (%) 51.3 53.7 57.9 61.8 65.7 64.7

Loan Growth (%, y-o-y) 21.5 16.3 21.8 24.7 25.7 22.7

Return on Assets (%) 2.2 2.5 2.7 3.5 2.9 2.6

Non Performing Loans (%) 8.0 8.2 7.6 5.8 7.9 8.3

Non Performing Loans (net of provision (%)) 1.2 3.0 2.1 1.7 3.7 4.8

Capital Adequacy Ratio (%) 23.0 19.4 20.9 19.4 19.5 19.5

Net Interest Margin (%) 0.4 0.3 0.5 0.6 0.5 0.5

Liquid Assets/Total Assets (%) 16.6 15.1 14.8 14.9 15.3 15.8

Core Deposits/Total Assets (%) 0.5 0.5 0.5 0.5 0.5 0.5

Cost Efficiency Ratio (%) 87.6 88.8 87.0 76.7 88.8 87.7

2 0 0 3 2 0 0 4 2 0 0 5Key Indicator

28


Intermediary Function

The intermediary function of banks continued to

improve, yet growth slowed in the fourth quarter of

2005 due to adverse macroeconomic conditions

attributable to the soaring global oil price and high

domestic interest rate. . . . . Despite the rising interest rate,

credit growth as year end of 2005 reached 22.7% with

LDR of 64.7%. Escalating production costs and

mounting cost of funds forced the real sector to

reevaluate their business expansion and consumption

plan during the fourth quarter of 2005, hence declining

growth in the demand for credit. However, the share of

credit in total earning assets increased from 53.6% to

56.2% bolstered by consumption credit growth of

36.8% (y-o-y).

working capital credit maintained the highest share in the

credit portfolio; achieving 46.6%.The reasons for this slow

growth were: (i) difficulties in finding new debtors that

are bankable; (ii) the banking industry tended to avoid

funding the business sectors sensitive to fuel price hikes;

and (iii) uncertainty in the business environment

surrounding taxation, the prevailing legal framework, labor,

investment and infrastructure perpetuated the high-cost

economy and raised the cost of funds.

Graph 4.1Loan Growth

%

-5

0

5

10

15

20

25

30

35

40

2005Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Working Capital Loans

Investment Loans

Consumption Loans

Graph 4.3Loan Growth per Type of Industry 2005

-20 -10 0 10 20 30 40 50

Trading

Others

Manufacturing

Transportation

Construction

Agribusiness

Services

Public Services

Mining

Electricity

%

Graph 4.2Loan to Deposit Ratio

Trillion IDR %

0

200

400

600

800

1,000

1,200

0

20

40

60

80

100

120

140

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Loan (LHS) Deposit (RHS)LDR (RHS)

The high preference of banks to expand loans in the

consumption segment was propelled by historically lower

NPLs compared to the corporate segment. However, bank

financing of business activities was sluggish, reflected by

slow growth of working capital credit and investment credit

at only 22.4% and 13.2% (y-o-y) respectively. As such,

29


Specifically, banks actively financed micro, small and

medium enterprises (MSME) as indicated by high credit

growth in 2005, reaching 25%; with a total credit share

of 23%. This statistic reflects that the role of banks in

encouraging MSME activities was satisfactory yet sub-

optimal.

Graph 4.4Loan per Business Sector

Construction AgrobusinessManufacturingOthers

ElectricityMiningPublic ServicesServices

TransportationTrading

18.8%

29.0%

27.1%

3.9%

5.1%9.8% 1.4%

1.3%

2.8%

0.8%

Graph 4.5Earning Assets

0

100

200

300

400

500

600

700

800

2000 2001 2002 2003 2004 Dec0

50

100

150

200

250

300

350

400

450

500

Trillion IDR Trillion IDR

Loans (LHS)

Bonds and Securities (RHS)

SBI (RHS)

Inter-Bank (RHS)

Graph 4.6Ratio of Loan to Earning Asset and Total Assets

0

10

20

30

40

50

60

70

Jan Jun Nov Apr Sep Feb Jul Dec May Oct

2002 2003 2004 2005

%

Loans/Total Assets

Loans/Earning Assets

Graph 4.7Growth and Share of MSME Loans to Total LoansΩ

Ratio of MSME Loans (LHS)

MSME (RHS)

%

10

15

20

25

30

35

40

22

23

24

25

26

27

%

2005

1 2 3 4 5 6 7 8 9 10 11 12

Credit Risk

Although the intermediary function improved, the

quality of credit deteriorated. Adverse macroeconomic

conditions, in particular subsequent to the soaring

domestic interest rate, heightened credit risk. This was

reflected by rising trends in both gross and net NPLs from

7.9% and 3.7% (June 2005) to 8.3% and 4.8% (December

2005) respectively. This was attributable to a lack of

prudential banking along with deteriorating business

conditions.

The quality of credits, especially investment, recorded

a falling trend. Gross NPLs in investment credit rose from

13.1% in June to 15.2% in December 2005; constituting

the most dominant NPLs. Gross NPLs in working capital

credit rose from 7.1% to 7.8%, however, NPLs in

30


consumption credit dropped from 2.5% to 2.2%. Fuel

price increases in October 2005 exacerbated inflation and

the domestic interest rate, which lead to a higher NPL rate

during the third quarter of 2005. Rapid acceleration in

investment credit NPLs indicated major problems in

investment activities and retarded investment credit

restructuring. Yet, the real sector managed to maintain

positive growth and NPL acceleration was controlled;

indicated by the trend reversal at year end.

The quality of property credit also declined, with NPLs

increasing from 4.3% to 5.0%. The largest segment of

property credit is mortgages, which also recorded the

Graph 4.11NPL of Property (in value)

-

500

1,000

1,500

2,000

2,500

3,000

2002 2003 2004 2005 Dec

Billion IDR

Construction MortgageReal Estate

Graph 4.8NPL and Loans

%

-

2

4

6

8

10

12

MarSep Dec Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec0

100

200

300

400

500

600

700

800

Trillion IDR

2002 2003 2004 2005

Gross NPLs (LHS) Net NPLs (LHS)Loans (RHS)

Graph 4.10NPL of Consumption Loans

0,0

0,5

1,0

1,5

2,0

2,5

3,0

2000 2001 2002 2003 2004 2005 Des

IDR Trillion

Sub-Standard DoubtfulLoss

Graph 4.12NPL of Property (in percentage)

-

5

10

15

20

25

30

35

2002 2003 2004 2005 Dec

%

Mortgage

Real EstateConstruction

Graph 4.9NPL per Type of Loans

0

5

10

15

20

25

30Working Capital LoansInvestment LoansConsumption Loans

Trillion IDR

Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov

2004 2005

31


highest quality among the other types of property credit.

The ratio of NPLs in mortgages was 2.5% while the NPL

ratios for construction and real estate recorded 10.3% and

7.7% respectively. However, the rate of distressed loans

for property credit as a whole remained tolerable and posed

no significant threat to financial system stability. Similarly,

the quality of credit for micro, small and medium-sized

enterprises (MSME) decreased, albeit less significantly than

corporate credit.

NPL within the indicative limit for a healthy distressed loans

ratio. High provisioning since 1999 has helped the banking

industry maintain stability despite increasing NPLs.

The near-term outlook for the first semester of 2006

is a continuation of prevailing conditions. The second

round effects of the oil price hikes and the planned

electricity tariff adjustments are expected to put more

upward pressure on inflation and the interest rate.

Consequently, the repayment capacity of corporate and

household debtors will weaken and be inclined to push

NPLs following a climbing trend. Notwithstanding, lending

will maintain potential growth, albeit flatter. However,

consumption credit will remain buoyant as this is perceived

to have the lowest risks. Contributing growth factors

include the January Package of the central bank, as well

as corporate and household optimism.

Graph 4.13NPL of MSME

0

1

2

3

4

5

6

7

8

9

%

2004 2005

Jan Feb Mar Apr Jun Jul Aug Sep Oct Nov DecMay Jan Feb Mar Apr Jun Jul Aug Sep Oct Nov DecMay

Investment Loans Working Capital Loans

Graph 4.14Loans, NPL and Provision for Loan Losses

0

10

20

30

40

50

60

70

80

90

100

0

100

200

300

400

500

600

700

800

1999 2000 2001 2002 2003 2004 Dec-05

NPL (LHS) Provision (LHS) Loans (RHS)

Trillion IDR Trillion IDR

Bad-debt Provision

Banks have sufficient capacity to withstand shocks

as they have accumulated ample provisioning. Despite

increasing gross NPLs, the credit risk buffer in the form of

bad-debt provisioning was abundant, visible from a net

32


Market Risk

Rising interest rates coupled with rupiah

depreciation exposed banks to higher market risks.

However, they maintained sufficient capital to absorb

unexpected losses emerging from market risks.

Additionally, banks maintained net open position at 2-

4% of capital in foreign currencies, far below regulatory

limits of 20% for overall and on-balance sheet position.

The stress test results proved that banks have sufficient

capacity to absorb market risk exposure. In addition,

the near-term outlook for market risk tends to be

moderate considering the stability of the exchange rate

and interest rate, manageable net open position,

adequate capital as well as the optimistic

macroeconomic condition. However, banks must remain

vigilant of market risks as the stability of the rupiah is

primarily determined by short-term capital flows, which

may suddenly reverse.

The results of the stress test show that there are

significant effects from fuel price hikes on bad debt

provision increases, which indicate increases in credit

risk exposure.

Premium fuel price hikes raise labor costs and, in

turn, reduce earnings before tax. This condition lessens

the repayment capacity of debtors, and consequently

banks are obliged to lift their bad debt provision to

absorb credit risk.

The pass-through effects of premium fuel price

hikes on bad debt provision adjustments are primarily

through the cost of labor as manufacturing companies

are still labor intensive. The labor intensive nature is

also reflected by no significant impacts from diesel fuel

price increases on bad debt provision.

The dominance of consumption and working

capital credits in the credit portfolio is a contributing

factor to the sensitivity of banks to premium fuel price

increases. These two types of credit are predominantly

utilized for household consumption and labor costs.

Applying a multivariate model, it is proven that

the most significant impact on bad debt provision is a

change in GDP (-1.5), followed by the inflation rate

(1.3), exchange rate (0.79), changes in JSX (0.16) and

finally the premium fuel price (0.11).

The sensitivity test indicated that premium fuel

price hikes of 87% would result in an expected bad

debt provision adjustment by as much as 9.82%. This

adjustment substantiates relatively high sensitivity to

premium fuel price increases. Therefore, this condition

requires prudent policy consideration regarding fuel

price hikes.

Box IV.1 Stress Test of Fuel Price Increase

Table Box IV.1.1Stress Test of Fuel Price Increase to Credit Risk

GGDP -1,5794 0,8668 -1,3691

GPREMIUMDN 0,1129 1,6597 0,1874

GIHSG 0,1571 2,6636 0,4184

INF 1,3316 0,5821 0,7751

GEXRATE 0,7914 0,1210 0,5706

GPREMIUMDN 0,1129 87 9,8219

VariableHistorical Value

(2004-2005)Coefficient

Expectation ofChanges in Provision

for Loan Losses

VariableHistorical Value

(2004-2005)Coefficient

Expectation ofChanges in Provision

for Loan Losses

33


Box IV.2 Stress Test of Market Risks

Stress tests of market risk are regularly conducted

to measure the resilience of banks vis-à-vis increasing

interest rate and exchange rate as well as price risks.

The stress tests are indispensable considering the

unfavorable macroeconomic conditions prevalent

during the second semester of 2005 attributable to

increases in the interest rate and the depreciation of

the rupiah.

Stress tests apply the following assumptions and

scenarios:

Exchange Rate Risk

Stress tests applying extreme rupiah depreciation

scenarios showed that banks will be able to maintain

CAR above 8%. Supporting factors include a low net

open position (NOP), which is far below the 20%

threshold. In addition, banks actively mitigate exchange

rate risk through hedging.

Price Risk

A significant impact of the recent soaring interest

rate has been a decline in the price of government

bonds (SUN), affecting banks» fixed-income trading

portfolio. Stress test results showed that, in general,

large banks maintain high resilience to price risks in

relation to falling government bond prices. The CAR

of large banks remains above 8% despite a decline in

government bonds up to 2000 bps because banks

maintain sufficient capital and the majority of them have

a greater share of investment than trading portfolio.

Scenario of Bond Price Decline

CAR (%)

100 200 500 1000 1500 2000bps bps bps bps bps bps

23.52%23.48%

23.33%

23.10%

22.86%

22.62%

22.00

22.20

22.40

22.60

22.80

23.00

23.20

23.40

23.60

Graph Box IV.2.1Stress Test of Price Risk

Table Box IV.2.1Stress Test Scenario

Interest Rate Increase (BI Certificate of 1Month) 100 - 300 bps

Decline in Bond Price 100 - 2000 bps

Rate USD/IDR 9500

Depreciation of IDR/against USD (poin) 500 - 5000

1 year Volatility 80%

Scenario and Assumptions

Graph Box IV.2.2Stress Test of FX Risk

Depreciation of IDR Againts USD

CAR (%)

16.00

16.20

16.40

16.60

16.80

17.00

17.20

17.40

500 1000 2000 2500 3000 4000 5000

17.28%

17.17%

16.97%16.87%

16.78%

16.60%

16.44%

34


Liquidity Risk

Changes in statutory reserves and the deposit

insurance scheme were introduced in the second semester

of 2005. The changes may place upward pressures on the

liquidity condition of banks unless they exercise rigorous

liquidity risk management. The minimum statutory reserves

were lifted and have been linked to the loan deposit ratio.

Furthermore, the coverage of the deposit insurance scheme

(blanket guarantee) has been reduced in light of its phasing

out plan. Since September 22, the government has

disposed inter-bank liabilities from the blanket guarantee

scheme; and, therefore, only deposits were insured. The

Graph 4.15Ratio of Liquid Assets to NCD

- Liquid Assets consist of Cash, Demand Deposit at BI, CBI, and BI o/n Facility- Non Core Deposits (NCD) consist of 30% Demand Deposits and Savings, and 10% Time Deposits maturing up to 3 months.

0

50

100

150

200

250

70

85

100

115

130

2002 2005

Trillion IDR

Liquid Assets (LHS) Liquid Assets/NCD (RHS)NCD (LHS)

Dec Jan Apr Jul Oct Dec

%

Graph 4.16Trend of Inter-Bank Money Market Rates

0

2

4

6

8

10

12

14

August September October November December

MorningSession 10.33 8.61 9.03 9.18 11.33 7.08 4.25 3.88 5.53 6.67 12.60 6.73 7.36 7.65 8.37 9.90 9.51 9.03 9.18

EveningSession 9.64 5.81 8.47 9.03 10.25 5.50 3.53 3.68 4.55 6.36 8.43 6.82 7.36 7.69 8.03 9.65 8.67 8.47 9.03

FX-onshore 3.13 3.18 3.70 4.13 2.45 3.25 3.33 3.46 3.40 3.17 3.43 3.45 3.63 2.96 3.70 3.60 3.69 3.7 4.13

FX-offshore 3.23 3.38 4.04 3.93 2.56 3.42 3.60 3.63 3.53 3.26 3.57 3.39 3.87 3.38 3.84 3.89 4.08 4.04 3.93

%

I II III IV I II III IV I II III IV III IV V I II III IV

Graph Box IV.2.3Stress Test of Interest Rate Risk

Pre Stress Test

CAR (%)

0.00

10.00

20.00

30.00

27.00% 26.89%

Post Stress Test

Interest Rate Risk

Based on the results of stress test, banks have

sufficient capacity to withstand interest rate risk

exposure. No significant decline in CAR was reported

under the sensitivity test of BI Rate increases by as much

as 300 bps. As interest rate spread was relatively wide,

banks could absorb increases in the cost of funds and

operational costs, reflected by a positive net interest

margin (NIM) despite the rising interest rate.

changes were perceived to put upward liquidity pressures

on banks.

Nevertheless, liquidity in the banking sector

remained in good shape despite the increase in statutory

reserve and the phasing out of the blanket guarantee.

Liquid instruments held by banks were ample;

demonstrated by the ratio of liquid assets to non-core

deposits at 105.7% as of December 2005. Conditions

in the inter-bank money market also remained stable

despite the changes. State-owned and private banks have

35


Graph 4.17Trend of FX and IDR Deposits

IDR (LHS)FX (RHS)

Trillion IDR

500

600

700

800

900

1,000

100

150

200

250

2002 2004

Feb Apr Jun Aug Oct Dec

2005 2006

Trillion IDR

Graph 4.18Allotment of Deposits (in IDR)

0.31%7.44%

8.31%

5.18%

4.29%

8.61%

15.90%

25.02%

25.00%

<= 7.5 Million

> 7.5 Million <= 10 Million

> 10 Million <= 25 Million



>100 Million <= 500 Million

>500 Million <= 1 Billion

>1 Billion <= 5 Billion

>5 Billion

traditionally been net lenders, while foreign and joint-

venture banks net borrowers. In general, no potential

systemic liquidity risks emerged, although one day in

August and in mid October 2005 the overnight interest

rates surpassed 40% and 50% respectively. These trivial

incidents occurred due to the transition of national

clearing system implementation and considerable

remittance of taxpayers» funds from banks to the state

treasury accounts. However, Bank Indonesia successfully

stabilized the market by expanding liquidity through Fine

Tune Expansion (FTE) with an interest rate of 200 basis

points over the BI Rate.

Total customer deposits held by banks increased

by 11.57%, reflecting steady public confidence in the

banking industry despite the phasing out of blanket

guarantees. Rising interest rates and the shift from

mutual funds were two driving forces behind significant

growth in customer deposits. Time deposits grew

dramatically reaching 49.4% of total deposits, while

demand deposits and savings represented 28.5% and

26.3% respectively.

(i) High dependency on short-term funding (savings,

demand deposits and time deposits maturing in less

than 3 months). These short-term funds account for

95.1% of total customer deposits held by banks;

(ii) Less diversified structure with a concentration of large

value deposits (over Rp100 million), accounting for

73.07% of total customer deposits. However, the

number of depositors in this segment is small. These

customers are typically sensitive to changes in the

offered rates yet posses bargaining power over banks.

Consequently, flight-to-quality risk may emerge.

The near-term outlook for liquidity risks remains

positive as banks are the primary investment channel for

Graph 4.19Structure of Deposits

> 100 million IDR(73.07%)

up to 3 months(95.10%)

Private(58.28%)

< 100 million IDR(26.93%)

> 3 months(4.90%)

Others(41.72%)Ownership

Tenor

NominalAmount

Time deposits have traditionally been a stable source

of funds, assisting banks to forecast, manage and mitigate

liquidity risks. Notwithstanding, the following weaknesses

in the funding structure of banks remain:

36


those holding surplus liquid financial assets given its

widespread distribution networks and service varieties.

Bank Indonesia will remain vigilant to liquidity risk

considering the gradual phasing out of the blanket

guarantee scheme. The limited deposit insurance scheme

that will commence in March 2007 is predicted to alter

the liquidity structure among banks.

banks to narrow their spread. Declining repayment

capacity due to adverse macroeconomic conditions

reduced the quality of banks» credit. This forced a

reduction in the operating income of banks, however, it

remained positive. Amid higher cost of funds banks

consistently maintained efficiency as shown by a stable

cost efficiency ratio.

Graph 4.21Deposit Structure as per Ownership

31.42%

5.71%1.32%

1.02%

State-Owned Companies

Insurance CompaniesPension FundIndividualsPrivate Companies

60.53%

Graph 4.20Deposits Structure as per Maturity Profile

Demand Deposits

Savings

Time Deposits up to 3 months

Time Deposits up to 3-6 months

Time Deposits up to 6-12 months

Time Deposits >12 months

2.0%2.2%

0.7%

25.1%

25.5%

44.5%

Graph 4.22Net Interest Income and Interest Rate

2.5

3.5

4.5

5.5

6.5

7.5

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

2004 20052001 2002 2003

DecDec Dec Dec Dec

% %

NII (T Rp) LHSDep 1 Month (RHS)SBI (RHS)

Profitability

Banking profitabil ity remained positive yet

decelerated, as indicated by a decline in the return on

assets (ROA). Narrower spread, triggered by rising interest

rates, and declining credit quality were among the factors

that contributed to declining bank profitability. Fuel price

hikes followed by rising domestic interest rates forced

The near-term outlook for the profitability of banks

is projected to decelerate, albeit remain positive. This is

a consequence of the second-round effects of adverse

economic conditions and the anticipatory measures taken

in the form of electricity tariff and fuel price hikes that

will reduce the repayment capacity of debtors.

Capital

Despite pressure from asset risks, banking capital

remained adequate. The ample bad-debt provision during

previous periods supported banking capital stability and

maintained positive profitability despite growing NPLs.

This shows that banks generally have the capability to

cope with higher unexpected losses emanating from

increasing risk exposure, particularly credit risk; the most

significant risk for the banking industry. Sufficient capital

in the banking industry contributed to the soundness and

resilience of banking system stability. Banks» capital is

37


Graph 4.23CAR of Commercial Banks

-

5.00

10.00

15.00

20.00

25.00

2004

Des Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2005

%establishing The Banking Mediation Institution;

expected to mediate disputes between banks and

their customers.

SHARIA BANKING

Sharia banks continued to perform their intermediarySharia banks continued to perform their intermediarySharia banks continued to perform their intermediarySharia banks continued to perform their intermediarySharia banks continued to perform their intermediary

function positively, and non-performing financingfunction positively, and non-performing financingfunction positively, and non-performing financingfunction positively, and non-performing financingfunction positively, and non-performing financing

remained tolerable.remained tolerable.remained tolerable.remained tolerable.remained tolerable.

The performance of sharia banks improved; shown

by growing assets and intermediary function. Assets were

dominated by micro, small and medium enterprises

(MSME) and the financing to deposit ratio achieved 97.8%.

Nonetheless, financing growth decelerated compared to

the previous year attributable to adverse macroeconomic

conditions. This will increase potential losses in financing

and displacement risk due to rising interest rates.

Intermediary Function and Financing Risks

After experiencing a boom during 2004, sharia banks

witnessed decelerating growth in 2005. Assets grew

significantly by 36.2%, which boosted sharia banks» total

asset share in Indonesia. The intermediary function also

improved considerably, as reflected by growth in financing

by 32.6% along with a financing to deposit ratio of 97.8%.

The vast majority of financing was in the form of

projected to remain adequate amidst heightening risks,

underpinning their intermediary function.

Measures to Safeguard Banking Stability

To bolster banking stability, Bank Indonesia continues

to follow all strategies laid out in the Indonesian Banking

Architecture (IBA). The progress of IBA continues unabated:

(i) Accelerated banking consolidation, supported by

Bank Indonesia Regulation no. 7/15/PBI/2005, 1st July

2005 pertaining to minimum tier-1 capital of Rp80

billion in 2008 and Rp100 billion in 2010. These

efforts are bolstered by the policy direction of banking

consolidation up to 2010 for all banks and the criteria

for well-managed/well-performing banks as well as

the requirements to become anchor banks. These

measures are supposed to encourage banks to

improve their risk-management, corporate

governance and performance.

(ii) Improving management and operational quality via

risk-management certification for officials. By the end

of 2005, 529 directors and commissioners as well as

1700 bank officials were certified.

(iii) Bank Indonesia fostered improvements in banking

infrastructure by establishing The Credit Bureau and

making it mandatory for banks to report all of their

debtors. Furthermore, Bank Indonesia is currently

Graph 4.24Assets, Deposits and Financing of Sharia Banks and

Sharia Business Unit of Commercial Bank

Billion IDR

25,000

20,000

15,000

10,000

5,000

0

%

140.0

120.0

100.0

80.0

60.0

40.0

20.0

-

Total Assets (LHS)Assets (yoy)Deposits (yoy)Financing (yoy)

I II III IV I II III IV I II III IV I II III IV

2002 2003 2004 2005

38


murabahah, accounting for 62.3%. Factors that

contributed to improving the Sharia Financing Scheme

include the larger appetitive of customers to participate in

the profit sharing scheme; linkage between sharia banks,

rural banks, cooperatives and pawn shops that

concentrates on MSME financing.

However, expansion of the intermediary function was

followed by increases in non-performing financing, which

peaked in the third quarter of 2005. This was attributable

to non-conducive macroeconomic conditions.

