Unlocking Indonesia's Domestic Financial Resources: The Role Of ...

UNLOCKING INDONESIA’S DOMESTIC FINANCIAL RESOURCES: THE ROLE OF NON-BANK FINANCIAL INSTITUTIONS December 2006 Poverty Reduction and Economic Management Finance & Private Sector Development Indonesia Country Management Unit

Document of the World Bank

ii Unlocking Indonesia’s Domestic Financial Resources: The Role Of Non-Bank Financial Institutions

THE WORLD BANK OFFICE JAKARTA Jakarta Stock Exchange Building Tower II/12th FL. Jl. Jend. Sudirman Kav. 52-53 Jakarta 12910 Tel: (6221) 5299-3000 Fax: (6221) 5299-3111 Website: www.worldbank.org/id THE WORLD BANK 1818 H Street N.W. Washington, D.C. 20433, U.S.A. Tel:(202)473-1000 E-mail:[email protected] Website:www.worldbank.org Printed in December 2006 This volume is a product of the staff of the World Bank. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries

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TABLE OF CONTENTS Foreword ..........................................................................................................................................viii Report Team and Acknowledgements ............................................................................................. ix Abbreviations...................................................................................................................................... x Executive Summary .........................................................................................................................xiii

CHAPTER 1 OVERVIEW ............................................................................................................ 1

The Importance of NBFIs & Capital Markets ................................................................................... 3 Mobilizing long-term domestic resources........................................................................................ 5 Reducing the Vulnerability of the Financial Sector .......................................................................... 6 Meeting other Government Objectives.............................................................................................. 7 Cross-Sectoral Issues And Recommendations................................................................................ 7 Key Sectoral Issues And Recommendations .................................................................................. 17 References ....................................................................................................................................... 29 Annex 1. Major Findings In The Nbfi Sector In Indonesia .............................................................. 30

CHAPTER 2 INDONESIA’S EQUITY MARKET .......................................................................... 35

Market Structure.............................................................................................................................. 35 Market Infrastructure ...................................................................................................................... 39 Legal Structure ................................................................................................................................ 40 The Corporate Sector....................................................................................................................... 40 Performance And Sustainability...................................................................................................... 45 Developmental Issues And Constraints.......................................................................................... 49 Legal, Regulatory, And Supervisory Issues .................................................................................... 52 Policy Recommendations ................................................................................................................ 57 Other recommendations.................................................................................................................. 59 References ....................................................................................................................................... 64

CHAPTER 3 INDONESIA’S BOND MARKETS .......................................................................... 65

Structure .......................................................................................................................................... 66 Issuers .............................................................................................................................................. 67 Investors ........................................................................................................................................... 71 Market Infrastructure ...................................................................................................................... 71 Intermediaries.................................................................................................................................. 73 Regulatory and Supervisory Structure............................................................................................ 74 Developmental Issues And Constraints.......................................................................................... 76 Legal Issues ..................................................................................................................................... 78 Policy Recommendations ................................................................................................................ 80 References ....................................................................................................................................... 87

CHAPTER 4 INDONESIA’S MUTUAL FUND INDUSTRY .......................................................... 89

Structure .......................................................................................................................................... 91 Performance And Sustainability...................................................................................................... 97 Developmental Issues And Constraints.......................................................................................... 98 Legal, Regulatory, And Supervisory Issues .................................................................................. 101 Policy Recommendations .............................................................................................................. 106 References ..................................................................................................................................... 112 Annex A. List Of Regulations Affecting Mutual Funds.................................................................. 113 Annex B. List Of Investment Managers With Total Assets Under Management......................... 114

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CHAPTER 5 INDONESIA’S PENSION FUNDS....................................................................... 115 Structure ........................................................................................................................................ 120 Size And Coverage ......................................................................................................................... 126 Performance And Sustainability.................................................................................................... 129 Developmental Issues And Constraints........................................................................................ 133 Legal, Tax, Regulatory, And Supervisory Issues........................................................................... 136 Policy Recommendations .............................................................................................................. 142 References ..................................................................................................................................... 152

CHAPTER 6 INDONESIA’S INSURANCE SECTOR................................................................. 153

Structure ........................................................................................................................................ 154 Performance And Sustainability.................................................................................................... 164 Legal Issues ................................................................................................................................... 167 Tax, Supervisory, And Regulatory Issues...................................................................................... 168 Policy Recommendations .............................................................................................................. 173 References ..................................................................................................................................... 179

CHAPTER 7 INDONESIA’S LEASING INDUSTRY .................................................................. 181

Structure ........................................................................................................................................ 182 Performance And Sustainability.................................................................................................... 185 Linkages With The Rest Of The Financial Sector ......................................................................... 187 Developmental Issues And Constraints........................................................................................ 188 Legal, Tax, And Regulatory Issues ................................................................................................ 189 Policy Recommendations .............................................................................................................. 191 References ..................................................................................................................................... 194 Annex A. Categories of Assets and Depreciation Methods .......................................................... 195 Annex B. Portfolio of Leasing Companies in Select Countries (2003) ......................................... 196 Annex C. The Concept of Transmission of Fiscal Benefits in Leasing ........................................ 197

CHAPTER 8 INDONESIA’S VENTURE CAPITAL INDUSTRY................................................... 201

Structure ........................................................................................................................................ 203 Performance and Sustainability .................................................................................................... 205 Developmental Issues and Constraints ........................................................................................ 207 Legal and Regulatory Issues ......................................................................................................... 208 Policy Recommendations .............................................................................................................. 210 References ..................................................................................................................................... 213

List of Tables

Table 1.1. Structure of the Financial Sector .................................................................................... 4 Table 1.2. Regional Comparison of Financial Sectors ..................................................................... 4 Table 1.3. Top 10 Market Share of Indonesian Financial Sectors.................................................. 10 Table 1.4. Financial Conglomerates in the Indonesian Financial Sectors .................................... 11 Table 1.5. Number of Actuaries in Various Countries, 2006 .......................................................... 16 Table 1.6. Number of Appraisers in Select Countries, 2006 .......................................................... 17 Table 2.1. Stock Markets in Select Countries, 1990–2004 ............................................................. 37 Table 2.2. Market Capitalization of the Top 20 Companies in Indonesia, 2006 ............................. 38 Table 2.3. Share of Firms with Debt to Equity Ratios above 200 Percent ..................................... 42 Table 2.4. Return on Invested Capital in Select Asian Countries, 1996–2004 ............................... 42 Table 2.5. Interest Coverage Ratio in Select Asian Countries, 1996–2004.................................... 43 Table 2.6. Share of Firms with Interest Coverage Less than 1, 1996–2004 .................................. 43 Table 2.7. Type of Account Holders and Shareholding Structure.................................................. 44 Table 2.8. Number of Retail Shareholders in Select Markets ....................................................... 45 Table 2.9. Assets Managed by Mutual Funds, 2004 and 2005........................................................ 45

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Table 2.10. Best-Performing Markets in the World, 2005.............................................................. 46 Table 2.11. Capital Mobilization in the Jakarta Stock Exchange ................................................... 47 Table 2.12. New Capital Raised as a Percentage of Market Capitalization................................... 47 Table 2.13. Cost of Capital in Select Economies ............................................................................ 48 Table 2.14. Overall Scores for Institutional and Market Infrastructure ........................................ 49 Table 2.15. Detailed Scores for Institutional and Market Infrastructure ...................................... 49 Table 2.16. Average Corporate Governance Score in Select Economies in 2003 and 2005.......... 54 Table 3.1. Bonds and Bank Loans Outstanding and Stock Market Capitalization, 2002–5 .......... 66 Table 3.2. Central Government Debt, 1999–2005 .......................................................................... 67 Table 3.3. Corporate Bond Issuance, by Sector, 2005.................................................................... 69 Table 3.4. Indicators of Corporate Bond Issuance, 2000–5 ........................................................... 70 Table 3.5. Investors in Government and Corporate Bonds ............................................................ 71 Table 3.6. Existing Debt Instruments, Regulatory Framework, and Authorities .......................... 75 Table 4.1. Net Asset Value of Mutual Funds, 1995–2005 ............................................................... 90 Table 4.2. Structure of the Financial Sector .................................................................................. 90 Table 4.3. Size of the Mutual Fund Industry in Asia, 2003.............................................................. 90 Table 4.4. Size of the Mutual Fund Industry in Asia, 1999–2002.................................................... 91 Table 4.5. Bond Investors, by Type of Bond ................................................................................... 92 Table 4.6. Fee Structure of Mutual Funds ..................................................................................... 94 Table 4.7. Income Tax Structure of Mutual Funds ......................................................................... 96 Table 4.8. Investment Horizon......................................................................................................... 99 Table 4.9. Authorized Capital Requirement for Securities Companies ....................................... 105 Table 5.1. Description of Pension Funds ...................................................................................... 122 Table 5.2. Total Assets in Pension Funds, 2003 and 2004 ........................................................... 126 Table 5.3. Distribution of Invested Assets in Pension Funds, 2004 ............................................ 127 Table 5.4. Assets of Private Pension Plans in Select Countries, 2001 and 2002......................... 127 Table 5.5. Pension Fund Reserves in Select Countries................................................................ 128 Table 5.6. Pension Fund Assets in Select Countries, 2003 .......................................................... 129 Table 5.7. Size of Indonesian Private Pension Funds, 2001–4 ..................................................... 129 Table 5.8. Operating Expenses of Jamsostek, 1999–2004 ........................................................... 130 Table 5.9. Total Expense Ratio and Return on Investment for Jamsostek.................................. 131 Table 5.10. Performance of Taspen, 2000–4................................................................................. 132 Table 5.11. Performance of Private Pension Plans, 2003-4......................................................... 132 Table 5.12. Prevailing versus Proposed Practices in Taspen ...................................................... 135 Table 5.13. Maximum and Actual Foreign Assets as a Share of Total Fund Assets................... 140 Table 6.1. Ownership Structure of the Insurance Industry, 1985 and 2004................................. 154 Table 6.2. Growth of the Insurance Industry, 2000–5 ................................................................... 156 Table 6.3. Concentration of Top Five Insurers in Select Countries, 2003.................................... 157 Table 6.4. Insurance Penetration in Select Countries, 2003/5..................................................... 158 Table 6.5. Density of Life Premiums in Select Countries, 2003/5................................................ 158 Table 6.6. Accumulated Assets of Insurance Industry in Select Countries, 2003/5.................... 160 Table 6.7. Life Insurance Policyholders, Sum Insured, and Premiums, by Type of Product...... 160 Table 6.8. Asset Allocation in Insurance Companies, 2005.......................................................... 160 Table 6.9. Structure of the Labor Force in Select Countries, Various Years, 2000–3 ................. 161 Table 6.10. Components and Risk Weights................................................................................... 165 Table 6.11. Risk-Based Capital of Insurance Companies – Required Margin ............................ 165 Table 6.12. Risk-Based Capital, by Level of Company Liabilities, as of December 31, 2004...... 165 Table 6.13. Risk-Based Capital of Insurance Companies ............................................................ 166 Table 6.14. Ratio of New to Renewal Business, by Type of Company, 2005................................ 166 Table 6.15. Growth of New and Renewal Premiums, 2001–2005 ................................................ 167 Table 6.16. Contribution of Premiums and Returns to Growth of Assets, 1999–2004................ 167 Table 7.1. Financing of Multifinance Companies, by Type of Company, 1996–2005 ................... 183 Table 7.2. Minimum Capital Requirement per type of Ownerhsip............................................... 184

vi Unlocking Indonesia’s Domestic Financial Resources: The Role Of Non-Bank Financial Institutions

Table 7.3. Financing of Multifinance Companies, by Source of Funding, 1996–2005 ................ 185 Table 7.4. Financial Performance of Multifinance Companies, 2000–5 ...................................... 186 Table 7.5. Quality of Financing of Multifinance Companies, 2000–4 ........................................... 186 Table 7.6. Commercial Banks and Multifinance Companies in Indonesia .................................. 187 Table 7.7. Bond Market Capitalization, 1999–2005 ...................................................................... 188 Table 7.8. Assets of Multifinance Companies, 2005 ..................................................................... 190 Table B. 1. Portfolio of First Leasing Company of India............................................................... 196 Table B. 2. Portfolio of ULC Mozambique..................................................................................... 196 Table B. 3. Portfolio of ULC Botswana.......................................................................................... 196 Table C. 1. Amortization Table ...................................................................................................... 197 Table C. 2. Post-Tax Return for a Bank Loan ............................................................................... 197 Table C. 3. Post-Tax Return of a Lease......................................................................................... 198 Table C. 04. Post-Tax Returns for a Range of Tax Depreciation Rates ....................................... 198 Table 8.1. Performance of Venture Capital and Private Equity Funds in Emerging Markets..... 202 Table 8.2. Number and Asset of Venture Capital Companies, by Type, 2000–5.......................... 206 Table 8.3. Characteristics of Investee Companies, by Sector, 2003 ............................................ 206 Table 8.4. Performance of Venture Capital Companies, 2000–5 ................................................. 206

List of Figures

Figure 1.1. Government’s Borrowing Program as a Percent of GDP, 1999–2006 .......................... 6 Figure 1.2. Indonesia’s Infrastructure Finance Needs..................................................................... 6 Figure 2.1. Listed Companies on the Jakarta Stock Exchange, 1995–2005 .................................. 36 Figure 2.2. Market Capitalization as a Share of GDP in Select Asian Markets ............................. 37 Figure 2.3. Share of 10 Largest Companies in Total Market Capitalization.................................. 37 Figure 2.4. Turnover Value in 10 Largest Companies in Select Asian Markets ............................ 38 Figure 2.5. Turnover Velocity in Various Asian Markets, 2005....................................................... 39 Figure 2.6. Debt-to-Equity Ratio in Select Asian Economies, 1996–2004 ..................................... 42 Figure 2.7. Corporate Rating Based on EMS in Select Asian Countries, ...................................... 44 Figure 2.8. Year-end Jakarta Composite Index, 1995–2006........................................................... 46 Figure 2.9. Liquidity and Market Structure..................................................................................... 51 Figure 3.1. Tradable Domestic Debt, End-2003 and End-2005...................................................... 68 Figure 3.2. Trading of Government Bonds in the Secondary Market, January 2002–May 2006 ... 68 Figure 3.3. Spread between Lending Interest Rate & One-Month Rupiah Time Deposit Rate .... 70 Figure 3.4. Sensitivity of Corporate Bond Yields to Ratings........................................................... 74 Figure 4.1. Composition of the Mutual Fund Industry, 1996–2005 ................................................ 92 Figure 4.2. Operation of Corporate Mutual Funds.......................................................................... 95 Figure 4.3. Operation of Collective-Investment Mutual Funds ...................................................... 95 Figure 4.4. Performance of Mutual Funds, 2005 ............................................................................ 97 Figure 5.1. Overview of Indonesian Social Security System......................................................... 120 Figure 5.2. Social SecuritySystem Structure ................................................................................ 123 Figure 5.3. Entitlement to Severance Pay and Long-Service Leave............................................ 137 Figure 5.4. Cost of Firing Workers ................................................................................................ 138

List of Boxes

Box 2.1. Novo Mercado: São Paulo’s New Market ......................................................................... 59 Box 3.1. Accounting and Auditing in Indonesia............................................................................... 76 Box 5.1. International Experience: Pension Sector Reform Experience in Chile........................ 116 Box 6.1. Typical Insurance Products ............................................................................................. 155 Box 6.2. Shariah Insurance............................................................................................................ 156 Box 6.3. Explaining Low Penetration and Density of Insurance in Indonesia ............................. 159 Box 6.4. Resolution of Insolvent Life Insurance Companies........................................................ 171 Box 6.5. International Experience: Insurance Sector Reform Experience in Mexico ................. 172 Box 8.1. International Experience: Venture Capital Industry in Taiwan (China).......................... 209

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FOREWORD Non-bank financial institutions (NBFIs) - such as insurance firms, pension funds, mutual funds, leasing and venture capital companies, and capital markets (including equity and bond markets) - have a key role to play in Indonesia’s future development. Well functioning NBFIs – alongside a sound banking system - can help achieve the Indonesian government’s objectives of increasing access to financial services, reducing the cost of financial services, and improving the stability of the financial system. A strong well diversified financial sector provides a solid foundation to support economic growth. That growth is good for poverty reduction has by now been well established with evidence from across the world. Nearly a decade after the onset of the economic crisis, Indonesia’s financial sector continues to be dominated by commercial banks. NBFIs in Indonesia are much smaller than those in several other large developing countries and in many countries of the East Asia region. In line with the economy-wide shift towards longer term development agendas and emerging development priorities, strengthening NBFIs is now an urgent policy imperative. Indonesia needs the long-term domestic resources that can be mobilized by NBFIs; these can be used to finance productive investments – including, among others, infrastructure. This provides a window of opportunity for much needed reforms. The Government clearly recognizes the importance of a strong financial sector - as articulated in the financial sector policy package in June 2006 and its ongoing implementation. While this is an excellent start, more challenges lie ahead on the path to comprehensive reform and strengthening of NBFIs. While each sub-sector has its own specific issues, there are also some common problems across sub-sectors. This report “Unlocking Indonesia’s Domestic Financial Resources – The Role of Non Bank Financial Institutions” – is intended to assist policy makers in developing a strategic vision for the future development of NBFIs. The main findings of this report have been widely disseminated through four workshops held during 2005 and 2006. We hope that the report will serve as a basis for informed discussion about the role of NBFIs, their ability to meet Indonesia’s objectives, and policy actions necessary to stimulate their sound development. The World Bank considers it a privilege to work with the Government in this critical area of financial sector reform and we stand ready to further support the Government in its future efforts. December, 2006

Andrew Steer Homi Kharas Country Director, Indonesia Chief Economist & Sector Director, PREM East Asia & the Pacific Region East Asia & the Pacific Region

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REPORT TEAM AND ACKNOWLEDGEMENTS This report is the result of a team effort consisting of staff and consultants of the World Bank, other donors, global experts and participants at four consultative workshops, and the Government of Indonesia. The Report team was led by P.S. Srinivas. Major contributors included: Noritaka Akamatsu, Yoko Doi, Yves Guerard, Kutlu Kazanci, Michael Pomerleano, Djauhari Sitorus, and Megawati Sulistyo. Inputs were obtained from Lim Choo Peng, Ismail Dalla, Hari Gamawan, Yongbeom Kim, Emmy Ruru, Richard Symonds, and Vishwanath Tumu. The report was prepared under the overall guidance of Khalid Mirza and Tunc Uyanik, former and current Sector Manager, Finance & Private Sector Development respectively; Homi Kharas, Director, Poverty Reduction & Economic Management Unit & Chief Economist, East Asia & the Pacific Region); and Andrew Steer, Country Director Indonesia. The report benefited from the advice of several reviewers including Anjali Kumar and Raden Pardede (peer reviewers), Gavin Forte, David Hawes, Rajiv Sondhi, Ramesh Subramanian, William Wallace, Armando Morales, Yoichiro Ishihara and Magda Loedin. Elizabeth Forsyth, Radhika Puri and Indra Irnawan edited and formatted the report. Ine Farina, Dinni Prihandayani, and Sema Muslu provided logistical support. Throughout the preparation of this report, the World Bank has received excellent support and cooperation from the Government of Indonesia. Particular thanks are due to H.E. Minister Aburizal Bakrie (formerly the Coordinating Minister of the Economy and currently the Coordinating Minister for Social Affairs) and H.E. Minister Boediono (Coordinating Minister of the Economy) as well as H.E. Minister Yusuf Anwar and H.E. Minister Sri Mulyani Indrawati (the former and current Minister of Finance respectively) for their active participation in workshops and other dissemination events at which this report was discussed. Thanks are also due to Dr. Darmin Nasution and Dr. Fuad Rahmany (former and current Chairman, Bapepam & LK respectively) and their staff for the whole-hearted support, encouragement, and cooperation. Mr. Herwidayatamo, former Chairman of Bapepam and Executive Director for Indonesia at the World Bank provided invaluable guidance to the team. The findings of the report were discussed at four workshops held in Jakarta during 2005 and 2006. Thanks are due to the more than 300 participants who attended each of these workshops and provided invaluable feedback. AusAID, the Canadian Embassy in Jakarta, the World Bank Institute, SunLife Financial, Manulife Financial, and the ASEM Trust Fund provided financial and organizational support for the workshops. The workshops were held in collaboration with a variety of domestic partners and stakeholders including Bank Indonesia, Directorate of Government Securities Management (DPSUN), Jakarta Stock Exchange, Surabaya Stock Exchange, KPEI, KSEI, the Inter Dealer Market, Indonesian Insurance Council, Indonesian Life Insurance Association, General Insurance Association of Indonesia, Association of Financial Institutions’ Pension Funds, The Association of Pension Funds, Indonesian Venture Capital Association, Indonesian Financial Services Association. Detailed presentations of these workshops are available at www.worldbank.org/id or from the World Bank’s Jakarta Office. The Team acknowledges the support of AusAID, IFC-PENSA, the Singapore and Japanese Consultant Trust Funds, the ASEM Trust Fund and the Government of the Netherlands (through the Dutch Trust Fund for Capacity Building) for providing financial support for the preparation of the report and the workshops

x Unlocking Indonesia’s Domestic Financial Resources: The Role Of Non-Bank Financial Institutions

ABBREVIATIONS Abbreviation Indonesian English AAJI Asosiasi Asuransi Jiwa Indonesia Association of Indonesian Life Insurance Companies APPI Asosiasi Perusahaan Pembiayaan Indonesia Indonesian Financial Services Association ASABRI PT Asuransi Sosial Angkatan Bersenjata Republik

Indonesia The Indonesian Armed Forces Social Insurance

ASEAN The Association of Southeast Asian Nations BAPEPAM & LK Badan Pengawas Pasar Modal Lembaga Keuangan Capital Market and Non Bank Financial Institution

Supervisory Agency BCBS The Basel Committee on Banking Supervision BEJ Bursa Efek Jakarta Jakarta Stock Exchange BES Bursa Efek Surabaya Surabaya Stock Exchange BI Bank Indonesia Bank Indonesia BI-RTGS Bank Indonesia's real-time gross payments system BI-SSSS Bank Indonesia's scrip-less securities settlement

system BKPM Badan Koordinasi Penanaman Modal The Investment Coordinating Board BPUI PT Bahana Pembinaan Usaha Indonesia CARAMEL Capital Assets Risk analysis Asset-liability matching

Management Earnings Liquidity DAI Dewan Asuransi Indonesia Indonesian Insurance Council DPLK Dana Pensiun Lembaga Keuangan Financial institution-based pension funds DVP Delivery-versus-payment EET Exempt exempt taxable ETF Exchange traded funds EU European Union FASBI Fasilitas Bank Indonesia Bank Indonesia rupiah deposit facility FITS Fixed income trading system GAAP generally accepted accounting principles GDP Gross Domestic Product HHI Herfindahl index HIMDASUN Perhimpunan Pedagang Surat Utang Negara Inter-Dealer Market Association IAI Ikatan Akuntan Indonesia the Indonesian Accountant Association IAIS International Association of Insurance Supervisors IAS International Accounting Standards IBNR Incurred But Not Reported IDM Inter-Dealer Market IFRS International financial reporting standards IFSL International Financial Services, London IGSTS Indonesian Government Securities Trading System IMF International Monetary Fund IOSCO The International Organization of Securities

Commissions IPO Initial public offering ISO International Standards Organization JAMSOSTEK PT Jaminan Sosial Tenaga Kerja Employees Social Security JATS Jakarta Automated Trading System JHT Jaminan Hari Tua Old Age Benefit Scheme KIK Kontrak Investasi Kolektif Collective Investment Trust KMK Keputusan Menteri Keuangan Ministry of finance decree KPEI Kliring Penjaminan Efek Indonesia Clearing and Settlement Corporation KSEI Kustodian Sentral Efek Indonesia Central Securities Depository LPS Lembaga Penjamin Simpanan Indonesian Deposit Insurance Corporation MAPPI Masyarakat Profesi Penilai Indonesia organization of professional appraisers in Indonesia MoF Ministry of Finance MOFiDS Ministry of Finance Dealing System NASD National Association of Securities Dealers NAV Net asset value NBFI Non-bank financial institutions NYSE New York Stock Exchange OECD Organization for Economic Co-operation and

Development OJK Otoritas Jasa Keuangan An integrated supervisory authority for the financial

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sector OTC-FIS Over-the-counter, fixed-income service PAI Persatuan Aktuaris Indonesia Indonesian Actuary Association Perseroan Terbatas

Limited Liability Company

PP Peraturan Pemerintah Government regulation PSAK Pernyataan Standar Akuntansi Keuangan Indonesian financial accounting standards RBC Risk Based Capital REIT Real estate investment trust Repo standard repurchase agreements SBI Sertifikat Bank Indonesia Central Bank Notes SJSN Sistem Jaminan Sosial Nasional National Social Security System SME Small to Medium Enterprises SRO Self Regulatory Organization TASPEN PT Dana Tabungan dan Asuransi Pegawai Negeri. Annuity pensions and endowment insurance benefits

scheme for government civil servants. THT Tunjangan Hari Tua Old Age Lump Sum Benefit WMI Wakil Manajer Investasi Investment manager license

Currency Equivalents

Currency Unit: Indonesian Rupiah (Rp.)

Year End of Year Average 1999 7,085 7,855 2000 9,595 8,422 2001 10,400 10,261 2002 8,940 9,311 2003 8,465 8,577 2004 9,290 8,939 2005 9,830 9,705

Fiscal Year of Indonesia

January 1 – December 31

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EXECUTIVE SUMMARY

Unlocking Indonesia’s Domestic Financial Resources The Role Of Non-Bank Financial Institutions A well diversified financial sector – with sound banks as well as non-bank financial institutions (NBFIs)1,– is key to supporting the Indonesian Government’s articulated development objectives of increased economic growth, greater job creation, and a better standard of living for Indonesians. Banks and NBFIs are both key elements of a healthy and stable financial system that complement each other and offer synergies. However, at present, Indonesia’s financial services industry continues to be dominated by banks – with nearly 80% of financial system assets (in 2005) in banks. The rest of the financial sector – including insurance, pensions, mutual funds, leasing, factoring, and venture capital companies - is still small, with less than 15 per cent of GDP in assets combined. Banks were at the heart of Indonesia’s economic crisis in 1997/98 – with more than 50% of (2000) GDP spent to recapitalize them. Given the scale of the banking crisis, policy attention has – until recently – been focused on strengthening the banking system and its regulation and supervision. In line with the economy-wide shift towards a long term development agenda, as articulated in the various policy packages released in 2006, strengthening NBFIs is now an urgent policy imperative. A well-developed NBFI system can play a major role in achieving Indonesia’s development goals and can enhance the stability of the country’s financial system. NBFIs have the potential to unlock long-term domestic resources for investment in sectors critical to growth, such as infrastructure, and increase access to low-cost financial services. The primary objective of this report is to assist policy makers in developing a strategic vision for the future development of NBFIs in Indonesia. It is hoped that the report will serve to create a basis for informed discussion about the role of the NBFI sector, its ability to meet Indonesia’s objectives, and policy actions necessary to stimulate its sound development. This report has two key outcomes in mind: development of a diversified financial sector and improved mobilization as well as allocation of long-term domestic resources for development. The report is organized as follows. Chapter 1, Overview, provides a synopsis of the report and highlights key recommendations. It begins by addressing cross-cutting issues that are common problems across many sub-sectors and then focuses on each sub-sector that the report covers. While detailed discussions and recommendations are presented in subsequent chapters, this chapter highlights a short prioritized list of policy actions that the study recommends as needing immediate policy focus. Regulation and supervision of NBFIs is still weak and needs to be strengthened; lack of adequate capacity and gaps in the regulations that have the potential to lead to regulatory arbitrage need to be addressed. With the decision to establish an integrated financial supervisory authority (OJK; Otoritas Jasa Keuangan) must come as a commitment to undertake a wider scope of regulatory reforms and to develop greater enforcement capacity. An important step that the report recommends is to immediately consider making Bapepam & LK (Badan Pengawas Pasar Modal Lembaga Keuangan, Capital Market and Non Bank Financial Institution Supervisory Agency) more independent. Enforcement is poor across a large spectrum of financial sector activities. Staff needs to be better trained to address compliance problems, and the enforcement

1 In this report, NBFIs includes capital (equity and bond) markets, insurance firms, pension funds, mutual funds, leasing, factoring, and venture capital companies

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of regulations needs to be coordinated across the different regulators; a problem the proposed integrated authority is intended to address. Effective competition in several NBFI segments in Indonesia is hampered by the existence of uneven playing fields. In some cases such as insurance, several large players are known to have solvency problems, which have yet to be addressed, and these adversely impact the rest of the industry; regulations that create an uneven playing field between incumbents and new entrants inhibit new entry. In pension funds, the role of the public sector is large and could potentially grow further as the social security law is implemented. Such imbalances need to be urgently addressed. Tax distortions impede the development of virtually all of the industries studied. A priority in this area is to take a comprehensive look at tax regulations and assess remedies. A deregulated and competitive environment creates new demands for financial expertise and skills. Such expertise is sorely lacking in Indonesia, and regulations are needed to facilitate the growth of the financial services professions. This can be done by establishing and promoting minimum uniform standards of education and qualifications. In addition, consideration should be given to opening the professions to foreign competition. Finally, Indonesia needs better-educated investors and there is a need to focus on investor education. The potential economic benefits of financial literacy are widespread: better-informed consumers and investors would improve market efficiency and help to keep unscrupulous operators at bay. To this end, the authorities are encouraged to develop a financial literacy program, in collaboration with the private sector. Chapter 2 deals with the Equity market. Indonesia’s equity market has risen steadily since 2002, and Jakarta Composite Index was among the top performers in the region in 2004 and 2005. As of December 2005, total market capitalization was Rp 801 trillion (30% of GDP). About 336 companies are listed on the exchange. The market is largely an institutional market with few individual investors having accounts. Well-functioning equity markets encourage entrepreneurship by providing a source of risk capital to complement bank financing. The Indonesian stock market is small, highly concentrated, and relatively illiquid. It is not a major source of risk capital, with limited new equity being raised since the crisis. It is yet to be a widely used store of value for assets – with fewer than 100,000 retail accounts in a country of 220 million people. The market is not yet a sound means to price risk adequately – given its concentration (10 of 336 listed firms account for half of market capitalization and trading volume) and limited liquidity (free float of the top 20 companies by market capitalization is less than 40 per cent). Moreover, transparency, information disclosure, and corporate governance are still weak, and that the securities regulator faces significant shortcomings in its ability to oversee the markets, supervise market participants, and enforce issuer compliance. Decisive policies are needed, both by the government and by market participants, such as the stock exchange, to enable the market to reach its full potential. In essence, there is a need to improve corporate governance, improve and strengthen the role of Bapepam & LK in supervision, improve market infrastructure, and improve corporate financial health. Chapter 3 focuses on Bond markets, which can supply long-term financing for the government, infrastructure projects, and corporations. Indonesia has achieved significant progress in building the core government bond market, but has not developed the corporate bond market. At end-2005, tradable government bonds outstanding amounted to Rp 389 trillion (14 per cent of GDP). Corporate bonds outstanding amounted to only Rp 63 trillion, representing 2 percent of GDP. Banks are the largest investors in government bonds – holding 71 percent of all government bonds, including recap bonds. Insurance and pension funds hold about 14 percent of government bonds. The key priorities in this area are to improve the coordination between Bank Indonesia and the Ministry of Finance, further enhance the certainty of periodic government issuance, improve the market infrastructure for government bonds, clarify the regulatory requirements for credit-rating agencies, and improve the collection of secondary-market pricing information.

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Chapter 4 addresses Mutual funds. Until early 2005, the Indonesian mutual fund industry grew rapidly – growing from assets under management (AUM) of Rp. 8 trillion in 2001 to nearly Rp. 104 trillion in December 2004. The industry’s growth was driven by the shift of individuals out of rupiah time-deposit accounts in commercial banks and into mutual funds that invested mainly in rupiah-denominated government securities, principally recapitalization bonds. However, massive redemptions rocked the industry subsequently, and assets under management fell to Rp 29.4 trillion (US$3 billion, 1.1 percent of GDP) by December 2005. The main causes for the debacle were a sudden rise in interest rates that caused the value of “fixed income” mutual funds – which were the vast majority of funds – to fall, leading investors into a panic. Despite its recent decline, the mutual fund industry should remain an important building block in Indonesia’s financial sector, helping individuals and institutions to manage risk and savings. Mutual funds have the potential to be a significant investor in government and corporate bonds. Yet Indonesia’s mutual fund industry is small compared with regional and global markets, and the capacity is weak. The structure is skewed toward fixed-income funds, and the range of products is limited. Despite extensive rules, disclosure and investor protection are inadequate, the concept of net asset value is not used, and sales procedures are poor. The priority for the sector is to bring regulation and supervision of the industry in line with international practices by restructuring the industry, strengthening enforcement and market discipline, and addressing the challenges of net asset valuation. Pension funds are the subject of Chapter 5. Indonesia’s pension sector is small controlling in total less than 4.7 percent of GDP in assets, compared with Thailand (8.4 percent), Malaysia (57 percent), and Australia (75 percent). While there is great potential to mobilize domestic resources, especially if the industry would undertake reforms and the government would promote pension funds, decisive measures are needed. The two defined-benefit plans for civil servants (Taspen; PT Dana Tabungan dan Asurasi Pegawai Negeri) and the armed forces (Asabri; PT Asurasi Sosial Angkatan Bersenjata Republik Indonesia, The Indonesian Armed Forces Social Insurance) are poorly funded and invested inappropriately with large holdings of short-term bank deposits. Together with Jamsostek (the defined contribution plan for formal sector workers), they suffer from lack of transparency and disclosure, weak management information systems, high expense ratios, and poor internal governance. Indonesia’s private pension funds are growing rapidly, and some positive steps have been taken to improve the industry, including a shift to risk-based supervision and the decision to create OJK, an integrated supervisory authority for the financial sector. The priorities for the sector are to formulate a coherent strategic master plan for providing retirement income in a fiscally sustainable way; undertake an actuarial audit and reform of Taspen and implement reforms before addressing funding issues; encourage outsourcing of Jamsostek’s activities to improve efficiency, and improve the asset allocation of private pension funds. Chapter 6 focuses on the Life Insurance industry (the non-life insurance sector is not dealt with in detail in this report, largely due the fact that the life insurance industry is a potential source of long-term resources – which is one of the focus areas of this report). The Indonesian insurance industry is small – with total assets of Rp. 75 trillion (US$ 7.7 billion) – 2.8 percent of GDP. Insurance penetration in Indonesia—premiums as a percent of GDP—is low, with premiums equal to 1.4 percent of GDP (life, 0.8 percent; non-life 0.6 percent). Insurance density – premium per capita – is US$ 14.5 per capita (life - US$ 6.4 per capita, and non-life, US$ 8.1 per capita). The industry is highly fragmented – with a large number of relatively small players in both life and non-life insurance sectors. There are large insurance companies in the industry that are widely considered to be insolvent and posing a potential systemic risk. While life insurance is traditionally an industry that produces long-term savings, in Indonesia this potential is not yet being fulfilled. Poor sales practices, and inappropriate products result in a high lapse rate i.e. many policies are not renewed. Many small insurers are undercapitalized and unlikely to withstand stiffer market competition in the future. The top priority for policy makers and regulators are to rationalize the

xvi Unlocking Indonesia’s Domestic Financial Resources: The Role Of Non-Bank Financial Institutions

industry including addressing the resolution of weak and bankrupt firms. The other priority in this area is to modernize and upgrade the institutional capacity of the regulator and improve enforcement. This includes developing a flexible approach to supervision that emphasizes risk management, consumer protection, and market discipline, developing a harmonized approach to risk-based capital management, and reviewing the approach to reinsurance. A sustained education campaign using a public-private partnership approach to promote the industry would help the development of the industry. The establishment of joint government-industry high-level committee to develop future action plans for the industry is also an important step. Chapter 7 deals with Leasing and consumer finance while Chapter 8 deals with the Venture capital industry. Leasing and factoring services provide financing for small and medium enterprises, while venture capital fosters innovation and entrepreneurship. Further development of these industries would broaden competition for financial services, introduce businesses and financiers to innovations such as cash-flow-based credit analysis, and provide small and medium enterprises with access to risk capital. The sector is small, but growing strongly in Indonesia, driven largely by consumer finance. To encourage further growth, the priorities are to put in place a reasonable but light level of regulation and supervision, allow depreciation of leased assets, widen the financing base, develop credit information systems, support corporate restructuring through private equity funds, separate the operation and management of venture capital funds, and develop legal trust vehicles.

CHAPTER 1 OVERVIEW

Indonesia has turned the corner from crisis management and is moving towards sustained growth and poverty reduction. Policy makers are focusing on longer-term development issues on a variety of fronts. This is evident by the actions of and policy pronouncements by the current Government since taking office in late 2004. That a strong financial sector is critical to support growth – and that growth is good for poverty reduction - has by now been well established with evidence from across the world. In Indonesia as well, a well diversified financial sector – with sound banks as well as NBFIs is key to support the Government’s articulated development objectives. Until recently, strengthening and supervising banks has been at the centre of Indonesian financial sector policy focus due to the scale of the economic crisis in the late nineties. In one of the costliest banking crises in the world, more than 50% of (2000) GDP was spent to recapitalize the banks and put them on a sound footing. It must be mentioned that several issues remain in the banking sector, in particular concerning the role and continuing problems of state owned banks as well as sound implementation of a financial sector safety net. However, these issues are dealt with in greater detail in other reports, and are outside the scope of this particular report. A well-developed NBFI system has the potential to fulfill these long-term developmental objectives by bringing further stability to the financial system, reducing the cost of financial services as whole and unlocking domestic resources for developmental purposes. A strong NBFI sector will allow the Government to place bonds in the domestic market, provide Rupiah financing for infrastructure purposes, provide financing for SMEs (and thereby create jobs) and enhance the financial security of Indonesians by allowing access to different kinds of risk-management products. The private sector in Indonesia needs to have access to different types of capital—risk capital from capital markets, short-term financing from banks, as well as longer-term financing through capital markets and institutional investors. Leasing and factoring services could help provide term funding for the private sector, especially small and medium enterprises, which are often constrained by collateral. As decentralization becomes firmly rooted, sub-national governments are looking to capital markets for resources for development. In particular, municipal bond markets and investors are needed. The Government is considering a national

2 Unlocking Indonesia’s Domestic Financial Resources: The Role Of Non-Bank Financial Institutions

contributory social security system, and these resources will require avenues for investment. Given all these likely demands, a sound NBFI sector could contribute in a big way to Indonesia’s development. Macroeconomic stability and a sound framework for macro policy are required for the sustained development of the financial sector. Maintaining this stability has been a challenge in post-crisis Indonesia in part due to underdeveloped financial markets, but macroeconomic foundations are now improving rapidly as interest rates and inflation move toward regional averages and the exchange rate stabilizes. These developments will naturally extend savings and investment horizons and risk tolerance but the likelihood of internal and external shocks remains high and both savers and investors need the ability to diversify to match currency and maturity profiles. This makes it an opportune moment to solidify a strengthening macroeconomic picture with a diversified and efficient financial sector – including further developing NBFIs. Improved financial markets in turn create the potential for higher sustained growth, raise domestic financing – including for investment in infrastructure, while making the economy more robust in the face of inevitable shocks. The primary objective of the report is to assist policy makers in developing a strategic vision for the future development of NBFIs in Indonesia. It is hoped that the report will stimulate an informed discussion on required policy initiatives to meet these goals. This chapter provides the overview of the report and specific recommendations in each sub-sector that the report covers – equity markets, bond markets, mutual funds, pension funds, insurance, leasing, and venture capital. While detailed discussions and recommendations are presented in subsequent chapters, the sections in this chapter highlight a short prioritized list of policy actions that the study recommends as needing immediate policy focus. This chapter then highlights several cross-cutting issues that affect the development of the NBFI sector as a whole and recommends concrete actions in these areas. In subsequent chapters, each sub-sector is examined in-depth, a fuller context for the recommendations in the overview provided, and a wider set of policy recommendations made for future development. For ease of policy focus, each subsequent chapter ends with a matrix of actions – prioritized as in the short term (less than one year) and medium term (1-3 years) that the Government should be focusing on. There are clearly limitations to a wide-ranging study such as this. First, at the request of the Government this study focuses on market/sector development issues. (In-depth work on regulatory structure issues – especially that of the establishment of OJK is being supported by the Asian Development Bank and AusAID). Clearly, a report on market development has to necessarily touch on regulatory issues and constraints – and make recommendations for reform, which this study does. But it does not go into depth on issues related to the OJK. Second, there was also a decision made early in the preparation process that the study will focus on key recommendations across a wide set of sub-sectors. As a result, therefore, the report identifies areas where further work is needed – especially on issues related to implementation. This study lays out a strategy and a vision for the NBFI sector – and highlights key policy decisions that have to be made in the process. In several cases, arriving at a detailed road-map of implementation issues will need further work. This report uses comparisons of Indonesia with other relevant economies where appropriate and helpful. For a more exhaustive comparison of Indonesia’s financial sector with those of other regional economies readers are referred to the recent World Bank publication – “East Asian Finance; The Road to Robust Markets” (2006).

3

THE IMPORTANCE OF NBFIS & CAPITAL MARKETS2 Deep and broad financial markets facilitate savings mobilization, by offering both individual and institutional savers and investors additional instruments and channels for placement of their funds at more attractive returns than are available on bank deposits. At the same time, deep and broad financial markets enhance access to finance for more firms and individuals, with competition also making such access more affordable. Developed financial markets also have the capacity to reduce volatility, distortions, and risk by operating in an environment that is transparent, competitive, and characterized by the presence of a diverse array of products and services, including derivative instruments that allow for effective risk management. Therefore, reforms in a country’s financial architecture often lay the groundwork for improved economic performance. In almost all advanced economies, financial systems deliver a broad range of financial services and sophisticated products, and the efficiency of such well-developed systems has contributed to macroeconomic stability and sustained economic growth and prosperity. Increased availability of funding and more efficient allocation of capital for productive private sector investment is beneficial economy-wide, with particular benefits for small and medium sized enterprises (SMEs) that are often constrained in their financing options prior to effective banking reforms and non-bank financial sector development. According to recent analyses, growth in private credit volumes and equity market capitalization as a percent of GDP have consistently been correlated with growth in per capita income. Thus, effective functioning of a full service financial system is essential for economic development and prosperity.3 Banks and non-bank financial intermediation are both key elements of sound and stable financial systems. Both sectors need to be developed as they offer important synergies. While banks dominate financial systems in many countries, businesses, households and the public sector all rely on the availability of a wide range of financial products to meet their financial needs. Such products and services are provided not only by banks, but also by insurance, leasing, factoring and venture capital companies, as well as mutual funds, pension funds and investment trusts. The ratio of equity market capitalization to banking system assets is high in most economically advanced countries, and there is a general tendency for the market capitalization-to-bank deposit ratio to increase with the level of economic development. By providing additional and alternative financial services, NBFIs improve general system-wide access to finance. They also help to facilitate longer-term investments and financing, which is often a challenge in the early stages of bank-oriented financial sector development. The growth of contractual/collective savings institutions such as insurance companies, pension funds, and mutual funds widens the range of products available for people and companies with resources to invest. These institutions also provide competition for bank deposits, thereby mobilizing long-term funds necessary for the development of equity and corporate debt markets, municipal bond markets, infrastructure finance, mortgage bond markets, leasing, factoring and venture capital. Collective savings institutions also allow for better risk management, while helping to reduce the potential for systemic risk through the aggregation of resources, allocation of risk to those more willing to bear it, and application of portfolio management techniques that spread risk across diversified parts of the financial system. Thus, countries have a lot to gain from deep and broad financial markets and a mature financial services industry. This development paradigm is increasingly recognized around the world,

2 This section draws on Bakker and Gross (2004). 3 The relationship between finance and economic growth has been explored in detail by, among others, the World Bank (2001)


especially in the aftermath of repeated emerging market crises in countries with bank-dominated financial systems.

NBFIs in the Indonesian Context Many of the above arguments are valid in Indonesia’s case as well. Indonesia’s financial sector is currently dominated by commercial banks (Table 1.1). The current situation and the above discussion on the role of NBFIs points to the need to further develop capital markets, pension funds, mutual funds, insurance companies, leasing companies, and venture capital funds in Indonesia, as these institutions are better geared toward bearing several types of risk. Indonesia needs strong NBFIs for at least three reasons: (i) they can play a critical in mobilizing and allocating domestic resources for financing development – an urgent priority (ii) they can reduce the vulnerability of the financial sector to future shocks and (iii) they can help meet other articulated Government objectives. In order to motivate the focus on NBFIs, this section provides a brief overview of the overall financial sector in Indonesia. A regional comparison reinforces the previous observations about the financial sector in Indonesia (See Table1.2). Compared to the region, the Indonesian financial sector is relatively underdeveloped, highly bank-dominated. NBFIs are relatively smaller in Indonesia as well. Table 1.1: Structure of the Financial Sector (Rp trillion)

Type of institution and year Assets (Rp trillion) Percent of assets Percent of GDP Banks (2005) 1,470.0 79.7 53.9 Non-bank financial institutions 374.5 20.3 13.7 Finance companies (2005) 67.7 3.7 2.5 Insurance companies (2005) 75.1 4.1 2.8 Pension funds (2004) 107.1 5.8 4.7 Securities firms (2004) 10.1 0.5 0.4 Pawnshops (pegadaian) (2005) 4.8 0.3 0.2 Rural institutions (2004) 14.7 0.8 0.6 Mutual funds (2005) 29.4 1.6 1.1 Venture capital companies (2005) 2.7 0.1 0.1 Outstanding corporate bonds (2005) 62.8 3.4 2.3 Total 1,844.5 100.0 67.6 Equity market capitalization (2004) 680 N/A 30.1 Equity market capitalization (2005) 801 N/A 29.4 Source: Bapepam & LK, Bank Indonesia Note: Numbers include some double counting because pension funds, insurance companies, and mutual funds invest in banks. Percent of GDP of each sector is calculated using the GDP of the year corresponding to year of the data. Total as a percent of GDP uses 2005 GDP figure. Table 1.2: Regional Comparison of Financial Sectors (US$ billion)

Indonesia Malaysia Thailand Singapore Sector Assets % of GDP Assets % of GDP Assets % of GDP Assets % of GDP Banks 151.5 53.9 166 159.8 172 114.9 213 233.4 Insurance companies 7.7 2.8 20 19.5 5 3.4 46 49.8 Pension funds 12.0 4.3 58 56.4 7 4.8 60 65.7 Mutual funds 3.0 1.1 21 20.1 18 12.2 18 20.0 Outstanding corporate bonds 6.5 2.3 40 *38.0 19 *12.3 30 *32.4 Others 10.5 3.7 n.a 0.0 n.a 0.0 n.a 0.0 Total 191.2 68.0 305 293.3 221 147.4 367 403.3 Equity market cap 82.5 29.3 168 162.2 119 79.4 148 162.3 GDP 281.3 100.0 104 100.0 150 100.0 91 100.0 Source: Respective central banks, public information, World Bank Note: Indonesian data as of 2005, the rest as of 2003. *:2004 data.

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Brief Summary of the Banking Sector Banking is the largest segment of the financial system, controlling nearly 80 percent of financial assets. Following the crisis, Indonesia’s banking sector was restructured. It is much healthier now, with fewer nonperforming loans, higher capital-adequacy ratios, and higher profitability. Most of the (previously private) banks taken over by the government during the crisis have either been either closed or sold back to the private sector. The government has also begun to sell minority stakes in state-owned banks. Regulation and supervision of the sector has been strengthened substantially, and the blanket guarantee on bank deposits in existence since the crisis is being gradually phased out as a deposit insurance scheme is being put in place. Despite these improvements however, a significant agenda of further reforms remains in the banking sector – with state owned banks being at the core of the agenda. Recent figures indicate that the two largest state banks – accounting for about 30 per cent of assets of the banking system, account for 2/3rds of the system’s NPLs. Improving governance at these institutions remains a challenge. Despite its size and recent improvements, the Indonesian banking sector is not a source of long-term capital. Similar to the banks of many countries in the region, Indonesian banks obtain most of their funding from short-term deposits, and more than 90 percent of bank deposits are less than one month in maturity. Prudent asset-liability management calls for banks to offer short-term, floating-rate loans, and this is what happens in the market. This liability structure therefore severely limits banks from being able to finance long-term assets. In addition, recapitalization bonds still feature prominently in bank balance sheets (17 percent of assets), and bank credit for investments is scarce. Since 2000, credit has grown 18 percent a year, with consumption lending growing 22 percent and investment lending growing 13 percent. The relatively slower growth of investment lending is the result of a poor investment climate, a dearth of attractive investment opportunities, and economic growth driven largely by consumption. In addition, although in the aggregate SME lending is growing rapidly (from a small base), the vast majority of SMEs in Indonesia continue to face constraints in access to credit. Bank lending is heavily collateral based – and with weak land titling and collateral documentation, especially for land, many SMEs find the banking sector hard to access.

MOBILIZING LONG-TERM DOMESTIC RESOURCES Indonesia has a large and growing need for long-term domestic resources. The government has established a substantial borrowing program since 1999, borrowing about 1 percent of GDP annually (see figure 1.1). In its debt management strategy, the government has articulated its desire to (i) increase the share of domestic debt vis-à-vis foreign borrowings and (ii) lengthen the maturity of domestic debt as much as possible. In addition, Indonesia’s infrastructure development program has large financing needs. The Bank estimates (Figure 1.2) that Indonesia needs to increase its spending on infrastructure by about 2 percent of GDP – US$ 5 billion per year – in order to reach the governments 6 percent per year medium term economic growth target. Much of this is expected to be financed from private sources. Clearly, local and international capital markets will have to provide much of this financing. Meeting these objectives will demand better functioning capital markets and NBFIs. At present, however, Indonesian institutional investors are relatively small and not yet a source of long-term capital. Indonesia’s pension funds (with assets of about US$12.5 billion, 4.7 percent of GDP) and insurance companies (with assets about US$7.7 billion, 2.8 percent of GDP) offer a pool of assets that have not yet been tapped for long-term investments. Currently pension funds and insurance firms invest a significant portion of their resources in short-term bank deposits, in essence transforming scarce long-term resources


into short-term assets. Corporate bond financing (including infrastructure financing) is small and a sound policy environment for securitization still needs to be put in place. Figure 1.1: Government’s Borrowing Program as a Percent of GDP, 1999–2006

1.0 1.2

2.4

1.3

1.7

1.1 1.00.7

0.0 0.0 0.0

-0.1 -0.2

0.50.8 0.8

1.0 1.2

2.4

1.4

1.9

0.6

0.2

-0.2-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1999 2000 2001 2002 2003 2004 2005 E 2006 P

Deficit Securities - Net Non Securities - Net

Figure 1.2: Indonesia’s Infrastructure Finance Needs

Source: Indonesia Averting an Infrastructure Crisis, World Bank, 2004

REDUCING THE VULNERABILITY OF THE FINANCIAL SECTOR The necessity for Indonesia to have a diversified financial sector - with well-developed NBFIs and capital markets - was brought home strongly during the 1997/8 crisis. In a famous speech in 19994, former Federal Reserve Chairman Alan Greenspan pointed out: “One wonder(s) how severe East Asia's problems would have been during the past eighteen months had those economies not

4 Remarks by Chairman Alan Greenspan before the World Bank Group and the International Monetary Fund, Program of Seminars, Washington, D.C., September 27, 1999.

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relied so heavily on banks as their means of financial intermediation. Had a functioning capital market existed, the outcome might well have been far more benign. Before the crisis broke, there was little reason to question the three decades of phenomenally solid East Asian economic growth, largely financed through the banking system, so long as the rapidly expanding economies and bank credit kept the ratio of nonperforming loans to total bank assets low. The failure to have backup forms of intermediation was of little consequence. The lack of a spare tire is of no concern if you do not get a flat. East Asia had no spare tires.” Indonesia still has no “spare tires”. It urgently needs to develop these if it is to reduce the vulnerability of its still bank-dominated financial system to future shocks, which will almost inevitably occur. It needs NBFIs and capital markets that can pick up the slack and act as shock absorbers – strong institutional investors such as pension funds and insurance firms; well developed capital markets – both equity and fixed income; and well-functioning other NBFIs such as leasing and venture capital firms that can support a variety of industries.

MEETING OTHER GOVERNMENT OBJECTIVES The Government’s financial sector reform agenda is motivated by three broad considerations – improving access to financial services, reducing the cost of financial services, and improving the stability of the financial system. The case for NBFIs in meeting some of these objectives has been made above. In addition, NBFIs improve the intermediation between savings and investments by providing healthy competition to banks – and thereby can contribute to reducing the cost of finance. Mutual funds and pensions and insurance firms enable a wider set of investors – including individual investors to participate through intermediaries and invest in instruments such as government and corporate bonds. Leasing firms provide an efficient means of broadening the access to financial services for a wider set of individuals and enterprises – especially SMEs. NBFIs broadly provide a set of products that can be used by the society to manage individual and corporate risks better. Given that Indonesia has placed many of these objectives high on its own developmental agenda, focusing on the development of NBFIs can be a strategy that is line with Government priorities.

CROSS-SECTORAL ISSUES AND RECOMMENDATIONS While NBFIs comprise a wide range of institutions – as highlighted in the discussion above – there are several common cross-cutting issues that several types of institution face. This section focuses on such issues and summarizes the findings for the NBFI sector in the areas of regulation, enforcement, creation of OJK, competition, taxes, skills, and investor education (see Annex 1 at the end of the chapter for a matrix summarizing the findings).

Regulation Weak regulation and supervision, as well as lack of adequate capacity of the agencies responsible for regulation and supervision of NBFIs is one of the primary reasons why the restructuring of the financial sector has been costly and the broad-based development of NBFIs in Indonesia has been slow. A recurring finding of this report is the lack of effective follow-up on legislation with clear and consistent elucidating regulations. As one example, the social security law (Law no. 40 of 2004) lacks details on benefits, contributions, and other major issues that affect the design of these schemes. All relevant laws need to be complemented by regulations elucidating them. In practice, there are considerable delays in promulgating timely regulations.


A second recurring deficiency consists of gaps in the regulatory landscape. For example, Jamsostek is a state-owned enterprise and thus has the Ministry of Finance as the de jure shareholder and the Ministry of State Owned Enterprises as the de facto shareholder with delegated responsibility for exercising rights of ownership. Jamsostek is subject neither to the Insurance Law for its insurance programs nor to the Pension Law for its old-age benefits program. It is subject to ad hoc government regulations under the general supervision and oversight of the Department of Manpower and Transmigration. Similarly, although Taspen provides old-age benefits to civil servants, its pension program was specifically exempted from the Pension Law. It does not need to comply with obligations imposed on other pension programs, such as the use of a custodian, the segregation of assets, and the appointment of an administrator distinct from the sponsor—that is, the government itself—or with any particular funding and solvency requirements. A third example of the present ambiguity regards the prudential framework for employer pension funds and financial institution pension funds. The framework is a series of decrees dealing with key issues such as funding and solvency requirements, investment regulations, tax treatment, and qualifications of fund administrators. However, it is silent regarding governance structure. Therefore, some sponsors copy the familiar structure of a board of commissioners and a board of directors for the pension fund, both with members appointed by the sponsor. Whether such a structure is legally necessary is unclear, and it leads to diffusion of accountability and responsibility, and higher operating costs.

Enforcement A recurring finding of this study is the poor level of enforcement across the entire spectrum of NBFI activities. In virtually every industry studied in this report—mutual funds, pensions, insurance, and leasing—there are enforcement problems. To cite a few examples: in the pension industry, noncompliance with the law mandating private contributions to Jamsostek is pervasive because enforcement is lax. Similarly, the securities enforcement capacity is increasingly tested in dealing with the complex regulatory issues confronting participants in the capital markets. However, Bapepam & LK is faced with a shortage of experienced staff to conduct complex investigations. The recent difficulty in implementing the mark-to-market regulation regarding net asset values of mutual funds is a case in point. A third example is the government’s timid response to insolvent insurance firms. There are several large insurance companies that are in substantial need of capital and Bapepam & LK has been reluctant to assess and publicize the true financial state of these companies. Bapepam & LK has withdrawn the licenses of some insolvent firms, but this action was substantially delayed and even after withdrawal, such firms have not been closed. Market sources indicate that some of these firms may be continuing to write new policies to the detriment of ignorant consumers. Consumer protection – which is paramount to maintaining market confidence – is thereby adversely affected and so is the future development of the industry. As financial markets grow, regulators will be asked with increasing frequency to ensure compliance with financial market laws and regulations. Often, the problem is inadequate resources - there are too few trained staff to address compliance problems. Governance issues and coordination across different regulators are also important constraints. The inability to preserve the integrity of financial markets by enforcing the regulations has potentially severe developmental consequences.

9

Competitive landscape Competition within and across segments of NBFIs is inhibited by the existence of an uneven playing field for different industry participants and the dominant role of the public sector in some segments. The insurance and pensions sectors provide illustrations of these issues. In insurance, the playing field has long been uneven due to differential capital requirements for new entrants and for existing participants – the latter having been grandfathered under old (and much lower) capital requirements. This effectively provides significant protection to the incumbents and makes it expensive for new private participants – domestic or foreign - to consider entry. This has led to difficulties in encouraging consolidation across a fragmented industry with many small, and some unviable, participants. The insurance industry also presents an example where a few dominant players widely considered to have solvency problems, continue to function without these problems being addressed - due to implicit or explicit support of the state. In several other countries, the insurance industry offers a one-stop package of services to private pension funds comprising the creation, registration, implementation, and administration of benefits and management of assets. In Indonesia, insurance companies, with the benefit of actuaries, and claims-processing expertise, have the competence to offer such services but are not permitted to do so. As a final example, the state plays a dominant role in the pension industry – and this role is potentially set to increase depending on the implementation of the social security law. This is clearly against international trends where the role of the state in pensions and social security provision is changing from one of provider to regulator. All these are examples of situations that need policy focus so that the competitive landscape of the NBFI sector can be changed and private participation encouraged. It is desirable to consider measures to increase competition. Many segments of NBFIs need to be fundamentally restructured so that more vibrant, competitive, and substantial players emerge. This can be done through addressing regulations that currently cater to vested interests and incumbents, reducing the role of the public sector and increasing the role of the private sector in NBFIs.

Risks in the Indonesian financial sector Due to the historic domination of the Indonesian financial system by banks, as well as the experience during the East Asian crisis, financial sector risks have been considered to be largely in the banking system. This report finds that there are also emerging areas of risks in the NBFIs that would need to be carefully watched and managed. One important area of risk build-up is the liabilities of the pension system. The implicit pension debt of the civil service pension system —the present value of the future stream of pension benefits already promised—is about 11 percent of GDP by some estimates (although an independent verification of this estimate needs to be undertaken). As the economy grows, and civil service wages rise, these obligations will grow as well unless the system is reformed and rationalized. There are other pension and social security programs from which liabilities arise, but about which little is currently known – for example, the armed forces pension fund and liabilities due to the implementation of the social security law. The insurance sector is another potential source of risk. Several large insurance firms are widely considered to have solvency issues, although the extent of these solvency issues has not been made public. Although the impact of these companies on the overall financial sector is likely to be limited (given the relatively small share of insurance assets in the economy), they pose a systemic risk to the insurance sector and require special handling. This report recommends that a prompt and detailed analysis of the options for resolving these companies be undertaken on an urgent basis, so as to form the basis for a discussion of resolution options. An early resolution would


facilitate the government’s desire to mobilize greater resources from the sector by creating an environment for growth. Equally, the universal experience suggests that the earlier a resolution is undertaken, the lower the cost of resolution is likely to be. There are also risks due to concentration of ownership. The Indonesian capital markets, both the equities and the bond markets are still relatively young, small, illiquid and ownership is not well diversified. For example, over twelve percent of government bond are owned by foreign investors. While this introduces potential risks should these investors liquidate their funds quickly, there is no quick fix to this problem. The long-term solution is to develop the local institutional and retail investors and diversify and develop the capital markets. Also as in many other developing countries, the Indonesian financial landscape is dominated by a few large players (see Table1.3). Table 1.3: Top 10 Market Share of Indonesian Financial Sectors

Sector Top 10 Market Share % Banking 63 Life Insurance 61 General Insurance 60 Pension 55 Multifinance 48 Securities 40 Source: Bank Indonesia, Infobank, Company Publication While at present financial conglomerates in Indonesia are still in an early stage, they are by no means insignificant. The most typical form of conglomerates is banks investing in non-bank financial institutions (Table 1.4). It is not easy to assess the level of financial conglomeration in the system due to dearth of publicly available data and absence of benchmarks. Bank Indonesia requires all commercial banks to provide their ultimate beneficiary owners. However, this is not yet a practice in the NBFI sector. Such a practice would increase transparency of ownership links and make it easier to assess the risks. Commercial banks in Indonesia have been permitted to play active roles in the pension and insurance sectors. In 2003, the largest financial institution pension fund was owned by Bank Negara Indonesia. Also, the employer pension funds of Bank BRI and Mandiri are in the top ten private pension funds in Indonesia. By year-end 2003, an estimated 10 banks, at least, were delivering bancassurance, with a potential market of around Rp 14 trillion, and at least 15 banks were offering mutual funds, investing mostly in government bonds. Banks have a large share of the mutual fund business. Up to June 2003, banking institutions sold around 85 percent (or roughly Rp 58 trillion) of the mutual funds (Siregar and James 2004, pp. 21–22). The situation can lead to potential conflicts of interest. For instance, because banks both extend loans to corporations and advise on investments of their mutual funds, they may seek to reduce their own lending risk by getting the funds they sell to invest in the firms to which they lend money. These and other sources of risk need to be carefully monitored and addressed on an ongoing basis.

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Table 1.4: Financial Conglomerates in the Indonesian Financial Sector, 2005

Banks Insurance Pension Funds Multifinance Securities Comment Group Assets (Rp trillion)

Mandiri Mandiri Pension Funds

Mandiri Securities

247.2

BCA Indolife Pensiontama (Life), Central Asia Raya (Life), Central Asia (General)

Same owner 153.4

BNI BNI Pension Funds

BNI Securities

Bank BNI has ownership at BNI Pension Funds and BNI Securities

150.1

BRI BRI Pension Funds

BRI has ownership at BRI Pension Funds

117.6

Danamon Adira Dinamika Multifinance

Danamon has ownership at Adira Dinamika Multifinance

66.5

Niaga GK Goh Indonesia

Niaga and GK Goh has same owner i.e. Commerce Asset Holding Berhard

39.3

Panin Panin Insurance (General) Panin Life

Bank Panin is owned by Panin Life. Panin Life is owned by Panin Insurance

39.6

Permata Astra Buana Astra Pension Funds

Astra Sedaya Finance, Federal International Finance

Has same owner i.e. PT Astra International

45.0

Tugu Pratama Indonesia

Pertamina Pension Funds

Has same owner i.e. Pertamina

5.1

Source: Bank Indonesia, Infobank, Company Publication, staff estimate

Taxes In virtually all of the industries studied in this report, tax distortions impede the development of the industry. It is important that a comprehensive look at tax regulations – and fiscal implications – be undertaken to enable the development of the sector. A concerted effort is needed to review the extent of tax distortions and ensure a level playing field. The entire gamut of tax issues is listed in Annex 1. It is important to note trade-offs are involved in changing the current tax-regime to one that can support Indonesia’s development objectives and one that is more in line with international best practice. Rationalizing the tax regime may involve some short-term reduction in revenues. However, given that the entire NBFI sector is small at present, the current revenue, and hence any potential short-term losses, are likely to be small. However, an improved tax regime could help support the growth of both the NBFI industry as well as the real sector, which would then be a source of additional tax revenues. More detailed assessment of these issues is necessary. The most obvious “quick fix” is the leasing industry. In most other countries where the leasing industry has developed, leasing is tax-neutral. For lessees, lease payments are treated as expenses, which can be set off against revenue when calculating taxable profit, while lessors benefit from deducting the depreciation on capital assets. In Indonesia, depreciation of leased assets is not allowed at present, for either the lessor or the lessee. The tax distortion raises the costs of capital, hinders the formation of capital, and retards the growth of client companies and the leasing sector. This tends to adversely affect SMEs most critically.


Following are several other illustrative tax distortions. In the pension industry, annuities are not attractive because single premiums paid out of a private pension fund to purchase a life annuity at retirement are taxable, ending the tax shelter. The treatment contradicts practices prevailing in many other parts of the world, which is exempt-exempt-taxable (EET). In the insurance industry, non-life companies are penalized more than life companies by the non-deductibility of incurred but not reported (IBNR) reserves, which are 40 percent of non-life liabilities. Finally, the fiscal treatment of insurance and pensions offers no great incentives; on the contrary, mutual funds offer much better tax advantages, being practically exempt from taxes, which partially explain the slow growth of both insurance and pension assets.

Access to finance There is a need to evaluate and analyze the access that households have to different types of financial instruments and markets. To this end, it would be useful to conduct household surveys of demand for and access to financial services. At present most of the information is generated from the supply side, with little systematic knowledge about what households look for and what constraints they face in accessing financial services. A substantial amount of survey work has been undertaken to assess enterprise-level access to finance. The results of these surveys and their policy implications need to be made more widely available. The findings of this report indicate that there is need for further analysis of each NBFI segment and its client base and undertake efforts to expand the client base both in terms of numbers and also by types of investors and by investors of different purchasing power. For instance, the mutual fund sector catered to over 250,000 unit holders as of December 2005, with three quarters being individuals. The first observation is that this is a small number given Indonesia’s large population. Next, the average unit holding of each investor was around Rp 300 million (around US$30,000), compared to GDP per capita of approximately US$1,300 indicates that the investors in mutual funds are high net worth individuals. It is important to analyze the breakdown of clients further across different sub-sectors and try to promote broader access across the economic spectrum.

Improving education Equally, there is a need to develop a base of active investors who invest in securities, pension funds, insurance companies, and collective-investment schemes. The development of institutional and retail investors hinges on educating investors in cities, towns, and rural areas about the benefits and risks of investing in securities, collective-investment vehicles, pensions, and insurance. Stock exchanges and securities regulators should fulfill a developmental role that complements their role in regulation and enforcement by raising the awareness of potential issuers of the role of the securities market in the economy and the viable alternative it can provide for funding business operations and expansion. Financial literacy is a global challenge. Throughout the world, retirement benefits are shifting away from “defined-benefit” programs, in which pensions depend on earnings and years of service, to “defined-contribution” programs in which citizens are being asked to assume a larger role in providing for their own retirement. While this creates and encourages individual choice and responsibility, it puts added responsibilities on the public. Therefore, the changes raise important questions: How informed are people to take on these new responsibilities? How informed are they about basic financial concepts? The answer seems to be not very much. One survey in Australia found that 37 percent of the people who owned investments did not know that the investments could fluctuate in value. In USA, 31 percent did not know that the finance charge on a credit card

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statement is what they pay to use credit.5 Well-aimed information can make a difference, though. In Sweden, which started a new pension system in 1999, a mixture of financial education and a media campaign prompted more people to choose their mix of investment funds for themselves. Indonesia needs better educated investors to form the foundation on which sound financial markets are built. The potential economic benefits of financial literacy in Indonesia are widespread. More informed consumers—not just investors—would improve the efficiency of markets and help to keep unscrupulous operators at bay. The authorities are therefore encouraged to develop a financial literacy program in collaboration with the industry.

