Indonesia
25 October 2011
Indonesia is continuing its march towards becoming a global economic power
Image: Shutterstock
While slowing growth in Asia hits the headlines, some commentators are pointing to bright spots such as Indonesia, where strong fundamentals are prompting economists to forecast a robust economy for the long-term.
In October, the Bank of Indonesia (BI) unexpectedly cut interest rates 0.25 basis points to 6.5 per cent, as the country’s central bank turns more upbeat about the outlook for inflation.
So far this year, Indonesia’s CPI headline inflation rate has been trending downwards and fell to 4.6 per cent in September compared to the same month in 2010. BI expects inflation to be below five per cent at the end of this year and sees it even lower in 2012.
In a recent report, Standard Chartered notes that Indonesia is set to become one of the world’s fastest growing economies – with full potential of eight to nine per cent from a current 6.5 per cent annual growth in GDP - in part due to a rising middle class and urbanisation.
“We expect Indonesia to enter the club of world’s largest economies in 2020 and the top six in 2030,” write Standard Chartered analysts.
In particular, the bank notes that Indonesia’s large domestic market cushions the economy from external shocks and fosters the development of banks, non-bank financial institutions and financial markets.
Indonesia is the world’s largest archipelago, covering over thousands of islands and kilometres along the equator, throwing up challenges in the development of infrastructure to knit the country together, a crucial factor if the “demographic dividend” is to be exploited. The country has one of the world’s youngest populations, with 60 per cent of the population below 30 years of age dominated by a higher concentration of early-age working population.
But the country must overcome various challenges such as bureaucratic inefficiencies and corruption, income and social inequality and, in part because growth opportunities are in the commodities and mining sector, environmental degradation.
At the same time, the financial services industry is expected to become an important beneficiary of growth dynamics and pressing infrastructure needs, and credit penetration is currently low, with a credit to GDP ratio of 32 per cent, compared with 70 per cent in Thailand and 90 per cent in Malaysia.
“We expect consumers and SMEs to be the key drivers of loan growth in the years ahead. We also see considerable growth potential for non-bank financial institutions such as insurers, mutual funds and finance companies. Rising incomes will encourage consumers to seek insurance and investment products in the form of mutual funds. The rise of the middle class will also boost demand for pension products; at the same time, Indonesia’s demographics are likely to remain highly favourable over the next two decades.”
Banking sagas
During the global financial crisis, the bailout of a small commercial bank, Bank Century, exemplified the challenges BI faces when its decisions are exposed to political processes.
The contested 2010 rescue plan devolved into bitter divisions over the fate of pro-market policymakers at the cabinet level, who also faced criminal investigations as a result.
That may not bode well for other complicated political processes that are sure to dramatically alter the banking sector and capital markets, chiefly the planned creation of a new regulatory body, the Otoritas Jasa Keuangan (OJK), based on the British Financial Services Authority (FSA) – legally scheduled for creation last year.
The BI law of 2004 requires the central bank to eventually relinquish its banking regulatory powers to the OJK, which will also incorporate BAPEPAM, the current capital markets regulator. But deadlock between BI, the parliament and the Ministry of Finance (MoF) has delayed the process.
BAPEPAM regulates the securities industry, while the MoF regulates insurers, finance companies and pension funds. However, should the OJK be created, the MoF could also hand over its regulatory responsibilities to the OJK, leaving the MoF primarily to manage fiscal policy.
“A key challenge for both BI and the MoF is the establishment of a crisis protocol that will provide a legal basis for BI, the MoF and the deposit insurance body (LPS) to bail out commercial banks in the next financial crisis, if needed. Without such a protocol backed by a law, regulators and policy makers could be reluctant to act rapidly contain even a minor liquidity crisis, which could spread to a full-blown banking crisis.”
In 1998, the local currency, the rupiah, plummeted amid a strong demand for US dollars starting a familiar downward spiral: nervous lenders refused to refinance maturing loans, investors cut down and then reversed funds flow, borrowers chased dollars followed closely by investors and several banks ran out of dollar notes. A difficult period of transition in the country followed the crisis. Standard Chartered, however, thinks an- other 1998 banking crisis is unlikely.
Equity markets
Using market capitalisation as a best measure of the development of equity markets across countries, Indonesia’s equity market has been one of the fastest growing among other significant economies, at compound annual growth rate (CAGR) of 30 per cent, during the last six years, though it is still notably small at 50 per cent of GDP in 2010, wrote Standard Chartered.