Notwithstanding, non-performing financing remained

manageable, as shown by the ratio of non-performing

financing (gross) of 2.8% at year end.

Liquidity Risk

Liquidity risk of sharia banks continued to be moderate.

The liquidity level improved and it appears that in the near

term, no systemic instability will emerge. Pooled funds in

sharia banks grew by 31.4% to Rp15.6 trillion attributable

to the expansion of the office network. Notwithstanding,

this seemed to be sub-optimal as the share of pooled funds

from sharia banks remained low at 1.23% of total deposits

in the banking industry. This was influenced by a shift in

preferences to conventional banks as interest rates rose.

Table 4.3Deposits of Sharia Bank

Wadiah Demand Deposits 1,620,115 2,045,333 154.1% 26.2% 13.7% 13.1%

Mudharabah Savings 3,263,759 4,370,568 102.6% 33.9% 27.5% 28.0%

Mudharabah Time Deposits 6,978,243 9,166,428 100.7% 31.4% 58.8% 58.8%

Total 11,862,117 15,582,329 107.2% 31.4% 100.0% 100.0%

Deposit SchemeOutstanding (IDR Million) Growth (y-o-y) Share

2004 2005 2004 2005 2004 2005

Graph 4.25Non Performing Financing

Billion IDR

800

700

600

500

400

300

200

100

-

%

I II III IV I II III IV I II III IV I II III IV

2002 2003 2004 2005

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

-

NPF Ratio of NPF

Table 4.2Financing of Sharia Bank

Musyarakah 1,270,868 1,898,389 315,3% 49,4% 11,1% 12,5%

Mudharabah 2,062,202 3,123,759 159,6% 51,5% 17,9% 20,5%

Piutang Murabahah 7,640,299 9,487,318 93,1% 24,2% 66,5% 62,3%

Istishna 312,962 281,676 5,7% -10,0% 2,7% 1,8%

Qard 98,928 124,862 na 26,2% 0,9% 0,8%

Ijarah 104,674 315,938 na 201,8% 0,9% 2,1%

Total 11,489,933 15,231,942 250,7% 178,6% 100,0% 100,0%

Financing SchemeOutstanding (IDR Million) Growth (y-o-y) Share

2004 2005 2004 2005 2004 2005

39


Profitability and Capital

Profitability growth of sharia banks slowed even

though, in value, profits were higher compared to the

previous period. The return on assets declined from 1.41%

in 2004 to 1.35% as assets outgrew profit. In addition,

sharia banks maintained ample capital adequacy due to

capital injections by several banks and therefore, the

average ratio of capital adequacy achieved 13.35%.

RURAL BANKS

The assets and intermediary function of rural banks grewThe assets and intermediary function of rural banks grewThe assets and intermediary function of rural banks grewThe assets and intermediary function of rural banks grewThe assets and intermediary function of rural banks grew

significantly, however, credit risks increased.significantly, however, credit risks increased.significantly, however, credit risks increased.significantly, however, credit risks increased.significantly, however, credit risks increased.

Amidst unfavorable macroeconomic conditions, rural

banks performed satisfactorily; demonstrated in total

assets, loans and deposit growth. The intermediary

function expanded, as reflected by significant growth in

the loan to deposit ratio, which was well above the

commercial banks. This was buttressed by the linkage

program between commercial and rural banks in the form

of channeling and alternative financing schemes.

Notwithstanding, loan growth was coupled with emerging

credit risks, which eventually restrained profitability.

Outlook of Banking Stability

In the near term, banking stability is expected to

remain in spite of growing credit risks as forecast inflation

and interest rates are steady. The capital adequacy ratio of

banks will be maintained far above 8%, providing ample

Table 4.4Financial Highlights of Sharia Bank

Assets 15,325,997 16,359,409 17,743,060 18,454,192 20,879,849

Financing 11,489,933 12,959,341 14,270,381 14,753,299 15,231,942

Deposits 11,862,117 12,258,803 13,357,524 13,357,973 15,582,329

Capital (BUS) 731,039 735,058 960,972 1,010,528 951,224

Profits of Current Year 162,366 70,963 100,531 198,601 238,639

Financing to Deposit Ratio 96.9% 105.7% 106.8% 110.4% 97.8%

Non Performing Financing 2.4% 2.8% 3.8% 4.7% 2.8%

Q 4-04 Q 1-05 Q 2-05 Q 3-05 Q 4-05

Million IDR

Table 4.5Key Indicators of Rural Banks

1 Total Assets 9,080 12,635 39.2 13,502 16,707 32.2 17,302 3.56 28.14 18,408 19,425 5.5

2 Loans 6,683 8,985 34.4 9,495 12,149 35.2 12,830 5.61 35.12 13,796 14,598 5.8

3 Deposits 6,126 8,868 44.8 9,309 11,161 25.9 11,583 3.78 24.43 12,233 12,700 3.8

- Savings 2,002 2,617 30.7 2,669 3,301 26.1 3,368 2.03 26.19 3,464 3,644 5.2

- Time Deposits 4,124 6,251 51.6 6,640 7,860 25.7 8,215 4.52 23.72 8,769 9,056 3.3

4 Profits/Loss 338 429 26.9 143 539 25.6 187 (65.31) 30.77 355 526 48.2

Current Year

5 LDR 77.0% 74.5% 77.0% 80.7% 81.4% 83.7% 85.2%

6 NPL 8.7% 8.0% 8.2% 7.6% 7.8% 7.8% 7.9%

7 ROA 3.7% 3.4% 1.1% 3.2% 1.1% 1.9% 2.7%

8 ROE 24.7% 25.0% 7.9% 25.4% 8.1% 16.0% 23.0%

No Key IndicatorsDec02

Dec03

∆ Dec 03- Dec 02

%

Mar04

Dec04

∆ Dec 04- Dec 03

%

Mar05

∆ Mar 05- Dec 04

%

∆ Mar 05- Mar 04

%

Jun05

Sep05

∆ Sep -Jun 05

%

40


buffers for unexpected losses. The risk-management

capacity of banks is expected to improve through the

certification program along with preparations towards

the adoption of Basel II commencing in 2008. In

addition, Bank Indonesia will foster stability through the

introduction of banking packages to boost the

intermediary function. Consequently, credit growth is

predicted to continue positively, yet slower. To this end,

banks are projected to prefer to allocate consumer

credits rather than corporate in order to diversify credit

risks.

MULTI-FINANCE COMPANIES

The growth of multi-finance companies deceleratedThe growth of multi-finance companies deceleratedThe growth of multi-finance companies deceleratedThe growth of multi-finance companies deceleratedThe growth of multi-finance companies decelerated

amidst rising interest rates.amidst rising interest rates.amidst rising interest rates.amidst rising interest rates.amidst rising interest rates.

Multi-finance companies continued to grow, albeit

slower. Financing from multi-finance companies grew

by 36.7% in 2005; lower than the previous year (67%).

Rising interest rates retarded the financing growth of

multi-finance companies forcing a review of financing

expansion. This condition also contributed to the higher

cost of funds of these companies, in particular originating

from banks. However, the trend of fund sources

indicated growing liabilities despite soaring interest rates.

Liabilities grew by 42.66% (y-o-y) compared to 71.74%

Graph 4.27Source of Funds of Multi-Finance Companies

-40

-20

0

20

40

60

80

100

120

2001 2002 2003 2004 2005

BankOffshore Loans

1 3 5 7 91 3 5 7 9 111 3 5 7 9 111 3 5 7 9 111 3 5 7 9 11

%

Graph 4.26Key Balance Sheet Items of Multi-Finance Companies

Assets

Billion IDR

Financing Liabilities Capital

10000

9000

8000

7000

6000

5000

4000

3000

2000

1000

0

2004Jun-05Sep-05

(y-o-y) previously. Furthermore, multi-finance companies

actively issued bonds in the domestic market to improve

liquidity, conversely, foreign loans receded. Bond

issuance by multi-finance companies reached Rp 3.5

trillion in the domestic market in 2005, in by those,

which have inherent underlying consumer activity, in

terms of automotive financing.

Financing Performance

Generally, multi-finance companies in Indonesia are

licensed to offer leasing, factoring, credit cards and

consumer finance. Since 2000, many multi-finance

companies have shifted their focus to consumer

financing because of huge demand. In addition, the

market for consumer financing grew 12% annually and

will continue to grow in concordance with expected

increases in income per capita as well as the size of the

labor force.

Consumer financing represented the largest

portfolio of multi-finance companies. Up to September

2005, the portfolio of consumer finance achieved 65.3%

of total financing, much higher than leasing, credit cards

and factoring which accounted for 29.3%, 3% and 2%

respectively. Consumer financing is more sensitive to

interest rate increases with higher credit risks compared

41


increased by 13%, yet insufficient to absorb financing

risk.

Business Risks

Collaboration between banks and multi-finance

companies supported the growth of consumption credit.....

Bank funding represented the major source of funds of

multi-finance companies. Furthermore, the channeling of

consumption credit increased its market share in the

financial system. Compared to banks, consumption credit

risk is higher as a result of the imprudent policies exercised

by multi-finance companies.

Graph 4.28Financing Structure of Multi-Finance Companies

70

60

50

40

30

20

10

0

%

Leasing Factoring Credit Card ConsumerFinancing

2004Sem 1-05Sem 2-05

Graph 4.29Capital of Multi-Finance Companies

Billion IDR

0

1

2

3

4

5

6

7

8

2002 2003 2004 2005

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

1 2 3 4 5 6 7 8 9101112 1 2 3 4 5 6 7 8 9101112 1 2 3 4 5 6 7 8 9101112 1 2 3 4 5 6 7 8 9

Offshore Debt/Equity (LHS)

Leverage (LHS)

Equity (RHS)

to other types of financing. Dissimilar to leasing and

factoring, consumer financing is less secure with very

limited security deposits and low resale value as well as

imprudent credit assessment.

Consumer financing growth was relatively high at

41.7% or Rp44.2 trillion (September 2005). Leasing

recorded high growth at 39.1% with credit card growth

at 56.4% while factoring contracted by 49.3%. Leasing

growth was fairly high owing to a high number of

automobiles purchased through the leasing scheme.

Credit cards issued by multi-finance companies were

buoyant as an increasing number of consumers prefer

cashless transactions. Stagnant growth in factoring was

attributable to the high credit risks associated with

financing through this scheme.

Capital

The capital in multi-finance companies was

adequate. The capital to asset ratio (CAR) was 12.2%,

adequate to withstand solvency risk. In addition, the

capital to earning asset ratio √calculated as the ratio of

capital against financing√ reached 17.13%, sufficient to

buffer credit risk. The institutions» leverage remained in

compliance to regulations with a debt ratio over capital

at 200%. In 2005, the capital of multi-finance companies

There is potential instability in the multi-finance

industry considering the following factors:

1. Increases in interest rates created more credit risk

faced by multi-finance companies. On the consumer

side, the increases in interest rates reduced their

repayment capacity.

2. Distress in one or more multi-finance companies may

spill over to banks as 44.5% of their sources of funds

belong to banks. Deterioration in the quality of multi-

finance companies may expose banks to greater credit

risk and spur systemic problems.

3. Tighter competition encouraged multi-finance

companies to be less prudent, particularly regarding

42


consumer financing. This was most prevalent for

motorcycle financing with neither security deposit nor

proper credit assessment.

4. There is a lack of prudential regulations and the

supervision of multi-finance companies is sub-optimal.

CAPITAL MARKET

Capital market stability remained manageable amidst priceCapital market stability remained manageable amidst priceCapital market stability remained manageable amidst priceCapital market stability remained manageable amidst priceCapital market stability remained manageable amidst price

pressure and increasing credit risk.pressure and increasing credit risk.pressure and increasing credit risk.pressure and increasing credit risk.pressure and increasing credit risk.

Stock Market

The stock market was dynamic and volatile with betterThe stock market was dynamic and volatile with betterThe stock market was dynamic and volatile with betterThe stock market was dynamic and volatile with betterThe stock market was dynamic and volatile with better

expectations at year end.expectations at year end.expectations at year end.expectations at year end.expectations at year end.

Transactions on the stock market were active with

a volatile index movement. The index achieved its highest

level in the history of the Indonesian stock market at

1192.30 (3rd August 2005) but then dramatically plunged

to the lowest level of the year at 994.77 (29th August

2005). Unfavorable macroeconomic conditions, in terms

of the depreciating exchange rate and rising interest rate,

affected index movements at the stock market. In

addition, high inflation following soaring global oil prices

and subsequent domestic fuel price hikes contributed

further bearish index movement. However, social and

political stability restored investor confidence and

optimistic expectations. At year end, the Jakarta

Composite Index followed a bullish trend growing by

16.24%, slightly below the previous year.

Stock Market Performance

Transactions on the stock market were fairly active

and the index surpassed the 1,000 level. Stock market

conditions improved due to a number of factors including

positive sentiment regarding macroeconomic indicators

in 2004; the removal of Indonesia from the NCCT blacklist

of FATF; and improvements in the sovereign credit rating

of Indonesia. However, index movement was also

hampered by externalities, primarily soaring oil prices,

high interest rates and rupiah depreciation.

Despite negative sentiment, stock market growth

remained positive. The JCI fluctuated, especially in August

from its highest ever level of 1192.30 (3rd August 2005) to

its lowest level that year of 994.77 (29th August 2005),

primarily attributable to expected soaring global oil prices

and the rising Fed Fund Rate. Abrupt fluctuations were

evidenced by high volatility, especially in August, at around

3.10%. However, volatility was subdued and hence, the

index gradually recovered; but adverse macroeconomic

indicators forced a sluggish recovery. At year end, the index

experienced a bullish rally and closed at 1162.64

attributable to a stable political and social environment.

Graph 4.30JCI and Transaction Volume

Source : Bloomberg

850

900

950

1,000

1,050

1,100

1,150

1,200

1,250

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

2005

29Dec

27Dec

16Nov

19Oct

28Sep

7Sep

15Aug

25Jul

4Jul

13Jun

20May

28Apr

6Apr

15Mar

21Feb

27Jan

5Jan

JCI Million

JCIVolume

Graph 4.31Volatility of Jakarta Composite Index

Source : Bloomberg

0

5

10

15

20

25

30

35

40

0

200

400

600

800

1000

1200

1400Expon. CI (RHS)JCI (RHS)VJSX (LHS)

(y = 509.23e-0.0013x))

1997 1998 1999 2000 2001 2002 2003 2004 2005

43


Optimistic expectations continued despite anxiety

surrounding the effects of sky-rocketing fuel prices, whose

immediate and second-round effects adversely influenced

the performance of issuers.

The stock trading of blue chips continued to serve

as the main drive of the stock market, followed by the

active trading of second liner stocks. In 2005, there were

two major corporate actions: The acquisition and tender

offer of HM Sampoerna (HMSP) and the block sell of PT

Bank Buana stocks, which boosted the JSX. The major

players in these transactions were foreign investors.

Compared to the first half of 2005, the stock trading

value slid by -33.68% and volume fell by -26.63%. The

average transaction value on the JSX was higher than in

2004; increasing by 62.9%. Cumulative net foreign

transactions in 2005 indicated net selling, primarily affected

by the HMSP transaction, of which the majority was owned

by foreign investors.

Stock market capitalization recorded an increase of

17.84% in accordance with stock issuance through Initial

Public Offering (IPO) and rights issues during this period.

Total transactions in 2005 reached Rp407.46 trillion, an

increase of 64.25% over 2004. Despite the increases in

stock capitalization and transactions the number of issuers

declined by 33.33% to only 8 issuers, which is far below

the JSX target of 15. This indicated that the stock market

Graph 4.32Prominent Events and JCI

600

700

800

900

1000

1100

1200

1300 USD/IDR 10,775

2004 2005

Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec

Source: Bloomberg

Tsunami

Australian EmbassyBombing

9 Sep 04Presidential Election

20 Sep 04

5 Apr 04

GeneralElection

5 July 04

GeneralElection Highest JCI

1192.20

Tender Offerof Sampoerna

SampoernaAcquisition by

P. MorrisBali Bombing II

1 Oct 05

Graph 4.33Trading Value and Volume at the JSX

Trading Value and Volume JCI

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

700

800

900

1,000

1,100

1,200

1,300

2004 2005

Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec

Source : CEIC and Bloomberg

Trading Value (Billion IDR)

Volume (Million Stocks)JCI

Graph 4.34Foreign Investor Transaction

Billion IDR

-

(15,000)

(10,000)

(5,000)

5,000

10,000

(20,000)

Foreign TransactionJCI

-

200

400

600

800

1,000

1,200

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2004 2005

Source : Bloomberg

JCI

Graph 4.35Market Capitalization

Capitalization

300

500

700

900

1,100

1,300

JCI

Capitalization (Billion IDR)

JCI

300,000

400,000

500,000

600,000

700,000

800,000

900,000

Jan Feb Mar AprMayJun Jul AugSepOct Nov Dec Jan FebMarAprMayJun Jul Aug SepOct NovDec

2004 2005

Source : CEIC and Bloomberg

44


remained sub-optimal in providing alternative financing

to bank financing. A number of corporations among the

eight using IPO conducted stock issuance during the

second half of 2005, namely PT Reliance Securities Tbk,

PT Mandala Multifinance, PT Excelcomindo Pratama Tbk,

PT Multi Indocitra and PT Asuransi Multi Artha Graha. PT

Excelcomindo Pratama (EXCL) is an example of a successful

issuer. EXCL shares climbed to Rp4,625 from the initial

offer of just Rp2,000, a rise of 131.25%, in just one week.

As a result, EXCL shares were excluded from the Jakarta

Composite Index calculation to avoid distortions as the

EXCL share situation did not reflect the fundamental

performance of the stock market. Furthermore, contrary

to JSX efforts to encourage more corporations to go public,

a few have tended to go private, namely PT Komatsu

Indonesia Tbk, PT Aqua Golden Mississippi Tbk and PT

Dankos Laboratories Tbk.

Sectoral Index Performance

The sectoral index moved variably in 2005 and

banking stocks were no longer dominant. Negative

sentiment stemming from the depreciated rupiah, rising

interest rates and a fundamental decline in issuer

performance spurred investors to shift their portfolio from

banking. Investors became more prudent in their financial

sector portfolios as they are sensitive to fluctuations in the

interest and exchange rates. Investors perceived that the

rising interest rate could trigger greater credit risk and

default.

Graph 4.37JCI and Financial Sector Index

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec105

115

125

135

145

155

165

175

700

800

900

1000

1100

1200

1300

JCI (LHS)

Financial Sector Index (RHS)

Source : Bloomberg

JCI FSI

Stocks of the mining sector experienced a bullish

trend as a result of rising commodity prices, primarily the

soaring global oil price. Mining sector stocks were actively

traded and perfectly correlated to movements in

international commodity prices. Unlike mining sector

stocks, soaring fuel prices raise production costs, which

affect the performance of issuers.

The telecommunications sector became the prime

mover of the stock market due to its solid prospects.

However, stocks of the telecommunications sector were

sensitive to movements in the exchange rate as the majority

of the equipment is imported. Rupiah depreciation raised

production costs and, therefore, triggered a decline in

corporate profit margins. In addition, stocks of the

agricultural sector performed promisingly, primarily

bolstered by rising crude palm oil prices, which raised the

agricultural stock index by as much as 61.97%.

In the near term, the potential remains for further

increases in the price of oil and the global interest rate has

raised concerns in the stock market due to the lackluster

performance of issuers and negative market sentiment.

Graph 4.36Number of Transactions at the JSX

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan FebMar Apr May Jun Jul Aug SepOct Nov Dec

2004 2005

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

Billion IDR

-

200

400

600

800

1,000

1,200Number of Transactions

JCI

Source : Bloomberg

JCI

45


Optimistic expectations regarding stock performance rest

mostly on the blue-chip and the mining sectors, especially

oil and gas. Foreign investors are expected to remain the

major players in the stock markets. Their transactions,

determined by domestic GDP growth, the global oil price

and the Fed Fund Rate, are projected to continue driving

volatility.

Mutual Funds

Redemptions of mutual funds continued and their netRedemptions of mutual funds continued and their netRedemptions of mutual funds continued and their netRedemptions of mutual funds continued and their netRedemptions of mutual funds continued and their net

assets value drastically droppedassets value drastically droppedassets value drastically droppedassets value drastically droppedassets value drastically dropped

The mutual funds industry continued its downbeat

trend as redemptions persisted. Fixed-income mutual funds

suffered their greatest decline as bond prices fell. The soaring

interest rate incited overly negative expectations and

panicked investors. In addition, protected mutual funds were

launched, however, they remained sluggish as investor

confidence failed to rebound. In the near-term, considering

waning investor confidence, the performance of the mutual-

funds market is projected to remain listless in 2006.

Mutual Fund Performance

The mutual funds industry continued its downbeat

trend as redemptions persisted. No rebound on the

performance of mutual funds occurred, as investors had

previously predicted; redemptions increasingly materialized

in the third quarter of 2005. Fixed-income mutual funds,

triggered by a downfall in bond prices as their underlying

assets, suffered the biggest net asset value decline. The

soaring interest rates incited overly negative expectations

on the further collapse of fixed-income mutual funds. The

vast majority of investors were inexperienced and hence,

contributed to the downfall of fixed-income net asset value.

Furthermore, the persistent slide in net asset value eroded

investor confidence in mutual funds. Coincidently, the

Graph 4.38Development of Infrastructure Sector index,

Mining and Agribusiness

850

900

950

1,000

1,050

1,100

1,150

1,200

1,250

200

300

400

500

600

700

Jan Jan Feb Mar Apr Apr May Jun Jul Aug Sep Sep Oct Nov Dec DecJul5 27 21 15 6 28 20 13 5 15 7 28 19 16 7 294

Source : Bloomberg

JCI (RHS)Mining (LHS)

Infrastructure (LHS)Agribusiness (LHS)

Table 4.6Net Asset Value of Mutual Funds (Trillion IDR)

Jan 90,99 2,28 5,55 9,4 108,22Feb 92,26 2,95 6,68 8,89 110,78Mar 78,92 4,54 8,11 10,72 102,29Apr 57,2 4,59 7,91 3,89 83,58May 56,06 5,05 8,07 12,84 82,02Jun 55,15 5,03 8,25 11,74 80,17Jul 50,26 5,35 8,83 11,67 76,11Aug 39,19 5,78 7,93 10,07 62,97Sep 16,46 5,78 6,69 2,63 31,56Oct 14,8 5,39 6,08 2,25 2,77 31,29Nov 13,45 5,33 5,85 1,95 2,99 29,57Dec 12,97 4,93 5,39 2,08 3,01 28,38

Month Fixed Income Equity Mixed Assets Money Market Protected Net Asset Value

Source: Indonesian Stock Exchange Supervision and Regulation Authority

46


pressures on net asset value occurred simultaneously with

the enforcement of mark-to-market rules. Mark-to-market

enhances market discipline and limits asymmetric

information.

In the fourth quarter of 2005 protected mutual funds

were launched, however, they performed sluggishly as

investor confidence failed to rebound. Investors in

protected mutual funds were generally not new players,

but those switching from fixed-income mutual funds.

Protected mutual funds guarantee a minimum return equal

to the initial investment; however, they are not risk free.

In the near-term, considering waning investor

confidence, the performance of the mutual-funds market

is projected to remain listless in 2006. Net asset value is

predicted stable as the trend of the interest rate flattens.

In addition, the performance of mutual funds in the future

will substantially depend on the improvement of mutual

fund infrastructure including regulations and education

to restore investor confidence.

Bond Market

Rising interest rates triggered price pressures and growingRising interest rates triggered price pressures and growingRising interest rates triggered price pressures and growingRising interest rates triggered price pressures and growingRising interest rates triggered price pressures and growing

risk in the bond market.risk in the bond market.risk in the bond market.risk in the bond market.risk in the bond market.

Escalating interest rates, both globally and

domestically, pressured local bond prices. The pressures

intensified as investor expectations for rising interest rates

persisted. Moreover, investors perceived that Bank

Indonesia took appropriate, yet untimely, interest rate

policy adjustments. This had asymmetric impacts on

government as well as corporate bonds, more specifically

in terms of liquidity.

Government Bond Market Performance

During the second half of 2005, the government

bonds (SUN), which serves as the domestic bond market

benchmark, dropped by 10% over the first half of 2005.