The Integrated Financial Regulatory and Supervisory Authority - Otoritas Jasa Keuangan (OJK) The report addresses several of the issues discussed above in individual sector-specific chapters. Therefore, only key issues have been highlighted in this chapter. On the issue of the OJK, however, this section contains the entire discussion – as the report does not revert to it in later sections. Global experience on the issue of an integrated financial regulator is mixed. There are arguments both in favor of such an arrangement as well as in favor of a model where there are different, but strong, regulatory authorities. In Indonesia, this debate is now moot, as a decision on establishing a new integrated regulatory agency - the OJK - to regulate and supervise banks, insurance companies, pension funds, capital markets, venture capital, and leasing has already been made. The Bank Indonesia Law no. 23/1999 has been amended in 2003 with the objective of transferring the supervisory role of the banking sector from Bank Indonesia to OJK by the end of 2010. In 2005, a presidential decree merging Bapepam and DGFI – has also been passed. Therefore, there are now two financial sector regulators in Indonesia – BI and Bapepam & LK. Given that a decision to establish the OJK has been made, the critical question now is one of effective implementation. This report recommends that for NBFIs, instead of waiting till 2010 for the establishment of the OJK, the current Bapepam-LK should be made independent immediately – and its capacity strengthened. Part of the process of making it independent from the Ministry of Finance is to give it the authority to raise its resources through levies on market participants. Budgetary independence should go hand-in-hand with greater operational independence. The case for an integrated regulatory agency in Indonesia, as in other countries, was based on the increasing presence of financial conglomerates. The case for immediately upgrading and strengthening Bapepam & LK can be made on the numerous gaps in the current regulatory and enforcement process – as identified throughout this report. An independent and strong Bapepam & LK would be more in line with BI – the banking regulator – and together they could more effectively form the basis for the new OJK. A stronger Bapepam & LK is also needed to develop a coherent policy and regulatory approach conducive to the development of NBFIs. The current draft OJK law is broadly sound. It provides OJK with consistent powers across all prudentially regulated sectors, encompassing licensing, standard making, information gathering, inspection, direction, investigation, statutory management, and transfer of business. In particular, it provides OJK with extensive powers with respect to conglomerates. The consistency and coherence of these powers is in line with international practice. There are significant risks as well as challenges involved in the process of establishment of such an agency, and these need to be kept in mind. First, the risk of political interference is very real in Indonesia, especially with an agency as powerful as OJK is intended to be. A further risk is that the financial sector expertise so necessary to designing and implementing a sophisticated, unified

5 “Financial Literacy: Caveat Investor,” Economist, January 12, 2006.


strategy will be lacking - and this will make it difficult to develop coherent policies and regulations. Therefore, regardless of the ultimate location of the agency, three conditions must be met: independence, adequate resources, and qualified staff. It should be kept in mind that simply changing the structure of the supervisory system will not correct the present problems with prudential and market conduct standards, surveillance, and enforcement. A single supervisory agency does not constitute a “quick fix” tool for addressing weak supervision of financial intermediaries. The lessons of experience from other countries—Australia, Korea, the United Kingdom, and others—has shown that making the decision to move to an integrated agency is the easiest part of the process. Implementation is the most demanding. It is fraught with problems regarding merging different regulatory cultures, assembling qualified expertise, and ensuring that the process is completed without neglecting the ongoing oversight of the financial industry. The expectations for OJK are very high. The deadline for this mammoth task is 2010. The establishment of a single supervisory agency needs considerable advance planning to ensure creation of a viable agency. Indonesia is moving to an integrated model of supervision with a significant advantage: ample time for preparation as well as the lessons of experience from other countries that have adopted a model of integrated supervision. Provided that sufficient effort is dedicated to planning during the transition period, OJK will be able to take over the responsibilities of the present regulators and supervisors and to minimize disruption to the industry when it commences operations. It is essential that the planning process start now to ensure that OJK is capable of exerting its responsibility at the time of transfer of authority. The tasks before the new agency are great. The plan to adopt a unified supervisory agency must come with a commitment to proceed with a much wider scope of regulatory reforms and to develop enforcement capacity in the country. It will have to harmonize industry-based regulations to prevent regulatory arbitrage, consider the regulation of financial conglomerates and holding companies, devise strong standards of accountability and performance, design an organizational structure, and build a relationship with Bank Indonesia and the Ministry of Finance. In addition, the agency will have to consider the work being conducted in the international regulatory community to formulate international standards and update national prudential requirements in line with evolving international standards. International agencies working in these areas include industry-based organizations such as the Basel Committee on Banking Supervision (BCBS), the International Association of Insurance Supervisors (IAIS), and the International Organization of Securities Commissions (IOSCO). Finally, OJK will have to demonstrate high standards of accountability, probity, and performance in its conduct. Indonesia has decided to establish a coordinating group, including representatives from Bank Indonesia, Bapepam & LK, with responsibility for starting the planning process. This is a step in the right direction, as the time for planning is passing quickly. The expected creation of OJK should not be an excuse for delaying reforms that could be implemented sooner. There is a need to accelerate the shift to an independent NBFI regulator today. The merger of Bapepam & LK offers an opportunity to create a strong and independent NBFI regulator. The Ministry of Finance could advance the process without waiting for the establishment of the OJK in 2010. It could unilaterally transform the merged Bapepam & LK into an independent regulator that looks after the capital markets and all NBFIs and protects investors and consumers.

Skills A deregulated and competitive environment creates new demands for financial expertise. Countries that liberalize and develop the financial system require a well-developed set of skills for

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measuring and assessing risk. Insurance and pension schemes require actuarial expertise, while collective-investment instruments require a high level of professional expertise such as investment managers and analysts. Despite the difficulty in measuring the differential in skills across countries and adjusting for productivity, there is evidence on the small role of financial sector services in many emerging-market countries. Employment in finance, insurance, real estate, and business services as a percentage of total employment is lower in countries such as Brazil (2.76 percent), Indonesia (0.75 percent), the Philippines (2.46 percent) and Poland (2.62 percent) than in the United States (11.28 percent). The following discussion of select professions indicates the challenges across the entire spectrum of financial professions. Actuaries. There were 324 members of the Indonesian Actuarial Association (Persatuan Aktuaris Indonesia, PAI) in 2006 – with 134 fellow actuaries (recognized by the international actuarial association) and 190 associate actuaries. Actuaries are essential to the smooth working of the insurance and retirement benefits sectors. They make it possible to assess and address risks. Nevertheless, actuaries are scarce in Indonesia. The quantitative data in Table 1.6 document the wide disparity in the availability of actuarial skills in Indonesia relative to other countries in the sample. While Singapore and Hong Kong (China) have 43 and 45 actuaries per million population, Indonesia has roughly 0.6 excluding associate actuaries. It is desirable for the Indonesian Actuarial Association, with government guidance, to take a more active role in developing the actuarial profession, including permitting foreign participation in the industry. Among its immediate challenges are to develop and implement rules for the accreditation of individual members and to recommend educational guidelines and a syllabus for an internationally recognized actuarial qualification. Appraisers. There were 1,800 members of the Indonesian Society of Appraisers as of December 2005.6 Appraisers reduce the risk involved in property transactions by assigning credible values to property based on standard methods: all participants recognize the methodology, and the valuation is consistent. For example, if a viable, securitized mortgage market is to develop, appraisers are needed to value property. A brief look at the quantitative data in Table 1.6 indicates wide differences in the availability of appraisal services in select markets. The density ranges from 907 appraisers per million population in the New Zealand to nine appraisers per million population in Indonesia. Further, the limitations are not only quantitative: the standards of certification are lacking. The information from Indonesia suggests that there is probably no consistent treatment of the appraisal and valuation profession with respect to training and regulation. Accountants. Indonesia has 43,500 registered accountants, but only 4,500 are members of Ikatan Akuntan Indonesia (IAI), the Indonesian Accountant Association, which has 6,000 members. The Ministry of Finance is responsible for the registration of accountants. Insolvency experts. INSOL International, the international federation for insolvency professionals, has only 28 members in Indonesia. 7 An inadequate number of professionals hampers the corporate restructuring process in Indonesia.

6 Masyarakat Profesi Penilai Indonesia/MAPPI www.mappi.or.id. MAPPI was established in 1981 and is the recognized organization of professional appraisers in Indonesia. The members of MAPPI work in appraisal firms, banks, and financial institutions, the Directorate of Land and Building Tax, insurance companies, auction houses, and property businesses. 7 INSOL International is a worldwide federation of national associations of accountants and lawyers who specialize in turnaround and insolvency. There are currently 35 member associations worldwide with more than 7,700 professionals participating as members of INSOL International. See http://www.insol.org/.


Chartered financial analysts. There are 37 chartered financial analysts (CFAs) in Indonesia.8 CFAs in the investment industry can set high standards of professional excellence and ensure market transparency. The present number of CFAs is entirely inadequate. Table 1.5: Number of Actuaries in Various Countries, 2006

Country Number of actuaries Number of actuaries per million Argentina 195 5.23 Australia 1,243 73.92 Brazil 665 4.45 Canada 2,443 95.97 Chile 9 0.79 China 58 0.05 Colombia 25 0.84 Croatia 49 10.91 Czech Republic 58 5.60 Denmark 291 56.76 Egypt, Arab Rep. of 8 0.14 Estonia 18 12.99 Finland 132 26.33 France 1,880 32.60 Ghana 1 0.05 Greece 76 7.41 Hong Kong (China) 298 45.54 Hungary 137 13.21 Iceland 18 74.69 India 150 0.17 Indonesia 134 0.6 Israel 105 29.06 Italy 258 4.55 Jamaica 16 6.37 Japan 1,077 8.69 Kenya 5 0.25 Korea, Rep. of 27 0.59 Latvia 17 6.76 Lebanon 10 3.67 Malaysia 42 1.96 Mauritius 10 8.82 Mexico 405 4.52 New Zealand 130 39.33 Nigeria 5 0.05 Norway 257 60.59 Philippines 77 1.06 Poland 11 0.29 Russian Federation 3 0.02 Singapore 114 43.07 Slovenia 36 18.03 South Africa 693 20.09 Spain 1,497 41.16 Sri Lanka 2 0.12 Sweden 306 35.51 Taiwan (China) 199 10.70 Thailand 17 0.35 United States 16,696 68.29 Venezuela, R. B. de 2 0.09 Vietnam 8 0.10 Zimbabwe 4 0.34 Source: International Actuarial Association of Actuaries

8 CFA Institute, formerly the Association for Investment Management and Research (AIMR), offers the CFA designation and global membership.

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Table 1.6: Number of Appraisers in Select Countries, 2006

Country Number of appraisers Number of appraisers per million population

Albania 170 52.1 Australia 4,963 295.2 Bulgaria 128 15.3 Canada 4,500 176.8 Czech Republic 300 29.0 Denmark 644 125.6 Estonia 80 57.7 France 850 14.7 Greece 350 34.1 Hungary 110 10.6 India 12,000 13.3 Indonesia 1,800 9.1 Italy 1,200 21.2 Latvia 72 28.6 New Zealand 3,000 907.7 Norway 920 216.9 Philippines 100 1.4 Poland 3,000 78.2 Romania 5,900 254.2 Russian Federation 3,000 20.4 South Africa 2,000 58.0 Spain 6,000 165.0 Sweden 800 92.8 Source: International Valuation Standards Committee

There is a strong correlation among the base of skills, the growth of non-bank financial intermediation, and the stability of the financial system. It is reasonable to conclude that poor practices and performance of NBFIs are linked to limited skills and human capital in the financial services sector. While effort is needed to strengthen the regulatory framework and enforcement capacity in the NBFI sector, there is an equal need to strengthen the capacity of the private financial sector. What can be done? Effort is required along three dimensions: First, regulations are needed to facilitate the growth of the financial services professions. It is important to establish and promote minimum uniform standards of education and minimum qualifications. Professionally recognized training and certification programs should be mandated as well to ensure the professional expertise, integrity, and responsibility of the various professions. Second, as the development of domestic skills is a time consuming process, consideration should be given to opening the professions to foreign competition at least temporarily, as domestic skills developed. Third, innovative approaches for improving skills using private sector initiatives should be pursued. The recent launch of the Institute of Risk Management and Insurance (STIMRA) which provides focused education and training in insurance is an example of step in the right direction.

KEY SECTORAL ISSUES AND RECOMMENDATIONS

Equity market Private sector–led economic growth requires well-functioning equity and corporate bond markets as a source of risk capital to encourage entrepreneurship and to provide the corporate sector with an alternative to bank finance. Sound capital markets also reduce the vulnerability of the economy to stresses in the banking sector. Currently, Indonesian capital market is not a major source of risk capital.


Indonesia’s equity market has risen steadily since 2002, and Jakarta Composite Index was among the top performers in the region in 2004 and 2005. As of December 2004 and 2005, total market capitalization was Rp 680 trillion (30% of GDP) and Rp. 801 trillion (29.4% of GDP), respectively (about the same as that of a single medium-size firm in the U.S. equity markets). About 336 companies are listed on the exchange. The market is largely an institutional market with few individual investors having accounts. Stock markets have three roles: first as a source of risk capital, permitting firms to mobilize equity; second, as a store of value for assets; and third, as a means to price risk capital adequately. The Indonesian stock market is small, highly concentrated, and relatively illiquid and does not yet efficiently undertake these functions. As initial public offerings are not a significant source of corporate funding, the equity markets are not a major source of risk capital. With the exception of 2004, when US$1.1 billion was raised, mostly through the privatization of state-owned banks, little new equity has been raised since the crisis. There are an estimated 100,000 retail accounts in Indonesia – in a country of 220 million people. They hold barely 5 percent of equities in their accounts. Although a larger number could be participating through omnibus accounts with securities brokers, the overall view is that the equity market is not a retail market – and is not seen as a store of value for assets. Finally, in order to be able to price risk appropriately, a key requirement is liquidity. The Indonesian market is dominated by a handful of companies—10 of the 336 listed companies account for more than half of market capitalization and nearly 55 percent of trading volume. The stock exchange is characterized by a substantial lack of liquidity and low turnover in which only a few companies are responsible for a large percentage of the total trading. Many stocks are dormant; out of 336 stocks, only about 30, mostly blue chips, are actively traded. One of the reasons that liquidity is so limited in many emerging markets is the low level of free float (the percentage of shares available for sale to the public). Even those companies that decide to go public do not sell a significant portion of their shares to the public. At present the free float in Indonesian equity markets for the top 20 companies by market capitalization is about 39.4 percent. Based on independent assessments (Report on the Observance of Standards and Codes), the enforcement of transparency, information disclosure, and corporate governance are still weak in Indonesia’s equity market, administrative sanctions for violation are particularly inadequate, although there are some efforts at improving the quality and timeliness of information and increase the level of liquidity in the securities markets. Robust disclosure (disclosure rules, monitoring and enforcement, and information dissemination) is positively associated with market liquidity. However, in order to enforce such discipline, the Indonesian securities regulator faces important constraints in resources and staff. Limited and unclear powers of the securities regulator also lead to significant shortcomings in its ability to oversee the markets, supervise market participants, and enforce issuer compliance. In a large country such as Indonesia – and with economic growth rates in the 5 plus percent range being sustained over several years now and likely to build further momentum in future, there is clearly potential for strong equity markets to support corporate growth. However, decisive policies are needed, both by the government and by the stock exchange, to enable the market to reach its full potential. The following recommendations deserve top priority: Chapter 2 provides a fuller discussion of the issues in addition to laying out the context and rationale for reforms. Key issues and recommendations that deserve top priority include: Improve corporate governance. Ultimately, investors invest in good companies in which they

have confidence. Good governance goes hand in hand with good finances to attract investors.

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To encourage good corporate governance, Jakarta Stock Exchange and Bapepam & LK may want to create a separate board or have a “quality certificate” with more stringent listing requirements for entities that have implemented exemplary governance practices9. Securities of the companies listed on such a board could be bought by mutual and pension funds or banks or could be bought on margin. The following actions are recommended to improve corporate governance: (a) establish nomination committees to strengthen the process for nominating and selecting independent commissioners, (b) conduct training and promote awareness among stakeholders as part of changing the business culture, (c) enhance the roles, responsibilities, and skills of independent board members and audit committees, (d) promote the separation of management from the owners and appoint professional managers, and (e) allow minority shareholders a greater voice in the selection of commissioners (that is, though cumulative voting).

Improve and expand the role of Bapepam & LK in supervision. Bapepam & LK may want to take over the direct supervision of broker-dealers. After all, it currently supervises all capital market participants, not just broker-dealers. As the market matures, broker-dealers may venture into activities beyond securities and futures trading that are more appropriately supervised by Bapepam & LK. However, the present method of funding Bapepam & LK—out of the government budget—may have to be changed. In many countries, the Bapepam & LK-equivalent organization is funded primarily out of a levy on the transactions effected on the exchange. This method would lend more credibility to the view that Bapepam & LK is an independent organization.

Improve market infrastructure. Global markets are moving toward greater automation and the use of higher or advanced technology systems in order to expand market operations and control. Exchanges are also merging worldwide to take advantages of economies of scale and to leverage resources. More efficient market operations also lower operational costs, improve regulation, and improve liquidity within the market. To accomplish these, it is suggested that Indonesia (a) demutualize and merge the Surabaya and Jakarta stock exchanges (b) complete the move to remote trading at an early date and (c) improve trading systems and implement improved straight-through-processing between market participants and infrastructure organizations. However, after the merger it would be helpful to have the possibility of alternative trading system or Electronic Communication Networks (ECNs) to function to keep the contestability of the market.

Improve corporate health. Investors benchmark companies globally and invest in the best companies in their respective industries. Ultimately, a market is only as good as the corporates listed in the market. Comparisons across the region consistently indicate that corporate leverage and profitability have improved in Indonesia since the crisis, but not nearly enough to be competitive globally. Indonesia therefore should treat corporate restructuring as an ongoing process. Consistent enforcement of existing securities laws as well as corporate financial monitoring programs can help corporations reach standards commensurate with international norms. While good macroeconomic management and improvements in the overall investment climate are essential to achieve sustained growth, they may not be enough. Increased productivity at the corporate level is also necessary. Detailed sector and industry level work to determine specific constraints and further improvements in the competition framework, business practices, labor productivity, and trade regimes that may be holding back productivity should be undertaken and recommendations implemented.

9 The New Market of Bovespa in Brazil lists companies that have voluntarily committed to adopt higher standards of corporate governance than those prescribed by laws and legislation.


Bond market The bulk of long-term financing for government bonds, infrastructure projects, and for investments in corporate growth will have to come from debt finance. Banks are a key source of debt finance, but given the liability structure - where 90 percent of bank deposits are less than one month in maturity - banks provide mostly short-term finance. Bank loans alone are therefore neither sufficient nor desirable to meet all the financing needs of the Indonesian economy. More diversified funding sources are required. Indonesia’s debt market currently consists of government debt, corporate debt, and bank debentures. Institutional investors such as mutual funds, pension funds, and insurance companies are a critical source of demand for bonds. On the supply side of instruments, Indonesia has achieved significant progress in building the core government bond market. As the market for government bonds has been growing rapidly, the rest of the market remains underdeveloped. At end-2005, tradable government bonds outstanding amounted to Rp 389 trillion (14 per cent of GDP)10. Corporate bonds outstanding amounted to only Rp 63 trillion, representing 2 percent of GDP. Consumer debt has been growing rapidly but corporate debt growth has been relatively slow, largely as a result of the reluctance of banks to finance corporations given the credit risks, the weak legal framework and judiciary for enforcing collateral and stagnant demand within corporations themselves. Nevertheless, the sustained growth of the economy is accelerating the corporate demand for long-term financing, and this trend is likely to continue. As a result, the volume of corporate bonds outstanding has tripled in the past few years, albeit from a small base. Despite the significant potential of mortgage-backed and other asset-backed securities, the domestic market for these instruments is nearly non-existent at present. The recent decentralization agenda has devolved significant investment decisions to local governments. While many local governments are still absorbing their increased funding and responsibilities and not yet focusing on long-term investment and financing, local government finance as well as infrastructure financing is likely to become increasingly important going forward. On the demand side, banks are the largest investors in government bonds – holding 71 percent of all government bonds, including recap bonds. Insurance and pension funds hold about 14 percent of government bonds. With the crash of the mutual fund industry in 2005 (see below), overseas investors have stepped in to take significant positions in the market – and owned about 12 percent of all outstanding government bonds as of April 2006. In terms of the corporate bonds, mutual funds were the largest holders with 49% at the end of 2004. However, in 2005, mutual funds holdings of corporate bonds decreased significantly due to the redemption run. Chapter 3 provides a fuller discussion of the issues in addition to laying out the context and rationale for reforms. Key issues and recommendations that deserve top priority are: Improve coordination between Bank Indonesia, Bapepam & LK, and the Ministry of

Finance. Policy issues involved in debt market development cut across the lines of authority of the Ministry of Finance, Bank Indonesia, and Bapepam & LK, so improving coordination is imperative. Developing the market also requires implementation of interdependent tasks requiring appropriate prioritization and sequencing. Yet effective coordination often does not automatically emerge – even among regulators - and thus strong leadership is necessary to lead and coordinate relevant efforts effectively. At senior levels, officials indicate that there has been improvement over time, but serious gaps persist in coordination at the operational level. Differences in perceptions regarding OJK as well as differences in skills across institutions make substantive coordination difficult. A high-level inter-institutional committee

10 Including non-tradable bonds at the central bank, government debt amounted to Rp 648 trillion, or 24 percent of GDP.

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needs to be formed and empowered to discuss and resolve issues that cut across jurisdictions in bond market development. The tripartite meeting among the Ministry of Finance, Bank Indonesia, and Bapepam & LK should continue.

Enhance the certainty of issuance. The Government has already in place policies to announce the issuance calendar in advance. The key next step is to be a price taker in the auctions i.e. auctions should not be canceled ex post (after receiving price quotes) based on political views regarding the price. Developing long-term credibility and predictability in this area is a cornerstone of developing the debt market.

Improve market infrastructure for government bonds. Primary issuance conducted through the BI-SSSS (Bank Indonesia’s real-time gross payments system) system should be used for bond buybacks as well and be made more inclusive to attract a wider base of investors. Money market liquidity should be encouraged via repo transactions. The decision to have KSEI (Kustodian Sentral Efek Indonesia; Central Securities Depository) participate in BI-SSSS as a sub-registry should be implemented.

Clarify the regulatory requirements for credit-rating agencies. The basis for authorizing credit-rating agencies is not clear, as Bapepam & LK rules do not stipulate specific requirements for the establishment and operation of a rating agency. Bapepam & LK rules should entail clear procedures for ratings and require qualification of credit analysts and a sound ownership structure that does not compromise its independence (for example, diversified and collective ownership by a group of banks or brokers, individuals without interest in major issuers, established foreign rating agencies, and potentially international investors and partners). The agencies should also have diversified sources of income beyond bond credit rating so that they are not tempted to issue ratings that please the issuers who pay their fees. Bapepam & LK is currently drafting new rules.

Improve the collection of secondary-market pricing information. In 2005, the Surabaya Stock Exchange was charging providers of such information, which creates a disincentive to report prices. Instead, it should charge users for the information. Next, Bapepam & LK should mandate reporting of over-the-counter transactions to enhance post-trade price transparency.

Mutual funds Until early 2005, the Indonesian mutual fund industry grew rapidly – growing from assets under management (AUM) of Rp. 8 trillion in 2001 to nearly Rp. 104 trillion in December 2004. The industry’s growth was driven by the shift of individuals out of rupiah time-deposit accounts in commercial banks and into mutual funds that invested mainly in rupiah-denominated government securities, principally recapitalization bonds. The majority of investors are individuals, with institutional investors accounting for less than a quarter of AUM. However, massive redemptions rocked the industry subsequently, and assets under management fell to Rp 29.4 trillion (US$3 trillion, 1.1 percent of GDP) by December 2005. The main causes for the debacle were a sudden rise in interest rates that caused the value of “fixed income” mutual funds – which were the vast majority of funds – to fall, leading investors into a panic. Investors had been mis-sold these products as deposit substitutes – with a higher return – and had not been adequately informed of the risks of such investment. In addition, enforcement by Bapepam & LK of mark-to-market regulations was weak. All in all, the role and importance of the mutual fund industry in Indonesia has declined dramatically in the recent past. Despite this however, the mutual funds industry remains an important element of Indonesia’s financial sector, providing individuals and institutions with a vehicle for managing risk and saving. Mutual funds can also be significant investors in government and corporate bonds. It is therefore critical to understand the causes for the debacle – and to implement appropriate reforms that can ensure that such episodes are not repeated. With a sound, well enforced regulatory framework,


the potential for growth is large. Even at its peak, penetration of the mutual fund industry in Indonesia was low: a scant 0.14 percent of the total population in Indonesia owned a mutual fund compared with 48 percent in the United States. Currently, Indonesia’s mutual fund industry is small compared with regional and global markets, and the fundamentals are weak. The current structure of the industry is skewed toward fixed-income mutual funds, and the range of available products is limited. In part, this is due to the limited universe of investible assets available in Indonesia. In part, this could also be because of poor governance in some mutual funds – which resulted in the 2005 debacle. Creating an environment that would encourage mutual funds to invest in other types of products would help to diversify risk and attract a wider base of investors. The government has established an extensive regulatory structure for custodian banks and outlined their responsibilities, but the absence of an explicit fiduciary obligation to protect investors is a source of concern. Despite extensive rules, disclosure is inadequate in the areas of investment policy and the calculation of net asset value and sales procedures are poor. Some of the largest mutual funds did not follow norms of valuation laid out by Bapepam & LK and enforcement was weak. Going forward, regulation and supervision of the industry need to be tightened and brought into line with international practices. Coordination between mutual fund products and unit-linked insurance products is needed, and deficiencies in disclosure and valuation need to be addressed. An important agenda for the near term should be an education campaign to develop the base of individual investors. Chapter 4 provides a fuller discussion of the issues in addition to laying out the context and rationale for reforms. The following issues and recommendations deserve top priority: Restructure the mutual funds industry. This is the top priority for Bapepam & LK. Investor

confidence is the most important element that underlies a sound mutual fund industry composed of credible fund family companies. Only when the industry is run by credible operators can the industry benefit from fast and sustainable growth. The role of the regulator is to provide a climate that encourages sound operators to participate in the industry. In this context, a re-licensing process including a review of fit-and-proper qualifications as well as financial soundness is needed to enhance the development of mutual funds. A re-licensing process is needed for all funds, without grandfathering provisions.

Strengthen enforcement and market discipline. The crisis in the mutual funds industry in 2005 was due to poor selling, poor enforcement, and weak valuation guidelines. Therefore, stronger enforcement is a top priority. In this regard, the authority has to be firm in enforcing rules and imposing sanctions to uphold market discipline and build investor confidence. Recent anecdotal evidence suggests that compliance among investment managers is low, indicating that Bapepam & LK should be more willing to use its enforcement power.

Address the challenges of net asset valuation. The 2005 redemption run strongly suggests that the mutual fund industry is confronting fundamental issues in marked-to-market asset valuation. In the current system, fund managers report bond prices to custodians and often overstate the bond prices to get higher net asset values. The reporting of bond prices must include bonds dealers and banks that are active players in the market to better represent actual prices in the market. Furthermore, a framework is needed to determine the securities for which “readily available market quotations” are available; for those that are not, there is a need to establish a basis for determining fair value. There are several acceptable methods for determining fair value of illiquid securities, and several methods would potentially be appropriate as long as it is enforced consistently and uniformly.

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Pension funds The pension industry is part of the national strategy for providing financial security in retirement for the population as a whole. A typical framework for such a strategy often consists of three basic pillars: (1) a publicly financed and managed pay-as-you-go system to provide basic income protection, (2) a mandatory funded individual account system linking contributions with benefits, and (3) voluntary individual or occupational pension savings. In addition, many systems typically encompass noncontributory social assistance for the life-long poor, and family and intergenerational support for the elderly. In the context of this framework, Indonesia does not have the first pillar, except to the extent that poverty alleviation programs constitute such a system. Jamsostek, a mandatory, defined-contribution scheme for private sector employees and state-owned enterprises, could be considered a second pillar, except that it provides lump-sum payments at retirement rather than income replacement; it is a state-owned enterprise. Although participation is mandatory, coverage is poor: less than a quarter of the formal private sector labor force participates. Nevertheless, the assets are invested in ways similar to privately managed funds. Indonesia’s employer-sponsored programs and individual arrangements clearly fall in the third pillar. The oversight of the pension industry – and therefore the responsibility for reforms – is scattered. The MoF is directly responsible for TASPEN – the civil service pension scheme and the private pension schemes (the financial institution and employer sponsored pension funds). Jamsostek is under the overall oversight of the Department of Manpower and Transmigration, although the MoF also plays a role in supervision. Asabri – the armed forces pension fund – is under the Ministry of Defense. Different laws govern each of these types of scheme. Therefore, while this section – and Chapter 5 – addresses issues related to all pension schemes, the authorities to which some of these messages are addressed are different – and extend beyond the MoF. However, to the extent that the MoF is ultimately responsible for financing any shortfalls from pension funds, -even those not directly under its oversight- the key messages are clearly relevant to it as well. In Indonesia, the pension sector is small, controlling in total less than 4.7 percent of GDP in assets, compared with Thailand (8.4 percent), Malaysia (57 percent), and Australia (75 percent). There is great potential to mobilize domestic resources, especially if certain key reforms restructuring the industry were to be implemented and the government and the industry itself were to promote pension funds. The two defined-benefit plans—Taspen (for civil servants) and Asabri (for the armed forces)—are poorly funded relative to the promised benefits and already require budgetary support11. A large portion (22 and 43 percent, respectively) of their assets is invested in time deposits. Both these pension funds and Jamsostek suffer from a lack of transparency and disclosure, weak management information systems, high expense ratios, and poor internal governance. An accurate picture of the financial state of these funds is not available. The fastest-growing segment of the pension fund industry is the financial institution pension funds (DPLK): the number of employers using such funds more than tripled over the past five years to nearly 2,417. covering nearly 800,000 employees with Rp. 3.9 trillion in assets. 1, 758 employer pension funds – covering 1.8 million employees – constitute the last segment of the pension industry with Rp 53.4 trillion in assets.

11 Taspen was in a cash-flow deficit (excess of payouts over contributions) of Rp 1.1 trillion in 2002, while Asabri was in a cash-flow deficit of Rp 200 billion in the same year. These deficits are funded out of the government’s general budgetary resources and are expected to grow dramatically in the coming years.


A major uncertainty to the pension system in Indonesia is the new social security law (Law 40/2004). The law mandates a national defined benefit social security system – with management of assets seemingly confined to the incumbent public sector providers. For formal sector workers, Law no. 40/2004 makes participation compulsory and obliges employers and participants to contribute a certain percentage of wages. For non-wage earners, nominal amounts are stipulated. There are no stipulations about minimum or maximum amounts of benefits or contributions or other parameters; such details are to be stipulated by regulations – which have yet to be issued. The situation created by Law no. 40 and the timing of its implementation are still very fluid, making it difficult to assess the impact on the pension industry. The new law permits two possibilities. If implemented well with the objective of providing basic income protection to all Indonesians – this could very well be an overall positive and provide genuine social security. However, if implemented with much more generous benefits, the law has the potential to seriously adversely impact government finances. The role of the public and private sector also need to be clearly defined. If the National Social Security System aims to achieve a high income-replacement ratio, it will crowd out the private sector and drain the available savings. If the coverage is more basic, the private sector could play a complementary role, especially for the higher-paid fraction of the labor force. Some positive steps to improve the private pension industry are in progress. A shift to risk-based supervision is under way, which eventually should alleviate unnecessary burdens and reward good governance. The creation of OJK, an integrated supervisory authority for the financial sector, is expected to improve the efficiency and capacity of supervision. In addition to implementing these changes as soon as possible, critical review and clarification of the legislation are advisable, and an adequate mechanism for the exchange of information is needed. A major challenge will be deciding how to treat the large informal sector. A comprehensive approach to reforming and strengthening all types of pension funds is a priority. A coherent strategy—or architecture— of what sort of social security system (and in that context what kind of pension funds) Indonesia wishes to provide for its citizens, in the context of the social security law is urgently needed. As evidenced by several countries in Latin America and other parts of the world, the ultimate result of a poorly managed and designed system is usually a government bailout, with attendant fiscal costs. Chapter 5 provides a fuller discussion of the issues in addition to laying out the context and rationale for reforms. The following issues and recommendations deserve top priority: Formulate a coherent master plan. A master plan is needed to provide a framework for the

provision of retirement income in a fiscally sustainable way, define the roles of public and private sectors, minimize fiscal costs, limit political capture of funds, and achieves long-term asset accumulation and sound investment policies.

Undertake an audit and reform of Taspen before addressing funding issues. In the current circumstances and state of weak governance of Taspen, it is not advisable for the government to think about funding its civil service pension obligations, although funding the program should be the long-term goal, after institutional issues have been addressed. Instead, the Ministry of Finance should (a) undertake an actuarial assessment of TASPEN’s liabilities (b) adopt reporting and accounting on the basis of full funding (c) continue the financing on a pay-as-you-go basis but recognize unfunded pension liabilities as part of government debt and (d) undertake a comprehensive institutional restructuring and streamlining of TASPEN.

Encourage outsourcing of activities at Jamsostek to improve efficiency. Jamsostek’s poor performance and governance adversely affects the image of the whole pension industry. As long as participants view their pension contributions as a tax – and not as an investment – the pension industry will find it difficult to grow. One way to improve Jamsostek’s performance is

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to introduce competition through outsourcing to improve its efficiency and hold it accountable to a comparable benchmark. As a first step, the management of a small part of Jamsostek’s assets – say 5 percent – could be outsourced to one or more private companies on a competitive basis.

Improve the asset allocation of private pension funds. Private pension funds would also benefit from better asset allocation and investment policies and lower costs. On top of this, they would benefit significantly from reform of the public pension system, which would improve the credibility and attractiveness of the entire sector.

Insurance This study focuses largely on the life insurance industry as it is a potential source of long-term resources. The non-life insurance sector is not dealt with in detail. The Indonesian insurance industry is small – with total assets of Rp. 75 trillion (US$ 7.7 billion) – 2.8 percent of GDP. Insurance penetration in Indonesia—premiums as a percent of GDP—is low, with premiums equal to 1.4 percent of GDP (life, 0.8 percent; non-life 0.6 percent). Insurance density – premium per capita – is US$ 14.5 per capita (life - US$ 6.4 per capita, and non-life, US$ 8.1 per capita). The industry is highly fragmented – with a large number of relatively small players in both life and non-life insurance sectors. There are large insurance companies in the industry that are widely considered to be insolvent and posing a potential systemic risk. While life insurance is traditionally an industry that produces long-term savings, in Indonesia this potential is not yet being fulfilled. Poor sales practices, and inappropriate products result in a high lapse rate i.e. many policies are not renewed. More than half of new sales replace business lost during the year, and of the business lost, close to 95 percent of terminations are due to lapses in payment and surrenders. Indonesian consumers also indicate a lack of confidence in long-term commitments such as life insurance contracts. Many small insurers are undercapitalized and unlikely to withstand stiffer market competition in the future. In addition, several firms have been identified as being unable to meet stricter capital requirements that have been imposed gradually since 2000, and their operating licenses have been withdrawn; however, these firms have not physically been closed yet. Resolving insolvent firms is linked to the development of a framework to protect policyholders – and this has not yet been developed. Analysis of insolvent insurance companies and design of an action plan on that basis is also required. International experience indicates that costs of resolution increase consistently as a resolution decision is delayed. The regulatory and supervisory regimes as well as institutional capacity of the regulator are in need of modernization and upgrading. A coherent strategy is needed for prioritizing the development of regulatory and supervisory policies and practices. Tasks on the agenda include (a) developing a flexible approach to supervision that emphasizes risk management and consumer protection and strives for greater market discipline in achieving desired regulatory outcomes; (b) developing a harmonized approach to risk-based capital management and application across all prudentially supervised industries, including a framework for assessing market-related risks; and (c) reviewing the approach to reinsurance. At present, reinsurance companies are treated essentially the same as property and casualty insurance companies, despite the significant differences in their risk profiles. Consideration also should be given to whether the supervisory approach to life and property and casualty companies is in need of greater differentiation. In particular, a sustained effort is needed to improve the quality and reliability of actuarial reports.


Chapter 6 discusses these in greater depth. The following recommendations deserve top priority: Rationalize the industry. Several insurance companies in Indonesia are weak, marginal, or

bankrupt. Weak companies are a dead weight on the economic system that stifles development through numerous channels. Poorly performing insurance companies are both a symptom and a cause of economic malaise, and their activities lead to structural problems in the economy. First, poorly performing insurance have poor underwriting skills and enter into unproductive investments. Poorly performing companies distort competition by creating an uneven playing field that disfavors good companies, which end up subsidizing them. The longer and more protracted the problem becomes, the harder it is for both the government and the industry to make the tough decision to resolve failing companies. Such companies should not be protected from normal market discipline. The first step in rationalizing the industry is to remove the grandfathering capital clause for existing insolvent companies and devise an active merger or exit strategy for them. Subsequently, a capable insolvency apparatus is needed to resolve the companies that do not meet risk-based capital requirements. The first priority is to assess the extent of problems in and devise an action plan for the large insolvent life insurance companies– if market views and expert opinion is confirmed - potentially pose a systemic risk.

Improve enforcement. The enforcement of the present regulatory regime is clearly deficient. The regulators are aware that several companies are insolvent, and have withdrawn licenses in some cases, but these have not yet been closed. The regulator needs to adopt consistent, even-handed, and transparent enforcement, including expanded risk-based examinations and stronger, simpler, rapid escalation procedures.

Promote the industry. A key second-generation issue is the development of the industry. The Bureau of Insurance and the industry and professional organizations, including the Indonesia Life Insurance Association, the General Insurers Association, and the Indonesian Association of Actuaries, need to jointly launch a sustained educational campaign to educate and promote the benefits of the insurance industry and of its products. The establishment of joint government-industry high-level committee to develop future action plans for the industry is also an important step.

Involve Indonesian regulators in IAIS. The IAIS represents insurance regulators and supervisors of some 180 jurisdictions in more than 130 countries, constituting 97 percent of the world’s insurance premiums. The leading insurance companies in the world are observers. The IAIS aims to contribute to improved supervision of the insurance industry on a domestic as well as on an international level in order to maintain efficient, fair, safe, and stable insurance markets for the benefit and protection of policyholders. Active Indonesian participation in the work of the IAIS would demonstrate to the entire world that Indonesian authorities are committed to improving the workings of the insurance industry in Indonesia.

Other NBFIs: Leasing and Venture Capital Companies Leasing and factoring services can play a big role in providing access to finance for small and medium enterprises. Venture capital is a critical element of fostering innovation and entrepreneurship. Further development of these industries is necessary to support Indonesia’s future growth. The Indonesian NBFI sector includes “multifinance” companies (which provide leasing, factoring, consumer finance and credit card services) and venture capital companies. These are not deposit-taking institutions. Leasing offers a financing vehicle for, among others, new, small, and medium firms that cannot meet the credit history and collateral requirements for traditional bank loans. It broadens competition for financial services and introduces businesses and financiers to innovations such as cash-flow-based credit analysis. Venture capital companies also support small and medium enterprises as well as entrepreneurship with risk capital financing.

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From 1988 until the financial crisis of 1997–8, the industry grew strongly, with the majority of financing in the form of leasing and factoring. The sharp rise in interest rates during the crisis adversely affected the growth and performance of multifinance companies. However, since 2001 the industry has recovered, and consumer finance has become the main driver of growth. As of September 2005, there were 237 multifinance companies, which had extended financing amounting to Rp 66.9 trillion. Consumer finance dominates the business (66 percent), followed by leasing (29 percent), credit cards (3 percent), and factoring (2 percent). Further development of these industries in Indonesia depends on several factors. The current regulations need to be reviewed and updated. Efforts are needed to stimulate the demand for services, and incentives are needed to encourage finance companies to support small and medium businesses. Chapters 7 and 8 deal with Multifinance and Venture Capital Industries respectively. The following recommendations deserve top priority: Put in place light level of regulation and supervision. In most developed countries, leasing

companies are not subject to prudential regulation. The lack of regulation relies on the argument that as long as leasing companies do not engage in deposit taking, there is no role for public regulatory authorities. However, there are strong arguments favoring light regulation to provide a more credible sector, especially during the initial phases of development as in Indonesia. Experience in developing countries has shown that some degree of prudential norms is desirable to prevent excessive risk taking, which hinders development of the industry. For instance, in the East Asian crisis, numerous leasing companies failed due to currency and maturity mismatches, setting back the development of the industry. The government should consider regulation and supervision of the leasing sector in the areas of entry requirements (licensing and relicensing, minimum capital requirements), balance sheet restrictions (maximum leverage ratios, single client and group exposure, limitations on insider transactions, provisioning requirements, asset-liability matching in terms of currency and maturity), associations among institutions, liquidity requirements, accountability requirements, insurance and support schemes, absolute minimum capital requirements, capital ratios, legal lending limitations on exposure to a single client, foreign currency and maturity mismatches, and reporting requirements. Equally, supervision should rely on off-site financial analysis, complemented by periodic risk-based examinations.

Allow depreciation of leased assets. The authorities should allow lessors to depreciate the leased asset under a financial lease and include depreciation in the calculation of tax for finance lease transactions. Doing so would reduce the costs of leasing. The government has announced its support for small and medium enterprise financing, and such an amendment would be consistent with that objective.

Widen the base of financing. In the present situation, the future funding of the industry depends largely on liquidity in the banking sector. Therefore, it is understandable that multifinance companies are seeking alternative sources of financing. From the perspective of the authorities, whose task is to maintain stability in the financial sector, decoupling the multifinance industry from the banking sector might be desirable in order to create a more competitive and diversified financial sector. Multifinance companies currently do not have access to public funds in the form of deposits – and this is appropriate. It is desirable to consider other alternatives, such as encouraging the participation of foreign equity capital and long-term funding from domestic institutional investors, such as pension funds and insurance companies.

Develop credit information systems. It is highly recommended that the government and Bank Indonesia allow private sector participation in consumer credit information systems. Private credit bureaus can better manage professional processing of bank data and retail


information in a format that facilitates the use of risk assessment and standardized pricing models by banks and multifinance companies. This in turn can help individuals and SMEs build a valuable asset – their credit history – which can then improve their access to finance.

Support corporate restructuring through private equity funds. The corporate restructuring process in Indonesia, while advancing, is not complete. The positive aspects of private equity vehicles—restoring companies to going-concern value rather than liquidation, removing the financial and management burdens from the banking sector, allocating resources more efficiently, improving the prospects to realize values—suggest that private equity can have a significant role to play in the corporate restructuring process. This fundamentally sound idea could be refined and implemented in Indonesia. Indonesia lacks a wide base of financial expertise to restructure medium-size companies. Therefore, considerable effort is needed to attract and build domestic expertise in financial engineering. If necessary, foreign expertise could be attracted as well.

Separate the operation and management of venture capital funds. The one-tier structure of venture capital operations runs counter to best practices, in which the ownership and management of capital are separated. It hinders the ability of venture capital companies to raise funds from investors. Allowing the management company to be separate from the venture capital company would facilitate the use of management expertise. The government will have to assess carefully the regulatory and supervisory implications of such a change. One possible route is to create venture capital funds using the legal and tax framework of a trust. This would provide a convenient entry point for institutional investors such as insurance companies and pension funds, as well as wealthy individuals, to invest in the equity of private growing companies.

Develop trust vehicles. In countries with a civil law tradition, such as Indonesia, the concept of trust, which separates management from beneficial ownership, is not recognized, and special legislation has to be passed. First, trusts need to be recognized as a legal vehicle. Second, the tax code needs to be made neutral for trusts, and there should be no sale, transfer, duty, or value added taxes.

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REFERENCES Bakker, Marie-Renee and Gross, Alexandra. 2004. “Development of Non Bank Financial Institutions and Capital Markets in European Union Accession Countries” The World Bank Ghosh, Swati, 2006. “East Asian Finance: The Road to Robust Markets” The World Bank Masyarakat Profesi Penilai Indonesia (MAPPI), www.mapi.or.id Siregar, Reza Y., and William E. James. 2004. “Designing an Integrated Financial Supervision Agency: Selected Lessons and Challenges for Indonesia.” University of Adelaide, School of Economics, and Nathan Associates, October. The Economist, 2006. “Financial Literacy, Caveat Investor, 12 January 2006 edition, The Economist. The World Bank, 2001. “ Finance for Growth: Policy Choices in a Volatile World”, World Bank Policy Research Paper. The World Bank. The World Bank, 2004. “ Indonesia Averting an Infrastructure Crisis, The World Bank. www.federalreserve.gov/boardDocs/speeches/1999/199909272.htm


ANNEX 1. MAJOR FINDINGS IN THE NBFI SECTOR IN INDONESIA

Area Equity & Fixed-Income Markets

Mutual funds Pension funds Insurance Leasing Venture capital

Structure Market is relatively small, highly concentrated, and relatively illiquid. IPOs are not a significant source of corporate funding

Elaborate system of corporate governance rules exist, but practice falls short of international norms

Market dominated by fixed income mutual funds, sensitive to the interest rate environment

Most funds structured as collective investment contracts with low investor protection

There are four types of pension programs, catering to different clientele; government employees (Asabri, Taspen), mandatory formal sector employees (Jamsostek), employer pension funds and financial institution funds

Pension fund sponsors have invested in expensive, wage-indexed systems, commonly prevalent in government and state-owned enterprises

Industry is small and highly fragmented

Insurance penetration and density is low

As retention ratios are low, the industry mobilizes limited long-term savings

Leasing is a part of the multifinance industry, which includes factoring, credit cards and consumer finance. The last dominates the business

Only about half of the licensed companies are actively operating

Most companies are not genuine venture capital companies as the industry is in the business of lending and rarely provides equity capital

Most companies are owned by the Government or business groups

Regulatory On an overall basis, the regulatory structure is reasonable for equity and fixed income markets. Although, for government bonds there are co-ordination issues between Bank Indonesia, BAPEPAM & LK and the MOF

There is no mandated reporting of secondary market trades

The current system applies inconsistent regulations and supervision on mutual funds, pension funds, and unit-linked insurance

Investor protection and disclosure are weak.

The framework for eligibility, qualifications, and codes of conduct of investment managers is inadequate

Having individual agents sell mutual funds makes it difficult to monitor and

National Social Security System Law is vague on details regarding benefits, contribution rates, major strategic policy options, and financing

Half of pension assets do not produce retirement income, being payable as a lump sum at retirement or earlier

Ambiguity in the laws and regulations has discouraged the creation of occupational pension plans: employers comply with mandatory programs before contributing to a voluntary program.

There is no regulation covering mutual insurance companies, although one of the largest insurance firms in Indonesia is a mutual firm

Regulation for winding up and liquidation of insolvent insurance companies is weak

Regulations governing unit-linked insurance products and mutual funds are not consistent

Clear, simple, and effective legal procedures are needed for reclaiming assets and enforcing business contracts

Leasing companies need access to other types of funding besides bank loans, preferably direct investment

The industry is too fragmented, and various regulations are not conducive to consolidation, including the restrictions on foreign ownership, investment size, and amount of paid-up capital

Regulations do not recognize profit-sharing financing, a common practice in the industry

The regulatory capacity is weak

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regulate the conduct of agents

Enforcement Rules and standards regarding disclosures, appropriate use of funds, accuracy of periodic reporting, and internationally consistent accounting standards exist. However, enforcement of these issues in both markets is slack

Inadequate enforcement of regulations; particularly in net asset value regulation, and disclosure of material information

Enforcement of mandatory contributions under Jamsostek is lax

There is weak enforcement of timely payment of employer contributions into pension funds

Enforcement of regulation across industry participants is not consistent and has protected small, marginal and unviable companies from normal market discipline

Difficulties in enforcement of leasing contracts is a key limitation facing the industry

Enforcement of reporting requirements is weak

Skills Quality of auditors needs improvement

There is a limited supply of high quality securities and financial analysts

The MoF’s cash management capacity is weak, which is one of the reasons for the lack of a treasury bill market

Training and skills of individual sales agents are inadequate

PAI standards on pension work are below international norms leading to low professional quality of actuarial reports

Lack of management experience and knowledge, results in poor quality and high-cost products and services and poor asset allocation

Low retention rate highlights the weak skills of the sales force

Actuarial skills are low as indicated by the quality and reliability of actuarial reports. Practices are not in accord with international best practices

Enforcement of tax policy is unreliable and unpredictable

Project appraisal skills are weak

Lack of skills in assessing credit risk discourages multifinance companies from offering products other than in consumer financing

The industry needs further training to assess cash flows and future prospects, rather than collateral, as is the current practice

Taxes Corporate dividends are subject to double taxation, which discourages companies from using the optimal mix of financing mechanisms

Transfer of assets from debt originator to SPV is considered a sale and hence

Fixed income mutual funds enjoy favorable tax treatment; returns from mutual funds are tax exempt for the first five years. This incentive is being re-evaluated in the proposed amendment

There is no harmonized tax policy covering all types of retirement savings

EET treatment is not fully implemented and double taxation is common.

The tax on capital transferred from a registered pension fund to an insurance company to purchase an annuity makes annuities relatively unattractive.

Tax policy is broadly in line with international norms but there are some areas of problems; such as, annuities are not attractive because single premiums paid out of a private pension fund to purchase a life annuity at

There is no coherent tax policy on leasing. For example, neither lessor nor lessee can claim depreciation on the leased asset in a financial lease

Tax regulations create an uneven playing field for different types of business in

Current tax incentive structure is misaligned with the products offered by the industry




subjected to taxes. The asset-backed securities market is therefore undeveloped.

s to the tax law

retirement are taxable, ending the tax shelter

Non-life companies are penalized more than life companies by the non-deductibility of IBNR reserves, which are 40 percent of non-life liabilities

Current tax treatment for life insurance is TTE versus the international norm of EET

the industry

Competition landscape

There is little competition from firms to list as there is a limited benefit for listing

The current structure of the two exchanges is not conducive to competition

Only Himdasun members participate in government bond auctions, limiting the degree of competition in the market

The industry is characterized by high fees and lack of comparative performance information

The state has a dominant role in the pension industry. To this extent, the playing field between the private sector and public sector is uneven. For example, voluntary plans have to compete with mandatory public programs

Under the National Social Security System Law there is no room for participation of the private sector or regional governments in the five mandatory programs

Differential capital requirements for incumbents and new players fosters an uneven playing field and hinders competition

The growth opportunities for the industry are limited by the fact that banks are the primary source of capital for the industry. Only those companies affiliated to banks have significant growth opportunities

The industry ends up competing against commercial banks, due to the practice of providing debt products. This limits opportunities for growth

Traditional providers of capital, such as pension and insurance companies, do not participate actively in this market

Access Access to equity and bond markets is relatively open; however foreign investors account for more than half of the market capitalization of the Jakarta Stock Exchange and there is limited

Investors comprise of a small number of affluent individuals. Institutional investors have very limited exposure in equity funds and prefer to invest directly in companies.

Coverage of the pension system is low

In principle access to the pension system is open to formal sector employees, which is only a third of the overall workforce. Less than a fifth of the formal sector actually participates in the pension system. Reasons for this

Access to insurance products is not perceived to be a problem, although the low per capita income and pricing of insurance products limits the demand for insurance products

The majority of leasing company portfolios consists of relatively larger companies. SMEs have lower access to leasing due to problems of collateral availability, reputational risk, and

Genuine venture capital financing is limited. Conversely, demand for equity financing from SMEs is low due to a cultural preference to retain control

33



interest amongst domestic investors

Secondary market in government bonds is accessible directly only to BI-SSSS participants. Others have to use the services of these participants for a fee

range from low per capita income to lack of trust in the institutions

credit risks

Developing investor base and investor education

Investors have a poor understanding of risk in both equity and fixed income markets. The Jakarta Stock Exchange has had limited success with its investor education programs

Investors are not well informed about the risks in mutual funds investing

Majority of workers and employers are not educated about the need for financial security in retirement and the advantages of building income-generating assets early in their career

Companies regard pension plans as an expense rather than as a tool for human resource planning and an efficient component of compensation

Investors have limited knowledge about the financial protection that insurance products offer

Private sector ratings of insurance companies are not available.

Actuarial skills are limited and affect both insurance and pensions industries.

SMEs are not necessarily well informed about leasing possibilities. This is compounded by the access issues.

There is a need to educate small and medium enterprises and entrepreneurs about the potential uses of venture capital and to increase awareness of the industry. There is also a need to educate venture capitalists so that they understand the difference between venture capital funds and bank loans and begin to rely more on cash flow assessments than on collateral assessments

CHAPTER 2 INDONESIA’S EQUITY MARKET

Over the past two decades, stock market development has been a catalyst for long-run growth in developing countries. Research shows that countries with better developed capital markets have more robust economies and rapid economic growth. By facilitating longer-term, more profitable investments, a liquid market improves the allocation of capital and enhances the prospects for long-term economic growth. According to Levine and Zervos (1996), “Countries with relatively liquid stock markets in 1976 grew much faster over the next 18 years than countries with illiquid markets, even after adjusting for differences in other factors that influence growth, such as education levels, inflation rates, and openness to trade. In promoting economic growth, a liquid stock market complements a strong banking system, suggesting that banks and stock markets provide different bundles of financial services to the economy.” Finally, mobilization of equity capital is more attractive than reliance on external debt, as the lessons from the Asian financial crisis show. Although a stock market has existed in Indonesia for some time, its activities took off in the late 1980s, after two government interventions. In 1977 BKPM (the Investment Coordinating Board) issued a government regulation requiring 24 foreign companies, to divest up to 20 percent of their ownership stake to the public. These forced listings, however, were not sufficient to create an active market, as the shares soon became illiquid, and some companies subsequently chose to delist. A decade later, in the late 1980s, Bapepam intervened by persuading domestic companies to go public and invited international fund managers to participate in these offerings. This intervention led to the boom of 1989–90 and the beginning of the securities industry in Indonesia.

MARKET STRUCTURE Indonesia’s market is relatively small, highly concentrated, and relatively illiquid. Although growing since the crisis, it remains relatively small in relation to the size of the economy. From December 1988 to July 1990, the number of companies listed on the Jakarta Stock Exchange (JSX) grew from 24 to 103; by the end of 2005, the number of companies listed had reached 336 (see


figure 2.1). Since the 1998 crisis, 51 companies have beendelisted, and 105 companies have been added. Although the number of companies involved is small, both the volume and value of shares traded and market capitalization as a share of GDP have increased significantly (see figure 2.2). As of December 2004 and 2005, total market capitalization was Rp 680 trillion (30% of GDP) and Rp. 801 trillion (29.4% of GDP), respectively. (see table 2.1). The market is also highly concentrated. Figure 2.3 shows the proportion of market capitalization taken up by the 10 largest companies in various Asian markets at end-2005. Jakarta, along with Hong Kong (China) and Colombo, had a concentration slightly in excess of 50 percent; see figure 2.4 for the concentration of turnover value in 10 companies. As in a number of Asian countries, many of the companies listed in Indonesia are family-owned businesses that float only a small proportion of stock. They tend to be managed as family entities, raising concerns about the rights of minority shareholders. For the top 20 companies by market capitalization, the free float (percentage of shares owned by the public) is approximately 39.4 percent (see table 2.2). According to Claessens, Djankov, and Lang (2000), “The correspondence between control and management is striking. On average, about 60 percent of companies which are not widely held have the controlling owner appoint a member of top management. Four-fifths or more of companies in Indonesia have managers who belong to the controlling group.” Finally, Indonesia’s market is relatively illiquid, in part because of its size. Turnover velocity, computed as the ratio of a market’s turnover value to its market capitalization, is one measure of market liquidity. Figure 2.5 shows the turnover velocity for various markets in Asia in 2005. Markets in Australia, Japan and Republic of Korea have higher turnover velocity ratios than Indonesia, where many stocks are dormant. Out of more than 330 stocks, no more than 30 stocks, mostly blue chips, are actively traded, and the top 10 constitute more than 50 percent of total market capitalization. Figure 2.1: Listed Companies on the Jakarta Stock Exchange, 1995–2005

238 253282 288 277 287

316 331 333 331 336

0

50

100

150

200

250

300

350

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: Jakarta Stock Exchange

37

Figure2.2: Market Capitalization as a Share of GDP in Select Asian Markets, End-2004

0%20%40%60%80%

100%120%140%160%180%200%

Austra

lian

Bomba

y

Bursa M

alays

ia

Colombo

Jaka

rta

Korea

NSE India

New Zea

land

Osaka

Philipp

ine

Shang

hai

Shenz

hen

Singap

ore

Taiwan

Thail

and

Toky

o

Source: World Federation of Exchanges Table 2.1: Stock Markets in Select Countries, 1990–2004

Country and indicator 1990 %

1995 %

1999 %

2000 %

2004 %

1990–2004 average %

Market capitalization of listed companies (percent of GDP) Indonesia 7.06 32.95 45.79 16.24 30.07 26.42 Morocco 3.74 18.04 38.87 32.70 50.07 28.68 Brazil 3.55 21.02 43.06 37.56 54.62 31.96 Thailand 28.00 84.58 47.74 24.04 70.58 50.99 Poland .. 3.35 18.00 18.79 29.40 17.39 Ratio of new equity to market capitalization Indonesia 6.16 56.03 8.21 1.60 18.00 Morocco — 4.16 0.52 2.01 11.32 4.50 Brazil — 4.02 2.98 2.57 1.15 2.68 Thailand — 3.73 11.04 6.09 2.00 5.72 Poland — 11.98 1.39 4.46 2.82 5.16 Turnover ratio Indonesia 75.78 25.27 46.97 32.92 43.10 44.81 Morocco .. 45.90 17.60 9.22 8.78 20.37 Brazil 23.56 47.85 52.97 43.48 33.13 40.20 Thailand 92.62 41.38 90.63 53.20 93.79 74.32 Poland .. 71.52 45.80 49.93 30.61 49.46 Source: World Federation of Exchanges, Staff Estimates — Not available. .. Negligible. Figure 2.3: Share of 10 Largest Companies in Total Market Capitalization in Select Asian Markets, End-2005

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

Austra

lian

Bomba

y

Bursa M

alays

ia

Colombo

Hong K

ong

Jaka

rtaKore

a

NSE India

New Zea

land

Osaka

SE

Philipp

ine

Shang

hai

Shenz

hen

Singap

ore

Taiwan

Thaila

ndTok

yo

Source: World Federation of Exchanges


Figure 2.4: Turnover Value in 10 Largest Companies in Select Asian Markets, End-2005

0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%90.0%

Austra

lian

Bomba

y

Bursa M

alays

ia

Colombo

Hong K

ong

Jaka

rtaKore

a

NSE India

New Zea

land

Osaka

SE

Philipp

ine

Shang

hai

Shenz

hen

Singap

ore

Taiwan

Thail

and

Toky

o

Source: World Federation of Exchanges Table 2.2: Market Capitalization of the Top 20 Companies in Indonesia, 2006

Top 20 stocks Market capitalization (US$ million) Free float (percent) PT Telekomunikasi Indonesia 16,085 48.8 PT Bank Central Asia 5,477 55.8 PT Bank Rakyat Indonesia 5,476 42.5 PT Perusahaan Gas Negara 5,422 29.6 PT Astra International 4,091 49.9 PT Bank Mandiri 3,478 31.1 PT Unilever Indonesia 3,389 15.0 PT Indosat 2,455 46.1 PT Bank Danamon Indonesia 2,230 29.7 PT Gudang Garam 1,904 26.1 PT International Nickel Indonesia 1,786 19.1 PT Bumi Resources 1,610 64.2 PT Bank Negara Indonesia 1,625 0.9 PT Indocement Tunggal Prakarsa 1,576 34.9 PT United Tractors 1,570 41.5 PT Semen Gresik 1,376 23.5 PT Kalbe Farma 1,361 47.0 PT Medco Energi Internasional 1,250 93.0 PT Astra Agro Lestari 1,089 20.2 PT Energi Mega Persada 1,072 68.5 Total 64,322 39.4 Source: Bloomberg

39

Figure 2.5: Turnover Velocity in Various Asian Markets, 2005

0%

50%

100%

150%

200%

250%

Austra

lian

Bomba

y

Bursa M

alays

ia

Colombo

Hong K

ong

Jaka

rtaKore

a

NSE India

New Zea

land

Osaka

SE

Philipp

ine

Shang

hai

Shenz

hen

Singap

ore

Taiwan

Thail

and

Toky

o

Source: World Federation of Exchanges

MARKET INFRASTRUCTURE Indonesia has a wide range of market infrastructure, including trading systems for equities, bonds, and other instruments: clearance, settlement, and depository systems, and securities firms. Indonesia has two principal stock exchanges—Jakarta Stock Exchange (JSX) and Surabaya Stock Exchange (SSX)—that trade equities (including company warrants), bonds (corporate and government), share options, and index futures. Other instruments traded on other markets in the ASEAN region but not traded in Indonesia include warrants, single-stock futures, index options, and exchange-traded funds. JSX started trading equity options last year, so far with little success, largely because options are not yet of interest to most retail investors and its trading system does not cater to market makers. Since mid-2000, JSX has had two listing boards: the main board and the development board. The main board caters to large companies with a track record, while the development board caters to small and mid-size companies with no profit record. Rather than attract new companies to list for the first time, the JSX development board handles listed companies that have been downgraded and are unable to comply with profitability and size criteria. As the crisis took its toll, out of around 350 listed issuers, just over 30 companies were on the main board. At one point, JSX considered adding a third board for “recovering companies” but later decided against it. JSX is one of the few exchanges in Asia that conducts transactions on a trading floor. Although the Jakarta Automated Trading System (JATS) matches buy and sell orders electronically, the orders are entered via trading terminals located on the floor. Orders are communicated between brokers’ offices and the floor by telephone. JSX has a disaster recovery program for the computer system but does not maintain a second “disaster floor” because doing so is both prohibitively expensive and impractical. JSX is in the midst of implementing remote trading, which will enable orders to be transmitted remotely via workstations. So far, fewer than half of the members have implemented remote trading. The expectation is that everyone will be connected by the end of 2006.


Indonesia also has the Surabaya Stock Exchange, which focuses on the trading of bonds and futures, instruments that JSX does not handle. However, the two exchanges still compete for listings, and many companies are listed on both exchanges. A special committee set up by Bapepam & LK and comprising representatives from Bapepam & LK and the four self-regulatory organizations have recommended demutualization of the exchanges through the formation of a holding company for the four self-regulatory organizations. Bapepam & LK has drafted the necessary capital market laws to take into account the demutualization and is awaiting parliamentary approval. In addition to the two stock exchanges, Indonesia has two systems for clearing, settlement, and deposits: Central Securities Depository (Kustodian Sentral Efek Indonesia, KSEI) and the Clearing and Settlement Corporation (Kliring Penjaminan Efek Indonesia, KPEI). System personnel and resources are spread over the four entities, with no economies of scale and virtually no interoperability. With few exceptions, the infrastructure is old, although there are plans to rectify this. Straight-through-processing capability of the individual participants is rated as good, but interoperability within the market is practically nonexistent. This situation is largely due to the individual business model associated with each of the market players. Finally, Indonesia has 173 securities companies, of which 142 administered client securities accounts (exchange member securities companies, as of end-2004). With little more than 15,000 trades per day, the industry maintains resources for trading volumes in excess of 10 times the current level. Between 1999 and 2001, as much as 60 percent of transaction value passed through 28 brokerages (out of 190 in total). In general, there are too many service providers, each with their own specific infrastructure model. Therefore, many security houses in Indonesia are not operationally profitable. In 2004, Bapepam & LK issued new regulations to raise the net working capital requirements with the objective of reducing the number of security houses. Out of 190, 125 complied with the new regulations. Companies that fail to comply may opt to form partnerships with those that do comply in order to continue functioning as a securities companies.

LEGAL STRUCTURE The overall legal framework for activities in the equity securities market is the Capital Market Law12 and rules used to implement it. The Law on the Limited-Liability Company no. 1/1995 governs the creation and structure of limited-liability companies. This is the basic law for the governance of corporations. The provisions of the Capital Market Law apply to corporations when they make a public offering, but otherwise the Law on the Limited-Liability Company is used to determine the internal operations of a company. Article 82 of the Capital Market Law gives Bapepam & LK the authority to issue rules regarding preemptive rights and conflict-of-interest rules for boards of directors of public corporations. Article 83 gives Bapepam & LK the right to issue rules regarding tender offers, and Article 84 does the same for mergers and consolidations. Bapepam & LK has issued rules pursuant to these statutory provisions.

THE CORPORATE SECTOR Ultimately, a stock market is only as healthy as the companies listed. Before 1997, corporations in East Asia—Indonesia, Korea, and Thailand, in particular—were investing in fixed assets at a rapid,

12 Law of the Republic of Indonesia no. 8/1996 Concerning the Capital Market.

41

unsustainable rate financed by excessive borrowing. The result of that reckless investment spree was high leverage, and poor profitability, reflected in low and declining returns on equity and capital and the misallocation of domestic and external capital. After the financial crisis, corporations in five Asian countries—Indonesia, Korea, Malaysia, the Philippines, and Thailand—undertook restructuring. Have financial practices in East Asia in general and in Indonesia in particular improved since then? Has financial performance improved? The answers to these questions are not of academic interest only. At the core of any successful equity market are good companies, worth investing in. Therefore, the answers to these questions have immediate implications for the ability of Jakarta Stock Exchange to thrive and mobilize new equity. The findings consistently indicate that corporate leverage and profitability have improved in Indonesia since the crisis, but not nearly enough. The analysis of corporate performance presented here compares the financial profile and performance of firms in Indonesia with those of firms in other Asian countries, using financial information on companies for the period 1996–2003 from the Worldscope database. The analysis is based on general manufacturing firms, extractive industries, and utilities with financial statements for three consecutive years ending in 1996. The comparator countries are France, Germany, Japan, the United States, and select countries of Latin America. The Worldscope database uses standard definitions to code financial accounts, minimizing differences in accounting terminology, presentation, and language. It then puts company data into a uniform format, which enhances comparability.

Leverage High leverage—measured by the debt-to-equity ratio—is an indicator of excessive borrowing, and low leverage is a sign of corporate health. During the crisis, companies in Asia were highly leveraged. The three most highly leveraged countries—Indonesia, Korea, and Thailand—had debt-to-equity ratios in the range of 100 to almost 400 percent, while companies in comparison countries had ratios of less than 50 percent (companies rated BBB in the United States average ratios of 84 percent). Leveraging rose sharply in 1997 and then fell, beginning in 1998. In all the crisis-affected countries, with the exception of Indonesia, which began deleveraging later, the ratio of debt to equity was below 100 percent by 2004 (see figure 2.6). Many companies rapidly built up debt in the run-up to the crisis; in 1996 less than 6 percent of firms in Indonesia had a debt-to-equity ratio above 200 percent, but by the end of 1997, the share had jumped to 43 percent (see table 2.3). The share of highly leveraged firms declined to 11.6 percent in 2004. Declining leverage is a sign of improved stability.


