Report and Recommendation of the President to the Board of ... · CMMP – capital market master plan CSP – country strategy and program DGFI – Directorate General of Financial

Report and Recommendation of the President to the Board of Directors

Project Number: 32507 November 2007

Proposed Loan and Technical Assistance Grant Republic of Indonesia: Capital Market Development Program Cluster (Subprogram 1)

CURRENCY EQUIVALENTS (as of 2 November 2007)

Currency Unit – rupiah (Rp)

Rp1.00 = $0.000100 $1.00 = Rp9,088

ABBREVIATIONS

ADB – Asian Development Bank APRA – Australian Prudential Regulatory Authority ASIC – Australian Securities and Investments Commission AusAID – Australian Agency for International Development BI – Bank Indonesia BPA – bond pricing agency CMDP – capital market development plan CMDPC – Capital Market Development Program Cluster CMMP – capital market master plan CSP – country strategy and program DGFI – Directorate General of Financial Institutions DMO – Debt Management Office DOT – Directorate of Taxes DPSP – Development Policy Support Program EET – exempt-exempt-taxable EU – European Union FATF – Financial Action Task Force FDI – foreign direct investment FGRSDP – Financial Governance Reforms Sector Development Program FGSSR – Financial Governance and Social Security Reform Program FSDPF – Financial Sector Development Partnership Fund FSPP – financial sector policy package GDP – gross domestic product GTZ – Deutsche Gesellschaft für Technische Zusammenarbeit

(German Agency for Technical Cooperation) KfW – Kreditanstalt für Wiederaufbau

(German Bank for Reconstruction and Development) IAA – Indonesian Accounting Association IAIS – International Association of Insurance Supervisors IMF – International Monetary Fund IOSCO – International Organization of Securities Commissions IPO – initial public offering JBIC – Japan Bank for International Cooperation JSX – Jakarta Stock Exchange KPEI – PT Kliring Penjaminan Efek Indonesia

(Indonesian Clearing and Guarantee Corporation) KSEI – Kustodian Sentral Efek Indonesia

(Indonesian Central Securities Depository) LIBOR – London interbank offered rate LPS – Lembaga Penjamin Simpanan (Deposit Insurance Institution) MOF – Ministry of Finance

MOU – memorandum of understanding NPL – nonperforming loan OECD – Organisation for Economic Co−operation and Development OJK – Otoritas Jasa Keuangan

(Consolidated Supervisory Authority for Financial Services) PAI – Project Administration Instructions PRC – People’s Republic of China PT SMF – PT Sarana Multigriya Finansial

(Secondary Mortgage Corporation) SEC – Securities and Exchange Commission SME – small and medium-sized enterprise SOE – state-owned enterprise SRO – self-regulatory organization SSX – Surabaya Stock Exchange TA – technical assistance TAMF – technical assistance management facility UNODC – United Nations Office on Drugs and Crime USAID – United States Agency for International Development WB – World Bank

NOTE

In this report, "$" refers to US dollars unless otherwise indicated.

Vice President C. Lawrence Greenwood Jr., Operations 2 Director General A. Thapan, Southeast Asia Department (SERD) Director J. Ahmed, Governance, Finance and Trade Division, SERD Team leader V.V. Subramanian, Senior Financial Sector Specialist (Capital Markets), SERD Team members T. Hla, Economist (Financial Sector), SERD

D. Kertzman, Senior Financial Sector Specialist (Legal and Regulatory), SERD R. O’Sullivan, Senior Counsel, Office of the General Counsel H. Purnomo, Project Officer (Financial Sector and Small-Medium Enterprise), Indonesia Resident Mission, SERD M. van der Auwera, Social Security Specialist, SERD

CONTENTS Page LOAN AND PROGRAM SUMMARY i

I. THE PROPOSAL 1

II. THE MACROECONOMIC CONTEXT 1

III. THE SECTOR 6 A. Sector Description and Performance 6 B. Issues and Opportunities 10

C. Lessons 14

IV. THE PROPOSED PROGRAM 17 A. Objectives and Scope 17 B. Policy Framework and Actions 17 C. Important Features 21 D. Financing Plan 21 E. Implementation Arrangements 22

V. TECHNICAL ASSISTANCE 25

VI. PROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS 25 A. Benefits 25 B. Social and Environmental Safeguards 25 C. Risks 25

VII. ASSURANCES 26 A. Specific Assurances 26 B. Conditions for Program Loan Effectiveness 27

VIII. RECOMMENDATION 27

APPENDIXES 1. Design and Monitoring Framework 28 2. Sector Analysis 33 3. Development Coordination Matrix 41 4. Policy Matrix and Development Policy Letter 43 5. List of Ineligible Items 62 6. Subprogram 2 63 7. Technical Assistance 65 8. Summary Poverty Reduction and Social Strategy 70 9. Environmental Assessment of the Policy Matrix 72

LOAN AND PROGRAM SUMMARY Borrower Republic of Indonesia The Proposal It is proposed that the Capital Market Development Program be

supported by a program cluster involving two back-to-back subprograms and a technical assistance (TA) grant of $1,200,000 for Strengthening Regulation and Governance. It is further proposed that subprogram 1 be supported by a loan for $300,000,000.

Classification Targeting Classification: General intervention

Sector: Finance Subsector: Finance sector development Themes: Sustainable economic growth, private sector development, and governance Subthemes: Promotion of economic efficiency and enabling markets; policy, institutional, legal, and regulatory reforms; financial and economic governance.

Environment Assessment

Category C

The Program Rationale

Financial sector reforms are crucial to raising Indonesia’s growth rate and to increasing the economy’s resilience. Since the Asian financial crisis in 1997, Indonesia has undertaken key financial sector reforms and has succeeded in restoring the banking sector to solvency and profitability. However, the rate of economic growth has not returned to pre-crisis levels. Indonesia needs investments, especially in infrastructure, but the domestic financial sector is not yet able to finance them. The financial sector is shallow and dominated by banks. Bank lending has not yet recovered to pre-crisis levels and banks’ balance sheets make them unsuited to the nation’s need for long-term financing. The nonbank financial sector, in particular, the capital markets, although still small, offer a major opportunity to reinvigorate growth thorough more efficient intermediation. The goal of the Capital Market Development Program Cluster is to promote the diversification and resilience of the financial sector while supporting the medium-term macroeconomic goals of the Government. The Program supports the Government’s financial sector reform agenda by focusing on capital markets. Most of its policy outcomes will be in line with the Government’s financial sector policy package (FSPP) and its capital market master plan, 2005–2009 (CMMP). The Program aims to strengthen transparency and information disclosure. This is essential to build confidence in capital markets and institutions, facilitate regulatory oversight, and, in turn, to promote price discovery and market liquidity. Both supply and

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demand sides of financial markets will be addressed. On the supply side, measures are proposed to deepen government bond markets, which are an essential building block for the development of corporate bond markets and inter-bank money markets. On the demand side, the investor base needs to be broadened by promoting institutional investors such as contractual savings and collective investment schemes. The Program aims to strengthen the underlying structure for securities trading, so markets can function with sufficient speed, efficiency and accountability. Deeper domestic capital markets and improved financial intermediation between savers and investors, supported by stronger regulation and supervision will increase the financial sector’s contribution to economic growth. Policy measures to improve financial governance and market efficiency, and to reduce systemic risks, are embedded in the Program and will help to strengthen investor confidence and the investment climate. The reform agenda is structured around the following policy outcomes, which form the basis of the Program’s four components:

(i) enhancing information disclosure and price discovery;

(ii) promoting deeper and more liquid financial markets;

(iii) improving market surveillance and investor protection; and

(iv) strengthening governance and human resource capacity.

The Program will consist of two single-tranche subprograms anchored on the Government’s financial sector reform programs. It will run from January 2006 to December 2010, with a single tranche loan of $300 million to be disbursed under subprogram 1 (2006–2007). Subprogram 2 is expected to be ready for Board approval about 18 months after subprogram 1 becomes effective. The policy actions have been divided into two phases: January 2006 to September 2007 for subprogram 1 (recognizing measures already taken by the Government), and October 2007 to June 2009 for subprogram 2. The Government’s medium-term reform agenda and its timing will be reviewed in light of the achievements of subprogram 1 and reform proposals for the policy environment may be modified if necessary, supported by subprogram 2. The Government envisages support from ADB of $200 million to $300 million for subprogram 2.

Impact and Outcome The expected impact of the Program is capital market growth and diversification, combined with stronger regulatory and supervisory capacity. It is expected that the Program will lead to an increase in the nonbank financial sector’s share of total financial assets. The reforms, which concentrate on improving information disclosure

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and enhancing market surveillance, will provide more protection for investors. To provide a basis for consolidated regulation of the nonbank financial sector and to move toward more functional regulation, oversight of the capital markets was recently combined with oversight of the contractual savings industries on which they depend, principally insurance and pensions. This will be achieved through the recently merged Bapepam-LK (the capital market and nonbank financial supervisory authority) and is expected to be formalized under a regulatory framework now being developed. A new risk-based approach to supervision, which originated in banking and has already been applied to some securities intermediaries, will be applied to contractual savings institutions and other capital market institutions, thus reducing the risk of regulatory arbitrage.

The Program Loan Financing Plan

A loan of $300,000,000 from ADB’s ordinary capital resources will be provided under ADB’s London interbank offered rate (LIBOR)-based lending facility for subprogram 1. The loan will have a 15-year term, including a grace period of 3 years, an interest rate determined in accordance with ADB’s LIBOR-based lending facility, a commitment charge of 0.75% per annum, and such other terms and conditions set forth in the draft loan agreement.

Period and Tranching

The program period is from January 2006 to December 2010, with a single tranche loan of $300 million to be disbursed under subprogram 1. Subprogram 2 will be submitted for Board consideration about 18 months after subprogram 1 becomes effective, subject to the Government’s readiness to undertake the reform agenda.

Counterpart Funds

The Government will use the local currency counterpart funds generated by the loan proceeds to meet program expenditures and associated costs of reform and additional budgetary allocation for development spending.

Executing Agency Bapepam-LK Implementation Arrangements

Bapepam-LK will be the Executing Agency for the Program and will monitor and facilitate the implementation of the agreed reform actions to ensure that they are carried out in a timely manner. DMO and the Directorate of Taxes (DOT), both under MOF, Bapepeam-LK, Menneg BUMN (the State Ministry of State Owned Enterprises), and the Financial System Stability Forum will be the implementing agencies. Bapepam-LK has established a program coordination committee headed by the Bapepam-LK chair with representatives from DMO, DOT, Menneg BUMN, Bappenas (National Development Planning Agency), and the Financial System Stability Forum. The committee is responsible for coordinating the implementation and sustaining of the program actions. The committee shall oversee the implementation of the policy actions detailed in the Policy Letter and the Policy Matrix,

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and provide guidance and direction to the Executing Agency, the Implementing Agencies and other relevant line agencies of the Borrower. ADB may be invited to participate in the meetings as an observer.

Procurement The loan proceeds will be used to finance the full foreign exchange costs (excluding local duties and taxes) of items produced and procured in ADB member countries (other than items specified in the list of ineligible items and imports financed by other bilateral and multilateral sources). The Government will certify its compliance with this formula with each withdrawal request. Otherwise, import documentation under existing procedures will be required. ADB reserves the right to audit the use of the loan proceeds and to verify the accuracy of the Government’s certification.

Program Benefits and Beneficiaries

The Program supports the Government’s agenda to establish the Indonesian capital market as a resilient and competitive market that supports higher growth for the national economy. It will provide a policy framework that encourages new financial instruments and tenors, and new kinds of intermediation. It will enhance information disclosure and facilitate price discovery, thus improving the efficiency with which financial markets price risk. This will help to create deeper and more liquid capital markets. It will also promote stronger intermediaries that are better able to mobilize and allocate resources and risks. Better market surveillance and investor protection are essential for capital market development. Together with the broader economic reforms being undertaken in Indonesia, the development of the capital markets will contribute to productivity growth, employment generation, and financial sector stability.

Risks and Assumptions While mitigation measures have been put in place for some of the key risks anticipated for program implementation, subprogram 1 still faces some risks. Sustaining Reforms. The financial and operational autonomy of Bapepam-LK, which is critical for effective supervision of the nonbank financial sector, will need to be supported by an appropriate regulatory framework. Reforms being undertaken by the Government may be opposed by vested or competing interests. The public and parliament will need to be persuaded of the longer-term benefits of reforms that have upfront costs. The consolidation of reform initiatives in recent years and the commitment to further reforms by the Government and a strong parliamentary coalition should ensure Indonesia is on the path to growth and poverty reduction. Governance and Capacity Constraints. Institutional and human resource weaknesses within Bapepam-LK may lead to delays in implementing reforms. To address this, technical assistance (TA)

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will be provided under the Program to help address capacity building. Further, the Government has agreed to commit, through its normal budgetary processes, appropriate provisions for human resources development to sustain capacity building efforts over the medium to long term. ADB’s Country Strategy and Program (2006-2009) envisages enhancing governance and reducing opportunities for corruption through its lending and TA operations. ADB has provided support for anticorruption measures, including procurement reforms, during the last 7 years. A number of ongoing loan-funded activities have an anticorruption and capacity-building focus. ADB has also actively supported the Partnership for Governance Reform -a cooperative relationship between the Indonesian Government, civil society, the private sector and Indonesia’s international development partners on governance reform. The Financial System Stability Forum, which began operations in June 2007, will provide a platform for exchanging information and ideas, and will help to coordinate the regulatory and supervisory activities of Bank Indonesia, Bapepam-LK, and the Lembaga Penjamin Simpanan (Deposit Insurance Institution). Successful implementation of the CMMP with the support of the Program should strengthen the capacity and authority of Bapepam-LK in regulating and ensuring good governance in the nonbank financial market. Lack of Commitment and Accountability. Lack of accountability, measurable outcomes, industry commitment, and tactical planning may mean that the CMMP runs into implementation difficulties. There are differences of view among stakeholders that will need to be resolved if policy reforms are to progress. However, progress is likely at present in view of the strong Government commitment to reform. The reform program is made more tractable by a phased plan for the implementation of well defined measures over the next 4 years, in line with the Government’s CMMP as well as its financial sector policy package. In addition, the establishment of an internal compliance bureau in December 2006 and a revised code of ethics will strengthen governance and accountability within Bapepam-LK. Enforcement Constraints. Bapepam-LK may have difficulty in addressing its compliance and enforcement mandate effectively. The Program focuses on strengthening its investigation strategies and enforcement skills through a clearly defined capacity building program within Bapepam-LK. Exogenous Shocks. Exogenous shocks to the economy that adversely affect growth prospects and threaten macroeconomic stability are a risk to achieving program outcomes. There is also a risk of a slowdown in the global economy and of a disorderly unwinding of global macroeconomic imbalances. However, overall, the economy’s vulnerability to external shocks has been decreasing, primarily because of sound debt and macroeconomic

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management. Indonesia’s ratio of total external debt to GDP fell from 49.3% in 2005 to under 37% in 2006. The Program, in conjunction with additional reform programs financed by ADB and the Development Policy Support Program financed by the World Bank and the Government of Japan will help to sustain the economy’s growth path while reducing the risks of macroeconomic instability.

Technical Assistance TA will be provided and implemented at the same time as the Program. The TA is estimated to cost $1,500,000 equivalent. ADB is administering a portion of the TA not exceeding the equivalent of $500,000 to be financed on a grant basis by the Financial Sector Development Partnership Fund (established by the Government of Luxembourg). In addition, ADB will provide the equivalent of $700,000 on a grant basis to be funded from the Technical Assistance Special Fund. The Government will provide the remaining $300,000 equivalent by providing counterpart staff and other support facilities. The objective of the TA is to complement the efforts to be undertaken by Bapepam-LK and the Government to build up capacity within Bapepam-LK and the capital market industry. The TA will support capacity building in five main areas:

(i) developing database and basic applied research skills in Bapepam-LK’s newly established research bureau;

(ii) carrying out on-the-job training for Bapepam-LK staff through secondments with regulators in other jurisdictions;

(iii) improving the market surveillance and regulatory skills of Bapepam-LK staff through short courses by local training institutions in collaboration with outside experts;

(iv) developing curricula for training programs, as well as standards for certification for professionals in fields related to capital markets (e.g. general insurance actuaries and surveillance training for SRO staff); and

(v) developing an econometric model and related capacity to allow for a better understanding of vulnerabilities in the nonbank financial sector by the Financial System Stability Forum.