The most dramatic declines occurred in August with a 5%

drop and in September with an 8% fall. The substantial

decline in the price of SUN drove all government bonds to

slump to their lowest level in the second semester of 2005.

The relatively low bond prices attracted investors to

repurchase, which corrected and stabilized the prices

through the end of 2005.

Graph 4.40Government Bond Prices

60

80

100

120

140

2005

30Jun

14Jul

28Jul

11Aug

25Aug

8Sep

22Sep

6Oct

20Oct

3Nov

17Nov

1Dec

15Dec

29Dec

Source: Bloomberg

FR0019

FR0020 FR0023

FR0025FR0004

FR0005

FR0017

FR0002

Graph 4.39Redemption and Subscription of Mutual Funds 2005

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Trillion IDR

0

20

40

60

80

100

120

Source : Babepam

Redemption

Subscription

NAV

Tightening monetary policy pushed the yield curve

to rise dramatically by 300bps-500bps, on average. In

addition, the tenor of yield curve extended following the

issuance of SUN serial FR0031 with 15-year maturity. By

year end, market correction flattened the yield curve.

However, the yield for investments with maturity of more

47


than 8 years remained high due to investor perception of

long-term investment associated with high risk and

uncertainty.

The rising yield curve lead Indonesian yield spread to

be the widest among countries in Asia, namely India, the

Philippines and Thailand. This attracted vigorous foreign

investment in short-term domestic bonds.

Notwithstanding, potential market instability may emerge

as the largest portfolio of foreign SUN purchases is short-

term. This may spur massive capital reversal and price

volatility in the event of confidence loss in the domestic

markets.

Corporate Bond Market Performance

Rising interest rates increased the cost of corporate

financing through the issuance of bonds; hence the

appetite of corporations to issue bonds subsided. However,

the soaring interest rate lowered bond prices and as a result

25 corporations bought back their bonds. This situation

may trigger liquidity shortages leading to price volatility

and subsequent market instability. Additionally, higher

interest rates compounded market and default risks.

Signals of higher default risks were amplified by the failure

of some corporations to pay off sinking funds. Against

this backdrop, investors lost their appetite to invest in

corporate bonds.

Graph 4.41Yield Curve

1 yr 2 yr 3 yr 4 yr 5 yr 6 yr 7 yr 8 yr 9 yr 10 yr 15 yr6

8

10

12

14

16

%

Source: Bloomberg

Jun 2005

Dec 2005

Dec 2004

Graph 4.43Value and Volume of Corporate Bonds

Dec Jun Dec

Trillion IDR

10

20

30

50

60

70

40

0 0

2

4

6

8

10

12

14

16

2004 2005

Value

Volume

Source: Surabaya Stock Exchange

Graph 4.42Country Yield Spread 2005

1yr 2yr 3yr 4yr 5yr 6yr 7yr 8yr 9yr 10yr 15yr-2

0

2

4

6

8

10

Source: Bloomberg

Indonesia

Philippine

India

Thailand

Listless corporate bond markets were reflected by

significantly fewer new issuers; falling from 16 to 6 in 2005.

In concordance with these developments, growth of

issuance volume and transaction value also decelerated.

In addition, the volume and value of corporate bond

issuance declined. The majority of new issuers of corporate

bonds originated from the financial sector, especially the

banking industry, as a way to bolster their financing

through subordinate loans. Other new issuers included

multi-finance companies with underlying business in

consumer financing.

48


Graph 4.44Interest Rate Rise and Its Impact on Bond Yield

12.0

12.5

13.0

13.5

14.0

14.5

15.0

15.5

6mth 2yr 4yr 5yr 6yr 7yr 10yr 15yr8yr 9yr

%

Source: Bloomberg

Yield-100bps

Yield-50bps

Yield

Table 4.7Volume and Issuance of Corporate Bonds

1999 76 857,59 23,174.433 852,331 21,766.975 25,504 6,828,483

2000 91 1,014,445 28,787.433 1,009,186 27,379.975 178,679 12,073,483

2001 94 1,067,695 31,662.433 1,050,482 29,614.255 219,975 14,307,763

2002 100 1,181,095 37,812.433 1,154,782 35,237.244 318,275 19,630,751

2003 136 7,877,420 63,835.526 7,693,356 60,921.506 6,829,849 44,925,013

2004 152 13,740,146 83,005.349 12,982,310 78,796.692 12,118,803 62,800,199

2005 158 15,996,146 91,080.349 15,238,310 86,871.692 14,262,516 63,570,941

Year

Source: Surabaya Bond Exchange

Bonds Issuance Issuance Realization Outstanding

Volume Total Issuance(Billion IDR) (Billion IDR)

IssuerVolume Total Issuance

(Billion IDR) (Billion IDR)Volume Total Issuance

(Billion IDR) (Billion IDR)

The prospects of the bond markets are positive,

albeit slower, as the financial performance of the issuers

is predicted to fade slightly. The government bonds

market is forecast to remain active and liquid despite the

flattening yield curve. Conversely, corporate bond

markets are projected to remain sluggish considering

uncertainties surrounding the financial performance of

issuers.

The economic recovery progress coupled with

government efforts is expected to restore investor

confidence and bolster market stability. In addition,

steady yet high interest rates will stabilize the short-

term yield curve.

Against this backdrop, investors could potentially

lose interest to invest in bonds maturing in over 8 years.

Consequently, liquidity distortion that exacerbates price

volatility may emerge from:

(i) limited long-term bonds, of maximum 8-year tenor;

and

(ii) a lack of short-term bonds with 1-year tenor.

49

Chapter V Financial Infrastructure

Chapter 5Financial Infrastructure

50


51


The Indonesian payment system was robust despite theThe Indonesian payment system was robust despite theThe Indonesian payment system was robust despite theThe Indonesian payment system was robust despite theThe Indonesian payment system was robust despite the

greater volume of settlementsgreater volume of settlementsgreater volume of settlementsgreater volume of settlementsgreater volume of settlements

Near-term risk to financial stability stemming from

potential disruptions in the payment system appears to be

small. The payment system operated smoothly and efficiently

despite the greater volume of settlements in the second

semester of 2005. In the future, Bank Indonesia will focus

on efforts to minimize risks in the payment system; and to

improve the quality and capacity of payment system services,

including the provision of better consumer protection.

LARGE VALUE AND RETAIL PAYMENT SYSTEMS

The Bank Indonesia Real-Time Gross Settlement (BI-

RTGS) system settles a range of large value payments on a

delivery-versus-payment basis and accounts for a significant

value of settlements between banks. There have been a

growing number of settlements since early 2005, however,

the BI√RTGS system remains solid and the success rate is

high, providing strong support to financial sector stability,

in particular banking.

The participant structure of BI-RTGS remained

unchanged from the previous year. Based on the sender,

national private commercial banks were the most active

participants due to remittances, inter-bank money market

transactions and their transactions with Bank Indonesia.

Based on the nominal value, Bank Indonesia represented

the largest sender as it had the highest value of monetary

operation transactions. So far, intra-day credit exposure

among RTGS participants can be mitigated to some extent

by system design, liquidity risk-management of banks, and

intensive oversight of the payment system.

Chapter 5Financial Infrastructure

Graph 5.1Settlements of BI-RTGS

-369

1215182124273033363942

Thousands Settlements

-

25

50

75

100

125

150

175

200

225

250

Rp. Trillion

20052004

Volume

Value

1Feb

2Oct

3Oct

16Apr

17May

16Jun

15Jul

8Dec

9Oct

10Dec

11Sep

14Dec

11Jan

11Feb

14Mar

12Apr

12May

10Jun

8Jul

5Aug

6Sep

4Oct

9Nov

Trend of Settlement Value

Trend of Settlement Volume

Graph 5.2Settlements of BI-RTGS as of Financial Institutions

20.7%

4.0%

13.4%

38.6%

2.4%

20.8%

0.0%

ForeignBanks

Joint VentureBanks

State-OwnedBanks

BankIndonesia

RegionalBanks

DomesticPrivate Banks

Non Banks

10.0%

21.0%

13.7%

3.9%

47.6%

0.2%3.6%

0

5

10

15

20

25

30

35

40

45

50

%

ValueVolume

Cash flow structure and profile indicated no major

potential for financial sector instability. During the course

of 2005, foreign and domestic commercial banks, shared

nearly equal portions as beneficiaries in terms of nominal

value, while in terms of frequency, the latter was leading.

This indicates that their transactions are predominantly of

retail value, while foreign banks transactions are of greater

value. Both types of banks have generally strong liquidity

profiles, hence, it appears that the near-term risks of

52


systemic liquidity problems in the large value payment

system will be small. In terms of operational capabilities,

the BI-RTGS system has been proven robust with a perfect

success rate. No major operational disruptions have

occurred since its establishment and, hence, the payment

system is therefore expected to remain safe and contribute

to financial system stability.

The retail payment system also grew steadily and is

robust. As in the large value payment system, nominal

value and frequency in the retail payment system increased

steadily by 2.63% during the second semester 2005. By

clearing region, Jakarta banking networks account for 50%

in nominal value of total national retail clearing. Ever

increasing clearing transactions did not constrain the

payment system and no bank is currently experiencing

liquidity shortfall. In addition, no bank is currently using

normal liquidity support or intra-day facilities provided by

Bank Indonesia; this reflects the enhanced capabilities of

banks to manage their daily liquidity. The smooth

operations in the large and retail payment systems continue

to contribute to the stability of the financial sector.

Table 5.1Settlements at BI-RTGS

Graph 5.3Volume and Value of Clearing Settlements

40

60

80

100

120

140

160

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

Settlement Advice - in ThousandTrillion IDR

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct

2004 2005

VolumeValue (Rp. Million) Monthly Trend of Settlement Volume

Monthly Trend of Settlement Value

Type of Banks

Beneficiary

Foreign Joint Venture State-Owned BankBanks Banks Banks Indonesia

Foreign Banks 10.34 1.59 3.84 0.37 0.02 4.53 20.69Joint Venture Banks 1.57 0.51 0.58 0.11 0.01 1.21 3.99State-Owned Banks 3.56 0.47 2.39 1.77 1.41 3.84 13.44Bank Indonesia 5.66 2.39 10.65 0.03 5.62 14.24 38.60Regional Banks 0.03 0.01 1.06 0.40 0.39 0.54 2.43Private Banks 4.84 1.42 4.40 1.01 0.45 8.71 20.84

TotalTotalTotalTotalTotal 25.9925.9925.9925.9925.99 6.406.406.406.406.40 22.9322.9322.9322.9322.93 3.693.693.693.693.69 7.907.907.907.907.90 33.0833.0833.0833.0833.08 100.00100.00100.00100.00100.00

RegionalBanks

Total

As of Settlement Value

Sender

%%%%%

PrivateBanks

Type of Banks

Beneficiary

Foreign Joint Venture State-Owned BankBanks Banks Banks Indonesia

Foreign Banks 1.73 0.50 2.43 0.10 0.07 5.25 10.08Joint Venture Banks 0.50 0.27 0.83 0.09 0.01 1.94 3.64State-Owned Banks 1.18 0.29 5.12 1.34 1.38 11.78 21.08Bank Indonesia 0.65 0.55 2.90 0.16 1.32 8.12 13.70Regional Banks 0.07 0.01 1.78 0.36 0.29 1.28 3.81Private Banks 3.82 1.24 11.28 1.06 0.57 29.73 47.70

TotalTotalTotalTotalTotal 7.957.957.957.957.95 2.872.872.872.872.87 24.3424.3424.3424.3424.34 3.113.113.113.113.11 3.653.653.653.653.65 58.0958.0958.0958.0958.09 100.00100.00100.00100.00100.00

RegionalBanks

Total

As of Settlement Volume

Sender

%%%%%

PrivateBanks

53


Box V.1 Improvement of the Efficiency and Integrity of the PaymentSystem

National Clearing System

In 2005, Bank Indonesia enhanced payment

system efficiency and capacity by establishing the

National Clearing System. This commenced on 29th July

2005 in Jakarta, West Java and Banten clearing regions,

and will gradually be applied in all clearing regions in

Indonesia. This clearing system accommodates paperless

inter-bank credit note transfers nationwide with greater

efficiency. Debit note transfers are still performed

through the current paper-based system using cheques,

demand deposit cheques and other paper-based debit

notes. The nominal value for credit transfers has a

threshold of less than Rp100 million. While for debit

transfers, there is no nominal value threshold except

for debit notes which are limited to Rp10 million.

Failure-to-Settle Scheme

To minimize the possibility of settlement failure,

Bank Indonesia began implementation of the Failure-

to-Settle (FtS) scheme on 28th November 2005. The

scheme is being implemented to comply with risk-

management principles in the payment system based

on best international practices. FtS includes liquidity

funding and loss-sharing agreements, between

participating banks, which put in place arrangements

to complete settlements in the payment system in the

event of a settlement member failing to pay. Through

the application of FtS, Bank Indonesia, as central

counterparty in the payment system, will no longer be

susceptible to credit or settlement failure risks

originating from participants of the clearing system. In

FtS, participants are required to deposit a pre-fund to

anticipate potential liabilities that may be unsettled at

the end of the day.

Supervision of the Payment System

To maintain the integrity of the payment system

and promote financial system stability, Bank Indonesia

supervises the payment system. The supervision

strategy complies with the Core Principles of

Systemically Important Payment Systems (CP SIPS). By

the end of 2005, Bank Indonesia used system and

operating procedures for payment system oversight

that comply with international standards and CP SIPS.

During 2005, Bank Indonesia examined the internal

control of eight BI-RTGS participating banks, to test

compliance with current regulations and standard

procedures. Non-Bank Indonesia local clearing systems

in Jakarta and all clearing notes printing companies

were also examined. Bank Indonesia will also examine

debit and credit card providers according to the BI

regulation that was enacted on 28th December 2004.

Improvements in the BI-RTGS System

Improvements in the features and performance

of the BI-RTGS system accommodated the latest

developments in the payment system. These

improvements are vital considering the central function

of BI-RTGS. Bank Indonesia updated all operating

systems from Windows NT to Windows 2003 for Head

Office, regional offices, as well as for branch offices of

129 commercial banks. Improvements were also made

in line with the implementation of the National Clearing

System and the Failure-to-Settle scheme.

54


Box V.2 Financial Safety Net (FSN) and the Deposit InsuranceInstitution (DII)

The sustainability of financial stability will also

depend on robust financial infrastructure. In particular,

an effective financial safety net is a vital component

of financial infrastructure. To this extent, the

government and Bank Indonesia drafted a

comprehensive financial safety net framework clearly

stating the roles, responsibilities and coordination

mechanism of relevant authorities. The framework

comprises of four core elements: (i) effective and

independent banking supervision; (ii) lender of last

resort for normal and systemic crisis periods; (iii) an

explicit deposit insurance scheme; and (iv) effective

crisis resolution. FSN needs effective coordination

amongst relevant authorities. To this end, a Joint

Committee comprising of the Governor of Bank

Indonesia, the Finance Minister and the Head of the

Board of Commissioners of the Deposit Insurance

Institution (DII) or LPS was established in 2005.

The FSN team mentioned above is currently

drafting a law concerning the Indonesian financial

safety net. The law will serve as a legal basis for relevant

institutions (Bank Indonesia, Ministry of Finance and

DII) in performing their respective roles and in

coordination to preserve financial system stability. As

the main avenue for coordination, the Financial

Stability Forum (FSF) comprising of Bank Indonesia,

the Ministry of Finance and the Deposit Insurance

Institution was also established (see Box V.3).

Deposit Insurance Institution (DII)

The Blanket Guarantee Program has helped

restore public confidence in the Indonesian banking

system. On the other hand, the guarantee program

put more pressure on the government budget and

has the potential for moral hazard by bank managers

and customers. Against this backdrop, Indonesia

established DII to perform an explicit and limited

deposit insurance scheme. DII was established based

on Law No 24/2004, with two primary functions: to

provide an explicit limited deposit insurance scheme

up to a particular amount; and to carry out the

resolution of failing banks.

Membership of DII is mandatory for all

commercial and rural (BPR) banks in Indonesia.

Insurance coverage includes demand deposits,

certificate of deposits, time deposits and other equally

defined deposits. The implementation of DII will be

in parallel with the roll-out of the government»s

Blanket Guarantee Program as per the following time

frame:

• 22 September 2005 √ 21 March 2006 : all bank

deposits are insured

• 22 March 2006 √ 21 September 2006 : all bank

deposits up to Rp5 billion are insured

• 22 September 2006 √ 21 March 2007 : all bank

deposits up to Rp1 billion are insured

• 22 March 2007 onwards : all bank deposits up to

Rp100 million are insured

The insured amounts are based on per costumer

per bank. In the case of bank failure, DII will insure

customer deposits up to a certain amount. While, non-

insured deposits will be resolved through the bank

liquidation process. DII is expected to preserve public

confidence in the Indonesian banking industry.

55


Box V.3 Financial Stability Forum

The continued stability of the financial system

requires concerted efforts from the various authorities.

Effective coordination and cooperation is urgently

required in response to potential instability and systemic

crises that frequently require mutual policy-making and

harmonization of policy issues. Currently, there are four

authorities with a focal role in financial sector

supervision and the financial safety net: The Ministry

of Finance, Bank Indonesia, the Indonesian Securities

Commission (Bapepam) and DII. As a vehicle of

coordination and information sharing among

authorities, on 30th December 2005, a joint decree

between the Minister of Finance, the Governor of Bank

Indonesia and the Chairman of DII was signed. The

joint decree sets out the establishment of the Financial

Stability Forum (FSF).

The main responsibility of FSF is to provide

information and recommendations to the joint

committee according to the prevailing laws of the

Deposit Insurance Company. The committee comprises

of the Minister of Finance, Bank Indonesia and the

Deposit Insurance Company.

There are four main functions of FSF: a) support

the responsibilities of the joint committee in the

decision-making process for failing banks that are

deemed systemic; b) coordinate and share information

to synchronize prudential rules and regulations in the

financial sector; c) discuss the issues of financial

institutions that are deemed systemic based on

information from the supervisory authority; and d)

coordinate initiatives in the financial sector, for instance,

Indonesian Banking Architecture (IBA), Indonesian

Financial Sector Architecture (IFSA) and Financial Sector

Assessment Program (FSAP).

FSF consists of a three-tier apparatus: the Steering

Forum is responsible for providing direction to the

Executive Forum with regard to the respective functions

of FSF mentioned above. The Steering Forum consists

of 7 senior officials from the Ministry of Finance, 3

members of the Board of Governors of Bank Indonesia,

The management of DII is based on a two-tier

system with a Board of Commissioners and Executive

Officers. The Board of Commissioners consists of 2

ex-officio staff (one BI senior official and one senior

member of staff from the Ministry of Finance) and 2

non ex-officio staff (external). Bank Indonesia is

supportive of DII and has already assigned some of

its staff members to the institution.

The establishment of DII has forced Bank

Indonesia to conduct bank supervision in a more

effective and transparent manner. At the date of

reporting, a Memorandum of Understanding

between Bank Indonesia and DII on a coordination

and information exchange mechanism was being

written.

56


and 1 senior official from DII. The second tier represents

the Executive Forum consisting of 6 second echelon

officials from the Ministry of Finance, 6 second echelon

officials from Bank Indonesia, and 2 directors from DII.

The third tier represents the Working Group and is

made up from officials of the Ministry of Finance, Bank

Indonesia and DII. FSF can form various taskforces to

manage initiatives and ad hoc projects like IFSA and

FSAP. FSF is expected to accommodate effective

coordination between the authorities and,

subsequently, bolster efforts to preserve financial

system stability.

57

Glossary

Administered Price : Prices determined by government decisions. In Indonesia, these include

prices for fuel, electricity tariffs.

Bilateral Swap Agreement (BSA) : An agreement where Bank Indonesia and its counterparties exchange

one stream of cash flows of foreign exchange against another stream.

The BSA is aimed at providing foreign exchange liquidity buffers for

stand by purpose. This will be used to hedge certain risks, particularly

foreign exchange and interest rate risks.

Bullish : A prolonged period of time when prices are rising in a financial market

faster than their historical average, in contrast to a bearish market which

is a prolonged period of time when prices are falling or tend to be

sluggish.

Capital Adequacy Ratio (CAR) : Ratio of capital to its risk-weighted assets. Basel Committee of Banking

Supervision (BCBS) set minimum CAR of 8% that every bank has to

provide.

Corporate Governance : The relationship between all the stakeholders in a company. This includes

the shareholders, directors, and management of a company, as defined

by the corporate charter, by laws, formal policy, and rule of law.

Emerging Markets : Countries that are in the process of moving from developing to more

industrialized ones.

Failure to Settle : A scheme which clearing a participant is liable to provide pre-fund or

initial deposits to cover its clearing balance when all clearing settlements

are done.

Financing to Deposit Ratio : A ratio of financing granted by to deposits received by banks. This term

is widely used in the Sharia-based principle (Islamic) banking industry.

Ijarah : Lease, rent or wage. Generally, Ijarah concept means selling benefit or

use or service for a fixed price or wage. An Ijarah contract is provided by

an Islamic bank.

Istishna : A term used in Islamic banking. This is a contract whereby a party

undertakes to produce specific goods and services, and made according

to certain agreed-upon specifications at a determined price and for a

fixed date of delivery. The production of goods includes any process of

manufacturing, construction, assembling or packaging.

Glossary

58

Glossary

Mudharabah : A profit sharing arrangement made between two parties i.e. the fund

provider and the entrepreneur (who provides expertise) to enable the

entrepreneur to carry out business projects. The profit-sharing ratio needs

to be pre-determined during the agreement.

Murabahah : A contract stipulating the sale of goods at a price which includes a

profit margin in addition to the cost. Such a contract is valid on condition

that the price, other costs and the profit margin of the seller are stated

at the time of the agreement on the sale.

Musyarakah : A partnership or joint venture for a specific business with a profit motive,

whereby the distribution of profits will be apportioned according to the

agreed ratio. In the event of losses, both parties will share the losses on

the basis of their equity participation.

Repayment Capacity : The capacity of a debtor to pay back its debt.

Rural banks : Regulated banks that provide financial services and credit to underserved

markets or populations in rural and sub-urban area.

Qard : An interest-free loan. The borrower is only required to repay the principal

amount borrowed, but he or she may pay an additional amount at his

absolute discretion, as a token of appreciation.

Wadiah : An agreement between a customer and an Islamic bank to keep his or

her deposits in the bank's custody. With the consent from the customer,

the bank will use the funds in accordance with the sharia (Islamic)

principle.

Article I

1a

Ar t ic le

Article I

2a

Article I

3a

This article discusses the causes of crises in emerging economies from the balance sheet perspectives. The

crises were results of multi-reinforcing factors: first, structural balance sheet weaknesses exposing the crisis-hit

countries to maturity, currency, and capital structure mismatches; second, high growth distortions attributable

to investors» excessively optimistic expectations, intensified by inflexible exchange rate regime and the high

interest differentials between mature and developing economies; third, frail domestic financial sectors a result of

poorly-designed financial liberalisation; fourth, feeble corporate sectors that were generally highly leveraged in

the eve of the crises; and finally, the absence of sound supervisory and regulatory frameworks. Financial systems

of emerging countries have tended to be too feeble to absorb significant amount of capital inflows, resulting in

declining asset quality and financial vulnerability. This condition will be a fertile ground for a crisis to erupt should

market discipline is sub-optimal and corporate governance is poor.

Article I

CRISES IN THE EMERGING MARKETS:A BALANCE SHEET PERSPECTIVE1

Endang Kurnia Saputra2

JEL Classification: E44, E58, E61

Studies focusing on financial crises in emerging

markets are myriad, yet a revisit to a number of cases of

the past financial catastrophe remains pertinent for two

rationales. First, after shocks in Mexico in 1994 followed

by Asian financial meltdowns in 1997, emerging countries

have always been more prone to financial shocks than

any developed economies. Second, most of measures

taken seemed fail to make financial system of these

countries capable to withstand shocks in the subsequent

years, as the exact roots of the problems were not

sufficiently observed.

However, some of these economies were star

performers prior to the crises. So, why did crises happen?