“Between 2008 and 2010, stock-market capitalisation growth has been led by the manufacturing, consumer-goods, and finance sectors. In contrast, the market share of infrastructure stocks has continued to decline, indicating slower growth than the market aggregate. The combined share of basic industry, property and agriculture stocks has remained small, at less than 15 per cent.”
It expects continuing growth in market capitalisation to be driven by three structural forces: corporates’ need for capital to fund growth, a move from labour intensive to capital intensive activities as well as a shift from primarily domestic operators into globally competitive players.
This should increase financing demand across sectors, but especially from high-value manufacturing, consumer-goods, and possibly mining and agriculture companies.
Indonesia has a low level of household and corporate leverage; going forward, banks and NBFIs will need to significantly increase their capital to meet financing demand, and this would typically be done via the debt and equity markets.
“Economic development often goes in tandem with economic reforms, including the privatisation of state-owned enterprises (SOEs)…Unfavourable market conditions and a failure to meet listing requirements are among the main impediments. The Ministry of State-owned Enterprises said in March 2011 that SOEs’ market capitalisation represented only about four per cent of total market capitalisation, compared to their potential to reach a 25 per cent share. As the economy expands, we expect initial and secondary offerings for SOEs to pick up in the years to come.”
Banks and NBFIs
Financial intermediation in Indonesia is low compared to other emerging-market economies, still, Standard Chartered expects significant long-term loan growth potential for the banking sector driven by small and medium sized enterprise and consumer loan growth but also potentially investment related spending, particularly for infrastructure projects.
Meanwhile, non-bank financial institutions (NBFIs) are gradually playing a more important role in Indonesia’s economy, which the MoF classifies as insurance funds, finance institutions and pension funds, instead labelling mutual funds as an asset class.
In its assessment of NBFIs, Standard Chartered notes that assets grew at a CAGR of 21 per cent between 2005 and 2010, while mutual funds recorded a CAGR of 39 per cent and total assets more than doubled in size during the same time frame. “Considering Indonesia’s population growth and rapid economic development, we expect robust growth in NBFIs to last another 10 to 20 years,” notes Standard Chartered.
Insurance is one of the most developed NBFI sectors with growth driven by two independent segments: the government social security programme and private life insurance.
In 2010, the five social and public state-owned insurance funds made up 42 per cent of Indonesia’s total insurance assets in 2010; they are non-competitive, invest in fixed income, and are growing steadily on the back of compulsory annual contributions.
Sec lending market
There is an OTC securities lending market in Indonesia, however, it is unclear what the size and scope of this market is. Brokers can enter into bilateral arrangements with approval from the BAPEPAM as long as they use a standardised agreement.
That is where Indonesian Clearing and Guarantee Corporation (KPEI) comes in. Operating since 2002 and trading since 2004, KPEI received a push as a result of regulatory mandates towards market development for growth and infrastructure.
As the CCP, it provides centralised services through electronic clearing (e-clear) as well as the standardised agreement to borrowers and lenders, which are also members of the clearing facility. Currently, there are 117 clearing members, of which 98 brokers and three custodian banks are participants in the SBL market.
At the moment, it has 118 stocks eligible for SBL from approximately 416 listed stocks on Indonesia’s capital markets, though every month the list is adjusted. Of eligible stocks, 23 are SOEs and 44 stocks are available for short selling.
“We try to eliminate systemic risk in collateral management. The transfer of the collateral is through the CCP…and we guarantee the settlement,” says Hoesen, president and director of KPEI.
Custodians are restricted from being borrowers but have been accepted as lenders to compensate for the fact that insurance, pension and mutual funds are barred from participating in equities-related SBL activities. Moreover, it is primarily a local broker lending to foreign broker borrowing market. Year-to-date, KPEI has seen over 1,450 transactions compared to roughly the same for all of 2010.
Transaction volumes are at some 560 million with a value at around $165 million.
Notably, there are no margin requirements for transactions, instead, the risk management model is integrated between the SBL side and the Indonesian Stock Exchange (IDX) with pooling of collateral. All SBL transactions are collateralised and as a result, transactions are subject to both the size of the lendable pool and the availability of collateral.
Hoesen explains that the system is designed such that any failure to return securities to the lender once they are recalled results in a payment of 125 per cent of the highest price on maturity date to the lender, guaranteed by KPEI through an alternate cash settlement.