Figure 2.6: Debt-to-Equity Ratio in Select Asian Economies, 1996–2004

050

100150200250300350400450500

1996 1997 1998 1999 2000 2001 2002 2003 2004

Ind onesia R epub lic o f Ko rea M alaysia Philip p inesThailand Ho ng Ko ng ( C hina) T aiwan ( C hina)

Source: Staff Estimates Table 2.3: Share of Firms with Debt to Equity Ratios above 200 Percent in Select Asian Countries, 1996–2004

Affected by the crisis Not affected by the crisis Year Indonesia Korea, Rep. of Malaysia Philippines Thailand Hong Kong, (China) Taiwan, (China)

% % % % % % % 1996 5.71 42.75 5.97 2.78 16.67 5.88 0.71 1997 42.68 45.78 9.32 8.11 35.83 6.67 0.65 1998 45.45 27.66 9.14 0.00 28.46 5.88 1.25 1999 33.33 12.92 9.78 7.32 23.88 3.70 0.64 2000 20.41 12.63 7.45 4.76 19.55 2.90 1.21 2001 17.61 13.87 5.37 3.64 17.11 1.83 4.18 2002 14.89 12.43 6.06 9.62 12.64 2.31 4.42 2003 17.99 10.15 7.61 11.76 10.38 3.04 4.07 2004 11.63 5.46 8.75 4.44 6.90 3.87 2.85 Source: Staff Estimates

Return on invested capital Due to the unmanaged rapid growth, corporate profitability declined, and firms could not earn an adequate return on invested capital (ROIC). As shown in table 2.4, before the crisis in 1996, Indonesia had an ROIC of 10.4 percent. When the crisis hit, the ROIC dropped from 6.9 in 1997 to 6.5 percent in 2001. In this context, it is notable that a typical BBB-rated company in the United States generates a return on capital of 13.4 percent. Several years of improvement brought Indonesia’s ROIC back to 10.4 percent in 2004. Table 2.4: Return on Invested Capital in Select Asian Countries, 1996–2004


% % % % % % % 1996 10.40 5.29 11.27 13.18 7.98 9.74 9.43 1997 6.90 3.63 9.91 7.81 −24.92 10.52 10.18 1998 9.03 6.29 6.85 10.50 11.54 8.30 6.92 1999 8.10 9.25 6.64 6.97 4.59 9.76 8.44 2000 7.81 7.12 6.54 5.15 6.72 11.97 11.26 2001 6.54 6.24 6.37 5.18 10.29 10.80 3.86 2002 11.76 7.72 6.24 4.60 11.54 11.00 5.92 2003 6.90 8.06 6.90 4.91 15.16 10.73 8.19 2004 10.35 10.27 7.24 6.14 16.82 11.92 12.41 Source: Staff Estimates

43

Repayment of debt All countries, except Indonesia, more than doubled their repayment of debt as a percentage of total expenses following the crisis (see table 2.5). Less borrowing combined with increased repayment of debt helped to reduce both the ratio of debt to equity and interest expenses (see table 2.6; figure 2.6). Table 2.5: Interest Coverage Ratio in Select Asian Countries, 1996–2004


% % % % % % % 1996 3.82 2.33 5.45 8.56 3.54 5.77 7.00 1997 1.78 2.04 4.83 3.75 2.26 5.48 7.26 1998 1.21 2.12 3.85 5.24 3.37 5.23 5.40 1999 2.44 3.14 3.38 4.38 2.21 7.65 6.36 2000 3.11 3.49 4.50 3.68 3.44 8.49 7.32 2001 2.85 3.93 4.97 3.98 3.63 9.09 5.25 2002 4.09 6.39 5.16 4.15 4.29 10.03 9.11 2003 3.86 8.36 5.90 4.02 6.98 12.11 14.27 2004 5.53 11.87 6.37 4.04 12.18 13.45 21.88 Source: Staff Estimates Table 2.6: Share of Firms with Interest Coverage Less than 1, 1996–2004


% % % % % % % 1996 5.63 11.51 8.53 30.00 7.41 6.49 1.44 1997 14.29 15.82 8.11 27.27 15.45 5.83 0.67 1998 31.67 13.02 18.75 40.00 12.20 9.43 8.33 1999 11.25 10.25 18.42 40.00 16.67 5.83 6.12 2000 17.86 12.00 15.00 20.00 12.40 8.11 8.75 2001 14.15 11.55 13.75 26.32 10.40 4.91 11.00 2002 12.98 5.52 12.12 13.89 7.60 6.25 5.60 2003 14.17 5.07 9.77 24.44 7.45 5.95 3.42 2004 17.33 6.31 7.48 19.57 2.19 7.33 4.79 Source: Staff Estimates

Credit soundness The emerging-market scoring (EMS) model assesses credit soundness. The model uses multiple discriminant statistical methodology to rate the financial soundness of firms using traditional financial ratios measuring the ratio of working capital to total assets, ratio of retained earnings to total assets, ratio of operating income to total assets, and ratio of book value equity to total liabilities. The EM score is then converted to a U.S. bond-rating equivalent. Firms are rated from A through D, with A being firms with the strongest performance and D being firms with the weakest. These scores are a proxy for corporate health. Corporations in Asia have improved their financial soundness in the years since the crisis, based on both the EMS ratings and the U.S. bond-rating equivalents (see figure 2.7). Healthy firms have increased their share of the corporate sector in all countries, with Korea and Thailand showing the most significant improvement in the percentage of firms rated A or B. Indonesia and Malaysia have had moderate improvement, while the Philippines still has a high share of corporations in relatively weak corporate health.


Figure 2.7: Corporate Rating Based on EMS in Select Asian Countries, 1997 and 2004

Rating based on EM Score in 1997 and 2004

0%

20%

40%

60%

80%

100%

1997 2004 1997 2004 1997 2004 1997 2004 1997 2004 1997 2004 1997 2004

INDONESIA KOREA(SOUTH)

MALAYSIA PHILIPPINES THAILAND HONG KONG TAIWAN

A B C D

Source: KSEI, Staff Estimates

Investors Foreign institutional investors are by far the largest investors in the domestic equity market, followed by domestic institutional investors (see table 2.7). Table 2.7: Type of Account Holders and Shareholding Structure in the Central Securities Depository, 2004

Type of investor Number of accounts

Percent of all accounts

Percent of shares held

Percent of market capitalization

Domestic Institutions 4,864 6 51.59 20.98 Individuals 71,488 80 9.16 4.93 Foreign Institutions 10,795 12 38.81 73.87 Individuals 1,986 2 0.44 0.22 Total 89,133 100 100.00 100.00 Source: KSEI, Staff Estimates Foreign investors. During the period 1989–96, foreign investors accounted for more than half of trading on the Jakarta Stock Exchange. They also owned Indonesia’s major securities companies and custodian banks. Foreign institutions make up a large portion of investors because domestic institutional investors prefer bank deposits and central bank notes (Sertifikat Bank Indonesia, SBI) to equity. On average, approximately 40 percent of trading is done among foreign investors. Retail domestic investors. There are an estimated 90,000 domestic retail investors in Indonesia. Table 2.8 lists the number of retail shareholders in various markets. Despite the small numbers, this situation represents significant potential for growth. Over time, the Jakarta market could double in size, which would be harder for more developed markets to achieve.

45

Table 2.8: Number of Retail Shareholders in Select Markets

Economy Number of retail investors (millions) Percent of population Australia 5.7 39 Japan 33.7 27 Korea Rep. of 3.9 8 Hong Kong (China) 1.0 24 Singapore 0.6 20 Source: Staff Estimates Institutional investors (mutual funds). Mutual funds provide a good alternative to direct investments for many retail investors. Mutual funds were first introduced in Indonesia in 1997. Because returns from mutual funds are tax exempt for the first five years, investors responded to lower interest rates by shifting away from time deposits and into mutual funds. Beginning in 1997, the Indonesian mutual fund industry grew consistently—despite a sharp dip in 1998 due to the crisis—and gained popularity in 2002 when mobilized funds soared from less than Rp 8 trillion at the end of 2001 to almost Rp 104 trillion (US$10.4 billion) as of end-2004 (see table 2.9). However, massive redemptions rocked the industry in 2005, and assets under management fell to Rp 29.4 trillion (US$3 trillion, 1.1 percent of GDP) as of December 2005. Although such funds may specialize in one of four types of financial assets (fixed-income, equity, money market, and mixed or balanced funds), the bulk of holdings are in bank recapitalization bonds. Mutual funds invest a negligible amount in the equity market and are insignificant when viewed against JSX’s total market capitalization. Nevertheless, the movement of private investors into mutual funds has the potential to widen the base of investors and deepen the market. (See chapter 4.) Table 2.9: Assets Managed by Mutual Funds, 2004 and 2005

2004 2005 Indicator

Amount Percent of total Amount Percent of total Net asset value Money market fund 9.4 9.1 2.1 7.1 Fixed-income fund 88.1 84.6 14.0 47.3 Balanced fund 4.6 4.5 5.5 18.6 Equity fund 1.9 1.8 4.9 16.8 Protected fund n.a. n.a. 3.1 10.2 Total 104.0 100.0 29.4 100.0 Number of funds Money market fund 31 33 Fixed-income fund 146 170 Balanced bund 46 78 Equity fund 23 30 Protected fund n.a. 18 Total 246 329 Source: Bapepam & LK n.a. Not applicable.

PERFORMANCE AND SUSTAINABILITY The Indonesian stock market has been performing well recently (see figure 2.8). Before the Asian financial crisis, foreign demand drove share prices on JSX up 148 percent in 18 months, while foreign institutions poured an estimated $3 billion into the Indonesian market. As the crisis loomed, shareholders in U.S. emerging-market funds made modest withdrawals in late 1996 and, seeing buying opportunities, used their cash inflows to purchase significant amounts of Asian equities during the last half of 1997. Portfolio managers generally remained committed and were net purchasers of equities in 1997. The composite index has been rising steadily since 2002, and


the Indonesian market was one of the best-performing markets in Asia and among the best in the world in 2005 (see table 2.10). While the performance of a benchmark is important, in standard financial economics analysis, equity markets contribute to stability and growth by mobilizing savings, storing wealth, allocating risk capital, and exerting market discipline on issuers. It is instructive to examine the performance of the Indonesian capital market along these four criteria. Figure 2.8: Year-end Jakarta Composite Index, 1995–2006

0

200

400

600

800

1,000

1,200

1,400

1,600

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Jan-06

Feb-06

Mar-06

Apr-06

May-06

Source: Jakarta Stock Exchange

Table 2.10: Best-Performing Markets in the World, 2005

Exchange Percentage change, 2005

Cairo & Alexandria Stock Exchanges 146 Colombia Stock Exchange 119 Cyprus Stock Exchange 68 Malta Stock Exchange 63 Istanbul Stock Exchange 59 Korea Stock Exchange 54 Osaka Stock Exchange 51 Tokyo Stock Exchange 44 Jakarta Stock Exchange 43 Weiner Borse 43 Source: World Federation of Exchanges 2006

Mobilization of savings Without a vibrant equity market, newer, smaller or riskier businesses may have difficulty obtaining financing. Equally, banks may have difficulty providing loans due to low levels of equity capital. The Indonesian market has been unable to serve as a major source of capital for issuers, and initial public offerings are not a significant source of corporate funding in Indonesia. The Asian financial crisis led quite a few companies to delist. Indonesia has had only 105 new listings in the past decade, and only 8 new companies were listed in 2005, despite the market’s solid performance. This compares with 72 in Malaysia, 70 in Hong Kong (China), 82 in Singapore, and 50 in Thailand. In most years, existing listings raise more funds from the market than new listings via initial public offerings (IPOs), as shown in table 2.11. A report by securities firm CLSA in September 2002 stated that, since the crisis, very few IPOs have been able to raise more than US$10 million, given the limited domestic appetite for primary paper and liquidity problems facing domestic and international institutions. IPOs raised more funds than existing listings in just two years, largely as a result of three large privatizations: Telkom in 1999 and Bank Mandiri and BRI in 2003. In 1999, 28 listed companies tapped a significant Rp 133 trillion from the market via rights issues, and in

47

2002 there were two large placements in the secondary market: US$110 million for Indosat and US$126 million for Telkom. The other large mobilization of equity capital took place in the aftermath of the crisis through preemptive rights. Table 2.11: Capital Mobilization in the Jakarta Stock Exchange, 1997–2005

Number of listings Percent of market capitalization Year New Existing IPOs Secondary offerings New capital raised

1997 — — 2.21 9.77 11.98 1998 — — 0.58 5.28 5.86 1999 9 28 0.07 29.50 29.57 2000 21 15 0.82 8.12 8.94 2001 31 14 0.53 1.73 2.27 2002 22 13 0.42 2.76 3.18 2003 6 11 2.06 0.99 3.05 2004 12 15 0.31 0.62 0.93 2005 8 N/A 0.44 0.76 1.41 Source: World Federation of Exchanges Why is the Indonesian market unable to mobilize capital (see table 2.12)? In part, the explanation resides in the arena of corporate governance. The links between mobilization of equity capital and corporate governance are extensive. Lack of controls on dominant owners who apply company resources to personal or unrelated use, uncontrolled executive compensation programs, management incentives that compromise long-term stability for short-term gain, and inadequate oversight of the integrity of financial disclosure create financial risks and weaken a company’s financial health. Alternatively, strong corporate governance, demonstrated, for example, by the presence of an active, independent board, can serve to support the credibility of financial disclosure and facilitate mobilization of fresh equity capital. As demonstrated in the next sections, corporate governance in Indonesia needs to be further improved. Table 2.12: New Capital Raised as a Percentage of Market Capitalization in Select Regional Exchanges, 1997–2005

Exchange 1997 1998 1999 2000 2001 2002 2003 2004 2005 Australia 5.58 5.38 5.06 4.86 1.77 3.36 4.48 3.47 3.98 Hong Kong (China) 7.73 1.39 3.16 9.56 1.63 3.06 3.85 4.20 3.64 Jakarta 11.98 5.86 29.57 8.94 2.27 3.18 3.05 0.93 1.41 Korea, Rep. of 4.45 9.78 10.46 3.10 2.05 2.91 2.31 4.20 0.67 Kuala Lumpur 4.69 0.46 1.22 1.38 0.59 2.76 1.10 1.06 1.11 Taiwan (China) 4.19 4.16 1.43 1.86 0.51 0.65 2.28 1.42 0.46 Thailand 4.74 26.53 11.38 5.46 8.98 4.01 3.87 2.03 2.87 Source: Staff Estimates, Various Sources

Storage of wealth With regard to storing wealth, Indonesian equity markets are not performing well. First, for all the listed companies, only a minority percentage of their shares is in public hands. At present, the free float in Indonesian equity markets for the top 20 companies by market capitalization is about 39.4 percent. The low level of free float contributes to the limited capacity to store wealth. Equally, to store wealth effectively, a market needs liquidity. A liquid market is one in which there is a reasonable amount of turnover or trading and where large transactions can take place quickly and efficiently. Accompanying the low levels of public float is low turnover (the percentage of shares traded as a percentage of market capitalization). The Jakarta Stock Exchange has modest turnover ratio—43 percent—with only the largest companies, by capitalization, responsible for a large percentage of the total trading that takes place.


Allocation of risk capital While the issue of allocation of risk capital is multifaceted and complex, we get a partial answer from a recent paper examining the international differences in firms’ cost of equity capital across 40 countries (Hail and Leuz 2006). The paper concludes that countries with more extensive disclosure requirements, stronger securities regulations, and stricter enforcement mechanisms have a significantly lower cost of capital. Indonesia’s cost of capital, at 16.6 percent, is high compared with that of developed and developing countries alike (see table 2.13). Table 2.13: Cost of Capital in Select Economies

Economy Cost of capital (percent) Argentina 12.81 Australia 10.72 Brazil 20.85 Canada 10.53 Chile 12.55 Germany 10.05 Hong Kong (China) 14.58 India 14.39 Indonesia 16.60 Korea, Rep. of 14.10 Malaysia 10.65 Source: Hail and Leuz 2006

Market discipline A financial system requires adequate infrastructure to function well. After the Asian crisis, it was recognized that Indonesia, as well as other countries in the region, suffered from weak infrastructure, poor corporate governance, weak auditing and accounting standards, and inadequate bankruptcy laws. Have remedial measures focused adequately on the prerequisite infrastructure, and how much progress has been made in this area? Moreover, has Indonesia improved its compliance with corporate governance standards, and does it comply with international norms? In order to assess the convergence of countries with international standards, we use scores from eStandards, which, since 2000, has been monitoring the progress of 83 countries in adopting and implementing international standards and codes established by the global standard-setting community.13 The assessments use publicly available information to measure compliance on a scale of six, ranging from full compliance (10 points) to insufficient information (0 points). Average scores are based on equally weighted scores across all the standards. The maximum score is 100 (full compliance in all areas), and the minimum score is 0 (insufficient information available for all of the standards). We focus on six areas related to institutional and market infrastructure and three areas related to financial regulation and supervision: Institutional and market infrastructure Financial regulation and supervision Insolvency Accounting Corporate governance Auditing Money laundering Payment and settlement systems

Banking supervision Securities regulation Insurance supervision

13. See www.estandardsforum.com

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It is instructive to review the results, subject to the usual caveat. Those quantitative scores are subjective by nature and mask vast qualitative differences, and information in the public domain is limited as well as of short duration. Using the average eStandards scores for institutional and market infrastructure, some countries—such as Korea—made great improvements between 2003 and 2005, while others did not (see table 2.14). Having said that, using the average score across the 12 areas, the 12 countries selected for the sample made progress during the period. Korea improved its average score more than 100 percent, while Indonesia made only modest progress, increasing from 28 to 39. Table 2.14: Overall Scores for Institutional and Market Infrastructure in Select Countries between January 1, 2003, and December 1, 2005

Country Starting score Ending score Percent improvement Minimum score Maximum score Indonesia 28.33 39.17 38.26 28.33 50.83 Malaysia 36.67 38.33 4.53 36.67 44.17 Korea, Rep. of 30.83 62.50 102.72 30.83 65.00 Thailand 28.33 46.67 64.74 28.33 46.67 Argentina 42.50 52.50 23.53 41.67 52.50 Brazil 30.00 50.83 69.43 30.00 50.83 Mexico 43.33 56.67 30.79 43.33 56.67 Russia 35.83 50.00 39.55 35.83 50.00 Turkey 33.33 49.17 47.52 33.33 49.17 Chile 37.50 61.67 64.45 37.50 67.50 Colombia 25.83 40.00 54.86 25.83 52.50 Poland 54.17 58.33 7.68 54.17 60.00 Source: eStandards Looking at specific areas, Indonesia has achieved a score of 60 in corporate governance and money laundering but has made little progress in insolvency and accounting and auditing (see table 2.15). Equally, other scores indicate that progress on financial regulation and supervision is uneven. Indonesia has made progress in banking supervision but is still weak in securities and insurance regulation. Table 2.15: Detailed Scores for Institutional and Market Infrastructure Scores in Select Countries

Insolvency Accounting Corporate governance

Auditing Money laundering

Payment and settlement systems

Country

2003 2005 2003 2005 2003 2005 2003 2005 2003 2005 2003 2005 Indonesia 10 0 60 10 10 60 30 10 10 60 0 30 Malaysia 0 30 10 30 80 60 60 10 30 60 0 0 Korea, Rep. of 10 30 10 30 30 60 60 10 60 60 0 80 Thailand 0 30 30 30 10 60 60 0 60 60 10 80 Argentina 0 60 10 30 0 60 60 60 80 60 0 0 Brazil 10 60 10 10 10 60 10 0 80 80 0 60 Mexico 0 60 0 30 10 60 60 30 80 80 30 30 Russia 30 10 30 30 60 60 60 10 30 60 0 60 Turkey 0 60 30 10 0 60 60 30 80 60 0 60 Chile 0 60 10 30 0 80 60 30 10 60 30 0 Colombia 0 30 10 10 0 30 0 10 60 60 0 30 Poland 0 60 30 10 60 60 60 30 10 30 80 80 Source: eStandards Note: The starting score is for January 1, 2003, and the ending score is for December 1, 2005.

DEVELOPMENTAL ISSUES AND CONSTRAINTS Despite a bullish run in the past couple of years, Indonesian equity markets suffer from fundamental weaknesses: an insufficient pool of listed companies, a high concentration of trading,


low liquidity, and lack of retail investors. A conscientious effort is needed to increase the number of listed entities and stimulate the demand for their securities.

Insufficient pool of listed companies When issuers on the London Stock Exchange were asked about their objectives for going public, their top three answers were (a) to raise funds to continue expanding their business, including acquisition plans, (b) to attain more credibility and a higher profile, and (c) to be able to offer share-based incentives for recruiting, retaining, and motivating directors and employees. Indonesian companies do not share these objectives; many family-owned, profitable companies prefer to remain private, as they feel that public scrutiny would restrict their growth. For many local companies, the equities market is the last, not the first, resort for corporate financing.

Small and medium enterprises Bapepam & LK has separate regulations governing the public offerings of small and medium enterprises, which are defined as legal entities that are established in Indonesia, have total assets of not more than Rp 100 billion, are not affiliated with or controlled by another company that is not a small or medium business, and not an investment fund. The offer has to be for not more than Rp 40 billion. Small and medium enterprises are given some leniency: they do not have to include an accountant’s report on the financial statements in the prospectus, can include two years of audited financial statements instead of three, and do not have to publish the prospectus in a daily Indonesian newspaper. Although these provisions provide some relief, small offerings are subject to virtually the same costly and time-consuming process of registration as large offerings. The capital requirements of small and medium enterprises are often too low, too sporadic, and too immediate to warrant the effort. At the same time, a loophole, called a safe-harbor provision, allows larger firms to raise equity in private offerings. A footnote to the Capital Market Law states that a company’s share offerings are not regarded as a public offering requiring a registration statement if (a) the offer is not made through the mass media, (b) the offer is not made to more than 100 persons, and (c) the shares are not allotted to more than 50 persons. This “safe-harbor” provision is considered generous in relation to similar provisions in more developed markets. For example, Australia limits such offers to those worth not more than A$2 million and involving fewer than 20 persons. The United States also has a limit of US$5 million for such offers, and various conditions are attached.

Lack of retail investors The Indonesian market does not have the support of local investors, especially retail investors. Retail investors contribute to the liquidity of a market because, unlike institutions, they are not restricted by institutional investment policies or herding. They invest in the shares of familiar companies that they believe will make them money, regardless of size. Retail investors improve the distribution of trading activity among all stocks and foster long-term investment. The ideal occasion for introducing a first-time investor to the securities market is at the IPO of a company seeking a listing on the stock exchange. This is the time when the entity is required to publish a prospectus showing detailed financial and historical information, and the business news carries reports on the company. For many small retail investors, obtaining information at this stage is often much simpler than obtaining information on an existing listing. In most countries, IPOs tend to favor institutions and relatively large individual clients of investment bankers and securities dealers. An IPO that is open to persons who are not clients of a securities company not only provides a faster way of attracting new investors into the market but, with the increased interest, creates greater demand for the IPO and improves liquidity of shares in the secondary market.

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Inadequate infrastructure JSX is vulnerable to a stoppage of trading should a catastrophe, such as a fire, flood, or terrorist attack, inflict damage to the floor14. Depending on the severity of the damage, trading could be halted for an indefinite length of time. Although JSX is in the midst of implementing remote trading, additional interface and communication are needed to connect to remote sites. As a result, in the short run, it is likely to be quicker to enter an order at a workstation on the floor than at a remote workstation. There is a risk that securities companies will delay moving to a remote system, leaving the exchange vulnerable to outages. In many countries, the Internet has become the dominant medium through which trading is conducted. For a large country like Indonesia, the ability to transact shares via the Internet would extend the reach of the market to retail investors in remote locations. The trading floor, coupled with the existing trading system, inhibits the growth and development of trading via the Internet. The JATS trading system, notwithstanding recent upgrades, was designed more than five years ago and is primarily a system for trading equities. Most trading systems, such as the London Stock Exchange and Euronext, are “hybrid” systems, capable of handling multiple instruments (cash, futures, options) and multiple matching techniques (continuous open auction, market making, periodic calls). Numerous studies have been conducted on trading systems and their suitability for stocks with different amounts of liquidity. Although there is no conclusive evidence, some types of systems are better for trading liquid stocks, while others are better for trading illiquid stocks. Figure 2.9 summarizes the picture. Indonesia needs to take this into account when designing new trading systems. Figure 2.9: Liquidity and Market Structure

Liquidity

Tran

sact

ion

size

Individual dealsLarge order size & lowliquidity prevent organizedmarketPrivate placement &brokered block trades

Indicative quoting/crossingSignificant price impact oflarge trade sizeLow liquidity hence highmarket maker spreads

Market MakingMarket maker providesliquidityMarket maker guaranteeimmediacy

Call auctionNo need of market maker inview of liquidityNo immediacy due to orderaccumulation betweenauctions

Continuous auctionHigh liquidity allowscontinuous trade with lowspreadsReduced immediacy forlarge orders

Source: McKinsey & Company and J.P. Morgan 2002

14 A bomb exploded in the basement of Jakarta Stock Exchange building in 2000.


Privatization As it makes gradual progress in the privatization of state-owned enterprises, Indonesia can learn from the experience of other countries. The new nations of Eastern Europe have sought to build up capital markets by privatizing state-owned enterprises. Many countries have used incentive packages, including bonus shares and discounts, to encourage retail investors to participate in privatizations. In a bonus structure, an investor receives X number of free bonus shares for every Y number of shares held for a given period (say a year) after the offering. A retail discount entitles the investor to a discount off the institutional offer price and is sometimes accompanied by a requirement to hold the allocated shares for a given period. Incentive structures are intended to prevent flipping and create a wide base of domestic shareholders (U.K. National Audit Office 1988). It has been estimated that a dollar used on retail incentives helps to attract about 29 times more investors than a dollar spent on underpricing. Individual-level analysis shows that flipping is reduced in the short term and diminished by at least 16 percent over a period of a thousand days. Well structured and targeted privatization can contribute significantly to domestic retail investors in the equity market.

LEGAL, REGULATORY, AND SUPERVISORY ISSUES Bapepam & LK supervises the securities market. In addition, there are four self-regulatory organizations: Jakarta Stock Exchange, Surabaya Stock Exchange, KSEI, and KPEI. Regulation focuses on the following issues: disclosure, corporate governance, conflicts of interests, and investor protection.

Disclosure Transparency and disclosure are the main legal issues in the equity market. The capital formation of corporations depends on the trust that investors have in the management and financial condition of the corporation. This trust can only be achieved when corporations fully and accurately disclose their financial and other business conditions to the investors. This transparency in operations begins with formation of the corporation, when a prospectus describes the business objective, management, and financial condition of corporation, and continues with the immediate disclosure of material facts related to the corporation and reporting on a periodic basis. Disclosure in the prospectus. The first issue deals with disclosure in the prospectus. In an initial public offering, the company must prepare and provide a prospectus to investors. This document sets out information regarding the company that is selling shares to the general public. The Capital Market Law, Article 71, provides that all purchasers must sign a statement indicating that they have read a prospectus before purchasing shares in a public offering. The prospectus provides basic information on the business goals of the corporation, the identity and background of the founding shareholders, the initial capitalization and capital structure of the corporation, the use of proceeds from the stock sale, and any significant assets or intellectual processes to be used by the corporation. In international practice, the accuracy of the information in the prospectus is so important that the sale can be rescinded if inaccuracies are discovered. This is regardless of the reason for the inaccuracy: an intentional misstatement, negligence, or a simple mistake. The officers, directors, and other professionals who prepared the prospectus can

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be held liable for inaccuracies unless they can show that they acted with “due diligence” in investigating and obtaining the information. Bapepam & LK Rule IX.C.2/1996 provides guidelines for the form and content of the prospectus. Article 78 provides that the prospectus cannot contain false statements or omit material information that would be necessary for the prospectus to be accurate. Misstatements in the prospectus can result in civil liability under Article 80, and Bapepam & LK can impose administrative sanctions under Article 102 as well as criminal liability under Article 104 in the Capital Market Law. One of the primary concerns reported during interviews taken in the course of this study was use of the proceeds of initial public offerings for purposes other than those set out in the prospectus. To counter this issue, Bapepam & LK Rule X.K.4 requires additional, subsequent reporting on the use of proceeds to the general meeting of shareholders, or bond trustees in the case of bonds, as well as to Bapepam & LK itself. Liability and sanctions for providing misleading or inaccurate information in a prospectus and in periodic reports regarding the use of proceeds are stated in the Capital Market Law. Violation of the use of proceeds could result in administrative sanctions under Article 102, and criminal liability under Article 107 but Bapepam & LK has difficulties in proving and punishing misappropriation cases. Disclosure in periodic reports. The second issue pertains to periodic financial reporting as required under Article 86 of the Capital Market Law. Rule X.K.2/2003 sets out the contents of periodic reports. Article 86 also requires the reporting of material events within two days following the event. Rule X.K.1 sets forth the type of information considered material. However, no civil liability is provided for misstatements or inaccuracies in periodic reports, though such activity could violate the general fraud provisions of Article 90, which include criminal liability for misstatements. Administrative sanctions by Bapepam & LK would apply under Article 102. Recent studies have found that Indonesia is higher than the regional average in providing investors with disclosure of corporate information and consumer protection (World Bank 2005). Therefore, the critical aspect to improving disclosure and transparency in Indonesia is enforcement of existing rules by Bapepam & LK. In fact, Bapepam & LK has stepped up its enforcement actions in the past two years. During 2004, Bapepam & LK imposed sanctions on 313 issuers for late submission of their semiannual financial reports, annual financial reports, other annual reports, or reports on the use of funds received from a public offering and for violations of rules regarding disclosure of information. The amount of fines totaled Rp 8.9 billion. In particular, Bapepam & LK fined two issuers a total of Rp 200 million based on seven specific violations. Therefore, total fines in 2004 imposed on issuers amounted to Rp 9.1 billion. The amount of fines in 2004 was 60 percent higher than in 2003, when they amounted to Rp 5.7 billion.

Corporate governance rules Indonesia has an elaborate system of corporate governance rules, which are not substantially different from those of industrial countries, but corporate governance practices often fall short of the recommendations, despite improvements since the crisis (see table 2.16). In particular, in 2004, a World Bank assessment of Indonesia’s corporate governance found the following: Indonesia’s business culture is based on relationships rather than rules, largely as a result of the high incidence of concentrated ownership, family-owned businesses, and controlling shareholders.


Enforcement of laws and regulations is still weak. Sanctions rarely go beyond fines, and the incentive system does little to discourage violators and promote good corporate behavior. Bapepam & LK’s capacity to enforce sanction for securities violations needs to be further improved; its ability to act independently as the security regulator is also still weak.

Transparency and reliability of financial reports and adequacy of disclosure remain major challenges. While Indonesian accounting standards are largely consistent with international standards, there is a gap between those standards and actual practices. External auditors do not provide the expected assurance, and tax authorities have discretionary power in assessing taxes.

The concept of independent commissioners was recently introduced for publicly listed companies and state-owned enterprises, but it is not clear whether these commissioners are able to act independently from the controlling shareholders and exercise effective oversight.

Table 2.16: Average Corporate Governance Score in Select Economies in 2003 and 2005

Economy 2003 2005 Singapore 77 70 Hong Kong (China) 73 69 India 66 61 Taiwan (China) 58 52 Korea, Rep. of 55 50 Malaysia 55 56 Thailand 46 50 China 43 44 Philippines 37 46 Indonesia 32 37 Source: Asian Corporate Governance Association Note: Countries are sorted by average scores in 2003

Conflict-of-interest rules Bapepam & LK Rule IX.E.1 governs conflict-of-interest transactions. This rule stipulates that attendance quorum representing more than 50 percent shares owned by independent shareholders is needed to undertake a conflict-of-interest transaction. It does not distinguish between transactions carried out in the normal course of business and those that are not. As presently drafted, compliance with the rule is virtually impossible. Although the difficulty of abiding by the requirements will discourage conflict-of-interest transactions, companies may skirt the regulations because there is no means of monitoring compliance. An amendment to this rule is in process. The amendment still will not distinguish between regular and irregular transactions; however, it will distinguish between transactions amounted to above Rp. 2 billion and below Rp. 2 billion or less than 0.5% of assets, whichever is higher. The second category of transactions would not require independent shareholders’ approval. Many exchanges (the United Kingdom, Hong Kong (China), Singapore, and Malaysia) have regulations dealing with such transactions. These regulations are generally more liberal than those of Bapepam & LK, but also more nuanced, classifying transactions into those that do not need to be publicly disclosed and are exempt from requiring shareholders’ approval, those that need to be disclosed publicly but are exempt from shareholders’ approval, or those that must have the approval of shareholders.

Investor protection Bapepam & LK recognizes and appreciates the need to protect the assets of investors in the event a securities company fails; therefore, Rule VI.A.3 (7) imposes an obligation on securities companies to insure against the risk of financial loss to account holders in the event of

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bankruptcy. In essence, to be a member of a securities exchange, security companies, and custodian banks must insure against the risk of financial loss to account holders in the event of bankruptcy, and the exchange determines the amount of insurance required. Insurance organizations are reluctant to undertake such policies, and, where they do, the premiums are prohibitively expensive. As a result, no securities company has bought such an insurance policy, despite the fact that this rule has been in force since January 2000. Bapepam & LK understands the problem that securities companies face and so far has not taken any action against companies for failure to comply with the rule.

Investor education Investor education is essential to broadening the investor base and achieving investor protection. Even in markets where the equity culture is well developed, investors have a poor understanding of risk. In a recent survey, conducted on behalf of the National Association of Securities Dealers (NASD) by Applied Research and Consulting, 1,086 investors were asked more than 50 questions about investing in stocks, bonds, and mutual funds. Among the findings of the survey, 97 percent of investors realize that they need to be better informed about investing, and nearly

half believe that they could have avoided a negative experience had they known more about investing.

Nearly 50 percent believe that stock market losses are insured. 70 percent fail to understand that when you buy on margin, you can lose all of your

investment, even if the value of your shares does not fall to zero. Nearly 80 percent do not understand the full meaning of “no-load” mutual funds. Almost 70 percent do not know why municipal bonds offer lower pre-tax yields than other

investments. In order to improve the public’s understanding of investing, JSX, in cooperation with Indonesian universities, has established corners at 36 locations in several cities. The JSX corners provide information and assistance to students interested in investing in the stock market. Simulated trading activities are shown on computer terminals, which also allow students to access the Internet and JSX Web site. Through these corners, JSX has targeted an important segment of the population, many of whom are potential investors in the market. JSX also has conducted investment seminars. Although useful, the penetration rate of these seminars is insignificant. The Hong Kong Securities and Futures Commission has used various media for investor education and found that television is the preferred channel for delivering information on investing. This is followed by newspaper, radio, and the Internet. Indonesia can learn from the experience of Hong Kong (China).

Other issues Other issues that need to be addressed include taxation, a separate board for small-cap listings and the demutualization of Indonesia’s exchanges. Tax incentives. Indonesian corporations pay dividends out of their after-tax earnings, and these payments are subsequently taxed as part of the shareholders’ income. Corporate profits are hence subject to double taxation: once at the corporate level and again at the individual level. The double taxation of dividends distorts financing decisions. The concern is that the tax treatment of dividends biases corporate investment decisions against issuing new equity and toward debt


financing and retained earnings, which are only taxed once. As a consequence, companies may not be using an optimal mix of financing mechanisms. Italy grants newly listed companies a 20 percent corporate tax rate in lieu of the 33 percent applicable rate for the three fiscal years following the listing of a company in Europe. In addition, newly listed companies can deduct the costs incurred in obtaining a listing. As a result, the capitalization of the Italian stock market rose from 18 percent of GDP to 50 percent. In 2001 Thailand also reduced the corporate income tax rate, with newly listed companies paying 20 percent and existing companies paying 25–30 percent, depending on their size. The reduction for newly listed companies lasts for only five accounting periods. The Jakarta Stock Exchange has proposed tax incentives to encourage companies to list, but so far the suggestions have not met with approval. Tax incentives, if adopted in Indonesia, may not be sufficiently attractive for companies to seek a listing. Many companies do not seek a listing because they are concerned that the disclosure of audited financial statements will notify the revenue authorities about the company’s potential underreporting of taxable income in prior years. The benefits of tax incentives in this situation are ambiguous, and prospective tax incentives in Indonesia need to be weighed carefully. Small-cap listings. Small- and medium-cap markets have met with varied success throughout the world. Other countries, such as Malaysia and Poland, have experimented with different boards or market tiers or with several exchanges with more lenient listing criteria to facilitate access to equity capital for smaller enterprises. Their goal was to facilitate access to equity capital for smaller enterprises. While London’s market for new firms is considered viable, other markets have failed. Most suffered from liquidity problems and were shunned by investors. Therefore, the Indonesian authorities need to have limited expectations about the capacity of a secondary board to mobilize fresh risk capital. Demutualization. Considerable funding is needed to ensure that the capital market keeps abreast of technology. As long as shareholding is tied to membership, access to external funding is restricted, and this can hinder development of the market. There is, therefore, a need to speed up the demutualization process in Indonesia. However, the transition to a demutualized entity might require concerted regulatory and supervisory efforts. Traditional exchanges play a significant role in supervising the compliance of securities companies with prudential capital requirements. Supervision of listed companies and their admission to listing also fall within the authority of the mutual exchange. Exchanges, such as the New York Stock Exchange, consider listing requirements, surveillance, and compliance an inextricable part of their role in the capital markets. In a demutualized environment, where enhancing shareholder value is of paramount importance, profit considerations might put pressure on exchanges to reduce the costs associated with surveillance and compliance. As a result, in the United Kingdom, Hong Kong (China), and Singapore, authorities have taken over the supervision of brokers and dealers. Fees from company listings form a significant portion of the revenue of an exchange, and, in its effort to generate more revenue, a demutualized exchange could sacrifice quality for numbers. In Hong Kong (China) and Singapore, these issues have been raised publicly, although so far no change has been made to the role of exchanges. Only in the United Kingdom has this role been transferred to the U.K. Listing Authority, which is part of the Financial Services Authority. The Indonesian regulatory authorities are well advised to consider their role with respect to listed entities as well as to surveillance of market participants in a demutualized setting.

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POLICY RECOMMENDATIONS Many countries in the region have adopted proactive policies to develop their stock markets. The Indonesian market is small compared with these markets, but the potential for growth is significant, given the size of the country and its vast natural resources. Deliberate policies are needed, by both the government and the exchange, if the full potential of the market is to be realized. The recommended policy actions by time frame are summarized in the following table. The policy recommendations are elaborated subsequently. Quick Wins (1 yr) 1 - 3 years Regulatory Undertake a comprehensive assessment and

analysis of corporate health Improve and expand the role of Bapepam & LK in supervision Simplify the rules governing conflicts of interests

Demutualization and merger of Jakarta and Surabaya stock exchanges. This is currently in progress, waiting amendment of the Capital Market Law Improve investor protection by implementing investor compensation scheme Improve market infrastructure with real-time messaging between market participants and infrastructure organizations, a new hybrid trading system, remote trading and “service provider” business model

Enforcement Improve corporate governance by creating special designations for exemplary governance practices, establishing nomination committees for selection of independent commissioners and instituting cumulative voting

Develop the Self-Regulatory Organizations to raise awareness and increase the effectiveness of implementation and enforcement of legislation and regulations to improve corporate culture and practices

Skills Enhance the roles, responsibilities and skills of independent board members and audit committees

Taxes Address double taxation of dividends

Competitive landscape

Competition for the local stock exchanges is regional and global. To be better prepared for such competition, merge the two exchanges and upgrade technology

Access Develop the base of domestic investors

Improve the environment for IPOs


Initiate investor education to attract new investors as well as support continuous development of the market Develop a policy for funding of education programs before demutualizing stock exchanges.

Consider establishing a separate not-for-profit organization to run investor education efforts on an on-going basis

Priority recommendations Of the highest priority are policies to improve corporate health and governance, improve market infrastructure, and strengthen supervision. Improve corporate health. Investors invest in the best companies in their respective industries after benchmarking them globally. Ultimately, a market is only as good as the companies listed in the market. The findings consistently indicate that corporate leverage and profitability have improved in Indonesia since the crisis, but not nearly enough to be competitive globally. Indonesia therefore should treat restructuring as an ongoing concern. The first step in helping corporations


to reach the standards commensurate with international norms is a corporate financial monitoring program. The data generated by such a program would provide an opportunity to undertake a more comprehensive assessment and analysis of corporate financial health in Indonesia. While good macroeconomic management is essential to achieve sustained growth, it is not enough. Increased productivity at the corporate level is the key determinant of growth and wealth. The authorities are advised as well to undertake industry-level studies to assess the productivity of key industries and to determine whether policies reforms (for eg: in areas such as competition, business practices, labor) can be implemented to increase productivity. Improve corporate governance. Ultimately, investors invest in good companies in which they have confidence. Good governance goes hand in hand with good finances to attract investors. To encourage good corporate governance, Jakarta Stock Exchange and Bapepam & LK may want to study the possibility of a separate board with more stringent listing requirements for entities that have implemented exemplary governance practices (see Box 2.1). Securities of the companies listed on such a board could be bought by mutual and pension funds or banks or could be bought on margin. The following actions are recommended to improve corporate governance: (a) establish nomination committees to strengthen the process for nominating and selecting independent commissioners, (b) conduct training and promote awareness among stakeholders as part of changing the business culture, (c) enhance the roles, responsibilities, and skills of independent board members and audit committees, (d) promote the separation of management from the owners and appoint professional managers, and (e) allow minority shareholders a greater voice in the selection of commissioners (that is, institute cumulative voting). Improve market infrastructure. Global markets are moving toward greater automation and the use of higher or advanced technology systems in order to expand market operations and control. The overall picture supports the straight-through-processing paradigm, permitting an overall reduction in error rates and operating risk coupled with a strong foundation for the access and distribution of information. More efficient market operation would lower operational costs, improve regulation, and improve liquidity within the market. To accomplish this, it is suggested that Indonesia (a) implement real-time messaging between market participants and infrastructure organizations, (b) evaluate a new hybrid trading system, (c) move to remote trading, (d) implement the model of a “service provider” business, and (d) demutualize and merge the Surabaya and Jakarta stock exchanges. Improve and expand the role of Bapepam & LK in supervision. Bapepam & LK may want to take over the direct supervision of broker-dealers. As the market matures, broker-dealers may venture into activities beyond securities and futures trading that are more appropriately supervised by Bapepam & LK. However, the present method of funding Bapepam & LK—out of the government budget—may have to be changed. In many countries, the Bapepam & LK-equivalent organization is funded primarily out of a levy on the transactions effected on the exchange. This method would lend more credibility to the view that Bapepam & LK is an independent organization.

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Box 2.1: Novo Mercado: São Paulo’s New Market

In April 2001, the São Paulo Stock Exchange (Bovespa) in Brazil launched new listing segments for companies that voluntarily abide by good corporate governance practices and disclosure. These new listing segments are known as Special Corporate Governance Level 1, Level 2, and Novo Mercado (New Market). Of the three, Novo Mercado has the most stringent corporate governance rules for listing. The New Market was created to stop the exodus of companies listing abroad, principally on the New York Stock Exchange, and to encourage technology companies to go public. High transaction costs and poor protection of minority shareholders were cited as the main constraints to trading on the Bovespa. The major features of Novo Mercado are as follows: Elimination of nonvoting shares, which strengthens investor rights by eliminating the

presence of preferred shares Imposition of much higher disclosure standards—U.S. GAAP (generally accepted accounting

principles) or IAS (international accounting standards)—which improves the information in quarterly reports by requiring, among others, consolidated financial statements and special audits

Provision of tag-along rights, which extend to all shareholders the same conditions provided to majority shareholders in the transfer of the controlling stake

Provision for tender offers, which obliges companies to hold a tender offer by the economic value criteria should a decision be made to delist from the Novo Mercado

Establishment of a single one-year mandate for the entire board of directors Minimum free float of 25 percent of the company’s capital stock Creation of a market arbitration panel for resolving conflicts between investors and

companies, which offers a safer, faster, and specialized alternative to investors Improvement in public share offerings, which must be held through mechanisms that favor

capital dispersion and broader retail access.

OTHER RECOMMENDATIONS

The following recommendations would support the high-priority recommendations in various ways.

Improve auditing and disclosure The auditing profession is weak and needs to be brought up to international standards of best practice. Along these lines, audit committees need to be made more effective by clarifying and strengthening their role and function.15 Audit committee members should be required to upgrade their knowledge and skills continuously, for example, through one of the institutions that train directors. In addition, the Capital Market Law (Articles 102-110) needs to be amended to strengthen the liability for making false financial statements and increase the penalties for doing so. However, in the short-term, difficulties with Indonesia’s judicial environment mean that effective enforcement of sanctions for non-compliance with regulatory requirements will remain a problem, although recently the Indonesian courts have given indications that corporate fraud, including white-collar crime, will be dealt with more stringently than in the past. A number of cases have resulted in imprisonment, which rarely occurred in the past when only a fine was

15 Examples of good practices are the recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees and the recommendations of the New York Stock Exchange Listing Committee issued in 2002.


imposed. By imposing stringent fines and imprisonment, the courts are signaling the importance of accountability and transparency as well as good corporate governance. These cases may well set a precedent for others to follow and should constitute a deterrent to poor practices. In Indonesia, the concepts of “whistleblowers” and “hotline” are not familiar concepts used to assist in the effort to identify fraud, corruption, and noncompliance with laws and regulations. Adoption of laws and regulations and creating awareness of this approach could facilitate Bapepam & LK’s and Bank Indonesia’s enforcement and could enhance compliance.

Develop the base of domestic investors There is an urgent need to develop a base of domestic investors. To build a broader base of domestic investors, it is necessary to have the concerted effort of all parties—JSX, SSX, KSEI, KPEI, Bapepam & LK, and securities brokers. Whether they are domestic or foreign, retail or institutional, investors expect the following: A transparent environment with adequate information flow Easy and wide access to the market at reasonable cost A good choice of investment products Due protection of assets Proper resolution of disputes.

Efforts directed at attracting domestic investors often create benefits for all investors. Incentive packages, including bonus shares and discounts, can be examined as possibilities to attract retail investors to participate in privatizations and IPOs.

Improve Minority Shareholder Protection Further improvements will be required to improve minority shareholder rights and the ease with which shareholders exercise those rights. These could include measures to further enhance shareholder rights by allowing minority shareholders a greater voice in the commissioners, including the introduction of mandatory cumulative voting for commissioners. Additionally, further steps should be taken to improve the process for nomination of independent commissioners. For instance, all public companies can be required to establish nomination committees. While class action and derivative actions are allowed, these are costly and, therefore, have been limited so far to only a few cases and none with a favorable outcome. The redress available to shareholders if their rights are violated remains limited. While Indonesia has an elaborate system of formal corporate governance rules, which in several respects may not be substantially different from OECD countries, corporate governance practices often fall short of the recommendations of the OECD Principles. The challenge now lies in raising awareness and increasing effectiveness of implementation and enforcement of legislation and regulations to improve the corporate culture and practices. This can be performed via support for shareholder activism and advocacy groups.

Educate retail investors Investor education not only can bring immediate benefits by recruiting new investors, but also is necessary for the continuous development of the market. A policy for how such activity will be funded should be mapped out before the JSX is demutualized and becomes a profit-making entity.

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Investor education is also a responsibility of the regulator in many countries. For example, in the United Kingdom, the Financial Services Authority has a statutory responsibility for investor education and discharges this responsibility by dedicating a separate section to this. Activities are financed from the fees that regulated firms pay to the Financial Services Authority. In the United States, a foundation was established to provide investors with high-quality, easily accessible information and tools to better understand investing and the markets. The NASD Investor Education Foundation, with an initial endowment of $10 million, functions as a separate, not-for-profit organization and complements NASD’s investor education efforts. Indonesia should consider establishing a similar organization. Bapepam & LK may want to assume such responsibilities.

Simplify the rules governing conflicts of interests Bapepam & LK should review this rule with a view to exempting transactions that do not exceed a prescribed value and are done in the ordinary course of business. At the same time, the audit committee of a listed entity should be required to review the fairness of all interested-party transactions and include a statement to this effect in the audit committee report that forms part of the annual report. Where there are no conflict-of-interest transactions for a year, a nil statement should be included.

Finalize demutualization The need to pursue demutualization is a given. Following demutualization, it will be important to continue pursuing market development policies. To ensure that this is done, a part of the revenues of the demutualized exchange could be used to set up a market development fund. There is a need to ensure that the developmental role of attracting more listings and more transactions by charging competitive fees is not undermined by efforts to improve profitability by raising fees. Hence, price changes by the demutualized exchange should be subject to the approval of Bapepam & LK. The practice of electing commissioners and directors once every three years is prevalent among listed companies. Bapepam & LK may want to require staggered terms and yearly elections of new commissioners and directors for all listed entities. Finally, having a separate board for small-cap listings is counterproductive; JSX should consider having just one board.

Merge the Jakarta and Surabaya stock exchanges In the medium term, the merger of Jakarta and Surabaya stock exchanges, followed by demutualization—and the integration of systems and back-office functions—can be an effective way to improve the overall market. Consolidation of stock exchanges is a global trend. For example, most recently, the New York Stock Exchange (NYSE) Group has demutualized and recently listed itself. The NYSE has made no secret of its desire to join forces with a European exchange. The NYSE also has reacted quickly and decisively to technological challenges by integrating Archipelago, an all-electronic exchange, and rolling out a hybrid trading platform that mixes electronic trading with its traditional open-outcry system. The challenges facing the NYSE and its response are not unique; it is illustrative of converging and accelerating trends among the world’s exchanges. These include a shift from mutual ownership to listed exchanges, rapid advances in and dissemination of technology, and increasingly sophisticated users who want to trade across borders and asset classes. Similarly, the last decade has witnesses globally a quantum leap in the consolidation of financial exchanges. The


trends have lead to rapid decline in costs and improved technology. Those trends raise difficult questions of who and how should regulate the global consolidated entities, and how. Slowly regulators are adapting and responding. Meanwhile, Indonesia has been slow to respond to the global trends and rationalize its stock exchanges. As a result, the Jakarta and Surabaya stock exchanges are functioning less than optimally. Indonesia needs to explore bold solutions, such as consolidation of the Jakarta and Surabaya stock exchanges, a change in platform, and Pan-Asian listings. In this context, Bapepam & LK needs to consider how to share regulatory oversight with a demutualized and private entity.

Develop the capacity of self-regulatory organizations Effective self-regulatory organizations, under the oversight of Bapepam & LK, are essential to development of a successful capital market in Indonesia. The executive summary to this report documents the weak professional capacity in Indonesia’s financial sectors. Therefore, a second-generation issue in development of the capital market in Indonesia is the need to nurture strong self-regulatory organizations with the institutional capacity and incentives to oversee both development and regulation of the market. There is an urgent need to strengthen professional institutions, with the objective being eventually to grant them self-regulatory responsibilities. Only when they are adequately developed should they be transferred self-regulatory authority. Probably the most critical self-regulatory organization to develop further is the stock exchange, which oversees market rules and regulations. To create and enforce industry regulations and standards, important professional and industry associations are needed for broker-dealers, accountants, lawyers, and the mutual and pension fund industry.

Improve the environment for IPOs JSX should be proactive in getting companies listed. Over the course of a year, it should work closely with public accountants and banks, whose clients come from various industries and who can provide a list of entities for potential listing. It should hold workshops for these clients to disseminate information on the advantages, mechanics, responsibilities, and costs of listing. Some of these efforts have been taken by JSX in the past few years.

Improve investor protection Bapepam & LK Rule VI.A.3 (7), which requires securities companies to insure against financial loss to account holders in case of bankruptcy, should be repealed. The insurance is not available or is too expensive, and the rule is not enforced. Nevertheless, the issue of investor protection needs to be addressed, and many markets have done so by implementing investor compensation schemes. Such schemes can take various forms, but they generally compensate investors, in full or in part, for the failure of a financial intermediary. Besides affording the necessary investor protection, such schemes bring added confidence to those who trade in the market, encouraging new investors who otherwise would not participate. In the Indonesian environment, where there is an institutional structure to guarantee ( a portion of ) savings deposits in banks, it would be difficult to persuade individuals to switch or transfer part of their savings to investments in equity without some form of guarantee fund. It is also appropriate, at this juncture, to replace Rule VI.A.3(7) with a guarantee fund so that the fund can be progressively built up as the market continues to develop and grow.

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Many markets have compensation schemes for investors, including the United States, Canada, the United Kingdom, Hong Kong (China), Singapore, and Malaysia. The Stock Exchange of Thailand has just announced its decision to set up an investors’ compensation scheme by the end of this year. Bapepam & LK and JSX will need to draft new rules to govern such a compensation scheme. Consideration should be given to the following: Limit the scheme to claims by retail clients because institutional clients are better equipped

to assess the risk of dealing with particular brokers and have greater capacity to reduce risk by diversifying their activities through several brokers

Cover losses arising from (a) any defalcation by a securities company, its directors, or employees or (b) the bankruptcy of a securities company

Limit payments to a certain percentage (say, 80 percent) of the loss, subject to a maximum amount (say, Rp 100 million) per client

Obligate persons who seek compensation from the scheme to subrogate their rights to prevent any person from “double dipping” into the funds of an insolvent company.

Most schemes are funded through a levy imposed on the market intermediaries. The advantage of a levy is that the compensation fund builds up over the years, and the levy can be waived when the fund reaches a certain size. This is the situation with the National Guarantee Fund of the Australian Stock Exchange. The downside is that the fund takes time to reach a sizable amount and may be insufficient to make the necessary payouts in the early years. It may be necessary to allow the scheme to borrow up to a certain amount from a bank or other institution. In a few countries, the government provides the necessary financing. A compensation scheme does not imply that clients can trade without risk. Hence there is a need to publicize that the scheme (a) only protects clients of securities companies, (b) only deals with the relationship between clients and brokers and does not cover losses arising from poor investment choices, and (c) imposes limits on the amount of compensation paid and therefore requires clients to bear some risks.


REFERENCES Claessens, Stijn, with Simeon Djankov and Larry Lang. 2000. “The Separation of Ownership and Control in East Asian Corporations,” Journal of Financial Economics 58 (1-2): 81–112. Hail, Luzi, and Christian Leuz. 2006. “International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?” Forthcoming in Journal of Accounting Research. Levine, Ross, and Sarah Zervos. 1996. “Stock Markets, Banks, and Economic Growth.” Policy Research Working Paper 1690, World Bank, Washington, DC, December. McKinsey & Company and J. P. Morgan. 2002. “The Future of Equity Trading in Europe.” February. World Bank. 2005. “Doing Business: Snapshot of Indonesia.” Washington, DC. Available at http://www.doingbusiness.org/ExploreEconomies/Default.aspx?economyid=90. World Federation of Exchanges. 2004. Annual Report 2004. www.estandardsforum.com/. www.acga-asia.org/.

CHAPTER 3 INDONESIA’S BOND MARKETS

Well-functioning government and corporate debt markets are the backbone of modern economies. Bond markets link issuers in need of long-term financing with investors willing to place funds in long-term interest-bearing securities. A mature domestic bond market offers a wide range of opportunities for funding the government and the private sector, with the government bond market typically creating opportunities for other issuers. Bond markets play a critical role by: Assisting governments in mobilizing financing for investment needs Assisting corporations in obtaining financing directly from the market, thereby subjecting

them to the discipline of the market as well as providing healthy competition for the banking system , and thereby reducing systemic risk

Providing investors with access to diverse types of financial instruments in which to invest both directly and indirectly through mutual funds, pension funds, and insurance firms

When a developed bond market is present, market forces have a much greater opportunity to assert themselves. A corporate bond market is dependent on and leads to greater accounting transparency through a growing community of financial analysts and rating agencies

In many countries, bond financing is the main source of long-term financing because banks’ shorter-term deposits constrain them from extending long-term loans. Countries need well-developed bond markets to improve the efficiency of allocation and increase the availability of capital. An added benefit is that a strong domestic bond market reduces the dependence on foreign capital inflows, and strengthens the resilience of a country’s financial system to external shocks. Indonesia’s bond market is still in the early stages, and further development is an important priority of the government. The government bond market has grown rapidly. From literally no government bonds prior to 1997, marketable government bonds now total Rp 389 trillion (14.2 percent of GDP). Although much of this was initially driven by recapitalization of the banking system, the government now accesses bond markets for its regular financing needs. Annual net


issuances are about 1 percent of GDP. Recently the government has adopted a debt management strategy to expand the share of domestic debt in total public debt. The corporate bond market, although much smaller than the government bond market, is also growing, with outstanding issues of about Rp 63 trillion. A well-functioning corporate bond market would allow Indonesian corporate issuers to finance themselves at lower cost using instruments better tailored to their needs. Banks are a key source of debt finance, but bank loans alone are neither sufficient nor desirable for meeting all the financing needs of the Indonesian economy. Growth of the corporate bond market is an important step toward diversifying the sources of corporate finance, decreasing the dependence on bank lending, and reducing the vulnerability of the financial system to future shocks. Demand from other sources is also growing. Indonesia is committed to an extensive agenda of infrastructure development, the vast majority of which is expected to be financed by private capital mobilized from domestic as well as international capital markets. Particular effort is being made to encourage the financing of private infrastructure projects through domestic bond markets, and in the medium term, subnational governments will increasingly need access to bond markets. All in all, the domestic debt markets must play an increasing role in Indonesia’s financial sector. It is therefore critical for the government to address the key policy issues constraining their development and to foster their growth. This chapter offers recommendations to this end.

STRUCTURE Indonesia’s bond market is still relatively small, compared to other products and regional markets, and the trading infrastructure is still evolving. The government is the dominant issuer, and commercial banks are major players as investors and intermediaries. The market consists of government debt, corporate debt, bank debentures, and government-owned enterprise debt, with government bonds dominating (see table 3.1). Central bank bills also constitute a significant part of the debt market, but they are issued for a special purpose—monetary policy—and not for financing investment. Bonds as debt instruments are a close substitute for bank loans (for borrowers) and for bank deposits (for savers). Table 3.1: Bonds, Bank Loans Outstanding and Stock Market Capitalization, 2002–5

Indicator 2002 2003 2004 2005 Banking loans

Amount (Rp trillion) 371.1 440.5 559.5 695.6 Percent of GDP 19.9 21.5 24.7 25.5

Government bonds Amount (Rp trillion) 419.4 403.4 402.1 388.9 Percent of GDP 22.5 19.7 17.8 14.2

Bank Indonesia certificates a Amount (Rp trillion) 76.9 101.4 94.1 54.3 Percent of GDP 4.1 5.0 4.2 2.0

Corporate bonds Amount (Rp trillion) 19.6 44.9 62.8 62.8 Percent of GDP 1.1 2.2 2.8 2.3 Percent of total 1.7 3.1 3.5 3.1

Stock market capitalization Amount (Rp trillion) 268.8 460.3 679.9 801.3 Percent of GDP 14.4 22.5 30.1 29.4

Total Amount (Rp trillion) 1,155.7 1,450.6 1,798.4 2,002.8 Percent of GDP 62.0 70.9 79.5 73.4

Source: Bapepam & LK, Bank Indonesia a. Held by commercial banks.

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ISSUERS The principal debt instruments are issued by the central government and by corporations. Central government debt. Indonesia has made significant progress in building a strong foundation for its government bond market. Prior to 1997, Indonesia had no domestic government bonds outstanding—due to a balanced-budget rule—and the government financed capital requirements from international, long-term, official sources of finance such as bilateral and multilateral loans. Shortly after the 1997–8 crisis, the government placed bonds in failed banks in order to recapitalize them. About Rp 430 trillion of so-called “recap” bonds were placed directly in banks between 1997 and 2000. In addition to recap bonds, about Rp 220 trillion of nontradable government securities were placed with Bank Indonesia (BI), which included Rp 144 trillion of non-interest-bearing bonds. The total of about Rp 654 trillion of domestic government debt represented about 52 percent of GDP at end-2000. In December 2002, the government began to issue domestic bonds. Between 2002 and 2005, the government raised approximately Rp 60 trillion by issuing domestic bonds, and the current stock of domestic government debt outstanding (including that at BI) is Rp 648 trillion (23.7 percent of GDP; see table 3.2). Table 3.2: Central Government Debt, 1999–2005 (Rp trillion unless otherwise noted)

Type of debt 2000 2001 2002 2003 2004 2005 Domestic

Bond issuance — — 2.0 11.7 23.6 22.6 Total amount outstanding 654 647 651 617 631 648 Percent of total 51.6 50.8 52.6 50.8 48.9 50.1 Percent GDP 47.0 38.4 34.9 30.2 27.9 23.7

External Total amount outstanding 613 627 587 598 660 646 Percent of total 48.4 49.2 47.4 49.2 51.1 49.9 Percent of GDP 44.1 37.2 31.5 29.2 29.2 23.7

Total Total amount outstanding 1,266.8 1,274.0 1,238.0 1,215.0 1,291.0 1,294.0 Percent of GDP 91.2 75.6 66.4 59.4 57.1 47.4

Source: Bank Indonesia, DPSUN (Ministry of Finance) Note: Exchange rate as of end of year. External debt excludes debt to the International Monetary Fund. In addition to new issuance, the Ministry of Finance has changed the structure of Indonesia’s domestic debt through buyback and asset-bond swap operations. It also has sought to build benchmark series by issuing fixed-rate instruments with medium-term maturity (for example, three to seven years) and to encourage securitization (see figure 3.1 and box 3.1).16 Trading in the secondary market has picked up significantly over the past several years, largely through the gradual liquidation of recap bonds and the issuance of new bonds by the Ministry of Finance (see figure 3.2). Recap banks, as net sellers, have been transferring their recap bonds from investment accounts to trading accounts and selling them gradually through the secondary market.

16 A shift from variable-rate instruments to fixed-rate instruments also reflects the Ministry of Finance’s strategy for reducing interest rate risk.


Figure 3.1: Tradable Domestic Debt, End-2003 and End-2005 (Rp billion)

Source: Bapepam & LK, Ministry of Finance Figure 3.2: Trading of Government Bonds in the Secondary Market, January 2002–May 2006

Source: Bapepam & LK Local government and local government–owned entity debt. From 1979 to 2004, local governments and local government enterprises borrowed almost exclusively from the central government. Terms of the loans were centrally determined and did not reflect the differences between the credit quality of individual borrowers. The total amount disbursed in this period was small—Rp 5.8 trillion, or less than 0.3 percent of GDP in 2004. However, the record of repayment was not good, with arrears at 48 percent in 2004. This borrowing was also accompanied by short-term loans obtained from state or commercial banks for purposes of managing cash flow.

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Since 2001, the government has launched an ambitious decentralization program and is developing a more ‘‘market-based’’ system of local government borrowing. Law no. 33/2004 laid the groundwork for local government borrowing. Local governments can now borrow from the central government, other local governments, banks, and financial institutions or from the public through local government bonds issued on the capital markets. They cannot borrow directly from international sources, except through funds on-lent by the central government. Local government borrowing is subject to (a) a cumulative maximum borrowing limit determined by the central government each year and (b) local government borrowing conditions (for example total debt outstanding not to exceed 75 percent of local government revenues minus obligatory expenditures and local governments not to have any arrears to the central government). The central government does not guarantee local government bonds, and a local government cannot guarantee a loan to a third party. The law also states that local government revenue and property cannot be pledged as security for local government borrowing except when a project is financed by a local government bond. Viewed from a purely fiscal perspective, many local governments in Indonesia have the capacity to take on debt. However, many local government are net savers, in aggregate, local governments saved more than Rp 35 trillion between 2001 and 2005 (1.3 percent of GDP in 2005). To date, no local government has issued a bond. In July 2005, PAM Lyonnaise Jaya issued Rp 650 billion in bonds. The company is a water treatment company for the western part of Jakarta and is operated under a concession contract with PAM Jaya on behalf of the government of DKI Jakarta. This transaction is the first bond issuance from a water company in Indonesia.17 Regional development banks, which are owned by regional local governments, are the only real local government-owned issuers of bonds in Indonesia. In 2005 there were two such issuances, amounting to a total of Rp 400 billion. Corporate debt. The corporate bond market is small, but growing. As of end-2005, there were 158 corporate bond issuers, with outstanding value of Rp 62.8 trillion (US$6.4 billion). Corporate bonds outstanding amount to only 2.3 percent of GDP, compared with the regional average of 20 percent. Corporate bonds are only about 3.1 percent of the domestic financing market (government debt, bank loans, and equity market) and have ample room to grow. Financial institutions, such as banks and multifinance companies, and infrastructure and energy companies are leading issuers of corporate debt (see table 3.3). With the exception of infrastructure and utilities, most non-bank issuers are rather small companies. The average size of issue is also small, about Rp 240 billion. Government-owned or -controlled enterprises and banks are also among the major issuers of corporate debt. These include four banks, two cement companies, three construction companies, three plantations, one energy company, one securities company, and one toll road, airport, and harbor company. Yet the aggregate volume of their bonds is still a small fraction of the corporate bond market, as they also rely on bank loans for financing investments. Table 3.3: Corporate Bond Issuance, by Sector, 2005

Sector Amount (Rp trillion) Percent of total Finance companies 3.1 38.5 Infrastructure and energy 2.9 35.7 Banking 2.1 25.8 Total 8.1 100.0 Source: Bapepam & LK

17 However, this company is different from local government–owned water companies in Indonesia because its private international sponsor enabled it to achieve an A− rating and gain access to the capital markets.


More generally, debt financing by corporations, including borrowing from banks, has grown slowly, despite the growth of consumer lending. The crowding out by government borrowing cannot be the only cause for this because the ratio of domestic government debt to GDP has been declining (table 3.2). In fact, the banking system has had abundant liquidity and lent aggressively for consumer financing, but not for corporate financing. Credit risks in the post-crisis environment and weaknesses in the legal framework and the judicial system for enforcing collateral are factors, as is the stagnant demand for long-term funds from the corporate sector. The debt-laden balance sheets and the stage of the business cycle also discourage companies from borrowing aggressively for investment. (See chapter 2 for a discussion of corporate finance in Indonesia.) More recently, the sustained growth of the economy is accelerating the corporate demand for long-term funds for investment in capacity expansion. The business cycle is also translating consumer demand into smaller inventory, greater use of production capacity, and, eventually, corporate investment in capacity expansion. The fundamentals behind the growing trend of corporate investment seem robust. Thus companies’ demand for long-term financing is likely to accelerate. As a result, the amount of corporate bonds outstanding multiplied fivefold from 2000 to 2005 (see table 3.4)—albeit from a small base. Table 3.4: Indicators of Corporate Bond Issuance, 2000–5 (Rp trillion)

Indicator 2000 2001 2002 2003 2004 2005 Number of issuers 91 94 100 136 152 158 Amount outstanding 12.1 14.3 19.6 44.9 62.8 62.8 Amount issued — 2.2 5.6 25.7 17.9 8.1 Source: Bapepam & LK - Not available. The spread between the deposit and lending rates is an important measure of the efficiency of financial intermediation and banks’ competitiveness vis-à-vis the bond market. Generally, the wider the spread, the more attractive bond-based financing will be. This is particularly true for publicly offered bonds. After the first quarter of 2004, banks have gradually been narrowing the spread, despite the emerging demand for corporate credit. As of January 2006, deposit rates ranged from 12.0 percent for one month to 12.9 percent for 24 months, while the lending rates ranged from 15.8 to 16.3 percent. The emerging competition with the bond market and the perceived improvement in borrowers’ credit are evident. Indonesian banks continue to have some of the highest spreads in the region (see figure 3.3). Figure 3.3: Spread between the Lending Interest Rate and One-Month Rupiah Time Deposit Rate, 2000–6

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INVESTORS At the end of October 2005, bank assets included Rp 296 trillion of government bonds. Claims on official entities and state-owned enterprises were rather small (Rp 28 trillion),18 implying that commercial bank lending for utilities and infrastructure is limited. Non-recap banks are dealers, while money brokers and securities companies are intermediaries. As can be seen in table 3.5, after the banks, institutional investors (pension funds, insurance companies, and mutual funds) are a critical source of demand for bonds. In addition, foreign investors have been investing in long-term rupiah bonds, which is a good sign for the government bond market, despite the risks. All three major types of institutional investors are expected to demand instruments other than government bonds in order to diversify their portfolio. Long-term corporate bonds are an important asset class for them. Table 3.5: Investors in Government and Corporate Bonds

Government a Corporate b Total Investors Amount

(Rp trillion) Percent of

total Amount


total Amount


total Banks 277.0 68.8 8.42 13.4 285.42 61.29 Other investors Mutual funds 9.5 2.4 28.32 45.1 37.82 8.12 Insurance companies 32.1 8.0 4.08 6.5 36.18 7.77 Pension funds 22.2 5.5 16.64 26.5 38.84 8.34 Offshore 49.7 12.3 0.00 0 49.7 10.67 Others 12.4 3.1 0.00 0 15.5 3.33 Total 402.9 100.0 62.8 100.0 465.7 100.0 Source: Surabaya Stock Exchange, Bapepam & LK a. As of April 2006 b. As of December 2005 In fact, institutional investors are the largest holders of corporate bonds, holding more than three-fourths, while individuals hold less than 1 percent. So far, insurance companies have been slower than pension funds to invest in corporate bonds due to stricter prudential requirements. Retail investors turn to mutual funds as an alternative to deposits, and mutual funds have invested largely in rupiah-denominated government securities (mostly recap bonds). In 2005, due to changing interest rates and problems with mark-to-market valuation, investors lost confidence in the mutual fund industry, and total assets declined from Rp 104 trillion at end-2004 to Rp 29 trillion at end-2005. (See chapter 4)

MARKET INFRASTRUCTURE This section describes the market infrastructure in the government and corporate bond markets as well as the role of intermediaries and credit-risk agencies.