I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on (i) a proposed program cluster to the Republic of Indonesia for the Capital Market Development Program Cluster comprising two subprograms, and (ii) a proposed loan for subprogram 1. The report also describes proposed technical assistance (TA) for strengthening regulation and governance including the administration of a grant from the Financial Sector Development Partnership Fund (FSDPF) and, if the Board approves the proposed loan, I, acting under the authority delegated to me by the Board, will approve the TA and the administration of the FSDPF grant. The program design and monitoring framework is in Appendix 1.

II. THE MACROECONOMIC CONTEXT 2. Economic Growth. Indonesia’s strengthening macroeconomic performance was reflected in a rising but still modest growth rate of 5.5% in 2006. This is faster than the average growth over the previous 3 years but still below the growth rates before the 1997 Asian financial crisis. A key constraint on higher growth is the investment rate, which, while showing signs of improvement, remains sluggish. Fixed investment grew by just 2.9% in 2006, far below rates achieved in 2004 and 2005, although it perked up in the fourth quarter when inflation and interest rates eased. Weak bank intermediation was another factor limiting investments and the growth potential. 3. Weak Investment Climate. Lack of investment stems not only from higher borrowing costs but also from continuing deficiencies in the business environment. Realized foreign direct investment and domestic investment both fell by a third in 2006, foreign direct investment to $6 billion and domestic investment to $2.2 billion. On the other hand, Investment approvals rose, indicating that investment could turn up soon. As a percentage of gross domestic product (GDP), gross fixed capital formation in Indonesia in 2006 was 24%, up slightly from 2005. That was below rates recorded for Viet Nam (33.1% in 2005) and Thailand (28.6%), but above Malaysia (20.2%) and the Philippines (14.2%). 4. Signs of Confidence. Inflation eased from above 17% in January 2006 to about 6.6% late in the year as the impact of the 2005 boost in fuel prices faded. The Government implemented bold fuel price adjustments in 2005 by reducing domestic fuel subsidies, thereby reducing the budget deficit by $4.5 billion for that year. The remaining domestic fuel subsidies are expected to be phased out, although no schedule has been provided. Citing improvements in the country’s fiscal management and the Government’s efforts to deal with corruption, international rating agencies Moody’s and Fitch raised Indonesia’s ratings outlook in early 2007 to positive from stable, though the B1 (Moody’s) and BB- (Fitch) sovereign rating has yet to reach investment grade, as it was before the crisis. The Government issued $2 billion in international bonds in 2006 and $1.5 billion in February 2007, bringing the total outstanding international bonds to $7 billion. Option-adjusted spreads on sovereign bonds maturing in 2014 narrowed to 157 basis points in late 2006 from 212 basis points early in the year. The stock market index soared by 55% over the year, with market capitalization rising to the equivalent of 37.4% of GDP from 30.0% in 2005. Foreign portfolio equity investment grew by almost 10 times to about $2 billion. 5. Reduced External Vulnerability. The current account surplus rose to $9.9 billion in 2006, or 2.7% of GDP. Foreign reserves reached $42.6 billion, equivalent to about 4.5 months of import cover and official debt repayment. Its strong external position enabled Indonesia to prepay its remaining $7.8 billion debt to the International Monetary Fund (IMF). Overall, the

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economy’s vulnerability to external shocks has been decreasing, primarily because of sound debt management. The ratio of total external debt to GDP has also declined steadily since the crisis, from over 150% of GDP in 1998 to just under 37% in 2006. The debt-service ratio rose to above 24.8% in 2006 from 15.5% in 2005, primarily because of the early repayment of IMF debt and the end of a postponement on debt servicing by the Paris Club to help the country handle its December 2004 earthquake and tsunami disaster. Public debt was reduced to 41% of GDP. The Government worked to contain its fiscal deficit and to redirect public expenditures toward development and social goals. The realized fiscal deficit in 2006 was 0.9% of GDP. In 2005, the deficit was 0.5%, mainly because new budgetary procedures delayed the release of funds that year. Portfolio investment has been strong; partly a result of the surge in global liquidity, but direct, long-term investment is tepid. Financial markets continue to experience bouts of volatility, influenced by global developments and policy delays, and aggravated by the shallowness of the domestic market.

Table 1: Main Economic Indicators of Indonesia

Item 1999 2000 2001 2002 2003 2004 2005 2006 GDP current prices (Rp trillion)

1,215.1

1,389.77 1,646.32 1,821.83 2,013.67 2,295.83 2,784.96 3,338.20

GDP growth (%)

0.8 4.9 3.64 4.50 4.78 5.03 5.7 5.48

Inflation (%)

1.9 9.3 12.6 10.0 5.1 6.4 17.1 6.6

BI Rate (%)

12.5 14.5 17.6 12.9 8.3 7.4 12.8 9.75

Net FDI ($ billion)

(1.9) (4.6) (3.0) 0.1 (0.6) (1.5) 2.2 2.9

Rp/$ (end of period)

7,630 9,595 10,400 8,940 8,465 9,290 9,840

9,020

Rp/$ (average of period)

7,842 8,379 10,233 9,317 8,562 8,926 9,706 9,164

BI = Bank Indonesia, FDI = foreign direct investment, GDP = gross domestic product Source: Government of Indonesia.

Table 2: GDP Growth in Selected Asian Economies (%)

Economy 2006 2007 2008 Developing Asia 9.4 8.8 8.4 China, People’s Republic of 10.7 10.0 9.5 Indonesia 5.5 6.3 6.8 Malaysia 5.9 5.5 5.8 Philippines 5.4 5.8 5.8 Thailand 5.0 4.5 4.8 Viet Nam 8.2 8.0 7.8

Source: International Monetary Fund. 2007. World Economic Outlook.

6. Continuing Reform Agenda. Indonesia has taken important steps to intensify its structural reform agenda, enhance the investment climate, improve public infrastructure, and strengthen financial sector intermediation. A time-bound investment policy package was introduced in February 2006 and an Investment Law was passed in March 2007. An infrastructure reform package was adopted in 2006 in support of the investment policy package.

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However, important and difficult issues related to tax and labor markets remain under discussion. 7. The Medium-Term Development Plan. The medium-term national development plan, 2004–20091 provides a clear set of targets that the Government wants to achieve by the end of the period. Among them are sustained growth of more than 6%, job creation to absorb 1.5 million new entrants into the labor market annually, achievement of Millennium Development Goal targets, and a reduction in the stock of debt to 31.8% of GDP. An investment climate survey conducted in December 20052 highlighted the cost of financing as one of the main constraints on establishing a conducive investment climate. The medium-term development plan sets out a good policy framework for the reforms and investments needed for each sector. Policies envisaged under the Government’s medium-term macroeconomic framework should help mitigate economic vulnerabilities, improve the business climate, and encourage investment. An optimistic scenario for the next 5 years is that pending laws and regulations are enacted, encouraging private sector development and accelerating GDP growth to 7−8%. Alternatively, if the country falters in its implementation of policies and fails to unblock funding constraints at the regional level, growth will probably remain below 6%. 8. Key constraints on accelerating GDP growth include an absence of: (i) a stable and consistent legal and regulatory environment, (ii) well-developed capital markets and nonbank financial sector, and (iii) adequate skills and institutional capacity within public and market institutions. In particular, the 1997 crisis raised awareness of the risks associated with a growth-oriented development agenda without a deep and diverse financial sector. Indonesia’s banking sector has rebounded from the crisis with nonperforming loans (NPLs) reduced and profitability and solvency restored. However, bank intermediation is declining, and banks’ reliance on short- term deposits makes them ill suited to provide the long-term funds needed for a sustained expansion of investment. The financial system is still bank-dominated, although increasing attention is being paid to the nonbank financial sector. An action plan for the nonbank financial sector was approved by the Government in November 2004 in consultation with ADB. The action plan included measures to support and implement the Government’s capital market master plan, 2005–2009 (CMMP). The CMMP is principally focused on strengthening capital markets by improving surveillance, increasing legal certainty, strengthening the role and quality of market players, expanding products, and developing Islamic financial products. 9. Financial Sector Reforms. Underscoring the priority accorded to achieving a deep and diverse financial sector, a financial sector policy package (FSPP) was introduced in June 2006. This aims to improve policy coordination and to advance the regulation and supervision of both banks and nonbank financial institutions. The FSPP is an annual exercise which reviews progress in a broad set of sectors targeted for reforms, while identifying and setting targets for additional sectors. The Coordinating Ministry for Economic Affairs, Bank Indonesia, Ministry of Finance (MOF), and Ministry of State-Owned Enterprises are signatories to the joint decree for implementing the FSPP. The FSPP complements the CMMP as well as Bank Indonesia’s vision of Indonesia’s financial architecture. The Government has signaled its commitment to continuity of reforms in this area through the release of another FSSP in 2007. 10. ADB provided significant inputs to the preparation of the above two financial sector policy packages. It has also been involved in the Government’s reform process through policy

1 Presidential Regulation 7/2005 on the Medium-Term National Development Plan issued on 19 January 2005. 2 World Bank Business Survey. 2005.

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dialogue and technical assistance (TA).3 The TA has provided support to implement the main elements of the action plan and the CMMP. These measures have established a good basis for further market development. While the proposed Program is predominantly focused on development of the capital market through the implementation of the CMMP, it also embraces some of the broader issues covered under the FSPP.

Table 3: Financial Sector Policy Package and Capital Market Master Plan, 2005–2009 4

Financial Sector Policy Package Capital Market Master Plan, 2005−2009 Launched June 2006 as joint effort between the Government and Bank Indonesia. Additional set of actions issued in 2007

Improve regulation and supervision of nonbank financial sector

Strengthen financial sector coordination Strengthen banking institutions and policy to improve the performance of state-owned banks

Establish independent capital market regulator

Strengthen nonbank financial institutions (insurance, pension funds, finance companies and venture capital firms)

Optimize information technology in capital market

Improve the liquidity, efficiency and integrity of the capital market.

Improve human resource skills and capacity

Clarify government privatization policy direction Formulate risk-based supervision Source: Coordinating Ministry for Economic Affairs and Bapepam-LK, Ministry of Finance, Government of Indonesia.

11. Other Supporting Programs. ADB is also involved in a series of program lending operations in conjunction with the World Bank’s development policy loans. These will support the Government’s broad-based, cross-cutting, medium-term investment climate and governance reform agenda. The first development policy loan was approved by the World Bank in 2004. In that year, ADB provided parallel support through financial sector and state-owned enterprise (SOE) reform programs. In 2005, at the Government’s request, ADB approved the Development Policy Support Program I (DPSP I).5 The second DPSP was approved in 2006.6 The DPSP series is embedded in the Government’s medium-term national development plan for 2004–2009. It supports the broad goal of the plan to stimulate high and sustainable economic growth (7% average annual growth by 2009 from about 4% before 2004) and halve poverty incidence (from 16.6% in 2004 to 8.2% by 2009). 12. ADB’s Country Strategy and Program (CSP). 7 Financial sector deepening that facilitates domestic resource mobilization was identified as one of the five key areas for ADB intervention under the CSP for 2006–2009. The CSP recommends using a single-tranche cluster approach for program loans to support the Government’s medium-term reform agenda. The CSP also envisages technical assistance in support of these loans. 13. The proposed Program cluster evolves from the Government’s medium-term national development plan to support its financial sector reform agenda in line with the CSP, with a principal focus on development of capital markets in Indonesia (Figure 1). 3 ADB. 2002. Technical Assistance to the Government of Indonesia for Establishing a Financial Services Authority.

Manila. 4 Supplementary Appendix B and C. 5 ADB. 2005. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the

Republic of Indonesia for Development Policy Support Program. Manila. 6 ADB. 2006. Report and Recommendation of the President to the Board of Directors on a Proposed Program

Cluster and Loan to the Republic of Indonesia for the Second Development Policy Support Program. Manila. 7 ADB. 2006. Country Strategy and Program (2006−2009): Republic of Indonesia. Manila.

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Realizing a safe and peaceful

Indonesia

Enhancing the prosperity of the

Indonesian people

Realizing a just and democratic

Indonesia

Consolidation of macroeconomic stability

Fiscal Program • Increase revenues • Increase efficiency and effectiveness of

government expenditure • Enhance government foreign loan management

Financial Sector Program

Financial Sector Policy Package

Nonbank Financial Sector• Enhance efficiency in

regulation and supervision • Harmonize sector laws in

accordance with international standards

• Improve financial and operational autonomy

• Develop risk-based system of supervision

• Coordinate different regulators

• Develop early warning system and financial stability assessment program

• Gradually implement IOSCO, OECD, and IAIS principles of supervision

• Enhance governance • Facilitate/provide growth of

new products

Banking Sector • Strengthen structure of banks • Improve coordination among

regulators • Enhance supervisory and

regulatory efficiency • Formulate early warning

system • Gradually implement the 25

Basel Core principle for effective banking supervision

• Enhance governance • Strengthen risk-based system

of supervision • Increase channel of credit to

SMEs • Develop microfinance

institution • Strengthen and consolidate

the banking industry through increased capital requirements

Addr

esse

d th

roug

h

Capital Market Master Plan (2005–2009) • Autonomous

regulation • Enhance human

resource skills • Optimize

information technology

• Formulate risk-based supervision

Supported by ADB through

Figure 1: National Medium-Term Development Plan and Capital Market Development Program Cluster Loan

Medium-Term Development Plan (2004–2009)

CMDPC Subprogram 1—2007 CMDPC Subprogram 2—2009

CMDPC = Capital Market Development Program Cluster, IAIS = International Association of Insurance Supervisors, IOSCO = International Organization of Securities Commissions, OECD = Organisation for Economic Co−operation and Development, SME = small and medium-sized enterprise. Source: Presidential Regulation 7/2005 on the Medium-Term National Development Plan issued on 19 January 2005; and Capital Market Supervisory Agency, Ministry of Finance. Indonesian Capital Market Master Plan 2005−2009. Republic of Indonesia.

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III. THE SECTOR A. Sector Description and Performance 14. Lack of Depth. Indonesia’s financial sector has stabilized but continues to exhibit structural vulnerabilities and risks. At an M2-to-GDP ratio of 47% at the end of 2006,8 Indonesia lags behind regional competitors such as Malaysia and Thailand, which have ratios of more than 100%. Indonesia has also performed poorly in relation to its neighbors in terms of the breadth of its financial markets. The market capitalization of Asian equities has trebled since 1997 and capitalization as a percentage of GDP in Southeast Asian economies such as Hong Kong, China; Malaysia; and Singapore compares favorably with that in Germany, the United Kingdom, and the United States. In terms of market value to GDP, despite increasing from 14.5% in 2002 to 37.4% in 2006, Indonesia’s equity market remains one of the smallest in the Asia and Pacific region. A more detailed sector analysis is provided in Appendix 2. 15. High Concentration of Banking Institutions. Banks account for about 80% of financial sector assets.9 Despite its size and recent improvements, the Indonesian banking sector is not a source of long-term capital as more than 90% of bank deposits have a maturity of less than 1 month. As a reaction to the 1997 crisis, bankers in general are risk averse in their approach to lending. Banks are reluctant to lend because many large companies are already highly indebted and they prefer to keep their funds in risk-free government bonds. As a result, loan levels have stayed below deposit levels, making banks very liquid. Much of this liquidity has been invested in short-term Bank Indonesia certificates, which have ballooned to a high of Rp190 trillion. 16. Better Risk Management in the Banking Industry. Since the NPL ratio of banks peaked at 48% in 1998, the asset quality of commercial banks has recovered. The gross NPL ratio for the banking industry fell from 7.6% in 2005 to 7% in 2006. The NPL ratio of 15 of the larger banks fell from 10.6% in 2005 to 8.4% in 2006, while those of the other banks are in the range of 3–4%. The Government has recently issued regulations providing more flexibility for state banks to write off their bad loans, so NPLs for state banks should decline in future. Stronger corporate balance sheets, including less reliance on external financing, have also reduced risks. The average capital adequacy ratio at about 20% in the banking industry is well above the prescribed prudential norm. Bank Indonesia’s vision of Indonesia’s financial architecture envisages consolidation in the banking industry through a reduction in the number of commercial banks from 130 to 80. Banking risk is moderate and controllable because of high capital adequacy ratios, improvements in the payment system, the introduction of a financial sector safety net, better risk management practices, and stronger corporate governance. Indonesia’s improvements to risk management are in line with the implementation of Basel II10 planned for 2008. 17. Undeveloped Nonbank Financial Subsector. The nonbank financial subsector still accounts for only 20% of total financial assets. The sector includes mutual funds (also known as investment companies), insurance companies, pension funds, securities brokers and dealers, pawnshops, rural institutions, and venture capital companies. In 2005, the nonbank financial sector accounted for Rp375 trillion in assets (13.7% of GDP). Pension funds and insurance firms account for about half of these assets. 8 The M2-to-GDP ratio (that is demand, savings, and time deposits or M2, divided by the output of goods and

services, namely GDP) is a common measure of financial depth. 9 Appendix 2, Table A2.3. 10 Recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.