At the same time, brokers can borrow securities directly from KPEI to avoid fails but must have an SBL contract to avoid the expensive penalty.
Looking to the future, KPEI’s development plan aims to create supply and demand in the market as the clearer conducts workshops and engages in discussions with regulators and relevant associations on initiatives.
“One initiative is to improve the ETF and derivative markets, so we can provide securities financing through the SBL. We are also looking to include the insurance, mutual and pension funds industries, but at the moment establishing the OJK is the priority for Indonesian regulators. Another initiative is to expand membership to custodians as general clearing members,” Hoesen says, adding that workshops and discussions with BAPEPAM and relevant associations are ongoing.
That multi-tier model of both individual and general clearing members comes from LCH.Clearnet, he explains, while to develop a bilateral scheme for the SBL market, KPEI is looking to the Korean model.
Custodians familiar with the market define the available securities lending activities as “fails related to support custody services”. Though there are plans to expand the role of custodians to become borrowers, for now they behave as settlement agents receiving instruction to transfer shares to KPEI.
DBS Bank (Indonesia) has made the service available to clients for almost a year, but the response has been below expectations.
Endang Triningsih, vice president of Securities Services at DBS, says that client are unsure of KPEI’s role in the market and express concerns over the level of counterparty risk they are exposed to as well as question procedures around timely replacement of shares out on loan.
Triningsih was involved with KSEI, Indonesia’s central securities depository, for seven years prior to joining DBS and participated in the development and implementation of scripless trading and book entry settlement. At that time, she introduced KSEI developments to local and foreign markets.
DBS clients that could benefit from SBL are generally local fund managers she explains. Since pension and insurance funds can only invest in government and corporate bonds by regulation, investment potential is limited.
Still, she notes that the commission is “very attractive”. KPEI charges 15 per cent to the borrower and provides 12 per cent as the commission to the lender. Domestic clients are subjected to a withholding tax rate of 15 per cent and offshore clients are subjected to a withholding tax rate of 20 per cent or other applicable treaty rate.
But to attract clients, more needs to be done she says. “KPEI, as the self regulatory organisation (SRO) and central counterparty, needs to do more education about their role and function in the Indonesian stock market and its development to foreign investors” Triningshih says, “The investors, local or foreign, may understand that actually, SBL could be an investment alternative instead of a settlement risk solution only.”
In October, the Bank of Indonesia (BI) unexpectedly cut interest rates 0.25 basis points to 6.5 per cent, as the country’s central bank turns more upbeat about the outlook for inflation.
So far this year, Indonesia’s CPI headline inflation rate has been trending downwards and fell to 4.6 per cent in September compared to the same month in 2010. BI expects inflation to be below five per cent at the end of this year and sees it even lower in 2012.
In a recent report, Standard Chartered notes that Indonesia is set to become one of the world’s fastest growing economies – with full potential of eight to nine per cent from a current 6.5 per cent annual growth in GDP - in part due to a rising middle class and urbanisation.
“We expect Indonesia to enter the club of world’s largest economies in 2020 and the top six in 2030,” write Standard Chartered analysts.
In particular, the bank notes that Indonesia’s large domestic market cushions the economy from external shocks and fosters the development of banks, non-bank financial institutions and financial markets.
Indonesia is the world’s largest archipelago, covering over thousands of islands and kilometres along the equator, throwing up challenges in the development of infrastructure to knit the country together, a crucial factor if the “demographic dividend” is to be exploited. The country has one of the world’s youngest populations, with 60 per cent of the population below 30 years of age dominated by a higher concentration of early-age working population.
But the country must overcome various challenges such as bureaucratic inefficiencies and corruption, income and social inequality and, in part because growth opportunities are in the commodities and mining sector, environmental degradation.
At the same time, the financial services industry is expected to become an important beneficiary of growth dynamics and pressing infrastructure needs, and credit penetration is currently low, with a credit to GDP ratio of 32 per cent, compared with 70 per cent in Thailand and 90 per cent in Malaysia.
“We expect consumers and SMEs to be the key drivers of loan growth in the years ahead. We also see considerable growth potential for non-bank financial institutions such as insurers, mutual funds and finance companies. Rising incomes will encourage consumers to seek insurance and investment products in the form of mutual funds. The rise of the middle class will also boost demand for pension products; at the same time, Indonesia’s demographics are likely to remain highly favourable over the next two decades.”