Government bonds After about Rp 430 trillion of recap bonds were placed in recapitalized banks in 2000, the primary issuance started in December 2002. The first issuance was made through arrangers that did book building without committed underwriting and distributed the bonds. Auctions started in 2003 as multiple-price auctions used by the automated bidding system built into Bloomberg. Only 18 Bank Indonesia, December 2005.


Bloomberg subscribers could place bids directly, although the primary auction was designed to be open to banks, money brokers, and securities companies that satisfy minimum requirements set forth in BI regulations. Auctions are now conducted on BI-SSSS, which is linked with Bank Indonesia’s real-time gross payments system (BI-RTGS) to achieve delivery-versus-payment (DVP) settlement. It is accessible by all banks, while securities companies and money brokers are granted access on an individual basis, according to Bank Indonesia’s regulation.19 Bond buybacks (as part of the government’s ongoing reprofiling exercises) are conducted on the Ministry of Finance Dealing System (MOFiDS), built on the Indonesian Government Securities Trading System (IGSTS) and offered by the Surabaya Stock Exchange to the Inter-Dealer Market (IDM). This limits direct participation to members of the Inter-Dealer Market Association (Perhimpunan Pedagang Surat Utang Negara—Himdasun); non-members have to bid indirectly through member dealers with whom they may be competing. The Himdasun was set up in March 2003. Its members consist of 14 domestic banks, six foreign banks, and four securities companies. Himdasun’s goal is to make Indonesia’s secondary market in government bonds more liquid by facilitating price information. Himdasun’s members act as a “de facto” primary dealers market, since the government has not designated official primary dealers. The launching of BI-SSSS linked with BI-RTGS has given a major impetus to development of the secondary market. By achieving DVP settlement, BI-SSSS eliminates the principal risk involved in the trading of bonds, which enables banks and other market participants to trade with a wide range of counterparties without worrying about their credit risk. The secondary market has been organized around IDM, while much of the trading takes place in the over-the-counter market. Most recently, market participants have signed a master repurchase agreement, which is another critical step forward in enhancing the market. The recent decision to adopt Bloomberg as an information platform for the IDM is an interesting attempt to improve the organization of the secondary market and enhance its transparency. Himdasun members already subscribe to Bloomberg terminals, and, therefore, it is a cost-free alternative to the IGSTS. Himdasun members, not Bloomberg, own the trade information captured by Bloomberg. Himdasun mainly handles the pricing of government securities. Bapepam & LK, implemented a regulation in January 2004 requiring mutual fund managers to use the Himdasun reference price for government bonds held by their funds. Himdasun uses the Bloomberg system for price discovery and electronic reporting of trading in government bonds. Currently, Himdasun offers near real-time bond pricing (reporting within five to 10 minutes of a trade). Price information is available on the Himdasun page of Bloomberg. It is not clear if or when Himdasun will provide corporate bond prices. Both corporate and government bonds list on the SSX. SSX started operating in 1989 as a regional stock exchange to support the development of East Java and eastern parts of Indonesia. SSX runs 80 percent of its operational activities in Jakarta, while its head office in Surabaya (East Java) functions mainly as a supporting office for information and as a training center. SSX runs two systems for government bonds, although these are not being used actively as trading platforms. Its over-the-counter, fixed-income service (OTC-FIS) provides quotations for bond transactions and is used by 16 banks and four securities companies.20SSX’s trading system, IGSTS, was

19 Bank Indonesia Circular March 21, 2003. Capital adequacy is a critical condition for the qualification. In the case of securities companies, Bapepam examines the net capital position of the applicant. Final approval is given by the minister of finance. 20 More information can be found at www.bes.co.id.

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launched in 2003 for government bonds by members of Himdasun. This system is not widely used, reporting only 5–25 percent of transactions.

Corporate bonds To be listed on SSX, corporate bonds must be rated investment grade by Indonesia’s credit-rating agencies, Kasnic or Pefindo, have a minimum issuance value of Rp 50 billion (US$5.2 million), show three years of financial statements, and have good growth prospects. However, current regulation requires bonds to be rated at the time of issuance, but not subsequently. Therefore, it is difficult for investors to obtain ongoing information on the performance of the companies in which they invest. Investors should demand ratings during the entire life of the bond. For bonds below investment grade, SSX may facilitate private placements. Secondary trading has been thin, with no easy way to obtain bid-ask prices. To remedy this, SSX launched a new Fixed-Income Trading System (FITS) for corporate bonds in July 2005 to provide real-time online bid-ask prices.

Money markets Money markets in Indonesia are thin, fragmented, and volatile, dominated by overnight call loans. Government securities repo transactions are quite infrequent. However, it is important for Indonesia to develop its money market (a) to reduce the interest-rate-risk premium by lowering liquidity risk and reducing volatility in short-term rates, (b) to enable investors to hold larger portfolios of term debt due to the lower liquidity risk in the money market, and (c) to increase competition in financial intermediation. The development of the money market is critically influenced by monetary policy, particularly in a bank-dominated market such as that of Indonesia. The excess reserves of the banking system need to be kept within an appropriate range so that the inter-bank market is not stifled by homogeneous bank demand for funds.21 To cope with the unpredictable volatility in bank reserves, Bank Indonesia has long relied on Fasilitas Bank Indonesia (FASBI), a rupiah deposit facility, to absorb the day’s excess liquidity from the banking system. While effective in stabilizing the money market, FASBI allows individual banks to trade liquidity with Bank Indonesia, not among themselves, thus discouraging development of the inter-bank market. Bank Indonesia is working to reduce the reliance on FASBI and increase the use of discretionary instruments, such as government securities repos.

INTERMEDIARIES Money brokers and securities companies are intermediaries for non-government bonds, which are traded in the over-the-counter market, not on exchanges. Both inter-dealer brokers and alternative trading systems are important organizers of what is otherwise a poorly organized over-the-counter bond market.

Credit-rating agencies Pefindo is Indonesia’s largest rating agency, established in 1994 through the initiative of Bapepam & LK and Bank Indonesia. Pefindo is a private limited-liability company owned by 100 domestic

21 That is, all banks would wish to buy bonds when there is too much excess reserve and sell when there is too little, thus stifling the market and increasing its volatility.


shareholders, including pension funds, banks, insurers, securities companies, and the Jakarta and Surabaya stock exchanges. Pefindo is an affiliate of Standard and Poor’s and adapts Standard and Poor’s methodology in its rating process. About 60 percent of its business is rating domestic investment-grade corporate bonds, and it also publishes credit opinions on corporate bond issuers. Pefindo recently started to incorporate good governance into its rating methodology.22 Indonesia’s only other rating agency is Kasnic Credit Rating Indonesia, incorporated in 1998. Kasnic is affiliated with Fitch Ratings through its shareholder Duff and Phelps.23 Kasnic focuses on asset-backed securities, including plans for securitized mortgages, which are not yet developed in Indonesia. (A secondary mortgage facility has been established, but it could take quite some time for the banking and legal structure to support it). Kasnic also rates small banks and some corporate bonds. A study of corporate bond yields and ratings indicates that there is a statistically significant negative correlation between bond yields and credit quality, controlling for years to maturity (t-value of 4.94; see figure 3.4). In fact, one would expect to find that years to maturity and bond yields are positively correlated as well, but this is not the case. The reason may be that there is a narrow distribution of maturities, and most bonds have zero to five years of maturity remaining; within this range, credit quality is a much more significant determinant of yields than maturity. Figure 3.4: Sensitivity of Corporate Bond Yields to Ratings

10.0

15.0

20.0

25.0

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Source: Pefindo Rating Agency, bond prices are weighted average prices of last 30 days as of March 10, 2006, taken from Bisnis Indonesia, Staff Calculation Note: Y-axis are bond yields in percentages, X-axis are bond rating rankings, from 1 representing AAA+ to 12 representing BBB−. The line represents a linear regression best-fit trend line.

REGULATORY AND SUPERVISORY STRUCTURE Bapepam & LK, through the Capital Market Law, is the primary regulator of the issuance of bonds, the bond market, and its participants (see table 3.6). In addition, according to Article 7(2), “A securities exchange must supervise members’ activities.” Himdasun is a self-regulatory

22 More about Pefindo and its methodology can be found at www.pefindo.com. 23 See www.kasnicrating.com for more information.

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organization authorized by Bapepam & LK, which, in turn, has the authority and power to access the audit trail of transactions that have taken place in IDM, when required for supervisory purposes. Table 3.6: Existing Debt Instruments, Regulatory Framework, and Authorities

Instruments and market

Issuers Main investors Trading venue Main law Regulator Notes

Government bonds

Central government

Commercial banks, mutual funds, pension funds, insurance companies

IDM, over-the-counter

Law on Government Bond, Bank Indonesia regulation

Ministry of Finance, Bank Indonesia

Fixed rate, variable rate, repos

Financial debentures

Commercial banks and multifinance companies

Insurance companies

Over-the-counter

Capital Market Law, Bank Indonesia regulation

Bank Indonesia —

Central bank bills (SBIs)

Bank Indonesia

Commercial banks

IDM, over-the-counter

Bank Indonesia regulation

Bank Indonesia —

Bank-subordinated debt

Banks Insurance companies

Over-the-counter


Bank Indonesia, Bapepam & LK

To strengthen bank capital

Corporate bonds

Joint stock companies

Insurance companies

Surabaya Stock Exchange, over-the-counter

Company Law, Capital Market Law

Bapepam & LK —

Medium-term notes

Joint stock companies

Insurance companies

Surabaya Stock Exchange, over-the-counter


Bapepam & LK Private placement

Convertible bonds, bonds with warrants

Listed companies

Insurance companies Pension funds

Surabaya Stock Exchange


Bapepam & LK Rarely available in market recently

Commercial paper

Listed companies, multifinance companies

Insurance companies Bank Listed companies

OTC Not regulated Not clear After the crisis, the on shore market has been dormant

Certificate of deposit

Commercial bank

Individuals, companies

Over-the-counter


Bank Indonesia Rarely available in market recently

Source: World Bank — None Indonesia has a basic legal and regulatory framework to support development of the corporate bond market. Bapepam & LK sets out requirements in detail, including the appointment of a trustee under a contract (trust indenture) to protect the interests of investors. The rules also cover issues such as bond ratings, but they do not deal specifically with the issue of collateral, which is left up to the trustee. Typical covenants include limitations on the amount of additional debt (particularly senior debt) that the issuer may incur, the incurrence of liens or funded debt by subsidiaries, the disposition of assets, the type of investment that the issuer may make, and the payment of dividends.


Bapepam & LK regulates issuance on the basis of disclosure of information, not merit, requiring public issuers to disclose information at the time of the public issuance of securities. The issuer is also responsible for continuous disclosure, which is to be made periodically at the time of the financial reporting period24 and whenever a corporate event affects the solvency or profitability of the issuer or the creditworthiness of the instrument. Disclosure of financial information is made on the basis of Indonesian financial accounting standards (PSAK), which are in line with international standards—that is, international accounting standards (IAS) and international financial reporting standards (IFRS; see box 3.1). Box 3.1: Accounting and Auditing Standards in Indonesia

The Indonesian Financial Accounting Standards (PSAK) are largely consistent with International Financial Reporting Standards (IFRS). Indonesia is moving toward full adoption of IFRS in 2008. PSAK requires further improvements in standards related to the valuation of fixed assets, accounting for goodwill and business combinations, measurement and recognition of assets, liabilities and equity, and accounting for land, agriculture, and grants. The legislation, regulation, and financial reporting framework are quite fragmented. One of the key areas in need of improvement is the quality of financial reporting. Establishing a multidisciplinary national steering committee would help to develop a country strategy and a detailed action plan to enhance the quality and reliability of financial reporting in Indonesia. The challenge remains to improve the effectiveness of implementation by strengthening market surveillance and enforcement on the part of Bapepam & LK and Himdasun. Although the oversight function is improving, there is still a perception that enforcement is not fully effective. This perception may be explained by a weak legal environment, the absence of accountants’ legal liability, lack of an appropriate risk management methodology, and insufficient training for regulatory staff. Furthermore, in response to the need to strengthen the accounting profession and move to international standards, a new Public Accountancy Law seeks to address two key areas: (1) accountants’ legal liability and (2) an independent public oversight system. It is recommended as well that the audit and review requirements of semiannual and quarterly reports be strengthened to the level of international best practice. At a minimum, it is important to require that independent auditors review semiannual reports and the quarterly financial statements required of large listed companies.

DEVELOPMENTAL ISSUES AND CONSTRAINTS Bond market development requires the involvement of several types of institutions and markets and is linked to the conduct of monetary and fiscal policy. Therefore, policy issues often cut across the lines of authority of the Ministry of Finance, Bank Indonesia and Bapepam & LK. Furthermore, different types of financial institutions are regulated by different authorities under different laws and regulations. Above and beyond coordination between different ministries and institutions, there is need for improved coordination within each of these ministries and institutions as well. For instance, the functions and responsibilities for managing contingent liabilities and local government borrowing are scattered across different departments under the Ministry of Finance and these departments do not always communicate or collaborate effectively. Therefore, coordination within and between institutions is a major issue. This is further

24 Annually and semiannually. Annual report must be audited by an accredited independent auditor.

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exacerbated by the fact that disparities in perceptions regarding OJK as well as differences in skills across institutions make substantive coordination difficult.

Limited access to BI-SSSS Custody and settlement have been significantly enhanced by the introduction of BI-SSSS, which now provides delivery-versus-payment settlement on a trade-by-trade basis. Although the achievement of DVP settlement is major step forward, it is available only for those who have access to BI-SSSS. BI-SSSS is built on the same network platform as that for BI-RTGS, which is accessible largely by banks. Bank Indonesia is selectively providing access to BI-SSSS for eligible money brokers and securities companies. Other market participants can have DVP settlement services only indirectly through the direct participants in BI-SSSS. This arrangement deters the participation of a wide range of non-bank financial institutions in the bond market due partly to the cost (fees charged by the direct participant) and partly to the need to disclose their investment and trading strategy to direct participants, who could be their trading counterparties.

Narrow participation in the repo market In 2005 a master repo agreement was signed. Previously, a separate repo agreement had to be signed for each repo transaction. Now, participants sign the master repo agreement once for all transactions covered under the contract. Consequently, the volume of repo transactions increased from approximately Rp 11 trillion in 2004 to Rp 107 trillion in 2005, while average maturity fell from between two and four weeks in 2004 to around two weeks in 2005. Most of the transactions are done by international banks and large domestic banks mainly to manage liquidity. Smaller banks are constrained by their limited experience and understanding of the product as well as their higher counterparty risks. Establishing a central counterparty for government securities could increase the participation of smaller banks in repo transactions. Non-bank financial institutions are not major participants in repo transactions because accounting and tax treatment of repos are more complicated for them than for banks. Diversifying the participants in the repo market would enable market participants, particularly bond dealers and market makers, to trade along the yield curve and finance carrying a long position in long-term bonds, while earning positive carry. This would enhance the market’s ability for term transformation and generate demand for long-term bonds.

Collection and distribution of pricing information Access to reliable pricing information is a prerequisite for investing in fixed-income securities and is essential for institutional investors to be able to value their investments. The provision of pricing information is not costless, and, in principle, beneficiaries should pay to obtain it. However, Bloomberg charges user fees based on the number of terminals subscribed, not on the volume of transactions conducted. Thus it is relatively more expensive for lower-volume traders, such as institutional investors, and the cost can be an impediment to broadening participation in the market. In addition, Himdasun collects real-time government prices and publishes them on its Bloomberg page. However, information on corporate bond prices is poor. The Surabaya Stock Exchange is currently charging the providers of such information, which creates a disincentive to report prices.

Weaknesses in the mutual fund industry Mutual funds represent another major source of demand for government bonds; however, this industry needs a major overhaul after the events of 2005. From a peak of nearly Rp 110 trillion assets under management, the industry currently has less than Rp 30 trillion and is continuing to


shrink. Several reasons are behind this dramatic turn of events, including macroeconomic volatility in 2005, misleading information on mutual fund products by sales agents and institutions, poor knowledge of investors, weak enforcement of regulations, and weak supervision. (See chapter 4)

Limitations placed on institutional investors Indonesia places a mix of prudent man and rule-based investment limitations on Indonesian pension funds and insurance companies that are very protective and reduce the investor’s discretion in making decisions on the risk-reward spectrum. Domestically, pension funds can invest in listed government and corporate bonds, and insurance companies can invest in bonds that are rated a minimum of A up to 20 percent of their total investment for each issuer. The regulation does not specify whether bonds need to be listed or not for insurance companies. Therefore, it is not clear whether insurance companies can invest in non-listed bonds. Pension funds can invest in non-listed domestic bonds between one and 10 years maturity without the need for a rating if the bond is fully guaranteed by the issuer and if the issuer has at least a three-year history of profit and is not affiliated with the pension fund. The requirement to have bonds listed on exchanges is intended to enforce adequate disclosure and credit-rating requirements, improve compliance with prudential regulatory standards, and promote market price transparency. However, it often adds unnecessary costs and inconvenience because bonds, particularly non government bonds, are traded in the over-the-counter market, not on exchanges. Finally, Indonesian pension funds are prohibited from investing in offshore assets, whereas Indonesian insurance companies can invest up to a maximum of 10 percent in offshore bonds, but have not yet done so in any significant amount.

Unsuitable structure of the market for fixed-income instruments The conventional order-driven trading system of a stock exchange is generally not suitable for trading fixed-income instruments. A quote-driven market run by market makers is difficult to establish because market making is a risky business and feasible only for liquid benchmark instruments. In addition, a significant portion of the trading will likely remain outside the market maker and requires negotiation of deals either directly between counterparties or indirectly through a broker (i.e. OTC).

LEGAL ISSUES The main legal issues in the bond market are the role of the trust agent, creditor rights and the issue of price discovery.

Role of the trust agent Most jurisdictions recognize the difference between holders of equity securities and holders of debt securities. Equity holders are the owners of a company and have the right to guide the company, participate in its profits, and share the increase in the market value of their shares. In contrast, debt holders are creditors of the company and simply receive the return of their principal and the agreed upon interest. As a result, both in practice and in law, an entity is often created to act on behalf of and protect the interests of bondholders. In international practice, the entity that acts on behalf of bondholders can be an elected bondholders committee or an appointed agent that is independent from the creditor and the

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debtors and thus theoretically able to act equitably on behalf of all bondholders. Finally, in cases where the debt is secured by collateral, the entity can be a trustee with responsibility for foreclosing on the collateral and returning the proceeds to the debt holders on an equitable and often prearranged basis. Under Section III of the Capital Market Law, all bond issues must have a trust agent to represent the interests of bondholders. Currently, only banks are licensed to act as trust agents, although the law allows Bapepam & LK to extend this responsibility to other entities as the market develops. The bank acting as trust agent must be disclosed in the prospectus pursuant to Bapepam & LK Rule IX.C.6. The services of the trust agents are to be set out in rules, and the terms of the contract between the issuer and trust agent are to be regulated by Bapepam & LK. However, Bapepam & LK has not issued extensive rules on the duties and contractual provisions of trust agents. Since most bonds issued in Indonesia are not collateralized, the duties of these trust agents are primarily to represent the interests of the bondholders before the issuer and in court in the event of a default, rather than to act as a trustee of assets used to collateralize the bonds. The fees of asset trustees usually are paid out of the proceeds of the sales of the collateral; however, the fees for non-collateral trust agents generally must be paid by the bondholders. In the event of default, these fees can be difficult to obtain from the bondholders or the bankrupt issuer. Market participants have continually voiced concern that they have no model—legislative, judicial, or practice—on which to base their activity as a trust agent nor do they feel they have any guidelines on remuneration and duties in the event of bankruptcy. Thus the parameters of their activity are based almost entirely on their limited experience in Indonesia and on the unregulated provisions as expressed in their contract with the issuer.

Creditor rights The development of a debt market is enhanced by a system of collateral to secure the debt in the event of default. The development of a collateral regime involves a number of elements such as the legal rights of a creditor over specific collateral, collateral registries to place the general public on notice of collateral liens, efficient mechanisms for the exercise of collateral rights, and the existence of an efficient legal system to enforce security judgments and conduct or assist in the seizure of collateral. The international practice for enforcing collateral rights varies widely, depending on the legal system in a particular country. In some instances, creditors are allowed self-help repossession of collateral without recourse to a court, usually for consumer goods and automobiles, while other jurisdictions require a court-issued judgment to transfer title of collateral to a creditor. Some countries allow court officials to seize collateral, while others allow the use of private collection agencies. Indonesian law recognizes three types of security interests in collateral. First, a mortgage is used for land. The Law Regarding Security Rights over Land and Objects Related to Law no. 4/1996 provides for mortgages on real property (land) and objects related to it. Second, the Law on Fiduciary Transfer no. 42/1999 provides for a security interest in movable property. Third, Indonesian Civil Code Article 1153 provides that a pledge can be used for movable property when the property pledged can be transferred out of the possession of the debtor and into the possession of the creditor or his agents. The different security interests have different degrees of efficacy. The mortgage system works well in theory but suffers from weak land records and lack of registration in large parts of the country. The fiduciary transfer system also works well, and a central registry has been established


in Jakarta and is operating in several other areas, but its use is limited. The pledge system is also effective in small transactions but is not practical in large commercial transactions where the debtor must retain possession of the collateral in order to carry on the business.

Nondiscriminatory order matching The Capital Market Law defines scope of business of an exchange vaguely and does not refer to the concept of nondiscretionary order matching to discover market prices. The concept of nondiscretionary order matching is important because it distinguishes the business of an exchange from that of a broker that also matches orders and executes trades. Its absence leaves ambiguity regarding whether an inter-dealer broker should be licensed as an exchange or as a broker and whether establishment of an alternative trading system can be permitted.

POLICY RECOMMENDATIONS The recommended policy actions by time frame are summarized in the following table. The policy recommendations are elaborated subsequently.

Quick Wins (1 yr) 1 - 3 years Regulatory Government bonds

Improve high-level and operational coordination between Bank Indonesia, BAPEPAM & LK, and the MoF to sequence and improve consistency of actions of different authorities and market participants to produce the optimal outcome in achieving the market development. Certainty of issuance has been enhanced by announcing the issuance calendar in advance. Now Government should be a price taker in the auctions, i.e. not cancel issues after bids have been obtained from the market Provide incentives to discourage foreign portfolio investors to be engaged in short-term speculation in the domestic bond market and to guide their investment in long-term instruments Establish a central counterparty for the settlement of retail trades in government securities. Corporate bonds Simplify procedures for follow-on corporate bond issuance Government and Corporate bonds Improve post-trade price transparency by (i) mandating post-trade price and volume reporting to a centralized information center, (ii) disseminating best pre-trade prices and (iii) authorizing a single body as an information center to receive and provide prices for illiquid bonds25 Discontinue immediately BES’s practice of charging the providers of trade price information

Government bonds Test a primary dealer system with a market making obligation. Further develop the repo market. Continue to reform of the monetary policy framework of Bank Indonesia to enhance BI’s ability to control the level of the day-to-day excess reserves of the banking system without relying too heavily on FASBI in order to develop the money market. (Elimination of FASBI will require sound government cash management by MOF) Encourage development of local government bond issuance on a selective basis Corporate bonds Clarify the requirements for credit-rating agencies Clarify duties of trust agents to protect corporate bond investors Develop a comprehensive securitization framework Government and Corporate bonds Create a sound legal and regulatory framework to govern electronic trading of bonds in the OTC market

25 Press release of Bapepam & LK dated 29th March 2006 on bond markets development stated plans to establish price discovery mechanism by issuing rules concerning obligation to report bond transactions and establishment of bond pricing agency.

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Enforcement Enforce the mandated secondary market price reporting

Improve and enforce legal framework for bankruptcy

Skills Improve the MOF’s capacity to project future government cash flows Improve the capacity of rating agencies to analyze securitizations and infrastructure securities26 Improve MoF’s government cash management

Taxes Exempt transfer of assets from originator to an SPV for securitization purposes from any taxation (including VAT) Address the issue of tax advantage given to transactions reported to authorized exchanges


Study the feasibility of interest rate / government bond futures market

Access Have KSEI participate in BI-SSSS as a sub-registry to increase institutional investors access to SUN bonds27 Develop the retail market for government bonds

Consider making KSEI as the central custodian of all securities including government bonds to enhance the efficiency of clearance and settlement and useful in promoting the regional market integration


Given the government interest issuing retail bond, Bapepam & LK should develop literature to educate the public about bonds and debt markets to encourage and enable retail participation in debt markets.

Design a comprehensive education program that includes not only bond markets but also the rest of the capital market and non-bank financial institutions.

Policy issues cut across the lines of authority of the Ministry of Finance, Bank Indonesia, and Bapepam & LK, so improving coordination is imperative. Developing the market also requires implementation of interdependent tasks requiring appropriate prioritization and sequencing. Thus strong leadership is necessary to lead and coordinate relevant efforts effectively. Developing the domestic debt market involves complex issues because various types of participants with conflicting business interests interact in it. Within the context of the need for better coordination, we offer the following recommendations, beginning with those of highest priority and then turning to supplemental recommendations.

Priority recommendations Improve coordination between Bank Indonesia, Bapepam & LK, and the Ministry of Finance. At senior levels, officials indicate that there is improvement, but serious gaps persist in coordination at the operational level. Differences in perceptions regarding OJK as well as differences in skills across institutions make substantive coordination difficult. A high-level inter-institutional committee needs to be formed and empowered to discuss and resolve issues that cut across jurisdictions in bond market development. The tripartite meeting among the Ministry of Finance, Bank Indonesia, and Bapepam & LK should continue. Enhance the certainty of issuance. This could be accomplished by announcing the issuance calendar in advance and being a price taker in the auctions. Auctions should not be canceled ex post (after receiving price quotes) based on political views regarding the price. Developing long-term credibility and predictability in this area is a cornerstone of developing the debt market.

26 Draft rule regarding credit rating agency is in preparation. 27 For trading of retail government bond, Bank Indonesia has appointed KSEI as sub-registry.


Improve market infrastructure for government bonds. Primary issuance conducted through the BI-SSSS system should be used for bond buy-backs as well and be made more inclusive to attract a wider base of investors and to obtain more competitive bids. Money market liquidity should be encouraged via repo transactions. The decision to have KSEI participate in BI-SSSS as a sub registry should be implemented. Clarify the requirements for credit-rating agencies. The basis for authorizing credit-rating agencies is not clear, as Bapepam & LK rules do not stipulate specific requirements for the establishment and operation of a rating agency. Bapepam & LK rules should entail clear procedures for ratings and require qualification of credit analysts and a sound ownership structure that does not compromise its independence (for example, diversified and collective ownership by a group of banks or brokers, individuals without interest in major issuers, established foreign rating agencies, and, potentially, international investors and partners). The agencies should also have diversified sources of income beyond bond credit rating so that they are not tempted to issue ratings that please the issuers who pay their fees. Improve the collection and dissemination of secondary-market pricing information. The Surabaya Stock Exchange is currently charging providers of such information, which creates a disincentive to report prices. Instead, it should charge users for the information. Next, Bapepam & LK should mandate reporting of over-the-counter transactions to enhance post-trade price transparency.

Other recommendations Test a primary dealer system for government bond auctions. The achievement of DVP for a wide range of market participants and development of a repo market should enhance the business feasibility of market making for benchmark government bonds. This, in turn, would open up the possibility of adopting a primary dealer system to enhance even further the primary and secondary markets. However, repos should be supported with appropriate clearing mechanisms, including not only sound account and collateral control but also net settlement of funds. In particular, BI-RTGS may need to be modified to handle netting of funds associated with repos. The government, BI, and their advisors have studied this issue extensively. Analysis of the pros, cons, and conditions necessary for such a system is available. Moving forward on this would improve liquidity in the secondary market, as the primary dealers would be obligated to perform market-making functions. However, a number of caveats are pertinent to this discussion. First, the introduction of a primary dealership system may require changing the secondary market structure, including some compromise of the pre-trade price transparency and the possible restriction of access to the Bloomberg E-Bond Trading Platform. In addition, a link between straight-through processing and settlement is needed for a wide range of participants and all qualified market operators (including inter-dealer brokers). Review foreign participation in domestic government bonds. Foreign participation in domestic government bond markets can have beneficial consequences for deepening the markets, but volatility in short-term flows implies risks to market stability as well. It is suggested that the government explores employment of incentives to encourage long-term holding of government bonds. Enable local governments and local government–owned entities to access bond market financing on a selective basis. Many local governments have the fiscal capacity—and the need—to take on debt. However, significant steps are needed to enable market-based financing for local governments: (a) restructure existing arrears; (b) improve the transparency, accountability,

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creditworthiness, accounting, and budgeting capacity of local government financing and implement meaningful audits; (c) clarify the existing framework for local government borrowing and allow local government to use assets and revenues that are not mandated for the provision of public services to count toward creditworthiness; (d) increase the capacity of the central government to monitor the fiscal risks of local government borrowing, including, in the short term, operationalizing the limits on local government borrowing recently codified in legislation; (e) adopt a more comprehensive regulatory framework to minimize expectations that the central government will support local governments in financial distress (moral hazard), to provide adequate protection for creditors, and to protect the provision of mandated public services; (f) consider devolving local tax bases (for example, property tax) to local governments to provide a base for borrowing and improve accountability; and (g) strengthen the capacity of credit-rating agencies and institutional investors to analyze local government credits. Given the many policy and regulatory issues yet to be addressed in detail, the lack of local government institutional capacity, difficulties in transitioning from non-market borrowing conditions to market discipline and widespread local government access to capital markets probably are not conceivable in the short term. Furthermore, Indonesian banks and non-bank financial institutions perceive the opportunities for growth to be elsewhere and consider local governments to be a poor credit risk. The issuance of bonds is likely to remain challenging for many local governments, given basic concerns about demand (creditworthiness) and supply (transaction cost and capacity). In the meantime, the government seems to be open to piloting local government bonds on a selective basis before establishing a comprehensive and adequate framework. Credit enhancement from private sector financial guarantee insurers (monolines) can offer a venue to help develop this market. Developed countries have used monolines successfully to facilitate the access of subnational government agencies and private sector infrastructure projects to international and domestic capital markets. Half of municipal debt in the US is insured by monolines, allowing states and local governments access to low-cost, long-term borrowings from institutional investors. Taking advantage of their risk assessment expertise and capacity to diversify and manage risks, monoline companies work with municipal governments and other issuers to improve access to the domestic bond market for infrastructure projects and local financing needs. The insurers collaborate with clients in a range of transactions, such as highways, hospitals, and water and sewage systems. By utilizing their highly rated financial guarantees and transaction structuring expertise, the guarantee companies enhance the marketability of issues and help their clients achieve lower borrowing costs. With decentralization, local governments are playing an increasingly important role in Indonesia. In this context and recognizing the need for greater access to infrastructure funding by local governments, it is desirable to explore the employment or establishment of private monoline insurers. Improve the ability and capacity of institutional investors to invest in government bonds. Among institutional investors, pension funds and insurance companies are major investors in government bonds internationally. However, in Indonesia, their role has been limited, with a significant share of resources invested in bank deposits. The reasons for this include weak capacity to make sound investment decisions, poor governance, weak accountability to individual contributors and policyholders and the existence of the blanket guarantee on bank deposits. All of these areas need to be addressed, beginning in the short term and continuing into a medium-term agenda. Increase retail participation in the bond markets. Important areas to consider for development of a retail investors base are (a) to identify and establish a cost-effective method and network of distribution, (b) to analyze the nature of the demand and design instruments to suit it (for example,


to avoid direct competition with bank deposits or mutual funds in terms of maturity), and (c) to provide liquidity in the secondary market. International experience shows that a retail investor base is difficult to develop for bond markets. This is partly due to the fact that, more often than not, these initiatives have been motivated by political considerations rather than a through economical analysis. Allow institutional investors to invest in subinvestment-grade bonds. Institutional investors should have access to a wider range of investment opportunities along the risk-return spectrum, provided this is done in a prudent manner. Subinvestment-grade bonds are such an instrument, and many countries allow institutional investors to invest in them. Simplify the procedures for new issues by established issuers. Established issuers that regularly tap the market should be allowed to follow simplified procedures in making new issues. Adoption of shelf registration of future issues could also be considered. A lead underwriter of an issue should play a greater role in advising the issuer on market timing as well as pricing and market demand. The usefulness of developing a mezzanine-level issuance channel in between the public offering and private placement could also be explored, especially as the number of institutional investors grows. The United States and other developed markets enable issuers to issue only to sophisticated investors with less stringent disclosure of information and credit-rating requirements. Such an approach would reduce the cost and improve the flexibility of issuance, which would enhance the market. The role of bond trustee would be important for preventing bonds issued through this channel from reaching unsophisticated investors. Clarify the duties of trust agents to protect the interests of bond investors. While the Capital Market Law, Section III, is commendable for requiring all bond issues to have a trust agent to represent the interests of investors, several areas require further elaboration and clarification: (a) the duties of trust agents, (b) the terms of the contract between a bond issuer and a trust agent, and (c) guidelines on the activities of trust agents, specifically fees, sources of remuneration in the event of bankruptcy, and specific duties in the event of bankruptcy and final discharge from responsibilities. Bapepam & LK should elaborate further on these issues as soon as possible because the Capital Market Law explicitly provides that issues related to the compensation and duties of a trustee should be set out in Bapepam & LK rules. As a related measure to protect investors, Bapepam & LK should also require disclosure of fees in public issuance documents. Develop the repo market. Various measures are needed to foster development of the repo market. Establishing a central counterparty for government securities has the potential to increase the participation of smaller banks in repo transactions. Flexible provision of inexpensive intraday credit and government securities lending services should also be considered to mitigate risks that a failure to pay or deliver securities will create a chain reaction of default. Securities lending services enable tripartite repos (repos with borrowed securities involving three parties), which significantly enhance the flexibility of using repos to fund liquidity. A legal and regulatory framework is needed, and BI-SSSS, its subregistries, and custodians need to build a sound capacity for valuing collateral. While these steps will help, ultimately BI’s tools for monetary policy implementation—for example, FASBI—will influence the development of this market. Improve the regulatory and legal framework for securitization. Indonesia would benefit from a comprehensive review of the business feasibility and market potential of securitization. An updated law on asset securitization should be drafted and implemented. Specifically, the government should introduce new legislation providing alternative vehicles for asset-backed securities, such as special-purpose corporations or master trusts. A draft law prepared in 2003 moves in this direction, but falls short of providing for a complete range of financial instruments. For example, the special-purpose corporation in the draft is required to be independent of the original creditor, and yet the corporation can only obtain assets from one original creditor, which

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defeats the purpose of the corporation as well as reducing its independence. In addition, provision should be made for a master trust arrangement. Securitization depends on tax-neutrality and clear accounting rules for valuation. The feasibility of securitization is highly sensitive to costs and therefore these costs should be minimized. For instance, market infrastructure, such as credit information systems and historical refinancing data, should be available at low cost. Property rights registries need to be linked, and the registration format needs to be standardized across regions to record priority of secured creditors, prevent multiple pledging of property, and enable effortless transfer. Improve the marketability of collateral. The law needs to provide for “true sale” of credit assets by the originator (for example, a bank) and segregation of risks of the assets sold to a trust from the originator. It should also provide bankruptcy remoteness for the special-purpose vehicle as the issuer. To ensure marketability of the instrument, Bapepam & LK rules should recognize asset-backed securities as “securities,” so that brokers can deal in them. Mortgaging of contract rights and receivables must be legally well founded. Commercial or contract law should require notification to the debtor of the transfer of creditor rights to special-purpose vehicles in order to legalize the transfer. The methodology of notification should be made as inexpensive as possible, while ensuring its effectiveness. It is worth reviewing the feasibility and benefit of allowing a special-purpose company without a track record and large capital reserves to issue asset-backed securities if certain conditions are met. Establish a futures market for repos. A deep and liquid repo market as well as securities lending services should further enhance the business feasibility of market making and, therefore, the viability of a primary dealer system. As a next step, the feasibility of establishing a government securities or interest rate futures market should be explored. Bank Indonesia needs to develop repos, which are more flexible than the current periodic SBI auctions (for example, Bank Indonesia could conduct periodic term repos and daily overnight repos to fine-tune the banking system reserves and short-term, particularly overnight, interest rates as the government’s projected cash positions are updated). Doing so should help Bank Indonesia to manage banking system reserves within a target range. This would reduce the volatility of the money market without compromising the banking system’s ability to respond flexibly to BI monetary policy signals. It would also help Bank Indonesia in its inflation targeting. Improve the regulatory framework for the secondary bond market. Securities law and regulation should provide a framework appropriate to the loose structure of the bond market, while ensuring fairness, transparency, and efficiency. Bapepam & LK is encouraged to consider providing a regulatory framework for an information system that facilitates bond trading but does not fall under the definition of a formal exchange (for example, alternative trading systems in the United States and the concept of multilateral trading facilities in the European Union directive on markets for financial instruments). When such non-exchange market organizers emerge, it becomes critically important to provide a level playing field and ensure fair competition. Improve the Ministry of Finance’s cash management and cash flow projections. In order for Bank Indonesia to use discretionary instruments, it needs accurate information on the government’s future cash flows and positions, a key factor causing the unpredictable volatility in bank reserves. The Ministry of Finance, together with Bank Indonesia, needs to enhance the ability of government to manage cash flows and, in particular, to project its future cash flows and positions. Other possibilities to enhance cash management include the introduction of a treasury bills program and management of excess cash balance in the money market. Those developments should reduce the volatility in bank reserves, thus reducing the need for Bank Indonesia’s monetary policy operations. Establish standards for credit guarantee service providers. Credit guarantee services support borrowing and bond issuance. In principle, provision of credit guarantees should be a commercial


service priced to reflect the risks taken. Whether to use it or not should be a business decision of the borrower or debt issuer, not a regulatory requirement. Banks, insurance companies, and investment guarantee companies could provide this service. Appropriate prudential standards and requirements are needed. Improve the legal framework for bankruptcy and enforcement. The availability of credible credit-rating and guarantee services will become even more important as the market develops new types of instruments, such as subnational debt and asset-backed securities. Credit-rating agencies and guarantee providers must develop expertise to rate and price the risks involved in such instruments. As a foundation for effective credit rating and guarantee as well as for borrowing and debt issuance more generally, there should be a clear legal basis for solvency, including laws governing bankruptcy, collateral, guarantees, and fiscal relationships between central government and subnational bodies, such as local governments, and an effective and efficient judiciary system to enforce the laws. Securities firms authorized to underwrite bond issues need to be capable of advising the issuer on the cost and benefit of obtaining credit guarantees and guiding it through the process of obtaining a credit rating. Ease the investment limitations on institutional investors. The investment criteria for pension funds and insurance companies need to be consistent and clear, especially with regard to liquidity requirements, listing, and ratings. For example, the requirement to list bonds on an exchange is intended to enforce adequate disclosure and credit-rating requirements, improve compliance with prudential regulatory standards, and promote market price transparency, but it adds unnecessary cost and inconvenience. Instead, regulations should be formulated on the basis of risks and solvency. Enhance the market for fixed-rate mortgages. To make mortgages more accessible to the population, banks need to offer fixed-rate mortgages. This, in turn, would require greater stability in interest rates over the medium term. Securitization of fixed-rate mortgages would be particularly useful. Long-term benchmarks of at least 15 years are needed. Weaknesses in the legal and judiciary system that frustrate repossession and liquidation of collateral need to be addressed. Key factors motivating banks to sell mortgage loans will likely be maturity mismatch and the concentration of their loan portfolio in mortgage loans.

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REFERENCES Bapepam & LK. 2005. “Capital Market Statistics Report.” Jakarta: Bapepam & LK. www.bes.co.id

CHAPTER 4 INDONESIA’S MUTUAL FUND INDUSTRY

A mutual fund is an investment company that pools money from shareholders and invests in a diversified portfolio of securities. Mutual fund investing is simple, accessible, and affordable. The many advantages to investing through mutual funds include professional management, diversification, variety, liquidity, affordability, convenience, and ease of record keeping as well as strict government regulation and full disclosure (Investment Company Institute 2004). Mutual funds should be subject to exacting internal standards and should be regulated. As part of this government regulation, all funds must meet certain operating standards, observe strict anti-fraud rules, and disclose complete information to current and potential investors. These laws are designed to protect investors from fraud and abuse. Provided that mutual funds are managed, regulated, and supervised properly, they have a salutary role in capital market development by introducing demand from a new set of investors. For instance, about 8,200 mutual funds are available in the United States, with goals and styles to fit most objectives and circumstances. An estimated 91.2 million individuals in 53.3 million U.S. households own mutual fund shares. In this way, they contribute to the virtuous cycle in capital market development. With all of these benefits, it is no surprise that the mutual fund industry in Indonesia has grown rapidly since its creation in 1997. The industry grew most rapidly after 2002, due to the dramatic increase in fixed-income funds, which invest mainly in rupiah-denominated government securities (mostly recap bonds used to recapitalize insolvent banks during the crisis). Declining interest rates (and rising bond prices) provided a favorable environment for launching recap bond funds. As of end-2004, mutual funds managed Rp 104 trillion (US$10.4 billion), which represented 6.3 percent of total financial assets and 4.5 percent of GDP (see Table 4.1). However, massive redemptions rocked the industry in 2005, and assets under management fell to Rp 29.4 trillion (US$3 trillion, 1.1 percent of GDP) by December 2005 (see Table 4.2). Indonesia’s mutual fund industry is small compared to regional and global markets. In 2003 mutual fund assets worldwide rose to US$14 trillion. By region, 57 percent of worldwide mutual fund assets were in the Americas, 33 percent were in Europe, and 10 percent were in Africa and


Asia-Pacific, and 5 percent were in East Asia, principally in Hong Kong (China) and Republic of Korea (see table 4.3). Table 4.1: Net Asset Value of Mutual Funds, 1995–2005

Indicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Net asset value Money market fund — 16 25 38 575 1,244 2,217 7,181 7,856 9,439 2,080 Fixed-income fund — 1,898 3,439 1,894 2,744 3,062 4,661 37,336 57,485 88,059 13,924 Balanced fund 315 350 862 522 729 650 635 1,795 3,734 4,648 5,468 Equity fund — 519 590 539 927 560 491 302 402 1,892 4,934 Protected fund 3,008 Total 315 2,782 4,917 2,992 4,974 5,516 8,004 46,614 69,478 104,038 29,415 Number of products Money market fund 0 6 21 22 23 26 29 31 20 31 33 Fixed-income fund 0 12 31 32 31 35 46 61 116 146 170 Balanced bund 1 1 3 4 5 8 10 17 30 46 78 Equity fund 0 6 22 23 22 25 23 22 20 23 30 Protected fund — — — — — — — — — — 18 Total 1 25 77 81 81 94 108 131 186 246 329 Source: Bapepam & LK — Not available Table 4.2: Structure of the Financial Sector (Rp trillion)

Type of institution and year Assets (Rp trillion) Percent of assets Percent of GDP Banks (2005) 1,470.0 79.7 53.9 Non-bank financial institutions 374.5 20.3 13.7 Finance companies (2005) 67.7 3.7 2.5 Insurance companies (2005) 75.1 4.1 2.8 Pension funds (2004) 107.1 5.8 4.7 Securities firms (2004) 10.1 0.5 0.4 Pawnshops (pegadaian) (2005) 4.8 0.3 0.2 Rural institutions (2004) 14.7 0.8 0.6 Mutual funds (2005) 29.4 1.6 1.1 Venture capital companies (2005) 2.7 0.1 0.1 Outstanding corporate bonds (2005) 62.8 3.4 2.3 Total 1,844.5 100.0 67.6 Equity market capitalization (2004) 680 N/A 30.1 Equity market capitalization (2005) 801 N/A 29.4 Source: Bapepam & LK, Bank Indonesia Note: * As of December 2004. Numbers include double counting because pension funds, insurance companies, and mutual funds invest in banks. Percent of GDP of each sector is calculated using the GDP of the year corresponding to year of the data. Total as a percent of GDP uses 2005 GDP figure. Table 4.3: Size of the Mutual Fund Industry in Asia, 2003

Economy Amount (US$ billion) Percent of total Percent of GDP China 20.5 2.8 1.4 Hong Kong (China) 534.3 71.7 340.3 Indonesia 7.5 1.0 3.6 Korea, Rep. of 140.1 18.8 23.2 Malaysia 18.4 2.5 17.7 Philippines 0.8 0.1 1.0 Singapore 11.8 1.6 12.9 Thailand 12.0 1.6 8.4 Total 745.5 100.0 26.6 Source: Asset Management Association of Korea; IMAS 2005. Securities and Futures Commission in Hong Kong (China); Dalla and Gamo 2004b.

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Table 4.4: Size of the Mutual Fund Industry in Asia, 1999–2002

1999 2000 2001 2002 Economy Amount

(US$ billion) Total

% Amount

(US$ billion) Total % Amount

(US$ billion) Total % Amount

(US$ billion) Total %

China 7.0 1.4 10.3 2.2 9.8 2.1 14.4 2.6 Hong Kong (China) 298.9 58.1 311.4 65.6 285.2 60.9 342.1 61.3 Indonesia 0.5 0.1 0.6 0.1 0.9 0.2 5.0 0.9 Korea, Rep. of 188.8 36.7 132.4 27.9 149.5 31.9 168.2 30.1 Malaysia 11.4 2.2 11.4 2.4 12.5 2.7 14.1 2.5 Philippines 0.1 0.0 0.1 0.0 0.2 0.0 0.5 0.1 Singapore 4.2 0.8 4.8 1.0 6.4 1.4 8.6 1.5 Thailand 3.5 0.7 3.6 0.8 4.0 8.8 5.5 1.0 Total 514.4 100.0 474.6 100.0 468.5 100.0 558.4 100.0 Source: Dalla and others 2004; Asset Management Association of Korea; IMAS 2005; Securities and Futures Commission of Hong Kong; Dalla and Gamo 2004b, 2004c, 2004d; World Bank, World Development Indicators; Oanda.com; Bapepam & LK online; Monetary Authority of Singapore; Securities and Futures Commission; Securities Commission in Malaysia. a. Includes unit trusts only; excludes funds managed by fund managers and investment-linked products.

From 1999 to 2002, in line with the general economic recovery in the region, the mutual fund industry rebounded, following growth of the domestic bond market in several countries (see Table 4.4). Several East Asian governments issued large amounts of government bonds to restructure and recapitalize their banking systems. These high-grade debt instruments were marketed to retail investors largely through mutual funds. Therefore, fixed-income mutual funds flourished, especially in Indonesia, Korea, Malaysia, and Thailand. Principal-guaranteed mutual funds also grew rapidly, especially in Hong Kong (China) and Singapore. With the overall recovery in the economy, decline in interest rates, and sharp improvement in corporate profits, investors have been reallocating their assets from fixed-income funds to equity funds. However, fixed-income mutual funds remain dominant in Indonesia, the Philippines, and Thailand.

STRUCTURE There are two kinds of mutual funds in Indonesia: corporate mutual funds (Perseroan) and (contractual) collective-investment mutual funds (Kontrak Investasi Kolektif or KIK). The mutual fund industry has a diverse range of products, participants (including custodians, managers, and investors), and channels of distribution.

Products Five types of mutual funds are available in Indonesia: equity, fixed-income, money market, balanced-mixed, and protected funds. As of December 2004, mutual funds held around 13.5 percent of outstanding government bonds, making them the largest holder of government bonds among the non-bank financial institutions. During the swift redemptions in 2005, investment managers were forced to sell their holdings of government bonds to pay investors seeking to redeem their funds, and mutual fund ownership of government bonds fell to 3.2 percent of total government bonds outstanding (see table 4.5). Nevertheless, the fixed-income mutual funds still dominated as of December 2005, at almost 50 percent of total funds. In April 2005 mutual funds held more than 45 percent of total nominal corporate bonds listed on the Surabaya Stock Exchange, the main exchange for trading corporate bonds, and this proportion likely declined even further by December 2005. Protected funds, a new type of mutual fund that protects the initial investment, started from a strong position, at 10 percent of total funds in 2005 (see figure 4.1).


Table 4.5: Bond Investors, by Type of Bond (percent)

Financial institution Government bonds a Corporate bonds b Banks 68.8 13.4 Mutual funds 2.4 45.1 Insurance companies 8.0 6.5 Pension funds 5.5 26.5 Offshore 12.3 0.0 Others 3.1 8.5 Total 100.0 100.0 Source: Surabaya Stock Exchange, Bapepam & LK, Staff Estimates a. As of April 2006 b. As of April 2005

Figure 4.1: Composition of the Mutual Fund Industry, 1996–2005

0

20,000

40,000

60,000

80,000

100,000

120,000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

ProtectedEquityBalancedFixed-incomeMoney market

Source: Bapepam & LK

Investment managers and custodians Funds are managed by investment management companies, which are securities firms licensed by Bapepam & LK to perform this service. Management activities are conducted by individual fund managers who work for the investment management company and have obtained a license from Bapepam & LK. In December 2005, there were 104 licensed investment management companies, but only 72 of these were managing mutual funds. Of the 104 licensed companies, 84 were national and 20 were joint ventures with foreign banks or foreign life insurance companies. Sixteen firms were affiliated with national commercial banks. These companies managed 329 mutual funds: 170 fixed-income funds, 30 equity funds, 33 money market funds, 78 balanced (mixed) funds, and 18 protected funds. The custodial services for mutual funds include administration, transfer services, and safekeeping. The Capital Market Law (Article 25) requires custodian banks to be unaffiliated with the investment management company. As of end-December 2005, there were 19 licensed custodians, but only 13 of these (three state-owned banks, five national banks, and five foreign banks) were providing custodial services for mutual funds.

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Investors The majority of mutual fund investors are individuals, accounting for three-quarters of subscriptions. There were 254,660 unit holders of collective-investment mutual funds in December 2005. Of these, 99 percent were domestic investors. The average unit holding of each investor was around Rp 300 million. Many individual investors are affluent. A number of investment managers interviewed for this report confirmed that the majority of retail investors buy mutual funds through commercial bank branches and that many are clients of the bank’s private banking department. Institutional investors, such as pension funds and insurance companies, have a small exposure to mutual funds, accounting for less than a quarter of subscriptions.28 They tend to invest in equity funds. Corporate treasuries tend to manage their idle cash directly or to deposit it at a bank in exchange for a promise of generous liquidity support in the event of need. Commercial banks are not buying mutual funds, although the Banking Law does not explicitly prohibit them from doing so. Commercial banks, however, are restricted to investments in the equities of corporations unless the investment is in a financial institution or is a temporary holding due to a loan workout. Another important impediment to the participation of institutional investors is a restrictive Bapepam & LK rule that prohibits ownership of more than 2 percent of the fund, thus theoretically ensuring that all mutual funds have a minimum of 50 investors.

Fees Investors who put money into a mutual fund gain the benefits of a professional investment management company. As with any service, using an investment manager entails costs. These costs are recovered from a mutual fund’s investors through charges either for sales or for operational expenses. Sales charges for an open-end mutual fund include front-end loads and back-end loads (redemption fees). Fund managers also charge annual fees for administering the fund. Most collective-investment mutual funds in Indonesia charge up-front and back-end fees. These include charges for fund management, custodial, and selling agent services. In addition to these charges, the mutual fund also pays for accountants, legal counselors, notaries, administration and marketing, registration and transaction of securities, insurance (if any), and taxes. Table 4.6 summarizes the typical fee structure. It appears that funds in Indonesia can charge as much as 3.25 percent in annual fees, as well as well as up-front and redemption fees. Compared with an average expense ratio of 1.5 percent for mutual funds in the United States, the fees charged by Indonesian mutual funds are quite high (Ferris and Yan 2002).

28 In end-2003, pension funds and insurance companies only invested around 5 percent of their net assets in mutual funds, which in combination represented less than 10 percent of total net asset value. The percentage of mutual fund investments in their portfolio did not change substantially in 2004 and 2005.


Table 4.6: Fee Structure of Mutual Funds (percent)

Type of fee Amount Fees charged to the mutual fund Investment management fee (annual) 0.30–2.00 Custodian bank fee (annual) 0.25 Selling agent fee (annual) 0.5–1.00 Fees charged to the investor Subscription fee (per transaction) 0.75–1.00 Redemption fee (per transaction) Ownership less than minimum period 0.5–2.50 Ownership more than minimum period 0.00 Transfer of funds (per transaction) 0.25–1.00 Source: Mutual fund prospectuses

Sales and distribution channels Collective-investment mutual funds are distributed through multiple channels: indirectly by commercial banks, insurance companies, and brokers and directly by investment management companies. Commercial banks take the lion’s share of the market, with more than three-fourths of net asset value. Many state-owned banks and insurance companies distribute collective-investment mutual funds managed by their won investment management company subsidiaries, while independent commercial banks (most of which are foreign owned) offer a variety of fund families distributed by different investment management firms. A collective-investment mutual fund is sold as a unit of participation and is offered to the public continuously until the number of units sold reaches the maximum number of units stated in the contract between the investment manager and custodian bank. At the initial offering, each unit must have a net asset value of Rp 1,000.29 Investment management companies set different minimums for the size of the initial subscription of their mutual fund products. Currently, the minimums range between Rp 250,000 and Rp 50 million. At the initial offering, both collective-investment mutual funds and corporate mutual funds must have investors (sponsors or founders) who have bought at least 1 percent of the units or shares. These investors are required to hold the units or shares for at least one year. In practice, these investors usually are parent companies of the investment management company or an affiliate of the corporate mutual fund.

Legal structure and taxes According to the Capital Market Law, mutual funds in Indonesia can take the form of a corporate mutual fund (Perseroan), which can be an open-end or a close-end30 fund, and a (contractual) collective-investment mutual fund (Kontrak Investasi Kolektif or KIK), which can only be an open-end fund (see figures 4.2 and 4.3). Indonesia’s legal system is based on civil law and hence does not recognize the concept of a trust (investment trust or trust company).

29. For U.S. dollar- and euro-denominated mutual funds, the starting net asset value is always US$1 and 1, respectively. 30. A closed-end mutual fund raises a fixed pool of capital and is traded like common stock.

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Figure 4.2: Operation of Corporate Mutual Funds

Source: Siamat 2003, pp. 256–7 * After obtaining operational licenses from Bapepam&LK

Figure 4.3: Operation of Collective-Investment Mutual Funds

Investor

Bapepam

Investment management company

Custodian bank

Broker

Capital marketMoney market

Effective Submitting registration statement

Supervision

Investment

Trade Instruction (Buy/Sell)

Instruction for payment and collection

Contract contained rights and obligations of: - Investment manager - Custodian bank - Investor

Place minimum 1%

Redemption

Continuous subcrip

Public offering

Source: Siamat 2003, pp. 256–7 Currently, KIK is the preferred legal form in the Indonesian mutual fund industry. The main differences between the KIK and a corporate mutual fund are as follows: Tax treatment of returns to investors. All returns from a KIK are tax exempt, but returns from

corporate funds (dividends and capital gains) are taxed. Best practice for mutual funds permit the tax treatment of certain types of income to "flow through" to the shareholders. If the mutual fund receives interest on bonds, it pays a dividend that is taxed at the recipient’s level. This "flow-through" treatment is essential to prevent double taxation and ensure the development of the mutual fund industry.

Investment

Directors

Custodian bank

Reksa Dana Perseroan Terbatas *

Promoter (f ound er )

Share h olders

Underwriter (If any)

Capital m arket Money m arket

Investment m anage ment

company

Initial fund minimal 1% Supervision

Asset

Instruction

Supervision

Contract

Management

Establish ment

Shares

Public o ffering

Cash p ayment


Cost and time of establishment. Corporate funds are more expensive to establish than KIKs. Furthermore, approval of the corporate funds’ articles of association, as required by the Ministry of Legal Affairs, is a lengthy and tedious process. On the contrary, collective-investment mutual funds are formed based on a notary’s contract between an investment manager and a custodian and take only a few days to set up.

Flexibility of structure. In addition, a single KIK can be used to issue several types of mutual fund products (or fund families). For corporate funds, each fund requires a separate corporation.

Liquidity. The corporate structure is not suitable for redemptions. Even if the corporate fund is listed on the exchange, which can be costly due to minimum listing requirements—that is, the minimum number of shares to trade is 500—investors cannot sell back shares because the listed corporate fund is a closed-end fund.

Governance. The corporate structure has far more protections for investors than the KIK. In the US, under the Investment Company Act of 1940, the board of directors of a mutual fund is charged with looking after how the fund operates and overseeing matters where the interests of the fund and its shareholders differ from the interests of its investment adviser or management company. Further, recent changes in mutual funds regulations, have gradually required changes that ensure that a majority of fund directors are independent. This "arms length" healthy tension between the investment adviser or management company and the independent directors helps to ensure that funds are run in the interest of the shareholders. The KIK structure has limitations, because there is no independent set of eyes reviewing the conduct and performance of the investment adviser or the management company.

Income from investments in mutual funds is subject to income tax. However, fixed-income funds are exempted during the first five years. Any dividends or proceeds received by the unit holders are not subject to income tax during this period. Table 4.7 presents the tax provisions applicable to mutual funds. Table 4.7: Income Tax Structure of Mutual Funds

Source of income PPh (income tax) treatment Cash distribution (dividend) General PPh rates Coupon bond and discount on bonds traded or reported on the stock exchange

Not a tax object for first five years after registration becomes effective

Interest on bank deposits and discounts on SBI PPh final (20 percent) Capital gains on shares PPh final (0.1 percent) Commercial paper and other promissory notes General PPh rates Profits, including redemption received by the unit holder Not a tax object Source: Mutual fund prospectuses Note: PPh or Pajak Penghasilan is the income tax. SBI is also known as BI certificate

Regulatory and supervisory structure Bapepam & LK is the regulator and supervisor of the mutual fund industry. The chairman of Bapepam & LK reports to the Ministry of Finance. Bapepam & LK’s Bureau of Investment and Research is responsible for the day-to-day monitoring of the mutual fund industry. The head of this bureau reports to the chairman of Bapepam & LK. The Capital Market Law (Law no. 8/1995) provides the main and highest legal framework for the mutual fund industry. Articles 18 to 29 specifically concern the creation and management of mutual funds (which locally are known as “reksadana”). In addition to the law, other forms of regulations also govern the mutual fund industry, including government regulations, minister of finance decrees, and Bapepam & LK rules (see annex A for the main regulations affecting mutual funds in Indonesia).

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PERFORMANCE AND SUSTAINABILITY Beginning in 2002, the mutual fund industry’s net asset value grew rapidly as individuals shifted from rupiah time-deposit accounts in commercial banks to mutual funds. Figure 4.4, which compares trends in the net asset value of mutual funds and the value of individual time-deposit accounts in the banking sector, supports the presence of this relationship. After a successful year in 2004, the mutual fund industry entered 2005 with great optimism. Indeed, net asset value reached a high of Rp 113.6 trillion in February 2005 (see figure 4.4). However, in March 2005 the industry was thrown into turmoil. The rate of SBI, which is widely used as the benchmark in the market, rose following higher-than-expected inflation, weakening of the rupiah, and rising fuel prices. Higher interest rates depressed the price of bonds, which translated into lowered net asset value. This worried investors. Massive redemptions from rupiah fixed-income funds caused significant contraction in total net asset value. In a vicious cycle, as the redemptions accelerated, net asset values dropped further. The situation was compounded by the fact that many investment managers did not use mark to market valuation, which is required because it shows the fluctuation in net asset value, and there was no reference price for securities traded over the counter, such as corporate bonds.31 The situation confused investors and had an adverse effect on confidence. Massive redemptions in fixed-income funds were unavoidable.32 This situation was similar to the redemptions that occurred in October 2003, only this time the amounts were much larger and the effects more systemic.33 Figure 4.4: Performance of Mutual Funds, 2005

-30

-10

10

30

50

70

90

110

130

Jan Feb M ar Apr M ay Jun Jul Aug Sep Oct Nov Dec

T ri l l io ns

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00%

Incoming/Outgoing FundsTotal NAVSBI 1 month

Source: Bapepam &LK

31. This was less of a problem for government bonds because all broker-dealers already use reference prices provided by the Inter-Dealer Market Association (IDMA or Himdasun) through a Bloomberg service. Bapepam recognizes Himdasun as a self-regulatory organization. 32. A large portion of the proceeds from mutual fund redemptions apparently was placed in deposits with onshore and offshore banks. A smaller portion of proceeds was placed in money market funds and mixed funds. 33. In September 2003, a handful of foreign-owned investment management companies voluntarily marked their bond portfolio with market prices and thus showed the fluctuation in net asset value. Because of that, their assets under management fell an estimated Rp 6 trillion by December 2003.


In April, Bank Indonesia bought Rp 6.5 trillion in government bonds, which helped bond prices to recover. In June, Bapepam & LK issued a circular requiring the use of price ranges for securities traded over the counter, which helped to remove uncertainty in the use of reference prices. In July, Bapepam & LK issued a regulation allowing investment managers to manage protected funds, which need to be held to maturity and offer a guaranteed yield based on the underlying instruments. In December, Bapepam & LK imposed sanctions on four investment managers (BNI Securities, Trimegah Securities, Bahana TCW Investment Management, and Mandiri Manajemen Investasi) for failing to use reference prices in calculating net asset value. The sanctions included a warning letter, notification of the director, a limitation on business activity, and imposition of a fine. Redemptions finally peaked in September 2005, when net asset value dropped to Rp 32.9 trillion, having fallen from Rp 113.6 trillion in February and from Rp 83.2 trillion in June.

DEVELOPMENTAL ISSUES AND CONSTRAINTS The 2005 crisis showed that there were fundamental issues in the industry. Good products, selling presentation, and solid understanding of investors regarding the nature of the products (especially fixed-income funds) are needed to create a sustainable industry. Further discussion on fundamental issues follows.

Misrepresentation of products In the initial years, sales agents failed to explain the nature of the product to investors, and this created the impression that the product was a banking product. Investors did not understand the relative impact of income and capital gain or loss on their investment returns. Given present disclosure requirements, they were not aware of the current yield or yield to maturity of their fund. Many thought that fixed income meant that the fund offered a fixed return and had a fixed market value. So when interest rates rose and the unit values of the funds that “marked to market” fell, agents encouraged their investors to rush for the exits, and they did.

Education to develop a base of retail investors Although the mutual fund industry in Indonesia has grown rapidly, penetration remains lower than in other countries in the region. In a more mature industry, such as in the United States, 48 percent of households own mutual funds. In Indonesia, the total number of unit holders at the end of June 2005 was 314,000, or around 0.14 percent of the total population. This is understandable given the short history of Indonesia’s mutual fund industry and capital market. The turbulence during the financial crisis is still fresh in the minds of many investors. An important agenda for the near term should be to develop the base of individual investors. As discussed earlier, individuals constitute the majority of investors in the mutual fund industry. Nevertheless, the potential for additional demand is enormous. According to Bank Indonesia statistics, as of end-June 2005, individuals held Rp 541.8 trillion in rupiah-denominated deposits at commercial banks, which accounted for almost 64 percent of total rupiah deposits in the banking sector. Of this amount, Rp 228 trillion, or 42 percent, were in the form of time deposits. A shift from time deposits to mutual funds could fuel significant growth in the industry. In order to realize this potential, individuals need to develop a better understanding of mutual funds and the capital markets in general. The massive redemptions in 2003 and 2005 brought home the point that the majority of individual investors who have bought mutual fund products do

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not yet understand what mutual fund investing is all about, particularly the risk side of it. Most of them still possess a so-called “time-deposit prism,” in which they feel that their investment will not fluctuate in value. This situation is not unique in Indonesia. Even in countries with a more highly developed investment culture, retail investors have a poor understanding of risk. Different from mutual fund investors in developed countries, most of whom have a long investment horizon, Indonesian investors have a short one (see table 4.8). Liquidity appears to be a key consideration for Indonesian investors. The fact that mutual funds are tax free for five years tends to focus expectations on the shorter rather than the longer term. Table 4.8: Investment Horizon

Term Indonesian mutual fund investors Developed market mutual fund investors Short term 1 month Up to 1 or 2 years Medium term 3 months 2–5 years Long term 6 months 5 or more years Source: Cadogan Financial 2005

Product innovations The authorities and all market participants should encourage innovation in the mutual fund industry and play a more active role in developing it. Innovative products include exchange-traded funds, real estate investment trusts, and other structured investment products. Exchange-traded funds (ETFs). In light of the recent debacle regarding mutual funds, the Indonesian authorities might consider introducing exchange-traded funds (ETFs) as a more reliable pooled product. As their name implies, ETFs represent a basket of securities that are traded on an exchange. They are traded as stocks, and the commissions are identical to commissions on stocks. In short, they are similar to index mutual funds. Exchange-traded funds have advantages and disadvantages. Being similar to stocks, they offer more flexibility than the typical mutual fund. They can be bought and sold throughout the trading day, allowing for intraday trading, without waiting for redemption of mutual funds. Traders have the ability to buy them on margin and to short them (in markets where these are allowed). Therefore, ETFs add both to liquidity and to effective price discovery. Low annual expenses make them cheaper than mutual funds. Similarly, the tax regimes can be designed to make them tax efficient. Finally, research suggests that a passive index fund beats the returns of 80 percent of actively managed funds over the long term. However, there are disadvantages. Unlike mutual funds, ETFs do not necessarily trade at the net asset value of their underlying holdings. In the absence of efficient market making, they could potentially trade considerably above or below the value of the underlying portfolios, similar to closed-end funds. Despite the disadvantages, ETFs can support the development of equity markets. They offer a diversified asset and add liquidity to trading. In this context, the Indonesian authorities are encouraged to address regulatory and tax measures that facilitate the formation of ETFs. However, before seeking to expand into products such as derivatives, the JSX should concentrate on convincing more companies to be listed and getting more people to invest in the market. Real estate investment trusts (REITs). Another product warranting consideration are REITs, which are listed securities on the stock exchange and invest directly in real estate, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. Equity REITs invest in and own properties (thus they are responsible for the equity or value of their real estate assets). Their


revenues come principally from rents on their properties. Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate or purchase existing mortgages or mortgage-backed securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans. The advantage of those products are that they take illiquid assets and covert them into liquid assets with a secondary market and thereby reduce the cost of capital. Further, they create a transparent pricing process for the underlying real estate assets. A precondition for their establishment is a trust legal structure.

Mutual fund ratings The rapid growth of the mutual fund industry has lead to greater transparency in a number of countries, such as independent rating systems. In the United States and other countries, Morningstar, Lipper, and other research firms provide independent mutual fund research. Those firms provide information and rankings on the objectives and performance of mutual funds, variable annuities, close-end funds and exchange-traded funds. Currently, select Indonesian newspapers and magazines calculate and publish information on the performance of mutual funds. However, the calculations are conducted simplistically: returns are not adjusted for risk, and rankings are not provided.

Regulation of non-bank financial institutions and cooperation with Bank Indonesia The present system of inconsistent regulation and supervision of essentially the same investment management vehicle needs to be revamped with the aim of achieving consistency. This inconsistency creates some of the regulatory and supervisory challenges discussed in the next section. Furthermore, the banking sector plays an important role in the mutual fund industry by providing a large network of selling points and potential investors. A number of banks also have large investment management companies as their subsidiaries. Adequate supervision and regulation of commercial bank activities in the mutual fund industry are needed to protect both institutions and investors.34 This requires closer cooperation between Bank Indonesia and Bapepam& LK.

Valuation of net asset value Issues surrounding the calculation of net asset value deserve special attention from Bapepam & LK. Under Article 22 of the Capital Market Law, investment managers are required to determine the fair market value of securities in the portfolio of an open-end investment fund in accordance with Bapepam & LK rules. Under Rule IV.C.2, the fair market value of exchange-traded securities is the closing price for actively traded securities. The custodian of the fund must calculate the net asset value based on the fair market value of the assets in the portfolio as determined by the investment manager (Rule IV.C.2.1.a). The custodian must send the net asset value of the fund to Bapepam & LK on a daily basis (Rule IV.C.3). Securities that are traded over the counter, such as corporate bonds, pose a problem for valuation. Where there is no usable closing price, the investment manager may use previous trading prices or comparable prices of similar securities to determine fair market value (Rule

34. In the second half of 2004, a small local commercial bank, Bank Global, sold a fictitious mutual fund to its customers. The bank convinced customers to convert their deposits to a mutual fund product offered by the bank. In fact, the bank had no license to offer mutual funds, and no funds were sent to a custodian bank. The bank also recorded fictitious bonds and credit to make up its financial figures. Bank Indonesia closed the bank in early 2005 due to a negative capital adequacy ratio. The government picked up the cost of the failure by repaying most of the bank depositors’ money.