In brief, the cause of emerging-market crises were

results of several reinforcing factors: first, the persistence

of high growth distortions with overly optimistic

expectations by investors, intensified by inflexible exchange

rate regime and the ≈attractive∆ interest differentials

1 This article is an extract of a paper made when the author was a Visiting Fellow at theBank for International Settlements (BIS). The author greatly appreciates review,commentaries and advice from Kostas Tsatsaronis and Ilhyock Shim. Also thank toChristian Dembiermont and Heather Grosse for the access to DBS On-line.

2 Please send feedback to: [email protected]

Article I

4a

between mature and developing economies; second, the

weakening of market discipline in feeble domestic financial

institutions as a result of heavy capital inflows and poorly-

designed financial liberalisation; and the absence of strong

supervisory and regulatory frameworks. These lethal factors

turned sour to sectoral and aggregate balance sheet

problems.

In more detail, the interpretation of the past crises

in emerging markets and their precipitating factors are as

the following:

• The vast majority of crisis-hit emerging economies

had persistent balance sheet weaknesses. In the

balance sheet of financial institutions and

corporations there were structural maturity, currency,

and capital structure mismatches. Additionally, some

crisis-hit countries also confronted solvency problems

due to their inability to raise greater income streams

to accommodate their expenditures;

• Some countries run substantial current account and

fiscal deficits. However, these countries financed

deficits with foreign debts, in which a sizeable portion

was short-term. Both foreign and domestic

investments have had never been able to suffice the

deficits;

• Credible policies were not seen by creditors. Some

emerging countries have persistent inability to reduce

debts and run surpluses, therefore creditors doubt

their policy credibility in the long run;

• Exchange rate pegs, in combination with sustained

interest rate differentials, has tended to reinforce bank

lending and spending booms. They foster incentives

for offshore borrowing by banks, non-banks, and

corporations. Poorly-enforced prudential regulation

and financial sector weaknesses turned the currency

to twin crises as a sizeable portion of pre-crises capital

inflows went through their banking systems. This

made excessive lending in and the absence of strong

supervision made financial sector the epicentre of

crises;

• Adverse external sector was also driving factors.

Interest rate hike in major countries and commodity

price shocks hit emerging countries as investors

became more risk aversive.

• Additionally, although internal factors did play role,

investor and creditors also worsened the situation.

First, they were overly optimistic on the sustainable

income streams and long-run positive returns in the

crisis-hit countries, as they have gone through

liberalisation and completed major changes in the

policy regime. Secondly, dramatic shifts in the

investors» and creditors» expectation on the

fundamentals of economy worsened the situation.

What is the primary driving factor behind the crises?

Looking back: imprudent liberalisation that was

implemented when supervisory and regulatory frameworks

of financial sector had not been prepared to keep abreast

with its rapid pace became the past policy failures. Some

countries, unfortunately, adopted big-bang liberalisation

approach proved fatal to the financial stability.

OVERVIEW OF THE CRISES

Although the episode showed different causes, the

crises in emerging markets exhibited similar origin3 . All

those crises were preceded by massive capital inflows as a

result of favourable exchange rate regime adopted by those

countries ranging from soft-pegged (East Asian countries,

Mexico, and Turkey) to hard-pegged (Argentina). The main

rationales for the adoption such regime are to: (a) combat

inflation (Mexico, Argentina, and Turkey); (b) attract capital

inflows and promote growth (East Asian countries). To

some degrees, this regime created a favourable

environment for investment, especially in East Asian

3 Primarily in Mexico (1994), East Asian countries (1997-1998), Argentina (2001-2002),and Turkey (2000).

Article I

5a

countries as it eliminated the perceived exchange rate risk.

The crisis was therefore hardly anticipated and in fact, none

seemed to believe that these economies would confront

financial meltdowns (Ortiz, 2002).

The crises commenced when these countries

experienced colossal reversal in the capital account after

they enjoyed massive capital inflows. The collapses of

capital account were evident in East Asian and Latin

American countries in the 90»s that were used to receive

the sizeable portion of international private capital.

Countries like Mexico, Brasil, and those in South East

Asia were among the successful ones in taking advantage

of globalization trends. However, their successes made

them increasingly dependent on international capital

inflows that were vulnerable to change of sentiment

among investors. The stable exchange rates were

considered as the main attractive points for investment.

The crisis-hit countries have adopted market-friendly

regimes and these attracted a great number of investors

to fuel economic growth.

However, capital inflows coupled with a number of

internal weaknesses mutually ignited the crisis. At first

stage, financial liberalization provided large space for

capital inflows as these countries promised high return

opportunities. Emerging countries in looked particularly

attractive with their rapid growth and stable exchange

rates as admitted by World Bank (2000). However, these

economies took a sizeable portion of foreign capital

inflows in the form of short-term, unhedged, foreign-

denominated currencies. These capital inflows were

intermediated through banks in most of countries. When

crises erupted, negative sentiment over the economy

fundamentals of other countries in the region created

unnecessary spill-over. These particularly occurred in East

Asia, where Thailand bath crises rapidly incited crises in

Indonesia, Korea, and Philippines and to a smaller degree

in Malaysia.

The crises had serious consequences. Output

contracted significantly in all crisis-hit countries, ranging

between 5%-60% of GDP. Brazilian case was exception

Graph A1.1Private Capital Inflows in Asia and Latin America

Latin America (Brazil, Argentina, and Mexico)(in Billion USD)

1994

1995

1996

1997

1998

1999

0.0 20.0 40.0 60.0 80.0

45.1

46.2

49.0

63.5

48.1

46.0

Asia (Indonesia, Thailand, Malaysia, Philippines, dan Korea)(in Billion USD)

1994

1995

1996

1997

1998

1999

0.0 20.0 40.0 60.0 80.0 100.0

74.5

78.5

65.5

48.1

23.0

35.0

Source : UNCTAD and International Financial Statistics

Sources : S.Griffith Jones (2004) and G. Hoggarth and V. SaportaΩ(2002)

Table A1.1Estimated Cost of Crisis

Year of Crisis Estimated of GDPOutput Loss (%)

(Based Year: 1990)

Argentina 1999 25,60 62,10

2002 37,10 64,30

Brazil 1999 96,70 19,34

2002 140,10 20,01

Indonesia 1997 238,60 51,00

Korea 1997 122,90 12,00

Malaysia 1997 60,60 39,00

Mexico 1994 78,10 21,22

Thailand 1997 210,50 67,00

Turkey 2001 29,00 7,00

Article I

6a

as this country had relatively stronger banking system, it

could therefore avoid two full-blown crises in 1999 and

2002. In Indonesia, the crisis turned to be

multidimensional one, with deep political and social

consequences.

Were the crises resultants of failures in macro

economy policies? The striking facts are that all crisis-

hit countries recorded solid growth before the crisis. All

the Asian crisis-hit countries grew at 7.57% in average

and so did their Latin American peers at 4,56%. The

Asian economies maintained fiscal prudence as shown

by government balance of either surplus (Indonesia,

Korea, Malaysia, and Thailand) or a slight deficit

(Philipine). These countries were so prudent that they

were often praised for their stringent fiscal policies in

responding to the capital inflows and developing an

overheating situation. These help explain why the crises

were hardly anticipated.

Another main common element was the financial

panic taking place and the self-fulfilling nature of the

events that followed. All crises were eventually triggered

by dramatic shifts in the investors» and creditors»

expectation on the fundamentals of economy. Self-

fulfilling panics represent an intrinsic shortcoming in global

financial markets. Crises occurred as investors exhibited

herd behaviour as a result of a confidence crisis. Radelet

and Sachs (1998) also pointed out that international

financial markets are prone to self-fulfilling crisis in which

individual creditors may act rationally. These arguments

were factual, financial crises would have been prevented

or at least alleviated should global players acted more

sensibly and there is a framework to deal with it.

Table A1.2Pre Crisis Key Macro Economy Indicator

Year of Crisis (T) Key Indicator T-2 T-1 T T+1 T+2

ArgentinaArgentinaArgentinaArgentinaArgentina 19951995199519951995 Real GDP Growth 6.3 5.8 -2.8 5.5 8.1Current Account Balance -3.4 -4.3 -1.9 -2.4 -4.1

Government Budget -0.2 -1.8 -2.3 -3.2 -2.1

Public Debt 29.2 31.1 35.9 37.4 36.2

ArgentinaArgentinaArgentinaArgentinaArgentina 20022002200220022002 Real GDP Growth -3.4 -0.5 -4.4 -10.9 8.8Current Account Balance -4.4 -3.3 -3.2 -3.8 -4.3

Government Budget -4.1 -3.5 -3.5 -1.3 0.5

Public Debt 47.4 50.8

BrazilBrazilBrazilBrazilBrazil 19991999199919991999 Real GDP Growth 2.7 3.3 0.2 0.8 4.2

Current Account Balance -3.0 -3.8 -4.3 -4.7 -4.2

Government Budget -5,9 -6,1 -7,9 -10,0 -4,6

Public Debt 33,3 34,6 42,4 47,0 49,2

IndonesiaIndonesiaIndonesiaIndonesiaIndonesia 19971997199719971997 Real GDP Growth 8,2 8,0 4,5 -13,1 0,8

Current Account Balance -3,3 -3,2 -1,7 4,2 4,1

Government Budget 0,8 1,2 -1,1 -2,3 -1,5

Public Debt 30,8 23,9 72,5 53,3 44,4

KoreaKoreaKoreaKoreaKorea 19971997199719971997 Real GDP Growth 8.9 6.8 5.0 -6.7 10.9

Current Account Balance -1.7 -4.4 -1.7 12.7 6.0

Government Budget 1.3 1.0 -0.9 -3.8 -2.7

Public Debt 8.4 8.0 10.4 10.4 10.4

%%%%%

Article I

7a

BALANCE SHEET PROBLEMS

The emerging markets had persistent source of

vulnerabilities in their balance sheets as the following:

1. Maturity Mismatch

In the balance sheets of the financial system and

large corporations there was structural mismatching of

maturities. The sizeable portion of emerging market banks

and firms borrowed short-term, due to three factors: (1)

short-term borrowings were cheaper; (2) only a handful

or creditors were willing to lend to these debtors at longer

tenor; and (3) perceived country risks remain high despite

positive development. These sources of funds were

mismanaged. The vast majority of corporations in Asia,

for instance, used loans to fund long-term investments

including capital formation or even building stocks of

property. Except in Malaysia, where equity investments

were higher than in the other crisis-hit Asia, debts were

primary source of fund to finance public and private sector

deficits. The resulting vulnerability takes the form of

liquidity riskƒthe inability to roll over debts that moves

these economies from growth into crises (See Table A1.3

and A1.4).

Apparently, maturity mismatch was enormous. This

adverse condition created rollover risk, as the vast majority

of emerging countries had huge stocks of short-term foreign

debts that would not be covered by their liquid reserves.

The pressures arose from short-term liabilities of government

sector (Mexico, Turkey, and Argentina) or banks (East Asia,

Brazil, Turkey, and Argentina). Also, in some countries

interest rate of short-term government debts increased

markedly prior to the crisis. This signalled creditors and

investors about higher probability of defaults and perceived

of currency risk, like those occurred in Brazil and Argentina.

Secondly, maturity mismatch triggered interest rate

risks. In financial sector, banks held short term source of

funds that were highly sensitive to rises in short-term

interest rates, while their assets portfolio were relatively

Table A1.2Pre Crisis Key Macro Economy Indicator (cont.)

Year of Crisis (T) Key Indicator T-2 T-1 T T+1 T+2

MalaysiaMalaysiaMalaysiaMalaysiaMalaysia 19971997199719971997 Real GDP Growth 9.8 10.0 7.3 -7.4 5.8


Government Budget 2.2 2.3 4.1 -0.4 -3.7

Public Debt 41.1 35.3 35.3 35.3 35.3

MexicoMexicoMexicoMexicoMexico 19941994199419941994 Real GDP Growth 2.0 4.4 -6.2 5.2 6.8

Current Account Balance -5.8 -7.0 -0.6 -0.7 -1.9

Government Budget 0.7 -0.2 -0.2 0.3 -1.0

Public Debt 25.3 35.3 40.8 31.1 25.8

PhilippinesPhilippinesPhilippinesPhilippinesPhilippines 19971997199719971997 Real GDP Growth 5.8 5.2 -0.6 3.3 3.9

Current Account Balance -4.8 -5.3 2.4 10.0 12.4

Government Budget -0.4 -0.8 -2.7 -4.3 -4.7

Public Debt 53.2 55.7 66.2 59.1 59.1

ThailandThailandThailandThailandThailand 19971997199719971997 Real GDP Growth 9.3 5.9 -1.4 -10.8 4.2


Government Budget 3.0 2.5 -0.9 -2.6 -2.9

Public Debt 4.6 3.7 4.6 10.8 20.4

%%%%%

Source: BIS, IFS

Article I

8a

Sum

ber

: BIS

, IFS

Lati

n A

mer

ica

Asi

a

BALA

NCE

SHEE

T VU

LNER

ABIL

ITIE

SBA

LANC

E SH

EET

VULN

ERAB

ILIT

IES

BALA

NCE

SHEE

T VU

LNER

ABIL

ITIE

SBA

LANC

E SH

EET

VULN

ERAB

ILIT

IES

BALA

NCE

SHEE

T VU

LNER

ABIL

ITIE

SLi

quid

ity R

iskLi

quid

ity R

iskLi

quid

ity R

iskLi

quid

ity R

iskLi

quid

ity R

iskST

Deb

t/Res

erve

s%

201.

022

1.0

203.

011

5.0

145.

014

9.0

161.

012

6.0

142.

0 2

78.0

277

.0 2

89.0

211

.0 1

45.0

151

.0 1

36.0

147

.0 1

54.0

155

.0 1

58.0

151

.0 4

5.0

47.

0 4

9.0

51.

0M

2/Re

serv

es%

602.

060

5.0

610.

034

5.0

365.

037

0.0

361.

057

0.0

310.

0 6

21.0

624

.0 6

20.0

651

.0 3

98.0

399

.0 4

00.0

451

.0 6

03.0

657

.0 6

33.0

624

.0 3

78.0

387

.0 3

50.0

399

.0ST

Deb

t/Tot

al E

xter

nal D

ebt

28.1

28.4

28.5

36.3

35.4

37.8

45.1

21.4

22.5

24.

1 2

7.1

28.

1 2

7.8

24.

5 2

5.7

28.

4 2

9.6

17.

7 2

0.9

24.

8 2

6.3

17.

8 1

7.3

17.

6 1

8.2

Coun

try

Solv

ency

Risk

Coun

try

Solv

ency

Risk

Coun

try

Solv

ency

Risk

Coun

try

Solv

ency

Risk

Coun

try

Solv

ency

Risk

Exte

rnal

Deb

t/GDP

%32

.031

.533

.052

.355

.251

.054

.031

.041

.028

.2 2

9.4

31.

0 3

1.1

58.

0 5

9.2

60.

0 6

3.1

42.

0 4

2.4

43.

0 4

3.8

36.

1 3

7.2

38.

0 3

8.4

Exte

rnal

Deb

t/Exp

orts

%19

7.2

199.

219

6.0

388.

038

9.0

376.

039

5.0

369.

030

0.0

110.

0 1

02.0

104

.0 1

01.0

147

.2 1

49.3

150

.0 1

55.2

161

.0 1

62.4

164

.0 1

65.2

42.

3 4

4.5

42.

0 4

3.5

Sove

reig

n So

lven

cy R

iskSo

vere

ign

Solv

ency

Risk

Sove

reig

n So

lven

cy R

iskSo

vere

ign

Solv

ency

Risk

Sove

reig

n So

lven

cy R

iskPu

blic

Deb

t/GDP

%34

.035

.135

.045

.145

.245

.055

.048

.073

.011

.0 1

1.2

12.

0 1

2.1

5.0

5.2

5.0

5.3

20.

5 2

0.1

24.

0 2

2.0

33.

8 3

4.0

35.

0 3

8.9

Publ

ic D

ebt/R

even

ue%

147.

814

8.6

155.

022

5.2

225.

922

6.0

271.

014

3.0

211.

0 5

5.0

56.

8 5

8.0

57.

6 2

2.0

27.

2 2

7.0

26.

1 1

85.0

185

.4 1

86.0

182

.0 1

52.0

153

.0 1

54.0

159

.0

Curr

ency

Mism

atch

Risk

Curr

ency

Mism

atch

Risk

Curr

ency

Mism

atch

Risk

Curr

ency

Mism

atch

Risk

Curr

ency

Mism

atch

Risk

FX E

xter

nal D

ebt/G

DP%

32.0

31.5

33.0

52.0

54.0

50.8

53.1

29.0

35.0

28.

2 2

9.4

31.

0 3

1.1

58.

0 5

9.2

60.

0 6

3.1

42.

0 4

2.4

43.

0 4

3.8

32.

0 3

2.1

33.

8 3

4.1

Gove

rnm

ent's

FX

Debt

/Gov

t's D

ebt

%52

.052

.053

.098

.097

.091

.092

.075

.025

.0 2

5.0

25.

0 2

8.0

28.

6 1

00.0

100

.0 1

00.0

100

.0 1

00.0

100

.0 1

00.0

100

.0 1

00.0

14.

0 1

4.0

15.

0

Capi

tal S

truc

ture

Capi

tal S

truc

ture

Capi

tal S

truc

ture

Capi

tal S

truc

ture

Capi

tal S

truc

ture

Equi

ty/F

DI%

45.0

45.0

47.0

12.0

12.3

11.0

9.0

75.0

45.0

23.

0 2

4.1

23.

5 2

3.4

45.

2 4

7.1

47.

2 4

4.0

41.

0 4

2.0

43.

5 4

4.0

78.

0 7

9.0

79.

2 7

8.4

FDI/G

DP%

2.0

2.0

2.0

1.2

1.2

1.3

0.5

3.7

3.7

(0.2

) (0

.2)

(0.3

) (0

.3)

2.4

2.5

2.6

2.6

2.1

2.1

2.1

2.4

7.0

7.0

7.2

7.0

FLO

W IM

BALA

NCE

FLO

W IM

BALA

NCE

FLO

W IM

BALA

NCE

FLO

W IM

BALA

NCE

FLO

W IM

BALA

NCE

Curre

nt A

ccou

nt/G

DP%

(6.8

)(6

.9)

(7.1

)(3

.4)

(3.8

)(3

.1)

(3.6

)(4

.3)

(1.7

) (4

.2)

(4.3

) (4

.4)

(7.9

) (7

.4)

(7.5

) (8

.1)

(8.2

) (1

.7)

(3.7

) (3

.4)

(4.0

) (4

.8)

(4.8

) (4

.4)

(4.2

)Fi

scal

Bal

ance

/GDP

%(0

.3)

(0.4

)(0

.2)

(2.3

)(2

.1)

(2.4

)(5

.6)

(6.3

)(5

.2)

1.0

1.0

0.1

0.1

0.0

0.0

1.7

1.1

0.1

0.8

1.6

0.2

1.0

1.2

2.4

1.0

ER

REG

IME

AND

CAPI

TAL

ACCO

UNT

ER R

EGIM

E AN

D CA

PITA

L AC

COUN

TER

REG

IME

AND

CAPI

TAL

ACCO

UNT

ER R

EGIM

E AN

D CA

PITA

L AC

COUN

TER

REG

IME

AND

CAPI

TAL

ACCO

UNT

Exch

ange

Rat

e Re

gim

eSo

ft Pe

gCB

S sin

ce C

onve

rtibil

ity La

wCra

wling

F loati

ngSo

ft Pe

gSo

ft Pe

gSo

ft Pe

gSo

ft Pe

gCu

rrenc

y O

verv

alua

tion

Overv

alued

High

ly Ov

erva

lued

Peg

No S

light

ly Ov

erva

lued

High

ly Ov

erva

lued

Sligh

tly O

verva

lued

Sligh

tly O

verva

lued

Capi

tal A

ccou

nt C

ontro

l

No (

Open

Cap

ital A

ccou

nt)

No (O

pen

Capit

al Ac

coun

t)Ye

sNo

No (O

pen

Capit

al Ac

coun

t)No

(Ope

n Ca

pital

Acco

unt)

No (O

pen

Capit

al Ac

coun

t)No

(Ope

n Ca

pital

Acco

unt)

Mex

ico

Arg

enti

naBr

azil

Kor

eaTh

aila

ndIn

done

sia

Mal

aysi

a

Tab

le A

1.3

Key

Bal

ance

Sh

eet

Vu

lner

abili

ties

1992

1993

1994

1998

1999

2000

2001

1998

2002

1994

1995

1996

1997

1994

1995

1996

1997

1994

1995

1996

1997

1994

1995

1996

1997

BANK

SYS

TEM

RIS

K EX

POSU

REBA

NK S

YSTE

M R

ISK

EXPO

SURE

BANK

SYS

TEM

RIS

K EX

POSU

REBA

NK S

YSTE

M R

ISK

EXPO

SURE

BANK

SYS

TEM

RIS

K EX

POSU

RENP

L sHi

gh V

ery H

igh

L ow

Low

High

High

High

Med

ium

Ove

ral B

anki

ng S

ecto

r Fra

gilit

yHi

ghHi

gh, a

lbelt

liqu

id in

199

8M

edium

Med

iumM

ediu

mHi

ghHi

ghM

ediu

man

d 19

99Co

nnec

ted

Lend

ing

NoNo

NoYe

s, Hi

ghYe

s, Hi

ghYe

s, Hi

ghYe

sG

over

nmen

t Dire

cted

Len

ding

NoNo

NoYe

s, Hi

ghYe

s, Hi

ghYe

s, Hi

ghYe

sAc

coun

ting

Stan

dard

sM

ediu

mM

ediu

mMe

dium

Mediu

mM

ediu

mW

eak

Wea

kM

ediu

m

BANK

ING

SEC

TOR

FRAG

ILIT

YBA

NKIN

G S

ECTO

R FR

AGIL

ITY

BANK

ING

SEC

TOR

FRAG

ILIT

YBA

NKIN

G S

ECTO

R FR

AGIL

ITY

BANK

ING

SEC

TOR

FRAG

ILIT

YG

ov. D

ebt/B

ank

Asse

ts%

22.0

21.0

23.0

23.0

24.0

21.0

20.0

15.0

14.0

8.0

7.8

7.9

7.6

6.7

6.8

9.0

9.1

8.0

7.8

8.1

7.9

7.0

7.1

7.2

7.3

Liqui

dity

ratio

rela

tive

to B

IS b

anks

%13

8.0

137.

014

0.0

67.0

68.0

70.0

72.0

70.0

72.0

224

.0 2

23.0

232

.0 2

54.0

504

.0 5

04.0

507

.0 5

06.0

224

.0 2

35.0

251

.0 2

53.0

67.

0 6

8.0

64.

0 6

7.0

Article I

9a

Table A1.4Key Policy Adjustment In Crisis-Hit Countries

Latin America Asia

Mexico Argentina Brazil Korea Thailand Indonesia Malaysia

1994 1999 2001 1998 2002 1997 1997 1997 1997

SECTORAL CRISISSECTORAL CRISISSECTORAL CRISISSECTORAL CRISISSECTORAL CRISIS

Currency Crisis Yes Yes Yes Yes No Yes Yes Yes Yes

Banking Crisis Yes Yes Yes No No Yes Yes Yes No

Domestic Bank Run No Yes Yes No No No No Yes No

Cross Border Bank Run No Yes Yes Yes No Yes Yes Yes Yes

Corporate Financial Crisis Yes Yes Yes No No Yes Yes Yes Yes, Modest

PRECIPITATING FACTORSPRECIPITATING FACTORSPRECIPITATING FACTORSPRECIPITATING FACTORSPRECIPITATING FACTORS

External Factors Yes Yes Yes Yes Yes Yes Yes Yes Yes

Financial Sector Weaknesses Yes Yes Yes No No Yes Yes Yes Yes, Medium

Corporate Sector Weaknesses Yes Yes Yes No No Yes Yes Yes Yes, Medium

Capital Account Reversal Large Very Large Very Large Medium Small Large Large Large Medium

Sudden Stop of Capital Inflows Yes Yes Yes No No No No No No

CRISIS RESOLUTION ANDCRISIS RESOLUTION ANDCRISIS RESOLUTION ANDCRISIS RESOLUTION ANDCRISIS RESOLUTION AND

MEASURESMEASURESMEASURESMEASURESMEASURES

Blanket Guarantee

Announcement No No No No No No Yes Yes No

Liqudity Support Yes No No No No No Yes Yes Yes

Banking Recapitalization Program Yes No No No No Yes Yes Yes Yes

Corporate Financial Restructuring Yes Yes Yes No No Yes Yes Yes Small

Fiscal Domestic Adjustment Large Large Large Modest Modest Large Large Large Modest

Deposit Freeze No Yes Yes No No No No No No

Capital Control No Yes Yes No No No No No Yes

DEFAULTDEFAULTDEFAULTDEFAULTDEFAULT

Defaults on Domestic and

External Debts No Yes Yes No No No No No No

Default on Private Corporate

External Debt No Yes Yes No No Some Some Some No

RESCUE PACKAGERESCUE PACKAGERESCUE PACKAGERESCUE PACKAGERESCUE PACKAGE

IMF Package Large Large Large Large Large Large Large Large No

Paris Club Restructuring No No No No No No No Yes No

POST CRISISPOST CRISISPOST CRISISPOST CRISISPOST CRISIS

Mandate for Central Bank to Unclear Unclear Unclear Unclear Unclear Yes Yes Yes Yes

conduct FSS Function

Financial Sector Masterplan No No No No No No Yes Yes Yes

Initiative

Sumber : BIS, IFS

Article I

10a

longer term. Also the vast majority of banks held long-

term asset portfolio with a fixed interest rate. This created

pressures as they were also exposed to the risk that an

increase in the interest rate may reduce the market value

of their debts (Thailand and Indonesia). In most countries

these conditions resulted in unwinding portfolio

investments and termination of credit line, two conditions

that put pressures on the exchange rates.