7

18. Need for Stronger Governance and Regulatory Regime. Financial sector regulation and supervision are under the authority of two main supervisory authorities. Banks are regulated and supervised by Bank Indonesia, the central bank, which in the aftermath of 1997 has undergone significant strengthening and has been given financial and operational autonomy. The Capital Markets Supervisory Agency (Bapepam), established in 1976 under Presidential Decree No. 52/1976, has weaker powers and capacity. It is responsible for the regulation and day-to-day supervision of capital markets in Indonesia and reports to the MOF. The MOF is responsible for high-level policy matters and Bapepam has some autonomy in relation to the conduct of investigations, inspections, and other regulatory functions. 19. In 1999, parliament passed a Banking Law to insulate the regulatory and supervisory framework from political interference. The legislation required the establishment of a consolidated supervisory authority for financial services, referred to as the Consolidated Supervisory Authority for Financial Services (OJK) by the end of 2002, to be able to cope better with financial conglomeration and innovation and to lower the cost of regulation by making efficient use of scarce resources. 20. However, prudential regulation of banks focusing on their safety and soundness and systemic risk is fundamentally different from the investor protection needs of securities or capital markets, which are focused on disclosure, fairness, and prevention of fraud through enforcement of business rules and punishment of offenders. As became evident following 1999, merging the two different approaches and cultures poses significant challenges, not least of which is the need to manage the risks of a decline in the quality of supervision during the transition phase. This challenge is made more complex in Indonesia where the two entities to be merged differed sharply in capacity and where systemic risks remain a key concern. Recognizing these risks, parliament amended the Banking Law in December 2003, thereby postponing the establishment of the OJK from 2002 to 2010. In the meantime, MOF prepared an action plan to improve the regulation and supervision of the nonbank financial sector in 2004. The insurance, pension, finance, and venture capital companies were to be regulated by the Directorate General of Financial Institutions (DGFI) in the MOF until 2005, when a presidential decree merging Bapepam and DGFI was issued. MOF merged Bapepam and the DGFI into Bapepam-LK as the sole regulatory and supervisory authority for the nonbank financial sector. The merger and the endorsement of a plan for improvements in the regulatory and supervisory structure of the newly created Bapepam-LK were significant steps toward strengthening supervision of nonbank financial services, including the capital markets. A senior (echelon 1)11 official has been appointed to head the merged entity, paving the way for a consolidation of nonbank financial institution supervision. Bapepam-LK is working to improve the operation of the merged regulators and to increase the capacity of its staff. Both the Australian Agency for International Development (AusAID) and ADB are supporting this transformation and providing training and human resource development assistance to Bapepam-LK. The Minister of Finance supports further strengthening of Bapepam-LK’s financial and operational autonomy. 21. Shallow Equity Market. Indonesia’s equity market has improved steadily since 2002 and was among the best performers in the region in 2004 and 2005. In 2006, it was among the top three bourses in the world with a growth of about 50% in market capitalization. However, the Indonesian capital market is the second smallest capital market in Southeast Asia (only the Philippines is smaller). In terms of market value to GDP, despite increasing from 14.5% in 2002

11 All structural positions in Indonesia’s national civil service are grouped into echelons, with echelon 1 being the most

senior.

8

to 37.4% in 2006, Indonesia’s equity market remains one of the smallest in the Asia and Pacific region. The number of companies listed gradually increased to 344 at the end of 2006, but this is still low by regional standards (Malaysia had 1,025 listed domestic companies at the end of 2006; Taipei,China 693; Thailand 518; and the Philippines 241). Although the number of companies involved is small, both the volume and value of shares traded in Indonesia and market capitalization as a share of GDP have increased significantly since 2002. 22. Promising Fixed Income Market. Although the capital market remains small and illiquid, Indonesia has issued significant volumes of government bonds. These dominate the market, there had been 56 issues by the end of 2006 with a market value of Rp419 trillion. The corporate bond market by comparison had seen 236 issues at end-2006 with a market value of Rp62 trillion. Government bonds represent about 13.3% of GDP (end-2006) and corporate bonds about 1.9%—low by the standards of neighboring countries. Government bonds comprise a mix of floating and fixed rate bonds—the recent preference of Bank Indonesia being for fixed rate bonds. Bank Indonesia has followed a strategy of consolidating bond issues—through buy-backs and asset swaps—and has sought to build benchmark issues. Current maturities go out to 20 years—a considerable extension of maturity since 2000. The Debt Management Office (DMO) issued its first treasury bills in June 2007 with a 12-month tenor. Banks hold about three quarters of government bonds by value. Retail investors are largely absent. A system of primary dealers was introduced in December 2006 and these dealers are expected to provide two-way quotes. In the secondary market, an over-the-counter market and the exchange market co-exist, both offering avenues for trading of all debt securities. 23. Issues of Governance and Capitalization in Contractual Savings. The insurance industry is small in terms of the ratio of premiums to GDP (1.8–2% for life insurance and 0.62% for general insurance). It is also characterized by a large number of companies and a relatively low level of capitalization. Insurance companies currently invest an estimated 25% of their assets in short-term deposits. The Government has introduced some important regulatory changes governing insurers since the Asian financial crisis, including a new risk-weighted capital adequacy regime to encourage mergers and an increase in the capital requirements for new insurance companies. Existing insurance firms have been allowed a grace period to meet these requirements. 24. The pension sector is still small and characterized by low coverage and limited capitalization. Four main types of funds dominate the pension sector. 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. There are two types of privately-managed funds—employer pension funds and financial institution pension funds—both of which are voluntary occupation schemes for private sector employees. These schemes are potentially important to pool financial resources and to diversify their investor base, but there are legal and regulatory impediments to this. Bapepam-LK oversees the voluntary pension schemes. In total, the pension industry controls 4.7% of GDP in assets, compared with Thailand (8.4%), Malaysia (57%), and Australia (75%). About half of the assets are in public programs, and half in private programs. 25. Market Infrastructure and Investor Protection. Indonesia’s two principal exchanges, the Jakarta Stock Exchange (JSX) and the Surabaya Stock Exchange (SSX), trade equities, bonds, share options and index futures. The SSX focuses on the trading of bonds and futures, instruments that JSX cannot handle. However, the two exchanges compete for listings and many companies are listed on both exchanges. A merger of the two exchanges is included in the CMMP and the 2006 FSPP. In addition, Indonesia has two systems for clearing, settlement,

9

and deposits: the Indonesian Central Securities Depository (KSEI), and the Indonesian Clearing and Guarantee Corporation (KPEI). JSX, SSX, KSEI, and KPEI are self-regulating organizations with the authority to set rules and oversee the activities of broker-dealers and custodian banks dealing in securities and bond trading. There are 125 securities broking companies in Indonesia. With regard to rating agencies, Pefindo is Indonesia’s largest and was established in 1994. It is an affiliate of Standard and Poor’s and has adapted its rating methodology. The only other rating agency is Kasnic Credit Rating Indonesia, incorporated in 1998. Kasnic is affiliated with Fitch through its shareholder Duff and Phelps. It focuses on asset-backed securities, including plans for securitized mortgages, which have not yet been developed in Indonesia. Development of the financial sector and the capital markets in particular is hampered by an inability to obtain and/or enforce timely commercial judgments. Support has been provided to the judiciary by other agencies to enhance its capacity (Appendix 3) but more assistance is required. 26. Need for Stronger Corporate Governance. In March 2005, a World Bank review assessed the extent to which corporate governance in Indonesia was in conformity with Organisation for Economic Co-operation and Development (OECD) standards. It concluded that a number of initiatives are underway that could eventually result in compliance with the OECD principles. However, practices and enforcement diverge. ADB has supported the development of a corporate governance code for state-owned enterprises and a strengthening of the governance standards under the listing requirements for the JSX. 12 Guidelines to improve performance and corporate governance at state-owned banks was issued in February 2007. 27. Sharia-Based Capital Market Products. Islamic finance in Indonesia is newer than conventional finance, but has grown rapidly. Bank Indonesia has developed a blueprint for sharia banking derived from Islamic values. Sharia-based capital market products were first introduced in Indonesia by a sharia investment fund in mid-1997. At the end of 2006, there were 20 sharia investment funds (5% of total investment funds in Indonesia). As of December 2006, the total net asset value of these funds was Rp664 billion (1.3% of the total net asset value of investment funds in Indonesia), 18.7% higher than in 2005. The Government plans to issue a new sharia bond called sukuks once the draft bill on sharia-based instruments that was submitted to the parliament in February 2007 is passed. 28. Need for Coordinated Supervision. There is a global trend toward financial conglomerates, and a tendency for banks and other financial institutions to compete in the same market segments. There is therefore a need for consolidated and coordinated supervision to prevent regulatory arbitrage by important institutions. Bank Indonesia has adopted consolidated supervision of financial groups and their subsidiaries, but there is also a need for information sharing and cooperation with Bapepam-LK in relation to entities that are covered by both regulators. Such cooperation mechanisms are common in other jurisdictions (e.g., the United States) and need to be extended to other supervisors such as the Deposit Insurance Institution (LPS).

12 ADB 2001. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the

Republic of Indonesia for State-Owned Enterprise Governance and Privatization Program. Manila.

10

B. Issues and Opportunities

29. Financial sector reforms are crucial to raising Indonesia’s growth rate and to enhancing the economy’s resilience. Since 1997 Indonesia has successfully undertaken key financial reforms, restoring the banking sector to solvency and profitability. However, economic growth has not returned to pre-crisis levels. Indonesia needs investments, especially in infrastructure, but the domestic financial sector is not yet able to finance them. The financial sector is shallow and dominated by banks. Bank lending has not yet recovered to pre-crisis levels and banks’ balance sheets make them unsuited to the nation’s need for long-term financing. The nonbank financial sector, in particular, the capital markets, although still small, offer a major opportunity to reinvigorate growth thorough more efficient intermediation. 30. Transparency and information disclosure have to be strengthened to build confidence in capital markets and institutions, facilitate regulatory oversight, and promote price discovery and market liquidity. The supply and demand sides of financial markets both need to be addressed. On the supply side, the government bond market needs to be deepened as it is an essential building block for the corporate bond and the interbank money markets. On the demand side, the investor base needs to be broadened by encouraging institutional investors such as contractual savings and collective investment schemes. The structure for trading of securities has to be strengthened to make markets fast, efficient, and accountable. Finally, the operational and financial autonomy of the regulatory and supervisory authorities needs to be strengthened to protect investors. 1. Enhance Price Information and Price Discovery 31. The Indonesian debt market has long suffered from a lack of price transparency in both government and corporate bonds and no entity is able to offer a credible and reliable fair valuation service to the overall market. Availability of reliable and timely information is critical for capital markets to function efficiently and for the prices to reflect the fundamentals. The OECD principles of good governance suggest that firms should disclose all material information in accordance with high standards of accounting and financial and nonfinancial disclosure. Previously, there was no mandatory post-trade reporting regulation for market participants in the government and corporate bond markets and no mechanisms to enable consolidation of market data or provision of real time information. Prior to November 2007, SSX provided an over-the- counter fixed income trading system that can be used to quote prices, review product information, and facilitate negotiation and trade reporting for government and corporate bonds but the dealers had few incentives to use the system. Effective November 2007, the over-the- counter fixed income trading system has been replaced by a centralized trading platform. Disclosure is generally weak for corporate bonds and enforcement of disclosure requirements has not been sufficiently rigorous. Despite the extensive rules governing mutual funds, disclosure in the areas of investment policy and the calculation of net asset value and sales procedures is inadequate. Many of the largest mutual funds do not follow the norms of valuation established by Bapepam-LK. Although listed companies adhere to the regular reporting of their financial results, there is still considerable room for improving the prompt disclosure of market-sensitive information and for strengthening the scope and content of disclosure. 2. Develop Deeper and More Liquid Capital Markets 32. The markets are smaller and the secondary markets are less liquid than those of most other Southeast Asian economies (para. 21). The market value more than trebled between 2000 and 2005 to $81 billion, but this was not a significant increase over the 1999 market

11

capitalization of $64 billion. While 2006 saw a sharp increase to $139 billion, Indonesia still remains the fourth smallest market in the Asia and Pacific region. The biggest constraint on the development of the bond markets is the limited liquidity in the secondary markets—which affects the efficiency of the market overall. Against this background, Indonesia faces two challenges: first, catching up with its neighbors; and second, ensuring that it is able to participate in ongoing efforts to integrate regional markets and economies. 33. Issuance and Market for Corporate and Government Debt Securities. The Indonesian corporate bond market is still at its infancy and is heavily dependent on bank finance. While the small corporate bond market has grown, the lack of a clear benchmark to price against hinders pricing, although improvements in government bond issuance are expected to address this. However, the Indonesian government bond market suffers from unequal market access, unequal transactional costs, skewed product distribution, and a lack of benchmark securities. The timetable for the issuance of government bonds is not published in advance and Bank Indonesia does not act as a price taker. It has rejected bids and canceled auctions. This increases the risk to participants, which increases the cost of debt and reduces the attractiveness of the market. The lack of market making by intermediaries and the absence of credible benchmarks (in short-, medium-, and long-term securities) or any form of hedging mechanism have affected overall price formation. In 2006, on average the Indonesian bond market experienced a daily spread of 70–100 basis points, one of the highest in emerging markets. A lack of inter-agency policy coordination hampers overall development and adds market distortions. 34. Another issue that affects market efficiency is the Bank Indonesia’s scripless securities settlement system, which undertakes the depository activity for government bonds but does not provide access for nonbanking institutions who are not subregistries. The level of system integration with the subregistries is poor and contributes heavily to operational costs and the lack of straight-through processing capabilities for the market as a whole. Issuance of government securities would improve with a coherent policy for debt issuance, a proper primary dealer system, and infrastructure to support the primary and secondary market for government debt securities. ADB is providing TA to Bapepam-LK (footnote 3) to create a more liquid, transparent and competitive bond market with greater and more harmonized access throughout the industry. 35. Repurchase markets. The Indonesian Government began a repurchase market in 2004 and launched a master repurchase agreement in 2005. However, market participants have major issues with the agreement as there is a lack of clarity with regard to its terms and conditions and the extent to which parties can exercise their rights in the event of default by a counterparty. As of June 2006, only five institutions had executed the master repurchase agreement to facilitate repurchasing transactions. Another key hurdle is the master repurchase agreement structure, which is based on a sale and buy-back with full legal transfer of securities, resulting in the participants being taxed at both stages of the transaction. 36. Market Liquidity. In 2006, of the 344 listed companies, 8% (29 companies) had no trade at all while 55% (189 companies) accounted for less than 0.1% of the total trading frequency on the JSX. The key reasons for the illiquidity of these shares are: concentrated share ownership causing minimum real free float, an absence of corporate action plans, weak investor relations, and insufficient provision of information to the public. As a consequence the market remains small and illiquid and this restricts the development of domestic institutional investors. The process of listing in Indonesia is unnecessarily cumbersome and time-consuming and companies have few incentives to list. Taxation has been a major issue, as unequal tax

12

treatment of institutions has significantly affected the overall participation of market intermediaries, especially securities firms. Stock option products were launched 2 years ago but did not find much favor with the market as the rules were not considered attractive. 37. It will be important for Indonesia’s capital market to develop supporting infrastructure. In addition to repurchase markets (para. 35), securities lending, margin trading (in particular, short selling), and a derivatives market need to be developed. The lack of these instruments and facilities reduces liquidity and increases the transaction costs of trading. Liquidity will also be improved through measures to widen the investor base, in part through encouraging the introduction of different types of products to suit the different risk preferences of investors. These include exchange-traded funds, municipal bonds, asset- and mortgage-backed securities, and sharia products. There were no significant government divestments of state-owned enterprises in 2005 and 2006. There needs to be a focused strategy and plan for the divestment of the Government’s ownership of SOEs in order to increase the supply of securities to the capital market. Private pension funds would also benefit from better asset allocation and investment policies and lower costs.