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IV.C.2.1.d). This has led to wide variance in the value that different investment managers place on the same bond. To resolve this problem, Bapepam & LK requires all investment managers to report the daily price of bonds in their portfolio. Bapepam & LK then calculates an average price, which is used as a reference price on that day. The most recent development is that Bapepam & LK allows a range of prices based on a predetermined standard deviation of price. Although the use of a reference price is mandatory, some investment managers apparently do not comply with this regulation, and the authority does not sanction them. This contributed to the redemption crisis in 2005.

Tax exemption on mutual fund products Fixed-income mutual funds enjoy favorable income tax treatment in Indonesia, as both interest income and capital gains from bonds are tax exempted for the first five years after a fund is created. The government apparently has sought to develop long-term funding through mutual funds. Lately, the effectiveness of this tax incentive for attracting investors in longer-term instruments has been debated.35 The tax authority has plans to revoke the tax exemption on bonds held in mutual funds, although most fund managers oppose the idea of phasing out the favorable tax treatment. There has been no clear statement from the tax authority and, therefore, no good communication between the tax authority and the industry. This condition creates uncertainty in the industry, which depresses activity in the sector.

LEGAL, REGULATORY, AND SUPERVISORY ISSUES The main legal issues pertain to investor protection, the valuation and pricing of funds, and the conflicts of interests for managers. In addition, issues arise with regard to the rules for minimum capital standards and disclosure, among others.

Role of custodians Custodians play critical roles. They have a key role in clearing and settlement, reconciliation, record keeping, reporting and tax processing. They equally safeguard assets to assure that they are not stolen, misappropriated, or used for non-fund-related activity. In some circumstances, they calculate the net asset value of the fund, review transactions to assure that they are in line with the fund’s objectives, and guard against the improper transfer of assets, such as to related parties. Therefore they are essential to the growth and integrity of capital markets. Article 25 of the Capital Market Law requires that the assets of all collective-investment mutual funds in Indonesia be held by a registered custodian bank, and Bapepam & LK has established an extensive regulatory structure for custodian banks. However, the custodial contract focuses largely on record keeping and safekeeping provisions. The Capital Market Law does not explicitly obligate custodians to protect investors and does not require custodian banks to take a proactive role in defending the interests of investors. Under Bapepam & LK Rule IV.B.2, the custodian bank has a more passive role—that is, to refuse instruction from the investment manager if it deems that it has violated regulations or the contract.

35. Given the size of fixed-income mutual funds, the tax revenue lost has been substantial. To illustrate, as of end-2004, the nominal amount of bonds in fixed-income mutual funds was Rp 88 trillion. Assuming that these bonds were paying a 10 percent coupon per year and a tax ratio of 20 percent, the revenue lost may have amounted to about Rp 1.7 trillion a year.


The absence of an explicit fiduciary obligation is beginning to cause problems in Indonesia. Custodian banks, facing ever-increasing competition, sometimes bow to pressures from investment management companies. For example, in one case a money market fund invested in securities with maturity longer than a year, and in another a money market mutual fund invested mostly in commercial paper issued by affiliated parties; both investments were contrary to Bapepam & LK rules. In these two cases, the custodian banks did not wave a red flag, although they were in a position to recognize the violations. Another challenge for the custodian bank lies in the widespread practice of holding an omnibus account, under which an agent bank keeps full information on the individual investors. According to Bapepam & LK rules, custodian banks must verify whether an individual investor exceeds the 2 percent limit on investment in a fund. In the case of omnibus accounts, custodian banks largely delegate this responsibility to agent banks, a practice that is susceptible to abuse. Custodian banks and Bapepam & LK do not pay enough attention to this issue. For example, an agent bank could systematically steal investors’ money by submitting false redemption requests to the custodian bank, which might not bother to verify whether the individuals actually claimed the redemption. In fact, a custodian bank delegates most of the functions of transfer agent and fund administrator to agent banks holding an omnibus account. Generally, the powers of a custodian bank in a (contractual) collective-investment mutual fund are weaker than those of directors in a corporate mutual fund; hence corporate mutual funds provide a higher level of protection to investors. For this reason, in many jurisdictions—for example, in Japan and Korea—corporate mutual funds are the mainstay of the mutual fund industry. Even in Indonesia, the Capital Market Law and Bapepam & LK rules provide a more comprehensive legal and regulatory framework for corporate mutual funds than for collective-investment mutual funds. Nevertheless, the majority of mutual funds are collective-investment vehicles.

Regulatory arbitrage In developing countries lacking a coherent policy framework and effective regulations, regulatory arbitrage can exacerbate the fragility of the financial system. Inconsistent regulations enable firms to choose the form of business that is the most loosely regulated. Unit-linked insurance products, which base the payout of the insurance on the performance of a pool of securities purchased with the insurance premiums, are similar to mutual funds.36 However, they are regulated by two separate regulatory regimes—insurance regulations and capital market regulations—thus allowing entrepreneurs to choose the more relaxed regulatory regime. Two major differences in the regulation of these two instruments pertain to the investment manager and the amount of disclosure required. Investment managers. The Capital Market Law requires all mutual funds, whether corporate or collective investment, to have a fund manager (Article 21). All investment managers must carry out their duties in the sole interests of the mutual fund (Article 27) and must be licensed (Article 30). In order to obtain the license, the owners, officers, and managers of a mutual fund must meet Bapepam & LK criteria as to experience, capacity, and good conduct.

36. Unit-linked life insurance uses premiums received to make a series of contractual purchases of free-standing mutual funds (often managed by the life insurance company itself or its investment management affiliate) or of a series of internally managed funds (not legally constituted as mutual funds but operated in almost the same way). In either case, market risk is transferred from the life insurance company as guarantor to the participant. The life insurance company’s role becomes increasingly that of investment manager, providing only a minimal life insurance parcel (death benefit), which is often required for tax reasons.

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However, the investment managers of insurance companies and banks that operate financial institution pension funds are not defined as such in the Capital Market Law and do not need to register with Bapepam & LK or meet its requirements (Article 1.11). There is a lack of uniformity as to the regulation of investment managers by Bapepam & LK. As a result, less-qualified individuals may be allowed to manage unit-linked insurance funds. Funds for unit-linked insurance and financial institution pension fund products and for collective-investment contracts should be managed by entities and individuals who have the same qualifications. Required disclosure and sales practices. Collective-investment mutual funds in Indonesia are governed by a number of detailed regulations regarding disclosure. Bapepam & LK Rule IX.C.6 governs the disclosures that must be made in the prospectus of a mutual fund. In addition, Rule V.G.1 prohibits investment managers of mutual funds from undertaking certain sales practices. Unit-linked insurance products are governed by Decision no. Kep–2475/LK/2004 of the Bapepam & LK, which sets forth the information to be included in the sales brochures for unit-linked products. Bapepam & LK’s rules are far more extensive than insurance rules in governing disclosure and sales practices. For example, investment funds must disclose specific risks, while unit-linked insurance products are only required to disclose general risks. More extensive disclosure of fees is also covered in investment fund rules, as are the rights of investors. In addition, the mutual fund must disclose information regarding the custodian and investment manager of a fund, while a unit-linked product is not required to do so; indeed, a custodian or investment manager is not even required to be associated with a unit-linked insurance product. More important, the method of calculating the value of the fund must be disclosed according to Bapepam & LK rules, although there is no rule for the valuation of unit-linked products, and funds are allowed to disclose their own method of calculation at varying levels of specificity. In addition, there are no prohibited sales practices for unit-linked insurance products, while Bapepam & LK has issued extensive rules on prohibited practices to avoid misleading potential customers. Disclosure of material information in the prospectus. While mutual funds provide an attractive way for many investors, they need to be transparent. Investors should be able to consider a number of factors before making an investment in a mutual fund. A prospectus should include 11 items of critical importance in investment decision-making. They are: the mutual fund's goals or objectives; its investment strategies; its risks; the kind of investors for whom the fund might be an appropriate or inappropriate investment; a table showing fees and expenses of the fund; a calculation of the variability of the fund's performance in the last 5 years (or life of the fund), accompanied by standardized performance data for the fund; the name of the fund's investment adviser; how investors may purchase shares of the fund, including any minimum investments; how investors may redeem their shares; when and how distributions are made by the fund; and other services the fund offers to investors. Equally funds should disclose related party transactions and distribution arrangements. Bapepam & LK Rule IX.C.6 sets the minimum information that must be included in the prospectus. However, disclosure is still inadequate regarding the nature of products, investment policy, and calculation of net asset value. Prospectuses tend to be vague about the intended exposure of the fund to different fixed-income instruments or the risks associated with these and provide little information regarding what securities may be purchased within each asset class and in what concentration. Furthermore, Bapepam & LK’s rules on the management of mutual funds (Rule IV.A3 for corporate funds and Rule IV.B1 for collective-investment funds) do not require investment managers to disclose this information, giving them great flexibility on the subject. The need for disclosure is even more important when the mutual fund invests in illiquid assets, such as some corporate bonds, commercial paper, or small-cap stocks. In such cases, investors are unable to assess the risks facing the mutual fund.


Rule IX C6 states that prospectuses should provide information on the definition, method of calculation, and period of announcement of net asset value. Yet current prospectuses do not provide meaningful information on all of these items. The most serious deficiency is the lack of information on the method used to calculate net asset value. This is essential because Bapepam & LK’s Rule IV.C.2 grants discretion to investment managers regarding the method used to value some types of securities or in circumstances where fair market value cannot be easily calculated.37

Eligibility, qualifications, and codes of conduct of the investment manager The Capital Market Law requires securities companies to obtain an investment management company license from Bapepam & LK (Article 30). In practice, investment management activities are performed by an individual who holds an individual license (Wakil Manajer Investasi or WMI) from Bapepam & LK.38 The law states that investment managers must carry out their duties in good faith and in a fully responsible manner in the sole interests of the mutual fund; otherwise, the individual will be held liable for losses resulting from his actions (Article 27). Given this requirement, it is important for Bapepam & LK to ensure that only individuals of high probity and capacity are eligible to work as investment managers. To obtain an investment manager license, the individual has to pass an examination and an interview with Bapepam & LK. The examination covers the basic technical skills of investment management. The license is valid for life. This is counterproductive, as the needed skills must evolve over time, together with the industry. A process is needed to ensure that licensed investment managers continuously update their skills and keep up with industry standards. The legal framework for the conduct of investment managers is outlined in Rule V.G.1 of Bapepam & LK. However, this guidance is too general and is not tailored to the specific situation of an investment manager for a mutual fund. Moreover, the rule does not deal specifically with many fraudulent acts particular to a mutual fund.

Conflicts of interest In Indonesia, the investment management business is not separated from the broker-dealer business. The Capital Market Law allows investment managers to conduct transactions with affiliated brokers provided that the commissions are determined at arm’s length (Article 41). There are jarring conflicts of interest in this setting. Under this regime, broker-dealers can sell their proprietary products to customers. Investment advisors are supposed to provide objective advice, not sell their in-house products or direct trades to their own brokers-dealers. Due to market pressures, in the United States the trends are for investment banks to sell their asset management operations.39 Another issue pertains to buying the shares of affiliated companies. Bapepam & LK Rule IVA.3 (for corporate funds) and Rule IV.B.2 (for collective-investment funds) state that investment managers can buy securities issued by an affiliated company up to 20 percent of the net asset value. Given

37. The current practice is simply to repeat Rule IV.C.2 in the prospectus. 38. Government Regulation no. 45/1995 on the operations of capital market activities requires each investment management company to have at least one director and one staff with a WMI license. A WMI-licensed individual can only work for one investment management company. As of June 2005, there were 1,472 WMI-licensed individuals in Indonesia. 39 Citigroup recently swapped its investment-management arm for the brokerage operations of Legg Mason, a regional

firm with a large presence in the southeastern part of America. And Merrill Lynch sold its funds to Black Rock.

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that some mutual funds have accumulated large portfolios, a 20 percent investment could represent significant ownership of the offered securities. It might not be in the best interests of investors to have such a large exposure to a single affiliated company.

Minimum authorized capital for investment management companies Investment management companies should maintain sufficient capital to manage various risks⎯the largest usually being operational risk⎯associated with managing clients’ money. In December 2004, the statutory minimum paid-up capital for an investment management company ranged from Rp 5 billion to Rp 55 billion, depending on whether or not the investment management company also provided broker-dealer or underwriting services (see table 4.9). The minimum required capital of Rp 5 billion for firms with only an investment management line of business is quite small compared to the size of mutual funds that companies manage. There is no limit on the size of collective-investment mutual fund that one company can manage.40 Table 4.9: Authorized Capital Requirement for Securities Companies (Rp million)

Type of business Authorized capital Net adjusted working capital Underwriter 50,000 25,000 Broker-dealer Does not administer client’s accounts 50 200 Does administer client’s accounts 30,000 25,000 Investment manager only 5,000 200 Underwriter and investment manager 55,000 25,200 Broker-dealer who administers the client’s accounts and manages the investments

35,000 25,200


Sale of mutual funds by banks Financial institutions are not licensed to distribute mutual funds; for this reason, their employees are licensed on an individual basis, as stipulated in Bapepam & LK Rule V.B.2. Although commercial banks may not register as an agent for mutual funds, individuals employed full time or on a commission-only basis at the commercial bank may receive a sales agent license to sell mutual funds (the local acronym is WAPRD), if they are affiliated with a licensed broker-dealer, which may also be affiliated with the commercial bank. The sales activity is usually concentrated in a single unit within the commercial bank, and that unit, not the entity regulated by Bapepam & LK, supervises the sales activities. Although an argument is made that Bank Indonesia regulates commercial banks, which supervise the sales people, Bapepam & LK should regulate sales activity through the commercial bank. Experience has shown that a setting fraught with conflicts can lead to failures of compliance with the rules of the securities regulator.41 Another problem is that, to obtain the sales agent license, an individual only needs to attend a two-day training course administered by Bapepam & LK, which covers basic features of mutual funds and the related regulations. The whole process is far from demanding, and no examination is required. Anyone attending the two-day course gets the license. As of December 2005, some 11,196 individual sales agents were licensed by Bapepam & LK. Some foreign commercial banks

40. The average size of assets under management of investment management companies is quite large. Small companies are already managing assets amounting to hundreds of billions of rupiah. Annex B lists the size of net asset value for each investment management company in Indonesia. 41. Lax regulatory oversight over sales agents increases the likelihood of misrepresentation or outright fraud involving mutual funds. In the second half of 2004, officers of a small bank, Bank Global, reportedly mobilized Rp 600 billion by selling fictitious mutual funds to depositors.


require sales agents to complete more rigorous internal training courses (often lasting a full month). Aside from the agents of these commercial banks, which care about their reputation, other sales agents face minimal, if any, professional standards.

POLICY RECOMMENDATIONS The recommended policy actions by time frame are summarized in the following table. The policy recommendations are elaborated subsequently. Creating a sound, creditable mutual fund industry requires transparency, market discipline, and adequate enforcement. The recommendations begin with the top priorities, notably restructuring of the industry, and then turn to supplemental actions.

Quick Wins (1 yr) 1 - 3 years Regulatory After the 2005 mutual fund debacle, Bapepam & LK should consider a re-

licensing process including fit and proper test of all sponsors and managers of securities companies that operate mutual funds without any grandfathering provisions Implement a methodology for calculation of net asset values and enforce consistent implementation Assess and publish the performance of all funds, including fees, with a standardized methodology on Bapepam & LK’s web site Liquidate funds not meeting guidelines Make regulation of sales practices and disclosure of mutual funds and unit-linked insurance products consistent to prevent regulatory arbitrage Bapepam & LK should consider linking the amount of assets under management to the amount of authorized capital

Improve governance structures of mutual funds by rationalizing the disadvantages of the corporate mutual funds structure and strengthen the fiduciary responsibilities of custodians to monitor and oversee the activities of mutual funds and to report improper conduct Include investor protection in Capital Market Law Lower investment limits in affiliated companies

Enforcement Improve regulatory reporting, and more importantly improve the analytical capacity to interpret and react to the reports/findings. Currently, Indonesian newspapers provide some information that is not very reliable The authorities should encourage the industry or should publish themselves information on performance and fees of mutual funds. Improve the mutual fund sales agent licensing program and consider changing the regulation to license institutions, not individuals to sell mutual funds Enforce “mark to market” valuation and subject violators to prohibitive penalties Enforce disclosure of material information in prospectuses

Aim to encourage separation of investment management and brokerage businesses

Skills Improve the eligibility, qualifications, and codes of conduct of investment managers Build the capacity of the professional association with the aim of transforming into a self regulatory organization42

42 The current Capital Market Law does not explicitly describe the role of professional associations or authority that Bapepam & LK has over them.

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Taxes Implement a strategy to shift away from the tax exemption for mutual funds which is distorting the market


Introduce exchange traded funds to increase liquidity, participation and competition and to serve as benchmarks


Initiate a comprehensive education program that includes seminars, investor relationship activities, and advocacy in the media

Partner with mutual fund industry to continue the education program Enhance regulation, enforcement and self-regulation for mutual funds and their asset management companies to ensure that investors understand risks when investing in fixed income funds.

Priority recommendations Restructure the mutual funds industry. This is the top priority for Bapepam & LK. The foundations for a sound mutual funds industry are credible fund family companies. Only when the industry is run by credible operators can the industry resume sustainable growth. The role of the regulator is to provide a climate that encourages sound operators to participate in the industry. In this context, a relicensing process, including fit and proper test of all sponsors and managers of securities companies that operate mutual funds is needed to enhance the development of mutual funds. This relicensing process should be implemented without any grandfathering provisions. Strengthen enforcement and market discipline. The crisis in the mutual funds industry in 2005 was due to poor marketing practices and inadequate disclosure of risks, poor enforcement, and weak valuation guidelines. Therefore, stronger enforcement is a top priority. In this regard, the authority has to be firm in enforcing rules and imposing sanctions to uphold market discipline and build investor confidence. Recent anecdotal evidence suggests that compliance among investment managers is low, indicating that Bapepam & LK should be more willing to use its enforcement power. Address the challenges of net asset valuation. The current redemption run strongly suggests that the mutual fund industry is confronting fundamental issues in marked-to-market asset valuation. In the current system, fund managers report bond prices to custodians and often overquote the bond prices to get higher net asset values. The reporting of bond prices must include bonds dealers and banks that are active players in the market to better represent actual prices in the market43. Furthermore, a framework is needed to determine the securities for which “readily available market quotations” are available; for those that are not, there is a need to establish a basis for determining fair value. There are several acceptable methods for determining fair value of illiquid securities, and any method would be appropriate as long as it is enforced consistently and uniformly.

Other recommendations The following recommendations would support the high-priority recommendations in various ways. Strengthen custodians to protect investors. When the majority of mutual funds are collective-investment vehicles, as in Indonesia, the custodian bank has the primary responsibility for

43 Bapepam & LK indicates that a new regulation that requires reporting of bonds transaction prices to a reporting agency will be issued.


protecting investors, and hence there is a strong case for Bapepam & LK to ensure that rigorous regulatory and supervisory frameworks for custodian banks are put in place. To start, Bapepam & LK should conduct a comprehensive review of the current regulatory and supervisory framework for custodian banks. To the extent that it is relevant and practical in the context of the Indonesian legal system, the review should be based on the best international standards and practices. Bapepam & LK may wish to consider amendments and improvements based on such a review. That said, some concrete recommendations are as follows: Include investor protection in the Capital Market Law Provide the legal requirement and authority for custodian banks to report improper conduct of

investment managers to the authority Allow the imposition of fines and sanctions on custodian banks that fail to perform their duties Discontinue the practice of the omnibus account and require custodian banks to maintain the

records of unit holders, as stated in Rule IV.B.2. Reduce the possibility of regulatory arbitrage. Since Bapepam & LK has developed more rigorous criteria for licensing investment managers, and since their activity, regardless of domain, falls within the purview of the securities laws, they should be regulated pursuant to the rules of Bapepam & LK. This action would require amendment of Article 1 of the Capital Market Law and related Bapepam & LK rules on investment managers. The regulator of pension funds and insurance industries might have to issue new rules to address the subject and needs to collaborate with Bapepam & LK44. The rules for disclosure and sales practices of mutual funds and unit-linked insurance products must be coordinated to ensure consistency between the two types of investment products. Thus the regulator of the insurance industry needs to tighten the current regulations on disclosure and sales practices of unit-linked insurance products so that they are at par with those of mutual funds. Improve the disclosure of material information in the prospectus. Bapepam & LK needs to address the deficiencies in disclosure practices along the lines previously discussed. In particular, Bapepam & LK should prescribe a methodology for calculating expenses for each class assuming a certain percentage return on an investment held for three years. Bapepam & LK could introduce transparency in two ways. It could require funds to disclose the methodology up-front in the prospectus and it could place a chart comparing the ranking and expenses for each fund according to the indicated methodology on its web site. Improve the eligibility, qualifications, and codes of conduct of investment managers. To complement the eligibility requirements set in PP no. 45/1995, there must be a well-structured and transparent screening process for ownership and management of investment management companies. This is usually accomplished through fit-and-proper assessments based on predetermined criteria. To maintain the technical skills of licensed investment managers, Bapepam & LK should consider requiring investment managers to pass periodic examinations as a condition for keeping their

44 Investment managers of insurance companies and commercial banks that run financial institution pension funds do not need to register with Bapepam & LK, however, based on a Ministry of Finance Decree, investment managers of pension funds and employee of insurance company that issue unit-linked products must have an individual licence as investment manager representative.

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license. In other professions, the use of credit points as a basis for ongoing professional development is quite common and effective. With respect to professional conduct, more detailed guidance is needed for investment managers. In some jurisdictions, the necessary details are provided by common industry standard or the association of investment managers. Bapepam & LK could take the initiative to start this process. Separate the broker-dealer from investment management. Consideration should be given to separating the investment management business from the broker-dealer business. Such a change apparently has been included in the draft revision of the Capital Market Law. Set minimum authorized capital for the investment management company. Bapepam & LK’s decision to increase the minimum capital for securities companies (including investment management companies) is a positive move. In addition, it should consider an absolute as well as net capital rule that ensures that the level of capital is commensurate with the level of risk that securities companies take on. The amount of authorized capital currently varies from Rp 5 billion to Rp 55 billion, and Bapepam & LK should consider linking the amount of assets under management to the amount of authorized capital. In the future, when investment management business is separated from broker-dealer business, Bapepam & LK should use the opportunity to increase the minimum amount of capital authorized for investment management companies. Regulate the sale of mutual funds. Regulating individual sales agents, while leaving the financial institutions (in particular, commercial banks) outside Bapepam & LK’s regulatory jurisdiction, is fraught with peril. Under the proposed approach, mutual fund distributors would be required to have an institutional business license. In return for this, they would be expected to train and supervise the activities of sales agents, as the institutions would be accountable directly to regulators for the activities of their employees. It is expected that the rapidly changing financial scene in Indonesia will render the registration of individual agents with Bapepam & LK impractical. Aside from this, the current system has more fundamental drawbacks for investor protection and risk management: there is no readily available database of qualified sales agents, and it is difficult for investment management companies and investors to determine whether the funds are sold through licensed agents. This is another reason to move from individual licenses to institutional licenses. In addition, to improve the level of competency and professional conduct, sales agents should be required to undertake and pass a sales agent examination organized by Bapepam & LK before receiving a license. Organizing “refresher” examinations is also worth consideration45. Reduce conflicts of interest. It is usually costly and time-consuming for a regulator to discover whether an investment manager has executed transactions at the best quotation available in the market at a specific time. In this situation, the most efficient way to protect investors is to prohibit all transactions between an investment manager and its affiliated broker-dealer. In addition, Bapepam & LK is advised to change the rule allowing 20 percent of net asset value to be invested in securities offered by an affiliated underwriter. It makes more sense to limit investments to a maximum percentage of ownership (both debt and equity) that one mutual fund can have in a single company, similar to the practices adopted in the banking sector. Develop a base of retail investors. Investor education has to be an important element of policy and strategy for the development of Indonesia’s capital markets and mutual fund industry. Designing a comprehensive education program that includes not only mutual fund products but

45 Bapepam & LK is to issue new regulations concerning licensing, registration and conduct of mutual funds sales agents.


also the rest of the capital market is a cost-efficient approach. A common form of investor education program is a general public awareness program that includes seminars, investor relationship activities, and advocacy in the media, to name a few. For mutual funds, this will require the provision of plain-language brochures on the main features of mutual fund investing. In many countries, the authority of the capital market takes lead responsibility to run and fund such a program, although the various industry participants should also have a role. Bapepam & LK should consider taking the lead with the industry in developing an educational program. Encourage product innovations and market infrastructure. To encourage product innovations, Bapepam & LK should provide support and the legal framework, which is still absent in Indonesia, to support the creation of new mutual fund products. Once this has been accomplished, market participants will have to take the opportunities forward. The initiative to make risk management tools available would normally come from market participants. However, the regulator’s “blessing and guidance” will make the process move a lot faster. The recent launching of the Indonesian master repurchase agreement for corporate bonds sets a good example. The process was started by the association of bond dealers, but it experienced delays and could not be finalized without the strong support of Bapepam & LK and Bank Indonesia. With regard to mutual fund ratings, Bapepam & LK should encourage independent mutual fund ratings.46 Independent ratings can help to increase transparency and foster competition in the market, which ultimately will benefit the industry and investors. Create a level playing field. This report takes the view that the treatment of financial instruments should offer a level playing field without exhibiting any favoritism. In essence, for each favorable tax treatment, there will be ingenious ways for many to reap the rewards, without any beneficial advantages system wide. In short, tax benefits cannot foster development of the industry. The long way—proper regulation and enforcement—is the best way for the development of the industry. Gradually adopt the corporate structure for mutual funds. According to the Capital Market Law, mutual funds in Indonesia can take the form of a corporate mutual fund or a collective-investment mutual fund. The majority of mutual funds now are collective-investment contracts. This report recommends that the authorities gradually transition to the corporate mutual fund structure. In the United States under the Investment Company Act of 1940, the board of directors of a mutual fund is charged with looking after how the fund operates and overseeing matters where the interests of the fund and its shareholders differ from the interests of the investment advisor or management company. Over the years, there have been numerous regulatory rule changes designed to improve fund governance, as well as efforts to provide fund directors professional development and education, and working to develop best practices that better protect fund shareholders. The crisis in the mutual funds industry in 2005 was not due to structure, and simply changing the structure will not solve the problem. The problem was poor selling, poor enforcement, and weak valuation guidelines. Therefore, enforcement is still the most important priority. With this caveat, Bapepam & LK should consider streamlining the processes of incorporation for corporate funds, while at the same time taking regulatory initiatives to shift funds to a corporate structure and improving governance. Rationalize KIK for securitization. Bapepam & LK has previously promoted the use of KIK for asset-backed securities. Although the collective investment contract is similar to a master trust, which is a common form for creating an asset-backed security in practice, it has drawbacks if

46. Bapepam reportedly has received proposals for establishing mutual fund–rating companies. Interested parties include commercial banks, securities companies, and international mutual fund–rating companies.

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publicly offered due to the underlying characteristics of a contract as set forth in the Capital Market Law and Bapepam & LK rules. Rule IV.C.2 requires the collective investment contract to report its value daily, but it does not give a means for valuing the assets that would be part of the portfolio of the contract, since it is unclear that the assets are themselves securities as defined in the Capital Market Law. In addition, it is not clear that the contract would have to be closed, although due to valuation problems, it is difficult to see how it could function as an open contract. Although Rule IX.K.1.5.b allows the contract to establish the terms under which asset-backed securities of a particular class could be transferred to other people, it does not mandate that they be freely tradable. This creates a hybrid between an open and a closed contract. Therefore, it is recommended that Bapepam & LK rationalize KIKs for securitization purposes or develop an alternative vehicle for securitization.


REFERENCES Cadogan Financial. 2005. Final Report on Indonesian Mutual Funds: Findings and Recommendations. Jakarta: Cadogan Financial. Dalla, Ismail, and others. 2004. Institutional Investors in Thailand. Washington, DC: World Bank. Dalla, Ismail, and Noel Gamo. 2004a. Institutional Investors in East Asia. Washington, DC: World Bank. ———. 2004b. Institutional Investors in Malaysia. Washington, DC: World Bank. ———. 2004c. Institutional Investors in the People’s Republic of China. Washington, DC: World Bank. ———. 2004d. Institutional Investors in the Philippines. Washington, DC: World Bank. Ferris, Stephen P., and Xuemin Sterling Yan. 2002. “Do Independent Directors and Chairmen Really Matter? The Role of Boards of Directors in Mutual Fund Governance.” Department of Finance, University of Missouri, Columbia. IMAS (Investment Management Association of Singapore). 2005. “Singapore’s Fund Management Industry.” Paper presented at the 10th Regional Meeting of Fund Associations in Asia, Makati City, the Philippines, March 11. Investment Company Institute. 2004. Mutual Fund Fact Book. Washington, DC: Investment Company Institute, May. Siamat, Dahlan. 2003. Manajemen Lembaga Keuangan. Jakarta: Lembaga Penerbit Fakultas Ekonomi Universitas Indonesia.

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ANNEX A. LIST OF REGULATIONS AFFECTING MUTUAL FUNDS

1. Undang Undang no. 8, 1995 (law), on the capital market

2. Peraturan Pemerintah (PP) no. 45, 1995 (government regulation), on organizing activities in the capital market

3. Peraturan Pemerintah (PP) no. 46, 1995, on procedures for examination in the capital

market

4. Peraturan Pemerintah (PP) no. 12, 2004, on amendments of PP no. 45, 1995

5. Keputusan Menteri Keuangan (KMK) no. 646/KMK/010/1995 (Minister of Finance decree), on ownership of shares in mutual funds by foreign investors

6. Bapepam & LK rules, including:

II.F.4 Examinations of mutual funds II.F.14 Guidelines for compliance test of mutual funds IV.A.1 Procedures for applying for a corporate mutual fund license IV.A.2 Guidelines for corporate fund articles of association IV.A.3 Guidelines for management of mutual funds under corporate fund form IV.A.4 Guidelines for contract of mutual fund management under corporate fund form IV.A.5 Guidelines for contract of asset safekeeping for mutual funds under corporate

fund form IV.B.1 Guidelines for management of mutual funds under collective-investment form IV.B.2 Guidelines for contract of mutual funds under collective-investment form IV.C.2 Fair market value of securities in mutual fund portfolios IV.C.3 Guidelines for announcing daily net asset value of open-end mutual funds IV.D.1 Guidelines for advertisement of mutual funds IV.D.2 Profiles of mutual fund investors V.B.2 License for selling agent for mutual funds V.G.1 Prohibited conduct of investment managers V.G.3 Guidelines for reporting for decision making by investment managers X.D.1 Reports of mutual funds VIII.G.8 Guidelines for accounting of mutual funds VIII.G.9 Information in mutual fund short summaries IX.C.4 Statement of registration for public offering of mutual funds with corporation

form IX.C.5 Statement of registration for public offering of mutual funds with collective-

investment form IX.C.6 Guidelines for format and content of prospectus of public offering of mutual funds X.N.1 Guidelines for monthly activities reporting by investment managers


ANNEX B. LIST OF INVESTMENT MANAGERS WITH TOTAL ASSETS UNDER MANAGEMENT AS OF DECEMBER 2005 Rp billion Investment manager Asset value Investment manager Asset value PT Schroder Investment Management Indonesia 6,804.6 PT Eko Kapital 72.8 PT Manulife Aset Manajemen Indonesia 2,995.8 PT Intru Nusantara 59.2 PT Sinarmas Sekuritas 2,713.7 PT Ciptadana Aset Manajemen 53.0 PT Bahana TCW Investment Management 2,592.2 PT Jisawi Finas Fund Management Company 48.9 PT Trimegah Securities Tbk 2,167.4 PT Mega Capital Indonesia 48.2 PT BNI Securities 1,215.0 PT Prospera Asset Management 45.3 PT Nikko Securities Indonesia 1,214.7 PT Tiga Pilar Sekuritas 44.4 PT Danareksa Investment Management 1,142.6 PT Panca Global Sekuritas 42.7 PT Fortis Investments 958.9 PT Surya Timur Alam Raya 38.5 PT NISP Sekuritas 812.2 PT Paramitra Alfa Sekuritas 35.2 PT Mahanusa Investment Management 711.3 PT Kuo Capital Raharja 34.3 PT Optima Kharya Capital Management 516.4 PT GMT Aset Manajemen 30.6 PT Panin Sekuritas 490.2 PT Lautandhana Investment Management 29.4 PT Kresna Graha Sekurindo 438.6 PT Anugra Nusantara Asset Management 23.6 PT Citigroup Securities Indonesia 431.8 PT Gani Aset Manajemen 19.8 PT Batavia Prosperindo Aset Manajemen 308.5 PT MLC Investment Indonesia 18.8 PT Niaga Aset Manajemen 273.1 PT Insight Investments Management 18.7 PT Samuel Aset Manajemen 267.0 PT Makinta Securities 13.6 PT First State Investments Indonesia 260.6 PT Danatama Makmur Sekuritas 11.1 PT PNM Investment Management 237.4 PT Treasure Fund Investama 10.5 PT Bhakti Asset Management 236.1 PT Semesta Indovest 10.1 PT Mandiri Manajemen Investasi 215.4 PT Jatim Investment Management 10.0 PT ABN AMRO Manajemen Investasi 201.8 PT Jakarta Aset Manajemen 9.3 PT Platinum Assets Management 188.0 PT Natpac Asset Management 9.0 PT Andalan Artha Advisindo Sekuritas 176.8 PT Corfina Capital 7.1 PT GK Goh Indonesia 163.8 PT Suprasurya 5.3 PT Dhanawibawa Artha Cemerlang 142.9 PT Eurocapital Peregrine Securities 5.1 PT BATASA Capital 125.3 PT GoldMany Asset Manajemen 4.9 PT Eficorp Sekuritas 124.9 PT Brahma Capital 4.8 PT Recapital Asset Management 124.3 PT Valbury Asia Securities 4.8 PT Equity Development Securities 118.0 PT Optima Investama 4.4 PT Pavillion Capital 112.9 Evergreen capital, PT 3.2 Brent Securities, PT 77.3 PT Pentasena Arthatama 1.9 PT Indo Premier Securities 75.5 PT Reliance Asset Management 1.0 Source: Bapepam & LK

CHAPTER 5 INDONESIA’S PENSION FUNDS

Since the early 1990s, attention has increasingly focused on public policy issues related to improving the pension systems in many countries across the world. Pension systems are essential because they provide a mechanism to reduce the risks of old-age poverty and enable workers to smooth their consumption over their entire life. Pension systems are thus an important part of the social safety net, and they need to be well designed and be fiscally and politically sustainable in order to achieve their objectives. This has led to pension reform in several countries. In the developing world, the majority of reforms thus far have occurred in Eastern Europe and Latin America, in the context of systems with relatively high levels of coverage and facing imminent fiscal difficulties. Where coverage levels are lower, including in Indonesia, the pressure for immediate reform is correspondingly lower. However, one of the lessons that can be drawn from international experience is that well-functioning and sustainable pension systems make important positive contributions to economic development. In this context, it would be in Indonesia’s interests to nurture development of the pension system. Indonesia’s changing demographics is one driver of the need to focus on pension system development. Indonesia has one of the youngest populations in the world, with more than 40 percent of its population below the age of 20. However, it is aging rapidly. Its old-age dependency ratio (the ratio of people over the age of 55 to those between the ages of 15 and 54) is currently 17 percent but is expected to rise to 40 percent within about 40 years. Rapid declines in fertility rates and increases in life spans over the past few decades will continue to contribute to population aging. Such a rapid aging of the population will demand that Indonesia put in place pension systems that can provide income security during retirement. (Broader social security issues also need to be considered, but that is outside the scope of this report.) From a financial sector perspective, pension funds play a critical role as institutional investors. They collect, pool, and invest resources that enable contributors to obtain income in retirement. Contributions are typically made over a working life spanning 30 or 40 years, and benefits are paid either as a lump sum at retirement or as an annuity over the remaining life of the individual. If the pension system is well structured, pension funds can mobilize valuable long-term domestic resources. Minimizing asset-liability risk requires pension funds to match the maturity of assets and liabilities, and this leads them to look for long-term investments. In many developing


countries, including Indonesia, pension funds’ long-term investments increase the overall efficiency of capital allocation in the economy. Box 5.1. International Experience: Pension Reform in Chile

A successful pension system leads to the accumulation of long-term assets, provides attractive returns to subscribers, and covers a larger proportion of the population. For instance, in 1980, Chile passed a revolutionary pension reform, introducing a new prefunded mandatory contribution system also known as the “AFP System”. The most fundamental characteristics of this system are: Individual accounts: contributions are capitalized in individual (personal) accounts (the rate of

contribution is defined in the law as a proportion of the wage) Private management, right to choose provider, competition and segregation: The worker is

free to choose among different registered, single-purpose, pension management institutions (the AFPs). AFPs are private and competitive firms whose purpose is to invest the funds in the capital market on behalf of its members. The law demands that pension fund assets and those of the fund-management company be totally separate from both the legal and accounting points of view.

Benefits: The amount of old-age pensions depends on the balance accumulated in each worker’s

personal account; life expectancy and that of the beneficiaries; and on the discount rate. In order to be entitled to this benefit, a man must be 65 years old while a woman must be 60 years old.

Disability and survivorship pensions are “defined benefits” with a value proportional to the taxable wage of the member. All contributing members who are not retired and members who are unemployed for a period of up to twelve months, are entitled to disability insurance in case of “non-labor” related accident or illness.

Minimum pensions: Members of the AFP system who fulfill certain requirements are entitled to minimum old-age, disability and survivorship pensions which are guaranteed by the State. This program of minimum pensions represents the “first pillar” of Chile’s pension system.

Payout alternatives: At retirement the worker can choose among three different payout alternatives: scheduled withdrawal; life annuity; and temporary income with deferred life annuity. Pensions, under all of these alternatives, are indexed to prices. Life annuities are sold by life insurance companies.

Role of State: The State plays mainly a “subsidiary role”, manifested in its responsibility to regulate and supervise the system, finance minimum pensions and provide certain guarantees.

Investment Regulation: Investments are strictly regulated. The law defines authorized instruments for pension

funds investments and sets maximum investment limits (as a percentage of the pension funds) by instruments, groups of instruments, issuers and related persons.

Investment procedures are also regulated. The law makes it mandatory for trading to be carried out in authorized secondary markets and primary markets that have certain characteristics.

Valuation of investments must be carried out at market prices, which are equal for all the AFPs, and are estimated by the regulator.

Custody of financial instruments must be carried out in authorized institutions. A Risk Rating Commission has responsibility to approve or reject the instruments which might be investment opportunities for the pension funds and to assign risk categories to fixed income securities, which influence maximum limits.

Although it is possible that most of investment risk could be controlled with a combination of strict supervision and regulations that ensure the transparency of operations and control for

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potential conflicts of interest, at the time the reform began, supervisory capacity was relatively low, and there was a certain degree of suspicion regarding the ability of the financial sector to manage social security resources. As a result, the decision was made to opt for quantitative limits. This particular form of regulation has proven effective as far as guaranteeing the safety of the funds is concerned, but it may have reduced risk-adjusted returns.

The regulation of the AFP system has undergone numerous changes since 1980. Most of the legal modifications carried out between 1981 and 2001 refer to the regulation of pension fund investments and the rules for benefits. The results of the new pension system are quite impressive. Coverage as the ratio between contributors and the total employed in the economy increased from 53% in 1982 to 70% in 1997. The number of pensioners in the AFP system increased from 4,465 in December 1982 to 363.351 in December 2000. The aggregate value of Pension Funds managed by the AFPs grew at a real annual average rate of 29% in the period 1981 to 2000, rising from US$ 300 million (0.9% of the GDP) in December 1981 to US$ 37,752 million (54.6% of the GDP) in December 2000. Real average annual investment return of pension funds was 11% between May 1981 and December 2006. Annual returns have shown considerable fluctuations, achieving a maximum of 29.7% in 1991 and a minimum of –2.5% in 1995. In June 2001, AFPs average management charges were equal to 2.3% of taxable wage (including the cost of the disability and survivorship insurance, which at that date represented approximately 0.8% of taxable wage), plus a fixed monthly charge of US$ 0.81. One criticism of the Chilean pension system has been regarding the level of insurance and management charges, which many observers view as high. The Chilean reform has been an important reference for reforms in many other countries. Thus, So far, - apart from Chile – eight Latin American countries (Perú, in 1992; Colombia and Argentina, in 1993; Uruguay, in 1995; Mexico, Bolivia and El Salvador in 1996; Nicaragua in 2000 and Dominican Republic in 2001) have passed reforms which include components of individual capitalization and private management. Outside Latin America there are the examples of Croatia, Hungary, Kazakhstan, Latvia and Poland, countries which have also introduced elements of individual capitalization and private management into their own pension systems. One of the most striking economic phenomena of the 1980s in Chile was the growth in the size of the capital markets. Although many factors explain this trend, circumstantial evidence suggests that the growing demand for financial assets from the AFPs may have stimulated the expansion in the volume of transactions. In turn, this had positive effects on market liquidity; trading costs, the supply of long-term funds, and the cost of capital for companies. Source: Chile’s Pension Reform After 20 Years, Rodrigo Acuña R., Augusto Iglesias P., December 2001

Indonesia’s pension assets are low compared with those of other developed and developing countries. Some of the important reasons for this low level are as follows: The mandatory defined-contribution plan covering the largest number of workers (6.9 million)

is managed by a public institution —Jamsostek—and is characterized by low level of participation, lax enforcement and poor investment return performance. In general, contributions to Jamsostek are considered a tax and not an investment toward retirement.

The civil service pension plan — Taspen —has the second largest coverage (4.6 million), and is almost entirely unfunded and operated on a pay-as-you-go basis.

Funded private pension plans are a relatively new development in Indonesia, having begun operations just about 10 years ago. Since then, the plans (and their sponsors) have had to contend with the region’s economic crisis.


Financial institution pension funds—employer-sponsored defined-contribution funds managed by financial institutions—are the fastest-growing segment of the market in terms of assets under management, but the number of plans offered is not increasing.

High mandatory termination benefits for formal sector workers under the labor law, lack of attractiveness of tax benefits due to low individual marginal tax rates, and uncertainty about the implications of a new social security law all create additional hurdles for the growth of the pension sector. Indonesia’s pension system is currently unable to meet the government’s social, financial, or fiscal objectives. Jamsostek’s program has low participation at less than 25 percent of the formal sector workers. The civil service pension system already imposes a drain on the national budget and is projected to do so at a faster rate in the future. The implicit pension debt of the government—the present value of the future stream of pension benefits already promised—is about 11 percent of GDP by some estimates. Both Jamsostek and Taspen are inefficient and costly in terms of their management. Employer-sponsored voluntary plans and financial institution pension funds are continuing to grow in assets, although declining in total numbers. The overall weak investment climate and prevailing uncertainties about labor regulations deter firms from opening new funds. In effect, from a social perspective the vast majority of Indonesians—in both the formal and informal sector—are still outside the pension system. From a financial perspective, the existing system does not provide sound management or mobilize the kind of resources needed to support long-term investments. From a fiscal perspective, the cost to the government of existing mandatory schemes continues to grow. The recent national social security law (Law no. 40 of 2004/SJSN; Sistem Jaminan Sosial Nasional, National Social Security System) addresses a real need but proposes a potentially unaffordable structure, creating an environment of uncertainty that can adversely affect the existing pension system. Indonesia does not have a real social security system at present, and it could be argued that such a system is needed. The new law calls for a national pension plan, along with health, accident, old age, and death benefits for all Indonesians. The law is short on details regarding the amount of benefits, contributions, and other major issues that affect the design of these schemes. Soundly designed and implemented, the fiscal costs of the law could be contained, a reasonable degree of social security could be offered to citizens, and the overall pension system could be strengthened. However, there is more than enough room in the law for the implemented system to become unaffordable and inconsistent with international best practices. It may create further complexity and confusion as different agencies start implementing it. The law has the potential to create expectations that might be difficult to manage, and hence its implementation requires the attention of policy makers. In terms of investments, both public and private pension funds invest a significant portion of their assets in short term bank deposits, creating maturity mismatches. The investment return performance (gross of operational expenses) of public and private pension funds are comparable to the yield on short-term government securities. Given these are asset pools managed by investment professionals, the nature and performance of investments should be better. In addition, pension funds incur a substantial administrative cost, which implies that the net return available to contributors is lower than that on Government bonds. There are large benefits possible by enabling pension funds to reach their potential to support Indonesia’s objectives for social, fiscal, and financial sector development. This chapter makes some key recommendations toward that end.

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Framework for Best Practices in Public Pension Programs The principles of best practice for public pensions funds largely concern governance, broadly defined, and are intended to ensure that public pension schemes have clear objectives, are free from conflicts of interest, and are operated in as transparent a manner as possible.47 They also aim to ensure that the operators of the scheme are accountable to members for their decisions and success or failure in meeting the objectives of the scheme. In short, public pension schemes should be operated in the best interests of those who bear the burden of their financial failings. The following principles represent best practices in governance and provide a reference point for considering the present practices in the Indonesian context: There should be clear roles and responsibilities within the pension fund. Clear roles,

objectives, and responsibilities are fundamental to transparency (and to accountability). The objectives should be set down by government—preferably in law—along with an explicit statement about the promises being made and any government guarantees involved.

The law establishing the management agency should provide unambiguous conditions under which members of the governing body of the agency can be appointed and removed. Whatever the precise legal form, the members of the governing body of the management agencies should operate with a fiduciary responsibility to the members of the scheme, and that single consideration should dictate the appropriate terms of appointment and dismissal.

The managing agency should be free from inappropriate interference from the government in pursuing its objectives and meeting its responsibilities. The government should remain at arm’s length from the investment decisions of the fund manager.

The processes for formulating and executing scheme policies should be open and transparent. The policy framework and the process of implementation should be disclosed and adequately explained.

The government should establish the structure of delegations permitted within the scheme. The essential point is that the structure of delegations should be well thought out and transparent to stakeholders. The structure of delegations should state clearly, where responsibility lies in the event of delegation. Responsibility should include the explicit requirement for the governing body of the management agency to monitor and review delegated powers.

The management agency should be required—by law—to establish internal governance structures and processes designed to minimize corruption, mismanagement, and fraud. These governance procedures should include the mandatory establishment of a risk management and audit committee with appropriate reporting lines. It should include a code of conduct for staff and senior executives, detailing how to deal with conflicts of interest. It should detail the roles and responsibilities of the different groups within the agency (board, senior management, audit committee, and so forth) and how they are to account for their actions. It should include a quality control process, and it should include rigorous documentation, review, and audit requirements for investment decisions and information technology support systems.

The government should require the management agency to be regulated and supervised by the same agency that is responsible for regulating private pension providers and, where feasible, to meet the same standards imposed on private providers. Not only is this requirement a matter of good governance, it is compatible with the objective of establishing competitive neutrality throughout the financial system.

47 The following draws closely on Carmichael and Palacios (2004).


STRUCTURE Four main types of funds dominate the pension sector in Indonesia (see figure 5.1). Jamsostek is a mandatory, publicly managed fund to which all formal sector employers and employees contribute. Taspen is a publicly managed pension fund for civil servants.48 Two types of privately managed funds—employer pension funds and financial institution pension funds—are voluntary occupation schemes for private sector employees (see table 5.1 for a summary of the main programs and agencies in Indonesia). Figure 5.1: Overview of Indonesian Social Security System

SCHEME GOVERNMENT EMPLOYEES SCHEMESLaw No. 8/1974 on government personnel policy

PRIVATE EMPLOYEES SCHEMESLaw No. 14/1969 on basic manpower regulations

LEGAL PROVISION Armed ForcesPresidential decree 8/1977

Civil ServantsPresidential Decree 8/1997

JAMSOSTEKLaw No. 3/1992

PROGRAMRetirementGovt Reg

No. 67/1991

Pension Law No. 6/1966

Health Care MOD Decree

Retirement Govt Reg

No. 25/1981

PensionLaw No. 11/1969

Health CareGovt Reg

No. 69/1991

Work Accident Old Age Health Care Death

FINANCIAL CONTRI-BUTION

Employee 3.25 % 4.75 % 2.00 % 3.25 % 4.75 % 2.00 % 2.00 %

Govt/Employer

State Budget

State Budget

0.24 % -1.74 % 3.70 % 3.0% -

6.0 % 0.30 %

BENEFITS

Lump sum payment on retirement

Annuity benefit for life

Medical expenses, hospitalizatio, maternity & medical equipment

Lump sum payment on retirement

Annuity benefit for life

Defined range of health care services

Transport, doctors, medicine, hospitalization & disability

Lump sum payment of contribution plus interest

INSTITUTIONSPt. AsabriGovtRegulation No. 68/1991

Pt. Asabri The Armed Forces Hospital/ Askes

Pt. TASPEN GovtRegulation No. 26/1981

Pt. TASPEN

Pt. Askes, GovtRegulation No. 6/1992

Pt. Jamsostek, GovtRegulation No. 36/1995

Pt.Jamsostek Pt.Jamsostek(optional)

Pt.Jamsostek

Source: International Labor Office (ILO), Jakarta, 2003

A typical national pension system has five pillars in one form or another :49 Zero pillar: noncontributory social assistance for the life-long poor First pillar: a publicly financed and managed pay-as-you-go system providing basic income

protection Second pillar: a mandatory funded individual account system directly linking contributions and

benefits Third pillar: voluntary individual or occupational pension savings Fourth pillar: family and intergenerational support for the elderly.

48 Asabri is a publicly managed pension fund for the security and armed forces. Little information is publicly available on this fund, although it is considered to have similar issues as Taspen, though on a smaller scale because it covers fewer employees. Hence it is not covered extensively in this report. 49. First, second, and third pillars are discussed in World Bank (1994). The zero and fourth pillars are discussed in Holzmann, Hinz, and Bank staff (2005).

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Under the Social Security Law no. 40 of 2004, the Indonesian government provides subsidy for the financially disabled, which corresponds more or less to the “zero” pillar. Indonesia does not have a first pillar, although the pension program proposed in Law no. 40 could play this role. Jamsostek could be considered a second pillar, except that it provides lump-sum payments instead of income replacement and is administered by a state-owned enterprise. Pension programs registered under Pension Law no. 11 clearly fit the third pillar and comprise both employer-sponsored programs and individual arrangements. As in many societies, Indonesia also has a strong tradition of family support for the elderly, which can be considered the fourth pillar. However, evolving demographic and societal trends in Indonesia, as in many other countries, are placing pressure on the extent to which this pillar could be relied on for support in the future.

Jamsostek Jamsostek functions as a short-term, tax-sheltered savings scheme, as opposed to the long-term retirement income scheme that it was designed to be and has the potential to be. As the social security program for private sector employees, Jamsostek’s old-age benefits program (JHT) is a collection of employer pension funds that pay lump-sum benefits at retirement or earlier termination. Employers and employees share a 5.7 percent contribution for the old-age scheme. Jamsostek provides three insurance programs—employment accident benefits, death benefits, and health care benefits—in addition to its old-age benefits program (the insurance programs are not discussed in detail in this report). Jamsostek’s structure has evolved over time. This mandate was originally given to a foundation (Yayasan) under the Department of Manpower and Transmigration. Regulation no. 33 of 1977 transformed the foundation into a limited-liability company named Perum Astek, with profits shared by the government and limited capital provided by the state. Later, by Regulation no. 36 of 1995, Perum Astek was transformed into a state-owned enterprise, Jamsostek, and given the monopoly to administer the social security scheme under Law no. 3 of 1992. Jamsostek is governed by a board of commissioners and a board of directors (under the dual-board system applicable to all limited-liability companies in Indonesia). All members of both boards are appointed by the central government, which also approves the budget, the financial statements, and the annual report. Some members of the board of commissioners are designated as representing the employees and the employers. Jamsostek is subject neither to the Insurance Law for its insurance programs nor to the Pension Law for its old-age benefits program. It is subject to ad hoc government regulations under the general supervision of the Department of Manpower and Transmigration (see figure 5.2). However, Regulation PP 28, issued in 1996, enacted some regulatory constraints applicable to Jamsostek and returned some supervisory responsibilities to the Ministry of Finance. This regulation was replaced in 2004 by PP 22, which contains expanded regulatory and reporting requirements directly inspired by insurance legislation; it gives a wider supervisory role to the Ministry of Finance but keeps Jamsostek outside the regulatory framework of the Pension Law and the Insurance Law. The Ministry of State-Owned Enterprises officially is the shareholder of the institution. Jamsostek sends an annual statement to each of its contributors that contains the initial balance, changes in and ending balance of contributions, and investment results.


Table 5.1: Description of Pension Funds

Description Taspen Jamsostek Employer pension funds

Financial institution pension funds

Type of fund Pension fund for civil servants

Mandatory social security for private employees

Voluntary Voluntary

Coverage 4.6 million (close to full coverage)

6.9 million (21 percent of formal workforce)

1.8 million employees (1,758 employers)

800,000 employees (2,417 employers)

Number of funds 1 1 271 21

Total assets Rp 15.5 trillion Rp 33.4 trillion Rp 48.9 trillion Rp 4.6 trillion

Benefit or funding type Pay-as-you-go

Defined benefit for insurance; defined contribution for old-age savings

265 defined-benefit funds; 34 defined-contribution funds (Dec 03)

Defined contribution

Bank deposits as a %of total assets 22 43 33 57 c

Investment returns (percent) 10.7 10.4 10.4 7.3

Operational costs as a percentage of benefits

20 23 9.8* 10.5*

Funding levels Very low; to be purely pay-as-you-go by 2007–8

Employers and employees share a 5.7 percent contribution for the old-age scheme

38 percent of Pension Funds funded below 80 percent a

Fully funded

Organizational structure

Limited liability corporation, dual board

Limited liability corporation, dual board

Special entity, single governing body

Special entity, single governing body

Governance All board members appointed by government

All board members appointed by government

Administrator personally responsible for losses due to neglect, supervisory board, no board of commissioners/ directors

Tax treatment of profits Taxed as a state owned enterprise

50 percent of profits taxed Private pension funds do not have profits

Tax treatment of contributions and benefits

Contributions are exempted (E), Investment returns are exempted (E), Benefits are taxed (T). However, EET treatment in practice is not always consistence.

Supervision Ministry of Finance Ministry of Finance b Ministry of Finance

Issues

Exempt from Pension and Insurance Law. Inefficient premium collection and claim application, unfunded liability

Exempt from Pension and Insurance Law. Low coverage, accelerated payouts, no segregation between different programs

Some underfunded plans. Expensive administrative structure. No separation between policy, operation, and oversight.

Expensive administrative structure. No separation between policy, operation, and oversight.

Source: Staff Estimates Note: Financial data is from 2004. Data marked by * is from 2003. a. 56 funds out of the 149 defined-benefit funds are reported to have a funded ratio below 80%. i.e. thay do not have enough assets to meet their liabilities. b. Department of Manpower and Transmigration sets policy issues related to Jamsostek and has operational control over it, but supervision belongs to Ministry of Finance. c. 2003 data

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Figure 5.2: Social Security System Structure

Department of Manpower&

Transmigration

Department of Manpower&

TransmigrationResponsible for:- Labor legislation- Supervision of

JAMSOSTEK

Responsible for:- Labor legislation- Supervision of

JAMSOSTEK

Ministry of Stated Owned EnterprisesMinistry of Stated

Owned Enterprises

Responsible for:- Oversight of public

limited liability companies (Perseros)

Responsible for:- Oversight of public

limited liability companies (Perseros)

Department of Finance

Department of Finance

Responsible for:- Supervision of

Insurance companies & pensions schemes

Responsible for:- Supervision of

Insurance companies & pensions schemes

Department of Health

Department of Health

Responsible for:- Provision of Health

Care (except Askes & Jamsostek)

Responsible for:- Provision of Health

Care (except Askes & Jamsostek)

National Social Welfare AgencyNational Social Welfare Agency

Responsible for:- Provision of Social

Welfare

Responsible for:- Provision of Social

Welfare

Ministry of Defense

Ministry of Defense

Responsible for:- Provision of Pensions

& Health Care for armed Forces Members.

Responsible for:- Provision of Pensions

& Health Care for armed Forces Members.

PRESIDENTRepublic of Indonesia

PRESIDENTRepublic of Indonesia

Coordinating Ministry for the EconomyCoordinating Ministry for the Economy

Responsible for:- Issues relating to the restructure of Social

Security In Indonesia

Responsible for:- Issues relating to the restructure of Social

Security In Indonesia

Coordinating Ministry for Social WelfareCoordinating Ministry for Social Welfare

Responsible for:- Efforts to empower the poor through poverty

alleviation policy

Responsible for:- Efforts to empower the poor through poverty

alleviation policy

National Planning Agency BAPPENASNational Planning Agency BAPPENASResponsible for:- Strategic planning and

development in Indonesia.

Responsible for:- Strategic planning and

development in Indonesia.

Social Security Reform Task ForceSocial Security Reform Task Force

PEOPLE’S ASSEMBLYPEOPLE’S ASSEMBLY

JAMSOSTEK

Responsible for delivery of social security programs to workers employed in “Legal Entity” workplaces

JAMSOSTEK

Responsible for delivery of social security programs to workers employed in “Legal Entity” workplaces

Askes

Taspen (retirement)

Asabri(Health Care)

Askes delivers Health Care

Services on behalf of Asabri

Private Pensions Funds Private Insurance Companies

Supervision Monitoring Monitoring MonitoringMonitoring

STRUCTURE OF THE SOCIAL SECURITY SYSTEM

Source: International Labor Organization (ILO), Jakarta 2003

Taspen Taspen is a pay-as-you-go pension fund for civil servants, with the government contribution equal to the current benefit payments minus the employees’ contributions. Taspen has two programs: an old age benefits program (THT) and a life pension program. THT is an endowment program combining savings and life insurance, payable in a lump sum at retirement or earlier death. Employees originally contributed to that program at the rate of 3.25 percent of salary, but the benefit formula was modified downward in 2001 following a major salary revision. Taspen’s life pension program is a larger program covering all civil servants. Its generous final-salary formula can pay up to 75 percent of final salary for life, with survivor benefits, all indexed on the basis of wage increases. Employees contribute 4.75 percent of salary. The government is payer of last resort for all programs under Taspen. The government also plays a major role in the payment of benefits. Until 1993, pensions and other benefits were paid from the central government budget, and employee contributions were accumulated to build up the fund. Starting in 1994, a portion of the payments was financed out of the accumulated assets, with the government contributing the remainder of the cost on a pay-as-you-go basis. Currently, the government contribution is set at 79 percent of payments, and the remaining 21 percent is drawn from the fund. On that basis, the fund will be depleted by about 2008, and the government will support the full pay-as-you-go cost minus the employee contributions.


Taspen has special legal status. Although Taspen’s old-age benefits program is a type of insurance program, it not subject to the Insurance Law. Nor is it subject to the Pension Law. Born as a state entity out of Ministerial Decision no. 380/MP/1960, Taspen’s legal structure changed in 1982 to become a limited-liability company on the basis of Regulation no. 26 of 1981. It is not subject to the usual regulatory framework and does not need to comply with obligations imposed on other pension programs, like the use of a custodian, the segregation of assets, and the appointment of an administrator distinct from the sponsor—that is, the government itself—or with any particular funding and solvency requirements. Although exempt from the normal regulatory framework, Taspen is subject to an ad hoc combination of regulations, decrees, decisions, and instructions from the Ministry of Finance. The Department of Manpower and Transmigration stipulates the minimum retirement age, which is currently set at 55. The Ministry of Finance is the single institution responsible for regulation and supervision of Taspen, although the Ministry of State-Owned Enterprises is its shareholder (figure 4.2). Taspen provides certain management services, such as collecting contributions, maintaining the database, and paying benefits. Taspen is governed by a board of commissioners and a board of directors. The government of Indonesia appoints all members of both boards and approves the budget, the financial statements, and annual reports.

Private plans Employer pension funds (also called occupational pension plans, autonomous plans, and private plans) are funds that the employer establishes for its employees. They can be either defined-benefit or defined-contribution programs. As of December 31, 2003, there were 307 employer pension plans in Indonesia. These plans are the conventional way to enroll participants. Unlike some other countries, Indonesian Pension Law does not allow for multiple-employer plans or association plans for self-employed professionals.50 Financial institution pension funds (FIPF) are defined-contribution programs open to employees and the self-employed who wish to accumulate retirement savings through a supervised and regulated tax-sheltered fund offered by a bank or insurance company.51 As of December 31, 2003, there were 31 FIPFs in Indonesia. The structure of employer and financial institution pension funds is reasonably similar, and most of the regulatory setup applies to both types, including locking in and mandatory annuitization at retirement. Indonesia only recently established a formal legal framework for private pension funds. Originally based on the 1926 Dutch Funds Ordinance, in the absence of any other specific law, private pension programs existed in various forms: self-administered funded or non-funded plans, group endowment policies, and Yayasans (a form of nonprofit foundation under the civil code), most offering only lump-sum payments at retirement. Many state-owned enterprises that operated a pension plan for their employees used the Yayasan formula. The Income Tax Law of 1984 offered tax incentives subject to registration with the Ministry of Finance, but it was barely used. There was no prudential framework for these programs. 50 However, the law recognizes that many employers are closely associated within conglomerates, not necessarily through affiliates or subsidiaries, and thus allows employers to co-sponsor a plan. Employees of co-sponsors are enrolled as participants, and the co-sponsor must delegate all of its responsibilities to the main sponsor. 51 The original intention of FIPFs was to cover individuals (employed or self-employed) who do not have access to an employer pension fund and to offer a vehicle for individuals to hold tax-deferred, vested benefits between the termination of employment and normal retirement age. However, some employers have begun to enroll their employees in an FIPF as individual participants and to support their participation administratively through payroll deductions, often contributing on their behalf.

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Pension Law no. 11 of 1992 is the basic legal framework for private pension funds in Indonesia. This law is based on the principle of “freedom to promise, obligation to deliver”—that is, while the creation of a pension program is voluntary, the rights of beneficiaries have to be secured. The main objectives of the ministry in putting forward the Pension Law “were to establish the rights of participants, to provide a regulatory standard, which would assure the ultimate receipt of pension benefits, to make certain that the pension benefits were used as a source of continuing income for retirees, to provide proper governance for the pension funds, to encourage the mobilization of savings in the form of long-term pension funds, and to see that such funds were not retained and used by employers for possibly risky or unsound investments, but instead would flow into the financial markets and be subject to risk-reducing requirements” (Cole and Slade 1996). These objectives remain valid today. Among others, the law lays out the duties, obligations, and authority of the supervisory board, mandates a clear separation of responsibilities between members of the supervisory board and the administrator, considers the administrator to be one legal person, and makes the administrator personally responsible for losses due to neglect of duty or obligations.52 Yayasans were given a year to adjust to the new law. Assets and liabilities were split, and a new entity was created to administer assets and liabilities for the pension component. The new Pension Law generally required modifications to the existing programs, in particular, (a) mandatory payments in the form of a monthly income for life, with continuing spousal pensions, which required annuitization of capital accumulations in lieu of lump-sum payments and (b) mandatory funding requirements, which required the payment of actuarially determined contributions to a distinct fund and the payment of stipulated contributions. The regulatory framework for private pension funds in Indonesia addresses several key aspects, but tax issues remain a problem. The prudential framework operates under Law no. 11 of 1992 and two overarching government regulations: Regulation no. 76 for employer pension funds and Regulation no. 77 for FIPFs. The framework is a series of decrees dealing with key issues such as funding and solvency requirements, investment regulations, tax treatments, and qualifications of fund administrators. A decree to protect the tax base from excessive erosion stipulates maximum contributions and benefits. One set of limits applies to defined-contribution programs that can be offered both by employers and by financial institutions. Another set of limits applies to defined-benefit programs that can only be offered by employers using either a monthly formula or a lump-sum formula. Despite further clarifications, tax issues remain a source of difficulty.53 The investment regime is a mixture of the “prudent person” rules prevalent in several developed economies and the “prescriptive” guidelines prevalent in several developing countries. Detailed limits are not prescribed for each asset class, but overall limitations are applied to achieve diversification of risks. In particular, the regime imposes a maximum limit of 10 percent of pension assets in any one party with an inner limit of 2 percent in one unit of land and buildings. The limit means that pension funds have to have a flexible exit strategy and avoid being a majority owner of a business. Fund sponsors are required to file an annual investment directive defining the investment policy to be followed by the fund administrator. Also stipulated are minimum requirements for what constitutes investment guidelines, the need for an investment plan, categories of eligible investments (foreign investments are excluded), conflict-of-interest rules, and rules on the valuation of assets.

52 Articles 17, 12, 10, and 21, respectively, of Law no. 11/1992. 53 On funding and solvency issues, normal monthly contributions have to cover the cost of projected benefits for the year in accordance with the actuarial valuation method, while deficits have to be amortized over a maximum period of 15 years, except for any initial pre-law deficit, which can be amortized over the period ending in 2024. However, if the assets of a fund do not meet the solvency liability, defined as a termination liability, the gap has to be amortized over a shorter period of only five years.


Private pension funds are considered a special entity according to Article 3 of the Pension Law. They are not a limited-liability company and thus do not have to have both a board of commissioners and a board of directors. Their governance rests on the principle of a single governing body. Article 10 defines the governing body as an administrator (Pengurus) distinct from the sponsor (Pendiri), properly qualified and fully responsible. Pension assets cannot be subject to claims other than for the stipulated benefits, and a legal person has to be clearly responsible for administration of the plan. A custodian must hold the assets under Article 30(5), and outsourcing of facilities and personnel, including from the sponsor, is allowed (Article 11). The administrator, as governing body, has full responsibility and determines the overall strategy, major plans of action, risk policy, annual budgets, and business plans, sets performance objectives, monitors implementation and performance, and oversees major capital expenditures. Neither the sponsor nor the supervisory board can interfere with implementation of the plan. In particular, the sponsor cannot dictate either the organizational structure or the selection or appointment of managers. The administrator is responsible to the sponsor (the founder), not the supervisory board. The fit-and-proper test applies to the administrator only, and the supervisory board has no legal responsibility, no accountability, and no executive or administrative responsibilities, only reporting and monitoring duties. Employer pension funds and FIPFs are supervised and regulated by the Bureau of Pension Funds, within Bapepam & LK. A bank can obtain a license to run an FIPF after obtaining approval from Bank Indonesia (Minister of Finance Decree no. 228/1993). In this case, on top of the Ministry of Finance, Bank Indonesia can also examine the bank’s FIPF operations as the supervisor of the banking sector. The bank itself is responsible for monitoring its subsidiary operations to ensure that they implement prudential principles as appropriate. The Bureau of Pension Funds requires pension funds to deliver an administrator’s statement, a financial report, an investment report (including investment portfolio position, investment return, and analysis and disclosure), an actuarial report (only for defined-benefit employer pension funds), and a semiannual technical report. It also requires pension funds to publish their audited financial statement in newspapers and to provide a summary of their investment report to their contributors one month after submitting their reports to the Bureau of Pension Funds.

SIZE AND COVERAGE As of 2004, Indonesia’s pension industry controlled assets of Rp 107.1 trillion. Assets were Rp 53.4 trillion (2.4 percent of GDP) in voluntary private pension plans, Rp 33.4 trillion (1.5 percent of GDP) in Jamsostek’s old-age benefits program, and Rp 15.5 trillion (0.7 percent of GDP) in Taspen (see table 5.2). Table 5.2: Total Assets in Pension Funds, 2003 and 2004 (Rp trillion unless otherwise noted)

2003 2004 Program Amount Percent of GDP Amount Percent of GDP Askes 1.9 0.1 2.2 0.1 Asabri 2.2 0.1 2.6 0.1 Taspen 11.9 0.6 15.5 0.7 Taspen, Asabri, Askes 16.1 0.8 20.3 0.9 Jamsostek 26.9 1.3 33.4 1.5 Private plans (Law no. 11) 49.4 2.4 53.4 2.4 Total 92.4 4.5 107.1 4.7 Source: Bapepam & LK Note: The 2005 figures were under preparation at the time of publishing this report.

