Transformation of the Financial Sector in Indonesia

Research Papers


September 2003

The source and deployment of finance are central issues in economic development. Since 1966, when the Soeharto Administration was inaugurated, Indonesian economic development has relied on funds in the form of aid from international organizations and foreign countries. After the 1990s, a further abundant inflow of capital sustained a rapid economic development. Foreign funding was the basis of Indonesian economic growth.
This paper will describe the mechanism for allocating funds in the Indonesian economy.
It will identify the problems this mechanism generated in the Indonesian experience, and it will attempt to explain why there was a collapse of the financial system in the wake of the Asian Currency Crisis of 1997.

History of the Indonesian Financial system

The year 1966 saw the emergence of commercial banks in Indonesia. It can be said that before 1966 a financial system hardly existed, a fact commonly attributed to economic disruptions like the consecutive runs of fiscal deficit and hyperinflation under the Soekarno Administration. After 1996, with the inauguration of Soeharto, a regulatory system of financial legislation, e.g. central banking law and banking regulation, was introduced and implemented, and the banking sector that is the basis of the current financial system in Indonesia was built up.

   The Indonesian financial structure was significantly altered at the first financial reform of 1983. Between 1966 and 1982, the banking sector consisted of Bank Indonesia (the Central Bank) and the state-owned banks. There was also a system for distributing the abundant public revenue derived from the soaring oil price of the 1970s. The publicfinance distribution function, incorporated in Indonesian financial system, changed after the successive financial reforms of 1983 and 1988, when there was a move away from the monopoly-market style dominated by state-owned banks (which was a system of publicfinance distribution that operated at the discretion of the government) towards a modern market mechanism.

The five phases of development

The Indonesian financial system developed in five phases between 1966 and the present time. The first period (1966-72) was its formative period, the second (1973-82) its policybased finance period under soaring oil prices, the third (1983-91) its financial-reform period, the fourth (1992-97) its period of expansion, and the fifth (1998-) its period of financial restructuring.

   The first section of this paper summarizes the financial policies operative during each of the periods identified above. In the second section changes to the financial sector in response to policies are examined, and an analysis of these changes shows that an important development of the financial sector occurred during the financial reform period. In the third section the focus of analysis shifts from the general financial sector to particular commercial banks’ performances. In the third section changes in commercial banks’ lending and fund-raising behaviour after the 1990s are analysed by comparing several banking groups in terms of their ownership and foundation time. The last section summarizes the foregoing analyses and examines the problems that remain in the Indonesian financial sector, which is still undergoing restructuring.

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