Banking sagas
During the global financial crisis, the bailout of a small commercial bank, Bank Century, exemplified the challenges BI faces when its decisions are exposed to political processes.
The contested 2010 rescue plan devolved into bitter divisions over the fate of pro-market policymakers at the cabinet level, who also faced criminal investigations as a result.
That may not bode well for other complicated political processes that are sure to dramatically alter the banking sector and capital markets, chiefly the planned creation of a new regulatory body, the Otoritas Jasa Keuangan (OJK), based on the British Financial Services Authority (FSA) – legally scheduled for creation last year.
The BI law of 2004 requires the central bank to eventually relinquish its banking regulatory powers to the OJK, which will also incorporate BAPEPAM, the current capital markets regulator. But deadlock between BI, the parliament and the Ministry of Finance (MoF) has delayed the process.
BAPEPAM regulates the securities industry, while the MoF regulates insurers, finance companies and pension funds. However, should the OJK be created, the MoF could also hand over its regulatory responsibilities to the OJK, leaving the MoF primarily to manage fiscal policy.
“A key challenge for both BI and the MoF is the establishment of a crisis protocol that will provide a legal basis for BI, the MoF and the deposit insurance body (LPS) to bail out commercial banks in the next financial crisis, if needed. Without such a protocol backed by a law, regulators and policy makers could be reluctant to act rapidly contain even a minor liquidity crisis, which could spread to a full-blown banking crisis.”
In 1998, the local currency, the rupiah, plummeted amid a strong demand for US dollars starting a familiar downward spiral: nervous lenders refused to refinance maturing loans, investors cut down and then reversed funds flow, borrowers chased dollars followed closely by investors and several banks ran out of dollar notes. A difficult period of transition in the country followed the crisis. Standard Chartered, however, thinks an- other 1998 banking crisis is unlikely.
Equity markets
Using market capitalisation as a best measure of the development of equity markets across countries, Indonesia’s equity market has been one of the fastest growing among other significant economies, at compound annual growth rate (CAGR) of 30 per cent, during the last six years, though it is still notably small at 50 per cent of GDP in 2010, wrote Standard Chartered.
“Between 2008 and 2010, stock-market capitalisation growth has been led by the manufacturing, consumer-goods, and finance sectors. In contrast, the market share of infrastructure stocks has continued to decline, indicating slower growth than the market aggregate. The combined share of basic industry, property and agriculture stocks has remained small, at less than 15 per cent.”
It expects continuing growth in market capitalisation to be driven by three structural forces: corporates’ need for capital to fund growth, a move from labour intensive to capital intensive activities as well as a shift from primarily domestic operators into globally competitive players.
This should increase financing demand across sectors, but especially from high-value manufacturing, consumer-goods, and possibly mining and agriculture companies.
Indonesia has a low level of household and corporate leverage; going forward, banks and NBFIs will need to significantly increase their capital to meet financing demand, and this would typically be done via the debt and equity markets.
“Economic development often goes in tandem with economic reforms, including the privatisation of state-owned enterprises (SOEs)…Unfavourable market conditions and a failure to meet listing requirements are among the main impediments. The Ministry of State-owned Enterprises said in March 2011 that SOEs’ market capitalisation represented only about four per cent of total market capitalisation, compared to their potential to reach a 25 per cent share. As the economy expands, we expect initial and secondary offerings for SOEs to pick up in the years to come.”
Banks and NBFIs
Financial intermediation in Indonesia is low compared to other emerging-market economies, still, Standard Chartered expects significant long-term loan growth potential for the banking sector driven by small and medium sized enterprise and consumer loan growth but also potentially investment related spending, particularly for infrastructure projects.
Meanwhile, non-bank financial institutions (NBFIs) are gradually playing a more important role in Indonesia’s economy, which the MoF classifies as insurance funds, finance institutions and pension funds, instead labelling mutual funds as an asset class.
In its assessment of NBFIs, Standard Chartered notes that assets grew at a CAGR of 21 per cent between 2005 and 2010, while mutual funds recorded a CAGR of 39 per cent and total assets more than doubled in size during the same time frame. “Considering Indonesia’s population growth and rapid economic development, we expect robust growth in NBFIs to last another 10 to 20 years,” notes Standard Chartered.
Insurance is one of the most developed NBFI sectors with growth driven by two independent segments: the government social security programme and private life insurance.