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However, the pension industry fails to contribute to long-term investments (see table 5.3). In 2004, 36.1 percent of the total pension fund assets were invested in bank deposits. Pension funds focus on short-term instruments for several reasons. Indonesian capital and financial markets offer a limited array of attractive products for institutional investors. Prior to the crisis, Indonesia had no domestic government debt. Therefore, investment in bank deposits began largely because there were no other options. Since the crisis, the blanket guarantee of bank deposits and relatively high yields have played a major role in keeping institutional investors in this market. The development of the bond market coupled with a reduction in deposit guarantees have led to a gradual movement away from time deposits and into capital market instruments. This indicates that pension funds would be interested in investing in the right instruments if they are made available. For instance, 5.3 percent of total pension fund assets were invested in shares, quite a low figure for pension portfolios. There are several understandable reasons, including modest levels of transparency, information disclosure, and corporate governance; absence of liquidity; low level of free float; limited base of skills among investment managers; and lack of adequate resources for securities regulation. A major constraint on pension funds is the lack of financial expertise. Thus, the realignment of investment policies will need to be accompanied by training and education. There is substantial room for Indonesia’s pension industry to grow. In comparison with regional and developed economies, the pension industry in Indonesia is quite small, even allowing for the level of the economy.54 In 2003, aggregate Indonesian pension assets barely reached 4.5 percent of GDP, with the private sector share being only 2.4 percent. This compares with the following international experience: private pension assets constitute 27 percent of GDP in OECD countries, 64 percent in Singapore, 17 percent in Hong Kong (China), and 9 percent in Thailand (2002 figures; see table 5.4). Table 5.3: Distribution of Invested Assets in Pension Funds, 2004 (Rp trillion unless otherwise noted)

Private pension funds Jamsostek Taspen Total Type of investment Amount Total % Amount Total % Amount Total % Amount Total %

Deposits 17.6 33.0 14.3 43.0 3.3 21.6 38.7 36.1 Corporate bonds 10.9 20.5 3.0 8.9 9.1 58.9 24.0 22.4 Government bonds 11.4 21.4 11.1 33.1 0.0 0.0 22.5 21.0 Shares 2.5 4.7 3.2 9.5 0.0 0.1 5.7 5.3 Real estate 2.4 4.5 0.6 1.9 0.0 0.0 3.1 2.8 Mutual funds 2.8 5.2 0.3 0.8 0.0 0.0 3.1 2.9 Other 3.5 6.5 0.1 0.3 0.0 0.0 3.6 3.3 Total invested assets 51.1 95.7 32.5 97.4 12.5 80.6 100.6 93.9 Other assets 2.3 4.3 0.9 2.6 3.0 19.4 6.5 6.1 Total assets 53.4 100.0 33.4 100.0 15.5 100.0 107.1 100.0 Source: Bapepam & LK Note: Other includes direct investments, Bank of Indonesia certificates, deposit certificates, letter of credit, and units. The structure of a country’s overall pension system plays a key role in determining the assets accumulated. Where the state provides generous pensions, there is less demand for private pensions. In addition, where the financing is through a pay-as-you-go system, the accumulated assets are low (see table 5.5). France, Germany, and Italy have a very low level of pension assets, but an important difference is that the figure is low in Indonesia because few pensions are promised; not because the financing is on a pay-as-you-go basis.

The coverage of the Indonesian pension system also is low, meaning that a small fraction of Indonesia’s labor force is enrolled in a pension system. Out of a total formal sector labor force

54. It is difficult to compare pension assets across countries because statistics are scarce, structure and definitions are not uniform, and the scope of the industry is ambiguous.


(excluding civil servants) of 33 million—all of whom are technically supposed to contribute—only 6.9 million employees (approximately 21 percent) are registered with Jamsostek. Even fewer contribute, and many withdraw their savings in a lump sum at each job change, effectively reducing their own retirement savings. Coverage of civil servants is high, since Taspen has nearly 100 percent coverage of about 4.6 million civil servants. In 2003 employee pension funds and FIPFs covered 1.8 million and 0.8 million employees, respectively (see tables 5.6 and 5.7). Therefore, out of a total formal sector labor force of 33 million, approximately 43 percent are enrolled in a pension system. Given Indonesia’s total population of 104 million active workers, a mere 14 percent of the overall labor force has access to a pension system.

Table 5.4: Assets of Private Pension Plans in Select Countries, 2001 and 2002

Assets (US$ billion) Percent of GDP Percent of market capitalization Country or region 2001 2002 2001 2002 2001 2002 Switzerland 269.0 335.6 109.4 125.5 43.0 61.4 Netherlands 407.1 417.0 106.0 99.6 81.3 103.3 United Kingdom 1,048.6 — 73.3 — 48.4 — United States 6,667.3 5,934.3 66.3 56.9 48.2 53.7 Canada 365.6 345.0 51.9 47.6 59.8 60.5 France 51.4 95.4 3.6 4.0 4.4 9.8 Germany 62.6 75.5 3.4 3.8 5.8 11.0 Italy 19.4 24.2 1.8 2.0 3.7 5.1 OECD 7,991.1 7,407.2 25.8 27.0 32.9 39.1 Euro area 641.5 736.1 12.3 13.4 20.0 30.1 Singapore — 56.5 — 63.9 — 55.3 Hong Kong (China) 24.5 27.7 15.0 17.1 4.8 6.0 Thailand 8.7 10.2 7.5 8.6 24.1 22.5 Indonesia 3.2 4.4 2.0 2.2 14.1 14.8 Source: OECD Global Pension Statistic Project. Note: Figures for asset size are total investment figures. — Not available Table 5.5: Pension Fund Reserves in Select Countries

Partially funded, defined benefit Centrally managed, defined contribution (provident funds)

Privately managed, defined contribution

Country GDP % Country GDP % Country or economy GDP % Egypt Arab Rep. of 33.1 Malaysia 55.7 Switzerland 117.0 Sweden 32.0 Singapore 55.6 Netherlands 87.3 Japan 25.0 Sri Lanka 15.2 England 74.7 Jordan 16.9 Kenya 12.1 Australia 61.0 Mauritius 13.1 Tanzania 9.4 Chile 45.0 Philippines 11.2 Swaziland 6.6 Denmark 23.9 Gambia, The 11.1 India 4.5 Argentina 3.0 Canada 11.0 Nepal 4.0 Colombia 2.9 Belize 10.5 Indonesia 2.8 Peru 2.1 Ghana 9.4 Brunei 2.4 Poland 1.1 Morocco 8.7 Zambia 0.7 Uruguay 1.0 Switzerland 7.1 Uganda 0.6 Bolivia 1.0 Korea, Rep. of 7.0 Mexico 0.5 Tunisia 6.9 Kazakhstan 0.5 Swaziland 6.6 Hungary 0.4 Jamaica 5.7 El Salvador 0.3 Costa Rica 5.4 Croatia 0.0 United States 5.0 Sweden 0.0 Yemen 4.0 Hong Kong (China) 0.0 Honduras 3.5 Senegal 1.6 Ethiopia 1.4 Algeria 1.2 Chad 0.5 Namibia 0.4 Paraguay 0.4 Source: Palacios and Pallares 2000

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Table 5.6: Pension Fund Assets in Select Countries, 2003

Country Number of active workers (millions)

GDP (US$ billion)

Pension assets as a percent of GDP

Pension assets (US$ billion)

Pension assets per active worker (US$)

Indonesia 104.0 239 4.5 11 104 Malaysia 10.4 105 57.1 60 5,769 Philippines 35.6 80 — — — Thailand 36.7 143 8.4 12 327 Australia 10.1 506 75.1 380 37,749 Canada 16.7 867 48.0 416 24,926 Japan 65.8 4,429 19.0 842 12,796 Source: Staff Estimates Note: Includes all pension assets, both public and private — Not available Table 5.7: Size of Indonesian Private Pension Funds, 2001–4 (Rp trillion unless otherwise noted)

Type of fund Number of funds

Assets Number of employers

Number of participants (millions)

Normal contributions

Employer pension funds 2001 314 33.4 2,011 1.1 — 2002 314 38.2 1,696 1.1 1.6 2003 307 45.6 1,758 1.8 2.1 2004 271 48.9 — — —

Financial institution pension funds 2001 29 1.4 1,171 0.5 — 2002 31 2.5 1,891 0.6 0.8 2003 31 3.9 2,417 0.8 1.1 2004 21 4.5 — — —

All funds 2001 343 34.9 3,182 1.5 — 2002 345 40.7 3,587 1.7 2.4 2003 338 49.4 4,175 2.6 3.3 2004 292 53.4 — — —

Source: Bapepam & LK — Not available

PERFORMANCE AND SUSTAINABILITY Typical performance metrics, such as return on investments and administrative costs, are difficult to come by in Indonesia for almost any type of pension fund. Nevertheless, this section compiles and analyzes information from a variety of sources to get an understanding of the performance of the various components of the system.

Jamsostek Jamsostek’s operating expenses—12 percent of contributions received or 23 percent of benefits paid as of 2004 —are very high. The performance of Jamsostek in collection and administration has been substandard, resulting in high administrative costs and low-quality services over most of its history. From 1999 to 2004, there has been only a slight improvement in the level of operating expenses and the levels at 2004 are still very high. (see table 5.8). Besides high operational expenses, Jamsostek has other expenses that drive up the total costs of providing benefits. In terms of total expenses as a proportion of benefits, Jamsostek’s expense ratio was nearly 60 percent in 2003, much higher than expense ratios in comparable systems. (see


table 5.9).55 Many systems operate with expense ratios below 10 percent, and even Chile, which is considered a very expensive system because it offers options and allows funds to compete for contributors, has expense ratios of less than 25 percent. Canada, for example, has overall administrative expenses below 2 percent of the benefits, and this level is declining.56 Clearly, one cause of such high expense ratios is the fact that Jamsostek is treated like any other state-owned enterprise; it pays taxes on its investment returns and pays the government a dividend from its earnings. For fiscal year 2003 and 2004, Jamsostek is reported unofficially to have paid the government a dividend of approximately Rp 337 and 105 billion (25 percent of its income) respectively. Dividends are unique to Jamsostek and are not present in other systems.57 Furthermore, the taxes and dividends Jamsostek pays is not clearly reported, making it difficult to assess the true nature of the overall cost structure. Jamsostek’s return on invested assets was 12.9 percent for 2003 and 10.4 percent for 2004. The returns are above the average annual inflation levels and average monthly deposit rates; however, when compared to the yield on government securities, such as the SBI 1 month yield of 11.7 in 2003 and 10.7 in 2004, Jamsostek’s investment return performance is not very impressive (see table 5.9). The inadequate investment returns coupled with very high expense ratios indicate that participants in Jamsostek receive a poor return on their contributions, which explains the difficulty that Jamsostek has in improving its level of coverage. Thus, Jamsostek not only has drawn assets away from private plans by competing for contributions but, by projecting a poor image of pension programs, has discouraged the development of new private plans as well. Table 5.8: Operating Expenses of Jamsostek, 1999–2004 (Rp billion)

Indicator 1999 2000 2001 2002 2003 2004 Contributions received 1,926.6 2,468.7 3,345.4 4,245.9 4,916.5 5,483.7 Claims paid 1,052.0 1,102.2 1,307.8 1,692.0 2,057.6 2,872.4 Operating expenses 285.5 232.9 279.1 379.7 517.2 650.2 Operating expenses as a percentage of

Contributions received 14.8 9.4 8.3 8.9 10.5 11.9 Benefits 27.1 21.1 21.3 22.4 25.1 22.6 Source: Jamsostek financial statements

55 While there are many ways to measure expenses, the benchmark used here is based on benefits, which are the product of Jamsostek and the core of its mission. In the case of a benefit benchmark, the entity appears to improve its performance if it can pay higher benefits for the same premiums or contributions. 56 In Canada, contributions are collected through the income tax–reporting system, and thus compliance is ensured through the tax enforcement mechanism. The Canada Pension Plan is charged for the marginal cost of collection and for specific enforcement expenses as well as for other administrative expenses. 57 Under the new social security law, Jamsostek will become nonprofit and tax exempt.

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Table 5.9: Total Expense Ratio and Return on Investment for Jamsostek (Rp billion)

Indicator 2003 2004 Total invested assets 26,907.3 32,530.2 Investment income 3,480.1 3,371.8 Benefits 2,057.5 2,872.4 Return on total invested assets (percent) 12.9 10.4 SBI 1 month yield (percent) 11.7 10.7 Bank 1 month deposit rate (percent) 9.6 6.2 Average annual inflation 6.8 6.1 Operating expenses 517.2 650.2 Investment expenses 150.7 116.8 Operating and investment expenses 667.9 533.4 Operating and investment expenses as a percentage of benefits 32.5 22.6 Other charges Taxes 3.7 N/A Dividends 336.5 105.0 PUKKa 9.8 N/A DPKPb 211.2 N/A Total other charges 561.3 N/A Total other charges as a percentage of benefits 27.3 N/A Total expenses and other charges as a percentage of benefits 59.7 N/A Source: PT Jamasostek Annual Report 2003, 2004 a. Fund for the Development of Small Enterprises. b. DPKP provides revolving loans, subsidized housing, and grants for medical services; it is not a Jamsostek program.

Taspen Taspen’s expense ratios are also high for the very limited range of functions it performs. Operating costs amount to about 20 percent of benefits (see table 5.10).58 In the absence of true cost allocation, it is nearly impossible to attribute costs to a specific program or function, but it appears that, based on the current fee structure, the THT program is subsidizing the pension program. Taspen’s return on invested assets was 14.6 in 2003 and 11 percent in 2004. These figures are above the average annual inflation levels and average monthly deposit rates; however, when compared to the yield on government securities, such as the SBI 1 month yield of 11.7 in 2003 and 10.7 in 2004, Taspen’s investment return performance has not performed much better than a portfolio invested in liquid short-term government securities (see table 5.10). Taspen employed 2,071 persons in 2004 and operates 40 branches across Indonesia as well as 4,000 service points in cooperation with banks and post offices. Significant differences between Taspen’s operational structure and that of many other civil service systems explain much of the higher operational costs. For example, individual civil servant contributions are not withheld centrally at source but are distributed to individual government units and have to be clawed back by Taspen, leading to delays, recording errors, and extra costs. Benefit claimants send forms to multiple offices across regions; instead of to one central office, creating opportunities for corruption. Taspen also has a complex corporate structure that can be substantially simplified.

58 A contribution or asset-based measure is meaningless since the government pays its share out of the budget.


Table 5.10: Performance of Taspen, 2000–4 (Rp billion)

Indicator 2000 2001 2002 2003 2004 Total invested assets 5,876 7,239 8,857 10,819 12,511 Investment income 673 1,068 1,452 1,575 1,376 Investment income as a percentage of total invested assets

11.5 14.8 16.4 14.6 11.0

SBI 1 month yield (percent) N/A N/A N/A 11.7 10.7 Bank 1 month deposit rate (percent) 11.2 14.5 14.4 9.6 6.2 Average annual inflation 3.8 11.5 11.9 6.8 6.1 Contributions 543 1,375 1,391 1,683 1,699 Benefits 691 755 977 1,079 1,389 Operating expenses 124 1,349 169 347 272 Operating expense as a percentage of Contributions 22.8 98.1 12.1 20.6 16.0 Benefits 17.9 178.7 17.3 32.2 19.6 Source: Audited financial statements The implicit pension debt in Indonesia is due to the unfunded liability under Taspen and Asabri. There is no official valuation of the liability of these plans. More important, there is no transparent reporting of the costs of the programs, and the government’s pension debt is not recognized on its balance sheet. Taspen projects that unfunded liabilities are in the order of Rp 300 trillion (about 11 percent of GDP). The figure has not yet been confirmed by independent actuarial calculations (Martineau and Guerard 2005).

Private plans In terms of operational costs, private pension plans operate much more efficiently than their larger public counterparts. In 2003, operational expenses of private pension plans were 9.9 percent of benefits, compared to 23 percent of Jamsostek and 20 percent of Taspen (see table 5.11).

Table 5.11: Performance of Private Pension Plans, 2003-4 (Rp billion)

2003 2004

Indicator Employer pension funds

Financial institution pension plans

Total Employer pension funds

Financial institution pension plans

Total

Assets 45,551 3,897 49,448 48,862 4,579 53,441 Total investment 43,409 3,816 47,225 46,619 4,511 51,130 Contributions 4,290 1,147 5,437 N/A N/A N/A Benefits 2,931 353 3,284 N/A N/A N/A Operational expenses 288 37 325 290 43 333 Investment result 4,949 378 5,327 4,866 329 5,195 Return on investment 11.4 9.9 11.3 10.4 7.3 10.2 SBI 1 month yield (%) 11.7 11.7 11.7 10.7 10.7 10.7 Bank 1 month deposit rate (%) 9.6 9.6 9.6 6.2 6.2 6.2 Annual average inflation 6.8 6.8 6.8 6.1 6.1 6.1 Operational expenses as a percentage of Assets 0.6 0.9 0.7 0.6 0.9 0.6 Contributions 6.7 3.2 6.0 N/A N/A N/A Benefits 9.8 10.5 9.9 N/A N/A N/A Source:Bapepam & LK

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In terms of return on investment, private pension plans returned 11.3 percent in 2003 and 10.2 percent in 2004. Their performance is quite similar to the return on investment of Taspen and Jamsostek and comparable to the government benchmark of SBI 1 month yield. This suggests that the private pension plans undertake similar investment strategies as their public counterparts, but are still more attractive because they are able to achieve similar returns with lower operational expenses despite their smaller sizes. While FIPFs and defined-contribution employer pension funds are fully funded by definition, several defined-benefit employer pension funds face funding shortfalls.59 According to 2003 reports, 78 out of the 149 defined-benefit funds (52 percent) reported a funding ratio between 80 and 120 percent, 15 funds reported funding ratios above 120 percent, while the balance reported funding ratios below 80 percent, with 5 percent reporting funding ratios below 40 percent. The regulator classifies pension funds into three levels of funding: (a) level 1: assets are equal to or exceed ongoing liabilities, (b) level 2: assets are lower than ongoing liabilities but are equal to or exceed solvency liabilities, and (c) level 3: assets are lower than solvency liabilities. Pension funds at level 1 are in surplus, while funds in the other two categories must pay special contributions, in addition to normal contributions, to amortize their deficits.60 At the end of 2002, based on actuarial reports covering 132 of the 277 employer pension funds, 37 percent were in surplus—that is, at level 1. The remaining 63 percent were in deficit, split between 24 percent at level 2 and 39 percent at level 3. The aggregate surplus in the 48 funds at level 1 amounted to Rp 1.3 trillion, whereas the aggregate deficit for the 84 funds at levels 2 and 3 amounted to Rp 5.4 trillion.

DEVELOPMENTAL ISSUES AND CONSTRAINTS The key issues constraining the development of each major type of pension fund are presented below, starting with the public funds and then turning to the private ones.

Jamsostek Jamsostek has the potential to provide true social security to private sector employees and to mobilize long-term domestic resources. Before it can realize this potential, however, major problems in its management have to be addressed. Jamsostek is weak in all three areas that are critical to the successful implementation of a social security scheme: registration, the collection, and recording of contributions, and the management and payment of benefits. Registration is weak because the law mandating private contributions to Jamsostek suffers from lax enforcement. In addition, Jamsostek’s own poor performance leads to massive evasion and poor incentives to comply. The recording of contributions is inefficient, inaccurate, and, in most cases, not current. The principal cause of this weakness is that management has not focused on the need to use modern technologies. All attempts to solve the problem have been poorly managed and superficial, ultimately compounding the problems rather then solving them. There is also an apparent lack of managerial experience and knowledge, which can be attributed to the policies concerning recruitment, skills enhancement, and promotion. 59 As it is normal for defined-benefit funds to oscillate between a surplus and a deficit position, some amount of shortfall may be temporarily acceptable. 60 The solvency liabilities are equal to the liabilities for benefits that would be payable should the plan be terminated at the reporting date. For example, while ongoing liabilities would reflect projected future salary increases in a final-average defined-benefit program, the solvency liabilities would reflect only accrued benefits at current salary levels with immediate vesting. Thus solvency liabilities normally are significantly lower than ongoing liabilities.


The weaknesses and shortcomings of the systems of registration and recording have affected the benefit payment system. Payments are delayed, and controls are inadequate to provide the required protection for contingencies; as a result, payment to third parties providing services to employees has been poorly managed. In summary, poor administration of the schemes and weak management, combined with deficiencies in enforcement and leakage from early withdrawals after five years of participation, have resulted in low effective coverage of employers and employees, a high default rate, inadequate protection of the covered population, and the failure of Jamsostek to achieve the intended objectives of the 1992 amendments to the law. Jamsostek also needs to strengthen its risk and human resource management systems. Managing a large securities portfolio, such as Jamsostek does, requires developing and implementing comprehensive procedures to monitor and control the nature, characteristics, and quality of the portfolio, the extent of risk assumed, and the returns against the risks assumed, using benchmarks. Jamsostek lacks clear procedural controls to ensure that investment activities are monitored frequently against policies and risk limits. Jamsostek has not established a mechanism to determine the maturity profile of its liabilities as a basis for determining the duration of its assets, although matching of assets and liabilities will become an increasingly important consideration as the fund matures. Jamsostek also does not have clear policies for optimizing the allocation of human resources. Human resources are and will remain the most important ingredient to ensure effective, consistent, and efficient delivery of services to its clients. Jamsostek’s deficiencies have been known to policy makers for several years. However, action so far has been limited. It is important for the government to recognize that inaction on its part comes at a substantial cost; especially, given the government’s goal of mobilizing long-term domestic resources. A well-managed Jamsostek can be one of the best instruments for achieving this objective, but that would require overcoming resistance from vested interests, who prefer the status quo.

Taspen The government faces two main issues with regard to the civil service pension system: management of the fiscal costs of the current scheme and the role and structure of Taspen in managing the scheme. The pension and old age programs for civil servants entail significant costs and liabilities as well as financial risks for the government. The defined-benefit plan is poorly financed relative to the benefit promises and has a significant negative cash flow. A performance audit completed for the Ministry of Finance in 2003 concluded that there were no reliable estimates for the costs and liabilities of the pension and savings programs. Taspen projects that unfunded liabilities are on the order of Rp 300 trillion (about 11 percent of GDP). The true financial state of both programs remains unclear, and there is no clear financing path. The programs have major implications for fiscal policy as well as for the budgets, the allocations to regional governments, and the management of government debt. As a first step, therefore, a thorough assessment of the financial and actuarial state of the civil service pension and savings program is needed. The role of Taspen in managing the program needs to be clarified as well. A simpler administrative structure would require separating the responsibilities between setting the policy through legislation and administering the benefits (see table 5.12). It also would mean segregating the responsibilities for policy and investments. This would eliminate major issues of control and supervision, allowing for a very light and simple approach to the remaining tasks that Taspen performs. Once the existing, small, base of assets is used up and the government begins to pay all the benefits out of its budget, such segregation will be automatic and the cost will be carried as government debt.

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Table 5.12: Prevailing versus Proposed Practices in Taspen

Prevailing practice Proposed practice Process of collecting data manually, billing, collecting contributions, and reconciling again

Self-billing, automatic transfer of money and data in parallel channels with post facto validation

Split between THT and the pension program

Integrated pension and endowment programs

Face-to-face meetings through a network of branches

Receipt of claim forms sent directly to a central office

Co-mingling of the administration of benefits and the management of assets

A simple administrative unit not involved in policy or investments

Source: World Bank, Taspen, MoF

Private plans The private pension fund industry has the potential to play a critical role in Indonesia’s overall pension system; however, it faces several major challenges that need to be addressed. Saving in employer pension plans and FIPFs is voluntary; therefore, these plans have to compete with a variety of other demands on individual and corporate savings as well as with other savings instruments—often on an uneven playing field. Employer defined-benefit pension schemes use the civil service scheme as a model, and this creates huge costs and disincentives for expanded coverage. Private pension funds also face high costs due to complex administrative structures. Lack of promotion of their benefits, poor financial literacy among potential contributors, and the high cost of insurance products compound the difficulties. The competition confronting private pension funds limits their attractiveness to employers and employees and hence reduces the resources mobilized. Being voluntary, private pension fund savings have a lower priority than emergency, health, and other immediate needs. Given the wage distribution, demographics, as well as past macroeconomic volatility, there is also a preference for liquidity and short-term returns. Participation in Jamsostek is mandatory, and this provides employers with less of an incentive to establish private plans. Mandatory termination benefits (under Law no. 13/2000) are also high by international standards. A worker with 20 years of service is entitled to termination benefits of nearly 25 months of wages. While few employers fund their liabilities for termination benefits, the mandatory provision of termination benefits acts as a major disincentive to establishing pension plans. Private pension funds also compete with mutual funds and time deposits on an uneven playing field. Mutual funds are completely tax exempt for five years from creation of a fund, while contributions to pension funds are merely tax deferred. The tax exemption of mutual funds comes with no strings attached: no locking in, no compulsory annuitization, no reporting, and no supervisory burden (see chapter 5). Given the added advantage of liquidity, it is not surprising that mutual funds are preferred. In the initial years, private pension funds competed with bank deposits, because deposits were exempt from taxation for some time. While this has been changed, the fact that a deposit guarantee is in place provides an added attraction to contributors who are trying to choose among savings alternatives. Many private sector funds follow the expensive role model offered by the major public sector plans, but this sets an unduly high bar, especially for small and medium-size enterprises. The public sector plans are of the final-average type, with indexation based on salaries and a low retirement age. The Department of Manpower and Transmigration has mandated a retirement age of 55, which also contributes to higher costs. This structure is not attractive to private sector employers.


The administrative structure created by employer pension funds is expensive and unwieldy. Some sponsors are culturally inclined to copy the familiar structure of a board of commissioners and a board of directors for the pension fund, both with members appointed by the sponsor. Whether such a structure is legally necessary is unclear: the Pension Law requires the segregation of assets, but not the physical separation of administration. This cumbersome structure has adverse effects on at least two counts: (a) there is no separation between policy making, oversight, and operations, as the administrator is also involved in operations, and (b) the reporting lines are blurred to the extent that the supervisory board injects itself between the administrator and the sponsor rather than functioning purely as a watchdog on behalf of the stakeholders. In addition to contravening good governance principles, mimicking the dual-board system results in a top-heavy, expensive organizational structure. Such a structure also reduces incentives to use outsourcing and makes the creation of a pension fund a bigger challenge than necessary. It is likely that this has weakened the synergy between the administrator and the sponsor, so that the pension plan has come to be seen as an expense rather than an important tool for human resource planning and an efficient component of total compensation. There has been little institutional or state promotion of pension benefits. Although the Pension Law specifically mandates the Bureau of Pensions to promote private pension plans, promotional activities were limited before the 1997–8 crisis and virtually nonexistent later. Neither the workers nor their employers are generally educated about the need for financial security in retirement and the advantages of building income-generating assets early in their career. Pension promises are less tangible than lump-sum payments, and deferred pensions have a much lower perceived utility than savings that can be accessed as needed. Institutional promotion by the Ministry of Finance would greatly enhance the credibility of occupational pension funds. To address this need, the Association of Pension Funds launched a new magazine, Info Dana Pension, in May 2004, but its distribution is limited to members, and it does not reach the vast majority of employers that do not have a pension plan. The association recognizes this limitation and plans to extend the outreach of the magazine so that more employers can learn about the advantages of pension funds as a component of compensation. The inability of the insurance industry to offer pension products is a further barrier to the development of pension funds. In many countries where the insurance industry is authorized to package and sell pension plans directly, the industry is aided by a large sales force that searches for clients: individuals, employers, and sometimes trade or professional associations. Vendors are quick to point out the tax advantages and cumulative gains. In Indonesia, unfortunately, the insurance industry was shut out of the direct marketing of employer pension funds by a restrictive elucidation of the Insurance Law. Although the Insurance Law appears to allow insurance companies to act as administrators of pension funds, the elucidation restricts this mandate to financial institution pension funds, depriving the industry as a whole of the push that the insurance network and sales force could provide, especially for small and medium-size employers. Allowing the insurance industry to package and market pension products would spur development of the industry.

LEGAL, TAX, REGULATORY, AND SUPERVISORY ISSUES

The Impact of Law no. 13/2000 on Private Pension Funds The legal obligations of employers under Law no. 13/2000 are onerous and a big hurdle to development of the pension fund industry. This law mandates very high severance benefits and long-service leave obligations that are quite out of line with international norms. The cumulative changes in these benefits since 1996 have doubled the cost of severance benefits and made

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Indonesia one of the most expensive countries in the world in this respect (LPEFE, Universitas Pajajaran 2004; see figure 5.3 and 5.4). On a pay-as-you-go basis—that is, without the benefit of return on investments on prefunded contributions—the cost of these obligations (equivalent to 25 months of salary after 20 years of service) represents 10.4 percent of pay. Although accounting regulations mandate the annual reporting of the accrual of these severance benefits, they are generally not prefunded. There is ambiguity in the law and regulations whether the severance payments could be offset by pension benefits payable at retirement. This would allow employers to prefund on a tax-sheltered basis and increase the security of workers. However, under the current ambiguous system, employers comply with the mandatory severance benefits at the expense of voluntary pension programs. Some employers are reducing this cost by subscribing to insurance contracts, and a small minority succeeds in offsetting the severance payments with pension benefits, but the fact that pensions are payable monthly and severance pay is payable in a lump sum remains a major hurdle. These high severance payments, in addition to creating major problems in the labor market, discourage employers from creating pension plans. The structure of these payments has served to increase demand for lump-sum payments as opposed to annuities. Although not formally a retirement savings program, the substantial lump-sum benefits payable on termination of employment and retirement are similar in nature and timing to those paid under the Jamsostek old-age benefits scheme, except that there is no mandatory funding requirement. These lump-sum payments do not ensure adequate income in old age, which is the same weakness affecting the Jamsostek old-age benefits program. This, in turn, adversely affects the annuities market as well as the possibility of providing true lifetime income security through annuities. Figure 5.3: Entitlement to Severance Pay and Long-Service Leave in the Event of Dismissal for Economic Cause, by Years of Service, 1986–2003

0

5

10

15

20

25

<1 year 3 years 5 years 10 years 20 years Maximum

Years of Service

Entit

lem

ent t

o se

vera

nce

pay

(mon

ths)

1986 1996 2000 2003

Source: Faculty of Economics Padjadjaran University. “Indonesia's Employment Protection Legislation: Swimming Against the Tide?” Nov 29, 2004


Figure 5.4: Cost of Firing Workers (Weekly Wages)

145

98

90

90

90

90

65

55

52

47

46

46

42

39

38

36

28

21

17

13

4

0

0

0

0

0

0 30 60 90 120 150

Indonesia

Vietnam

ChinaKorea

Taiwan, China

Philipp inesMalaysia

Vanuatu

Solomon IslandsThailand

Kiribati

Regional AverageSamoa

CambodiaPNG

Lao PDR

FijiTimor Leste

Mongolia

Hong Kong, ChinaS ingapore

Tonga

Marshall IslandsMicronesia

Palau

New Zealand* Least Cost - Global

Source: World Bank, Doing Business Database

Tax treatment The fiscal treatment of registered pension funds does offer some tax incentives, but exempt-exempt, taxable (EET) treatment is not fully implemented.61 In the Indonesian context, the tax differential is low for most workers, and the impact of deductibility is not very visible, given that the tax withheld by the employers is deemed the final tax unless a tax return is filed to claim a refund; very few employees file a tax return. In essence, lower tax rates make the differential smaller, generating less pull than high marginal rates. Bureaucratic requirements result in the loss of tax deferral and double taxation, and this also occurs when individuals are denied the deductibility of contributions from income because of deficiencies in the employer’s administration of the payroll. The difficulty appears to be that the principles are not clearly stated in the Income Tax Law, and therefore circulars can easily enact rules that contravene the underlying policy and rationale of the EET approach. In addition, the tax structure makes annuities unattractive. There is a transfer tax when capital is transferred from a registered pension fund to an insurance company to purchase an annuity, and this discriminates against annuitants who have to purchase an annuity, because otherwise the return on assets would remain tax sheltered until paid out.

Early withdrawals The demand for early withdrawals from private pension funds is a difficult issue that needs to be resolved. Participants contributing voluntarily to employer pension funds and FIPFs are not

61 Under EET, contributions are deductible from taxable income, the returns on assets are not taxable, and the benefits are taxed as paid. This approach is common in industrial countries. The conventional use of the word “exempt” is somewhat misleading, since the effect is not an exemption but a deferral of taxes until the benefits are paid out.

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expected to withdraw contributions just made, especially since in the long term the main part of the assets is the compounded return on contributions. An issue that has been raised is the option of allowing participants to withdraw their contributions, exclusive of accumulated interest, prior to retirement. Some participants are enrolled by their employer and can choose to withdraw promptly the contributions made on their behalf. Some employers make the contributions on a locked in, contractual basis, but financial institutions do not always respect this restriction. Early payouts defeat the purpose of having a long-term retirement savings program and deprive the participant of the tax advantages of a sheltered investment vehicle and, of course, of financial security in retirement. How to keep the financial institution pension funds attractive for voluntary participants and how to limit abuses from participants who systematically withdraw contributions deposited on their behalf are important questions that need to be addressed. One solution would be to allow only a portion of the contributions to be withdrawn, subject to a maximum limit. However, in the long run, investor education about the benefits of long-term investment and asset accumulation is a key to resolving this issue.

Investment in foreign assets Indonesian pension funds are relatively small and invested largely in time deposits. Indonesia currently prohibits pension funds from investing in foreign assets. However, there are several arguments favoring diversification into foreign assets。 As shown by the experience of Argentina, a sustainable system cannot be invested only in domestic government bonds and bank deposits; more diversification of assets is needed. There are concerns that investment in foreign assets may reduce and crowd-out investment in domestic assets. However, investment in foreign assets improve risk diversification and reduce volatility; therefore, encouraging more participation and increasing the total size of the investible assets over the long run. While domestic allocation as a percentage may be smaller, the actual size may be larger because of a larger whole. Openness to invest in foreign assets also sends a strong positive message to the markets. Permitting Indonesian institutional investors to invest offshore could improve Indonesia’s capital market openness and hence its attractiveness to foreign investors. Many countries allow foreign investments, and some, like the United Kingdom or the United States, have no restrictions. Canada recently removed the 30 percent foreign limit in force for the past few years, which previously had been increased from a long-standing 20 percent. Table 5.13 summarizes international practices. Indonesia’s rationale for prohibiting pension funds from investing in foreign assets are that there are significant domestic investment needs and attractive domestic investment opportunities. Furthermore, pension fund administrators have little experience in investing overseas and it is harder to regulate and supervise foreign investments. However, permitting investment in foreign assets in the medium to long-term would further improve the variety of instruments available, the sharing of expertise, and the diversification of risk.


Table 5.13: Maximum and Actual Foreign Assets as a Share of Total Fund Assets in Select Countries

Foreign assets (percent) Country

Maximum limit Actual share Argentina 10 9 Canada 30a 15 Chile 25 16 Colombia 10 — France — 5 Germany 30 — Hungary 30 3 Italy P — Japan 30 23 Mexico 10 — Peru 8 7 Poland 5 0 United Kingdom P 23 United States P 11 Source: World Bank Note: P, prudent-man rule applies. — Not available. a. Abolished in 2005

Regulatory forbearance in pre-funding One result of the 1997–8 crisis has been to grant regulatory forbearance to employers’ obligations to fund their liabilities in pension funds.62 The law provides for timely payment of contributions on a monthly basis, and arrears cannot exceed three months. However, a more tolerant procedure is now in effect, and arrears beyond three months are permitted without the pension funds incurring any penalties. This needs to be remedied at an early date to enable greater security of pension benefits.

Social Security Law no. 40/2004 For formal sector workers, Law no. 40/2004 (SJSW Law) makes participation compulsory and obliges employers and participants to contribute a certain percentage of wages. For non-wage earners, nominal amounts are stipulated. Registration, the collection of contributions, the investment of assets, the payment of benefits, and the administration of the social security programs are the exclusive responsibility of four existing administrators. Each of these four state-owned enterprises enjoys a monopoly over a particular category of participants. There is no room for participation of the private sector or regional governments. The four state-owned enterprises enjoy a special nonprofit, tax-exempt status. The government of Indonesia is mandated to pay the contributions for poor and financially disabled persons. In addition to these contributions, the government may “perform special actions” to maintain the financial health and soundness of a program fund, which is interpreted as a guarantee of last resort.

62 The Pension Law provides two remedial measures for disciplining an employer pension fund for failure to pay contributions in a timely manner: (a) the founder may request a suspension of the contributions for a maximum period of one year if the firm has suffered financial losses for three consecutive years, and (b) the pension fund can be dissolved and its assets liquidated at the request of the founder or if the minister determines that the fund cannot meet its obligations or that the suspension of contributions endangers the financial condition of the fund. The dissolution is carried out by a liquidator appointed by decree of the minister. Dissolution of the founder triggers the automatic dissolution of the pension fund. The rights are liquidated by purchasing annuities from an insurance company or by transferring funds to a financial institution pension fund.

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There are no stipulations about minimum or maximum amounts of benefits or contributions or other parameters; such details are to be stipulated by regulations. The health program covers the actual delivery of services to the participant and family by the public providers as distinct from a health insurance scheme that would pay providers (public or private) for the delivery of services. As a result, this provision has been interpreted as closing health insurance to private insurance companies; health premiums now represent 5.7 percent of total premiums in the life sector. The programs propose a comprehensive set of benefits, but the law is short on details, including the amount of benefits, contribution rates, and even major strategic policy options, except for the fact that the pension shall be a defined-benefit program. The financing approach is unclear. Despite these limitations, Law no. 40 of 2004 fits nicely with the new approach to pension systems. As the law targets the whole labor force, a specific issue for Indonesia is the treatment of the large “informal” sector, which has remained a challenge in most countries. The provision of a government subsidy for the financially disabled corresponds more or less to a “zero” pillar. The pension program proposed in Law no. 40 could play the role of the first pillar. This basic income protection could be in the form of a uniform flat benefit, perhaps regionally adjusted, financed by wide-based contributions. An alternative to pay-as-you-go financing of the first pillar would be a constant-level percentage to avoid intergenerational inequity. A level percentage stabilizes the contributions to the system without accumulating reserves as high as fully funded reserves, because the fund acts only as a stabilizer. Given the level of development of the financial system, weaknesses in the enforcement of the prudential framework, and governance issues, ensuring the gradual accumulation of assets in public systems is potentially a strategically prudent option for Indonesia at this time. Once appropriate institutional structures are in place, greater pre-funding could be undertaken. The old-age benefits program, which is equivalent to individual savings accounts, acts as a second pillar. By limiting the amount of publicly managed assets, the proposed program reduces the risks, avoids the concentration of assets under one public decision maker, and leaves more room for contributions to a third pillar that would be privately managed and invested competitively. The third pillar would be complementary to both the first and second pillar; the combined level of these pillars is a major policy issue, as it would govern the potential development of the private pension industry and the degree of diversification of the capital market. The situation created by Law no. 40 and the timing of its implementation are still very fluid, making it difficult to assess the impact on the pension industry. The structure and the level of both the old-age savings and the pension program will be key determinants. If the National Social Security System aims to achieve a high income-replacement ratio, it will crowd out the private sector and drain the available savings. If the coverage is more basic, the private sector could play a complementary role; especially, for the higher-paid fraction of the labor force. Thus, it is important to define the roles of the public and private sectors in Law no. 40. This includes determining (a) the amount of contribution to be mandated for the old-age benefit program and (b) the formula and amount of life pension under the pension program. In addition, it is important to ensure that the parameters respect fiscal and monetary constraints, the capacity to pay of the economy, and the need to foster competitiveness and diversification, and thus to reduce risk.

Role of custodians Pension funds need a custodian to hold the assets of the fund. Only banks can act as custodians for a pension fund, whether it is an employer or a financial institution fund. The Pension Fund Law no. 11/1992, Article 6, requires that custodians be appointed for pension fund assets (excluding


assets such as property, land, and buildings). Article 30(5) states that the custodian can only release assets on instructions from an executive for the pension fund. The custodian is responsible for safeguarding the pension plan’s financial assets; however, the law does not address the wider range of responsibilities of custodians for investment funds. (For a more detailed discussion of role of custodians, refer to chapter 4)

Qualifications of investment managers Many pension fund professionals engaged in investment management are not adequately trained and do not need to meet the investment manager requirements of Bapepam & LK, Indonesia’s supervisory agency for the capital markets. There are regulations for the executive officer of a pension fund to meet Bapepam & LK qualifications and be knowledgeable about pension funds, but not for the rest of the staff.63

Relation between investment managers and other institutions There are no rules regulating possible conflicts of interest, such as front running or related-party transactions that could arise from the activities of individual investment managers of the pension funds. Even entities that transfer management to a Bapepam & LK-licensed investment manager could have unresolved conflict-of-interest problems. The law should be amended to regulate the sale of financial institutional pension plans. Equally, the law should require executives who act as portfolio managers to be sufficiently vetted as to ability and independence.

POLICY RECOMMENDATIONS The recommended policy actions by time frame are summarized in the following table. The policy recommendations are elaborated subsequently. Some of the policy recommendations cut across the authority lines of more than one department in Government and require a high level of coordination. The most important examples of this are the implementation of Law 40 (Coordinating Ministry for Social Welfare), prefunding of Law 13 (Department of Manpower and Transmigration), and recommendations regarding Taspen and Jamsostek which require the coordination of Ministry of Finance, Ministry of State Owned Enterprises, Department of Manpower and Transmigration and Bapepam & LK. Quick Wins (1 yr) 1 - 3 years Regulatory Determine the respective roles of the private and

public sector in providing retirement income; this could be done by a Presidential regulation under Law 40/2004 Initiate an actuarial audit of Taspen to determine the costs associated with the current design and the potential impact of integration with Law 40 / 2004 Improve Jamsostek’s governance and financial management. Begin improving Jamsostek’s performance by creating competition via

Formulate a coherent master plan to increase the provision of retirement income in a fiscally sustainable way, minimize costs and ensure long term asset accumulation through sound investment policies Continue the “pay as you go” financing of the civil service pension for the time being but review the accounting and reporting of costs and liabilities; consider optimal design changes Encourage efficiency and cost reduction in public and private pension funds to become competitive and commercially attractive and credible for members.

63 Minister of Finance Decree no. 513/KMK.06/2002, December 4, 2002, requires that the executive officer of an employer or financial institution pension fund must meet qualifications and be knowledgeable about pension funds. Less formally, the head of the investment department of an insurance company generally has a Bapepam license as an executive of an investment manager.

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outsourcing. As a first step, contract a portion of the assets to private managers Prevailing regulatory and licensing investment management requirements apply only to executive directors. The investment management professionals in the pension industry should equally meet Bapepam & LK’s investment manager requirements and be knowledgeable about pension funds Clarify regulation to allow prefunding of the termination benefits mandated by Labor Law 13 / 2000 through a tax-sheltered vehicle such as a registered pension plan

Promote increased out-sourcing of tasks and services, starting with asset management, for Taspen and Jamsostek Subject public pension plans and their administrators to a proper regulatory framework. Develop such framework in anticipation of the implementation of OJK and Law 40 / 2004 Increase regulatory and supervisory capacity in collecting and analyzing data regarding investments and solvency. Expand scope of audits but eliminate duplication Modify the regulatory framework to allow for alternative methods of annuitization of defined contribution plans or other lumps sums

Enforcement Improve off-site supervisory capacity including data capture via regulatory reporting , and equally important – analysis Enforce more timely funding of pension obligations under Law 11 of 1992 Undertake risk-based on-site inspections to verify the data, method and assumptions in critical areas such as calculation of liabilities and asset valuation Clarify the implementation of pension regulations to segregate responsibilities for policy and operations in pension funds

Accelerate shift to sound implementation of risk based supervision Improve governance of pension plans, including public ones After improving governance and performance of public pension funds, improve enforcement of mandatory collections Reduce administrative burden and costs by revamping the dual board structure to a single board structure

Skills Open up to the actuarial profession to international expertise Require the actuarial association to promote the application of its pension practices professional standards

Develop the professional associations in pensions with the objective of reaching true self-regulatory capacity, and ability to educate, certify and discipline their members Increase risk management skills to match assets and liabilities, measure performance against relevant benchmark Strengthen domestic actuarial profession

Taxes Remove the transfer tax applied on funds transferred from registered pension fund to insurance to purchase an annuity Optimize the implementation of the EET tax treatment for pension funds

Clarify EET treatment of pension funds in the Income Tax Law and improve payroll withholding administration to permit deductibility of contributions Formulate a consistent solution to early withdrawals


Monitor implementation of the Social Security Law and model the financial implication of various implementation scenarios to form the basis for further analysis

Clarify the implementation of the new Social Security Law no. 40/2004, especially regarding benefits, contribution rates, major strategic policy options, and financing. Qualify the role of public provision in the new system to allow private participation and competition, e.g. allow insurance companies to participate in the health program


Educate the public and the employees on benefits of tax-sheltered pension savings and promote the industry Promote retirement income as opposed to lump sums and a wider use of pension plans by employers as an efficient tool for HR management

Sustain an educational and promotional campaign


The foremost challenge facing Indonesia is to devise a coherent policy for the pension industry, followed by reform of Taspen, improved efficiency at Jamsostek, and improved asset allocation among private pension funds. A discussion follows of priority recommendations and followed by specific suggestions for each type of pension plan in Indonesia.

Priority recommendations Formulate a coherent master plan. A master plan covering all types of pension provision is needed to increase coverage in a fiscally sustainable way, minimize costs, limit political capture of funds, achieve long-term asset accumulation and sound investment policies as well as define the roles of private and public sector. Undertake an audit, assessment, and undertake reform of Taspen before addressing funding issues. Given the current circumstances with inadequate governance and inefficient operations of Taspen, it is not advisable for the government to focus on funding its civil service pension obligations. Funding the program should be the long-term goal once institutional issues have been addressed. Instead, the Ministry of Finance should (a) perform an audit, assessment, and undertake reform of Taspen, (b) in the meantime, adopt reporting and accounting based on full funding and (c) continue the financing on a pay-as-you-go basis but recognize unfunded pension liabilities transparently as part of government debt. At the same time, it is recognized that the regulation and supervision of Taspen is spread over various departments and the responsibilities and reporting lines are not clear. Therefore, it is also important to review and clarify the roles and responsibilities of all parties involved in management and supervision of Taspen to be able to implement the recommendations of the recommended audit. Encourage outsourcing of activities at Jamsostek to improve efficiency. Efficiency improvements at Jamsostek can be motivated by creating competition in asset management. An easy and important first step would be to outsource the management of a small portion of Jamsostek’s assets (say 5 to 10 percent to start with) to private asset management firms. This would provide a benchmark to compare and measure the investment performance of the assets Jamsostek continues to manage. Such competition and comparison likely to contribute to increased transparency and provide a basis for reforms. Improve the asset allocation of private pension funds. Private pension funds would also benefit from better asset allocation and investment policies and lower costs. On top of this, they would benefit significantly from reform of the public pension system, which would improve the credibility and attractiveness of the entire sector.

Jamsostek Jamsostek was designed to be a long-term retirement-income scheme. Instead, it has morphed into a short-term tax-sheltered savings scheme. Its expenses are very high, and its coverage is low. It has the potential to be the foundation for a strong and well designed retirement-income scheme that generates significant long-term resources. Before it can realize its potential, however, major problems in its management have to be addressed. Subject Jamsostek to a proper regulatory framework and hold it accountable. Subjecting Jamsostek to a proper regulatory framework and holding it accountable for its financial performance and governance should be the primary objective of the Ministry of Finance and other involved agencies. At the same time, reforms should be initiated in parallel to improve performance and significantly reduce expenses. Two key steps that the Ministry of Finance could take are (a) to determine the requirements for financial governance and sound management and

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(b) to establish a performance benchmark to be imbedded in a contract of services. This would require inter-ministerial coordination, especially with the Department of Manpower and Transmigration and Ministry of State Owned Enterprises. Improve governance. Jamsostek has the potential to be a key instrument in the government’s efforts—both to expand the coverage of social security and to mobilize long-term resources. It is important that contributors be given the appropriate incentives and confidence in the institution in order to create demand for its services. The most important need for the government regarding Jamsostek is to improve governance. This is an issue more of political will than of technical solutions. Participants have long had negative perceptions about Jamsostek and viewed contributions to it as a tax. This has led to widespread evasion and a very low level of coverage, especially for a so-called mandatory scheme. The current governance structure within Jamsostek and the defined responsibilities of the members of the board of commissioners do not adequately empower and equip the board with rights and qualifications needed to protect the rights of the members they represent.64 Delineate clear lines of responsibility. Jamsostek is a state-owned enterprise with the Ministry of State Owned Enterprises as shareholder and the Department of Manpower and Transmigration in charge of oversight and supervision. The lines of authority are blurred. While the Ministry of Finance is concerned about fiscal implications, the Department of Manpower and Transmigration is more concerned about benefits rather than sound financial management practices. Delineating clear lines of accountability and responsibility is therefore a priority. Improve compliance. Improving compliance with Jamsostek’s law is another priority. Rampant evasion can partially be curbed by improving the fund’s institutional capacity and performance. There is need for the government to improve its enforcement of the law to support its dual objective of providing financial security in retirement and accumulation of long-term assets to be invested in long-term investments. Improve management. Management of the public pension schemes has major economic and social implications. Therefore, it is important to assess accurately the performance of investments, and this can be accomplished by calculating returns using the time-weighted rate of return, setting benchmarks, establishing risk limits in the context of the aggregate exposure, establishing systems and processes for analyzing cash flow, and adopting information technologies capable of handling and recording accurate and current data. Improve the actuarial control cycle. A fundamental problem is inadequate actuarial capacity within Jamsostek. Developing actuarial expertise is the first step toward strengthening the actuarial control cycle, defining and collecting the necessary data, and monitoring the quality of data through regular validations, better analysis of the allocation of expenses, and more reliable estimation of the rate of return that can be credited to participant accounts. Improve portability through the design of a portable identification number. A centralized registration system with security features to prevent duplicate registration is needed to ensure that a unique identification number is issued to employees as required under the new law. These numbers can be used throughout the life of the employees, irrespective of the region where they are employed and independent of their employers. This would simplify data management and reduce the room for errors.

64 Although the SJSN law modifies existing reporting relationships of Jamsostek by creating a Social Security Council, the importance of a proper internal governance structure remains a priority.


Taspen Improve governance. As with Jamsostek, improving Taspen’s governance is a high priority. Restructure the programs. Taspen’s pension programs need to be rationalized and restructured. For the old-age savings program, the government should choose between a defined-contribution or defined-benefit formula (currently it is both). If defined benefit is chosen, it should consider integrating the retirement part with the pension and outsourcing the life coverage. If defined contribution is chosen, the current administration could either be continued without a government guarantee or be outsourced. International practice is to move toward defined contributions, at least beginning with all new civil servants. Spinning off the insurance component of Taspen’s old-age savings program to a conventional group insurance policy would allow merging the retirement defined-benefit lump-sum component with the defined-benefit pension and rebalancing the sharing of contributions. Simplify the administrative structure. Taspen’s day-to-day administration of its pension and insurance programs could be simplified and made more cost-effective by building on the government’s existing information databases and administrative machinery. Functions such as collecting taxes or contributions, maintaining an employee database, keeping records, managing payroll, cash, accounting, communications, and reporting already exist within the government’s existing systems outside of Taspen. Taspen’s parallel branch structure is redundant as the government’s own network spans the entire country. In addition, For instance, pension contributions could be deducted up-front centrally and used to pay benefits (rather than the current practice of distributing civil service salaries gross of pension to each administrative unit and then having Taspen struggle to collect contributions back). This would be a cost-effective practice that avoids duplication and diminishes the burden of coordination. Simplified administrative processes would require the government to improve its human resource database. By concentrating the efforts on one database, the information could be more up-to-date, more complete, and more widely useful, saving the costs of duplication, effort, and time by the various counterparts providing information. Furthermore, benefit payments could be outsourced, and claims could be submitted centrally. Base pensions on final-average salary. Moving from a final salary to a final average would stabilize costs. This could be controlled further by linking the indexation to prices rather than wages, which is sufficient to protect the purchasing power of the pensions in payment. A legacy feature is that allowances are treated differently than the base salary; integrating their treatment would remove some distortions, while simplifying the formula. Raise the retirement age. Increasing life expectancy will make the current retirement age of 55 unsustainable; a gradual increase is needed to adapt the program to demographic evolution. Harmonize current programs with new programs under Law no. 40. Harmonizing Taspen with the national programs stipulated under SJSN Law no. 40 may be facilitated by splitting the current formula into a basic defined benefit and a complementary earnings-related defined contribution. Such a move could accommodate regional variations, as regions take responsibility for the compensation policy, and could even lead to some sharing in the administration of components of the programs. International experience shows that governments, like many employers, seek to shift some of the risks to the participants by replacing part of a defined-benefit final-average pension with a defined-contribution formula or a target-benefit approach. Remove the dual board structure of public pension funds. The current dual board structure contravenes good governance principles and results in a top-heavy and expensive organizational structure. Such a structure also reduces incentives to use outsourcing and makes the creation of

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a pension fund a bigger challenge than necessary. Therefore, it is recommended that the government removes this dual board structure and allows a single board.

Private plans Over the years, in many countries, voluntary occupational pension plans and individual pension products have created a large pool of assets that have provided the economy with long-term capital for accelerating economic development. Being privately managed as opposed to publicly administered, they are in general efficient in allocating capital based on economic efficiency and productivity. They help to make capital markets dynamic as they are invested competitively. As institutional investors, many pension administrators can claim to have promoted good governance and transparency in the capital markets. Indonesia is advised to encourage the development of private pension plans, both individual and occupational, and the following recommendations would support this effort. Promote the pension system. A sustained campaign is needed to educate and promote the benefits of pension plans for employers, employees, and the self-employed. Moreover, efforts to promote enhanced communications between actuaries and sponsors should result in better advice as to the financing of pension funds, thus reducing the volatility of contributions and increasing solvency. Encourage pre-funding of severance payments dictated by Law no. 13 on a tax-sheltered basis. Law no 13 dictates high severance payments that reduce an employer’s willingness and capacity to offer pensions. However, the negative impact of Law no. 13 could be mitigated to some extent if employers were induced to pre-fund the severance benefits through a tax-sheltered vehicle such as a registered pension plan. This would be advantageous for both the employer and the employees, since it would increase the security of payments. It would also tap another avenue for mobilizing long-term domestic resources. In the context of the ongoing debate about amendments to the tax legislation, it is important to move in this direction via the coordination of Ministry of Finance and Department of Manpower and Transmigration. Offer alternative models for structured settlement in the retirement period. Both employer pension funds and financial institution pension funds should adopt a flexible alternative to the mandatory purchase of life annuities from an insurance company. For example, this could be scheduled withdrawal for a fixed period or a variable-rate annuity with a scheduled payout option similar to the Life Income Fund permitted in several jurisdictions of Canada. Other countries offer alternative models for structured settlement over the retirement period. Essentially, these proposals would allow participants to retain the investment and mortality risks totally or partially in order to share in the potential returns of the market rather than having to accept a guaranteed life annuity. Allow pension funds to invest in foreign assets. There are significant benefits to be obtained by permitting pension funds to invest in foreign assets, as having even a small percentage of foreign investments in the portfolio would improve the diversification of risks, increase competition, and expose Indonesian asset managers to international best practices. The experience of other countries indicates that allowing pension funds to invest in foreign assets will not result in significant changes in investment policies, but it will allow funds more flexibility in managing risks. It is recommended that Indonesia takes a measured approach to permit investments in foreign assets while improving the capacity of its pension fund administrators and supervisors related to foreign investments. Improve the capacity of in-house asset managers. Pension funds in Indonesia rarely outsource the investment of assets, but a high proportion of the investments are in time deposits. In-house


managers have limited experience with other types of investments. Pension funds will need to diversify their investments, which will create a growing need for training and certification of in-house managers. Use one auditor for financial statements and the investment portfolio. The requirement of two auditors—one for financial statements and one for the investment portfolio— should be removed, allowing funds to use one auditor for both statements. Simplify the administrative structure and reduce costs. A simpler administrative structure could be achieved by eliminating the appointment of members of the administrator as directors and favoring outsourcing of certain functions and leveraging employer’s facilities. Private pension plans will have to face the same harmonization issue as public plans. Doing so would require integrating the pension benefit formulas. Broaden the role of custodians. Custodians should be given broader fiduciary responsibilities to monitor and oversee the activities of a pension fund and ensure that the investments are in line with the law, rules, and investment direction of the fund. Strengthen the rules governing investment managers. Regulations on the sale of financial institution pension plans should require executives who act as portfolio managers to be sufficiently vetted for their ability and independence. Implement EET tax treatment. Implementing the standard EET tax treatment as originally contemplated would not have a measurable impact on government revenues. However, implementation of the first “E” on contributions also requires improvements in the payroll system and procedures of the employers. The taxes on investment income are almost “E” in Indonesia except for a few exceptions. These exceptions create very little tax revenue but create administrative cost and uncertainty in the treatment of investment income. It is recommended that the authorities evaluate the removal of these exceptions to the rule. The final “T” treatment of benefits is taxation at the time of disbursement. However, when a defined contribution plan transfers capital to purchase an annuity, this transfer is taxed, although it is not for disbursement. Therefore, it is recommended transfers to purchase annuities is not taxed at time of transfer. The proceeds should be taxed when they are released to the member. Discontinue the lax definition of timely payment. The practice of carrying arrears beyond three months as assets of the pension fund should be discontinued, as it is detrimental to the equitable treatment of participants and endangers the solvency of the fund. Improve the regulation and supervision of private pension funds. Among the various recommendations for regulation and supervision, one of the highest priorities is joining the International Organization of Pension Supervisors (IOPS)65 to benefit from international experience as well as developing policies and practices in two areas: the development of a better system for capturing, managing, and analyzing data, and moving to a more risk-based approach to supervision. The regulations under which the Bapepam & LK currently operates are largely compliant with international best practice. Nonetheless, improvements could be made in a number of areas: Management and governance Require administrators to be professionally qualified, licensed, and regulated, which would

considerably enhance the capacity for self-discipline as well as risk-based supervision

65 http://www.iopsweb.org/

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Increase the duties and responsibilities of the supervisory boards and require education and training of members of those boards

Review the regulations to clarify the relationships between the administrator and the founder and custodian

Portfolio management Review and clarify the investment regulations regarding related-party investing and

transactions Review the regulations dealing with portfolio and related limits and clarify them to ensure no

inconsistencies Develop a regulation for dealing with issues related to pension plan mergers and splits.

Solvency Review the funding and solvency regulation over the longer term to remove the requirement

for a minimum amortization period Clarify the coordination of special payments in cases where a plan has both an unfunded

liability and a solvency deficiency; specify treatment of revaluation of gains or losses in such cases

Resolve the treatment of full payment of benefits when a plan has a solvency deficit Require Bapepam & LK to be notified when an actuary of a pension plan resigns or is

terminated Adopt an immediate requirement that plans with solvency deficits be subject to annual

actuarial valuations Reporting requirements Review the penalty provisions for late filings Consider the introduction of large immediate penalties and a scale that increases the

penalties proportionally with the number of overdue days. Scope of audit Expand the mandated scope of the external annual audit where a pension plan has a solvency

deficit to include operational issues, such as compliance verification and reporting on data problems

Require that the accounting standards to be compliant with those of the International Accounting Standards Board (IASB)

Require that the external auditor be independent of the founder, administrator and custodian Require that the audit report include a complete inventory of overdue contributions according

to due date, especially for contributions overdue more than three months Registration of plans Review the administrative requirements for the registration of new plans and amendments to

existing plans Adopt modern communication techniques and ensure full availability of all policies and

answers to frequently asked questions Optimize the use of electronic access to material and filings Document all existing information and policy decisions regarding plan termination, liquidation,

mergers, and spin-offs and make the information available electronically Data management and analysis Conduct a comprehensive review of all computer-based systems and applications, including

data entry and automated analysis Eliminate manual inputs and modify procedures to permit on-line query and analysis of the

database


Review the availability of data and the capability of storage to maintain time series of key data related to investments and financial position

Risk-based supervision Review the risk measurement parameters and evaluate them, emphasizing the key variables

so as to improve the focus of the current system Enhance the analysis of those key variables to improve the effectiveness of supervision Review the extraction and analysis of actuarial bases and increase efforts to store time series

of actual investment performance, rates of salary increase, and so forth to permit the validation of actuarial assumptions

Focus analytic efforts on plans with solvency deficits and unfunded liabilities

Actuarial support Improving the capacity of actuaries and creating demand for high-quality supervision are essential to improving governance of pension funds and therefore to developing the industry. The following recommendations are intended to emphasize the importance of strengthening actulial capacity. Adopt high standards for actuaries. Adopting higher educational requirements, a credible examination and monitoring process, entry and certification qualifications, a code of professional conduct, standards of practice, a formal and transparent disciplinary process, and adequate resources to support members would bring many benefits. Some of the benefits would be almost immediate (code of conduct, disciplinary process); others would emerge gradually (level of education, standards). There would be more opportunity for cross-fertilization, as experience of the recent emergence of a vibrant actuarial association in countries such as India has demonstrated. In particular, PAI needs to undertake the following: (a) upgrade its syllabus, educational standards, and disciplinary process to meet international requirements and be able to negotiate mutual recognition agreements, (b) adopt and implement an action plan for drafting and implementing standards covering various practice areas, (c) adopt and enforce a continuing professional development program meeting minimum standards, and (d) coordinate its exams with academic exams and internationally recognized exams and promote partnerships with actuarial schools in other countries to achieve dual recognition of degrees. In December 2005, PAI moved in a positive direction by qualifying for full membership in the International Actuarial Association, which will allow it to negotiate mutual recognition agreements.66 Open the actuarial profession to certified actuaries from other countries. Given the need to increase the number and quality of actuaries in Indonesia, permitting international professionals to practice in Indonesia can be helpful to fulfill some of the capacity shortfall, incentivize PAI to upgrade its standards and widen its membership, and achieve skills and knowledge transfer. To accomplish this, the Ministry of Finance could release rules stipulating that fully qualified actuaries of an association that is a full member of the International Association of Actuaries can practice in Indonesia and, subject to applicable requirements, be recognized by the Ministry of Finance for statutory purposes. To leverage the incentive, it could further stipulate that the Ministry of Finance may administer its own requirements but also will recognize actuaries who have been accepted by PAI under mutual recognition agreements. Current members will be exposed to peer pressure on issues of discipline, standards, education, and performance and will enhance the potential of Indonesia-based entrepreneurs to penetrate regional markets. On an ongoing basis, the government could review the decision based on state of development of the domestic actuarial profession. 66 See http://www.actuaries.org/LIBRARY/Newsletters/Dec2005_EN.htm.

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Develop the association of pension funds. The Association of Pension Funds in Indonesia is yet to develop into a true self-regulatory organization that is capable of providing certification and education to its members and enforcing discipline and compliance among members. Foster demand for better supervision. In parallel, the Ministry of Finance should support the demand for excellence by strengthening the implementation of its regulatory and supervisory standards for financial institutions in line with best practices. This is essential for a risk-based approach. It should also consider creating an Office of the Actuary and promoting international partnerships with other actuarial schools with the objective of achieving dual recognition of actuarial degrees. In turn, users of actuarial services need to demand higher-quality services by setting minimum standards of performance for actuarial reports.


REFERENCES Acuña R. Rodrigo & Iglesias P. Augusto 2001 “Chile’s Pension Reform After 20 Years” the World Bank Social Protection Discussion Paper Series No. 0129, The World Bank. Bureau of Insurance. 2004. 2004 Annual Report. Jakarta: Bapepam & LK Bureau of Pension Funds. 2003. 2003 Annual Report. Jakarta: Bapepam & LK Carmichael, Jeffrey, and Robert J. Palacios. 2004. “A Framework for Public Pension Fund Management.” In Public Pension Fund Management, ed. Alberto R. Musalem and Robert J. Palacios. Washington, DC: World Bank. Cole, David C., and F. Betty Slade. 1996. “Building a Modern Financial System: The Indonesian Experience” Cambridge, UK: Cambridge University Press. Holzmann, Robert, Richard Hinz, and Bank staff. 2005. “Old-Age Income Support in the 21st Century: An International Perspective on Pension Systems and Reform” Washington, DC: World Bank. International Labor Office. 2003 “Social Security and Coverage for all: restructuring the social security scheme in Indonesia; Issues and Options” Jakarta ILO, Indonesia Jamsostek, 2003. 2003 Annual Report. Jakarta: PT Jamsostek -------------- 2004. 2004 Annual Report. Jakarta: PT Jamsostek LPEFE, Universitas Pajajaran. 2004. “Indonesia’s Employment Protection Legislation: Swimming against the Tide?” Universitas Pajajaran, Bandung, November. Martineau, Jean-Noel, and Yves Guerard. 2005. “Implementing an Indonesian National Social Security System, Phase I Report.” May. Palacios, Robert, and Montserrat Pallares-Miralles. 2000. “International Patterns of Pension Provision” Social Protection Discussion Paper 0009, Washington, DC: World Bank, April. Wilshire Consulting. 2005. “Permissible Equity Markets Investment Analysis.” April. World Bank. 2004. “Indonesia: Averting an Infrastructure Crisis; A Framework for Policy and Action.” Working Paper 29887, Indonesia Infrastructure Department, East Asia and Pacific Region, World Bank, Washington, DC. World Bank. 1994. Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth. Washington, DC: Oxford University Press. World Bank and International Monetary Fund. 2005. Doing Business Database. Washington, DC www.iopsweb.org/ www.actuaries.org/LIBRARY/Newsletters/Dec2005_EN.htm.

CHAPTER 6 INDONESIA’S INSURANCE SECTOR

Insurance transfers the risk of a potential loss from one entity to another in exchange for a premium and duty of care. Insurance is essentially a form of risk management used to hedge against the risk of financial loss, such as property and life. For instance, entrepreneurs and households use insurance products to minimize the risks of loss from a variety of causes outside their control, such as death or accidents. In developing economies, where the various risks are more pronounced, the benefits of insurance are even more important. Equally, the increased frequency of natural catastrophes over the last decade has raised the need for developing countries to consider public interventions to support the development of risk-sharing catastrophic insurance products. To put the importance of the global insurance industry in perspective, International Financial Services London (IFSL 2005) estimates that, at the end of 2004, insurers held US$ 14.5 trillion of funds under management, about four-fifths of which were from life insurance and the remainder mostly from health, property, and casualty insurance, while the premiums reached US$ 3.3 trillion. Advanced economies account for the bulk of global insurance. With premium income of US$ 1.217 trillion in 2004, North America was the most important region, followed by the European Union (US$1.109 trillion) and Japan (US$ 492 billion). The top four countries accounted for nearly two-thirds of premiums in 2004. The United States and Japan alone accounted for half of world insurance, much higher than their 7 percent share of the global population. In contrast, emerging markets account for more than 85 percent of the world’s population but generate only 10 percent of premiums. But China’s life insurance and savings business demonstrates the potential for other developing countries. Over the past decade, it has increased by about 30 percent each year, making China the world’s fastest-growing major market for life insurance. Rapid growth is expected through 2008, when life insurance will likely generate US$100 billion in premiums, surpassing France and Germany. The advantages of developed insurance markets are numerous. There is ample economic theory and evidence documenting that the ability to share risk efficiently is essential to welfare and growth. Second, developed insurance markets reduce the need for government intervention via explicit and implicit government guarantees and the potential call on fiscal resources in the event


of catastrophes. Finally, the assets under management in the life insurance industry are indicative of the potential of the industry to accumulate assets. Because the liabilities of life insurance companies are of long duration, prudent management of assets and liabilities mandates long-term investment. Insurance companies can have a considerable impact on development of the domestic fixed-income as well as equity markets. Due to the importance of the life insurance industry in capital formation, and the focus of this report on long-term domestic resource mobilization, the majority of this chapter focuses on the life insurance industry. As documented in the chapter, Indonesia’s life insurance industry currently produces business that has little savings element and, hence, mobilizes few genuinely long-term resources. As is typical in most developing countries, the evolution of the insurance business in Indonesia has focused on building the industry. Historically, capital requirements for companies were lax and licensing requirements were loose. The industry was sheltered from international competition, and there was significant state involvement in traditional insurance markets. This has resulted in a larger number of industry participants, but the relative aggregate size of the industry is small in relation to other countries in the region. The quality and quantity of human resources and training facilities are limited. In this context, the Indonesian authorities should consider promoting the development of an enabling environment for the private sector insurance companies. The authorities should be equally concerned with ensuring the efficiency of public providers and a level playing field between public and private institutions. The authorities should seek to strengthen regulation and supervision, structure appropriate tax treatment, and improve corporate governance.

