International financial markets have been highly volatile for almost a year now, as the repercussions of the euro zone debt crisis drag on. Meanwhile, weak economic data coming out of the United States have also taken their toll on investor confidence and growth projections worldwide.
Just as at the start of the global financial crisis in 2008, Indonesia will not be immune to a more pronounced downturn, especially as the economies of China and India also start to slow. Despite Indonesia’s relatively strong recent economic performance, and its sound positioning to absorb short-term shocks with conservative fiscal policies and forex reserves at twice the levels seen in 2008, the question on many minds today is: Can Indonesia weather the slowing world economy and financial market turbulence as it successfully did in 2008-09, or could its financial sector start to buckle under the strain, as it did back in the Asian financial crisis of 1997-98?
Indonesia has devoted great attention to improving the stability of its financial sector since the 1997-98 crisis and the flaws it exposed, and it is fair to say that a great deal has been accomplished. The banking sector is much stronger and more resilient to crises now than it was in 1997-98, as proven by the turbulence that tested it in 2008-09. The main reasons the financial sector passed that test unscathed were its sound macroeconomic policies, greatly improved banking supervision and regulation, prudence by bankers themselves and the timely response of authorities at times of stress.
The question is whether Indonesia has done enough to secure the soundness of its financial sector going forward in the current volatile global environment. Of course, this depends to an extent on just how bad that external environment becomes: Are we looking at a possible Greek exit from the euro, or a major euro-zone banking crisis, or both of these mixed in with a stalled US recovery? The answer is that Indonesian policy makers need to assume the worst-case scenario when strengthening the financial sector, not because it will happen but simply because there is a risk it could.
Indonesia’s strong recent financial sector performance has acted as a buffer against real spillovers from recent market instability and demonstrates that no repeat of the 1997 meltdown of the financial sector will happen this time. However, further strengthening of authorities’ ability to address the risks to the sector would be prudent, and potentially crucial, in view of the risks that lie ahead.
Already a number of policies have been put in place to deal with capital outflows, but more measures are necessary to bolster Indonesia’s defenses at this uncertain time.
First, Indonesia needs to put into place a stronger legal basis for its crisis management protocol, and this would in turn require a financial system safety net (FSSN) law to be passed. In the past, the challenge has been to ensure effective cross-institutional coordination at times of financial sector stress.
An FSSN law would provide a stronger legal framework for coordination and rapid decision-making processes to prevent and manage any crisis situation. Such a legal mandate is all the more critical in view of the uncertainty created in the wake of the government bailout of Bank Century in the 2008 crisis and the hesitation that this might cause among senior government decision makers were there to be a similar situation now.
In practical terms, the FSSN law would need effective coordination by a committee, namely a Financial System Stability Forum, consisting of the minister of finance, the governor of Bank Indonesia and the heads of the Indonesian Deposit Insurance Agency (LPS) and Financial Services Supervisory Authority (OJK) . The FSSN law would also provide clarification on how and when emergency liquidity assistance to failed banks could be provided at times of crisis. This would help to mitigate against the kind of misuse of emergency credit that occurred in Indonesia during the 1998 Asian financial crisis.
Second, Indonesia needs to continue to implement the Basel II accords across its banking sector.
Basel II aims to create an international standard that bank regulators can use when creating rules about how much capital banks must put aside to guard against the types of risks they face.
By standardizing the regulations at an international level, consistency is maintained so that this does not become a source of competitive inequality among internationally active banks. Having made good progress so far, Indonesia still has some way to go in this area to ensure that its banking sector conforms to Basel II standards.
At the same time, Basel III has now been published by the Basel Committee. G-20 countries, including Indonesia, have committed to implementing this next stage of international banking regulations starting Jan. 1, 2013.
Third, in Indonesia’s capital markets there is a need for regulators to have adequate enforcement powers with meaningful sanctions for those who digress so that powerful market players cannot unduly influence markets. They would help to improve investor confidence and ensure that Indonesia’s capital markets remain attractive even during the most uncertain of times, when foreign investors tend to become most risk averse.
Fourth, in view of the continuing uncertainty in global financial markets, it is even more important for the authorities controlling Indonesia’s financial sector to avoid policy uncertainty at all costs. Any hint of doubt, hesitation or overreaction among decision makers is likely to undermine already fragile investor confidence. The more institutionalized mechanisms that are in place, the less likely it will be for policy uncertainty to become apparent.
One thing seems clear: In the current volatile environment, although applause for good policy may be muted, there are likely to be serious penalties for bad policy.
Last, the decision to establish the OJK to soon take over the current regulatory and supervisory functions in capital markets and non-bank financial institutions of the Capital Market and Financial Institution Supervisory Agency (Bapepam-LK), followed by the transfer of Bank Indonesia’s responsibilities for the supervision and regulation of the banks, potentially poses risks at such an uncertain time.
So far, Indonesia is to be congratulated on the successful selection of a credible team for the Board of Commissioners to the OJK, but the greatest risks and real challenges lie in the implementation of the transition.
For example, critical supervisory competencies could be lost in the transition. It is therefore crucial to ensure that there is legal and operational clarity on roles and responsibilities, and close coordination among the OJK, Bank Indonesia, LPS and Bapepam-LK. In addition, it is important to ensure that the human capital and institutional knowledge built up by Bank Indonesia and Bapepam-LK is not lost, but transferred to the OJK.
As the experience of 2008 has already confirmed, Indonesia has made great strides in strengthening its financial sector and protecting its real economy from global financial turmoil. However, more remains to be done if Indonesia is to give itself the best possible chance of navigating successfully the turbulence that lies ahead, regardless of the external shocks that may come its way.
P.S. Srinivas is lead financial economist at the World Bank office in Jakarta.