Working Paper
The Banking System and Monetary Aggregates Following Financial Sector Reforms

This paper discusses the process, problems and impacts of the financial sector reform in Indonesia, particularly since the late 1980s. The reform has encouraged a surge in private sector capital inflows to supplement the already high domestic savings for financial investment and consumption expenditures and spur economic growth in the 1990s. The surging capital inflows, however, have complicated macroeconomic management as they put pressures for the real exchange rate appreciation and overheating the economy. To restore and maintain internal and external stability of the economy this paper suggests the curbing of expansion in domestic aggregate demand. The surest way to restrain domestic demand is to have a surplus in the public budget. This requires a revision of the long standing fiscal policy which is based on the 'balanced budget principle': capping the budget deficit to the level that can be financed by concessionary development aid package. Moreover, the width of exchange rate intervention, under the present managed floating system, needs to be widened to allow greater use of monetary policy for maintaining internal stability. On micro level, the capability of the banking system to extend credit and create money supply has to be restrained by better implementation of the prudential rules and regulations which govern the system. However, the fragile banks need to be restructured in order to improve their financial and other capabilities to compete in the riskier market environment. Business conglomeration which allows cross-ownership between financial and non-financial firms in the private sector needs to be rationalized to prevent moral hazard or internal transactions where loans are given to sister companies without proper risk evaluation.