STRUCTURE The Indonesian insurance industry is small but highly fragmented. As of December 2004,67 there were 162 insurance companies in Indonesia, comprising 57 life insurers, 101 non-life insurers, and four reinsurance firms (see table 6.1).68 Life, non-life, and reinsurance assets amounted to Rp 44.9 trillion, Rp 19.2 trillion, and Rp 953 billion, respectively, totaling Rp 65 trillion (US$7.3 billion, or 2.9 percent of GDP). See box 6.1 for a brief review of insurance products. Table 6.1: Ownership Structure of the Insurance Industry, 1985 and 2005

Life companies Non-life companies Reinsurance Indicator 1985 2005 1985 2005 1985 2005 Number of companies 21 51 67 97 4 4 Percent of total assets State 41 7 61a 14 99 — Joint venture — 49 14 16 — — Private 59b 44b 25 71 — 100 Top five companies 93 53 64 43 100 100 Assets (Rp billion) 409 53,940 512 21,206 263 978 Source: Cole and Slade, 1996, Bapepam & LK — Not available a. Includes a quasi-state firm b. Includes mutual insurance firm

67 2004 is the latest year for which insurance data are currently available. 68 In addition, there are five “social insurance” firms: state-run institutions offering pension or insurance services to civil servants, the security forces, and formal private sector employees.

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Box 6.1: Typical Insurance Products

Life. Life insurance pays a stipulated sum to a designated beneficiary on death of the insured. Life business is essentially long term and thus has the potential to generate longer-term liabilities. Life products can include a variable mix of short-, medium-, and long-term products. Life insurance generates more asset accumulation than non-life insurance. Non-life. Non-life insurance protects individuals and businesses from specific losses other than death. Non-life products are short term in nature, and so liabilities in the non-life sector are relatively short term. Reinsurance. Reinsurance is a mechanism for spreading the risks that the insurance industry assumes from policyholders. Through reinsurance, the industry’s losses are absorbed and distributed among a group of companies so that no single company is over-burdened with the responsibility of offering coverage to its policyholders. Reinsurance can handle catastrophes, unexpected liabilities, and a series of large losses that might be too great for an individual insurer to absorb. Without it, most insurers would be able to cover only the safest of ventures, leaving many risky but worthwhile ventures without coverage. In essence, reinsurance enlarges the underwriting capacity of the primary carrier (McIsaac and Babbel 1995). Annuities. An annuity usually pays a fixed amount of benefits every year for the life of the person or for a term of years. A simple life annuity provides benefits until a person dies, even if the death is premature. A joint and survivorship annuity pays benefits to the annuitants during the period of their joint lives, with the annuity to continue to the survivor when the first annuitant dies. Social insurance. Social insurance typically provides with a financial security net either during working life or in retirement.Typical components include a basic level of income, health, and disability benefits. In addition, companies that comply with Shariah principles offer takaful insurance products (see box 6.2 for a description).69 Shariah insurance has grown in Malaysia as well. A recent publication of Bank Central Malaysia summarizes the 20-year experience of the takaful industry in Malaysia,70 where four takaful operators have managed to occupy a market share of 5.1 percent of the insurance industry. Assets reached more than RM 5 billion in 2004, of which RM 4.3 billion was in life insurance. Insurance has a long history in Indonesia. Asuransi Jiwasraya was founded by the Dutch in 1859, and Asuransi Jiwa Bersama Bumiputera was created as a mutual insurer in 1912 by Indonesian teachers. At independence in 1945, the vast majority of the Indonesian insurance market was controlled by foreign-owned insurance companies.71 However, following a number of closures and nationalizations, by 1985 the market was dominated by state or quasi-state companies, which held 41 percent of life insurance assets, 61 percent of the non-life sector, and 100 percent of the social insurance sector; mutual insurer Bumiputera held 38 percent of the life market. After absorbing the full impact of the economic crisis, the insurance industry has been growing since 1999 (see table 6.2). Over the period 2000–5, assets and premiums in the life sector almost tripled. In the non-life sector, assets increased by around 75 percent, while premiums increased by around 90 percent. There was little variation in the number of companies in the industry over the period, with the number of direct commercial insurers, excluding social insurers, declining from 169 in 2000 to 152 in 2005. 69 There are three categories of takaful models, which all work on the basis of cooperative risk sharing among participants: nonprofit, al mudharaba, and al wakala. In Indonesia, the preferred model is al mudharaba, which facilitates the injection of capital. 70 “Malaysian Takaful Industry, 1984–2004” (http://www.bnm.gov.my/). 71 Cole and Slade (1996).


Box 6.2: Shariah Insurance

Islamic financial products—banking and insurance—are aimed at investors who want to comply with the Islamic laws (Shariah). Islamic finance is developing at a remarkable pace. Since its inception three decades ago, the number of Islamic financial institutions worldwide has risen from one in 1975 to more than 300 today in more than 75 countries. They are concentrated in the Middle East and Southeast Asia (with Bahrain and Malaysia the biggest hubs). Total assets worldwide are estimated to exceed $250 billion and are growing at an estimated 15 percent a year. In countries where Islamic financial products are offered, their coverage and extent vary significantly, including from situations where the sector is entirely Islamic (Iran and Sudan) to others where conventional and Islamic systems coexist (Indonesia, Malaysia, Pakistan, and the United Arab Emirates). Some countries have opted for a clear separation between these types of institutions, while others have allowed conventional financial institutions to set up Islamic windows, opening the way for some of the largest multinationals to participate. Islamic finance has prospered in Indonesia, thanks to growing demand for products that adhere to Shariah. Equally the industry is growing because of the wide range of financial institutions offering Shariah products. While gaining ground, the industry faces unique regulatory challenges. Undoubtedly, one of the biggest challenges is developing a framework for governing, supervising, and regulating Islamic financial institutions. To begin with, there is no common approach among countries where Islamic financial institutions exist. One of the two main views held by regulators in Malaysia and Republic of Yemen, for example, is that Islamic financial instituions should be subject to a supervisory and regulatory regime that is entirely different from that of conventional banks. The second main view recognizes the uniqueness of Islamic financial institutions’ activities but favors putting them under the same supervision and regulatory regime as conventional financial instituions, with slight modifications and special guidelines. Bahrain and Qatar are examples of countries that practice this latter form of supervision and regulation. Table 6.2: Growth of the Insurance Industry, 2000–5 (Rp trillion)

Indicator 2000 2001 2002 2003 2004 2005 Life insurance companies

Total assets 18.7 22.4 26.3 32.9 44.9 53.9 Total investments 14.2 17.3 20.4 26.6 36.4 45.4 Net premiums 7.0 9.1 11.2 13.7 18.3 21.6 Investment yields 2.1 1.8 1.0 2.0 3.8 3.7 Claims and benefits paid (4.2) (5.2) (5.5) (6.5) (8.7) (11.2) Increase in premium reserves (2.9) (2.5) (2.9) (4.5) (7.6) (8.3) Total costs (2.2) (3.1) (3.6) (4.1) (4.4) (2.5) Net income (0.1) 0.0 0.2 0.5 1.0 1.2 Percent of net premiums −2.1 0.5 1.5 3.4 5.5 5.6% Return on investments 14.8% 10.3% 4.7% 7.4% 10.5% 8.2% Total cost as % of benefits 53.4% 58.9% 65.4% 63.6% 50.3% 22.0%

Non-life insurance and reinsurance companies

Total assets 12.6 14.8 15.8 17.2 20.2 22.1 Total investments 8.2 9.4 10.0 11.4 13.7 14.8 Gross premiums 7.0 10.0 11.9 12.7 14.3 15.9 Premiums paid (2.9) (3.7) (4.6) (5.2) (6.0) (8.3) Net premiums 4.0 6.3 7.3 7.5 8.3 7.7 Investment yields 0.8 0.9 0.5 0.8 1.2 0.9 Claims and benefits paid (3.6) (5.8) (6.0) (5.5) (5.2) (7.6) Claims and benefits received 2.3 4.0 3.8 3.1 2.4 3.9 Net claims and benefits paid (1.3) (1.8) (2.2) (2.4) (2.8) (3.8) Total costs (1.3) (1.5) (1.7) (2.0) (2.1) (2.4) Net income 0.9 1.1 0.9 1.2 1.7 1.5 Percent of net premiums 23.3 17.0 11.9 16.0 20.2 20.0% Return on investments 10.3% 9.3% 4.7% 6.9% 8.6% 6.1% Total cost as % of benefits 36.1% 26.6% 27.9% 35.9% 39.7% 31.1% Source: Annual Reports. Bureau of Insurance, Bapepam & LK

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The insurance market is moderately concentrated. The 10 largest life insurance firms control nearly three-fourths of industry assets. The smallest 10 firms account for less than 1 percent of the market, while the smallest 42 firms combined control just 10 percent of the market. Herfindahl indexes are a measure of the concentration of an industry. The Herfindahl index (HHI) for life insurance companies is between 800 and 900, while it is between 300 and 400 for the non-life and reinsurance sectors. Markets in which the HHI is between 1,000 and 1,800 points are considered to be moderately concentrated, leading to the conclusion that the life insurance sector in Indonesia is close to being moderately concentrated, while non-life is not concentrated. Table 6.3 compares the concentration of the top five companies in Indonesia with that in other countries. Indonesia is less concentrated than its neighbors are—Thailand and the Philippines—but only marginally different from Malaysia. Table 6.3: Concentration of Top Five Insurers in Select Countries, 2003

Country Life premiums (US$million)

Population (million)

Top five insurers as a % of total

Population per top insurer

Active population per top insurer

Indonesia* 1,373 234.9 48.4 22.7 9.8 Malaysia 3,465 23.1 54.8 2.5 1.1 Philippines 702 84.4 88.0 14.9 5.9 Thailand 3,222 64.3 71.9 9.2 5.1 Australia 22,341 19.7 55.9 2.2 1.1 Canada 22,841 32.2 28.6 1.8 1.0 Japan 381,335 127.2 31.7 8.1 4.2 Source: Insurance Information Institute 2005, Swiss Re 2004b Note: Life premiums increased to US$2.2 billion in 2005, with top five insurers representing 51% of the industry. The Indonesian figures in the table are 2003 figures to compare the data across different countries in the same time-period.

Penetration Insurance penetration in Indonesia—premiums as a percent of GDP—is low, with premiums equal to 1.4 percent of GDP in 2005 (life, 0.8 percent; non-life 0.6 percent, see table 6.4). Penetration takes into account the capacity to pay, and there is a strong correlation between the level of income per capita and the portion spent on insurance. A Sigma study (Swiss Re 2004a) shows an S-curve depicting the empirical relationship between economic development represented by GDP per capita and the share of life insurance premiums in GDP. As income increases, insurance penetration is expected to rise, since insurance premiums grow proportionately faster than the economy. US$8,000 per capita has been suggested as a threshold above which penetration accelerates. Penetration varies from 9.0 percent (life, 5.1 percent) for OECD countries to about 3.4 percent (life, 2.2 percent) for the ASEAN countries. It is therefore not surprising that penetration in Indonesia, where income per capita is low, is also low.


Table 6.4: Insurance Penetration in Select Countries, 2003/5 (US$ unless otherwise indicated)

Total insurance premiums Life premiums Non-Life premiums Country

Amount (billion) % of GDP Amount (billion) % of GDP Amount (billion) % of GDP Indonesia 2005 3.8 1.4 2.2 0.8 1.6 0.6 Indonesia 2003 3.1 1.2 1.4 0.6 1.7 0.6 Malaysia 5.6 5.4 3.5 3.3 2.2 2.1 Philippines 1.2 1.5 0.7 0.9 0.5 0.6 Thailand 4.9 3.5 3.2 2.3 1.7 1.2 Australia 40.4 8.0 22.3 4.4 18.1 3.6 Canada 59.2 6.8 22.8 2.6 36.3 4.2 Japan 479.1 10.8 381.3 8.6 97.7 2.2 ASEAN 24.3 3.4 14.6 2.2 9.6 1.2 OECD 2,709.8 9.0 1,533.2 5.1 1,176.6 3.9 Source: Bapepam & LK for Indonesian data. Swiss RE, OECD for data regarding other countries Note: The comparisons are made using aggregate or regional averages, but comparisons that are more specific focus on six countries: three developing economies that can be seen as a short-term benchmark and three developed economies that illustrate the longer-term potential. The three developing economies are Malaysia, the Philippines, and Thailand. For the developed economies, Australia is a close neighbor in the region, Japan is a developed Asian economy, and Canada represents a North American economy. Indonesia is a civil code country, and Canada has a legal system that combines the civil code in Quebec with the common law in other provinces; its legislation has inspired some of Indonesia’s pension and insurance legislation.

Density While penetration is a normalized comparator taking into account the capacity to pay, density—that is, the premium per capita—is more indicative of the capacity to accumulate assets (see box 6.3). In 2005 density for life and non-life insurance combined was US$17.6 in Indonesia (life, US$10.1, non-life, US$7.5). There are wide disparities in insurance density among countries, especially in life insurance (see table 6.5). In 2003 density for life varied from over US$3,000 to US$6.4, with a ratio of 469 to 1 between the largest and the lowest figures: GDP per capita had a range from US$ 34,874 to US$970 in 2003—, with a ratio of 36 to 1. The much larger disparity in densities indicates that densities increase much faster than the rate of increase of GDP per capita (see Table 6.5). Table 6.5: Density of Life Premiums in Select Countries, 2003/5 (US$ unless otherwise indicated)

Country Life premiums Density GDP ($ billion) GDP per capita

Indonesia 2005 2.2 10.1 281 1,296 Indonesia 2003 1.4 6.4 239 970 Malaysia 3.5 140.3 105 4,251 Philippines 0.7 8.6 80 983 Thailand 3.2 52.0 143 2,306 Australia 22.3 1,128.3 506 25,556 Canada 22.8 722.8 887 28,070 Japan 381.3 3,002.6 4,429 34,874 ASEAN 14.6 31.3 666 1,423 OECD 1,533.2 1,331.3 29,957 26,002 Source: Bapepam & LK for Indonesian data. Swiss RE, OECD for data regarding other countries

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Box 6.3. Explaining Low Penetration and Density of Insurance in Indonesia

Insurance density in Indonesia is lower than other South East Asian countries such as the Philippines, Thailand and Malaysia. Indonesia is slightly below the S-curve (insurance penetration as a function GDP per capita), while the Philippines is very close and India, China, Malaysia, Republic of Korea, Singapore, Taiwan (China), and Thailand are all above the S-curve. The low penetration and low density in Indonesia cannot be explained by a generous social security system that would provide the average family with a financial security net either during the working life or the retirement years. On the contrary, outside government employees, Indonesia has a very low level of social security coverage. Some analysts suggest that cultural and religious differences, including close family ties and religion-based reservations about insurance, may explain some of the variation. For instance, life insurance is generally underdeveloped in many Middle East countries with large Islamic populations, that are significantly below the S-curve, despite higher income per capita. Three countries significantly below the S-curve are Turkey, the United Arab Emirates, and Kuwait. However, the life insurance is growing in other predominantly Muslim countries such as Malaysia. Therefore, one cannot attribute the lack of development of the insurance sector to cultural and religious factors alone. A recent IMF research paper (Erbaş and Sayers 2005) correlates the level of non-life insurance penetration in 70 countries with income level, financial sector depth, country risk, a measure of cost of insurance, and the World Bank governance indexes. Low- and high-income countries and the Middle East and North African region are also examined. The paper finds that the institutional quality-transparency-uncertainty nexus is the dominant determinant of insurability across countries, surpassing the explanatory power of income level. Insurability is lower when governance is weaker. Institutional quality as it reflects on the level of uncertainty may be the deeper determinant of insurability. The implications for Indonesia are straightforward: a stronger institutional and regulatory setting, improved transparency in the insurance sector, and improved confidence regarding the value of long-term financial promises will support the growth of the industry. Finally, a common observation is that there has been little institutional or state education regarding the benefits of insurance and that the public is generally uneducated about the use of insurance products, especially life products, which are less tangible than motor vehicle or fire insurance. Equally, the fiscal treatment offers no great incentives; on the contrary, mutual funds offer much better tax advantages, being practically tax-exempt, which explains why the growth of mutual fund assets has overtaken the growth of both insurance and pension assets.

Accumulated assets Statistics about the amount of accumulated assets give a different perspective on the relative size of the industry in different countries (see table 6.6) Indonesia’s insurance sector has not yet achieved significant asset accumulation. Besides low penetration and density levels, Indonesia also suffers from a high level of expenses: assets are accumulated by the surplus of premium over expenses. Indonesia’s life insurance industry produces business that has little savings element, and hence, the industry currently mobilizes few genuinely long-term resources. By its nature, the life insurance industry should generate long-term savings. In Indonesia, businesses with a high long-


term savings content (endowments, whole life, annuities, and unit-linked products (non-traditional)) account for 45 percent of the total insurance business, as measured by premiums (see table 6.7). However, when measured by sum insured, the proportion of these products falls to 26 percent (see table 6.7). Table 6.6: Accumulated Assets of Insurance Industry in Select Countries, 2003/5 (US$ billion unless otherwise indicated)

Non-life insurance Life insurance Total life and non-life Country GDP Amount % of GDP Amount % of GDP Amount % of GDP

Indonesia 2005 281 2.2 0.8 5.5 2.0 7.7 2.8 Indonesia 2003 239 2.0 0.8 3.8 1.6 5.8 2.4 Malaysia 105 4.4 4.2 15.8 15.1 20.2 19.2 Philippines 80 1.4 1.8 — — — — Canada 887 63.0 7.1 224.9 25.4 288.0 32.5 Japan 4,429 284.0 6.4 1,631.1 36.8 1,915.1 43.2 Source: Bapepam & LK for Indonesian data. Swiss RE, OECD for data regarding other countries — Not available Table 6.7: Life Insurance Policyholders, Sum Insured, and Premiums, by Type of Product, 2005 (Rp trillion unless otherwise noted)

Number of insured (millions) Sum insured Premiums Plan

2005 Total % 2005 Total % 2005 Total % Endowments a 5.3 14.0 88.0 10.5 9.9 24.8 Nontraditional a 0.7 1.8 61.5 7.3 6.1 15.2 Whole life a 0.5 1.4 65.3 7.8 1.7 4.3 Annuity a 0.3 0.8 3.3 0.4 0.2 0.6 Pension annuity a 0.0 0.1 0.3 0.0 0.1 0.3 Total saving producing product

6.9 18.0 218.6 25.9 18.0 45.2

Term insurance 17.4 45.5 202.9 24.1 1.8 4.5 Health 2.7 7.0 58.6 7.0 1.7 4.3 Personal accident 4.3 11.4 143.8 17.1 0.3 0.8 Total 31.3 100.0 623.8 100.0 21.8 100.0 Source: Annual Report, Bureau of Insurance, Bapepam & LK a. Products producing savings content.

Asset allocation Insurance assets, especially life insurance, are long-term in nature. In Indonesia, 26 percent of these assets are invested in short-term bank deposits, creating a maturity mismatch. (See Table 6.8) Table 6.8: Asset Allocation in Insurance Companies, 2005 (Rp million unless otherwise noted)

Life insurance Non-life insurance Total Type of investment Amount Total % Amount Total % Amount Total % Deposits 9.2 20.3 6.6 44.4 15.8 26.3 Corporate bonds 6.9 15.2 2.4 16.2 9.3 15.4 Government bonds 13.7 30.2 1.0 6.8 14.7 24.5 Shares 4.0 8.9 0.9 5.9 4.9 8.2 Real estate 1.2 2.6 0.2 1.4 1.4 2.3 Mutual funds 6.6 14.5 0.7 4.5 7.3 12.1 Other 3.8 8.3 3.1 20.8 6.8 11.4 Total invested assets 45.4 100.0 14.8 100.0 60.2 100.0 Source: Bapepam & LK

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Labor force structure: Compensation and capacity to pay The structure of the labor force and compensation is a key determinant of the potential market for insurance. Cross-country comparisons must take into account differences in the activity rates and the structure of compensation. Indonesia has a small formal sector (see table 6.9).72 The participation rate of the population age 15+ in the labor force is about 72 percent, but wage earners in the formal sector constitute about 33 percent of the workforce or 21 percent of the population age 15+. While the table does not show a dramatic variation in participation rates between the ASEAN countries, Indonesia stands apart, with Thailand, as having a relatively small or urban population. Table 6.9: Structure of the Labor Force in Select Countries, Various Years, 2000–3

Country and year Total population

(millions)

Population age 15+

(millions)

Population age 15+ as a percent

of total

Active population (millions)

Activity rate Urban

population as a percent of total

Indonesia, 2003 214.5 153.7 72 100.8 66 43 Malaysia, 2000 23.3 15.6 67 9.6 62 59 Philippines, 2001 78.3 49.4 63 33.4 68 60 Thailand, 2003 62.5 48.4 77 35.3 73 20 Australia, 2003 19.9 15.9 80 10.1 63 91 Canada, 2002 31.3 24.9 80 16.7 67 79 Japan, 2003 127.6 109.6 86 66.7 61 79 Source: Swiss Re 2004b Note: Indonesia’s active population of 100.8 million is composed of 9.1 million unemployed, 32.6 million formally employed, and 59 million informally employed. The wide disparity between urban and rural wages indicates that the market for contractual savings in Indonesia is likely to be predominantly urban. In 2003, urban wages were 118 percent of the average wage, and rural wages were 73 percent, (i.e. urban wages were 162 percent of rural wages on average). On the basis of Rp 8,578 per U.S. dollar in 2003, this converts into monthly wages of US$93.79 (urban), US$58.09 (rural), and US$79.85 (average). Lower-paid rural workers are unlikely to generate significant contractual savings. Inequalities in the distribution of income may also explain the lack of appetite for life insurance as a savings product or as a form of protection. If we look at inequalities in the distribution of income in different countries, Indonesia has a pattern closer to that of developed economies than to its regional counterparts. If we apply this distribution to the average income per country, Indonesia’s top quintile has the lowest average income in the region; and not surprising by it is significantly lower than that of developed economies, a gap reflected in the insurance density statistics. As a whole, developing economies show a greater concentration of income in the top quintile and, while Indonesia shows the lowest ratio, it is not much different from that of Thailand and Malaysia.

72 Although the definition of the formal and informal sector, or the distinction between wage earners and non-wage earners, varies by entity, such as the Bureau of Statistics or the Ministry of Manpower and Transmigration, the variation for our purposes is not significant.


Legal framework The basic legal framework of the insurance sector is the Insurance Law of 1992,73 modified by significant changes in 1999/2000 with the introduction of risk-based capital requirements.74 The law covers the licensing and supervision of insurance companies, insurance brokerage companies acting on behalf of the insured, and insurance agents acting as a marketer on behalf of insurance companies. It also regulates the type of insurance business that can be engaged in by a company, such as life, non-life, and reinsurance, and provides for regulation of the corporate form of a registered entity and its solvency margin, technical reserves, and investment parameters. It governs business conduct, premiums, terms and conditions, and claims settlement. The details of these provisions are, for the most part, left to the insurance regulator, which elaborates the rules. Until 2005 there was no provision for the sale of linked products—that is, products where the payout of the contract is linked to the performance of a specified group of securities, known as universal life or variable annuities in the United States. Due to political considerations, the social insurers—Taspen, Asabri, and Jamsostek—which are the largest insurance programs in Indonesia, remained outside the scope of the prudential framework set by the 1992 Insurance Law. Each of these institutions operates under its own separate legal framework (see chapter 5). This seriously curtails the jurisdiction of the Ministry of Finance—the regulator of the insurance sector—over the social insurers.75 The 1992 law created difficulties and weaknesses for the sector. Prudential regulations were enacted, but at the same time, there was a strong reluctance to imply state responsibility for insolvent companies. The regulator’s flexibility in controlling substantive elements of the sector was curtailed by subjecting these to government legislation instead of ministerial decrees. There were other key political compromises as well. (a) Instead of “grandfathering” the only existing mutual company as an exception, the industry was kept open to new mutual entrants subject to a future law for mutual insurance firms, and such a law does not yet exist. In effect, therefore, the largest life insurance firm in the country is outside the legal framework. (b) The elucidation, which in Indonesia has force of law, weakened the right of individuals to choose their provider by redefining “freedom” as the freedom to elect an Indonesian company, meaning that coercive sales practices continue to plague the industry. (c) As discussed, the “social insurers” are exempt from the law. (d) Insurance companies are restricted to managing financial institution pension funds, a form of collective defined-contribution individual account, thus excluding employer pension funds, which are the key market through which to enroll the workforce on a group basis. A major step toward reform of the sector was taken in 1999, when the minimum capital requirements for insurance companies were modified and risk-based capital requirements were introduced. Regulation no. 63 of 1999 prescribed a quantum jump in the minimum paid-up capital requirements, which increased from as low as Rp 2 billion to as high as Rp 100 billion. However, this higher requirement only applies to new companies—existing companies are grandfathered

73 Insurance Law no. 2 of 1992 and Regulation no. 73 of 1992 74 There were earlier attempts to stimulate the development of the insurance sector by removing the monopoly of the government and encouraging private sector investment in the industry. For example, Presidential Decree no. 65 and Minister of Finance Decree no. 578, both in 1969, were aimed at opening the market and protecting the freedom of choice for the insured. They were only partly successful, competition was limited, and the continued slow development of the insurance and pension business, the lack of clarity, and the gaps in existing legislation motivated the Ministry of Finance to reform the sector by developing new legislation. 75 This status prevails, although Law no. 40, promulgated in October 2004, aims to rectify this to some extent.

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under the old capital requirements—and even the revised capital requirements are relatively mild.76 More significant was the adoption of a ministerial decree on financial soundness. This decree updated a number of provisions relating to assets, liabilities, and investments but, which is more important, introduced phased-in risk-based capital solvency requirements for both life and non-life insurers, which reached their final level in 2004. The objective was to have insurers that are more reliable even if it meant fewer of them. A broad estimate was that only a third to half of the existing insurers would be able to meet the new requirements. Risk-based capital is still being implemented, and several companies have already been identified as too weak to meet these requirements. However, industry consolidation is progressing only slowly due to weak enforcement. Several ministerial decrees were issued in 2003, followed in 2004 by a series of decisions by the Bureau of Insurance introducing incremental improvements. Decree no. 422 addresses business conduct, but it also requires companies to file a report projecting their ability to meet their obligations over at least the next five years. Decree no. 424 of November 2004 clarifies the requirements for insurance under Shariah principles, updates the investment limits, allows for 20 percent foreign investments, and introduces the basis for further stipulations regarding insurance programs linked to investments which were issued as KEP 2475/LK in 2004. But more important, it issues modified guidelines for computing the minimum solvency margin. Finally, insurance companies, like other financial institutions, have to comply with the new requirements enacted in May 2003, regarding money laundering and terrorist activities under the “know your client” principle.

Regulatory and supervisory framework Bapepam & LK is the regulator and supervisor of the insurance sector. Industry and professional organizations, including the Indonesian Insurance Council (DAI), the General Insurers Association, Association of Indonesian Life Insurance Companies (AAJI) and PAI, also play a role in the support of the industry. Under the law of 1992, regulation aimed to protect the industry in general and the domestic industry in particular. It carefully avoided assuming responsibility for failing companies and policyholder protection. In the tradeoff between developing the industry and protecting Indonesian consumers, growth of the industry was the priority. Since 2000, a shift in paradigm has been initiated for management and regulation of the industry. The emphasis used to be first on encouraging the survival of companies, second on enforcing the law, and only third on protecting policyholders. Now the focus is shifting first on protecting policyholders, second on enforcing the law, and only third on encouraging the (selective) survival of companies. The new industry framework is built around three pillars: consumer protection, distribution requirements, and minimum standards. Consumer protection supports policyholder rights and protects against unfair or inconsistent treatment. This covers misselling, misrepresentation, and—in the event of mergers, acquisitions, and company restructuring—assumption reinsurance. Distribution requirements mean that agents must meet minimum industry qualifications before being authorized to sell insurance, and brokers must meet minimum brokerage association qualifications, including professional indemnity and fidelity bonding, (licensing eventually could be replaced by Indonesian professional qualifications and self-regulation). Minimum standards mean that participants must meet the minimum

76 For example, the minimum capital is Rp 5 trillion for banks.


requirements of solvency standards (risk-based management), product standards, investment standards, and business standards. In 2000 Indonesia became the first country in Asia to implement modern risk-based capital requirements for both life and non-life insurers.77 Rather than compromise the ultimate target for solvency margins, the Bureau opted instead for forbearance permitting gradual implementation that would allow companies to adjust and mitigate the impact of uncertainty in the initial parameters. The decree required companies to meet only 5 percent of the risk-based capital minimum solvency margin by March 31, 2000, and only 15 percent by year-end 2000. These guidelines constituted the biggest change in the prudential framework since adoption of the law in 1992. Bureau of Insurance has been moving toward risk-based supervision; however, more rapid progress is necessary. For example, the classification of each company under an expanded set of risk-based categories has been implemented as follows: red means that policyholder’s values are at risk; orange means that policyholder’s protection is threatened; yellow means that a company’s financial strength is weakening; and green means that no action is needed. Improved escalation procedures are in place in line with the stages recommended: letter of direction, warning letter, notification to the directors and commissioners, business activity limitation (PKU), business revocation, and bankruptcy. Although it was recognized that further improvements in the reserving and reporting practices were needed, including dynamic solvency or stress testing, the guidelines were implemented on the basis of current reporting practices for assets and liabilities as a first phase of the reform. The second phase was implemented in the form of a requirement for a five-year minimum projection of the financial condition of the company under various scenarios. However, there has been no sustained effort to improve the quality and reliability of regulatory reports, the third phase of the original planning. Since 2004, the RBC requirements have reached the ultimate level of 120 percent. This has improved the protection of policyholders, and the Bureau has indeed become more selective regarding the survival of companies. The higher uniform minimum capital requirements for all insurers introduced by Regulation no. 63 of 1999 were a major step in the right direction, but they applied only to new companies, and large gaps remain. Hence, consolidation of the industry is still incomplete.

PERFORMANCE AND SUSTAINABILITY The latest risk-based capital results are as of December 31, 2004, the date at which the full 120 percent risk-based capital was fully phased in. These results are preliminary. The required solvency margin is the sum of the margins computed separately for three types of insurance business, including reinsurance: conventional insurance programs, conventional insurance programs linked to investment, and insurance based on Shariah principles. The results of the calculations are submitted by companies in the form of a worksheet showing the amount calculated on each of the six components in table 6.10. The formula for the calculations does not differ significantly by the type of business, except for the obvious adjustment to component 5.

77 The search for a consensus was arduous, as only scarce local data were available to determine the initial parameters, which as best estimates would incorporate some margin for error. Recognizing the potential difficulties and the need for flexibility, the new risk-based capital solvency requirements were not incorporated in a ministerial decree, but the power to stipulate technical guidelines for computing the minimum solvency margin was delegated to the director general of financial institutions.

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Table 6.10: Components and Risk Weights

Components Risk weights (percent) 1. Asset default risk 34.32 2. Cash flow mismatch 40.29 3. Foreign currency mismatch 6.33 4. Discrepancy of actual and expected claims 13.81 5. Insufficient premium due to investment experience 5.18 6. Inability of the reinsurer to meet its claim obligations 0.07 Source: Bapepam & LK The following table (Table 6.11) summarizes individual ratios for 44 companies with positive ratios, but there is no detail for eight companies that had not yet filed a report. The required margins represent, on average, 8.6 percent of liabilities and are distributed as follows: Table 6.11: Risk-Based Capital of Insurance Companies – Required Margin

Level of liabilities No. of Companies 0–7 percent 11 7–10 percent 13 10–15 percent 10 15+ percent 10 Source: Bapepam & LK The aggregate average margins are distorted by significant negative margins for just a few companies and very large margins for companies that have very little business but very high solvency margins was eliminated. To enhance the significance of the analysis, the average of those companies that have a negative solvency margin and split the remaining companies by amount of liabilities classified as those below Rp 100 million, those between Rp 100 million and Rp 1 billion, and those above Rp 1 billion. This analysis covers 86.8 percent of liabilities, and the results are presented in table 6.12, compared with the requirement of a 120 percent risk-based capital ratio at that date. Table 6.12: Risk-Based Capital, by Level of Company Liabilities, as of December 31, 2004 (Rp trillion)

Indicator Below Rp 100 million Rp 100 million to Rp 1 billion

More than Rp 1 billion Total

Invested assets 0.5 7.3 21.4 29.2 Total assets 0.6 7.9 22.4 30.9 Total liabilities 0.4 6.2 19.4 26.0 Solvency margin 0.2 1.8 3.0 4.9 Risk-based capital margin 0.1 0.7 1.5 2.2 Risk-based capital ratio (%) 314 265 196 220 Source: Bapepam & LK a. Excludes missing reports and companies with negative risk-based capital ratios. Excluding non-invested assets from the calculation of the solvency margin would reduce the overall risk-based capital ratio to 206 percent, still well above the minimum 120 percent required. Individual results show that the high average ratios result from the distortion caused by a limited number of very high ratios, indicating poor asset management. Results for individual companies are more variable, although on the basis of total assets, no company with a positive ratio is below 120 percent:


Table 6.13: Risk-Based Capital of Insurance Companies

Risk-based capital ratio Number of companies 0–120 percent 0 121–140 percent 11 141–200 percent 13 201–300 percent 7 301–600 percent 8 601+ percent 5 Source: Bapepam & LK The reported risk-based capital should be viewed with caution for several reasons. The risk-based capital reports are generated by the companies based on a template supplied by the Bureau, which tests the reports for consistency. It would be desirable to have independent on-site examinations to validate in-depth the veracity and accuracy of the basic input from the companies. A second source of concern is that large systems are required for capturing data and managing information. It is not clear whether the industry has adequate management systems. Third, assets are often reported at book values and not marked to market. Finally, some of the missing reports may be for companies with a ratio below 120 percent that are still struggling with the reporting. Their inclusion would have an adverse effect on industry soundness. Finally, the formula and factors imbedded in the calculation formulas as established in 1999 were derived mostly from the Canadian model, with limited adjustments, as no domestic experience was available.

Premiums, contributions, and assets More than half of new life insurance sales—measured by premiums—replaces business lost during the year (see table 6.14 and 6.15). Policy maturities and deaths are only a small part of terminations: lapses in payment account for more than 70 percent and surrenders for more than 20 percent, totaling close to 95 percent of all terminations.78 By contrast, in Malaysia, surrenders and lapses were 10 and 7 percent, respectively, in 2003. As new business entails higher upfront commissions and administrative expenses than renewal business, this reduces the proportion of income that accumulates and is invested. The industry apparently suffers from a lack of quality control in the sales process. Better-qualified agents select better clients, sell them products they really need, leading to a viable clientele and therefore higher profitability. Table 6.14: Ratio of New to Renewal Business, by Type of Company, 2005

Sum insured (Rp trillion) Type of company New business Terminations Termination as % of New Business State-owned 3.6 1.8 50.0 Private 137.2 97.5 71.1 Joint venture 98.9 31.8 32.2 Total 49.3 26.6 54.7 Source: Bapepam & LK

78 These figures are for sums insured; we do not have Indonesian statistics for termination of premiums by cause, but surrenders and forfeitures are 30 and 40 percent, respectively, showing that higher-premium policies are more prone to termination.

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Table 6.15: Growth of New and Renewal Premiums, 2001–2005

Indicator 2001 2002 2003 2004 2005 New life premiums (US$ billion) 0.42 0.60 0.77 1.1 1.0 Total life premiums (US$ billion) 0.88 1.28 1.62 2.1 2.2 Life assets (US$ billion) 2.17 2.94 3.84 5.0 5.6 Ratio of assets to annual premiums 2.5 2.3 2.4 2.4 2.5 Renewal premiums as a percent of total premiums

51.9 53.0 52.4 52.4 45.6

Ratio of assets to renewal premiums 4.8 4.3 4.5 4.6 5.4 Source: Bapepam & LK An important factor in the accumulation of assets is the duration of business. Other things being equal, a longer duration means that, for a given amount of new premiums, total annual premiums will be higher and assets will accumulate faster. Also, since issue expenses, including first-year commissions, are higher on new than on renewal business, longer duration means that a greater share of the premiums will come from renewals. Even if new premiums benefit from healthy growth, terminations for various causes slow down the growth of renewal premiums and the accumulation of assets. Although the insurance industry could use more capital, a larger and more professional agency force, and fewer companies, the existing capacity of the industry could easily meet much higher demand. Contributions, defined as the sum of premiums and returns on investment minus claims and expenses, show surprising variations (see table 6.16). While the claims and the returns on assets are country specific, expenses can be benchmarked internationally. Despite improvement in 2004, the expenses are higher in Indonesia than for example, in Malaysia. Most of these expenses are composed of administrative expenses. This suggests that the industry is not managed efficiently. Table 6.16: Contribution of Premiums and Returns to Growth of Assets, 1999–2004 (percent of total premiums)

2004 1999 2000 2001 2002 2003

Indonesia Malaysia Indicator

Claims 64.0 61.4 59.5 50.3 48.7 48.9 35.7 Acquisition expenses 15.8 16.2 18.5 18.3 17.0 14.4 15.7 Other expenses 20.5 16.3 16.6 14.6 14.0 10.2 6.7

Contributions Premiums 5.1 11.0 9.8 22.4 32.2 29.9 41.9 Returns 17.1 33.5 22.4 10.3 15.9 23.4 30.6 Total 22.2 44.5 32.2 32.7 48.1 53.3 72.5

Source: Bapepam & LK, Association in Malaysia The other major difference is in the contribution of returns, with Malaysia’s being much higher than the Indonesian contribution. The difference is due to the fact that assets in relation to premiums are higher in Malaysia than in Indonesia, which reflects the longer duration of policies.

LEGAL ISSUES The principal legal issues regarding insurance pertain to the pricing of insurance-linked products and the relation of investment managers with other institutions.


Pricing of unit-linked products Unit-linked products, known as universal life or variable annuities in the United States, are sold on the basis of their net asset value, but the valuation rules of the Bureau of Insurance are less specific than those of Bapepam & LK for mutual funds and do not specify a methodology for valuing assets in the portfolio or calculating the net asset value (Decision no. Kep—2475/LK/2004 of the Bapepam & LK Paragraph 4.f). As a result, the pricing of insurance-linked products does not even have the provisions of Rule IV.C.2 to provide guidance in the determination of value, and thus the net asset value of linked products is even less well regulated than that of mutual funds. (See chapter 4 for valuation issues related to mutual funds).

Relation of investment managers with other institutions Management of the investment of linked insurance policies can be carried out by departments within the insurance company. Although the individuals involved generally receive some training, the departments do not need to meet the requirements of an investment manager registered with Bapepam & LK. Each institution determines the qualifications for the head of the department,79 but the department, as a whole does not need to meet Bapepam & LK requirements. Moreover, there are no rules for insurance companies related to front running or for related-party transactions, which would regulate possible conflicts of interest arising from the activities of individual investment managers. Even those entities that transfer management to a Bapepam & LK-licensed investment manager could have unresolved conflict-of-interest issues.

TAX, SUPERVISORY, AND REGULATORY ISSUES A strong insurance sector ultimately requires effective regulation and supervision, and supportive conditions. In Indonesia, the need to improve regulation and its enforcement is critical given the number of insurance companies at risk of losing their license.

Taxation Indonesia essentially follows international accounting principles, and insurance companies are taxed on their profits, just like other corporations. For insurance companies, the reserves for statutory purposes, excluding liabilities for claims incurred but not reported (IBNR), are deducted for tax purposes subject to approval by the Ministry of Finance. There is a final tax of 20 percent on interest income and 15 percent on dividend income, with some exceptions. Capital gains on listed shares are taxed only at 0.1 percent. Provisions for adverse deviations and solvency such as risk-based capital margins and catastrophe reserves are not deemed policy liabilities and are not deductible. This is in accordance with normal practices. The tax regime for policyholders is also broadly in line with international norms, although here again, improvements are possible. Death benefits and proceeds from policies that have been in force for three years are not taxable. If the policy has been held less than three years, there is a withholding tax of 15 percent, and the excess of the proceeds over the premiums paid is deemed

79 Minister of Finance Decree no. 513/KMK.06/2002, December 4, 2002, requires that the executive officer of an employer or financial institution pension fund must meet qualifications and be knowledgeable about pension funds. Less formally, the head of the investment department of an insurance company generally has a Bapepam license as an executive of an investment manager.

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taxable income. There are two exceptions: (a) contributions and benefits under financial institution pension funds registered with the Ministry of Finance enjoy the same EET treatment as other pension plans,80 and (b) under a recent ruling, premiums paid by companies to finance mandatory severance benefits payable under Labor Law no. 13 are deductible as a business expense. Lack of harmonization between tax policy and public policy objectives. The main objective of the tax regime should be to avoid discriminatory treatment and to ensure a level playing field where taxation does not distort economic decisions or hamper competition. With the convergence of the products offered by banks, insurance companies, and mutual funds, the issues have become more complex. Indonesia applies diverse treatments in comparable circumstances, and there seems to be little harmonization of tax policies with national policy objectives. The government has provided different tax advantages to achieve specific public policy objectives. A common example is the tax-exempt treatment of mutual funds. A review of these policies and of the results obtained in relation to the objectives would provide Indonesia with a range of policy options that could guide rationalization of the current mixture of tax policies. Unpredictable enforcement of tax policy. While Indonesia’s tax regime for insurance firms is broadly in line with international norms, the main problem for the insurance industry is that enforcement of tax policy is capricious and unpredictable. Problems with arbitrary tax administration and implementation are pervasive. Companies and individuals are regularly exposed to reversals and arbitrary decisions at the local level, and precedents do not rule the day. For example, contrary to common sense and normal practice, in one instance a local tax assessor decided that claims paid should not be accepted as a deductible expense because provision had already been made in the IBNR. The company went to court, although the outcome was far from uncertain. Unattractive treatment of annuities. The mandatory purchase of a life annuity deters participation. Indonesia’s annuities market is handicapped by several factors: a lack of competition, volatile interest and exchange rates, and people’s ostensible preference for short-term contracts. Moreover, the tax regime discriminates against the payment of annuities to retirees directly out of a defined-benefit employer pension fund and makes it unattractive for pension funds to insure annuities at retirement. Single premiums paid to an insurance company out of a financial institution pension fund or an employer pension fund to purchase a life annuity at retirement are taxable, which ends the tax sheltering. As the purchase of an annuity from an insurer is mandatory for FIPF and DC Programs, this treatment is unfair to retirees. Annuitization is not a financially attractive option, which hinders development of the market.

Disclosure and transparency The public disclosure requirement for insurance companies aims to protect the insurance-buying public. The evolution of regulatory policies emphasizes a three-pronged approach: capital, supervision, and transparency. Contrary to banks and securities companies, where the public may react to gradually worsening news about a financial institution by taking its business elsewhere, the insurance-buying public enters into long-term arrangements and is in no position to transfer its business elsewhere without incurring significant penalties. For that reason, disclosure and transparency at least as important for insurance companies as for short-term-oriented financial institutions. 80 Exempt, exempt, taxable (EET) means that the contributions are deductible from taxable income, that the returns on assets are not taxable, and that the benefits are taxed as paid. This approach is frequent in industrial countries. The conventional use of the word “exempt” is somewhat misleading, since the effect is not an exemption but a deferral of taxes until the benefits are paid out.


A complete set of risk-based capital ratings of all insurance firms is not available from the regulator/supervisor. In North America, the attribution of ratings to insurance companies and their publication are left to the private sector, with recognized rating organizations such as Standard & Poor’s, Moody’s, and Best rating insurance companies on the basis of their claims-paying ability. In Indonesia, such private sector ratings are not available, and only the insurance supervisory authorities are in a position to provide the insurance-buying public with such information. Publishing the ratings of all insurance firms would not only make the information more accessible to the public but also enable the Bureau of Insurance to promote the insurance business and the credibility of institutions. At present, companies are required to publish their financial reports, including the risk-based capital ratio. The Bureau monitors the publications and ensures that the numbers published are identical to those in the filing. However, the Bureau does not publish the ratios. Minor ongoing industry initiatives contribute only modestly to disclosure.81 Institutional communications are a more effective promotional and informational tool than publication by each company of its own results. The publication could be done jointly with the industry associations.

Actuarial support Indonesia needs to develop and strengthen its actuarial profession substantially. Although sound insurance and pension industries depend on strong actuarial support, in Indonesia, there is a dearth of actuaries with strong professional standards. For instance, by comparison with the guidance available from other actuarial associations, PAI offers only limited support and investment in developing standards.82 Clearly, developing a strong actuarial profession will take time.

Policyholder protection There is ongoing debate about the creation of a policyholder protection scheme in Indonesia. In part, the discussion is driven by the phasing out of the blanket guarantee for bank deposits and the creation of a bank deposit insurance scheme. Drawing on the analogy, various parties have raised the possibility of a similar consumer protection mechanism for the insurance sector. The convergence of financial services and markets, and financial regulations across segments of the industry with the aim of reducing the risks of instability is often given as a reason to advocate policyholder protection. Globally, the growth of bancassurance and the convergence of bank and insurance products are creating a trend toward the creation of protection funds83. Critics of the policy holder protection scheme in Indonesia argue that the discussion is driven by the expected consolidation of the industry as licenses of insolvent firms are gradually withdrawn. Their view is that policyholder protection funds indirectly subsidize mismanagement of the weaker companies at the expense of healthy firms. Clearly, the marginal situation of a number of companies in Indonesia could weaken the financial condition of many protection schemes, and, in the presence of adverse economic fluctuations, a large bankruptcy may trigger other insolvencies and potentially cause a chain reaction that would damage the whole industry. This report’s view is that it is premature for a policyholder protection scheme to be implemented in Indonesia. Industry restructuring – with the resolution of firms (large and small) in financial difficulties - should be a priority before any such scheme is considered (Box 6.4). The credibility of

81 These include the promotion done through Proteksi, Majelah Asuransi Indonesia, Indonesia’s insurance magazine. 82 A comparison of the Web sites of several international actuarial associations quickly demonstrates this. 83 Out of the 30 OECD countries, at least 21 have some form of policyholder protection; such funds also exist in non-OECD countries.

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such a scheme and the willingness of the healthy firms in the industry to voluntarily participate in it for their own benefit and for that of their customers will depend on restructuring preceding the establishment of the scheme. Box 6.4. Resolution of Insolvent Life Insurance Companies

There are several large life insurance companies that are widely considered to have solvency problems. These companies play a key role in the sector. There are indications that their financial condition continues to deteriorate, increasing their actuarial deficit. Although the impact of these companies on the overall financial sector is likely to be limited (given the relatively small share of insurance assets in the economy), they pose a systemic risk to the insurance sector and require special handling. This report’s view is that a prompt and detailed analysis of the options for resolving these companies should be undertaken on an urgent basis, so as to form the basis for a discussion of resolution options. An early resolution would facilitate the government’s desire to mobilize greater resources from the sector by creating an environment for growth. Equally, the universal experience suggests that the earlier a resolution is undertaken, the lower the cost of resolution is likely to be. The assessment of the financial condition of these companies should be mandated by the Ministry of Finance on the basis of well-defined, transparent performance criteria. The scope of the audit not only should cover the financial condition but also diagnose operational capacity, including risk management systems, information systems, underwriting controls, and treasury operations. Based on the findings, the Ministry of Finance will be in a better position to prepare a quantitative and qualitative plan of action addressing the deficiencies identified in the international audit for each. In the absence of adequate information, it is premature to speculate about alternative resolution options. Further analysis of the quantitative aspects (number of policyholders, assets and liabilities, and deficits) and qualitative aspects (e.g.: quality of the distribution system, realizing that a purchaser might decide that transforming a large sales force is just as hard as building one from scratch) would be necessary to determine an action plan with the proper timing and sequencing of intervention. Also, the authorities need to accept the inevitability of either an injection of capital or a guarantee of future losses on existing business in some form for some large insolvent firms, before the companies can be resolved.


Box 6.5. International Experience: Insurance Sector Reform in Mexico

Mexican insurance industry has been one of the fastest growing segments of the Mexican financial services. Indeed, since 1997, the average annual growth, in real terms, has been 7.7% , more than double that of the economy as a whole. Such outstanding performance can be explained by the structural changes that took place in the last decade under an environment characterized by deregulation and liberalization processes. These changes were also supported by the country’s macroeconomic stability, the rapid convergence to NAFTA, and real wages’ expansion. Legislative reforms were introduced through out the studied period that had a major impact in the insurance industry. By 1997, the legal framework for annuities (Pension Insurances Derived from the Social Security Laws) was introduced. In this sense, it was established that the insurance companies that wanted to offer such products should be specialized carriers (monolines). One of the major structural changes that have had significant implications was the North America Free Trade Agreement (NAFTA) effective from January 1, 1994. As part of this agreement, Mexico opened up the insurance market for carriers from the United States and Canada. Other agreements like the one signed with the European Union in 2001, permit companies based in jurisdictions from those regions, to enter Mexican market with 100% subsidiaries. It can also be observed that a more open and dynamic market has favorably impacted competition. By 1994, there were 48 insurance companies, while by September 2005 the number had increased to 87. It is important to notice that the major increases in the absolute number of companies were in two periods: between 1994 and 1997 with 22 and between 2000 and 2003 with 15. The first period’s increase can be explained mainly by the entrance of 17 subsidiaries as part of NAFTA. The second period can be explained by three additional structural changes: the establishment of insurance companies specialized in annuities, the regularization process of Insurance Companies Specialized on Health Insurance , and the growing trend of the industry that create incentives to new carriers to be set up. The impact of increased competition can be seen in the average operational cost as well. By the end of September 2005, average operational costs had been reduced by 46% as compared to those in 1994. An improved environment for insurance company exit and entries also enabled the market to evolve faster. For instance, by September 2005, only one company was state-owned, one was a mutual society and 85 were private companies, out of which two companies were reinsurers . The main structural changes in the recent years were the privatization of Aseguradora Hidalgo in 2002, which was incorporated into MetLife, the exit of two mutual insurance societies, and the entry of a reinsurance company in 1997 and the exit of another one in 2004 . Source: Mexico Financial System Stability Assessment

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POLICY RECOMMENDATIONS The recommended policy actions by time frame are summarized in the following table. The policy recommendations are elaborated subsequently Quick Wins (1 yr) 1-3 years Regulatory Give BAPEPAM & LK increased independence and

funding, if necessary through a modified mini-OJK law. Undertake financial and actuarial assessment of insolvent life insurance companies. Develop options to address any issues that are identified Close down insolvent insurance companies whose licenses have been withdrawn Formulate a strategy for the remaining insolvent companies Develop and issue concrete regulations for wind-ups and liquidations of insurance companies Launch a review of the RBC parameters on the basis of experience since 2000

Emphasize the switch to consumer protection (market conduct) from industry protection Develop market discipline though enforcement of transparency and disclosure Update the RBC guidelines and minimum capital requirements Regulators should play a more active role in international forums such as IAIS Develop a sound regulatory framework, standards for corporate governance, supervision and accounting and auditing based on Syariah principles for insurance in association with the standard-setting body - the Islamic Financial Services Board (IFSB) and the support of the industry Carefully consider the pros and cons of establishing of a policy holder protection fund as many issues are involved. Restructure industry first before establishing such a fund.

Enforcement Improve off-site supervisory capacity including data capture via regulatory reporting , and analysis Make systematic review of actuarial reports prescribed under Act 31 KMK 422 and Act 18 KMK 426 Undertake risk-based on-site inspections to verify the data, methods and assumptions in critical areas such as liabilities calculations and asset valuations

Accelerate the shift to risk-based supervision by making better use of the prescribed third party actuarial reports Strictly and evenly enforce minimum capital requirements to subject participants to market discipline Improve overall enforcement capacity and enhance the powers to intervene early

Skills Open up to the actuarial market to international actuarial participation Require the Indonesian Actuarial Association to adopt Insurance Practices Professional Standards Improve sales practices to reduce policy lapses and cancellations, and decreasing delivery expenses that erode premiums and long term assets

Develop the capacity of the domestic actuarial profession in collaboration with the Indonesia Actuarial Association Conform to the changing international standards for accounting treatment and reporting of financial products

Taxes Do not impose a premium-tax on non-life premiums Remove the tax applied on funds transferred from registered pension funds to insurance firms to purchase an annuity

Review the consistency of the tax regime and apply a tax neutral treatment that creates a level playing field for all the financial services providers Ensure consistent taxation of insurance companies, which is currently uneven and unpredictable Improve the tax treatment of insurance products to accelerate long term asset accumulation



Permit insurance companies to offer private pension products regulated under Law 11, not only FIPFs Develop a basis for the comparative assessment of insurance companies (For example CARAMEL)

Restructure and provide exit for underperforming / insolvent companies to encourage a healthy industry capable to mobilize fresh capital Publicize information regarding the soundness of insurance companies, e.g. insurance ranking to improve the consumers’ access to information market discipline.

Access Develop a sound regulatory framework, including business conduct and consumer protection requirements for micro-insurance products

Promote micro-insurance initiatives through joint private-public initiatives modeled after the successful initiatives in other countries


Initiate educational campaigns on the benefits of insurance

Encourage the private sector to publish insurance company ranking and ratings Sustain education campaigns on benefits of insurance

Priority recommendations Rationalize the industry. Several insurance companies in Indonesia are weak, marginal, or bankrupt. Weak companies are a dead weight on the economic system that stifles economic development through numerous channels. Poorly performing insurance companies are both a symptom and a cause of economic malaise, and their activities lead to structural problems in the economy. First, poorly performing insurers have poor underwriting and investment skills and might enter into poor contracts. Poorly performing companies distort competition by creating an uneven playing field that disfavors good companies, which might end up subsidizing them. The longer and more protracted the problem becomes, the harder it is for both the government and the industry to make the tough decision to resolve failing companies. Such companies should not be protected from normal market discipline. The first step in rationalizing the industry is to remove the grandfathering clause on capital for existing companies and devise an active merger or exit strategy for them. Subsequently, a capable private and public insolvency apparatus is needed to resolve the companies that do not meet risk-based capital requirements. The first priority is to assess the true financial condition of large insolvent life insurance companies and if found necessary, to resolve them, to prevent a potential systemic risk. Accelerate the shift to an independent regulator. The expected creation of OJK should not be a reason to delay reforms that can be implemented sooner. The merger of Bapepam and the Directorate General of Financial Institution offers an opportunity to continue the creation of a strong and independent regulator for NBFIs. The Ministry of Finance could advance the process without waiting for the establishment of the OJK in 2010. It could unilaterally transform the merged Bapepam & LK into an independent regulator that looks after the capital markets, insurance and pensions and other NBFIs and protects NBFI consumers. Improve enforcement. The enforcement of the present regulatory regime is deficient. The regulators are aware that several companies are insolvent, but have not yet intervened. In other cases, licenses have been withdrawn but companies not yet closed. The regulator needs to adopt consistent, even-handed, and transparent enforcement, including expanded risk-based examinations and stronger, simpler, rapid escalation procedures. Promote the industry. A key second-generation issue is the development of the industry. The Bureau and the industry and professional organizations, including DAI and AAJI as well as the Indonesian Association of Actuaries, need to launch a sustained educational campaign to educate and promote the benefits of the insurance industry and of its products. The establishment of joint

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government-industry high-level committee to develop future action plans for the industry is also an important step. Involve Indonesian regulators in IAIS. The IAIS represents insurance regulators and supervisors of some 180 jurisdictions in more than 130 countries, constituting 97 percent of the world’s insurance premiums. The leading insurance companies in the world are observers. The IAIS aims to contribute to improved supervision of the insurance industry on a domestic as well as on an international level in order to maintain efficient, fair, safe, and stable insurance markets for the benefit and protection of policyholders. Active Indonesian participation in the work of the IAIS would demonstrate to the world that authorities are committed to improving the workings of the insurance industry in Indonesia. It would also provide a forum from which to learn about international experience on issues relevant to Indonesia.

Other recommendations Restructure the industry as a precondition to considering creation of a policyholder protection scheme. Given the substantial heterogeneity across insurance firms in Indonesia, any such scheme would be unlikely to succeed unless restructuring efforts are undertaken first. Thus, a precondition for considering the creation of a policyholder protection scheme in the future is to restructure the industry and establish a sound regulatory regime. In this context, any consideration should be deferred to an appropriate point in the future. Enhance the sales force. The sales force needs improvement to enhance the quality and duration of the business written by enforcing professional standards for brokers, agents, and supervisors. Create strong self-regulatory organizations with the institutional capacity and incentives to oversee both market development and regulation. This will help strengthen industry and professional associations, as well as help progress on key decisions such as which regulatory responsibilities, and when, should be transferred to the industry associations. In particular, the Indonesian Association of Actuaries needs to make a quantum leap in its capacity, such as a certification and training program. Allow the insurance industry to offer pension products. At present, the life insurance industry cannot directly offer pension products except through financial institutions pension plans. Insurance companies should also be allowed to package pension plans for small and medium employers, and the rules for financing severance benefits under Law no. 13 on a pre-tax basis should be clarified and private firms allowed to save for these in pension plans. Opening the pension market to insurance companies would conform to international practices and enable the insurance industry to build on existing tax incentives. So would the extension of the tax sheltering to life annuities purchased from registered pension plans. Make annuities more attractive. Annuities could be made more attractive by preserving the tax shelter or allowing annuities to be paid out of the fund on the basis of life expectancy. Thus the retiree would continue to share in the market performance, and pension funds would be allowed to purchase annuities without paying taxes at the front end and without losing their tax shelter. Moreover, information campaigns could make individuals less resistant to annuities by creating awareness of their advantages. Attract fresh capital to the industry. Venues are needed to bring fresh capital in the industry, including, if necessary foreign capital. At present, the industry suffers from a severe shortage of


capital.84 This is especially true for existing companies, which were exempted from the higher capital requirements imposed on new companies. The industry in general may need as much as $750 million in additional capital.85 Actively promote and encourage foreign entry. Foreign companies can bring unique skills in sales management, underwriting, and operations that will help to improve the quality of the distribution systems—a prerequisite for selling better products. Clarify the regulations for linked products. Clarification of the regulations governing linked insurance products is needed. Specifically, (a) Bapepam & LK needs to regulate market-linked insurance products as investment funds, (b) the valuation of linked insurance products needs to be brought in line with the rules of Bapepam & LK, and (c) rules to deter front running and related-party transactions are needed to discourage possible conflicts of interest arising from the activities of individual investment managers of linked insurance products. Improve the capacity for liquidating companies. To minimize the hardship on policyholders, the liquidation process needs to be clear, flexible, and transparent. In Indonesia, several improvements are needed in this regard. The first is to define the specific conditions that require appointing an administrator for winding up and liquidating an insurance company. It would be helpful to have a wider definition that provides a clear basis for action. As part of this effort, special regulations are needed for wind-ups and liquidations, as the general commercial law for bankruptcy and liquidation is not specific enough. In particular, the rules for determining policyholder priority need to be detailed in the regulations. Enhance the powers to intervene early. Powers of intervention need to be made more flexible, be available for earlier use, and cover a wider range of issues. Powers could be made more flexible by separating the powers from the current limited procedures, which are unduly onerous by international standards. For example, one improvement would be to give the supervisory authority the power to require remedial measures early in the process and on an acceptable timetable. The current business law should be considered a last resort to avoid final sanction; it is not a tool for early and remedial action. The power to intervene in a graduated manner and to impose immediate corrective actions in an emergency is desirable. Therefore, the powers of intervention should be enhanced to enable actions to be initiated in advance of the process currently in place, which is a sanction more than a precondition for other interventions. Additional actions are needed to bring Indonesia’s supervisory powers and enforcement up to international standards. These include the power to restrict business activities, stop the issue of new policies, withhold approval for new activities, direct the company to stop unsafe or unsound practices and to take particular actions, impose conditions on a license, ring-fence one or more companies that belong to a financial group, arrange for the compulsory transfer of obligations from a failing to a viable insurer, revoke the license of an insurer, and remove and replace owners, managers, and directors. The current complex procedures for determining when these powers can be used should be simplified and enforcement capacity built up. Enhance the powers to impose sanctions. Sanctions deter unlawful behavior and need to cover the obligations imposed by laws and regulations. The sanctions available under the Insurance Business Law, Article 17, should be elaborated further and extended. A complete range of sanctions would include the power to remove and replace owners, directors, and managers; bar

84 This shortage may explain the continuous negative trade balance of the industry, which amounted to more than Rp 3 trillion in 2003, up from Rp 2.5 trillion in 2002. This shortage is mainly associated with reinsurance. 85 As per the chairman of the General Insurers Association, Frans Y. Sahusilawane, in the December 2004 issue of Proteksi.

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individuals from the business of insurance; apply fines and other punitive sanctions against insurers and individuals for failing to comply with the law; apply sanctions against individuals for withholding information from the supervisory authority, providing misleading information, or failing to provide information in a timely fashion; and take action against individuals or entities conducting insurance business without a license. The sanction for a breach of each part of the Insurance Law and regulations should be elaborated, including processes for appeal and review. Elaborate rules and procedures for transactions related to mergers, transfer of ownership, and demutualization. It would be useful to elaborate the process for undertaking mergers, transfer of ownership, and demutualization, as well as the use of reinsurance as a tool in resolution. Such actions may be required of an insurance company in difficulty, and companies will be more willing to undertake them if the rules are clear and detailed. Processes used in other jurisdictions may be adapted relatively easily to the Indonesian context. Reconsider the recent proposal to impose a premium tax on non-life premiums. Currently, there is no tax on premiums, but a proposal has been prepared to impose such a tax on non-life premiums. There is no specific rationale for this proposal. Non-life coverage for Indonesians is low, and Indonesians do not benefit from a sufficient level of protection against losses from adverse events. Such a proposal would make it even harder for the industry to make available useful products to a larger proportion of the population and would not be in the public interest. Consider carefully industry proposals to improve the tax treatment of insurance products with the objective of accelerating the buildup of long-term assets. Any tax incentive should be designed to encourage long-term investments. The specific proposals being developed should make explicit the causal relationship between the changes proposed and the expected results. Subsequently, outcomes should be monitored to guide future policy. Develop a more comprehensive system of ratings. For insurance companies, the solvency ratio is the equivalent of the ratio of capital and surplus to assets for banks; although the ratio itself is important, it is only a partial measure of soundness. As in the case of banks, an insurance company’s solvency ratio should be only one of the factors analyzed under a rating system. An equally important aspect is the qualitative analysis of management. Qualitative analysis of insurance company management and a usable rating system would complement risk-based capital solvency ratios. As a complement to publishing risk-based capital results or as an alternative, ratings could be disclosed on the basis of a more comprehensive management evaluation system, such as CARAMEL (Capital Assets Risk analysis Asset-liability matching Management Earnings Liquidity), that the public could understand more easily.86 One option would be to seek the help of international rating agencies in developing a usable rating system for insurance companies. Another step would be to encourage publication of a complete set of risk-based capital ratings of all insurance firms. Open the actuarial profession to foreign actuaries. Opening the profession to certified actuaries from other countries would create incentives for the PAI to upgrade standards, widen membership, qualify for full membership in the International Actuarial Association, and thus be able to negotiate mutual recognition agreements. Regulations should be drafted to permit fully qualified actuaries of an association that is a full member of the International Association of Actuaries to practice in Indonesia and, subject to applicable requirements, be recognized by the Ministry of Finance for statutory purposes. On an ongoing basis, the government could review the decision based on the state of development of the domestic actuarial profession.

86 This is an adaptation of the CAMEL (Capital Assets Management Earnings Liquidity) approach to bank analysis, which was developed to assist bank examiners in their work.


Adopt a medium- to long-term strategy for strengthening the actuarial profession. Adopting higher educational requirements, a credible examination and monitoring process, entry and certification qualifications, a code of professional conduct, standards of practice, a formal and transparent disciplinary process, and adequate resources to support members would bring many benefits.87 In particular, PAI needs to undertake the following: (a) upgrade its syllabus, educational standards, and disciplinary process to meet international requirements, (b) adopt and implement an action plan for drafting and implementing standards covering various practice areas, (c) adopt and enforce a continuing professional development program meeting minimum standards, and (d) coordinate its exams with academic exams and internationally recognized exams and promote partnerships with actuarial schools in other countries to achieve dual recognition of degrees.

87 Some of the benefits would be almost immediate (code of conduct, disciplinary process); others would emerge gradually (education, standards). There would be more opportunity for cross-fertilization, as experience of the recent emergence of a vibrant actuarial association in India has demonstrated.

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REFERENCES Bureau of Insurance, Various years, Annual Reports, Bureau of Insurance, Bapepam & LK Cole, David, and Betty F. Slade. 1996. Building a Modern Financial System: The Indonesian Experience. New York: Cambridge University Press. Demirgüç-Kunt, Aslι, and Edward J. Kane. 2001. “Deposit Insurance around the Globe: Where Does It Work?” NBER Working Paper 8493, National Bureau of Economic Research, Cambridge, Mass., July. Erbaş, S. Nuri, and Chera L. Sayers. 2005. “Institutional Quality, Knightian Uncertainty, and Insurability.” 12th Annual Conference of the International Association of Insurance Supervisors, Vienna, Austria, October. IFSL (International Financial Services London). 2005. www.ifsl.org, London, November. IMF. 2001 Mexico Financial System Stability Assessment, IMF Country Report No. 01/192: http://www.imf.org/external/pubs/cat/longres.cfm?sk=15443 Insurance Information Institutes. 2005. International Insurance Fact Book 2005: www.internationalinsurance.org Malaysian Takaful Industry, 1984–2004, http://www.bnm.gov.my/ McIsaac, Donald A., and David F. Babbel. 1995. The World Bank Primer of Reinsurance. Washington, DC, September. Swiss Re. 2004a. “Exploiting the Growth Potential of Emerging Insurance Markets.” Sigma 5. ———. 2004b. “World Insurance in 2003.” Sigma 3.

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CHAPTER 7 INDONESIA’S LEASING INDUSTRY

In many countries, leasing has grown quickly because it offers advantages to all parties. The potential advantages to the lessee are simpler security arrangements, availability of medium- and long-term financing to purchase equipment, convenience because outside collateral is not needed, lower transaction costs, ability to finance a higher percentage of the capital cost of equipment than bank borrowing, flexibility (the ability to structure leasing contracts to meet the cash flow needs of the lessee), and tax incentives that reduce the costs of financing. Leasing companies benefit equally. In countries where weak collateral laws hinder bank lending, leasing offers the advantage of simpler repossession procedures, because ownership of the asset lies with the lessor. Because the lessor purchases the equipment directly from the supplier, there is no opportunity for the lessee to direct the funds to other purposes. Simple documentation keeps transaction costs down. And because leasing companies are usually not deposit takers, they tend to be less regulated than banks and have lower capital requirement. The benefits for economic development are widespread. More small and medium-size enterprises can access financing. Increased competition stimulates new product development (leasing to new sectors, cross-border leases, and so on) and reduces spreads. Leasing also helps to expand private investment in capital equipment and supports the development of capital markets. On the asset side, it introduces to the capital markets small and medium businesses that previously relied on informal financing, supplier credit, and internal cash generation than on formal financial markets. It also expands the financing options for larger companies. On the liability side, the efforts of leasing companies to mobilize debt and equity help to deepen and broaden domestic capital markets. Although leasing companies are at a disadvantage when competing with the leasing subsidiaries of commercial banks, which can tap the low-cost funding of depositors from their parent company, stand-alone leasing firms compete more vigorously for market share and focus on building a portfolio.


