|Project Rationale and Linkage to Country/Regional Strategy
A number of development constraints have continued to restrain growth in the financial markets. First, the "twin silo" approach to financial sector supervision exhibits a number of weaknesses. The banking sector is regulated by Bank Indonesia, the country's central bank while the capital markets, insurance, and nonbank financial sectors are regulated by Bapepam-LK. This means that regulation of financial conglomerates is bifurcated and cannot be applied on a consolidated basis. Regulations covering one part of the financial sector often constrain development in the other. Disparate access to resources and the lack of qualified immunity for nonbank regulators has produced an uneven application of supervision which is susceptible to arbitrage. Responsibility for financial sector development is likewise split between the two regulators and the Ministry of Finance's Fiscal Policy Office (FPO). The end results of these issues include a lack of coordinated development, low investor confidence, and limited domestic participation in the capital markets. An increase in foreign capital inflows due to an upgrade in Indonesia's credit rating has made the need to address these problems and modernize the supervision of financial markets even more urgent.
Government debt issuance continues and the outstanding debt stock has increased. However, the size of the debt market, relative to GDP, has declined as the pace of issuance has not mirrored the growth in the economy. This situation has been exacerbated by the fact that half of the outstanding government debt stock is thinly traded or not tradable. Market participants currently have no effective hedging mechanisms such as repurchase agreements, for example, and no derivatives. This forces market participants to close positions rapidly in response to nominal events and creates a feedback loop of elevated volatility. The FMDIP establishes a framework to increase the stock of tradable government debt by converting bank recapitalization bonds into government debt. However, more needs to be done to help develop more efficiently functioning primary and secondary government debt markets and to boost the role of the contractual savings subsector as a source of domestic demand for capital markets products. The contractual savings subsector needs to migrate to more advanced portfolio management methodologies but is constrained from doing so by an acute shortage of trained risk management professionals, including actuaries.
To address these issues, the government has made it a priority to strengthen the financial sector's infrastructure and assure investors of stability and proper governance. It has begun to harmonize supervision across the financial sector, reduce regulatory arbitrage, and improve the overall competence and integrity of supervision. Under the FMDIP, the government will launch an independent, unified financial sector regulator through the newly authorized Integrated Financial Services Authority (OJK). The FMDIP also includes support for significant revisions to the three primary sector laws governing capital markets, insurance, and pensions. This is intended to provide a legal framework for harmonized supervision, as well as supervisory immunity and the power to resolve problem institutions. While the establishment of OJK represents a landmark in the government's reform efforts, broad-based TA will be necessary to ensure its success. Support will be needed to ensure rapid integration of diverse corporate cultures within the new organization so that it can exercise its regulatory function effectively. The operational and procedural standards OJK adopts will have to reflect international sound practices. In addition, the creation of OJK has triggered FPO's emergence as the Government's designated agency for coordinating financial sector policy. Specifically, the FPO's responsibilities will now expand beyond fiscal matters to include high-level coordination of financial sector development and stability. This will provide FPO and ADB more flexibility to address a wider range of development constraints, including taxation issues, which had proven challenging under Bapepam-LK. To ensure a smooth transition across all affected agencies, FPO will require a rapid build-up of technical capacity. It will need these skills to maintain the existing momentum of financial sector reform and to exercise its expanded mandate efficiently and effectively.
Concurrent efforts are also needed to develop the domestic debt markets and to encourage domestic investors to participate in the capital markets. Many of these reforms are currently being supported by ADB and are complex and technically challenging. ADB is currently providing real-time technical advice to senior policy makers through an onsite resident advisor. This assistance has been directly responsible for a number of key reforms completed under the FMDIP and will be continued. Further, specific steps are needed to encourage broader and deeper participation in the government debt market. Basic inventory management tools, including the Global Master Repurchase Agreement (GMRA) and interest rate derivatives, must be provided to support the efforts of primary dealers to make two-way markets. These tools, which will strengthen risk management and reduce volatility, will foster a more active Government debt issuance program. In conjunction with these efforts, the tax code applicable to the financial system as well as specific financial transactions must be modified to provide the proper incentives to support financial sector development.
Finally, efforts are needed to raise awareness of the important role played by contractual savings in financial sector development and economic growth. Financial literacy must be improved both within and outside of the government to reduce entrenched resistance to coordinating efforts to develop Indonesia's financial system. In addition, the reforms already implemented under the FMDIP must now be further supported by building technical capacity in the sector. Developing greater actuarial and risk management capacity in the insurance subsector is particularly important, because this will lead to enhanced returns and provide more diverse choices to investors.