2. Currency Mismatch

Albeit the data is slightly limited, currency mismatch

was the persistent source of vulnerability in the past crisis

episodes. The vast majority of emerging countries

borrowed in foreign currency to fund investments with

income streams in local currency. This is because emerging

markets agents, public and private, are often unable to

borrow in local currency from residents due to lack of

savings. As a result, capital for investment were often in

foreign denominated currency predominantly in US Dollars.

At the government level, currency mismatch risk was

substantial in Mexico, Brazil, and Argentina. In the financial

sectors, the mismatches were significant in East Asia and

to a lower degree in Brazil (in the 1999 episode). Currency

mismatches were also substantial in the real sector

(corporations and households) in East Asia, Turkey, and

Argentina. In Brazil, (before the private sector increased

its holdings of foreign currency denominated assets in

1998). This mismatch in denominations posed balance

sheets to substantial foreign exchange risk. A major

currency depreciation resulted in bankrupts of a large part

of the financial institutions and their customers

predominantly corporate borrowers. This had been more

disastrous in the absence of a currency hedge (See Table

A1.3 and A1.4).

However, exchange rate adjustment appeared to be

necessary steps to be undertaken to reduce the deficit in

current account and eliminate the big gap that may arise.

The adjustments were far more difficult in an emerging

country whose debts were in foreign currency and whose

external debts were enormous. The case in East Asia

reflected this condition. Their private sectors in particular

confronted difficulties after a large swing of currency

depreciation that increased their foreign debt exposure.

Mexican government confronted similar difficulties related

to their short-term debt instrument (tesobonos).

3. Capital Structure Mismatch

The imbalance of capital structure in emerging

markets led them to vulnerabilities in time of external

shocks because of the absence of equity cushion. Almost

all emerging countries relied on debt financing rather than

equity at all level: government (higher senior debt than

junior debt), firms (high debt to equity ratio or leverage)

and financial institutions (higher liabilities and capital

formation may be depleted due to NPLs). Equity financing

in the form of FDI were ranging from 3%-5% of GDP,

except in Malaysia whose FDI was 12% of GDP therefore

it could insulate itself from excessive capital outflow.

Malaysian private sector financed themselves in ventures

that share risks and gains with its stakeholders, a condition

that protected its private sector from default amid the crisis

(See Table A1.3 and A1.4).

Unlike Malaysia, Argentina, Thailand and Korea

relied on debt financing instead of equity financing.

Argentina»s problem was structural and therefore reliance

on debts was inevitable. Korean government encouraged

capital inflows in the form of debt that mainly came from

Japan before the crisis. Thailand the tax regime favoured

corporate debt over equity including those applied in

finance companies and in the form of lease financing.

Leverage ratios (debt to equity) in Korea and Thailand were

very high at the onset of the crisis, especially can be found

in chaebols. Capital structure mismatch were worsened

by undercapitalized banks and financial institutions, except

Article I

11a

in Brazil and Argentina (before 2001) where banking sector

was relatively solid. Consequently, once liquidity and

currency shocks hit the balance sheets of banks and other

financial institutions, there was only limited capital buffer

to absorb unexpected losses.

UNDERLYING BALANCE SHEET VULNERABILITIES

The symptoms of balance sheet weaknesses leading

to mismatches were evident before the crises erupted.

These were mainly due to liquidity deterioration prior to

the crises. Chang and Velasco (1998) argued that the Asian

crisis had its roots on international illiquidity problem, as

evidenced by sharply rising ratios of hard currency short-

term liabilities to liquid assets. Hence, these countries were

extremely vulnerable to a reversal of capital inflows, which

occurred massively in the second half of 1997. In Asia, the

ratio of short-term loans due to international banks to

reserves showed increasing trends, implying that a higher

probability of international illiquidity and maturity

mismatch in the near future. This is coherent with the fact

that all crisis-hit countries were dependent on foreign debts

to close their saving-investment gaps. Unfortunately, a

sizeable portion of these debts was short-term maturing

particularly in Korea, and Mexico.

In the East Asian countries, except in Indonesia, the

ratio of short-term foreign debt to international reserves

increased during 1990 to 1997, except in Indonesia that

had stable ratio. It had fallen sharply in the Philippines,

however this was probably an exception as the Philippine

undertook its Brady debt restructuring of 1991. The ratio

turned to more than 100% for Indonesia, Korea and

Thailand in the middle of 1997. Hence, it is obvious that

East Asian countries confronted financially fragile

situations in the eve of crisis, as their international reserves

were not sufficient to repay their short-term debts,

particularly in the case of foreign lenders did not make

an extension (roll-over). In Malaysia and the Philippines,

the ratio was lower than 100%, these countries were

therefore least affected, albeit this is too hasty to conclude

that those countries were insulated because of lower

ratio.

Correspondingly, the same ratio was slightly lower

for Latin American countries. However, this is not to say

that in term of liquidity they were less vulnerable that their

Asian peers. The ratio of short-term debt to reserves was

below 100% in Brazil; however it exceeded 100% in

Argentina and Mexico. Hence, the Latin American peers

appeared to be in the same vulnerability compared to their

Table A1.5External Debt Structure and Short-Tem Vulnerabilities

Region

AsiaAsiaAsiaAsiaAsiaIndonesia 2,200.0 1,730.0 1,704.0 51.6 61.1 59.0 97.7 2.3 97.3 2.7 97.9 2.2Korea 1,061.0 1,610.0 2,060.0 66.5 72.5 67.9 88.5 11.5 93.4 6.6 94.1 6.0Malaysia 217.0 252.0 612.0 25.7 59.1 56.5 96.9 3.1 89.1 10.9 89.7 10.3Philippines 3,185.0 992.0 848.0 33.3 44.2 58.8 95.3 4.8 94.6 5.4 84.1 15.9Thailand 591.0 926.0 1,453.0 60.2 74.3 65.7 94.2 5.8 94.1 5.9 94.4 5.6

Latin AmericaLatin AmericaLatin AmericaLatin AmericaLatin AmericaArgentina 2,092.0 1,326.0 1,210.0 24.6 56.6 53.8 99.3 0.7 98.6 1.4 95.4 4.6Brazil 2,628.0 700.0 792.0 37.6 55.4 62.2 95.8 4.2 102.0 -2.0 89.4 10.6Mexico 2,238.0 1,721.0 1,187.0 31.1 48.8 45.5 99.6 0.4 97.8 2.2 96.9 3.1

ST Debt To ST Debt To Total Debt External Debt in Local and Foreign Currency (%)International Reserves (%) (%)

1990 1994 1997 1990 1994 1997

1990-1993 1994-1995 1996-1997

Foreign Local Foreign Local Foreign LocalCurrency Currency Currency Currency Currency Currency

Source: BIS

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between domestic and foreign borrowing costs prompted

banks and firms to seek offshore financing. Secondly,

offshore special financial centres like Labuan Offshore

Centre (Malaysia) also distorted the markets as they provide

special incentives to borrowers and lenders. Finally,

regulatory arbitrage was behind the abundant flows of

foreign borrowings. Banks were subject to lower income

tax for interest income generated from foreign currency-

denominated loans (eg in the Philippines). They were also

subject to lower reserve requirements for foreign currency.

Overall, three other prevailed attributes have played

significant roles igniting balance sheet weaknesses: short-

term foreign currency liabilities, the presence fixed or

limited flexible exchange rate regime, and inadequate

international reserves. These factors left their financial

systems vulnerable to shifts in investors» sentiment and

expectation. Two channels through which foreign currency

liabilities were harmful especially to their private sectors:

first when central banks devalued the currency that sharply

reduces profitability and debt-service capabilities. Secondly,

banks transfer exchange rate risk to the private sectors as

they lent in foreign currency while the vast majority of

borrowers» revenues were in domestic currency. These

have been the major feature of crisis in Mexico, Indonesia,

Thailand, Korea and to a lesser degree in Malaysia and the

Philippine.

Apart from massive capital reversal, balance sheet

problems in the past crises were triggered by several

mutually reinforcing factors. It might commence with

devaluation on one currency inciting herding behaviour

of investors that ended up with a rapid withdrawals of

foreign capital, bank runs, and dramatic downturn of real

economy. On the other side, all crises were apparently

exacerbated by financial and corporate sector weaknesses.

Feeble financial institutions and highly leveraged corporate

sectors magnified the negative impacts of exchange rate

devaluations and capital withdrawals as occurred in Asia.

Asian peers. The data hence indicate that the short-term

external liabilities of the crisis-hit countries grew faster than

their liquid international assets. This trend might have

triggered international creditors to interpret that these

countries» international liquidity position were in tatters,

the event that further created a loss of confidence and

ultimately ignited financial crises. In fact, indeed, they did

have illiquidity problem before the crisis. The inability of

Mexico to roll over its large stock of short-term debt

securities (the tesobonos), for instance, was an evidence

that liquidity shortage in its financial system was a key in

triggering the financial crisis in December 1994 (Chang

and Velasco, 2001; Gil-Diaz, 2001).

The unprecedented increase of short-term debt after

liberalization explained why emerging markets were

susceptible. In East Asia, foreign creditors significantly

increased their loans to the crisis-hit countries during the

first half of 1990»s as they saw prospective business and

economic growth. As a result, short-term debts were more

than doubled during the first half of 1990»s and significantly

increased by three-fold during 1997. All East Asian

economies were increasingly dependent on external

financing for growth especially during 1990-1994 where

their industries grew tremendously. Similar case was found

in the Latin American peers, albeit the ratios of short-term

to total debt and reserves were not as alarming as their

Asian peers.

Beside the maturity structure, the currency

composition of the financial system liabilities of the crisis-

hit countries was susceptible to vulnerability. A sharp

increase in foreign borrowings was tremendously

denominated in foreign currency. What were the primary

drivers of this pattern? There are three answers. First, the

blend of high domestic interest rates and commitment to

a fixed exchange rate had driven domestic banks and

corporations to borrow in offshore markets. The Asian

Development Bank (1998) explained that the large spreads

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Both exogenous and endogenous factors played mutually

reinforcing roles in all crisis episodes.

THE LINKAGE BETWEEN BALANCE SHEET AND

CRISES

How was the link between balance sheet weaknesses

with the crisis? Problems in balance sheet at the private

sectors (corporations and banks) and the country level at

almost all crisis-hit countries had blown into balance of

payments (BOP) crises. The pressures on BOP were

augmented because of:

(1) Creditors stopped their credit lines and to serve

external debt payments private sectors and

government had to liquidate domestic assets and

exchange them into foreign currency;

(2) International investors exhibited herd behaviour due

to asymmetric information and therefore unwound

their portfolio investments and change them into

foreign currency;

(3) Loss in domestic confidence drove domestic investors

to convert their liquid portfolios in banks and capital

markets to foreign currency (predominantly USD). In

Mexico, Argentina, and some Asian countries

investors sold local assets and withdrawal funds from

local banking system and invested them in the safe

harbour overseas.

Those lethal combinations put pressure on the

exchange rate and depleted reserves as the vast majority

of crisis-hit countries had pegged exchange rate regime.

Current accounts also deteriorated as the crisis-hit countries

had limited ability to generate resources greater than their

investors» desire to hold external assets. For instance, in

time of crisis it was too difficult to boost exports to generate

more foreign exchange sources, primarily due to: (a)

overseas creditors cut credit lines and (b) the vast majority

of export components were imported and put downward

pressures on exchange rates.

How did sectoral problems trigger the crises?

Weaknesses in banking and corporate sectors» balance

sheet augmented weaknesses in the country level balance

sheet, In the East Asian and Mexican episodes,

deterioration in balance sheet strength of corporations and

banks (predominantly systemically important ones) sparked

enormous capital reversals that were also exacerbated by

information asymmetry. Investors» panic led to pressures

on the exchange rates. Hence, corporations with foreign

currency denominated debt push upward pressures on

NPLs of banks. Currency crises then became intertwined

with banking crises. On the other hand, in Argentinean

and Russian episodes, balance sheet weaknesses of

government ignited weaknesses of banking sector balance

sheet as they held sizeable portion of claims to government

(mostly short-term) therefore resulting banking crises. Both

episodes were exacerbated by depreciation of exchange

rates.

Balance sheet weaknesses had also tremendous

impact on output decline. In corporate sector, they reduced

expenditures during the downturn to restore their financial

soundness. Corporations with weak balance sheet were

unable to finance production. In financial sector, banks

cut credit line and applied more stringent credit rules

resulting in credit crunch. Banks also limited their lending

to the household sector and therefore limited their ability

to finance consumption or even investment. Government

also cut spending and central banks exercised tight biased

monetary policy. These combinations significantly lowered

aggregate output at national level as in the East Asia and

the former Mexican episodes (Table A1.1).

In brief, the past emerging market crises have shown

us that balance sheet inter-linkage across sectors of the

economy can amplify weaknesses in individual sectors and

propagate a crisis across sectors, to the balance of

payments, and to the sovereign. Such interlinkage may

complicate the policy response and magnify the costs of

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crisis resolution. There is also uncertainty regarding the

effectiveness of policies, which depends critically on the

perceived credibility of the corrective measures when the

reputation of the authorities tends to be at its lowest level.

And there is uncertainty regarding the political support

for reforms. Policy makers face the additional challenge

of quickly mobilizing public support for often unpopular

measures.

DRIVING FACTORS BEHIND BALANCE SHEET

PROBLEMS

1. Imprudent Financial Liberalization

There are similarities in Asian and Latin American

crises: financial liberalization were implemented prior to

the crises, yet the proper sequencing for such a successful

liberalization were not well-designed. The crisis-hit

countries in Latin America and East Asia opened up their

capital account and financial sectors and therefore called

≈emerging markets∆ that attracted Foreign Direct

Investments (FDI √ in both Latin America and Asia),

portfolio investments (in Latin America) and bank loans

(in East Asia).

In Asia, in the late 1980s and the 1990s the

governments of the crisis-hit countries implemented

policies designed to move toward a freer, more market-

oriented financial system. This trend included the

deregulation in banking sectors, revoking the ceiling of

interest rates and the easing of reserve requirements on

banks. in Indonesia, for instance, interest rate ceiling were

revoked in 1983 and banking sector was deregulated to

ease the opening and licensing commercial and rural banks

in 1988. Like Indonesia, Malaysia also deregulated their

financial sector in 1988-89. Between 1991 and 1996

Korea eased marginal reserve requirements, from 30% in

to 7% percent in 1996. Korea eased operational licensing

of foreign banks in 1993 and so did Thailand in 1993.

Latin American countries also liberalized their

financial sector in 1990»s as responses to the ≈lost

decade∆ era of 1980s √stagnation of economic growth

and the rise in inflation associated with the 1980»s debt

crises. Chile and Argentina deregulated its capital account,

FDI and exchange rate during 1976-1979. Mexico

deregulated FDI and its exchange rate regime during

1980-1985 as well as its capital account in 1991 and

subsequently 1995. While Brazil took a softer approach

by gradually deregulating its capital account during the

period of 1986-1990, while its FDI was done during 1991-

1995. Colombia moved in the same direction at around

the same time, also motivated by earlier lost decade.

However, the development in Colombia hindered by the

fact that the country has security problems. The

liberalization in emerging countries, in fact, has failed to

create benefits and long term sustainable growth, albeit

in its early stage where massive capital inflows came in it

helped recipient countries ease the external balance

pressures.

As a result of liberalization, enormous capital inflows

come to the region, however such a poorly-staged

liberalization has detrimental impacts to both regions. In

Asia, substantial foreign funds became available at

relatively low interest rates, as investors in search of new

opportunities shifted massive amounts of capital into these

countries. As in all boom cycles, stock and real estate prices

Graph A1.2Domestic Financial Liberalization Index, 1973 - 2002

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

Asia

Latin America

Developed Ctries

Source: B Stalling (2004)

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in the region shot up initially, so it attracted even more

funds. However, domestic allocation of these borrowed

foreign resources was inefficient because of weak financial

systems as a result of poorly-staged deregulation.

Deregulation in Asia has driven keener competition among

banks and financial companies. As a result, these financial

institutions took excessive risks as the results of rapid loan

portfolio expansions. Also, keener competition forced

banks and finance companies to offer more attractive

terms both in asset and liabilities sides. In the absence of

strong risk management and prudential supervision, these

led financial sectors to vulnerabilities.

Financial liberalization has also an adverse impact

on the international liquidity position of the financial

system. Clearly, lower reserve requirements allow the

banking industry to maintain a lower degree of liquidity.

Chang and Velasco (2000) also argued that although

financial liberalization may be desirable on efficiency

grounds, it directly exacerbates international illiquidity and

increases the possibility of a financial run. Empirical study

by Kaminsky and Reinhart (1996) found that out of twenty

six banking crises, eighteen were preceded by financial

liberalization. Furthermore, in the light of liberalization,

the presence of fixed exchange rate regime was

disincentive, as it gave borrowers a false sense of security,

encouraging them to take on dollar-denominated debt.

Besides that, in the countries affected by the crisis

(particularly East Asia), exports were weak in the mid-1990s

for a number of reasons, including the appreciation of the

U.S. dollar against the yen, China»s devaluation of the yuan

in 1994, and the loss of some markets following the

establishment of the North American Free Trade Agreement

(NAFTA). The massive capital inflows and weakening

exports were reflected in widening current account deficits.

Unfortunately, a sizeable chunk of the capital inflows was

in the form of short-term borrowing, leaving the countries

vulnerable to external shocks.

The Wyplosz study (2001) explains that liberalization

including those in emerging countries opened up easier

business opportunities for the banking and financial

sectors, resulting in less prudent operations. In countries

with significant supervision and regulation drawbacks,

these can be easily lead to excessive risk-taking activities.

Interestingly, Wyploz also argues that financial liberalization

is significantly more destabilizing in emerging countries

than in the developed ones. Then, emerging countries tend

to have greater procyclicality after going through

liberalization. The work of Wyploz seems to be in

conformity with empirical findings by Rossi (1999),

Demirgüc-Kunt and Detragiache (1998) and Eichengreen

et al (1995). With samples include developing and

advanced economies, these three studies found that

currency and financial sector crises are closely-related with

the aftermath of liberalization. Aizenman (2005) reassessed

financial liberalization in Latin America in the 1990s. He

stated that liberalization in Latin America failed due to

poor governance and this has been the extreme bottleneck

inhibiting growth in that region. Interestingly, he also

argued that the gains from liberalization during 1990s in

Latin America are overestimated.

Capital account and financial sector liberalizations

in emerging countries were imprudent as they showed

two adverse attributes:

First, supervisory and regulatory frameworks did not

keep abreast with the rapid pace of liberalization. In Asia,

for instance, regulatory and supervisory authorities were

not ready yet to monitor the rapid growth of banks and

financial institutions, as they lacked independence, legal

basis, and resources. Speed of prudential regulation was

much slower than the developments of risky transactions

in the financial sector. During the transition period, financial

liberalization built up the seed for vulnerabilities by

augmenting the exposure to credit and foreign exchange

risks (e.g. in Indonesia, Thailand, Mexico, and Brazil).

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Financial institutions √predominantly in East Asia-

confronted keener competition and greater pressures to

invest in riskier loan portfolios. In the absence of stringent

prudential supervision and risk management, this condition

built up substantial foreign exchange and credit risks. Many

banks in Indonesia, for instance, engaged in foreign

exchange lending to residents supported by domestic

resources. When the crisis erupted, most of the loans were

in default.

Secondly, poor sequencing. The sequencing of

financial liberalisation in emerging countries were not

consistent with the pace of market development. In the

capital account aspect, emerging countries liberalized

capital accounts too soon and without preparation, that

caused over borrowing and asset price bubbles. In financial

sector aspect, the pace of financial liberalization did not

match with the pace of regulatory development of the

domestic financial sector. In Indonesia, for instance,

liberalization create regulatory arbitrage, in which banks

had tremendously competed with less regulated

competitors. This encouraged the exploitation of regulatory

drawbacks by certain types of institution. In Latin America,

macro-economy stability was overlooked when

liberalization took place. As suggested by Aizenmann

(2005), Latin America did not make good order of financial

liberalization, as their macro-economy conditions have not

yet been in the priority for improvements. Instead, they

went through some radical reforms in trade and financial

sector while their economies have not yet been stabilized.

Imprudent liberalization in emerging countries

provided bitter yet valuable experience. First, capital inflows

are beneficial to recipient countries in easing the external

constraint, keeping domestic interest rates down, thus

facilitating higher investment and growth. However, as

dramatically illustrated by the past crises, the surge of

capital inflows can also be detrimental to macroeconomic

management and create instability. Typical signs of the

problems large capital inflows can bring are widening

current account deficits, unsustainable consumption levels,

weaker monetary control and consequently upward

inflation pressure and real appreciation, and consequently

vulnerability to flow reversals. A current account deficit

may be sustained provided the economy grows fast enough

to generate resources to service the capital inflow

associated with it. This threshold is, of course, a matter of

judgment, which depends on forecasts of economic

growth and other assumptions. But judgements can differ,

and investors may at some point take a widening current

account as a sign of impending devaluation, causing a

reversal of the capital inflow and with it, a prospect of

exchange rate instability.

2. Inflexible Exchange Rate Regime

There is only little doubt that exchange rate pegs

contributed to the financial meltdowns in emerging

markets. There was variation of fixed exchange rate system

in the pre-crisis era: from hardly pegged (eg. Argentina)

to crawling peg (eg Brazil) and managed floating (eg.

Indonesia). However, the fixed and semi-fixed regime

combined with persistent interest rate differentials fostered

bank lending and spending booms in emerging markets.

These spurred offshore borrowing by corporations and

creditworthy banks. In this regime, central banks often

intervened foreign currency markets and assumed foreign

exchange risks that would arise. As Calvo and Mendoza

(1996) explained, the fixed exchange rate regime gave

incentives to allocate foreign capital without taking into

consideration any currency and maturity risks, as these

are being implicitly transferred to the central bank. For

example, as Asian countries strived to catch-up growth,

their currencies experienced real appreciation. This made

borrowers more ignorant to the foreign exchange risks as

reflected by their huge amount of foreign-currency

denominated liabilities, which were mostly unhedged.

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The fixed regime was detrimental in the recent

crises, as it distorted borrowing decisions by both banks

and non-banks borrowers. In Asia, for instance,

borrowers overlooked foreign exchange risks as they were

convinced that central banks would intervene and

stabilize the foreign currency markets. In Argentina,

borrowers take USD denominated loans as they were

convinced that one to one convertibility system will last

forever and totally eliminate foreign exchange risk.

Central banks had always emphasized that they were

keen to maintain the this regime as it is proven stabilizing

the currency. This regime therefore provided adverse

incentives to the borrowers.