38. Mutual Exchange Structure. The mutual structure plus the existence of two competing exchanges without clear roles suggests that the exchanges will be slow to innovate and to respond to investor and issuer needs and that they will regulate poorly. Mutual structures are generally recognized to be a poor governance structure for modern exchanges. An exchange offering all exchange-traded products and run as a commercial company—ideally with its own listing—would serve the Indonesian market better. A feasibility study on a possible merger of

Figure 2: Efficiency of the Indonesian Securities Markets

Liquidity CInvestor base very low Institutional investors limited Savings rate low at 25% Free float very small Not many listed companies B

Transaction costs (explicit taxes, commissions, fees and impact) Transaction costs high

compared with other regional exchanges

A Information to price accurately

• 90% of the bonds traded are government securities

• Crowding out other instruments

• True yield curve yet to emerge

• Plan to establish Bond Pricing Agency

• Dealers mostly banks • Need to improve

transparency in pricing • One credit-rating agency • Limited issues of private

debt papers • Disclosure needs

improvement

Corporate Governance

• High concentrated ownership of the publicly listed corporate sector

• Limited float • Low corporate

governance • Minority shareholders

need legal empowerment

• Bankruptcy law needs revision

Market Infrastructure and Mechanisms

Complementary Structure

• Mutual exchange structure

• Settlement T+3 (3 days after the date of trade)

• No investor protection fund

• Short selling/margin trading needs revision

• Not many hedging instruments

• Not so very conducive tax environment

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the two exchanges revealed that it makes business sense for them to merge, and that this would improve governance and lead to savings through shared information technology and human resources. 3. Improve Market Surveillance and Investor Protection 39. Regulatory Structure. A strong Bapepam-LK is needed for a coherent policy and regulatory approach to the nonbank financial sector. However, Bapepam-LK is still part of the MOF and does not have the same autonomy or human resource capacity as Bank Indonesia. A crisis in the mutual fund industry in 2005 revealed the consequences of weak regulation, although swift and resolute action by Bapepam-LK prevented a more serious crisis. A better resourced and more autonomous regulator of nonbank financial institutions is needed before the establishment of the OJK in 2010. The merger of Bapepam and DGFI to form Bapepam-LK offers an opportunity to create such a strong and independent regulator. Bapepam-LK staff lack legal immunity when carrying out their supervisory functions. Revisions to the Capital Market, Pension and Insurance Laws also need to be accelerated so legislation complies with International Organization of Securities Commissions (IOSCO) principles for securities, International Association of Insurance Supervisors core principles, and OECD guidelines for occupational pensions. Major steps are also being undertaken to strengthen the integrity of public institutions such as MOF and Bapepam-LK through major restructuring of key departments, combined with significant pay increases for staff and the introduction of strict performance and ethical standards. 40. Regulation and Supervision. The legal and regulatory environment for mutual funds needs to be improved. The legislation is an amalgam of US regulations for corporate funds (which do not exist in Indonesia) with a few references to contractual funds (i.e., all mutual funds in Indonesia). The sections of the Capital Market Law that pertain to mutual funds and the associated regulations need to be amended in order to restore investor confidence in mutual funds following the recent crisis and to develop the industry. Bapepam-LK’s investigation procedures need to be streamlined and the flow of information improved so administrative sanctions can be imposed more easily. For suspected criminal offences, better coordination and cooperation with the judicial branch is needed. To strengthen its internal governance and accountability Bapepam-LK needs to establish an internal compliance bureau with a code of conduct for officials and staff. Bapepam-LK’s organizational structure needs to move toward a more functional approach to address gaps in regulatory and supervisory oversight and to harmonize regulation and supervision. 41. Investor Protection. Indonesia does not have an investor protection fund to protect investors in the event of broker default. The rules require securities firms to take out insurance to cover this eventuality but such insurance is not available and the rule has not been enforced. This exposes investors to significant risk and is likely to deter investors of all sizes from participating in the market. Investor protection funds are typically built up by contributions from brokers. 42. International Cooperation. Bapepam-LK has entered into bilateral arrangements with domestic and foreign regulators and is seeking membership of the IOSCO multilateral memorandum of understanding. However, it is currently prevented from joining because of a lack of legal clarity with regard to its powers to (i) share confidential data with other regulators, (ii) access bank records and identify beneficial ownership of shares, and (iii) guarantee confidentiality of requests from foreign regulators. Bilateral MOUs with foreign capital markets regulators will help strengthen information sharing.

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43. Risk-based Supervision in Contractual Savings Industry. In 2000 Indonesia became the first country in Asia to implement modern risk-based capital requirements for both life and general insurers. The Bureau of Insurance has been moving toward risk-based supervision although more rapid progress is necessary. Implementation of risk-based capital regulations need to be reviewed and corporate governance standards enforced. The pension industry also needs to move toward risk-based supervision. 4. Improve Governance and Human Resource Capacity 44. Coordination among Regulators. If there is more than one regulator, each needs to have very clear and precise objectives, be subject to extensive disclosure requirements, and be publicly accountable.

There also need to be adequate arrangements, preferably documented, to

ensure the regulators cooperate when necessary, and that they have powers to exchange relevant information. Incentives for regulatory arbitrage should be recognized and minimized, and regulatory gaps spotted and filled at an early stage. Formal coordination between Bank Indonesia, the MOF, and the Deposit Insurance Institution (LPS) needs to be clearly outlined to prevent potential risks to the system’s stability. 45. Anti-Money-Laundering Regime. While considerable progress has been made in strengthening the anti-money-laundering regime for the banking sector, the nonbank financial sector in Indonesia currently lags in comparison, in terms of the effectiveness of regulations and supervision, as well as in the capacity of institutions to comply with the law. To reduce the risk of nonbank financial institutions being used as conduits for money laundering, regulations, supervision (capacity, enforcement powers, and sanctions), and capacity for compliance will need to be strengthened to achieve parity with the banking sector. 46. Institutional Capacity. The newly created Bapepam-LK will require support over the medium term for it to become an effective regulator. Governance of regulatory agencies and market institutions requires staff with graduate level education in actuarial science and finance and experience in regulatory practices and market surveillance in developed markets. Acquiring these skills is a pre-condition for success but will be a major challenge, requiring the Government to commit adequate resources over the medium and long term if technical and regulatory excellence is to be achieved. C. Lessons 47. ADB’s Financial Sector Intervention in Indonesia. ADB has undertaken four major financial sector operations in Indonesia addressing banking, capital markets, pensions, and insurance over the last 19 years. The thrust of financial sector reforms over this period moved from a focus on deregulation of the banking sector and capital market to implementation of a comprehensive set of reforms aimed at strengthening potential safeguards while encouraging market forces and market efficiency. The rapid growth that occurred after deregulation and the subsequent problems in the banking sector highlighted inadequacies in the legal, regulatory, and supervisory frameworks, while underpinning the importance of a long-term approach to strengthening capacity.

15

48. First and Second Financial Sector Program (1988 and 1992).13 The first program was aimed at improving domestic resource mobilization by the financial sector, reducing market segmentation, and encouraging competition among financial institutions, while ensuring the soundness of the financial system. The main objectives of the second program were to ensure the long-term strength and stability of the financial system by introducing prudential safeguards and creating and strengthening basic legal, regulatory, and supervisory frameworks. 49. Financial Governance Reforms Sector Development Program (FGRSDP).14 ADB’s support to the financial sector was an integral part of an IMF-led multidonor rescue package to help Indonesia overcome the Asian financial crisis. The intent of the program was to help Indonesia respond to the immediate exigencies of the crisis, as well as to reduce the country’s vulnerability to future crises. FGRSDP made significant progress in improving the governance of financial and public sector allocation of resources. Despite delays in implementation, the policy measures supported by FGRSDP helped restore financial sector health through consolidation of state-owned banks, closure of insolvent private banks, recapitalization of viable banks, and the transfer of nonperforming loans to the Indonesian Bank Restructuring Agency. Through FGRSDP, ADB was one of Indonesia's key development partners throughout the crisis, and the program provided an essential platform for continuing policy dialogue at the highest level. FGRSDP was rated as successful. 15 However, continued weaknesses in financial sector governance have undermined the potential for higher growth. 50. Financial Governance and Social Security Reform Program (FGSSR 2002).16 In 1999, parliament passed a Banking Law which was pivotal in insulating the regulatory and supervisory framework from political interference. In 2000, the Government asked ADB to support the development of a blueprint for an integrated financial services supervisory institution, referred to as the OJK, to make efficient use of scarce regulatory resources and strengthen harmonization of regulation across sectors. The legislation required the establishment of the OJK by the end of 2002. The FGSSR was broadly conceived to support the effective implementation of nonbank financial sector reform, including establishing the OJK, restructuring pension plans, amending relevant laws and regulations, and consolidating the insurance sector. 51. FGSSR-I has been partly effective in achieving its goals, although OJK in its intended form remains a medium-term objective (paras. 18–20). The merger of Bapepam and the DGFI into Bapepam-LK, and the endorsement of a plan for continuing improvements in the regulatory and supervisory structure of the newly created entity are significant steps towards strengthening the supervision of nonbank financial services. Market participants see these as positive moves that will facilitate supervision along functional lines and encourage greater participation by institutional investors in capital markets. However, continued capacity building is required and the legal framework for enforcement needs to be further improved.

13 ADB. 1988. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the

Republic of Indonesia for Financial Sector Program. Manila; and ADB. 1992. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Republic of Indonesia for Second Financial Sector Program. Manila.

14 ADB. 1998. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Republic of Indonesia for Financial Governance Reforms Sector Development Program. Manila.

15 ADB. 2004. Completion Report on the Financial Governance Reforms and Sector Development Program. Manila. 16 ADB. 2002. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the

Republic of Indonesia for Financial Governance and Social Security Reform Program. Manila.

16

52. Continuing Support through TA. ADB TA (footnote 3) has focused on strengthening Bapepam-LK, and provided support for the preparation of a nonbank financial sector action plan, an assessment of Indonesian standards in meeting IOSCO principles for capital market regulation, and evaluation of training needs within Bapepam-LK. It has also supported the development of the bond market, improvements to the research and surveillance functions of Bapepam-LK, and the preparation of regulations and guidelines for Islamic financial products. The measures included under the program reflect extensive dialogue, including a major workshop on key issues and findings from the TA in Jakarta in November 2006. 53. Lessons Learned. Broadly-based reforms require long-term institutional development and must be fully aligned with the Government’s national and sector development plans. The program cluster approach is a useful tool in this regard, as it combines a long-term approach covering a wide range of policy and institutional reforms and with flexibility to adjust to changing circumstances. It allows the gradual introduction of critical components in the sector, including a comprehensive legal framework and an action plan. Program clusters can also enable benchmarks to be established and unify policy makers who advocate reforms. The program completion report (PCR)17 for FGSSR recommended a framework based on single-tranche programs within a program loan cluster to provide more flexibility while focusing on achievable, upfront outcomes. Much of the success of such an approach will depend on a genuine commitment by stakeholders. The Indonesia country assistance program evaluation18 noted that the ADB financial sector projects and programs in Indonesia have generally performed well. 54. These key lessons demonstrate the importance of (i) a medium-term policy framework supported by a program cluster and tranching structure that ensures adequate time and flexibility in formulation and implementation of a reform agenda; (ii) participatory dialogue; (iii) the emergence of a stakeholder voice and a reform champion; and (iv) TA design that ensures adequate resources are made available for a sufficient duration, with a view not only to developing policy recommendations, but also to supporting implementation. The Program is a medium-term program cluster that reflects (i) ADB’s confidence in the Government’s commitment to a medium-term agenda in which it has ownership; (ii) a focus on a broad assessment of progress and the implementation capacity of the authorities, rather than on traditional conditions; and (iii) a program design that will assist the authorities to implement their strategy.

Table 4: Strategic Focus for ADB Financial Sector Operations in Indonesia

Constraints Medium-Term

National Development Plan Targets

Lessons from ADB operations CSP Areas of Engagement

Lack of depth and breadth in the financial sector

Private financing of infrastructure

• Post-crisis reforms inadequate to achieve greater depth

• ADB long-term support for regulatory reforms • Support to be translated to achieve faster

market and product development

Financial sector deepening

Source: ADB. 2006. Country Strategy and Program: (2006−2009): Republic of Indonesia. Manila.

17 ADB. 2006. Completion Report on the Financial Governance and Social Security Reform Program. Manila. 18 ADB. 2006. Country Assistance Program Evaluation. Manila.

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IV. THE PROPOSED PROGRAM A. Objectives and Scope 55. The goal of the proposed Capital Market Development Program is to promote financial sector diversification and resilience while supporting the medium-term macroeconomic goals of the Government, in particular an average annual GDP growth of 5.5–7.6% during 2005–2009 and halving the poverty rate from 16.6% to 8.2% during the same period. The expected outcome of the Program is sufficient capital market growth to diversify the markets, combined with a stronger regulatory and supervisory capacity that will ensure the resilience of the financial sector and the economy as a whole. It is expected that the Program will lead to an increase in the nonbank financial sector’s share of total financial assets. To ensure this outcome, a policy reform program has been initiated over January 2006−December 2010 aimed at enhancing information disclosure and improving price discovery, creating deeper and more liquid capital markets, providing for better market surveillance and investor protection, and strengthening governance and human resource capacity in market institutions. The Program supports the Government’s financial sector reform agenda, with a focus on the development of capital markets. 56. A program cluster modality is proposed, consisting of two single-tranche subprograms anchored on the Government’s financial sector reform programs. The program period is from January 2006 to December 2010, with a single tranche loan of $300 million to be disbursed under subprogram 1 (2006–2007) based on a range of upfront actions taken by the Government in the core areas. As shown in the policy matrix in Appendix 4, the actions have been split into two phases, January 2006−September 2007 for subprogram 1 (recognizing measures already taken by the Government), and October 2007−June 2009 for subprogram 2. The Government’s medium-term national reform agenda and its timing will be reviewed in light of the achievements of subprogram 1 and possible changes in the policy environment. It will be modified if necessary and supported by subprogram 2. The Government envisages support from ADB of $200 million−$300 million for subprogram 2.

B. Policy Framework and Actions 57. The policy measures supported by the Program include a set of sector reforms to promote financial diversification by enhancing the growth and development of capital markets. The reform agenda is structured around the following policy outcomes, which form the basis of the four components of the Program:

(i) enhancing information disclosure and price discovery, (ii) promoting deeper and more liquid financial markets, (iii) improving market surveillance and investor protection, and (iv) strengthening governance and human resource capacity. 1. Component 1: Enhancing Information Disclosure and Price Discovery

58. These policy actions are the most important for the development of the capital markets. Bapepam-LK has issued rules requiring prompt disclosure of secondary trading in bonds and for issuers of bonds to have an annual rating while their securities are outstanding. This will enable market valuation of fixed income instruments. Effective November 2007, the over-the-counter fixed income trading system at the SSX has been replaced by a centralized trading platform, which has many advantages over the previous system as it adds value to fixed-income trading

18

with improved trade execution, transparent pricing, competitive data and lower costs. Subprogram 1 supports the issuance of regulations to establish a bond pricing agency in the private sector. These measures will improve transparency and lead to a fairer trading environment in the bond market. They are aimed at addressing the major regulatory failures in 2005 that resulted in the mispricing of fixed income securities in mutual funds and a resultant loss of confidence among mutual fund investors that led to a fall in the assets under management. The bond pricing agency is expected to be established in 2008 with a mandate to provide an independent and objective daily fair value of all bonds. All issuers and public companies will be required to provide information on corporate governance as part of their annual reports. Policy measures under component 1 are summarized below and the individual policy actions are in Appendix 4: (i) 1.1 strengthen price information disclosure; (ii) 1.2 enhance market valuation of fixed income instruments; and (iii) 1.3 improve market transparency.