In 2010, the five social and public state-owned insurance funds made up 42 per cent of Indonesia’s total insurance assets in 2010; they are non-competitive, invest in fixed income, and are growing steadily on the back of compulsory annual contributions.
Sec lending market
There is an OTC securities lending market in Indonesia, however, it is unclear what the size and scope of this market is. Brokers can enter into bilateral arrangements with approval from the BAPEPAM as long as they use a standardised agreement.
That is where Indonesian Clearing and Guarantee Corporation (KPEI) comes in. Operating since 2002 and trading since 2004, KPEI received a push as a result of regulatory mandates towards market development for growth and infrastructure.
As the CCP, it provides centralised services through electronic clearing (e-clear) as well as the standardised agreement to borrowers and lenders, which are also members of the clearing facility. Currently, there are 117 clearing members, of which 98 brokers and three custodian banks are participants in the SBL market.
At the moment, it has 118 stocks eligible for SBL from approximately 416 listed stocks on Indonesia’s capital markets, though every month the list is adjusted. Of eligible stocks, 23 are SOEs and 44 stocks are available for short selling.
“We try to eliminate systemic risk in collateral management. The transfer of the collateral is through the CCP…and we guarantee the settlement,” says Hoesen, president and director of KPEI.
Custodians are restricted from being borrowers but have been accepted as lenders to compensate for the fact that insurance, pension and mutual funds are barred from participating in equities-related SBL activities. Moreover, it is primarily a local broker lending to foreign broker borrowing market. Year-to-date, KPEI has seen over 1,450 transactions compared to roughly the same for all of 2010.
Transaction volumes are at some 560 million with a value at around $165 million.
Notably, there are no margin requirements for transactions, instead, the risk management model is integrated between the SBL side and the Indonesian Stock Exchange (IDX) with pooling of collateral. All SBL transactions are collateralised and as a result, transactions are subject to both the size of the lendable pool and the availability of collateral.
Hoesen explains that the system is designed such that any failure to return securities to the lender once they are recalled results in a payment of 125 per cent of the highest price on maturity date to the lender, guaranteed by KPEI through an alternate cash settlement.
At the same time, brokers can borrow securities directly from KPEI to avoid fails but must have an SBL contract to avoid the expensive penalty.
Looking to the future, KPEI’s development plan aims to create supply and demand in the market as the clearer conducts workshops and engages in discussions with regulators and relevant associations on initiatives.
“One initiative is to improve the ETF and derivative markets, so we can provide securities financing through the SBL. We are also looking to include the insurance, mutual and pension funds industries, but at the moment establishing the OJK is the priority for Indonesian regulators. Another initiative is to expand membership to custodians as general clearing members,” Hoesen says, adding that workshops and discussions with BAPEPAM and relevant associations are ongoing.
That multi-tier model of both individual and general clearing members comes from LCH.Clearnet, he explains, while to develop a bilateral scheme for the SBL market, KPEI is looking to the Korean model.
Custodians familiar with the market define the available securities lending activities as “fails related to support custody services”. Though there are plans to expand the role of custodians to become borrowers, for now they behave as settlement agents receiving instruction to transfer shares to KPEI.
DBS Bank (Indonesia) has made the service available to clients for almost a year, but the response has been below expectations.
Endang Triningsih, vice president of Securities Services at DBS, says that client are unsure of KPEI’s role in the market and express concerns over the level of counterparty risk they are exposed to as well as question procedures around timely replacement of shares out on loan.
Triningsih was involved with KSEI, Indonesia’s central securities depository, for seven years prior to joining DBS and participated in the development and implementation of scripless trading and book entry settlement. At that time, she introduced KSEI developments to local and foreign markets.
DBS clients that could benefit from SBL are generally local fund managers she explains. Since pension and insurance funds can only invest in government and corporate bonds by regulation, investment potential is limited.
Still, she notes that the commission is “very attractive”. KPEI charges 15 per cent to the borrower and provides 12 per cent as the commission to the lender. Domestic clients are subjected to a withholding tax rate of 15 per cent and offshore clients are subjected to a withholding tax rate of 20 per cent or other applicable treaty rate.
But to attract clients, more needs to be done she says. “KPEI, as the self regulatory organisation (SRO) and central counterparty, needs to do more education about their role and function in the Indonesian stock market and its development to foreign investors” Triningshih says, “The investors, local or foreign, may understand that actually, SBL could be an investment alternative instead of a settlement risk solution only.”
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