3. Overly Optimistic Expectation

Overly optimistic expectations by creditors and

market participants had also played roles, particularly in

the Asian and Mexican episodes. All creditors of these

countries were optimistic on the sustainable income

streams, as they have gone through after major changes

in the policy regime. Korea, additionally gained entry to

the OECD in the eve of the crises, adding to the country»s

positive points. These factors have lead to overborrowing,

as financial market institutions fail as efficient information

conduits between depositors and borrowers (McKinnon

and Pill, 1996). Corporations with a high risk-return profile

had strong incentives to borrow and invest heavily, as their

exposure was limited by bankruptcy laws or generally poor

legal frameworks. This results in higher bank lending, which

underpinned excessively optimistic expectations about

future growth prospects.

4 Financial Sector Weaknesses

Financial sector weaknesses were apparently the

main sources of crises. These include excessive lending,

deficient regulation and supervision, poor risk

management, lack of transparency. Banking sector was in

the centre of financial turbulence primarily in the past

crises, primarily in Asia, where sizeable pre-crises capital

inflows went through their banking systems. A list of

underlying shortcomings in financial sector is as the

following:

Excessive and Poor Lending Practices

This line of reasoning suggests that a significant

problem in these cases was excessive bank lending

following financial market liberalisation. This fact was

evident in Asia and to some degree in Latin America

predominantly in Mexico in the run up of the crisis. Bankers

exercised poor lending practices without paying attention

to risk management. To some degree, bad lending practices

in emerging Asia, exacerbated by political influences,

connected lending and preferential policy lending to state

owned enterprises. In many cases, lending were

underpinned non-transparent business practices. Lending

booms also become in major crisis roots in Latin America.

As Gavin and Haussman (1998) found, the empirical link

between lending growth and financial crisis in Latin

America is very strong. This was the case in Argentina

(1981), Mexico (1994), Colombia (1982-1983) and

Uruguay (1982).

There were three significant deficiencies of bank

lending in emerging countries. First, bankers traditionally

relied on collateral as primary source of repayment. This

factor was at odds with conventional wisdom that credit

assessment should be based on cash flow analysis and the

capacity of the debtors. Hence, this made banks susceptible

to excessive risk taking and declines in asset values.

Secondly, bank loans were increasingly used to fund

investments that turned out to be economically unfeasible.

Rampant connected lending exacerbated the crises, as

these loans were generally made on political pressures or

cronysm predominantly in Indonesia, Korea and Thailand.

Structure of conglomeration has aggravated connected

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lending. Indonesian banks, for instance, were used to be

owened by non-bank conglomerates generally tied to the

country»s center of power. Third, banks had excessive

sectoral concentration of loans, primarily to export-oriented

industries.

As result of poor credit practices, banks confronted

substantial credit risks. Average NPLs rose albeit

significantly reduced after the bad loan transfers to bank

restructuring agency. Also, some of the NPLs were

denominated in foreign currency, as sizeable capital inflows

went through banking system. This has posed banks with

significant vulnerabilities to both credit and market risks

when debtors collapsed.

and capital account liberalization was implemented.

Regulatory and supervisory frameworks over financial

institutions were weak in risk-management and the capital

adequacy along with relatively substandard loan

classification and loan loss provisions. This was apparent

in East Asia and Mexico, where banking supervision

capacity was unable to keep abreast with the swift increase

in the banks» portfolio. In the run up to the crisis, East

Asian banks developed large asset-liability mismatchesƒ

unhedged foreign exchange borrowings invested in less

productive sectors and short-term funds lent long into

property sectors. These factors seem left unnoticed to bank

supervisors that were overwhelmed by the significant

increase in the number of banks, their assets and braches

(Table A1.3 and A1.4).

In addition, the lax of prudential enforcement is

another major deficiency. Prudential rules started to

gradually adopting international best practices when the

crisis was building up, yet the primary deficiencies were in

enforcement. These deficiencies became apparent

particularly on connected lending, when the debtors were

closely-related to political agents and centre of powers

(eg Indonesia). There was undoubtedly political interference

in banks, in terms of both policy lending and pressure on

supervisors not to take action against well-connected

owners of banks. Secondly, financial sector regulators and

supervisors (central bankers) generally lacked

independence, making them susceptible to political

interference and government pressures. Central banks

senior officials in all countries were appointed by the head

of the state or minister. The less independent central banks

were apparent in East Asia countries.

Ineffective market discipline allowed banks and other

financial institutions to take excessive risks. This was

particularly pervasive in South East Asia countries,

Argentina, and Brazil. Inadequate accounting and

disclosure practices had weakened market discipline.

Table A1.6 NPLs in Asia

Distressed Loans

Malaysia June-9 18.1

Sout Korea June-98 32.1

Thailand May-98 47.7

Indonesia March-98 58.7

Month %

Another fundamental problem was weakness in the

infrastructure of business laws that made it difficult for

banks to take and realize collateral and to put insolvent

companies into liquidation. In fact, the ultimate

responsibility for poor lending and risk management

practices must rest with the management of the banks

themselves. Indeed, there have undoubtedly been failures

in supervisory practices, as demonstrated by the reform

measures that are now being put in place in a number of

countries.

Feeble Supervision

With the exception of Argentina and Brazil, the crises

represented the fact that domestic financial systems were

not well-supervised and regulated when financial sector

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Banks tended to conceal related party transactions and

made many attempts to cover such risky transactions.

Nonviable institutions were given forbearance leading to

excessive risk taking, increased moral hazard, and this

conditions prevented market agents from exerting

discipline. Consequently, market participants did not

identify the weaknesses and had no access to predict the

crisis.

Moral hazard problems might emerge in some

countries as they have government guarantee schemes to

individual financial institutions that left bankers to take

inappropriate risk taking. Also, for those having no

government guarantee, authorities of these countries

pursued the constructive yet ambiguous guarantee scheme

by adopting the notion ≈too big too fail∆. Hence, big or

state-owned banks even technically insolvent were

recapitalized even before the crises erupted. Bank

management can afford to indulge in reckless lending

behaviour because they believe that government will bail

them out if they fail. Similarly, depositors have less incentive

to check the creditworthiness of the banks with which

they place funds.

5. Corporate Sector Weaknesses

Corporate sectors also exhibited weaknesses

predominantly on their liabilities side and poor accounting

practices. Corporations especially in East Asia were

generally highly leveraged and were granted substantial

amount of offshore borrowings which were un-hedged

in the eve of the crises. These weaknesses were

transmitted to financial sector via three primary channels:

(1) defaults leading to NPLs dramatic hikes on

consolidated basis; (2) infringement of loan covenants

leading to a significant downgrade of debtors business

prospect and higher loan loss provisions; (3) high foreign

exchange risk exposure, in which a sizeable portion was

in a form of short-term borrowings. This problem was

aggravated by difficulties in seizing and foreclosing

collaterals due to a number of adverse legal issues and

significant drop in collateral value.

Graph A1.3Average Debt to Equity Ratio (1988-1996) (%)

0.00

50.00

100.00

150.00

200.00

250.00

300.00

350.00

400.00

222.40

110.30

211.50

377.60

115.00

45.00

140.00

110.10

Thailand Malaysia Indonesia Korea Philippines Argentina Brazil Mexico

Graph A1.4Short and Long-term Leverage of Corporations in Asia

0.00

20.00

40.00

60.00

80.00

100.00

120.00

67.10 72.9058.20 59.60 51.20

32.90 27.1041.80 40.40

48.80

Thailand Malaysia Indonesia Korea Philippines

(1988-1996) ST Debt (%)(1988-1996) LT Debt (%)

High leverage posed corporations in emerging

markets to a high degree of risk. In the aftermath of most

liberalization in merging countries, corporate sectors

responded with high rates of investment. However, they

were substantially dependent on external sources of funds

to make up for the lack of capital from shareholders» equity

and retained earnings. In other words, corporations in these

countries have always relied on high levels of external

financing, primarily from the banking system. By looking

at Asia, the most highly leveraged corporate sector was

that of Korea followed by Thailand and Indonesia. Similarly,

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the case of highly leveraged corporate sector was found

in Brazil followed by Mexico, primarily due to banks.

Corporations in emerging markets had greater reliance

on short-term debt, predominantly in Malaysia and

Thailand. Nevertheless, the highly dependence on banking

sector is a common feature in emerging markets, where

the vast majority of their capital markets are

underdeveloped; hence banks are the primary

intermediation channels.

Corporations also exercised poor transparency and

accounting practices. A study by La Porta et al (1998) and

report by IMF (1999) revealed that relatively weak and poor

disclosure standards of East Asian corporations allowed

them to conceal their actual financial positions even they

were not financially viable. There were three major poor

practices: first, hidden high corporate leverage especially

those referring to related-party transactions and off-

balance sheet financing; secondly, high-level foreign

exchange risk exposure by corporations and banks

exposure resulting from large, short-term borrowing in

foreign currency was not being reported properly; and

third, profitability might be overstated to attract more

lending from banks. In Thailand, for example, an increase

in corporate leverage in 1995 and 1996 was correlated

with declines in profitability, meaning that poor financially

managed firms were increasingly dependent on external

financing to accommodate declining revenues (Claessen

et al, 1998). In most countries, even operationally viable

firms were highly indebted, and banks tended to extend

loans for resolving their problems. As a result, technically

insolvent corporations were not being disciplined to declare

bankruptcy.

Ownership structure contributes to the weak

governance and excessive risk taking by corporations. In

East Asian countries, banks and financial institutions often

belong to non-financial conglomerates, that use their

financial wings to absorb public deposits to overcome the

insufficiency of their own source of funds. Claessen et al

(1998) showed that about two-third of publicly listed

companies in East Asia belongs to larger groups, that many

of them had one or more financial institutions. This had

led corporations to take excessive risks and debts. Market

allocation of resources then became inefficient, as this

extensive corporate-bank links made funds easily accessible

for solely influential borrowers. Governments, which utterly

controlled state-owned banks, also often influenced banks

and financial institutions to grant preferential access for

special projects and firms, which some were not financially

viable. Government exercised their political power to

lending decisions. These were used to be apparent in most

East Asian countries, where government and business

groups (eg. chaebols) influenced lending decisions. The

fact that all state-owned banks CEO were appointed by

government with their political dimensions without taking

any consideration to their ≈fit and proper∆ record led banks

to leaning towards government influence. This case was

apparent in Mexico (Gil-Diaz, 2001) and the East Asian

crisis-hit countries. ≈

6. Lack of Policy Credibility

Considering the imbalances, emerging countries have

persistent difficulties in managing large stock of external

debts as well as the current account and fiscal deficits. A

large stock of debt usually the product of large past deficits

and emerging countries with large macroeconomic

imbalances often have difficulties in choosing financing

option that would limit their exposure to crises. In

Argentina and Mexico, for instance, the ongoing fiscal and

current account deficits have led to concerns with regard

to their credibility to reduce persistent imbalances to avoid

unsustainable debt accumulation.

The persistent solvency problem in some emerging

countries (e.g. in Argentina) -reflected in ratios of external

debt and public debt to GDP- had never been successfully

Article I

21a

reduced overtime. In other words, some countries have

failed to run a stable debt ratio. On the other hand, some

economies have never been able to generate large primary

surplus to stabilize their debt ratio, as their revenues

declined while interest payments have tended to increase

overtime.

7. External Factors

Although internal weaknesses were apparent,

external shocks did play role in precipitating the crisis. In

Asia, the sharp rise in the value of the dollar that began

two years prior to the crisis had a major impact. The rising

dollar induced substantial exchange rate appreciation for

the crisis countries because, as estimates of basket

weights indicate, they were tying their currencies closely

to the dollar by giving the dollar heavy weight. The result

was significant slowdowns in export growth that probably

contributed to the region-wide crisis. Additionally, the

Chinese devaluation of 1994 and the prolonged Japanese

recession were also two factors. China and Japan reduced

imports from Southeast Asia, and China undercut exports

of similar products of the crisis-hit countries. In Mexico,

a substantial rise in U.S. interest rates was one of the

most important triggers. In Argentina, Brazilian

devaluation in 1999 stumbled its economy country to a

heavy crisis.

POLICY LESSONS

Prompt responses to balance sheet weaknesses will

be the first line of defence to prevent capital account crises

like many emerging markets have experienced. Sectoral

balance sheet weaknesses can be addressed by high-level

preventative measures in all sectors:

a. The crises have shown the drawbacks of the monetary

and financial surveillance system, particularly in most

Asian countries. Therefore, strengthening both macro

and micro prudential surveillance is a very

fundamental issue. Micro-prudential supervision,

which includes all on and off-site surveillance of the

safety and soundness of individual institutions, has

the focus on the soundness of individual financial

institutions (Crockett, 2000). While macro-prudential

surveillance, aiming at monitoring the exposure to

systemic risk and at identifying potential threats to

stability arising from macroeconomic or financial

market developments, and from market

infrastructures.

b. The crises have shown that central banks have

overlooked structural vulnerabilities in their financial

system. As regulatory structures have aggravated

emerging financial crises, it is essential for all central

banks to strengthen regulatory and supervisory

frameworks as part of their macro-prudential

activities. In addition to that, central banks need to

shift more attention to capital markets and the need

to prevent costly financial crises.

c. Real sector (household and corporate) are the first

line of defence in preventing balance sheet

weaknesses. In the first level, household must exercise

prudence in managing their expenditure and their

debts to financial institutions. Corporate sector must

prudently manage their balance sheet against shocks.

This may include equity formation to achieve a

reasonable level of leverage, better debt

management, and most importantly better corporate

governance. Corporations must pay attention to

manage secure level offshore debts and maintain

liquid assets both in local and foreign currencies that

can provide adequate buffers to withstand liquidity

shocks. Corporations must also adopt hedging

strategies that will mitigate risks arising from currency

volatility.

d. Financial institutions, particularly banks, must be

extremely vigilant to all risks that may arise as result

Article I

22a

of maturity and currency mismatches. Therefore,

effective risk management is a must. Also, banks and

similar financial institutions must meet regulatory

requirements for risk measurement and capital

adequacy (e.g. Basel capital standards for banks). Non-

bank financial institutions must also be adherent to

effective mitigation of currency and maturity

mismatches and implement effective risk

management. Financial authorities must provide

incentives for banks and financial institutions to

manage risks better.

e. Governments must ensure that public debts are well-

managed and well-structured. They must also concern

that public sector indebtedness remains on a

sustainable path and that a credible strategy is in place

to reduce excessive levels of debt. Debts must be well-

structured in terms of maturity, currency, or interest

rate composition. Balance sheet risks in national level

can be addressed by keeping debt at prudent levels

and by maintaining adequate reserve levels therefore

a country can insulate itself against shocks into their

debt structure.

f. Authorities must provide strong incentives to promote

quality corporate finance. Incentives favouring debts

over equity must be eliminated and deposit insurance

must be limited and explicitly stated so that they do

not distort economy and burden government with

implicit contingent liabilities. Authorities must

encourage the development of markets for hedging

instruments and therefore provide incentives allowing

corporate sector to finance themselves in such ways

that will avoid large balance sheet mismatches.

g. For growth, most emerging countries will probably

stay to rely on external savings. In turn, external

savings would raise domestic investment and growth

and stimulates savings that eventually contribute to

the elimination of net foreign debt. Therefore, foreign

direct investment must be driven by long-term

profitability expectations, it is less dependent on

financial market sentiment than debt or portfolio

equity flows.

h. Liberalization maybe desirable, but must be

undertaken carefully. Proper sequencing is

important. As Wyploz»s study (2001) shows,

liberalization in developing and developed nations

has a very contrasting result. In the developed

economies it tends to be less risky, while developing

economies tend to have more vulnerability after

undertaking liberalization. Therefore, proper

economic conditions that is achieved before

liberalization will avoid unnecessary vulnerabilities

in the financial markets.

CONCLUSION

Some prominent factors have precipitated crises in

emerging markets:

• First, the existence of boom distortions with overly

optimistic expectations by investors, underpinned by

inflexible exchange rate regime and the sustainable

interest differentials between mature and developing

economies. Private and government sectors spending

booms, fuelled by overborrowing, have increasingly

led to twin banking and currency crises in many

emerging markets. Capital inflows have always been

attracted by financial liberalizations and by fixed

exchange rate regime contributed to lower perceived

exchange rate risk.

• Second, the weakening of market discipline in feeble

domestic financial institutions and corporate sector

as a result of heavy capital inflows and poorly-

designed financial liberalisation.

In the absence of strong supervisory frameworks,

these combinations have repeatedly turned sour to sectoral

and national balance sheet problems.

Article I

23a

Financial systems of emerging countries have tended

to be to feeble too absorb significant amount of capital

inflows, resulting in declining asset quality and financial

vulnerability. This condition will be a fertile ground for a

crisis should market discipline is sub-optimal and

supervision is poor. As long as herding behaviour remains

a prominent feature of global capital markets, emerging

countries even with strong macroeconomic fundamentals

are advised to pay close attention to indicators of financial

vulnerability, in particular to short-term debt/reserve levels

as well as to currency and maturity mismatches.

To avoid crisis of from a recurrence, emerging

countries must pay closer attention to:

• Developing knowledge and information of the type

and magnitude of sectoral balance sheet mismatches

that will help in crafting effective policy measures for

crisis prevention;

• Resilient financial sector with high quality of market

discipline are two keys of preventing financial

instability. Only with reliable accounting systems and

disclosure requirements to ensure transparency will

it be possible to strengthen bank and non-bank

balance-sheets and to enforce prudential regulation

through serious, internationally adaptive, and

independent supervisory arrangements;

• Albeit the ≈wish list∆ is long, and has been

lengthening (Goldstein and Turner, 1996), the vital

components for effective enforcement of prudential

regulation will at least comprise of:

a) adherence to international standards, most

importantly those related to capital adequacy;

b) independent central banks. Central banks also

need to strengthen both macro and micro

prudential surveillance as the crises have shown

the drawbacks of the monetary and financial

surveillance system.

Article I

24a

Table A1.7Prominent Empirical Study of Financial Crisis

No. Study By Year Objectives Sample Variables Findings

1 Asli Demirguc-Kunt and 1997 To observe determinants 65 developing countries Interest rates, Loans, Terms Countries with low growth and high inflation,

Enrica Detragiache of systemic banking crisis of Trade, Budget Deficit, M2 high interest rates will confront higher prob -

/Reserve, GNP per capita ability of financial crises. As well , crises will

occur in a country whose law and order is

weak

2 Asli Demirguc-Kunt and 1998 To observe the impact of 53 developing countries Interest, Loans, TOT, Budget Financial liberalization will increase the likeli -

Enrica Detragiache financial liberalization on Deficit, M2/Reserve, GNP hood of a crisis, unless financial system is strong

financial stability per capita, liberalization

dummy variable

3 Asli Demirguc-Kunt and 2000 To observe the impact of 61 developing countries Interest, Loans, TOT, Budget Explicit deposit guarantee will increase the

Enrica Detragiache various explicit deposit Deficit, M2/Reserve, probability of financial crisis, particularly in a

insurance schemes on GNP per capita, dummy country whose financial sector is weak.

financial stability variable for deposit

guarantee

4 Barry Eichengreen and 2000 To observe the impact of 110 developing Reserves, debts, current A country will confront higher probability of

RoseΩ exchange rate regime on countries account deficit, budget crisis, should bank fails to intermediate loans

the probability of deficit, exchange rate and if exchange rate regime is inconsistent in

financial crisis regime, GDP/Capita, application

Growth, dummy variables

for exchange rate regime

5 Glick and Hutchinson 1999 To observe the cause of 90 countries GDP Growth, inflation, Emerging countries have a greater likelihood of

banking and currency dummy variables for twin crisis particularly after financial

crises. Measure of currency and banking crises liberalization

individual and twin

occurrence of crisis

6 Gourinchas, Valdes and 1999 To observe the impact of 91 developing countries GDP gap, banking and Lending booms will increase the probability of

Landerretche lending growth to currency crisis, real interest balance sheet problems and BOP crisis

financial crisis and to rate, inflation, current

identify the stylized facts account deficit, real

about lending booms effective ER, capital flows,

ST debt, terms of trade

7 Hardy and Pazarbasioglu 1998 To determine the signifi- 38 countries GDP growth, consumption A country will confront crisis if there is

cance value of leading growth, investment growth, persistent slowdown in GDP growth, capital

indicators in predicting deposits, loans, foreign inflows, ICOR, and real exchange rates. In

crisis, particularly in the currecny liabilities, inflation, addition, it will also confrint crisis if TOT

aftermath of Asian crisis REER,TOT deteriorated

8 Kaminsky and Reinhart 1998 To observe the links 20 countries M2 multiplier, loans, interest Banking crisis will precede currency crisis, the

between currency and rates, TOT, M2/Reserve, converse will not be true. As well, financial

banking crisis deposits, RER, GDP growth, liberalization will precede banking crisis

government budget deficit

Article I

25a

Table A1.8S&P Sovereign Credit Rating

Emerging Asia:Emerging Asia:Emerging Asia:Emerging Asia:Emerging Asia:Thailand A BBB - BBB -Malaysia A+ A BBB -Indonesia BBB B CCC+Philipines BB+ BB+ BB+Korea AA- B+ B+

Latin America:Latin America:Latin America:Latin America:Latin America:Brazil BB- BB - B+-Argentina BB BB BBMexico BB BB BB

Rating Rating LowestJuly 1, 1997 January 31, 1998 During 1998

Rating Rating LowestJuly 1, 1997 January 31, 1998 During 1998

Table A1.7Prominent Empirical Study of Financial Crisis (cont.)

No. Study By Year Objectives Sample Variables Findings

9 Rossi 1999 To observe the links 15 developing countries GDP growth, interst rates, A country with feeble prudential supervison,

between capital account inflation, M2/Reserve, higher deposit insurance, and lax of control on

liberalization, prudential TOT, inflation, credit, outflow will have greater probability of

supervision, and financial GDP per capita, exchange financial crisis

crisis rate control, prudential

regulatory and super-

visory regimes.

10 Mendis 1998 To observe the effect of 41 developing countries Capital inflows, TOT, M2/ Countries with peg exchange rate are exposed

TOT shocks, capital flows reserve, debt, inflation, to greater probability of crisis

and interaction of RER, exchange rate regime

exchange rate regime

Sumber : BIS, IFS

Source: Standard and Poor»s

Article I

26a

Allen, M, R Rosenberg, C Keller, B Setser, and N Roubini,

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Borio, C (2003):∆Towards a macroprudential framework

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Borio, C and P Lowe, (2002):∆Assessing the risk of banking

crises?∆, BIS Quartely Review, pp. 43-46, Basel,

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Beck, T, Demirguc-Kunt, A and Levine, R (2003) : ≈Bank

Concentration and Crises∆, NBER Working Article

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Calomiris, C (2003): ≈Lessons from Argentina and Brazil∆,

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Corsetti, G (1998): ≈Interpreting the Asian financial crisis:

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Corsetti, G, P Pesenti and N Roubini (1999): ≈Article Tigers,

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Chang R and A Velasco (1998): ≈Financial crises in

emerging markets A canonical model∆, NBER

Working Article, no 6606, Boston, MA

Claessens, S, P Alba, and S. Djankov (1998): ≈Thailand»s

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and Stefan Koberle, eds., Competitiveness and

Sustainable Economic Recovery in Thailand,

Washington DC: World Bank.

Claessens, S, S Djankov and L C Xu (2000): ≈Corporate

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World Bank Research Observer, vol 15 no 1, February,

pp 23-46.

Claessens, S, D Klingebiel and L Laeven (2003): ≈Financial

Restructuring in Systemic Crises: What Policy to

pursue?∆ in M Dooley and J Frankel, eds. Managing

Currency Crises in Emerging Markets, The University

of Chicago Press, Chicago, IL.

Claessens, S, D Klingebiel and L Laeven (2003): ≈Financial

Restructuring in Systemic Crises: What Policy to

pursue?∆ in M Dooley and J Frankel, eds. Managing

Currency Crises in Emerging Markets, The University

of Chicago Press, Chicago, IL.

Crockett, A (2000): ≈Marrying the micro- and macro-

prudential dimensions of financial stability∆,

Remarks before the Eleventh International

Conference of Banking Supervisors, held in Basel,

20-21 September.

Demirgüc-Kunt, A, E Detragiache and P Gupta (2000):

≈Inside the Crisis: An Empirical Analysis of Banking

System Distress∆, IMF Working Article, No. 156,

October, Washington DC.