2. Component 2: Promoting Deeper and More Liquid Financial Markets

59. The policy actions under subprogram 1 are designed to promote liquidity so investors can buy or sell within narrow margins without affecting the market price. Depth and liquidity are essential to achieve market efficiency and resilience in the face of volatility and uncertainty in expectations and in financial flows. On the supply side, the Government proposes a sequence of measures to develop deeper and more liquid securities markets, particularly at the short end of the market, where repurchase agreements will be encouraged. To facilitate the development of the repurchase market subprogram I supports the issuance of guidelines clarifying the accounting treatment for repurchase transactions, while under subprogram 2, Bapepam-LK will cooperate with Bank Indonesia to promote the use of the master agreement in all open market repurchase transactions, whether with Bank Indonesia’s certificates or with new treasury bills issued by the Debt Management Office. Subprogram 1 also supports the development of benchmark yields for government bonds by concentrating issuance of government bonds at selected maturities of 5, 7, 10, 15, and 20 years. A primary dealer system has been established with market-making responsibilities in government debt securities to ensure two-way quotes, thereby supporting the secondary market. To develop the short-term government debt market, treasury bills of 12 months maturity have been issued. The Government will gradually progress issuance of treasury bills down to 1 month maturity with the longer term objective of gradually replacing short-term bills issued by Bank Indonesia. Revised regulations on short selling and margin trading are expected to be issued by the end of 2007. The Government has also divested itself of 15% of its holding in the state-owned PT Bank Negara Indonesia through an initial public offering in August 2007. It plans to seek parliamentary approval to divest itself of 11 more SOEs by the end of 2007 and 16 more in 2008, thereby increasing the supply of securities to the capital markets. 60. To develop the investor base, subprogram 1 supports the issuance of government bonds in small denominations to attract the retail public. Rules have been issued to facilitate the issuance of new products such as municipal bonds, sharia-based instruments, exchange-traded funds and securitization of asset-backed receivables such as mortgages. Development of the housing finance industry is another priority and amendments are planned to Presidential Decree 18/2005 to enable the Secondary Mortgage Corporation (PT. Sarana Multigriya Finansial) to lend up to 10 years enabling it to develop a critical mass of primary mortgage receivables. This measure is expected to lead eventually to a secondary market for the securitization of mortgage receivables. Many of these new products will also benefit from MOF’s amendments to the tax

19

law now under consideration by parliament. A draft decree to provide tax incentives to increase the number of listed companies and the pubic float of shares has been submitted by MOF under subprogram 1 for presidential approval within 2007. 61. The infrastructure for trading is also being enhanced. Screen-based trading has been introduced countrywide. The merger of the two stock exchanges in a new exchange in Jakarta has been approved by their shareholders. The Corporate Law has been amended to allow for stock exchange companies to be owned by a single legal entity. This is expected to improve governance of the stock exchange while broadening ownership and integrating offerings of debt and equity securities. Policy measures under component 2 are summarized below and the individual policy actions are in Appendix 4: (i) 2.1 develop the government bond market; (ii) 2.2 improve secondary market liquidity; (iii) 2.3 improve overall market access and reduce transaction costs; (iv) 2.4 develop new market sectors, products and hedging instruments; (v) 2.5 enhance performance of contractual savings industry; (vi) 2.6 strengthen governance of stock exchange; and (vii) 2.7 promote more conducive tax environment for capital markets development.

3. Component 3: Improving Market Surveillance and Investor Protection

62. Indonesia recognizes that the IOSCO principles for investor protection provide a basis for the development of modern capital markets. In line with these principles, Bapepam-LK’s operational and financial autonomy is being enhanced through legal and regulatory measures designed to provide strengthened regulation of capital markets and the contractual savings industry. Subprogram 1 supports the development and submission of a proposal to the Minister of Finance to consider an appropriate regulatory structure for the capital markets and the nonbank financial institutions supervisory agency. This would be independent of the Ministry of Finance but report to the Minister of Finance, with powers to recruit staff outside the civil service code. After addressing the constraints to the recruitment of staff under the civil service code, subprogram 2 will support the implementation of the regulatory framework. Amendments to the Capital Market Law, the Insurance Law, and the Pension Law have been drafted under subprogram 1 to strengthen the regulators’ oversight and enforcement powers in line with international best practices. They have been submitted to the Minister of Finance with the aim of submitting them to parliament for consideration in 2008. The draft amendments include adequate provisions for legal immunity from civil suits for staff of Bapepam-LK while carrying out their duties and acting in good faith. The proposed measures for greater operational and financial autonomy will also be accompanied by greater accountability. To ensure appropriate regulation of capital markets and contractual savings products, irrespective of who is providing those products, subprogram 1 supports a move toward a more functional approach to regulation, which will be phased in over 2007–2009. Risk-based supervision will be extended to all institutions in the capital markets and the contractual savings industries. 63. Bapepam-LK has entered into bilateral MOUs with a number of the foreign regulators to strengthen information sharing, particularly in connection with securities fraud. Bapepam-LK also proposes to enter into agreements with foreign regulators to exchange information for cross-border regulatory enforcement. 64. Regulation of the mutual fund industry will be strengthened under subprogram 1, which will also support a feasibility study for a securities market investor protection fund. Subprogram

20

2 will support a plan for its implementation. The key will be to provide investor protection through market surveillance and regulation. Policy measures under component 3 are summarized below and the individual policy actions are in Appendix 4: (i) 3.1 strengthen autonomy, accountability, supervisory, and regulatory powers of

Bapepam-LK; (ii) 3.2 promote international cooperation; (iii) 3.3 rationalize the organizational structure of Bapepam-LK; (iv) 3.4 enhance risk-based supervision of contractual savings industry; and (v) 3.5 strengthen investor protection.

4. Component 4: Strengthening Governance and Human Resource Capacity

65. To improve governance there needs to be better coordination among the regulators, notably MOF, Bank Indonesia and related agencies such as LPS. For a more consolidated approach, addressing harmonization and coordination of supervisory and regulatory methods and policies, reporting and information exchange and dissemination, and consumer protection and education, an MOU on the establishment of a Financial System Stability Forum was signed in June 2007 by MOF, Bank Indonesia, and LPS. Subprogram 1 supports the establishment of the forum which will be strengthened over the program period. The forum aims to promote information exchange among fiscal and monetary authorities and cooperation in financial supervision and surveillance. The forum has members from the financial supervisory and regulatory agencies and will make a number of important recommendations, including on the financial system architecture and implementation of the financial sector assessment program. To reduce the risk of nonbank financial institutions being used as conduits for money laundering, subprogram 1 will support a systematic approach to money laundering and know-your-customer rules for nonbank financial institutions. 66. A medium- to long-term agenda will be needed for human resource development. The Program will support the strengthening of the actuarial profession. Bapepam-LK has signed an MOU with the University of Indonesia to develop and adopt a plan of collaboration to serve the research needs of the capital markets and contractual savings industries. These collaborative efforts will become fully operational under subprogram 2. In addition, Bapepam-LK has adopted a medium-term plan to develop regulatory information and the research capability to meet current and future needs. The Program’s associated TA (Appendix 7) will help meet immediate needs as well as support a systematic approach to medium- and long-term capacity building efforts. The Government will commit enough resources to meet the capacity-building needs in the area of capital markets and nonbank financial institutions over the medium and long term. Based on initial feasibility studies, $18 million over the 2008–2012 period will be allocated in the Government budget for human resource development over the medium term (e.g., support for secondments, specialized recruitment and advanced training, specialized training, and support through academic institutions). With well-trained regulators, regulatory implementation and effectiveness will be significantly enhanced. Policy measures under component 3 are summarized below and the individual policy actions are in Appendix 4: (i) 4.1 improve overall financial sector risk-management though better coordination; (ii) 4.2 strengthen the anti-money-laundering regime; (iii) 4.3 strengthen actuarial profession; and (iv) 4.4 enhance industry skills and capacity for capital markets and contractual savings.

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C. Important Features 67. The Program has a number of distinct and innovative features. First, there is strong Government commitment to the development of capital markets through the CMMP and the FSPP. These initiatives represent a combination of economic, business, legal, and regulatory factors designed to enhance the role of the Indonesian capital market as an engine of economic growth. Second, the Program supports qualitative changes to processes to ensure effective implementation. It focuses on outcomes and allows for greater flexibility in actions necessary to achieve compliance. Third, it is predicated on the need for a policy and institutional response to significant market developments since the completion of the FGSSR. Fourth, the Program has helped establish a program coordination committee that will be responsible for implementing the action plan adopted for the CMMP and the FSPP. Fifth, it includes an indicative policy reform agenda for subprogram 2 that builds upon subprogram 1 reforms, thus providing for flexibility in developing subprogram 2. D. Financing Plan 68. The proposed single-tranche loan for subprogram 1 of $300 million will help the Government meet its medium-term financing needs. The loan will be provided from ADB’s ordinary capital resources. It will have a 15-year term, including a grace period of 3 years, an interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, and a commitment charge of 0.75% per annum.19 The Government has provided ADB with (i) the reasons for its decision to borrow under ADB’s LIBOR-based lending facility on the basis of these terms and conditions, and (ii) an undertaking that these choices were its own independent decision and not made in reliance on any communication or advice from ADB. The Republic of Indonesia will be the Borrower. The loan for subprogram 1 will be released in one tranche when the conditions of the policy matrix have been met and upon loan effectiveness. The Government envisages a loan of $200 million to $300 million to finance subprogram 2. The processing of subprogram 2 will be subject to adequate progress of reforms and the Government’s readiness to continue with its reform agenda. 69. Government debt as a share of GDP improved to 41% in 2006 from 45% in 2005 and is projected to fall to about 30% in 2009. The fiscal deficit is projected to increase from the original estimate of 1.1% of GDP to 1.5% in 2007. The Government has sought $2.1 billion in program loans (Table 5), based on its decision not to exceed its limits on the issuance of domestic bonds. The modest increase in the deficit target for 2007 and 2008 from earlier projections is expected to create some room for additional development spending. With high projected revenues and secure financing, development spending is projected to increase from 3.1% of GDP in 2006 to 3.9% in 2010 keeping the debt levels sustainable over the medium term. On a consolidated basis, total government investment is projected to increase from 4.8% in 2005 to 7.7% in 2010.

19 There will be no commitment charge for the single-tranche loan if it is declared effective and disbursed within

60 days after the signing of the Loan Agreement. Currently the waiver on the commitment charge of 0.50% is applicable to all interest periods commencing from 1 January 2007 up to and including 30 June 2008.

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Table 5: Government’s 2007 Revised Budget Deficit Projections

Categories Revised Projection ($ billion)

% of GDP

A. Deficit (6.44) (1.5) B. Financing 6.44 1.5 Of which: Domestic 7.83 1.9 Of which: External (1.39) (0.4) C. External

• Multilateral and Bilateral Program Assistance

2.10

• Others 2.57 • Repayments (6.06)

D. Total External Assistance (1.39) Source: Directorate General of Debt Management, Ministry of Finance, Government of Indonesia.

Table 6: Sources of Multilateral and Bilateral Assistance ($ million)

Loans from Development Partners

ADB

WB

JBIC

Total

PRMAP 400 — — 400 CMDPC 300 — — 300 DPSP 200 600 100 900 IRSDP 200 100 300 DRMP 200 200 Total 900 800 400 2,100

— = not available, ADB = Asian Development Bank, CMDPC = Capital Market Development Program Cluster, DRMP= Disaster Recovery Management Program, DPSP = Development Policy Support Program, IRSDP = Infrastructure Reform Sector Development Program, JBIC = Japan Bank for International Cooperation, PRMAP = Poverty Reduction and Millennium Development Goals Acceleration Program, WB = World Bank. Source: Directorate General of Debt Management, Ministry of Finance, Government of Indonesia.

70. The size of the proposed loan is based on (i) the economic importance of the financial sector, (ii) the significance of the proposed reforms over the medium term, (iii) the Program’s development impact, and (iv) the Government’s overall financing needs. The political costs involved in implementing the reforms are considerable and will be felt immediately. Although the economic benefits will greatly outweigh the costs, they will take time to emerge fully. Vested interests benefit from the current weak enforcement of securities, pension and insurance subsector regulation; regulatory arbitrage; and the absence of adequate risk management, supervision, and transparency in securities trading. Nevertheless, the cost of a delay in implementing the reforms would be substantially higher for the economy than the adjustment costs. Market forces need an effective and transparent regulatory framework. In the absence of timely reforms, the financial sector will continue to be ineffective in intermediating resources for productive investment, financial institutions will remain vulnerable to systemic risks, and investors will be vulnerable to fraud and misconduct. E. Implementation Arrangements

1. Program Management 71. Bapepam-LK will be the Executing Agency for the Program and will monitor and facilitate the implementation of the agreed reform actions to ensure that they are carried out in a timely

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manner. DMO and the Directorate of Taxes (DOT), both under MOF, Bapepeam-LK, Menneg BUMN (the State Ministry of State Owned Enterprises), and the Financial System Stability Forum will be the implementing agencies. Bapepam-LK has established a program coordination committee headed by the Bapepam-LK chair with representatives from DMO, DOT, Menneg BUMN, Bappenas (National Development Planning Agency), and the Financial System Stability Forum. The committee is responsible for coordinating the implementation and sustaining of the program actions. The committee shall oversee the implementation of the policy actions detailed in the Policy Letter and the Policy Matrix, and provide guidance and direction to the Executing Agency, the Implementing Agencies and other relevant line agencies of the Borrower. ADB may be invited to participate in the meetings as an observer.

2. Implementation Period

72. The implementation period for Subprogram 1 is from January 2006 to September 2007. The Government has completed all actions in the policy matrix for subprogram 1.

3. Procurement and Disbursement

73. The loan proceeds will be used to finance the full foreign exchange cost (excluding local duties and taxes) of items produced and procured in ADB member countries, excluding ineligible items, and imports financed by other bilateral and multilateral sources. In accordance with the provisions of ADB’s Simplification of Disbursement Procedures and Related Requirements for Program Loans (1998), the reimbursement procedure will be used to disburse the loan proceeds based on certification by the Borrower. No supporting import documentation will be required if during each year the value of Indonesia’s total imports minus imports from nonmember countries, ineligible imports, and imports financed under other official development assistance is equal to or greater than the amount of the loan expected to be disbursed during such year. The Government will certify its compliance with this formula with each withdrawal request. Otherwise, import documentation under existing procedures will be required. ADB reserves the right to audit the use of the loan proceeds and to verify the accuracy of the Government’s certification.

4. Anticorruption and Fiduciary Assessment

74. The Government was advised of ADB’s Anticorruption Policy (1998, as amended to date) and its Combating Money Laundering and the Financing of Terrorism Policy (2003). Consistent with its commitment to good governance, accountability and transparency, ADB will require the Government to institute, maintain, and comply with internal procedures and controls following international best practice standards for preventing corruption or money laundering activities or the financing of terrorism and covenant with ADB to refrain from engaging in such activities. 75. The proposed Program directly addresses anticorruption issues in the financial sector through its core focus on strengthening protection for investors against fraud and misrepresentation. This is part of a broader Government agenda to fight corruption and improve its public financial management systems. Presidential Decree 80/2003 sets out the basic principles of procurement: transparency, open and fair competition, economy, and efficiency. Several state auxiliary bodies have been established with mandates to fight corruption: the Commission for Eradication of Corruption, the National Ombudsman Commission, the National

24

Law Commission, and the Commission for the Eradication of Money Laundering.20 Further, the DPSP cluster (footnote 5) has a core focus on improving governance and anticorruption initiatives. It promotes transparency in public finance management and aims to strengthen the existing independent oversight mechanisms by improving the auditing framework. The Government has reorganized MOF, separating the budget and treasury functions, and has initiated steps to increase efficiency and transparency and reduce corruption in public finance management. The Government also places significant emphasis on strengthening internal control systems and overall public finance management, with support from the World Bank.21

5. Accounting, Auditing, and Reporting

76. ADB retains the right to audit the use of the loan proceeds and to verify the accuracy of the Government’s certification for the withdrawal applications. Before withdrawal, the Government will nominate an account (the Deposit Account) at Bank Indonesia to receive the loan proceeds. The account will be managed, operated, and liquidated in accordance with terms satisfactory to ADB. Bapepam-LK will submit progress reports on policy and institutional reform implementation to the program coordination committee and to ADB. These will be submitted in such form and in such detail as ADB may request, and should include (i) progress made and problems encountered during the period in review, (ii) steps taken or proposed to be taken to remedy problems encountered, (iii) proposed detailed activities for program implementation, and (iv) expected progress based on (ii) and (iii) above.