Experience suggests that several factors enable leasing companies to flourish88: A high standard of cash-flow-based credit analysis and supervision of clients, complemented

by follow-up and equipment insurance procedures Competent partners Access to long-term local currency funds from insurance companies or pension funds, or

access to the local bond market Asset-liability matching, which allows leasing companies to match fixed-rate leases with

fixed-rate term funding, or, if only floating rates are available (locally or internationally), a regulatory framework that allows periodic adjustments of lease rates.

Financial information transparency, such as credit information systems. Leasing can play a significant role in Indonesia’s non-bank financial sector, especially in financing of SME’s.

STRUCTURE In Indonesia, leasing is part of multifinance industry. To describe the structure of the Indonesian multifinance industry, this section addresses the range of business considered as part of the industry, the size of the industry, the regulatory and supervisory structure governing the industry, and the sources of funding.

Range of business The multifinance industry originated from the leasing industry, which has been present in Indonesia since 1974 (joint decrees of the minister of finance, minister of trade, and minister of industry in 1974). The current structure of multifinance began in December 1988, when the government issued a package of decrees deregulating the financial sectors. Currently, multifinance companies can conduct leasing, factoring, and consumer and credit card finance. In the past they also could undertake securities trading and venture capital.89 We deal with each in turn. Leasing. Presidential Decree no. 61 of 1988 and the following minister of finance decrees set out the definition of each business under the multifinance industry (Decree no. 1169/KMK.01/1991 for leasing and Decree no. 1251/KMK.13/1988 for factoring90). The leasing business offers both financial leases and operating leases. Leasing can only finance capital goods, which are defined as tangible fixed assets that have economic life of more than one year and are being used—directly and indirectly—to produce, enhance, or smooth the production and distribution of goods and services. Financial leases can be of several types: direct lease, sale and lease back, and syndicated lease. A transaction is categorized as a financial lease if it meets the following criteria: The total of lease payments plus residual value of the leased asset is equal to the acquisition

price of the asset and profit thereon. 88 Carter, Barger, and Kuczynski, 1996. 89 Securities trading was removed in November 1989, and venture capital was spun off in October 1995 by minister of finance decrees. 90 No. 1251/KMK.13/1988 was replaced by Decree 448/KMK.017/2000 and subsequently by Decree No. 172/KMK.06/2002 which stipulates that Multifinance industry includes leasing, factoring, credit cards, and consumers finance business.

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The lease term is for a minimum of two years for capital goods in category 1, three years for capital goods in categories 2 and 3, and seven years for capital goods in the category of buildings. The categories are stipulated in Article 11 of Law no. 7 of 1983 on Income Tax.91

The lease agreement contains provisions regarding the purchase option of the lessee. A transaction is categorized as an operating lease if it meets the following criteria: The total payment during the first term does not cover the acquisition price of capital goods

and profit thereon of the lessor The lease agreement does not contain provisions regarding the purchase option of the lessee.

Factoring. Factoring is the purchase, sale, and management of debts and short-term claims of a company arising from domestic or overseas trade transactions. Factoring includes both financing and nonfinancing services. Nonfinancing services include credit investigation, sales ledger administration, control of credit and collection of debts, and credit risk management. Consumer finance. Consumer finance is the activity of financing goods for consumers wherein repayment is via periodic payments. The credit card business allows consumers to purchase goods and services with the use of credit cards as means of payment. Unlike leasing and factoring, which are used solely for commercial purposes, consumer finance and credit cards are used by individuals to purchase consumer goods and services. Most consumer financing is used to purchase new and used cars or motorbikes. Recently, consumer financing has been made available for purchasing electronic appliances and furniture.

Size of the industry From 1988 until the financial crisis of 1997–8, the industry grew strongly, with the majority of financing in the form of leasing and factoring. The sharp rise in interest rates during the peak of the financial crisis adversely affected the growth and performance of multifinance companies. However, since 2001 the industry has recovered, and consumer finance has become the main driver of growth. As of December 2005, there were 236 multifinance companies (although only 132 were operational), which had extended financing amounting to Rp 67.7 trillion. Consumer finance dominates the business (68 percent), followed by leasing (28 percent), credit cards (2 percent), and factoring (2 percent); see table 7.1. Table 7.1: Financing of Multifinance Companies, by Type of Company, 1996–2005 (Rp trillion unless otherwise noted)

Factoring Leasing Credit cards Consumer finance Year Amount Total % Amount Total % Amount Total % Amount Total %

Othera Total

1996 8.0 30.1 12.1 45.4 0.1 0.2 6.4 23.8 0.1 26.7 1997 10.1 26.4 16.9 44.2 0.4 1.1 10.6 27.7 0.2 38.3 1998 8.0 27.0 15.6 53.0 0.4 1.4 5.2 17.8 0.3 29.5 1999 6.4 28.8 10.9 49.2 0.3 1.5 4.3 19.4 0.2 22.2 2000 6.6 22.3 13.7 46.7 0.4 1.4 8.5 29.0 0.2 29.4 2001 3.3 10.6 14.1 45.8 0.8 2.6 12.4 40.1 0.3 30.8 2002 3.2 9.4 12.6 37.1 1.1 3.4 16.6 48.9 0.4 33.9 2003 3.2 8.3 11.6 30.2 0.8 2.1 22.7 59.1 0.1 38.3 2004 2.5 4.6 14.5 26.4 1.5 2.8 36.0 65.5 0.4 54.9 2005 1.4 2.0 19.1 28.3 1.8 2.2 45.4 67.5 0.0 67.7 Source: Bank Indonesia, Bapepam & LK a. Deposits at commercial banks and direct investments.

91 A more detailed description of each category is provided in annex A.


Regulatory and supervisory structure Multifinance companies are supervised and regulated by the Bureau of Banking and Financial Services, which is under the Bapepam & LK of the Ministry of Finance. However, since 1995, through a joint decree of the Minister of Finance (no. 707/KMK.017/1995) and the Governor of Bank Indonesia (no. 28/9/KEG/GBI), Bank Indonesia has had the mandate to supervise multifinance companies in the areas of offshore borrowing, borrowing from commercial banks, issuance of promissory notes, quality of assets, and accuracy and adequacy of reporting. This joint supervision continues today. Clear regulatory and supervisory lines of authority should be determined between the two agencies to avoid ambiguity. Unlike other non-bank financial institutions, no law governs the multifinance industry exclusively. Presidential Decree no. 61 of 1988 is the highest regulation that addresses the multifinance industry. It was issued in December 1988 as part of a package of regulations of financial sectors (commonly referred to as the PAKDES 1988). Subsequently, various decrees of the Minister of Finance have been issued to govern or implement specific activities or areas within the multifinance industry. With respect to legal status of the entity, a multifinance company can be established as a limited-liability company or a cooperative by an Indonesian citizen or as a joint venture by a foreign enterprise and an Indonesian citizen or legal entity. Multifinance companies must obtain a business license from the Ministry of Finance. Different types of ownership have different minimum capital requirements, as follows: Table 7.2: Minimum Capital Requirement per type of Ownerhsip

Type Minimum statutory capital (Rp) Private company 10 billion Joint venture company 25 billion Cooperative 5 billion Source: Bapepam & LK

Funding sources A multifinance company is expressly prohibited from accepting funds from the general public in the form of demand deposits, savings, and time deposits. A multifinance company is also prohibited from issuing promissory notes, except to guarantee a bank loan, and from providing guarantees in any form to any party. Given this regulation, a multifinance company in Indonesia has three ways to obtain funding: raise equity, issue bonds, or obtain a commercial bank loan. The regulation allows a multifinance company to receive bank loans from onshore and offshore sources. The gearing is set at 15 times net worth, of which foreign debt is five times net worth. Net worth includes subordinate loans. Most funding for multifinance companies comes from loans from commercial banks. The latest official statistics show that commercial bank loans and the issuance of bonds account for around 49 and 10 percent, respectively, of the outstanding funding of multifinance companies. Funding from offshore borrowing constitutes a significant portion as well (see table 7.3). In addition, some large multifinance companies have issued bonds in the domestic capital market and listed their shares on the Jakarta Stock Exchange.

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Table 7.3: Financing of Multifinance Companies, by Source of Funding, 1996–2005 (Rp trillion)

Type of borrowing 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Domestic borrowing

Banks 11.9 15.5 14.4 10.7 11.3 14.2 13.2 14.7 20.8 25.0 Non-banks 1.0 1.5 3.0 3.7 5.8 3.7 3.4 1.0 0.7 4.4

International borrowing Banks 9.2 19.3 16.4 8.6 7.6 7.0 5.6 6.9 18.6 24.2 Non-banks 1.5 1.8 2.7 2.3 4.9 4.1 4.2 4.8 4.3 7.1

Bonds 0.3 0.5 0.9 0.6 0.8 0.7 1.7 4.0 8.9 10.2 Subordinated debt

Domestic 0.1 0.1 0.4 0.4 0.5 0.5 0.3 0.2 0.2 0.2 International 0.2 0.5 0.9 1.0 1.3 1.8 1.7 1.7 1.9 0.1


PERFORMANCE AND SUSTAINABILITY The sharp increase in interest rates at the peak of the financial crisis in 1998 led to systemic distress in the leasing and factoring industry. That said, although the number of valid operating licenses did not decline significantly, only 132 multifinance companies are estimated to be in operation. After the financial crisis, interest rates began to fall steadily from 2002 and the industry started to rebound. As a result, the financial performance of multifinance companies improved. By the end of 2002, the earning and equity of multifinance companies turned positive again. In 2004 the assets of the industry grew 58 percent year-on-year, and from 2001 to 2004 assets grew at a compound annual rate of 28 percent (see table 7.4). The growth rate was lower in 2005 but the total financing still exceeded the amount disbursed in 2004. Consumer finance is a lucrative business because interest margins are high. It has been the main driver of growth in recent years. This business benefits from declining interest rates and strong growth of private consumption. Most multifinance companies only provide consumer financing, and only a handful of multifinance companies offer leasing and factoring financing. The portfolio of consumer finance grew annually by 59 percent in 2004 and 26 percent in 2005; and recorded a 38 percent compound annual growth rate from 2001 to 2005. Most purchases are for cars and motorbikes. An estimated 70 percent of total car sales are in the form of credit sales, of which consumer finance companies take 70 percent and commercial bank loans get the remaining 30 percent. In the case of motorbikes, credit sales account for 90 percent of sales, of which consumer finance takes almost 100 percent.92 As a result, the portfolio of multifinance assets is skewed toward the financing of consumer automobiles. This is in contrast with other jurisdictions, where the portfolios are more diversified.93

Credit card business also has been growing substantially in line with the trend in consumer finance. However, only a small portion of this growth is captured in the statistics because most credit card issuers are commercial banks. Despite a significant increase in volume, the quality of consumer and credit card finance (issued by multifinance companies) so far has remained sound (see table 7.5). In the case of consumer finance, less than 1 percent of outstanding financing is not performing, which is lower than in the banking sector.

92 Estimated by the Indonesian Financial Services Association (IFSA). In 2005 total car and motorbike sales reached 533,841 and 4.6 million units, respectively. 93 To illustrate, annex B lists the portfolios of leasing companies in a few other countries.


Unlike consumer and credit card finance, the leasing and factoring businesses have not picked up substantially since the crisis, largely because the demand for corporate financing is modest.94 Moreover, multifinance companies are facing stiff competition from commercial banks flush with liquidity and are unable to offer financing at more competitive rates. The lack of skills regarding credit risk in leasing also has discouraged multifinance companies from entering these markets. Some legacy of the defunct leasing and, in particular, factoring during the financial crisis is still present on the balance sheet of multifinance companies. For instance, only about three-quarters of outstanding factoring claims can be classified as performing as of 2005 (table 7.5). Table 7.4: Financial Performance of Multifinance Companies, 2000–5 (Rp trillion unless otherwise noted)

Year 2000 2001 2002 2003 2004 2005 Number of companies 245 245 244 239 237 236 Total assets

Amount 35.8 37.3 39.9 50.1 78.9 96.5 Percentage change — 4.2 7.0 25.6 57.5 22.3

Financing Amount 29.4 30.8 33.9 38.3 54.9 67.6 Percentage change — 4.8 10.1 13.0 43.3 23.1

Equity Amount (2.7) (0.6) 3.0 8.5 10.7 15.2 Percentage change — — — 183.3 25.9 42.0

Profit-loss Gain (loss) 2.6 (0.1) 1.8 1.9 3.0 3.5 Percentage change — — — 5.6 57.9 16.7

Return on equity (percent) — 16.7 60.0 22.4 28.0 23.0 Return on assets (percent) 7.3 −0.3 4.5 3.8 3.8 3.6 Source: Bank Indonesia, Bapepam & LK — Not available Table 7.5: Quality of Financing of Multifinance Companies, 2000–5 (percent)

Year and indicator Leasing Factoring Credit cards Consumer finance 2000

Performing 69.0 42.7 66.8 94.7 Doubtful 12.4 4.2 1.5 1.6 At loss 18.6 53.1 31.7 3.7

2001 Performing 76.5 28.9 75.7 96.3 Doubtful 7.8 6.4 2.3 1.6 At loss 15.7 64.7 22.0 2.1






94 The association has indicated that demand for leasing of machinery in the plantation and mining sectors has increased in recent years, but lack of data prohibits further analysis.

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LINKAGES WITH THE REST OF THE FINANCIAL SECTOR The Banking Law prohibits commercial banks from providing leasing and factoring financing. However, commercial banks can issue credit cards and provide consumer loans, which are similar to the consumer finance business of multifinance companies. Difficulties in mobilizing domestic financing are one of the most serious constraints to expansion, and multifinance companies are critically dependent on funding from commercial banks. This has created a situation in which commercial banks influence the assets that multifinance companies fund. In the past few years, commercial banks have preferred consumer financing. The lending process is typically as follows: (a) a multifinance company deploys funds to finance “approved” assets, (b) receivables from a “desirable” transaction are presented to a bank for discounting, and (c) the multifinance company redeploys the funds to repeat the cycle. Indonesian banks benefit from this relationship: overhead tends to be lower because multifinance company staff are less expensive than bank staff, and the multifinance company extends the reach of a bank into new areas. Multifinance companies that have a stronger financial position enter into a scheme of joint financing with commercial banks. Under such a scheme, multifinance companies and commercial banks share in financing their customers.95 Typically, multifinance takes a smaller portion of the financing than commercial banks. Another scheme available in the market is channeling, whereby commercial banks provide full financing and multifinance companies only manage the receivables and earn a fee. In a more recent development, commercial banks have taken one more step to make the two industries closer by acquiring multifinance companies directly. Various acquisitions have taken place, mostly by large commercial banks, and these have increased the number of commercial banks with subsidiaries in the multifinance business (see table 7.6). Table 7.6: Commercial Banks and Multifinance Companies in Indonesia

Bank Multifinance company Bank Negara Indonesia BNI Multifinance Pembiayaan Artha Negara Bank BNP Paribas Utama Leasing Indonesia Bank Bumi Arta Balimor Finance Bank Central Asia BCA Finance Bank Danamon Adira Dinamika multifinance

Saseka Gelora Finance Bank Niaga Niaga International Factors Clipan Finance Indonesia DKB Panin Finance

Bank Panin

Verena Oto Finance Bank Resona Perdania Resona Indonesia Finance Bank Sumitomo Mitsui Indonesia Exim SB Leasing Bank UFJ Indonesia U Finance Indonesia

BII Finance Center Bank Internasional Indonesia Wahana Otomitra Multiartha

Bank Rakyat Indonesia UJF BRI Finance Bali Tunas Finance Bank Permata KDLC BancBali Finance

Bank Mega Para multifinance GMAC Lippo Finance Bank Lippo Pacific United Finance

Source: Infobank, September 2005; Investor, October 2005

95 Consequently, they share the margins. In the event of default, they also share recovery from resale of the assets.


To diversify sources of financing, a number of multifinance companies have mobilized funds from the domestic bond market and equity market (through initial public offerings). Thus far, 10 multifinance companies are listed on the Jakarta Stock Exchange. Multifinance companies have been more active in the bond market. Various large multifinance companies have issued rupiah bonds, which are listed on the Surabaya Stock Exchange. Bond issuances by multifinance companies have been taking a more significant portion of the bond market, by value, since 2002 (see table 7.7). Table 7.7: Bond Market Capitalization, 1999–2005 (Rp trillion unless otherwise noted)

Indicator 1999 2000 2001 2002 2003 2004 2005 Corporate bonds

Amount 14.2 18.9 18.8 21.5 45.4 58.8 57.8 Percentage change n.a. 33.1 (0.5) 14.4 111.1 29.5 (1.8)

Multifinance company bonds

Amount 0.6 0.8 0.7 1.7 4.0 8.9 12.8 Percentage change n.a. 51.9 (11.2) 123.9 138.7 121.4 43.8

Multifinance company bonds as a percent of total corporate bonds

4.2 4.2 3.7 7.9 8.8 15.1 22.2

Source: Bapepam & LK; Surabaya Stock Exchange, Staff Estimates n.a. Not applicable.

DEVELOPMENTAL ISSUES AND CONSTRAINTS The essence of leasing is a contractual arrangement that allows one party (the lessee) to use an asset owned by the leasing company (the lessor) in exchange for specified periodic payments. Legal ownership (retained by the lessor) is separated from economic use of the asset (held by the lessee). The leasing company focuses on the lessee’s ability to generate cash flow to service the lease payments, rather than its credit history, assets, or capital base. This arrangement is particularly suited to the needs of new SMEs that do not have a long history of financial statements, credit history, or collateral requirements, which are needed to obtain a traditional bank loan. Leasing offers other benefits as well: it broadens competition in financial services and introduces businesses and financiers to innovations such as cash-flow-based credit analysis. Many governments have promoted leasing as a way to encourage the growth of SMEs. Indonesia has a large number of small and medium-size enterprises. Their significant contribution to the economic growth of the country has been well documented, and the government has made promoting the growth of SMEs a priority. However, many small and medium-size enterprises are facing financial constraints that make it difficult for them to grow further. Currently, leasing has not yet been used to support growth of the SME sector in Indonesia, although the experiences in other countries suggest that leasing could be a quick solution to problems of SME financing. However, the government and industry participants need to address a number of issues before SMEs in Indonesia can harvest the same benefits from leasing. Key developmental issues are discussed below.

Inadequate enforcement of contracts and collateral repossession One of the most important limitations confronting the industry is the enforcement of business contracts. Clear, simple, and effective legal procedures for repossessing assets if the terms of the lease agreement are breached are essential for development of the leasing industry. In many instances, multifinance companies report that they are unable to repossess leased assets even

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though they are the legal owner. In the case of leasing, companies often require collateral of 10–30 percent, which essentially prohibits the leasing company from providing full payout financing to the lessee. Weak enforcement is particularly evident if the leased assets are not movable (for example, plants and machinery) and less evident if the assets are movable (for example, automobiles and electronic appliances). In such an environment, it is not surprising that most multifinance companies essentially provide only consumer finance.

Weak project appraisal skills Experience suggests that a high standard of cash-flow-based credit analysis of clients, complemented by follow-up and supervision procedures, is critical to the success of leasing companies. Although there has been marked improvement in risk assessment, there is a need to improve technical skills in the industry, particularly with careful portfolio management. A worsening of the macroeconomic climate usually affects small and medium-size firms quickly. Leasing companies, particularly those with concentrated portfolios, are vulnerable to adverse macroeconomic changes. Such firms often form a high percentage of leasing customers. Furthermore, if credit is tightened, leasing companies may suffer from financing constraints or term mismatches. Project appraisal skills also are needed, including (a) identifying the risks inherent in a transaction, (b) diversifying risk via a balanced portfolio, and (c) pricing undiversifiable risk via the marketplace by incorporating a risk premium into pricing. In Indonesia, however, most leasing companies conduct their business on the basis of assets (ease of repossession, active resale market) rather than cash flow from operations largely due to relatively weak project appraisal skills.

Narrow funding sources The multifinance companies have been relying heavily on the commercial banks for funding. Almost 70 percent of multifinance financing is from commercial bank loans, and only a few large multifinance companies use the bond market to raise funds.96 Multifinance companies are restricted from issuing money market securities except nontradable promissory notes issued as collateral to bank loans (Article 27 of Minister of Finance Decree no. 448/KMK.017/2000). The industry has been pressuring the government to permit them access to other venues of short-term financing.

LEGAL, TAX, AND REGULATORY ISSUES This section considers two major legal, tax, and regulatory issues: the need to consolidate the multifinance industry and the need to design a tax environment that supports leasing.

Incomplete consolidation of the industry Consolidation of the industry by reducing the number of multifinance companies is one policy measure that the authority should consider. Out of 236 licensed multifinance companies, only 132 (56 percent) are still operating97.

96 Bond dealers suggest that the illiquid corporate bond market and limited number of institutional investors have meant that corporate bond initial public offerings of less than Rp 250 billion and with rating of below “A” do not attract the interest of investors. Most multifinance companies have difficulty meeting these requirements. 97 This is not an official statistic and is sourced from the Infobank Magazine. Bapepam & LK indicates 200 companies submitted their 2005 financial report to the authority.


The industry is fragmented, with too many small companies. The asset size of these companies ranges from Rp 12 billion to Rp 15 trillion (see table 7.8). A good start toward this end has been made. The authority has not issued any new licenses since 2002, based on Minister of Finance Decree no. 185/KMK.06/2002. To ensure the development of healthy companies, the authority allows a company to open additional branches if it is a profit-making company on the basis of its last audited financial statement and its latest monthly financial statement. Table 7.8: Assets of Multifinance Companies, 2005

Asset size Number of companies

More than Rp 500 billion 37 Rp 100 billion to Rp 500 billion 49 Rp 50 billion to Rp 100 billion 26 Below Rp 50 billion 86 Total 198 Source: Bapepam & LK However, various regulations are not conducive to consolidation. Foreign ownership is restricted to a maximum of 85 percent of equity capital (Presidential Decree no. 61/1988, Article 3). Acquisition is also hindered by a regulation restricting a multifinance company from subscribing more than 25 percent of the paid-up capital of the investee company. Finally, there is a restriction on investment size, whereby total investments made by a multifinance company cannot exceed 40 percent of its own equity (Minister of Finance Decree no. 448/KMK.017/2000, Article 26).

Uneven tax regulations In many countries, leasing is an important source of capital formation in the economy. Leasing companies are offered a regulatory, legal, and tax environment that provides equal treatment compared with other sources of capital investment financing. The right tax regime needs to be conducive to development of the leasing industry. The Indonesian definitions of finance and operating leases are in line with international norms.98 In virtually all countries, with some exceptions, governments grant tax incentives to leasing. However, in Indonesia financial leases have failed to provide fiscal benefits to lessees because the tax regulation (Minister of Finance Decree no. 1169/KMK.01/1991) prohibits lessors from claiming depreciation the asset. This practice goes against the intrinsic nature of the leased asset, wherein legal title remains with the lessor, who consequently should be entitled to claim depreciation. Indeed, this practice is also at variance with the Indonesian decree on leasing, which states that a leasing company is the legal owner of the asset during the tenure of the lease. Not allowing the lessor and the lessee to depreciate setoffs negates the useful role that leasing companies could play in deriving fiscal benefits.99 Tax regulations are inconsistent in several areas, creating an uneven playing field for different types of business in the multifinance industry. These include the following issues:

98 A finance lease is simply a pure financing transaction wherein the role of the leasing company is to provide finance and not to assume the risks and rewards of ownership of the asset. The lessee pays lease rental for use of the asset, which is calculated to amortize the investment in the lease and to return a profit to the lessor for having undertaken the financial intermediation function. On receiving the computed lease rental, a lessor has no further interest in the leased asset, which is transferred to the lessee via an express provision in the lease agreement. Thus in a finance lease, a lessor seeks to recover the entire investment in the lease from a single source, while in an operating lease, the lessor assumes the risk of residual value by not recovering the entire investment from a single lessee. 99 Annex C describes the concept of transmitting fiscal benefits from the lessor to the lessee under a finance lease.

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Leasing can only be offered to taxpayers with a tax identification number. This puts a strain on leasing activities vis-à-vis consumer finance activities, which are not subject to similar requirements.

While a finance lease is exempt from value added tax, an operating lease does not have a similar exemption.

While financial leases are allowed a tax-deductible doubtful reserve up to 2.5 percent, operating leases, factoring, and consumer finance are denied a deduction.

While lease rentals from financial leases are free from withholding taxes, rentals from operating leases do not enjoy an exemption.

These inconsistencies reflect the lack of a coherent leasing policy. In certain circumstances, there really is no economic merit in discriminating between the two types of leases. Such intervention discourages the growth of the leasing industry.

POLICY RECOMMENDATIONS The recommended policy actions by time frame are summarized in the following table. The policy recommendations are elaborated subsequently. Quick Wins (1 yr) 1 - 3 years Regulatory Allow lessors to claim depreciation of

leased assets Implement light regulation and supervision on industry Restructure and encourage consolidation of industry

Enforcement Improve the enforcement of lease contracts and strengthen legal processes for repossession of assets & consumer protection

Skills Improve project appraisal skills

Taxes Conduct a comprehensive assessment of tax regulations


Encourage consolidation in the industry

Access Widen the base of financing options Permit private participation in developing consumer credit information systems

The Indonesian authorities could foster development of the multifinance industry by taking actions on several fronts.

Priority recommendations Put in place an adequate level of regulation and supervision. In most developed countries, leasing companies are not subject to prudential regulation. The lack of regulation relies on the argument that as long as leasing companies do not engage in deposit taking, there is no role for public regulatory authorities. However, there are good arguments favoring light regulation in Indonesia to provide a more credible sector, especially during the initial phases of development. Experience in developing countries has shown that some degree of prudential norms is desirable to prevent excessive risk taking, which hinders development of the industry. For instance, in the Asian crisis, numerous leasing companies went bankrupt due to currency and maturity mismatches, setting back the development of the industry. The government should consider


regulation and supervision of the leasing sector in the areas of entry requirements (licensing and relicensing, minimum capital requirements), balance sheet restrictions (maximum leverage ratios, single client and group exposure, limitations on insider transactions, provisioning requirements, asset-liability matching in terms of currency and maturity), associations among institutions, liquidity requirements, accountability requirements, insurance and support schemes, absolute minimum capital requirements, capital ratios, legal lending limitations on exposure to a single client, foreign currency and maturity mismatches, and reporting requirements. Equally, supervision should rely on off-site financial analysis, complemented by periodic risk-based examinations. As the industry develops, the level of this regulation can be reduced. Allow depreciation of leased assets. The authority should allow lessors to depreciate the leased asset under a financial lease and include depreciation in the calculation of tax for finance lease transactions. Doing so would reduce the costs of leasing. The government has announced its support for small and medium enterprise financing, and such an amendment would be consistent with that objective. Develop credit information systems. Existing credit information systems should be expanded so that they are accessible to multi-finance companies also. In addition, it is highly recommended that Bank Indonesia consider allowing private sector participation in credit bureaus. Private credit bureaus can better manage professional processing of bank data and retail information in a format that facilitates the use of risk assessment and standardized pricing models by banks and multifinance companies. Widen the base of financing. In the present situation, the future funding of the industry depends largely on liquidity in the banking sector. Therefore, it is understandable that multifinance companies are seeking alternative sources of financing. From the perspective of the authorities, whose task is to maintain stability in the financial sector, decoupling the multifinance industry from the banking sector might be desirable in order to create a more competitive and diversified financial sector. However, giving multifinance companies access to public funds in the form of deposits, as in the banking sector, is not an option. It is desirable to consider other alternatives, such as encouraging the participation of foreign equity capital and long-term funding from domestic institutional investors, such as pension funds and insurance companies.

Other recommendations Encourage consolidation in the industry. Restructuring and consolidation will benefit the industry by removing weak players and predatory pricing. Two venues offer this possibility: foreign participation and a process mandating relicensing of all companies, designed to weed out dormant companies. Foreign investors have been able to buy a majority of shares in commercial banks and insurance companies, and thus there is no rationale for precluding them from acquiring multifinance companies. Foreign capital that comes with expertise and skills should be encouraged. In the long run, this will enhance the capacity of the industry in terms of both financial soundness and human resources. The authority should amend the presidential decree and the respective Minister of Finance decrees limiting foreign ownership and restricting investments in leasing companies. The authorities equally need to revoke the licenses of those companies that have not been active or operational in the past few years. The authority should provide advance notification of the conditions under which a multifinance license will be revoke. Conduct a comprehensive assessment of tax regulations. A comprehensive assessment of tax regulations that are related to multifinance companies—and other financial institutions for that matter—is warranted to ensure that the present tax regime does not discourage the growth of financial services. In many jurisdictions, tax and fiscal incentives are commonly given to encourage certain financial transactions. For instance, investment in plant, machinery, and other

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assets is encouraged via tax-deductible reserves for investment in those assets or through an investment allowance, or higher depreciation rates are allowed for certain types of assets or to encourage the flow of capital into desired areas that are perceived to be less commercial and more socially valuable, such as pollution control equipment, energy saving equipment, and so on. Improve the enforcement of contracts & Consumer protection. The government understands the issue of creditor rights and legal enforcement and is taking remedial measures. However, this is likely to be a long-term developmental issue. In addition, to support the government’s efforts, multifinance companies through their professional association (APPI) must be continuously committed to enforcing contracts. The authority must also improve the current legal framework for protecting consumer right, in particular in relation to settlement of consumer complaints and dispute resolutions.100 Improve project appraisal skills. Continuing capacity development and training are desirable. The authority might wish to explore this issue with the cooperation of the association of multifinance companies. For a start, a minimum set of technical qualifications for those working in the multifinance industry should be established. Equally, the association of multifinance companies could offer ongoing professional development through certifications and examinations.

100 There is currently Law No. 8 / 1999 on consumer protection, which applicable to all type of goods and services,


REFERENCES Carter, Lawrence W., Teresa Barger, and Irving Kuczynski. 1996. Leasing in Emerging Markets, Lessons of Experience 3, Washington, DC: International Finance Corporation. Rachmat, Budi. 2002. Multi Finance. CV Novindo Pustaka Mandiri, Jakarta. Siamat, Dahlan. 2003. Manajemen Lembaga Keuangan. Jakarta: Lembaga Penerbit Fakultas Ekonomi Universitas Indonesia. Infobank, September 2005 Investor, October 2005

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ANNEX A. CATEGORIES OF ASSETS AND DEPRECIATION METHODS Category Method of depreciation Assets in this category Category 1 50 percent (declining balance) or 25 percent

(straight line) on assets with a beneficial life of four years

Computers, printers, scanners, furniture and equipment constructed of wood and rattan, office equipment, motorcycles, special tools for specific industries and services, kitchen equipment, manual equipment for agriculture, farming, forestry, and fishery industries, light machinery for the food and drink industries, motor vehicles for public transportation, and equipment for the semiconductor industry

Category 2 25 percent (declining balance) or 12.5 percent (straight line) on assets with a beneficial life of eight years

Furniture and equipment constructed of metal, air conditioners, cars, buses, trucks, speedboats, containers, and the like, machinery for agriculture, plantation, forestry, fishery, food and drink, and light machinery, logging equipment, equipment for construction, heavy vehicles for transportation, warehousing, and communication, telecommunications equipment, and equipment for the semiconductor industry

Category 3 12.5 percent (declining balance) or 6.25 percent (straight line) on assets with a beneficial life of 16 years

Machinery for general mining other than oil and gas, machinery for the textile, timber, chemical, and machinery industries, heavy equipment, docks and vessels for transportation and communication, and other assets not included in the other categories

Category 4 10 percent (declining balance) or 5 percent (straight line) on assets with a beneficial life of 20 years

Heavy machinery for construction, locomotives, railway coaches, heavy vessels, and docks

Building category 5 percent (straight line) on assets in the permanent building category with a useful life of 20 years or 10 percent (straight line) on assets in the nonpermanent building category with a useful life of 10 years

Included in the cost of buildings is the land and building transfer duty (BPHTB) on building rights



ANNEX B. PORTFOLIO OF LEASING COMPANIES IN SELECT COUNTRIES (2003) Table B. 1: Portfolio of First Leasing Company of India (percent)

Type of asset Lease Hire purchase Land 0.3 0.0 Plant and machinery 82.9 76.2 Air conditioners, refrigerators, water coolers 0.6 0.4 Office equipment 2.2 7.2 Furniture 1.8 6.5 Automobiles 12.2 9.8 Total 100.0 100.0 Source: Staff Estimates

Table B. 2: Portfolio of ULC Mozambique

Sector Percent of total assets Agriculture 3.3 Construction 9.6 Manufacturing 22.5 Transport 40.0 Services 19.0 Retail and distribution 5.7 Source: Staff Estimates

Table B. 3: Portfolio of ULC Botswana

Sector Percent of total assets Agriculture 1.8 Building and construction 16.2 Manufacturing 1.6 Mining 1.4 Retail and wholesale 23.2 Trade, hotels, restaurants 26.7 Tourism 15.9 Transport 12.0 Other 1.2 Source: Staff Estimates

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ANNEX C. THE CONCEPT OF TRANSMISSION OF FISCAL BENEFITS IN LEASING For a leasing company to transmit fiscal incentives to end users such as small and medium-size enterprises, two ingredients are needed: Access to high-depreciation assets, which typically have 60 percent and higher depreciation

rates. A leasing company should be entitled to depreciation (as is the case in most countries since the lessor is the legal owner of the asset).

Availability of tax capacity. Tax capacity refers to taxable profits of a company to absorb the depreciation charge from high-depreciation assets. Typically, a leasing company’s tax capacity is represented by taxable profits from leasing operations.

To understand the mechanics of transmitting fiscal benefits from the lessor to an end user, it is necessary to understand the relationship between the pre-tax return (used in pricing a financing transaction such as a bank loan) and its post-tax return, which is calculated as follows: Post-tax return = Pre-tax return x (1 − tax rate). For example, suppose Bank XYZ finances a US$1 million loan for a period of five years at 10 percent a year, payable in arrears. The annual repayment is US$263,797.48. Table C.1 confirms the calculation: Table C. 1: Amortization Table

Year Opening balance Financing return (10 %) Total due Repayment Closing balance

1 1,000,000 100,000 1,100,000 263,797 836,203 2 836,203 83,620 919,823 263,797 656,025 3 656,025 65,603 721,628 263,797 457,830 4 457,830 45,783 503,613 263,797 239,816 5 239,816 23,982 263,797 263,797 0

Source: Staff Estimates

Post-tax return for a bank loan If the income tax rate is 33.33 percent, the after-tax return from the transaction would be 10 percent x (1 − tax rate) = 6.67 percent, as can be confirmed by calculating the post-tax internal rate of return from the cash flows set out in the last column of table C.2. Thus the post-tax return is equivalent to the pre-tax return x (1 − tax rate), or 10 x 0.67 = 6.67 percent. The taxable income is the interest portion of the repayment set out in table C.1.

Table C. 2: Post-Tax Return for a Bank Loan

Year Taxable income (financing income)

Income tax Pre-tax flows of transaction

Post-tax flows of transaction

Amount (million)

1 100,000 −33,333 263,797 230,464 230,464 2 83,620 −27,873 263,797 235,924 235,924 3 65,603 −21,868 263,797 241,930 241,930 4 45,783 −15,261 263,797 248,536 248,536 5 23,982 −7,994 263,797 255,804 255,804

Source: Staff Estimates Note: The internal rate of return of the transaction is 6.67 percent.


The rate of return that matters to a financial institution is the post-tax return of 6.67 percent (and not the pre-tax pricing rate of 10 percent). While table C.2 sets out the post-tax calculation for a bank loan, the post-tax return for a leasing transaction, using the same example as above, but with a tax depreciation rate of 40 percent a year, using the written-down value method, is set out next. The post-tax calculation for a leasing transaction is different than the calculation for the post-tax return from a loan because the method of calculating taxable income is different for leasing than for a bank transaction.

Post-tax return of a lease A leasing company first includes the entire repayment from the transaction (lease rental) as taxable income, unlike the bank transaction, wherein only the finance income for a year is included as taxable income. Since the lease rental from a lessee also includes repayment of principal, a leasing company applies a depreciation charge to the taxable income (lease rental) to unbundle the principal embedded in the lease rental. The calculation of the post-tax return from a lease transaction is set out in table C.3: Table C. 3: Post-Tax Return of a Lease

Year Lease rental Depreciation Taxable income Income tax After-tax flows Amount (million) 1 263,797 −400,000 −136,203 45,401 309,198 309,198 2 263,797 −240,000 23,797 −7,932 255,865 255,865 3 263,797 −144,000 119,797 −39,932 223,865 223,865 4 263,797 −86,400 177,397 −59,132 204,665 204,665 5 263,797 −129,600 134,197 −44,732 219,065 219,065

Total 1,318,987 −1,000,000 318,987 −106,329 1,212,658 n.a. Source: Staff Estimates n.a. Not applicable.

Influence of depreciation on the post-tax return The post-tax return (calculated from the post-tax flows in the last column of table C.3) is 7.30 percent for the lease (compared to 6.67 percent for the bank loan). Tax depreciation influences the post-tax return: the higher the depreciation rate, the higher the post-tax return from the lease. Table C.4 sets out post-tax returns from a range of tax depreciation rates: Table C. 04: Post-Tax Returns for a Range of Tax Depreciation Rates (percent)

Tax depreciation rate Post-tax return

25.0 6.77 40.0 7.30 50.0 7.60 66.7 8.00

100.0 8.51 Source: Staff Estimates As can be seen, the higher the depreciation rate, the higher the post-tax return from a lease. Financial institutions use the post-tax return from a transaction.

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Pricing flexibility Therefore, if we assume that a financial institution requires 6.67 percent as its post-tax return, a bank will be compelled to price the bank loan at 10 percent. However, a leasing company will have greater flexibility in setting pricing for the lease, as can be seen: With a tax depreciation rate of 40 percent, the pre-tax equivalent pricing rate can drop to 9.1%. With a tax depreciation rate of 50 percent, the pre-tax equivalent pricing rate can drop to 8.8%. With a tax depreciation rate of 66.67 percent, the pre-tax equivalent pricing rate can drop to

8.4%. With a tax depreciation rate of 100 percent, the pre-tax equivalent pricing rate can drop to

7.8%. These rates are the outcome of an iterative calculation that generates the 6.67 percent post-tax return. In other words, the leasing company is able to transmit fiscal benefits to end users by lowering the lease rental without compromising its profit objectives, an event that is impossible to accomplish with a non-leasing transaction. The above example assumes that the lease is signed on the first day of the tax accounting year, which is not necessarily the case. The post-tax return is higher if the lease is signed toward the end of the tax accounting year. Thus using an extreme example of a 100 percent tax-depreciation item and signing the lease on the last day of the tax accounting year, the post-tax return (10 percent) is equivalent to the pre-tax return (10 percent). The tax shielding generated by the transaction completely nullifies the effect of the tax. Since post-tax is now equal to pre-tax, a leasing company can price the transaction at 6.67 percent (as against the 10 percent that a financial institution would be compelled to charge) and thus transmit fiscal benefits to end users without compromising the company’s profit objective.

CHAPTER 8 INDONESIA’S VENTURE CAPITAL INDUSTRY

Venture capital and private equity is a broad term that refers to equity investments not traded in public stock markets. Venture capital is capital provided by outside investors for financing for new, growing, or struggling businesses. Venture capital investments generally are high-risk investments that offer the potential for above-average returns. A general partner usually manages the partnership, but the bulk of funding comes from limited partners, which are usually large institutions with large amounts of available capital, such as state and private pension funds, university endowments, insurance companies, and pooled investment vehicles. Private equity generally refers to investments of a similar nature but in a later stage. This report discusses both venture capital and private equity investment. Venture capital firms serve several important roles. First, they provide a source of risk capital in companies or projects that are start-up or at a very early stage of product development. These projects usually would not attract complementary sources of finance such as loans and cannot raise money in the major public stock markets without a demonstrated track record. Second, they provide strategic direction, disciplined professional management, and governance to promising entrepreneurs. Typically venture firms sell most of their shares within about five years of their initial investment when the company floats its shares on a public stock market. In this way, the venture capital offers a virtuous cycle of new listings and capital mobilization on public exchanges. Nearly $180 billion of private equity was invested globally in 2004. U.S. firms have traditionally been the biggest participants in venture deals, but non-U.S. venture investment is growing. In 2004, nearly 66 percent of global private equity investments and 62 percent of funds raised were managed in North America. Between 1998 and 2004, Europe increased its share of investments (from 24 to 26 percent) and funds raised (from 18 to 31 percent). The share of investments and funds for the Asia-Pacific region was raised 6 percent, while the share for the rest of the world


fell. The Indian Venture Capital Association estimates that funding of Indian companies had reached $1 billion in 2004. In China, venture funding more than doubled from $420 million in 2002 to almost $1 billion in 2003. Nascent efforts in other developing countries such as Tunisia are bearing fruit, and risk capital investment companies (SICAR) are becoming an important source of equity. The latest data from Cambridge Associates’ Emerging Markets Private Equity Index show that emerging-market private equity funds are beginning to deliver the kind of top-level returns that excite institutional investors. Index results show the recent trends: (a) emerging-market private equity is beginning to deliver results comparable to and better than counterparts in the United States and West Europe, and (b) the performance of private equity in emerging markets has improved significantly in the past two years. Two years earlier, the same Cambridge index showed abysmal performance, with negative returns across all time intervals. This turnaround is mainly the result of a significant increase in divestments in 2004 and 2005, including an estimated US$16 billion returned to investors from emerging-market funds in 2005 (see table 8.1). Table 8.1: Performance of Venture Capital and Private Equity Funds in Emerging Markets (percent)

Index One year Three years Five years 10 years

Emerging-market venture capital and private equity index 18.0 6.7 0.2 1.8 Asian private equity index 10.6 5.5 0.1 1.8 Central East Europe and Russia private equity index 52.2 22.2 12.6 9.0 Latin America private equity index 16.1 −2.8 −8.9 −5.5 U.S. private equity index (December 31, 2004) 23.5 12.3 5.0 12.3 West Europe private equity index (December 31, 2004) 31.2 27.0 17.9 19.2 MSCI emerging-market index 17.0 19.2 4.5 4.9 S&P 500 6.7 2.8 −3.2 10.8 Emerging-market venture capital and private equity index (June 2003)

−9.3 −9.1 −4.6 •4.1

Source: Cambridge Associates LLC U.S. Venture Capital Index®, Cambridge Associates LLC Private Equity Index® Cambridge Associates LLC Proprietary Database, Standard & Poor’s, and Morgan Stanley Capital International. Note: Data are from March 31, 2006, unless otherwise noted. Venture capital plays two important roles. It finances a segment of the economy—small and medium enterprises (SME)—with a strong potential for growth but with difficulty obtaining financing through traditional channels because the firms are either young or their technology, products, or services have potential, but have not yet demonstrated performance. Because it is speculative, it provides high returns to the companies willing and able to take on risk. It also plays a role in developing the capacity of local industry, with venture capital companies providing managerial expertise and advice to relatively inexperienced companies. For example, venture capital companies may work closely with local universities and research institutions to identify products and processes of interest to the companies. Given the importance of the SME sector and the benefits that venture capital can bring to it, the Indonesian government is interested in fostering the venture capital industry. In 1973 the Indonesian government established a state-owned company, Bahana Pembinaan Usaha Indonesia (BPUI),101 with a mandate to develop SMEs and their entrepreneurial skills through the provision of equity financing and technical assistance in areas such as the preparation of feasibility studies and the marketing of products. In 1988, through Presidential Decree no. 61/1988, the government formalized the venture capital industry, together with multifinance companies, as an alternative source of non-bank financing for business. In response, BPUI established a subsidiary—Bahana Artha Ventura—that provides financing to SMEs through venture

101 Bahana Pembinaan Usaha Indonesia is owned by Bank Indonesia (80 percent) and the Ministry of Finance (20 percent).

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capital investment.102 This company helped to establish regional (provincial) venture capital companies throughout Indonesia. In 1995 the Ministry of Finance separated the venture capital business from the multifinance business as a result of Minister of Finance Decree no. 469/KMK.17/1995. This led to the creation of private venture capital companies owned by fully domestic (national) investors or partly by foreign companies through joint-venture companies. Given its short history as an independent industry, the venture capital industry in Indonesia is still small and underdeveloped. It constitutes a very small segment of Indonesia’s financial sector. As of end-2005, it accounted for only 0.1 percent of total assets of Indonesia’s financial institutions. The industry has very few links to other types of financial institutions. The authorities have encouraged commercial banks to support the growth of SMEs, but thus far no bank has a subsidiary in the venture capital industry. Instead, commercial banks lend directly to small and medium firms. Pension funds and insurance companies also can invest in SMEs, and their portfolios have a small portion of direct equity investment, but none of these investments is in a venture capital company. Similarly, links with the capital market are also limited. No single investee company has been listed on a stock exchange.

STRUCTURE The regulations state that a venture capital company is an entity that participates in the equity of another company for a certain period of time. This definition is broadly similar to the definition in other countries. However, venture capital companies in Indonesia rarely provide pure equity financing; rather, they typically provide three types of financing: (a) equity participation, (b) convertible bonds, and (c) profit sharing (or limited participation). For the first and second option, the investee company has to be a limited-liability company (Perseroan Terbatas), whereas for the third option, it could be a Perseroan Terbatas or a cooperative. The profit-sharing financing could take the form of a “pure” or “managed” profit-sharing scheme. The pure scheme usually follows one of the following: Profit sharing based on revenue. The percentage of profit shared is taken from the investee

company’s revenue. Profit sharing based on net profit. The percentage of profit shared is taken from the investee

company’s net profit. The portion of profit distributed to the venture capital company is usually higher than the portion of equity that it owns in the investee company.

The “managed” profit sharing is a scheme whereby the venture capital and investee companies agree on a targeted monthly internal rate of return. The rate could be revised upward if the financial performance of the investee company is above expectations and vice versa. In the recent past, venture capital firms in Indonesia have typically been seeking to earn a rate of around 18 percent on its investment, which is far less than what small and medium enterprises have to pay for financing in the informal sector. In addition, venture capital companies charge a processing fee of around 1 percent at the time of finalizing the transaction. In reality, the majority of venture capital financing takes the form of either convertible-bond investments (19 percent) or profit-sharing agreements (80 percent). In some instances, venture

102 Minister of Finance Decree no. 250/KMK/04/1995 states that SMEs are eligible for venture capital investment if net annual sales are below Rp 5 billion.


capital companies provide funding that is backed by collateral with a value of more than 100 percent of the financing. This is similar to a commercial banking loan, albeit with fewer restrictions. Therefore, most venture capital companies in Indonesia do not provide genuine risk capital. They are in the business of lending, not in the business of taking on equity risk, as is typical of venture capital companies in other parts of the world.

Legal and ownership structure Excluding joint ventures, most venture capital companies in Indonesia either are owned by the government (that is, provincial governments and Bahana Artha Ventura) or belong to a large business group. Stand-alone venture capital companies—as found in other parts of the world—are rare. Ownership by a business group is common because large companies usually have business relationships with SMEs. These large companies have a business interest in ensuring that their vendors and distributors are viable. SMEs can take the form of (a) a limited-liability company (Perseroan Terbatas), (b) a cooperative, or (c) some other form (for example, limited partnership and proprietorship). The largest category in terms of value is the limited-liability company, but most companies fall in the category of “other.” All venture capital companies in Indonesia use a single-tier structure, where venture capital companies directly manage venture capital funds. The vast majority of venture capital investment is made when the investee company has reached the expansion stage103. Foreign institutions are allowed to own up to 85 percent of a venture capital company.

Regulatory and supervisory structure Venture capital companies wanting to operate in Indonesia must obtain a license from the Ministry of Finance and are subject to regulations governing capital structure, investments, term of investments, and tax treatment. The guidance and oversight of regional venture capital companies are performed by the Bureau of Banking, Financing and Guaranteeing, which is currently under the Bapepam & LK of the Ministry of Finance, with the assistance of Bahana Artha Ventura. The venture capital industry is regulated by a presidential decree and by minister of finance decrees. There is no law dealing directly with this industry. The minimum paid-up capital, by type of entity, is as follows: For a national private company, Rp 3 billion For a cooperative, Rp 3 billion For a joint-venture company, Rp 10 billion.

The regulation states that the investment by a venture capital company must assist in the following: The development of new inventions The development of a company in the initial stage of business and experiencing financial

difficulties A company developing its business A company experiencing a decline in business The development of research and engineering projects The development of new technology applications and technology transfer from domestic or

overseas sources.

103 Aylward (1998)

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To encourage venture capital investment, the income of venture capital companies (that is, its share of the investee company’s profit) is exempt from income tax if (a) the investee company is operating in certain sectors, as stipulated by the regulation, and (b) the investee company is not listed on the stock exchange. According to Regulation no. 62/2002, venture capital income is tax exempt in the following industries or areas: (a) the production of exports, (b) manufacturing of electronic components, (c) processing of farming, livestock, and fishery products, (d) SMEs as defined by the government, (e) low-cost apartment in urban areas, (f) farming, plantation, forestry, livestock, and fishery, (g) land, sea, and air transportation, and (h) services to export facilities. In addition, any gain from the sale or transfer of equities of investee companies is subject to a final income tax of 0.1 percent if the investee company is an SME (a) with annual net sales not exceeding Rp 5 billion and (b) not listed on a stock exchange. The investment by a venture capital company in an investee company must continue as long as the investee company does not sell its shares on the stock exchange and for a term not exceeding 10 years. In the event an investee company sells its shares on the stock exchange, the venture capital company is required to sell its shares within 36 months.104 There is no separate accounting or tax regulations other than notifications granting tax exemptions for income from the investments. Therefore, venture capital companies are required to account separately for income that is tax exempt and income that is not tax exempt. Venture capital companies are prohibited from raising funds from the public and are not allowed to issue debt securities. They must rely on the injection of funds from shareholders (in the case of a Perseroan Terbatas) and members (in the case of a cooperative). Bahana Artha Ventura and regional venture capital companies have received financing support from the government105 and two-tier loans from the Japan EXIM Bank.106

PERFORMANCE AND SUSTAINABILITY The performance of the venture capital industry has not been encouraging. The number of venture capital companies has not changed in recent years, indicating that the industry has not attracted new private investors. As of end-2005, there were 60 venture capital companies (see table 8.2), of which 26 were government-owned firms, one for each province of Indonesia. The majority of investee companies are in the trading and service business, so most venture capital investment is also in these types of businesses (see table 8.3). Total assets of venture capital companies were estimated at Rp 2.7 trillion , or only 0.1 percent of GDP in 2005. The return on investment has been small, volatile, and declining. As a result, assets and capital have been declining over the years (see table 8.4). However, the industry has been recording growth with respect to the number of investee companies and the size of investments. This is consistent with the large number of SMEs in the economy and their dire need for funds to further growth.107

104 The sale of shares must be reported to the Ministry of Finance within three months after the transaction is completed. 105 In 2002 the Ministry of SMEs and Cooperatives loaned state funds called MAP (Modal Awal Padanan) to Bahana Artha Ventura and regional venture capital companies. The amount was Rp 1.25 billion each. In turn, these venture capital companies had to finance at least 12 investee companies with a maximum amount of Rp 150 million each. 106 Made in 1997, these loans will be due in 2008. The estimated outstanding amount now is Rp 1.2 trillion. 107 There is no official figure for the total number of SMEs in Indonesia, but it is estimated to be more than 40 million. According to the Ministry of SMEs and Cooperatives, an estimated 42.5 million SMEs accounted for 56 percent of GDP at end-2004, and only 60 percent of total SMEs had access to loans provided by formal financial institutions.


Table 8.2: Number and Asset of Venture Capital Companies, by Type, 2000–5

2000 2001 2002 2003 2004 2005 Type Private national 18 18 19 20 22 24 Joint venture 15 16 15 14 12 10 Provincial 26 26 26 26 26 26 Total 59 60 60 60 60 60

Assets (Rp billion) Private national 1,319 1,315 1,414 1,293 1,230 2,096 Joint venture 373 207 191 173 399 148 Provincial 958 966 908 831 795 426 Total 2,650 2,499 2,513 2,297 2,424 2,670 Source: Bapepam & LK

Table 8.3: Characteristics of Investee Companies, by Sector, 2003 (percent)

Sector Share of all investee companies Share of venture capital investment Trading 40 28 Services 32 41 Manufacturing 12 17 Agribusiness 3 5 Livestock 9 7 Others 4 3 Total 100 100 Source: Bapepam & LK Table 8.4: Performance of Venture Capital Companies, 2000–5 (Rp billion unless otherwise noted)

Indicator 2000 2001 2002 2003 2004 2005 Investment amount Private national 754 780 806 884 1,020 1,081 Joint venture 302 303 303 266 267 322 Regional 628 911 1,139 1,228 1,345 1,339 Total 1,684 1,994 2,248 2,378 2,632 2,742 Number of investee companies Private national 521 544 575 620 716 2,389 Joint venture 70 71 72 63 84 78 Regional 4,357 6,342 8,898 9,593 10,246 10,574 Total 4,948 6,957 9,545 10,276 11,046 13,041 Profit (loss) Private national 9 (39) 26 27 10 29 Joint venture 27 (12) (2) 8 (15) (11) Regional 22 40 27 7 3 10 Total 58 (11) 51 42 (2) 28 Return on investment (percent) Private national 1.2 (5.0) 3.2 3.1 1.0 2.7 Joint venture 8.9 (4.0) (0.7) 3.0 (5.6) (3.4) Regional 3.5 4.4 2.4 0.6 0.2 0.8 Total 13.6 (4.6) 4.9 6.6 (4.4) 0 Source: Bapepam & LK

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DEVELOPMENTAL ISSUES AND CONSTRAINTS The government needs to address several issues that are hindering development of the venture capital industry.

Limited supply Limited supply is the most important reason for the limited flow of deals in the industry. Few offshore-based venture capital companies have shown an interest to invest in the country.108 The perception of Indonesia’s overall investment climate is still weak and less favorable than that of neighboring countries. A recent paper109 analyses the determinants of venture capital for a sample of 21 countries. The paper considers the importance of IPOs, GDP and market capitalization growth, labor market rigidities, accounting standards, private pension funds, and government programs. It finds that IPOs are the strongest driver of venture capital investing. Observations from around the world support this conclusion. The United States has both an active venture capital industry and well-developed stock markets. Venture capital can flourish only if the venture capitalist can exit from a successful portfolio company through an initial public offering (IPO), which requires an active stock market. Equally private pension fund levels are a significant determinant over time but not across countries. In this context, it is understandable that in order to have a vibrant venture capital market in Indonesia, concerted efforts are needed to develop the equity market and facilitate IPOs. Equally the pension system needs to be strengthened. Another factor that could discourage venture capital companies is the climate of poor corporate governance in many local corporations. Problems with regard to transparency of financial reporting, reliability of financial information, standards of accounting and auditing, and tax filing and administration hinder the development of private equity.110

Structure of formal sector Government agencies, state-owned enterprises, and large business groups are the largest providers of jobs in Indonesia. The vast majority of companies are started as family-run businesses, and they commonly remain family owned even after they become much larger in size. Entrepreneurs who own and run these businesses are not usually willing to share ownership with outside investors. This also is evident in the low proportion of public ownership (free-float of shares) on the Jakarta Stock Exchange111.

108 A few regional venture capital companies are still investing, but these are mostly companies that had invested in Indonesia in the past. They have the experience and networks within the local business community and are relatively comfortable with the current state of the economy and investment climate. It is believed that some of these companies are financed by Indonesians residing outside of Indonesia. Nevertheless, the amount of investment is very small. 109 Jeng and Wells (2000) 110 See chapter 2 on equity markets for a fuller discussion of corporate governance issues. 111 The free-float ratio is about 39.4 percent (see chapter 2). Some listed companies show a high percentage of public ownership, but the founder is generally still the single largest shareholder.


Limited source of funds Indonesian venture capital companies have limited sources of funds for investment. These only include funds from the shareholders or members and, in the case of Bahana Artha Ventura and the provincial venture capital companies, subordinated borrowings from the government. This is in contrast to the practice in other countries, where institutional investors such as pension funds and insurance companies have substantial portions of venture capital investment. Wealthy individuals are another potential source of funds, but in Indonesia, this segment of investors has not invested in venture capital.

LEGAL AND REGULATORY ISSUES The legal and regulatory frameworks should support the venture capital industry. Some key issues are discussed within this context.

Separation of operation and management Venture capital operations can be based on a one- or two-tier structure. In a one-tier structure, the investor provides the resources and makes investment and divestment decisions through the board of directors and a committee representing the shareholders and management. The one-tier structure has several limitations. First, the board of directors or management might be inexperienced in venture capital, resulting in poor decisions. Second, the ability to raise additional resources for investment is limited, as it depends on the capacity and continuous support of existing shareholders or members. In a two-tier structure, the investors provide the resources to a venture capital fund, and a separate venture capital management company makes these decisions. In Indonesia, the current regulation only deals with the one-tier structure; consequently, the two-tier structure does not exist. In the two-tier structure, venture capital funds pay management fees to a capital management company. In some instances, the management company also receives shares of dividends or revenues from the investee companies. This is particularly true when a foreign-based management company is involved.

Licensing requirement and foreign ownership Convenience and ease of entry to the industry are key drivers of growth in the venture capital industry. In this regard, the current requirement for venture capital licensing and the limit of 85 percent on foreign ownership make little sense for venture capital companies that are financed by private investors or institutions.

Regulation for reporting The regulation requires all venture capital companies to submit operational and financial reports twice a year in addition to the audited annual report. However, the reports do not provide adequate meaningful information and the enforcement of this regulation is also weak. In addition, there is no clear sanction for companies that have failed to meet this regulation. This has led to a situation where reliable statistics and database of the industry are not available and thus prohibits the authority to undertake effective monitoring and supervision.

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Box 8.1. International Experience: Venture Capital Industry in Taiwan (China)

When the Taiwan (China) formally established the venture capital industry in 1983, the Ministry of Finance formed an Administrative Committee on Venture Capital Investment Enterprises to regulate the formation of venture funds. Since 1983, 199 venture funds have been formally registered, with total paid-in capital of NT$ 134.1 billion (US$4.1 billion). Of these (as of 2005), 176 are active and operational, 12 had not yet been formally launched, and 11 have either relocated or discontinued their operations. Of the 176 operating funds, 27 manage their own funds whereas the remaining 149 use outside venture capital management or consulting firms. There are 79 venture capital management firms in Taiwan (China) with an average of two managed funds and NT$ 1.65 billion (US$0.1 billion) capital under management. Prior to 1995, the formation process for venture funds was rather slow with one to seven new funds formed per year. This period is considered the developmental stage of Taiwan's venture capital industry. From 1996 to 1998, however, the number of new venture funds experienced a dramatic rise, increasing from 34 in 1995 to 114 by 1998. Therefore, 1996-1998 is considered the expansion stage of Taiwan's venture capital industry. Beginning in 1999, the rate of new venture fund formation slowed down, signaling the industry's transition into the mezzanine stage. Due to the domination of small and medium enterprises (SMEs) in industry in Taiwan (China), and the absence of large conglomerates seeking vertical integration, small-to-medium technology companies have learned to thrive in a highly segmented market space. At the same time, the government has supported the development of the high technology industry via regulations. For instance, the government established The National Industrial Technology Research Institute (ITRI) as a center for high technology research and development and human resources development. In addition, the Hsinchu Science and Technology Park serves as a base for nurturing high technology companies with growth potential. Furthermore, the steady growth of Taiwan's capital markets and reduced application costs to small-to-medium technology companies seeking to list on the Taiwan Stock Exchange or the GreTai Securities Market (formerly known as the Over-The Counter Securities Exchange) have contributed to making investment in high technology companies an attractive prospect. This has resulted in continued growth for Taiwan's venture capital industry, which is second globally only to the US. Over the past 18 years, Taiwan venture funds have invested NT$ 90 billion (US$2.8 billion) in domestic high technology companies, which has led to the emergence of a high technology industry of over NT$ 1 trillion (US$31 billion) in size. Beyond the simple infusion of capital, venture funds also provide early stage technology companies and entrepreneurs with an excellent environment for the further development and expansion of the high technology industry. Therefore, it can be said that the development of Taiwan's technology industry is reliant upon a three-pronged source: the venture capital industry, the ITRI and the Hsinchu Science and Technology Park. Many national governments, including those of Japan, Korea, Malaysia, Thailand, Singapore, Macau, New Zealand, Canada, Israel, Germany, Switzerland, France, and China, have expressed interest in Taiwan's successful venture capital model. The government-led development of Taiwan's venture capital industry has been the subject of much study and discussion in many Asia-Pacific countries seeking to implement their own systems. In the aftermath of the Asian economic crisis of 1997, Taiwan SMEs have survived and built a strong foundation for growth, thereby drawing the attention of other Asian nations. A large part of the credit for the survival of SMEs goes to venture funds; in fact, Taiwan's venture capital model has been so successful that many of Taiwan's venture funds have been asked by other reginal nations to expand abroad.


POLICY RECOMMENDATIONS The recommended policy actions by time frame are summarized in the following table. The policy recommendations are elaborated subsequently. Quick Wins (1 yr) 1 - 3 years Regulatory Encourage corporate restructuring

private equity activity Separate operation and fund management Separate profit sharing from venture capital Clarify the role of the Ministry of Finance

Encourage foreign ownership. Encourage institutional investors to invest in venture capital companies Improve regulatory and enforcement capacity

Skills Revitalize the industry association

Improve financial reporting

Enforcement Improve enforcement of regulation on reporting requirement

Taxes Assess the Government support and fiscal incentives


Improve the investment climate Improve liquidity in the stock market


Educate local entrepreneurs about venture capital

Several changes are needed if Indonesia is to encourage a vibrant, viable venture capital industry willing to take on risks and support promising small and medium enterprises. We begin by offering the recommendations that we consider to be the top priority and then offer suggestions for supplemental actions.

Priority recommendations Support corporate restructuring through private equity. There is a need for a more differentiated approach to venture capital from a policy perspective. Private equity is generally better understood and implemented globally than venture capital and early stage government funded investments. Later stage private capital investing is contributing to the restructuring of the European industry as well as fueling the growth of venture capital in Europe. The corporate restructuring process in Indonesia, while advanced, is not complete. The positive aspects of private equity vehicles— improving competitiveness and thereby restoring companies to going-concern value rather than liquidation, removing the financial and management burdens from the banking sector, allocating resources more efficiently—suggest that private equity can have a significant role to play in the corporate restructuring process. This fundamentally sound idea could be refined and implemented in Indonesia. Indonesia lacks the financial expertise to restructure medium-size companies. Therefore, considerable effort is needed to attract expertise in financial engineering. The Indonesian government is encouraged to support the restructuring efforts of private equity companies with more capital, foreign corporate finance, and venture capital expertise. For instance, the Indonesian authorities could retain foreign firms with corporate finance expertise to manage the portfolio of firms in need of restructuring. The firms

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could rely on funding from Indonesian financial institutions. This effort could pave the way for a restructuring industry in Indonesia. Separate the operation and management of venture capital funds. The one-tier structure of venture capital operations runs counter to best practices, in which the ownership and management of capital are separated. It hinders the ability of venture capital companies to raise funds from investors. Allowing the management company to be separate from the venture capital company would facilitate the use of management expertise. The government will have to assess carefully the regulatory and supervisory implications of such a change. One possible route is to create venture capital funds using the legal and tax framework similar to that of a trust. This would provide a convenient entry point for institutional investors such as insurance companies and pension funds, as well as wealthy individuals, to invest in the equity of private growing companies.

Other recommendations Improve the investment climate. A vibrant venture capital industry can only flourish within the context of a vibrant economy. To achieve the latter, Indonesia’s investment climate clearly has to be improved. The government is aware of this and is committed to undertaking reforms. Some positive actions have been taken to date. Nonetheless, this is an ongoing process, and it may take some time before results become available. However, the message that the government is serious about addressing this issue and consistently pursuing the right actions could change perceptions faster and jump-start the industry. Improve liquidity in the stock market. Overall, Indonesia’s equity market is relatively small, highly concentrated, and relatively illiquid. Many studies indicate that countries with an active stock market are more likely to have a vibrant venture capital industry as well. Recent research on private capital has demonstrated that opportunities for redeeming investment are the foremost consideration for venture capitalist firms. There are a number of ways for venture capital to exit an investment, but research suggests that IPOs are the preferred way. Although the secondary stock market in Indonesia has improved in recent years, IPOs have not been very active. Improve financial reporting. Companies in their early phases of development are relatively risky. If the market does not have good information on them, investors will demand a high premium, resulting in more expensive funding for these companies. This cost of asymmetric information can be reduced in various ways and improving accounting standards is one of them. With good accounting standards and regulation, venture capital companies need to spend less time checking accounting information. Therefore, the government is encouraged to improve accounting standards and to help to expand the capacity of companies and auditors to provide financial reports that live up to these standards. There is also needs to improve enforcement on the requirement for reporting from the venture capital companies and to improve the provision of information in the reports. Encourage foreign ownership. Since venture capital supports domestic entrepreneurship and growth of the economy, foreign venture capital can be welcomed. Regulations should ease licensing and ownership requirements for independent private venture capital companies. Full ownership by foreign institutions can be permitted. Encourage institutional investors to invest in venture capital companies. Pension funds and insurance companies should be encouraged to make more investments in venture capital


companies. Currently, no major regulatory impediments112 prohibit them from entering the industry, apart from the limit on total exposure in the portfolio. The lack of investment from these institutions is more the inability of investment officers to evaluate and analyze investment opportunities as well as historical preference of more liquid investments. Assess the government support and fiscal incentives. Venture capital companies now receive income tax exemptions for investment made in certain industries. Government supports and incentives are expensive, and can only be justified if their impact to stimulate growth of the industry is obvious. International experience with the use of subsidies suggests that they sometimes benefit only a select portion of the target audience with little if any impact on fostering the government’s objectives. Therefore, it is desirable to assess the benefits and costs of such policies including the provision of the tax advantages. Similarly, the performance of Bahana Artha Venture and the provincial venture capital companies must also be assessed objectively. The Japanese EXIM fund is winding down, and the government has to assess the impact of this on these institutions. A decision on the future of these institutions – including considering options of privatization and closure – needs to be taken. Clarify the role of the Ministry of Finance. The Ministry of Finance needs to ensure that its staff has the right skills and appropriate capacity to monitor and analyze the industry, to evaluate current policies, or to propose new ones for developing the industry further. The quality of information will have to be improved to support this objective. Capacity building efforts need to continue. Revitalize the industry association. An active association is needed to represent the interests of venture capital companies to the authority and to support development of the industry. However, the industry association is currently dormant and poorly resourced. Therefore, venture capital companies should restructure their industry association. It is important to identify the educational and training needs of the venture capital industry and to nurture a professional association capable of building capacity. Educate local entrepreneurs about venture capital. The presence of a sufficient number of skillful entrepreneurs in the economy is key for having a successful venture capital industry. Unfortunately, there is no easy solution to this issue. Clearly, there is a need to educate local entrepreneurs about venture capital. The government, through Bahana Artha Venture, and the association of venture capital companies could take the initiative to launch such a program. Improving corporate governance practices is equally important.

112 Perhaps an exception is the regulation of Jamsostek, which requires the permission of shareholders to take equity investment and is generally prohibited from making private placements.

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REFERENCES

Aylward, Anthony. 1998. “Trends in Venture Capital Finance in Developing Countries” IFC Discussion Paper 36, Washington, DC: World Bank. Jeng, Leslie A. and Philippe C. Wells. 2000. "The Determinants of Venture Capital Funding: Evidence Across Countries" Journal of Corporate Finance 6: 241-89. Dossani, Rafiq and Martin Kenney. 2002. ”Creating an Environment for Venture Capital in India”. World Development Vol. 30 No.2: 227-53. Rachmat, Budi. 2005. Modal Ventura: Cara Mudah Meningkatkan Usaha Kecil & Menengah. Jakarta: Ghalia Indonesia. Siamat, Dahlan. 2003. Manajemen Lembaga Keuangan. Jakarta: Lembaga Penerbit Fakultas Ekonomi Universitas Indonesia. Cambridge Associates LLC, www.cambridgeassociates.com

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