Devlin, R, R. Ffrench-Davis and S Griffith-Jones (1995);

≈Surges in Capital Flows and Development: An

Overview of Policy Issues∆in R. Ffrench-Davis and S

Griffith-Jones (eds) Coping With Capital Surges: Latin

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Reinned, Boulder and London

Eichengreen, B and C Arteta (2000): ≈Banking crises in

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Article I

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Center for International and Development Economics

Research Working Article, August.

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the predictive porwer of measures of financial

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Working Articles, no. 22 pp. 233-239, Basel, April

14.

Gavin, M and R Hausmann (1996): ≈The Roots of Banking

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and L Rojas-Suarez (eds), Banking Crises in Latin

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pp.27-63

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Crisis∆ The Cato Journal , Vol.17, No.3, Spring/

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Crises: How Common Are Twins?∆, Federal Reserve

of San Francisco and UC Sants Cruz.

Gourinchas, P-O, R Valdes and O Landerretsche (1999):

≈Lending Booms: Some Stylized Facts,∆ Princeton

University and Central Bank of Chile, August.

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of Banking Crises: Was Asia Different?∆, IMF Working

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Developing and Transitional Countries: Diagnosis and

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Article II

29a

The property sector has both direct and indirect effects on banking conditions. Historical experience has

shown that the dynamic cycle of the property industry can influence banking stability and macroeconomic

conditions. Irrational property industry development coupled with speculation tend to propagate asset bubbles,

which disrupt the national economy, including banking stability. Therefore, it is imperative to be knowledgeable

with the dynamic financing behavior of the property industry, particularly during the post-crisis period.

Article II

Post-Crisis Financing Behaviour In The Property Industry:Survey Result

Gantiah Wuryandani, Martinus Jony Hermanto, Reska Prasetya

INTRODUCTION

In general, the property industry follows a similar

trend as national economic growth. Enhancements in

property industry signals, as leading indicators, reflect the

recovery of economic activities. Nevertheless, the

development of the property industry has to be monitored

carefully since it can have polar outcomes. On the one

hand, the property industry can be a catalyst to stimulate

economic activity because an increase in property sector

activity directly boosts various activities in other related

sectors through a multiplier effect. All economic activities,

both goods as well as services, in essence require products

from the property sector as one of their production factors.

As a consequence, the demand for products from the

property sector always rises in harmony with economic

growth.

On the other hand, an irrational property industry

may spur negative impacts on the economy. An

oversupplied but uncontrolled property sector may lead

to disruptions in the national economy triggered by a

plunge in property prices, particularly when the bubble

bursts. This situation affects financial stability in two key

areas, namely disturbances in liquidity and banks» collateral

value, as well as debtor performance. Liquidity problems

and decreasing collateral will reduce a bank»s capacity to

mitigate non-performing loans. This trend may lead to

financial system instability and will eventually harm the

national economy as a whole.

Experiences in Indonesia and other countries have

proven that boom-bust growth in the property sector

explicitly affects financial stability and eventually impinges

on macroeconomic stability. During the pre-crisis period,

Article II

30a

property developers expanded significantly, financed by

banks. As the Crisis occurred, sharp rupiah depreciation

coupled with sky-rocketing interest rates devastated

property developers and triggered a collapse in the property

industry. Post crisis, bank financing in the property industry

was suspected to be less dominant. However, further

research is required to identify whether banks» financing

still plays a role in the property industry through developers

(supply). Furthermore, which credit risks are associated

with the property industry and their implications on

financial system instability should be observed.

Information and data collection is carried out

through surveys of three groups of respondents, namely

developers, customers and banks, chosen based on non-

random purposive sampling. The survey covers eight major

cities considered to have dynamic property markets based

on the value of property credit allocated to that area,

namely Jabotabek, Yogyakarta, Semarang, Surabaya,

Makassar, Medan, Batam and Palembang. Although Bali

also has a dynamic property market, it is excluded from

the survey due to the relatively small amount of banking

credit data and its majority non-resident ownership. The

survey was conducted in 2005 and focused on post-crisis,

property sector activities.

PRODUCTION AND SELLING

The property industry was rejuvenated in 2000 and

has grown rapidly since. The residential property market

has grown significantly each year and this trend is predicted

to persist as the need of housing arises along with the

growth in population. Concentrated property industry

activities are found in Jabotabek and major cities in Java

such as Surabaya.

During the post-crisis period, property sales tended

to be in the form of pre-selling (the indent system) with

down payments and installments. The share of pre-selling

accounted for around 75% of every property segment,

excluding shopping malls and office buildings. Conversely,

post-selling (in-stock property product) only makes up

around 20-25%. Post-selling is less preferable due to

financing problems and the high risks involved with

stockpiling property. Experience during the pre-crisis and

crisis period forced developers to innovate property sales

through pre-selling, which enabled guarantees with lower

risks and cost of inventory. In addition, developers were

able to partially finance production through down

payments from customers.

Property purchases are dominated by both bank

credit and installments; cash only accounted for 25%. Cash

purchases are supported by developer policy which

provides buyers with soft cash payments (with an extensive

installment period of up to 24 months). The average

payment installment period is 6 to 8 years for residential

Graph A2.1Production of Property Industry

0 5,000 10,000 15,000 20,000

1999

2000

2001

2002

2003

2004

OfficeIndustrial EstateShopping MallRetailApartmentHouse > 70 sqmHouse < 70 sqm

Unit

Graph A2.2Growth of Property Industry

5.6

25.8827.8

35.75

30.9

0

5

10

15

20

25

30

35

40

45

50

2000 2001 2002 2003 2004

%

Article II

31a

is also financed through joint ventures among developers.

The scheme of this financing combines financial sources

with other fixed asset sources, such as land. The proceeds

are then divided according to the initial agreement. Under

such conditions, the marketing and selling of property can

be performed by two different developers.

In general, financing property through credit allocation

constitutes a medium-term (1-5 years), and is dominated

by the residential and small office/home office (SOHO)

segments. The credit installment ratio over income remains

under the normal limit, 20-30% on average, for all types of

property, except industrial zones. For industrial zones, the

credit installment ratio over income is far greater than for

all other types of property. Stagnant investment is suspected

to have triggered this tendency, and consequently, industrial

property selling and leasing is becoming unprofitable. These

conditions, if persistent, could raise the probability of default.

Graph A2.3Marketing System of Property Product

4263

4570

5096

5635

6958

9448

12087

12479

15333

17721

23318

28966

0 5000 10000 15000 20000 25000 30000 35000

1999

2000

2001

2002

2003

2004

Unit

Pre Selling

Post Selling

Graph A2.4Method of Payment

2764

3207

3727

3915

4528

7620

9588

9842

12700

15437

21742

26786

0 5000 10000 15000 20000 25000 30000

1999

2000

2001

2002

2003

2004

Unit

Installment

Cash

properties of less than 70 m2, whereas a relatively shorter

installment period, around 6 to 6.5 years, is given to

residential properties of greater than 70 m2. This

demonstrates that the credit and installment systems

provide opportunities for the low-income population to

purchase property due to the longer installment period.

Therefore, customers bare less of the burden and banks»

credit performance is maintained.

Insufficient capital prompts developers to apply for bank

credit, however, interest rates are not the major factor.

Nonetheless, as capital is insufficient, developers still review

interest rate variables when applying for credit. Other

significant variables upon applying for credit are security, the

political environment, legal assurance and company revenue.

PROPERTY CONSUMPTION

The majority of property consumption is in the form

of residential and SOHO. Residential property consumption

grew very significantly after 2000, which indicated bold

SOURCES OF PRODUCTION FINANCING

The share of self-financing in property production

has increased to around 60-80%, supplemented by a down

payment of around 20%. In addition, financing from banks

has shrunk to 20-30%. Financing through non-bank

financial institutions is insignificant. Property production

Table A2.1Ratio of Installment to Revenue

Type of Property

House < 70 30.78House > 70 29.67Apartment 21.25Retail 27.61Shopping Mall 23Industrial Estate 60

%

Article II

32a

rejuvenation of the property industry. Lower inflation and

rupiah appreciation supported this inclination. Property is

now considered as a promising investment outlet, coupled

with the fact that purchasing power has recovered.

However, property consumption slumped in 2001 but was

followed by significant increases through to 2004.

2004, with the majority in the residential segment, whilst

the retail and shopping mall segments remain relatively

insignificant. The residential segment has a 6 to 10-year

credit period, whereas the commercial segment has a

relatively shorter credit period of less than 5 years.

Graph A2.6Purchase Through Credit

1999 2000 2001 2002 2003 20040

20

40

60

80

100

120

140

160

180

Shopping Mall

Retail

Apartment

House > 70 sqm

House < 70 sqm

Thousand Units

Graph A2.5Purchase of Property

1999 2000 2001 2002 2003 20040

20

40

60

80

100

120

140

160

180

200

Thousand Unit

ApartmentHouse < 70 House > 70

Retail Shopping Mall

Graph A2.8Source of Financing of Property Customers

0

20

40

60

80

100

%

House < 70 House > 70 Apartment Retail Shop.Mall

Loan from Non Bank Bank Loans Equity

Graph A2.7Cash Payment

0

10

20

30

40

50

60

1999 2000 2001 2002 2003 2004

Soft CashHard Cash

%

Property purchases can be made through both cash

and credit. Cash is classified as hard cash with a short

installment term or soft cash with a longer installment

term. Soft cash payments are slightly dominant over hard

cash. Hard cash payments are preferred when inflation

drops, the rupiah appreciates and residential inflation is

low enough to support consumer liquidity. Furthermore,

credit purchases precipitously increased during 2003 and

SOURCES OF CONSUMPTION FINANCING

Consumer financing to purchase property,

particularly in the residential segment, primarily originates

from mortgages besides personal funds. In the apartment

segment, personal funds are preferable to mortgages,

whereas the SOHO segment prefers the opposite. The

shopping mall segment favors non-bank financing. The

share of bank financing in property consumption lies

between 40-60%. Mortgages tend to be medium to long

Article II

33a

Graph A2.9Credit Tenor

term, whilst commercial property credit is more likely to

have a short to medium term.

Credit installment ratio over income on average

covers around 25-30%, with the highest ratio of 32% for

the retail segment. This ratio is relatively secure since it

indicates sufficient repayment capacity of debtors. Credit

stipulation surfaced more due to insufficient funds (capital)

rather than interest rates. The decision to apply for credit

is predominantly affected by income level (the ability to

repay credit by the customer), interest rates and property

prices. Inflation, the exchange rate and security are also

contributing factors when applying for credit.

apportioned to working capital credit and investment

credit, each accounting for 20%. The portion of property

sector credit in terms of total bank credit achieved 30%;

balanced throughout the country. In general, the number

of banks allocating consumption credit is far greater than

those allocating working capital credit and investment

credit. This demonstrates the reluctance of banks to provide

working capital credit and investment credit in the property

sector. The maturity periods of investment and

consumption credit are generally long term, above 5 years.

Long-term consumption credit represents 80% of total

consumption credit and long-term investment credit

represents 50-60% of total investment credit.

The sources of bank funding to finance the property

sector is primarily from deposits, with only 1% originating

from bonds. Therefore, it is evident that banks still very

much rely on public funds. In the event that a bank loses

its credibility and ≈bank run∆ occurs, inherent vulnerabilities

that will ruin banking stability. However, the vast majority

of depositors lack knowledge of investment alternatives,

other thank banks. Thus, public funds tend to be

concentrated in banks.

Banks» policy regarding the maximum property credit

installment ratio to income is around 36%, with the highest

ratio of 36.7% for working capital credit and investment

Graph A2.10Ratio of Collateral to Income

0 5 10 15 20 25 30 35

%

House < 70 sqm

House > 70 sqm

Apartment

Retail

Shopping

BANK FINANCING

The share of mortgages accounted for 60% of the

portfolio in property sector credit. The remainder is

Graph A2.11Type of Loans in Property Financing

%

0

10

20

30

40

50

60

70

1999 2000 2001 2002 2003 2004

Investment Loans (IDR)

Investment Loans (FX)

Consumption Loans (IDR) Working Capital Loans (IDR)

Working Capital Loans (FX)

0 50 100 150 200 250

Shor

tM

ediu

mLo

ng

Shopping

Retail

Apartment

House > 70 sqm

House < 70 sqm

Thousand Units

Article II

34a

credit, whereas consumption credit is around 35.8%. In

practice, the maximum ratio policy is not fully adhered to

when allocating credit. The realization of the installment

ratio is relatively low, approximately 20-23%, while the

lowest ratio applies to working capital credit. This indicates

that banks are becoming more conservative in approving

property credit.

Graph A2.12Ratio of Installment to Income

36.7 36.7 35.8

22.020.5

23.4

0

5

10

15

20

25

30

35

40

45

50

Investment Laons Working Capital Loans Consumption Loans

Policy Realization

%

Table A2.2Production Plan

Type of Property Product Short Term Medium Term Long Term

House < 70 11,295 61,921 71,383

House > 70 4,196 12,090 14,228

Apartement 5,242 4,596 402

Retail 520 2,069 1,477

Shopping Center 3 30 50

Industrial Estate 10 10 10

Office 66 211 2

UnitUnitUnitUnitUnit

In allocating property investment credit, banks take

into consideration security and political factors, debtor

income and legal assurance. Furthermore, the exchange

rate, interest rates, inflation and prevalent property prices

influence the decision to allocate property credit. Tax is

considered a factor that has less effect on property credit

approval. On the other hand, approvals for working capital

credit and consumption credit are extremely susceptible

to property prices and debtor income. Therefore, in

essence, the credit approval rating applied by banks is

determined by the predicted repayment ability of the

debtor.

PROSPECTS OF PROPERTY AND ITS FINANCING

Property developers plan to expand their efforts

primarily in the residential segment which is expected to

record sharp growth over the medium to long term. High

optimism in the residential segment is related to increases

in the population and the government program to develop

public housing to the tune of 1 million units. In contrast,

the construction of apartments will experience a significant

slump, particularly over the long term. The retail segment

has peaked and thus, short-term expansion is relatively small.

However, it will grow modestly over the medium term but

then will slide again over the long term. Moreover, office

property has begun to rise and will grow significantly over

the medium term. Shopping malls are following a similar

trend to office properties. Unlike any other property types,

industrial zones will remain sluggish due to adverse

economic conditions that have not fully recovered from crisis.

Based on developer perceptions of the property cycle,

in general the cycle remains bullish, more specifically; it is

buoyant with an optimistic outlook. The shopping mall

segment is still growing; however, it is estimated to be

nearing its peak. Conversely, based on net balance,

Article II

35a

respondent perceptions of industrial property show that

strong optimism surrounds the residential segment, whilst

the other segments inspire pessimism. The perception of

industrial property prospects are determined by

macroeconomic conditions, the social and political

situation, security and interest rates. In addition, the

exchange rate is considered insignificant in terms of

property industry prospects.

In terms of consumer perceptions, property will be

purchased over the long term, namely more than 5 years.

This is related to prevailing unfavorable economic

conditions and greater purchasing power over the long

term. Besides consumption, consumers purchasing

property for renting purposes show a rising trend in the

long term, particularly in the residential segment. This is

attributable to the better investment outlet alternative.

Furthermore, the plan to purchase other commercial

properties, such as apartments and shopping malls is

relatively small.

Graph A2.13Cycle of Property Industry (Perception of Producer)

Shop.Mall

Industrial Estate

Office

Apartment

Retail

Housing

Graph A2.14Net Balance of Developer Perception

Industrial EstateShopping centerRetail

Housing < 70 sqm Housing > 70 sqm Apartment

-20

-10

0

10

20

30

40

50

Short Term Medium Term Long Term

Banks» plan to expand; primarily in mortgages rather

than in investment and working capital credit for all terms.

This is supported by the lower credit risk in mortgages

compared to other types of credit, as evidenced by low

NPLs. Moreover, the management of NPLs in mortgages is

less complex as its market is highly liquid. On the contrary,

the plan to allocate working and investment credits in the

short-term will be limited. In the long term, all types of

Graph A2.15Property Buying Plan

0

10

20

30

40

50

60

70

80

Consumption Lease Investment

Short Term (1yr) Medium Term (1-5 yr) Long Term (>5yr)

%

House > 70 sqm

Retail

House < 70 sqm

Apartment

Shopping Mall

Consumption Lease Investment Consumption Lease Investment

Short TermM

edium Term

Long Term

0 2 4 6 8 10 12

Consumption Loans

Working Capital Loans

Investment Loans

Graph A2.16Property Financing Plan

Article II

36a

property credits are projected to increase. This projection

takes into consideration uncertainty in the short-term

economic condition, however, over the long term the

economic condition will improve. In conclusion, banks will

become more conservative in their allocation of property

credits, specifically to developers.

Banks perception of the property cycle shows that

the residential segment is following a bullish trend. In

addition, the apartment and retail segments are moving

towards their respective peak points. Shopping malls,

industrial zones and offices all show a persistent bearish

trend. In the long term, all segments are considered

buoyant and in the short term, only the residential segment

is deemed upbeat. This perception indicates that

investment and production activities are still sluggish.

CONCLUSION

The pattern of financing in the property industry

post-crisis experienced a shift from the pre-crisis situation,

during which time the role of banking in financing the

property sector focused more on consumers than property

developers. This development sparked innovation in

property financing, namely through pre-selling, in which

production only commences after a down payment has

been received, and through hard cash installments. With

these payment schemes, developers are able to eliminate

inventory risk and consumers benefit from a more

manageable payment burden as well as the ability to

monitor the construction process. The advantages for

both parties have driven the development of these

payment schemes.

Banks plan to actively expand mortgages due to

the lower risk compared to other types of credit. Besides,

the non-performing loans of mortgages are more

manageable due to high liquidity in the market.

Furthermore, good margins coupled with lower credit

risk and the prevailing risk-weighted asset policy has

encouraged banks to actively allocate mortgages.

Nevertheless, banks must remain cautious considering

that the performance of mortgages is sensitive to income

and purchasing power, which are affected by

macroeconomic conditions.

REFERENCE

1. Alexander HB, ≈ Ketika Keseimbangan Pasar Terjadi∆,

Properti Indonesia, Juni 2005.

2. Badan Pusat Statistik, ≈Kerangka Teori dan Analisis

Tabel Input-Output∆, Januari 2000.

3. Badan Pusat Statistik, ≈Tabel Input-Output∆ Indonesia

2000, Jilid I-III, PT Berkarya Asa Jaya, 2002.

4. Badan Pusat Statistik, ≈Teknik Penyusunan Tabel

Input-Output∆, Januari 2000.

5. Davis, E Philips & Zhu Haibin, ≈Bank Lending and

Graph A2.18Net Balance of Bank Perception

-12 -7 -2 3 8

Housing < 70 sqm

Housing > 70 sqm

Apartment

Retail

Shopping Mall

Industrial Estate

OfficeLong Term

Medium Term

Short Term

Graph A2.17Cycle of Property Industry (Perception of Banks)

Industrial Estate

Shopping Mall

Office

Apartment

Retail

Housing

Article II

37a

Commercial Property Cycles : Some Cross-Country

Evidence∆, BIS Working Paper No.150, 2004

6. Hoffman, Boris, ≈The Determinants of Private Sector

Credit in Industrialized Countries: Do Property Prices

Matter?∆, BIS Working Paper No.108, 2001.

7. Miller, Ronald E dan Peter D Blair, ≈Input-Output

Analysis-Foundations and Extensions∆, Prentice Hall,

Inc, Englewood Cliffs, New Jersey, 1985.

8. Pusat Studi Properti Indonesia, ≈Kinerja Pasar

Perumahan 2004 dan Prospek Bisnis Properti 2005∆,

Jurnal Properti, Edisi XI tahun 2005-03-02

9. Pyhrr, Stephen A., Stephen E. Roulac and Waldo

L.Born, ≈Real Estate Cycles and Their Strategic

Implications for Investors and Portfolio Managers in

the Global Economy∆, Journal of Real Estate Research,

vol 18 no.1, 1999.

Article III

39a

BACKGROUND

Basel II is a revised framework for capital

measurement and standards stipulated in Basel I (1988)

and its amendments (1996). Its primary objectives are to:

(i) bolster international banking system security and

stability; and (ii) preserve a conducive environment and

level playing field among competing internationally active

banks. Basel II is expected to provide a framework for the

calculation of a bank»s capital adequacy that is more risk

sensitive. Instead of offering a static approach as in Basel

I, Basel II offers flexibility to capital measurement, starting

from a standardized approach to more complex approaches

for calculating risk-weighted assets for credit, market and

operational risks.

In specific areas of Basel II, the supervisory authority

of a country is permitted to apply national discretion

different from that of other countries. This is to

accommodate differences in countries» conditions,

provided that the discretion is consistent with the main

purpose of the Basel II framework. For instance, in the

standardized approach (SA) for credit risk, debtors that

meet the retail criteria are entitled to a risk-weighted asset

of 75%. However, each supervisory authority has to

evaluate whether the risk-weighted assets are deemed too

low, taking into account historical default experience in

the retail segment of that particular country.

This article discusses the suitability of applying risk-

weighted assets of 75% to retail loans, taking into account

retail exposure criteria set in Basel II and default experience

in Indonesia. Furthermore, it also establishes criteria for

retail exposure to be entitled to risk-weighted assets of

75%.

Taking the different statistical and structural conditions of each country into account, Basel II allows authorities

to exercise tailored national discretion. This article briefly provides the results of a study on the possibility of

exercising national discretion in the context of the Indonesian retail banking segment. Based on historical data,

retail loans in Indonesia are suitable for risk-weighted assets of 90%.

Article III

National Discretion of Retail Banking Risk Exposure:The Case of Indonesia

Gusti Ayu Indira, Indra Gunawan, and Minar Iwan Setiawan

Article III

40a

Box A3.1 Retail and Default Criteria in Basel II

a. Retail Criteria

(i)(i)(i)(i)(i) Orientation criterionOrientation criterionOrientation criterionOrientation criterionOrientation criterion √ the exposure is to an

individual person or persons or to a small business.

(ii)(ii)(ii)(ii)(ii) Product criterionProduct criterionProduct criterionProduct criterionProduct criterion √ the exposure takes the form

of any of the following: revolving credits and lines

of credit (including credit cards and overdrafts),

personal term loans and leases (e.g. installment

loans, auto loans and leases, student and

educational loans, personal finance) and small

business facilities and commitments. Securities

(such as bonds and equities), whether listed or

not, are specifically excluded from this category.

Mortgage loans are excluded to the extent that

they qualify for treatment as claims secured by

residential property.

(iii)(iii)(iii)(iii)(iii) Granularity criterionGranularity criterionGranularity criterionGranularity criterionGranularity criterion √ The supervisor must be

satisfied that the regulatory retail portfolio is

sufficiently diversified to a degree that reduces

the risks in the portfolio, warranting the 75% risk

weight. One way of achieving this may be to set

a numerical limit that no aggregate exposure to

one counterpart can exceed 0.2% of the overall

regulatory retail portfolio.

(iv)(iv)(iv)(iv)(iv) Low value of individual exposuresLow value of individual exposuresLow value of individual exposuresLow value of individual exposuresLow value of individual exposures- The maximum

aggregated retail exposure to one counterpart

cannot exceed an absolute threshold of 1 million

euros.

b. Default Criteria

Basel II considers default to have occurred

providing that either one or when either or both of

the two following events have taken place:

1. The bank considers that the obligor is unlikely to

pay its credit obligations to the banking group in

full, without recourse by the bank to actions such

as realizing security (if held).

2. The obligor is past due more than 90 days on any

material credit obligation to the banking group.

Overdraft will be considered as being past due

once the customer has breached an advised limit

or been advised a limit smaller than current

outstanding.

The indicators of obligor»s unwillingness to pay

include:

a. The bank places the credit obligation on non-

accrued status.

b. The bank makes a charge-off or account-specific

provision resulting from a significant perceived

decline in credit quality subsequent to the bank

taking on the exposure.

c. The bank sells the credit obligation at a material

credit-related economic loss.

d. The bank consents to a distressed restructuring

of the credit obligation where this is likely to result

in a diminished financial obligation caused by the

material forgiveness, or postponement, of

principal, interest of (where relevant) fees.

e. The bank has filed for the obligor»s bankruptcy or

a similar order in respect of the obligor»s credit

obligation to the banking group.

f. The obligor has sought or has been placed in a

bankruptcy or similar protection where this would

avoid or delay repayment of the credit obligation

to the banking group.