6. Counterpart Funds 77. Counterpart funds generated by the Program will be used by the Government, under arrangements satisfactory to ADB, to meet program expenditures and associated costs of reform and additional budgetary allocation for development spending.

7. Monitoring and Review 78. ADB will, in cooperation with MOF and Bapepam-LK, carry out periodic reviews of progress and outcomes of subprogram I following the subprogram I period. The Government will keep ADB informed of the outcome of policy discussions with other multilateral and bilateral agencies that have implications for program implementation, and will provide ADB with the opportunity to comment on any resulting policy proposals. ADB, in collaboration with MOF and Bapepam-LK, will review program performance about 6 months after loan effectiveness to review the outcome of subprogram 1 and begin preparation of subprogram 2. In addition to the progress reports, MOF and Bapepam-LK will submit within 30 days of the subprogram 1 review by ADB, a report that will evaluate implementation of the policy reform measures under subprogram 1. This report will also assess the impact on the sector, describe lessons identified during the program period, and outline reforms and assistance needed for the development of the sector, to enable processing of subprogram 2.

20 ADB has been closely involved in the establishment and strengthening of the anti-money-laundering regime in

Indonesia through TA support as well as policy-based loans. 21 Government Financial Management and Revenue Administration Project approved in December 2004

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V. TECHNICAL ASSISTANCE 79. Technical assistance estimated to cost a total $1,500,000 equivalent, of which $700,000 will be financed from the ADB Technical Assistance Special Fund and $500,000 equivalent will be provided from the Financial Sector Development Partnership Fund22 on a grant basis and will be administered by ADB. The TA will focus on supporting Bapepam-LK in its capacity building program over the medium term. Details of the proposed scope and implementation arrangements are in Appendix 7.

VI. PROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS A. Benefits 80. The Program supports the Government’s development agenda to establish the Indonesian capital market as a resilient and competitive market that supports higher growth for the national economy. The Program will provide a policy framework that encourages financial innovation in terms of new instruments and tenors, and new kinds of intermediation. It will enhance information disclosure and facilitate price discovery, thus improving the efficiency with which financial markets price risk. This will help to create deeper and more liquid capital markets. At the same time, CMDPC will promote stronger intermediaries that are better able to mobilize and allocate resources and risks. Better market surveillance and investor protection will promote stability and resilience and are essential for capital market development. Together with broader economic reforms in Indonesia, the reform of capital markets will thus contribute to productivity growth, employment generation, and financial sector stability. B. Social and Environmental Safeguards 81. The Program will not entail any involuntary resettlement or have a negative impact on indigenous people or the environment. It is classified as category C for involuntary resettlement, impact on indigenous people, and impact on environment. The Program is a general intervention aimed at supporting sustainable economic growth and in that respect is expected to have an indirect positive effect on poverty reduction. Appendix 8 contains the summary poverty and social impact analysis and Appendix 9 the environmental impact analysis. C. Risks 82. While mitigation measures have been put in place for some of the key risks anticipated during program implementation, subprogram 1 still faces some risks. 83. Sustaining Reforms. The financial and operational autonomy of Bapepam-LK, which is critical for its effective supervision of the nonbank financial sector, will need an appropriate regulatory framework. Reforms being undertaken by the Government may be opposed by vested or competing interests. The public and parliament will need to be persuaded of the longer-term benefits of reforms that have upfront costs. The consolidation of reform initiatives in recent years and the commitment by the Government and a strong parliamentary coalition to continue with reforms should ensure Indonesia is on the path to growth and poverty reduction.

22 Contributor: Government of Luxembourg.

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84. Governance and Capacity Constraints. Unless institutional and human capacity building takes place within Bapepam-LK, there may be delays in implementing reforms. TA support will help address these capacity weaknesses and the Government has agreed to commit, through its normal budgetary processes, appropriate provisions for human development to sustain capacity building efforts over the medium and long term. ADB’s Country Strategy and Program (2006−2009) envisages enhancing governance and reducing opportunities for corruption through its lending and TA operations. ADB has provided support for anticorruption measures, including procurement reforms, during the last 7 years and a number of ongoing loan-funded activities have an anticorruption and capacity-building focus. ADB has also actively supported the Partnership for Governance Reform—a cooperative relationship between the Government, civil society, the private sector and international development partners on governance reform. The Financial System Stability Forum which began operations in June 2007 will provide a platform for exchanging information and ideas, and for coordinating the regulatory and supervisory activities of Bank Indonesia, Bapepam-LK, and the Lembaga Penjamin Simpanan, the three member regulatory agencies. Successful implementation of the CMMP with the support of the Program should strengthen the capacity and authority of Bapepam-LK in regulating and ensuring good governance in the nonbank financial market. 85. Lack of Commitment and Accountability. Lack of accountability, measurable outcomes, industry commitment, and tactical planning mean that the CMMP may run into implementation difficulties. There are differences of views among stakeholders that will need to be resolved if policy reforms are to progress. However, progress is likely at present in view of the strong Government commitment to reform. The reform program is made more tractable by a phased plan for the implementation of well-defined measures over the next 4 years, in line with the Government’s CMMP as well as its financial sector policy package. In addition, the establishment of the internal compliance bureau in December 2006 and the revised code of ethics will strengthen governance and accountability within Bapepam-LK. 86. Enforcement Constraints. Bapepam-LK may have difficulty implementing its compliance and enforcement mandate effectively. The Program will help to strengthen its investigation strategies and enforcement skills through clearly defined capacity-building programs within Bapepam-LK. 87. Exogenous Shocks. Exogenous shocks to the economy that adversely affect growth prospects and threaten macroeconomic stability are a risk to the achievement of program outcomes. There is also the risk of a slow down in the global economy and of a disorderly unwinding of global macroeconomic imbalances. However, overall, the economy’s vulnerability to external shocks has been decreasing, primarily because of sound debt and macroeconomic management. Indonesia’s ratio of total external debt to GDP fell from 49.3% in 2005 to under 37% in 2006. The Program, in conjunction with additional reform programs financed by ADB, and the DPSP being financed by the World Bank and the Government of Japan, will help to sustain the economy’s growth path while reducing the risks of macroeconomic instability.

VII. ASSURANCES

A. Specific Assurances 88. In addition to the implementation of the actions specified in the policy matrix and to the standard assurances, the Government has given the following specific assurances, which are incorporated in the Loan Agreement.

27

(i) Continuity and coordination of reforms. The Government will carry out the policies and actions in accordance with the schedule of policy reforms contained in the policy matrix and ensure sustainability of the reforms beyond the subprogram 1 period.

(ii) Policy dialogue. The Government will keep ADB informed of (a) the progress

made in carrying out the TA attached to the program cluster from time to time, and (b) the policy discussions with other multilateral and bilateral agencies that have implications for implementation of subprogram 1 and will provide ADB with an opportunity to comment on any resulting policy proposals. The Government will take ADB’s views into consideration before finalizing and implementing any such proposals.

(iii) Counterpart funds. The Government will use the local currency counterpart

funds generated by the loan proceeds to meet program expenditures and associated costs of reform and additional budgetary allocation for development spending.

B. Conditions for Program Loan Effectiveness 89. The Government will have accomplished all subprogram 1 tranche release conditions. It will have established the program coordinating committee, which will be chaired by Bapepam-LK with representatives from the DMO, DOT, Menneg BUMN, Bappenas, and the Financial System Stability Forum.

VIII. RECOMMENDATION 90. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve

(i) the program cluster to the Republic of Indonesia for the Capital Market Development Program; and

(ii) the loan of $300,000,000 to the Republic of Indonesia for the Capital Market

Development Program Cluster (subprogram 1) from ADB’s ordinary capital resources, with interest to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility; a term of 15 years, including a grace period of 3 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board.

Haruhiko Kuroda President

13 November 2007

28 Appendix 1

DESIGN AND MONITORING FRAMEWORK Design Summary

Performance Targets/Indicators a

Data Sources/Reporting

Mechanisms

Assumptions and Risks

Impact Greater financial sector diversification and resilience

Increase in nonbank financial sector’s share of total financial sector assets from 20% in 2005 to 25% in 2009

Reports and statistics published by Bank Indonesia, MOF, and SROs

Assumptions Macroeconomic stability Sustained strong commitment of the Government to capital market reforms Political stability Resistance to reforms from vested interest Risks Exogenous economic shocks

Outcomes Increased contribution by the capital market to domestic financing

Increase in market capitalization by 30% from 2006 to 2009 A doubling of the number of individual holders of market securities, equity and government bonds, including through mutual funds between 2006 and 2009.

Reports and statistics published by Bank Indonesia, MOF, and SROs ADB review mission

Assumptions Sustained public confidence Risks Delays in enactment of legislative changes Ability of Bapepam-LK to coordinate effectively with all the agencies involved Absorptive capacity of Bapepam-LK

Outputs 1. Enhancing information disclosure and price discovery Stronger price information disclosure Better market valuation of fixed income instruments. 2. Deeper and more liquid financial markets Development of government bond market

Bond pricing agency established by 2008 Reduction in spreads from 20–30 basis points to under 10 basis points in the Benchmark issues of Government bonds from 2006 to 2009 Benchmark for 3, 5, 7, 10,15 and 20-year bonds created (2007–2009)

Bapepam-LK and industry reports Market reports and feedback Bapepam reports ADB review missions Market reports and Bapepam reports

Appendix 1 29

Design Summary

Performance Targets/Indicators a

Data Sources/Reporting

Mechanisms

Assumptions and Risks

Development of new market products including hedging instruments Improved market liquidity Enhanced performance of contractual savings industry. 3. Improving market surveillance and investor protection Strengthened autonomy, accountability, and powers of Bapepam-LK

T-Bills issued for maturities ranging from 12 months down to 1 month (2007–2008) More new products issued such as sharia-based investment products, asset-backed securities, exchange traded funds, municipal bonds and other derivative products such as stock options (2007–2009) Increase in number of listed companies by 15% to 400 by 2009 Increase in number of IPOs—percentage of IPOs to market capitalization increased by 1.5–2% per year Increase in issues of corporate securities from Rp68 trillion in 2006 to Rp100 trillion in 2009, an increase of 47% Trading value/market capitalization increased by 20-25% every year Assets of private pension funds increased by 5–7% every year. Private Gross premium to GDP increased from 1.6% to 2% by 2009. Regulatory framework for strengthening Bapepam-LK to provide more financial flexibility and operational autonomy implemented. Draft amendments to capital markets, insurance, and pension laws submitted to parliament in 2008 for approval

MOF and DMO data Announcement of offerings on Bank Indonesia website Bapepam-LK reports and SRO reports Bapepam-LK reports and SRO reports JSX annual reports and Bapepam-LK annual reports Industry feedback JSX annual reports Bapepam-LK annual reports Industry feedback JSX annual reports Bapepam-LK annual reports Industry feedback Bapepam-LK reports Pension industry/Association report Proposal submitted to Minister of Finance Finalized regulatory framework

Assumptions Market for such products Assumptions Propensity to save for old-age

30 Appendix 1

Design Summary

Performance Targets/Indicators a

Data Sources/Reporting

Mechanisms

Assumptions and Risks

Increased investor confidence and investment in capital market products Improved governance in stock exchange through merger of the two stock exchanges 4. Strengthening governance and human resource capacity Strengthened overall financial sector risk management Enhanced industry skills and capacity for capital markets and contractual savings Strengthened actuarial profession

Investor protection fund set up by 2009 JSX and SSX merged in 2008 Ministry of Finance Decree issued to establish and operationalize the Financial System Stability Forum by end September 2007 Stronger insurance companies with increase in capital and full implementation of risk-based capital framework by end of 2009. Risk-based supervision introduced for private pension industry in 2008 Medium-term plan to develop regulatory information and research capabilities. Implemented over 2008–2012 Increased number of training programs provided through Society of Actuaries—continuous

SRO reports and Bapepam-LK reports JSX and SSX reports Bapepam-LK reports Industry feedback ADB review missions MOF, Bank Indonesia, and LPS reports ADB TA reports Industry feedback Bapepam-LK reports Copy of adopted plan Society of Actuaries feedback ADB TA reports ADB review missions

Appendix 1 31

Activities with Milestones 1. Bapepam-LK Capital Market Institutions Bureau issues (1) Rule X.M.3 on 31 July 2006, (2) Rule No. IX.C.11 on 14 December 2006 for secondary trade reporting 2. Bapapam-LK issues regulation on bond pricing agency by August 2007 3. Bapepam-LK issues (1) Rule X.M.3 on 31 July 2006, and (2) Rule No. IX.C.11 on 14 December 2006 for securities companies to submit audit financial report 4. Bapepam-LK Accounting Standards and Disclosure Bureau issues revised Rule X.K.7 in December 2006 for additional information on code of ethics on corporation 5. Bapepam-LK issues Rule VIII.G.13 on 28 November 2006 relating to guidelines on the development of the repurchase market 6. Bapepam-LK finalizes regulations on short-term and margin trading to meet international best practices by 30 September 2007 7. DMO/Bapepam-LK announces issuance of government debt securities with tenors of 3,5,7,10,15, and 20 years by August 2007 8. DMO initiates issuance of T-bIlls of 12 months maturity in May 2007 and progressive issuance of short-term bills down to 1 month 9. DMO/Bapepam-LK establishes the system of Primary Dealers with mandatory responsibilities of market making and underwriting commitments in December 2006 10. Bapepam-LK approves exchange rules to implement screen-based trading in 2006 11. MOF/DMO issues retail bonds in August 2006 and March 2007 12. Bapepam-LK issues rules for the establishment of exchange traded funds in December 2006 13. MOF issues decree and Bapepam-LK rules to facilitate the issuance of municipal bonds in April 2007 14. MOF prepares draft bill for Government to issues sharia-compliant government bonds (Sukuk) and submit for parliamentary approval in February 2007 15. Bapepam-LK facilitates development of sharia-based capital market by establishing a mechanism for effective cooperation and coordination between Bapepam-LK and the National Shariah Board; and (2) adopting regulations to enable the issuance of sharia-based securities in November 2006 16. Bapepam-LK submits draft amendments to the Presidential Decree (No 19/2005) to the Minister, MOF by September 2007 which enable PT SMF to lend for tenors up to 10 years in order to develop a critical mass of primary mortgage-backed receivables 17. Bapepam-LK participates and completes in a study on introduction of stock options and index-based options by 30 September 2007 18. Bapepam-LK provides technical support to Indonesian Accounting Association (IAA) to adopt accounting standards for the application of sharia principles in sharia-based capital market by 30 September 2007 19. Bapepam-LK drafts amendments to the Pension Law to permit alternative payout options in addition to annunitization of defined contribution accumulation by 30 September 2007 20. Bapepam-LK drafts amendments to the Insurance Law to strengthen the legal basis for sharia-based operations and submits to the Minister of Finance by 30 September 2007 21. Bapepam-LK pursues and accelerates the merger process of the Jakarta Stock Exchange and Surabaya Stock Exchange to formalize the merger by 30 September 2007 22. MOF facilitates parliamentary discussions by 30 September 2007 on relevant provisions in draft tax laws to allow for more conducive tax environment for capital market development 23. MOF, DMO, Bank Indonesia formalize establishment of interagency committee to improve coordination among themselves and other market players for the development of the Government bond market by 30 September 2007 24. Bapepam-LK submits draft law by 30 September 2007 to Minister of Finance giving Bapepam-LK greater operational and financial autonomy and strengthened power to regulate and supervise all nonbanking sector laws 25. Bapepam-LK submits by 30 September 2007 to Minister of Finance draft amendments to the three sector laws (capital market, pension and insurance) to achieve greater compliance with international best practices and principles (IOSCO,

Inputs • ADB program loan of

$300 million • ADB TA $700,000 • Financial Sector

Development Partnership Fund $500,000

• Support from ongoing AusAID TA for an amount of $385,000 to complement the capacity-building component

• Government commitment of approximately $18 million over the 2008–2012 period to support nonbank financial institution and capital market related human resource development, incremental to current budget levels

32 Appendix 1

IAIS and OECD) 26. Bapepam-LK establishes internal compliance bureau to strengthen governance, and develops and adopts an internal code of conduct for officials and staff in December 2006 and January 2007 27. Bapepam-LK enters into further bilateral MOUs with foreign securities regulators by 30 September 2007 to strengthen information sharing, particularly in connection with cross-border securities fraud 28. Bapepam-LK completes an assessment by 30 September 2007 of its ability to meet benchmarks under the IOSCO multilateral memorandum of understanding (MOU) 29. Bapepam-LK develops a plan by 30 September 2007 to move toward functional regulation in order to address gaps in regulatory and supervisory oversight and harmonize regulation and supervision 30. Bapepam-LK reviews by 30 September 2007 the risk-based parameters used in the insurance industry with a view to strengthening risk-based supervision. 31. Bapepam-LK analyzes by 30 September 2007 the feasibility of creating a securities market investor protection fund 32. Bapepam-LK strengthens regulations for collective investment schemes by preparing draft amendments to the Capital Market Law and submitting them to the Minister of Finance by 30 September 2007 33. Bapepam-LK provides clear rules and guidelines by 30 September 2007 on asset valuation and disclosure rules on asset valuation and requires the prospectus for each investment fund to disclose the valuation method 34. Bapepam-LK issues three new rules in August 2006 on mutual fund sales agents-to improve the professionalism of mutual fund sales agents and representatives by requiring a licensing, examination, and registration system. 35. Bapepam-LK improves the quality of debt issuance by issuing rules requiring issuer of debt securities to provide rating information annually in.2006 36. Financial System Stability Forum established and formalized by 30 September 2007 through a joint decree between Ministry of Finance and Bank of Indonesia 37. Government issues the National Strategy for the Prevention and Eradication of the Crime of Money Laundering in Indonesia (2007–2011) in March 2007, Minister of Finance issues Regulation 74/PMK.012/2006 in August 2006 covering pension, insurance and finance companies, and Bapepam-LK issues similar rules covering capital markets by September 2007 38. Bapepam-LK supports PAI in pursuing programs to strengthen actuarial profession-throgh ADB assisted TA.-by 30 September 2007 39. Bapepam-LK develops and adopts a plan by 30 September 2007 to create a research institute to serve the needs of the capital markets and the contractual savings industries 40. Bapepam-LK develops and adopts a medium-term plan to develop regulatory information and the research capability at Bapepam-LK to meet current and future needs

ADB = Asian Development Bank, CMDP = Capital Market Development Plan, DMO = Debt Management Office, IAA = Indonesian Accounting Association, IAIS = International Association of Insurance Supervisors, IOSCO = International Organization of Securities Commissions, IPO = initial public offering, JSX = Jakarta Stock Exchange, LPS = Lembaga Penjamin Simpanan (Deposit Insurance Institution), MOF = Ministry of Finance, MOU = memorandum of understanding, OECD = Organisation for Economic Co−operation and Development, PAI = Satuan Aktuaris Indonesia (Society of Actuaries of Indonesia, PT SMF = PT Sarana Multigriya Finansial (Secondary Mortgage Corporation), SEC = Securities and Exchange Commission, SRO = self-regulatory organization, SSX = Surabaya Stock Exchange, TA = technical assistance. a In the absence of a timeframe it is expected that the indicated outputs will occur at the latest by end of the Program

period.

Appendix 2 33

SECTOR ANALYSIS 1. Regional Comparison. In terms of composition and growth, Indonesia’s financial system has not progressed compared with those of its neighbors. In 2005 Indonesia’s banking assets as a percentage of GDP were 49.8%, equity market capitalization was 28.9%, and bonds outstanding were 19.6%, much lower than Hong Kong, China; Republic of Korea; Malaysia; and Singapore (Table A2.1). Corporate bonds were a very small percentage of the overall bonds outstanding in these economies, including Indonesia. Although the Indonesian capital market has been the best performing in the region and equity market capitalization has tripled in recent years (37.6% in 2006), issues of breadth and depth of the market and enforcement of regulation and supervision remain to be addressed. The long-term debt market has been constrained by delays in pension and insurance sector reforms. Much liquidity is locked up in government bonds.

Table A2.1: Financial Systems in Selected Asian Economies (% of gross domestic product)

Banks Assets Equity Market Capitalization Bonds Outstanding Economy 1997 2004 2005 1997 2004 2005 1997 2004 2005 PRC Hong Kong, China Indonesia Republic of Korea Malaysia Philippines Singapore Thailand

124.6

205.1 31.1

37.9

100.9 56.1

122.0 79.7

176.4

337.5 14.6

130.1 169.0 66.5

176.8 129.2

163.1

444.6 49.8

93.5

159.4 63.2

185.4 103.6

11.2

234.5 12.2

8.1

93.2 37.7

110.8 15.1

23.1

519.5 28.8

57.1

153.3 33.0

202.3 71.4

17.8

593.6 28.9

91.2

138.0 40.4

220.4 70.1

12.9

26.0 1.9

25.2 57.0 22.4 24.7 7.1

24.9

46.3 22.6

83.3 90.0 28.4 73.1 41.1

24.4

46.6 19.6

76.2 88.0 36.7 68.2 40.8

PRC = People’s Republic of China. Sources: International Monetary Fund, International Financial Statistics; Bank for International Settlements; Asian Development Bank, Asian Bonds Online; and Ghosh, Swati R. 2006. East Asian Finance: The Road to Robust Markets. Washington, DC: World Bank. 2. Indonesia’s investment to GDP ratio of 21.3 % in 2006 was low compared with ratios in other economies in the region, although the International Monetary Fund has projected that it will rise to 26.2% by 2009. 3. Banking Institutions in Indonesia. The financial sector is dominated by banks, which account for about 80% of the sector’s assets. However, although the nonbank financial sector as a percentage of GDP is small, it is poised to grow. There are 130 banks: 5 state-owned banks, 72 private banks, 11 foreign banks (100% foreign ownership), 26 regional banks, and 16 joint venture banks. The regulators plan to reduce the number of banks to about 80 through mergers. One proposal is a minimum capital requirement of Rp100 billion by 2010. In 2006, seven small banks were bought by foreign banks. The profitability of Indonesia’s banks, as measured by the rate of return on assets, has improved since the Asian financial crisis. The return on assets was estimated to be 2.6% at the end of 2005—up from negative 18% in 1998. Much of this improvement in profitability occurred during 2002–2004. The capital base of banks remains strong, with average capital adequacy ratios of 19.3% at the end of 2005.

34 Appendix 2

Table A2.2: Health of the Indonesian Banking Sector (%)

1997 1998 1999 2000 2001 2002 2003 2004 2005 Nonperforming loan ratio 7.2 48.6 32.9 18.8 12.1 7.5 6.8 6.2 7.6 Rate of return on assets 1.4 (18.8) (6.1) 1.6 1.5 2.0 2.6 3.5 2.6 Capital adequacy ratio 9.1 (15.7) (8.1) 2.1 18.9 22.4 19.4 19.4 19.3 Source: Bank Indonesia.

4. Deposit Insurance. To restore public confidence in the banking sector following the financial meltdown in 1997, the Indonesian government was compelled to pursue a blanket guarantee program. Under this program, all deposits at banks are insured. Indonesia now has a Deposit Insurance Institution (LPS). Parliament enacted Deposit Insurance Law 24/2004 on 22 September 2004 which stipulates that the Deposit Insurance Institution has two core functions: (i) to guarantee customer deposits, and (ii) to resolve failing banks. The Deposit Insurance Institution carries out a limited and explicit deposit insurance scheme, under which deposits are currently insured up to Rp100 million. 5. Nonbank Financial Subsector. The nonbank financial subsector still accounts for a relatively low 20% of total financial assets. The sector includes mutual funds (also known as investment companies), insurance companies, pension funds, securities brokers and dealers, pawnshops, rural institutions, and venture capital companies. In line with Indonesia’s long-term development agenda and development priorities, the Government considers development of the nonbank financial sector to be an urgent policy imperative. At present, however, Indonesian institutional investors are relatively small and not yet a source of long-term capital. Indonesia’s pension funds and insurance companies invest a significant portion of their resources in short-term bank deposits.

Table A2.3: Structure of the Financial Sector

Type of Institution and Year Assets (Rp trillion) % of Assets % of GDP Banks (2005) 1470.0 79.7 49.8 Nonbank 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) (including both public and private)

107.1

5.8

4.7

Securities Firms (2004) 10.1 0.1 0.4 Pawn Shops (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 1844.5 100 67.6 Equity Market Capitalization (2005) 801.0 — 28.9 Equity Market Capitalization (2006) 1249.1 — 37.4

— = not available. Source: Bapepam-LK. 6. Insurance. Insurance premiums, particularly life insurance, grew rapidly before the crisis. However, the insurance industry suffered heavily from the rupiah devaluation. Unlike in

Appendix 2 35

banking, there have not been large-scale corporate failures among insurers, mainly because regulations required insurers to hold a high proportion of their funds in bank deposits. The insurance industry in Indonesia is small and premiums are only 1.8% of GDP (1.18% in life and 0.62% in general insurance). As of August 2006, there were 51 life insurance companies, 97 general insurance companies and 4 reinsurance companies. In addition, two companies administered social security and three managed civil servants and armed forces insurance. The industry is heavily concentrated, with the top five general insurance companies accounting for 51% of general insurance assets and the top five life insurance companies accounting for 55% of life insurance assets. The licenses of 8 companies—five life and three general insurance companies were withdrawn in 2006. The Government is still to address the remaining one state life and two insolvent general insurance companies. Insurance companies currently invest an estimated 25% of their assets in short-term deposits. 7. To enable insurers to meet increased capital requirements, the Government now allows foreigners to own up to 99% of listed insurance companies. The insurance industry must be consolidated into fewer but stronger companies. Policy holders must be protected and standards raised in anticipation of reductions to barriers to entry with equal treatment under freer trade agreements. There is also a need to increase the quality of professional services to the pension and insurance industry, especially actuaries and accountants but also asset managers. Quality is a prerequisite to a shift toward risk-based supervision.

Table A2.4: Ownership Structure of the Insurance Industry, 1985 and 2005

Indicator Life Insurance

Companies General Insurance

Companies Reinsurance 1985 2005 1985 2005 1985 2005 Number of Companies 21 51 67 97 4 4 % of Total Assets: State 41 7 61 14 99 — Joint Venture — 49 14 16 — — Private 59 44 25 70 Assets (Rp billion) 409 53,940 512 21,206 263 978 — = not available. Source: Bapepam-LK.

8. Pensions. In Indonesia, the pension sector is small, controlling less than 4.7% of GDP in assets, compared with Thailand (8.4%), Malaysia (57%), and Australia (75%). As of 31 December 2006, there were 297 private pension funds in Indonesia with net assets of Rp69.17 trillion covering privately-managed employer pension funds and financial institution pension funds. Investments totalled Rp66.59 trillion. Only 12% of the workforce is covered by public pension and old-age savings programs, provided by PT Jamsostek for private sector workers, by PT Taspen for civil servants, and by PT Asabri for the military. Less than 2% of the workforce is covered by voluntary private pensions. The number of employers using financial institution pension funds more than tripled over the past 5 years. The Private Pensions Law 11/1992 will be reviewed and amendments will be submitted together with the amendments proposed to the Capital Market Law and the Insurance Law. Since 1987, 100 pension funds, mainly defined-benefit employer pension plans, have been liquidated and few new funds are being created. The main impediments are: (i) private pensions have to compete with other financial products, such as mutual funds and insurance, which are more flexible (allowing for early withdrawals) and have better tax regimes; (ii) private pension savings have to be converted into annuities with unattractive rates upon retirement age; (iii) although taxation of private pensions is theoretically an exempt-exempt-taxable (EET) regime, in practice this is not the case; (iv) the investment regulations do not meet international standards; (v) potential

36 Appendix 2

contributors may not have enough funds for voluntary contributions for private pensions after compulsory contributions to public pensions and related labor law provisions have been met. 9. The uncertainties that prevent the growth of the pension industry need to be resolved together with the uncertain implementation of Law 40 on the National Social Security System and debates around the funding of benefits under Law 13 of 2003 on Labor. Bapepam-LK is undertaking steps to improve the private pension industry, in particular to increase risk-based supervision. 10. Equity Market. In 2006 there was a sharp increase in market capitalization to $139 billion but Indonesia remains the fourth smallest market in the Asia and Pacific region (only New Zealand, the Philippines, and Sri Lanka are smaller). The top 5% of companies in Indonesia represented 67% of market value and 68% of turnover (the averages for developing Asian markets are 61% of market value and 50% of turnover). 11. Rights of minority shareholders are not well protected and standards of corporate governance remain low. Liquidity is limited by the size of the market. The turnover of domestic company shares in 2006 was $48 billion—less than $200 million per day. However many developing Asian markets are relatively illiquid—2006 turnover in Malaysia was only $75 billion, in Thailand it was $101 billion, and in the Philippines $11 billion. Indonesia’s turnover velocity of 35% in 2006 is comparable with many other markets. The amount of capital raised is small, with the Jakarta Stock Exchange (JSX) raising $985 million in 2005—$363 million from initial public offerings (IPOs). JSX also operates a second tier market, the development board, to provide a platform for small and medium-sized enterprises and new companies. At the end of 2005 there were 125 exchange member securities companies. This is a large number—Malaysia had 38 and Thailand 49—and most do not make a profit given the small size of the market. Bapepam imposed more stringent capital requirements in 2004 which reduced the number of firms but the number still seems excessive.

Table A2.5: Summary of Jakarta Stock Exchange Operations

Indicator 1999 2000 2001 2002 2003 2004 2005 2006 2007 a Equity Market Capitalization (Rp trillion)

451.8

259.6

239.2

268.4

460.4

680.0

801.3

1,249.1

1,422.8

Trading Volumes (billion shares)

178.5

134.5

148.4

171.2

234.0

411.8

401.9

429.5

357.4

Trading Value (Rp trillion) 147.9 122.8 97.5 120.8 125.4 247.0 406.0 440.0 328.8 Jakarta Composite Index 676.9 416.3 392.0 424.9 691.9 1,000.2 1,162.6 1,805.5 2,055.4

Equity Market Capitalization to GDP (%)

37.2

18.7

14.2

14.4

22.6

28.9

28.9

37.4

Listed Companies 277 287 316 331 353 331 336 344 340 No. of New Issuers 21 31 22 6 12 8 12 1 No. of Trades (’000) 3,092 2,953 3,724 4,012 4,811 4,046 Total Funds Raised (Rp trillion)

8.58

14.06

6.34

9.66

16.38

4.32

a As of 30 May 2007. Source: Jakarta Stock Exchange. 2007.

Appendix 2 37

Table A2.6: Valuation of Selected Asian Bourses

Index Location Price a P/E b Estimated P/E

SHSE-SZSE300 IND

People’s Republic of China

20,041.1 30.90 29.61

Hang Seng Hongkong, China

20,310.2 14.85 15.85

BSE Sensex 30 India 13,961.4 25.55 20.50 Jakarta Composite Indonesia 1,836.5 25.53 18.82 Nikkei 225 Japan 17,225.8 37.02 43.16 Kuala Lumpur Composite

Malaysia 1,096.2 17.35 16.68

PSEI Philippines 2,976.9 15.72 16.81 Straits Times Singapore 2,985.8 14.44 16.30 Kospi Index Republic of

Korea 1,435.3 12.21 14.39

SET Thailand 679.8 9.40 10.94 P/E = price to earnings ratio. a Closing price, as of 2 January 2007. b 2006 Source: Bloomberg.

12. Indonesia has fewer IPOs than any other country in the region apart from the Philippines. In terms of the total funds raised through IPOs in Asia, Indonesia represents 1%, compared with 67% for Hong Kong, 20% for the PRC, and 7% for Singapore in 2006. The main deterrent to companies going public is taxation. This is being addressed under the Program.

Table A2.7: Percentage of New Listings and Delisting to Market Capitalization

Indicator 2000 2001 2002 2003 2004 2005 2006New Listings (companies)

21 31 22 6 12 8 12

Total Value (Rp trillion) 2.13 1.34 1.12 8.76 3.24 3.55 3.10 % of IPO to Market Capitalization

0.8 0.6 0.4 1.9 0.5 0.4 0.2

Delisting (companies) 11 2 7 4 14 3 4 Total Value (Rp trillion) 11.65 0.28 0.99 0.61 8.89 3.58 — % of Delisting to Market Capitalization

4.5 0.1 0.4 0.1 1.3 0.4 —

Source: Jakarta Stock Exchange. 2007. 13. Indonesia has the lowest percentage of local equity investors per capita in Asia (Table A2.8).