Article III

41a

DEFINITION AND CRITERIA USED

a. Retail Criteria

This study sets out the following criteria used to

categorize claims as retail exposure:

(i) The claim has a credit limit of Rp500 million;

(ii) The claims are used to finance productive

investment; neither residential mortgage nor small

office/home office (SOHO) are used in the study;

(iii) The obligors are simply a person, persons, small

businesses or private entities, not the central

government, local authorities or state-owned

companies.

b. Default Criteria

This study adopts default criteria as stipulated in

BI Decree number 31/147/KEP/DIR. Under this decree, a

default is deemed to have occurred if:

1. The obligor is past due, exceeding 90 days and/or

is classified as sub-standard, doubtful, or loss;

2. Principle, interest, and other claims are in arrears

when earning assets mature;

3. The obligor fails to meet terms and conditions other

than principle and/or interest payments, which may

lead to default.

Additionally, BI Decree number 7/2/PBI/2005

regarding the Quality of Earning Assets sets out default

criteria as the following:

1. Repayment capacity: principle payment in arrears

exists and/or interest or other claims for at least 90

days, repetitive overdrafts to cover operational

losses and cash flow deficits, deteriorating

relationship between the obligor and the banks,

incomplete credit documentation, poor legal

binding of collateral, and infringement of credit

covenants.

2. Financial statements: low profits, high leverage ratio,

tight liquidity, restrained operating cash flows, highly

sensitive to interest and exchange rates, and deficit

financing cash flows.

3. Business prospects: credit is potentially sub-standard

if the industry and business activities indicate limited

growth potential, are affected by adverse

macroeconomic conditions and by tight competition;

inexperienced management is prevalent; relationships

with affiliate companies and groups burden the

debtor; and/or problems with workers arise.

ASSUMPTIONS

This study is based on the following assumptions:

• Following paragraph 455 of Basel II, the exposure of

an obligor is based on the value per credit facility,

instead of per total facilities granted. Therefore, it is

possible for an obligor, whose credit facilities are more

than one, to remain classified as retail; despite

meeting criteria to be classified in the corporate

segment.

• In this study, the data period covers 4 years and 10

months, from September 2000 to June 2005;

however, Basel II states a minimum 5-year data period.

This is due to a revision in the debtor information

system in September 2005.

• Collateral data from the banking reporting system

does not distinguish between eligible and non-eligible

collateral (defined according to Basel II). For the

purpose of this assessment all collateral data is

assumed to be non-eligible taking into account that

generally, collateral in Indonesia is in a physical form

(physical collateral, classified as non-eligible collateral);

not in the form of cash and securities (eligible

collateral).

• Due to data limitation, for the purpose of this study

it was assumed that there were no written-off

accounts or improving accounts. In other words, if a

positive difference exists between the number of NPL

Article III

42a

accounts in period t over period t-1, then that value

is assumed to be the number of default accounts (see

equation (1)).

CALCULATION METHOD

1. Probability of Default (PD)

a. Framework of Basel II

One-year PD is the probability of a debtor to

experience default in the upcoming 1 year. Banks planning

to adopt the advanced Internal Rating Based (IRB) approach

for credit risk have to apply a valid debtor PD estimation

for each retail bank pool, utilizing 5 years of historical data.

According to Basel II, the PD value for retail exposure is

highest between the 1-year PD of internal borrower grade

and 0.03%.

b. Foundation of Theory

The theory to calculate annual PD is:

c. PD Calculation Method

The banking reporting system is the data source for

the study. This system provides information regarding the

number of accounts for every classification. Category 1

and 2 are classified as performing, whereas 3, 4 and 5 are

classified as non-performing.

The framework to identify the number of defaults in

a particular month is as follows:

Illustration of the Main Principal Framework toCalculate the Number of Default Accounts.

Deterioratingclassification (default)

(+)

( - ) ( - )

Number ofnon-performing

accounts (t)

Number ofperforming

accounts (t-1)

Improvingclassification.

Write off

1-year PD for rating X =

Number of debtors with rating X (at the beginning

of the period) which experienced default by the

end of the period (the subsequent one year)

Total debtors with rating X at the beginning of

the period

To improve accuracy, PD is calculated on a trailing

basis year-on-year for a period of 58 months (September

2000 to June 2005), using the following formula:

Where:

= Trailing 1-month, default rate on month t.

= The number of debtors with good quality credit

(performing) at the beginning of the year, but

experience default in month t.

= The number of debtors with good quality credit

(performing) at the beginning of the year (or in

month (t-11)).

11

11

−

−∑

=t

t

t

t

I

Y

D

tD

tY

tI

Or, in the form of an equation:

NPL of month (t) = NPL of month (t-1) + deterioratingNPL of month (t) = NPL of month (t-1) + deterioratingNPL of month (t) = NPL of month (t-1) + deterioratingNPL of month (t) = NPL of month (t-1) + deterioratingNPL of month (t) = NPL of month (t-1) + deteriorating

classification (classification (classification (classification (classification (defaultdefaultdefaultdefaultdefault) √ improving classification √ ) √ improving classification √ ) √ improving classification √ ) √ improving classification √ ) √ improving classification √ write offwrite offwrite offwrite offwrite off

Or

∆∆∆∆∆ NPL = deteriorating classification (default) √ improving NPL = deteriorating classification (default) √ improving NPL = deteriorating classification (default) √ improving NPL = deteriorating classification (default) √ improving NPL = deteriorating classification (default) √ improving

classification √ classification √ classification √ classification √ classification √ write offwrite offwrite offwrite offwrite off (1)

A positive difference between NPL (t) and NPL (t-1)

will occur if the number of defaults is greater than the

sum of accounts classified as improving plus the written-

off accounts of that month, and vice versa.

To improve accuracy in the NPL calculation, data from

each individual bank was subsequently categorized by type

of loans, namely capital, investment or consumption. For

further illustration, refer to Appendix 1: Example of a

default calculation for Bank A.

The total y-o-y defaults for the industry were

determined based on the sum of y-o-y defaults of each

Article III

43a

bank. This value was then used to calculate the annual PD

of the banking industry (trailing for 58 months). The results

of the simulation using monthly industrial data from

September 2000 to June 2005 are presented in Table 1.

Almost 75% of approximately 12 million retail

accounts in the Indonesian banking industry constitute

consumption credit. Working capital loans and investment

credit represent only 19.95% and 5.13% respectively.

It is interesting to note that consumption credit has

the lowest 1-year PD at 4.58% despite the fact that it is

non-productive. In contrast, investment credit and working

capital credit have larger PD values at 8.30% and 5.22%

respectively. In total, the 1-year PD for retail is 4.89%,

slightly above to the 1-year PD of consumption retail.

2. Loss Given Default (LGD)

a. Framework of Basel II

LGD is a percentage of a bank»s loss in contrast to

the default exposure. In other words, LGD is 1 minus the

recovery rate.

LGD = 1 √ Recovery RateLGD = 1 √ Recovery RateLGD = 1 √ Recovery RateLGD = 1 √ Recovery RateLGD = 1 √ Recovery Rate (2)

For banks which implement a foundation IRB

approach, the LGD value is set by the supervisor: 45% for

senior exposure and 75% for junior exposure (subordinated

exposure). For banks which implement an advanced IRB

approach, Basel II states that banks should estimate LGD

values that reflect a deteriorating economic condition

based on a minimum of 5 years» recovery rate data, not

merely based on collateral market value estimations.

b. LGD Calculation Method

Data extracted from the banking reporting system

to calculate LGD are collateral value and outstanding

exposure for classifications 3, 4 and 5 (non-performing).

The steps necessary to determine LGD are as follows:

i. The industrial LGD value estimated is the average LGD

of all banks throughout the 58-month period.

ii. For each bank, the LGD value is 1 minus the recovery

rate (RR), or LGD = 1 √ RR.

iii. In this study, the recovery rate (RR) is assumed to be

fully based on the residual value received by a bank,

or RR = acquisition value of collateral / outstanding

exposure.

The following assumptions were applied to

determine the recovery rate value:

1. Collateral is assumed to be in a physical form,

excluding financial collateral.

2. The acquisition value is assumed to be 70% of the

collateral market value; the remaining 30% is used

as expenses (for instance lawyers» fees to foreclose

the collateral). This information is in line with common

practices, where a 30% discount may be allotted to

banks which prefer to fire sell or liquidate collateral

immediately.

3. From the above proceeds, a maximum of 100% is

reserved for banks, since any excess will become the

right of the debtor.

An illustration of bank credit LGD calculation

conforming to usage type is available in Appendix 2: An

Table A3.1Annual PD Calculation for Performing Retail Exposure Result

Credit Type Probability of Default Ratio to Total Credit

Working capital credit 5.22% 19.95%

Investment credit 8.3% 5.13%

Consumption credit 4.58% 74.92%

TotalTotalTotalTotalTotal 4.89%4.89%4.89%4.89%4.89% 100%100%100%100%100%

Article III

44a

example of LGD calculation for Credit Consumption of

Bank A. The LGD value is then averaged to calculate the

LGD value for the industry as a whole.

Table 2 shows that consumption credit has the lowest

recovery rate value (highest LGD) compared to working

capital credit and investment credit. On the other hand, the

share of retail consumption credit is the largest. This effect

leads to a relatively large overall retail LGD of 60.33%.

3. Capital Charge

The formula to calculate capital charge is:

Capital charge (K) = LGD x N [(1 - R)-0.5 x G(PD) + (R/(1-

R)0.5 x G(0.999)] √ PD x LGD

While, to calculate risk-weighted asset is:

K x 12.5 x exposure at default (EAD)

For banks adopting the IRB approach, Basel II offers

3 different approaches to calculate capital charge for retail

exposure:

1.1.1.1.1. Mortgage Mortgage Mortgage Mortgage Mortgage exposure satisfies the criteria set forth in

paragraph 231 of Basel II using

Correlation (R) = 0.15Correlation (R) = 0.15Correlation (R) = 0.15Correlation (R) = 0.15Correlation (R) = 0.15

2.2.2.2.2. Qualifying revolving retail exposure Qualifying revolving retail exposure Qualifying revolving retail exposure Qualifying revolving retail exposure Qualifying revolving retail exposure is exposure which

satisfies the criteria in paragraph 234 and is not

default using


3.3.3.3.3. Other retail exposure Other retail exposure Other retail exposure Other retail exposure Other retail exposure is retail exposure that does not

satisfy any of the above categories and is not default.

The correlation is calculated using the following

formula:

Correlation (R) = 0.03 x (1 √ Exp (-35 x PD))/(1 √ ExpCorrelation (R) = 0.03 x (1 √ Exp (-35 x PD))/(1 √ ExpCorrelation (R) = 0.03 x (1 √ Exp (-35 x PD))/(1 √ ExpCorrelation (R) = 0.03 x (1 √ Exp (-35 x PD))/(1 √ ExpCorrelation (R) = 0.03 x (1 √ Exp (-35 x PD))/(1 √ Exp

(35)) + 0.16 x [1 √ (1 √ Exp (-35 x PD)) / (1 √ Exp (-35))](35)) + 0.16 x [1 √ (1 √ Exp (-35 x PD)) / (1 √ Exp (-35))](35)) + 0.16 x [1 √ (1 √ Exp (-35 x PD)) / (1 √ Exp (-35))](35)) + 0.16 x [1 √ (1 √ Exp (-35 x PD)) / (1 √ Exp (-35))](35)) + 0.16 x [1 √ (1 √ Exp (-35 x PD)) / (1 √ Exp (-35))]

For the purpose of this study, it is assumed that retail

exposure data is classified as other retail exposure. This

simplification is due to the limitation of the reporting

system to differentiate between revolving retail exposure

and non-revolving retail exposure. Hence, based on the

formula used in the Other Retail Exposure category, and

the previous result of PD = 4.89% PD = 4.89% PD = 4.89% PD = 4.89% PD = 4.89% and LGD = 60.33%LGD = 60.33%LGD = 60.33%LGD = 60.33%LGD = 60.33%,

the following outcome is obtained:


Capital charge (K) = 0.071

Thus,

Risk-Weighted AssetsRisk-Weighted AssetsRisk-Weighted AssetsRisk-Weighted AssetsRisk-Weighted Assets = 12.5 x K = 12.5 x K = 12.5 x K = 12.5 x K = 12.5 x K

= 12.5 x 0.071

= 88.36% = 88.36% = 88.36% = 88.36% = 88.36%

CONCLUSION

1. Based on data from the past 5 years, the largest

portfolio in Indonesian banking retail exposure is

consumption credit (75%).

2. Based on the usage type, consumption retail exposure

has a lower historical PD compared to retail working

capital credit and retail investment. In other words,

exposure used for working capital and investment

has a tendency of higher default. Overall, banking

retail PD in Indonesia is 4.89%.

3. In accordance with the historical data of collateral

for retail exposure over the past 5 years, the ratio of

Table A3.2Usage Type √ Retail Industry LGD (%)

Working Capital Credit Investment Credit Consumption Credit

Recovery Rate 44,99 43,7 28,54 39,67

Loss Given Default 55,01 56,22 71,46 60,33

UnitUnitUnitUnitUnit

TotalType of Credit

Article III

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collateral value to credit value varies considerably

from bank to bank. Furthermore, retail consumption

credit is generally without collateral; therefore, the

recovery rate of this credit is the lowest. On average,

the Indonesian LGD value for banking retail is

60.33%.

4. The result of risk-weighted assets for other retail

exposure based on the IRB approach is 88.36%.

5. Based on the above historical data, retail credit in

Indonesian banking is not eligible for risk-weighted

assets of 75% (as suggested in Basel II), and therefore,

a minimum risk-weighted asset of 90% is proposed.

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Appendix A3.1Example of Default Calculation for Bank A

Years Months Number ofPerforming Account Working Capital Investment Consumption Working Capital Investment Consumption TOTAL

2000 9 3,692,261 267,407 20,696 26,246 - - 350 350 63,962

10 3,779,638 209,640 20,089 26,596 - - 328 328 63,612

11 3,712,753 135,125 14,045 26,924 - - - - 76,442

12 3,701,748 82,727 5,402 22,831 - - 26,889 26,889 76,442

2001 1 3,618,109 62,229 4,370 49,720 - - - - 58,083

2 3,668,670 60,353 3,853 21,413 845 1,866 - 2,711 58,279

3 3,703,529 61,198 5,719 20,566 7,050 342 2,068 9,460 78,069

4 3,789,318 68,248 6,061 22,634 - - - - 68,609

5 3,688,502 66,646 4,627 20,622 4,574 - - 4,574 69,508

6 3,694,059 71,220 3,704 20,387 2,970 259 749 3,978 66,624

7 3,748,165 74,190 3,963 21,136 - - 14,095 14,095 69,417

8 3,802,293 73,267 3,906 35,231 1,175 402 - 1,577 62,833

9 3,802,547 74,442 4,308 24,350 - - - - 63,388

10 3,659,601 70,131 4,055 20,836 - - 13,158 13,158 82,064

11 3,838,027 51,436 3,845 33,994 - - - - 72,511

12 3,888,929 51,150 3,729 19,784 2,571 - 5,959 8,530 78,892

2002 1 3,868,693 53,721 3,142 25,743 - 196 - 196 73,609

2 3,854,937 52,716 3,338 23,887 - 880 21,621 22,501 98,343

3 3,855,525 51,493 4,218 45,508 - - - - 76,101

4 3,910,756 50,395 3,511 43,177 899 - - 899 77,878

5 3,870,874 51,294 3,501 42,616 1,411 279 - 1,690 97,108

6 3,934,923 52,705 3,780 42,477 4,433 398 1,940 6,771 96,631

7 3,943,494 57,138 4,178 44,417 6,282 1,229 - 7,511 100,280

8 3,948,194 63,420 5,407 43,518 2,075 57 - 2,132 121,518

9 3,928,514 65,495 5,464 41,478 12,776 3,170 2,730 18,676 122,095

10 3,961,482 78,271 8,634 44,208 2,922 178 505 3,605 108,174

11 4,010,898 81,193 8,812 44,713 - 1,628 4,753 6,381 107,807

12 4,085,780 79,832 10,440 49,466 2,606 - 641 3,247 104,383

2003 1 4,073,757 82,438 9,595 50,107 24,930 - - 24,930 101,136

2 4,055,150 107,368 9,484 46,453 - 259 - 259 93,116

3 4,110,310 79,386 9,743 46,354 919 858 - 1,777 93,328

4 4,192,746 80,305 10,601 30,055 13,544 936 5,649 20,129 91,551

5 4,156,785 93,849 11,537 35,704 811 402 - 1,213 101,046

6 4,199,791 94,660 11,939 35,392 4,430 1,264 4,726 10,420 104,012

7 4,231,197 99,090 13,203 40,118 27,691 - 1,058 28,749 95,313

8 4,241,145 126,781 11,689 41,176 - 2,709 - 2,709 67,358

9 4,253,923 126,521 14,398 36,381 3,949 806 - 4,755 64,649

Loan Type Monthly NPLs Number ofDefault Accounts

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Appendix A3.1Example of Default Calculation for Bank A (cont.)

Years Months Number ofPerforming Account Working Capital Investment Consumption Working Capital Investment Consumption TOTAL

10 4,251,960 130,470 15,204 36,287 2,602 636 - 3,238 59,894

11 4,275,666 133,072 15,840 36,163 - 1,526 1,431 2,957 58,113

12 4,385,398 132,508 17,366 37,594 - - - - 55,942

2004 1 4,332,292 125,936 16,785 34,498 16,910 - - 16,910 63,671

2 4,416,685 182,846 13,171 31,330 - 471 - 471 48,702

3 4,412,523 125,765 13,642 30,907 - - - - 60,717

4 4,426,129 121,011 13,482 29,555 21,103 - 8,521 29,624 62,284

5 4,371,535 142,114 13,287 38,076 - 2,191 1,988 4,179 47,489

6 4,427,294 140,610 15,478 40,064 - 732 989 1,721 43,310

7 4,430,332 119,517 16,210 41,053 643 151 - 794

8 4,529,605 120,160 16,361 34,271 - - - -

9 4,645,416 114,261 14,318 33,013 - - - -

10 4,502,731 113,260 11,543 32,293 - 383 1,074 1,457

11 4,528,095 133,095 11,926 33,367 - 786 - 786

12 4,436,073 107,273 12,712 31,586 5,651 - 2,078 7,729

2005 1 4,414,426 112,924 11,911 33,664 213 - 1,728 1,941

2 4,444,749 113,137 11,572 35,392 10,417 - 2,069 12,486

3 4,450,881 123,554 11,411 37,461 - 573 994 1,567

4 4,456,467 118,142 11,984 38,455 - 1,570 13,259 14,829

5 4,505,462 110,690 13,554 51,714 - - - -

6 4,755,803 102,307 11,607 44,343

Loan Type Monthly NPLs Number ofDefault Accounts

For each bank and the respective usage type, the number of accounts is classified into performing and non-performing. The number of default accounts in a particular month is the differencebetween the NPL of t and the NPL of t-1. Total default is the sum of each default of every type of credit. Total year-on-year default is the sum of monthly total default for the consecutive 12months.

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Appendix A3.2.Example of LGD Calculation for Credit Consumption of Bank A

Years Months Outstanding Collateral Procurement Value Capping 100 %(1) (2) (3) = 70% x (2) (4) = min (2) & (3)

2000 9 1,122,743 139,506 97,664 97,664 8.78 % 91.22 %

10 942,597 150,430 105,301 105,301 11.17% 88.83 %

11 583,188 87,758 61,431 61,431 10.53% 89.47 %

12 580,963 75,505 50,754 50,754 8.74% 91.26 %

2001 1 430,178 65,602 45,921 45,921 10.66% 89.34 %

2 540,674 77,616 54,331 54,331 10.05% 89.95 %

3 520,198 75,263 52,684 52,684 10.13% 89.87 %

4 562,109 82,334 57,634 57,634 10.25% 89.75 %

5 501,300 76,722 53,705 53,705 10.71% 89.29 %

6 550,665 87,586 61,310 31,310 11.13% 88.87 %

7 573,829 82,521 57,765 57,765 10.07% 89.93 %

8 529,074 86,078 60,255 60,255 10.18% 89.82 %

9 612,750 74,628 52,240 52,240 8.53% 91.47 %

10 566,858 57,588 40,312 40,312 7.11% 92.89 %

11 297,113 41,290 28,903 28,903 9.73% 90.27 %

12 265,439 133,939 93,757 93,757 35.32% 64.68 %

2002 1 287,706 23,603 16,522 16,522 5.74% 94.26 %

2 326,588 27,618 19,333 19,333 5.92% 94.08 %

3 340,309 31,094 21,766 21,766 6.40% 93.60 %

4 325,188 16,444 11,511 11,511 3.54% 96.46 %

5 414,251 17,514 12,260 12,260 2.96% 97.04 %

6 434,760 18,129 12,690 12,690 2.92% 97.08 %

7 488,759 89,909 62,936 62,936 12.88% 87.12 %

8 477,293 26,316 18,421 18,421 3.86% 96.14 %

9 487,542 29,035 20,325 20,325 4.17% 95.83 %

10 528,408 29,649 20,754 20,754 3.93% 96.07 %

11 546,936 29,876 20,913 20,913 3.70% 93.30 %

12 487,930 20,614 14,430 14,430 2.96% 97.04 %

2003 1 542,448 24,711 17,298 17,298 3.19% 96.81 %

2 585,841 24,434 17,104 17,104 2.92% 97.08 %

3 551,669 25,525 17,868 17,868 3.24% 96.76 %

4 651,588 31,526 22,068 22,068 3.39% 96.61 %

5 846,771 36,500 25,550 25,550 3.02% 96.98 %

6 808,827 42,148 29,504 29,504 3.65% 96.35 %

7 870,832 41,836 29,285 29,285 3.36% 96.64 %

8 949,003 47,882 33,517 33,517 3.53% 96.47 %

Non Performing Loans Adjustment of Collateral ValueLGD

(6) = 1 - (5)Recovery Rate(5) = (4) / (1)

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Appendix A3.2.Example of LGD Calculation for Credit Consumption of Bank A (cont.)

Years Months Outstanding Collateral Procurement Value Capping 100 %(1) (2) (3) = 70% x (2) (4) = min (2) & (3)

9 860,993 47,309 33,116 33,116 3.85% 96.15 %

10 881,851 47,803 33,462 33,462 3.79% 96.21 %

11 836,479 47,789 33,452 33,452 4.00% 96.00 %

12 793,080 41,246 28,872 28,872 3.64% 96.36 %

2004 1 721,506 34,310 24,017 24,017 3.33% 96.67 %

2 851,551 32,974 23,082 23,082 2.71% 97.29 %

3 771,141 35,133 24,593 24,593 3.19% 96.81 %

4 796,467 34,808 24,366 24,366 3.06% 96.94 %

5 880,393 36,184 25,329 25,329 2.88% 97.12 %

6 864,992 29,629 20,740 20,740 2.40% 97.60 %

7 847,429 34,659 24,261 24,261 2.86% 97.14 %

8 830,925 34,720 24,304 24,304 2.92% 97.08 %

9 752,220 33,474 23,432 23,432 3.12% 96.88 %

10 772,871 33,833 23,683 23,683 3.06% 96.94 %

11 803,170 33,467 23,427 23,427 2.92% 97.08 %

12 755,848 33,238 23,267 23,267 3.08% 96.92 %

2005 1 811,526 34,547 24,183 24,183 2.98% 97.02 %

2 817,141 32,055 22,439 22,439 2.75% 97.25 %

3 980,389 36,473 25,531 25,531 2.60% 97.40 %

4 933,824 38,674 27,072 27,072 2.90% 97.10 %

5 947,301 48,273 33,791 33,791 3.57% 96.43 %

6 1,053,409 42,907 30,035 30,035 2.85% 97.15 %

Non Performing Loans Adjustment of Collateral ValueLGD

(6) = 1 - (5)Recovery Rate(5) = (4) / (1)

AverageAverageAverageAverageAverage 5.81%5.81%5.81%5.81%5.81% 94.19 %94.19 %94.19 %94.19 %94.19 %

Documents

Bank Indonesia, Financial Stability Review, No 4 - April 2005