Table A2.8: Stock Exchange Investors to the Total Population (million)

Economy Estimated Total

Investors Population Investor/

Population (%) Singapore 1.4 4.3 32.6 United States 95.1 297.3 32.0 Japan 31.8 127.3 25.0 Australia 4.9 19.9 24.6 Malaysia 4.2 23.5 17.9 Hong Kong, China 1.4 8.0 17.5 Republic of Korea 4.9 48.5 10.1 Indonesia 0.3 220 0.1 Source: Jakarta Stock Exchange. 2005.

38 Appendix 2

14. Fixed Income Market. The Indonesia bond market remains small and illiquid. Government bonds represented about 13.3% of GDP (at the end of 2006) and corporate bonds about 1.9%—low by the standards of neighboring countries. Bonds offered to the public must be listed on the Surabaya Stock Exchange (SSX). Issuance of government bonds is by auction. Banks are the main holders of government bonds, with about three quarters of the total by value. Retail investors are largely absent. Trading of government bonds is increasing, but corporate bond trading averages only Rp316 billion per day. The SSX provides trading systems for bonds but these are little used and most trading is over the counter. A system of primary dealers has recently been established and they are expected to provide two-way quotes. There is a requirement to report trades to the SSX and trade details are published. 15. Government securities trades are settled electronically through Bank Indonesia’s scripless securities settlement system, which offers delivery versus payment settlement through links to the real time gross settlement system. Bank Indonesia’s scripless securities settlement system is also used for the auctions of government bonds. Bapepam-LK is the primary regulator of bond issuance and trading, but the securities exchanges are responsible for monitoring the activities of their members. The inter dealer market association for government securities (Himdasun) has self-regulatory responsibilities and is the custodian of the transaction data reported by its members. Listed bonds are required to have a rating at issue but are now required to maintain their annual rating. 16. The Debt Management Office issued its inaugural treasury bills for 12 months tenor in June 2007. The target tenors of issuance are 3 months, 6 months, 9 months and 12 months securities. In parallel, Bapepam-LK is working on a focused plan to develop the bond market.

Table A2.9: Overall Issuance of Government Bonds

Indonesian Government Bonds

Total Outstanding % of Total Outstanding

Rp $ Rp $ Tradable Securities Fixed Rate 238,564,501,000,000 5,500,000,000 34 100 Variable Rate 180,186,698,000,000 26 Subtotal Tradable 418,751,199,000,000 5,500,000,000 60 100 Nontradable Securities with Bank Indonesia

Fixed Rate 271,655,273,841,443 0.39 Variable Rate 274,366,754,841,443 0.39 Subtotal Nontradable 274,366,754,841,443 0.40 Total Outstanding 693,117,953,841,443 5,500,000,000

Source: Directorate General of Debt Management, Ministry of Finance, Government of Indonesia. 17. Collective Investments. The mutual fund industry has been in the spotlight in recent years because of the tremendous growth in the number of funds focusing on government bonds. The major players include alliances from the recapitalized banks who transferred their recapitalized bond holdings to mutual fund subsidiary companies and began aggressively selling units similar to deposit products. There were 104 licensed investment management companies at the end of 2005 but only 74 were active. At the end of 2005, Bapepam-LK had licensed 19 custodians but only 13 were active. The laws and regulations governing these investments are not clear—they apply mainly to corporate funds which are rare in Indonesia. As a result, features that are important in contractual funds, such as the role of the custodian, are not properly covered. Sales agents are largely unregulated, and similar products issued by insurance companies are subject to different regulations. Bapepam-LK has tried to address

Appendix 2 39

some of these issues by issuing new rules, but in future regulation and supervision need to be brought in line with international standards. Nevertheless, mutual funds remain an important savings vehicle for individuals and institutions.

Table A2.10: Mutual Fund Industry in Indonesia, 1996–2006

Year No. of

Investment Funds

Unit Holders

Net Asset Value (Rp billion)

Number of Outstanding Units

1996 25 2,441 2,782,322.50 2,942,232,210.52 1997 77 20,234 4,916,604.80 6,007,373,758.55 1998 81 15,482 2,992,171.40 3,680,892,097.26 1999 81 24,127 4,974,105.00 4,349,952,950.82 2000 94 39,487 5,515,954.10 5,006,049,769.66 2001 108 51,723 8,003,769.80 7,303,771,880.36 2002 131 125,820 46,613,833.20 41,665,523,049.21 2003 186 171,712 69,477,719.80 60,020,745,572.82 2004 247 299,063 104,037,824.60 84,700,701,702.71 2005 328 254,660 29,405,730.00 21,262,143,379.98 2006 403 202,991 516,200,744.00 — Source: BAPEPAM reports.

18. Developing Sharia-based Capital Market Products. At the end of 2006, there were 20 sharia investment funds (5% of the total number of investment funds in Indonesia) with a total net asset value of Rp664 billion (1.3% of the total and 18.7% more than in 2005). JSX launched the Jakarta Islamic Index on 3 July 2000, consisting of 30 shares which are considered to meet sharia principles. At the end of December 2006, the market capitalization value of the index reached Rp620 trillion or 50% of JSX’s total market capitalization value. The trading volume of the stocks listed in the Jakarta Islamic Index at the end of 2006 was 940 million shares (25% of the total JSX volume), while the trading value was Rp1,243 billion (46% of the total JSX value). The Government plans to issue a new sharia bond called “sukuks” once the draft bill on sharia-based instruments that was submitted to the parliament in February 2007 is approved. Issues related to value-added tax are under consideration by the Directorate of Taxes. 19. Market Infrastructure. JSX and SSX are mutual in structure. JSX was established in 1912 and SSX in 1987. JSX is the recognized for stock listing and trading, whereas SSX is mainly for listing and trading of bonds and derivative products. The Capital Market Master Plan (2000–2004) requires brokers to insure against losses, but this is not being adhered to. There is no fund to compensate investors in the event of broker failure. Clearing and settlement is performed by Indonesian Clearing and Guarantee Corporation (KPEI), owned 90% by JSX and 10% by SSX. This self-regulatory organization (SRO) was established in August 1996. Since 2001, it has been providing securities lending and borrowing services to help clearing parties meet their temporary needs and prevent failure of transaction settlements. Indonesian Central Securities Depository (KSEI) is a nonprofit SRO which performs depository and settlement function. KSEI was founded in December 1997. The three SROs (JSX, SSX, and KPEI) own 16.5% of KSEI shares, 9 custodian banks own 36%, 31 securities companies own 33.5%, 4 registrars own 4%, and the remaining 10% is kept in the form of treasury stock. KSEI’s main role is to facilitate central securities depository requirements, including the deposition of securities that are either traded on Indonesian stock exchanges or over-the-counter, and the

40 Appendix 2

management of securities accounts owned by securities companies and custodian banks in KSEI’s system.

Table A2.11: Market Intermediaries

Institutions Number Stock Exchanges 2 Clearing Guarantee Corporation 1 Central Securities and Depositories 1 Securities Company 125 Supporting Institution 32 Supporting Profession 2,695 Investment Advisor/Credit Rating Company 18 Source: BAPEPAM-LK. 2006.

20. Other Products and Services. These include (i) exchange traded funds, (ii) asset backed securities (although no company has issued such securities since regulations were introduced), (iii) single stock futures, and (iv) stock lending and borrowing. A presidential decree on secondary mortgage financing was issued in February 2005 establishing the Secondary Mortgage Corporation (PT Sarana Multigriya Finansial). Its function is to purchase qualified mortgages from financial institutions and issue bonds backed by these assets. The target market for these mortgage-backed securities will be long-term investors, such as insurance companies and pension funds. It is expected that, during PT SMF’s first 3 years of operations, it will lend to financial institutions, which will on-lend for qualifying mortgages, in order to build up a critical mass of primary mortgage receivables. The loans will help build qualified mortgage portfolios for purchase by PT SMF, as well as a track record for lower- and middle-income sectors of society.

Table A2.12: Products and Intermediaries Variance of Products in Indonesian Capital Markets (JSX & SSX)

Product Details Transaction Value

in 2006 (Rp trillion) % Existing Products

Equities 344 equities traded in JSX & SSX 451.0 47

Equity-based derivatives 3698 contracts traded 0.6 0 Government bonds Traded in SSX 435.6 46 Corporate bonds Traded in SSX 67.8 7 Total 955.0 100 New Products Exchange Traded Fund To be launched in 2007 Sukuk (government-sharia bond) To be launched in 2007 Indonesian Depository Receipt To be launched in 2007 Asset-based Securities To be launched in 2007-2008 Secondary Mortgage Facility To be launched in 2008 Real Estate Investment Trusts Launch date not available Single Stock Future Launch date not available

JSX = Jakarta Stock Exchange, SSX = Surabaya Stock Exchange. Source: Bapepam-LK.

Appendix 3 41

DEVELOPMENT COORDINATION MATRIX Banking and Formal Credit (including SMEs and trade finance)

Capital Markets, Corporate Governance, and Nonbank Financial Institutions

Rural and Microfinance

ADB Financial Sector and Social Security Reform Program

• Timeframe: 2002–2004 • Budget: $250 million (policy-based) loan

Support for financial sector and social security-related reforms Establishment of a Financial Services Authority

• Timeframe: 2002–2007 • Budget: $1,500,000 TA grant

Technical and capacity building support to Bapepam-LK Development of an anti-money-laundering Regime (Phase II)

• Timeframe: 2004–2006 • Budget: $500,000 TA grant

Technical and capacity-building support to PPATK for implementation of the anti-money-laundering regime

SME Export Development Project • Timeframe: 2002–2007 • Budget $85 million loan

(credit line)

Australia AusAID Technical Assistance Management Facility (TAMF) III

• Timeframe: 2004-2009 • Budget: Aus$26 million total;

Current annual budget approx. A$1.8 million. Main focus is on supporting restructuring of Bapepam-LK and strengthening the anti-money-laundering regime. Other areas include support for debt management, fiscal policy, SOE divestment, the Financial System Stability Forum, bank oversight, and development of the financial sector policy package Government Partnership Fund

• Timeframe: 2005–2010 • Budget: up to A$50 million total.

Provides TA and training support including support for secondments of Australian staff to Indonesian counterpart organizations and vice-versa. Scope includes support by ASIC and APRA to Bapepam-LK on areas such as risk-based supervision, prospectus review, surveillance, and enforcement; and support from Reserve Bank of Australia to Bank Indonesia. There is also a scholarship program for Bapepam-LK staff

Germany KfW (proposed) credit line for small and medium industries

• Budget: €27 million loan; €1.5 million grant; €3 million TA grant

GTZ Promotion of Small Financial Institutions. MFI-related TA support to Bank Indonesia.

United States USAID Support to the Deposit Insurance Agency (LPS)

• Timeframe: 30 months

USAID Capacity-building support for the insurance industry through support for establishment of Institute of Risk

USAID Guarantee facility to Bank Danamon for micro- and small enterprise loans in tsunami-affected areas.

42 Appendix 3

Banking and Formal Credit (including SMEs and trade finance)

Capital Markets, Corporate Governance, and Nonbank Financial Institutions

Rural and Microfinance

• Budget: $3.6 million TA and training support along with provision of IT equipment for establishment and operationalization of LPS

Management (offers degree in risk management and insurance)

Recapitalization of Sharia revolving fund for micro enterprises in Banda Aceh

• Budget: $50,000 grant USAID anti-money-laundering/CFT-related TA support.

World Bank TA support to Bapepam-LK to review

business sustainability of employer pension funds (DPPK).

• Budget: $60,000

Survey of 3,000 rural households regarding access to financial services

Support for Judicial Reform AusAid Indonesia Australia Legal Development Facility

• Timeframe: 2004–2009 • Budget: A$22 million total

Includes support for implementation of the Supreme Court’s blueprint for reform IMF/Netherlands Program on Legal and Judicial Reform in Indonesia

• Timeframe 2000–2004 Support to Supreme Court for development of blueprint for judicial reform EU Judicial Reform

• Timeframe: 3 years Support to the Supreme Court for implementation of blueprint for judicial reform UNODC Strengthening Judicial Integrity and Capacity

• Timeframe: 2004- Support to the Supreme Court for implementation of blueprint for judicial reform ADB = Asian Development Bank, APRA = Australian Prudential Regulatory Authority, ASIC = Australian Securities and Investments Commission, AusAID = Australian Agency for International Development, DPPK = Deutsche Arbeitsgruppe zur Psychologie der Persönlichen Konstrukte, EU = European Union, KfW = Kreditanstalt für Wiederaufbau (German Bank for Reconstruction and Development), GTZ = Deutsche Gesellschaft für Technische Zusammenarbeit (German Agency for Technical Cooperation), IMF = International Monetary Fund, SME = small and medium−sized enterprise, TA = technical assistance, TAMF = technical assistance management facility, UNODC = United Nations Office on Drugs and Crime, USAID = United States Agency for International Development. Source: ADB Staff and Development Partners.

Appendix 4 43

POLICY MATRIX AND DEVELOPMENT POLICY LETTER

POLICY MATRIX Indonesia Capital Market Development Program Cluster

Program Impact: Financial Sector Diversification and Resilience Program Outcome: Increased contribution by the capital market to domestic financing by:

(1) enhancing information disclosure and price discovery; (2) promoting deeper and more liquid financial markets; (3) improving market surveillance and investor protection; and (4) strengthening governance and human resource capacity in market institutions.

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009)

(1) Enhancing information disclosure and improving price discovery

1.1 Strengthen price information disclosure

1.1.1 Bapepam-LKa to issue rules to (i) require traders to promptly disclose secondary trading in government securities (e.g., price) ; and (ii) require issuers of corporate debt securities to provide details of any material changes to rating agency (which will then determine whether the issue will be rerated) as well as to update the rating on the anniversary of bond issuance

Bapepam-LK

(accomplished)

Bapepam-LK to monitor progress toward real time price information

1.2 Enhance market valuation of fixed income instruments

1.2.1 Bapepam-LK to issue rule to enable establishment of an independent bond pricing agency

Bapepam –LK

(accomplished)

Bapepam-LK to support the establishment of a bond pricing agency (by the private sector)

1.3 Improve market transparency

1.3.1 Bapepam-LK to revise rule concerning obligations of issuers and public companies to include additional information on corporate governance as part of annual reports. Rule to include provision for disclosure of information on board committees (e.g., audit, remuneration, nomination)

Bapepam-LK

(accomplished)

Bapepam-LK to develop internal processes, procedures, and systems to enable prompt public disclosure of changes in beneficial ownership of officers, directors and significant shareholders with 5% holding of public companies in line with international good practice

44 Appendix 4

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009)

(2) Promoting deeper and more liquid capital markets

2.1 Develop government bond market

2.1.1 MOF, Bank Indonesia and SROs to formalize establishment of inter-agency committee to improve coordination for development of the government bond market

MOF/DMO

(accomplished)

Bapepam-LK to consider enhancing the role of Himdasun (primary dealers association) in the bond market to support regulatory surveillance

2.2.1 Bapepam-LK to issue guidelines to clarify accounting treatment of repurchase transactions to facilitate the development of the repurchase market

Bapepam-LK

(accomplished)

Bapepam-LK in coordination with Bank Indonesia to address issues constraining wider adoption of the master agreement for repurchase transactions

DMO and Bank Indonesia to develop a centralized securities borrowing and lending program for government bonds

2.2.2 Bapepam-LK to prepare revisions to regulations on short selling and margin trading in securities to incorporate international best practices. Regulations to, among other things, clarify securities eligible for short selling; uptick rule; and other measures to address related risk

Bapepam-LK

(accomplished)

Bapepam-LK to issue revised rules on short selling and margin trading

2.2.3 Debt Management Office (DMO), Ministry of Finance (MOF) to (i) gradually develop the benchmark yield curve by issuing appropriate benchmark maturities for Government debt securities with tenors of 5, 7, 10,15, and 20 years and (ii) develop an annual auction calendar

DMO

(accomplished)

DMO to provide quarterly updates to an annual auction calendar to market participants to provide clarity on issuance expectations

2.2 Improve market liquidity

2.2.4 DMO to issue T-bills of 12 months maturity to initiate the development of the short-term Government debt market

DMO

(accomplished)

DMO to progress issuance of short-term T-bills down to 1 month maturity

Appendix 4 45

A

ppendix 4 45

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009)

2.2.5 Ministry of State-Owned Enterprises (MSOE) to develop a pipeline of candidate SOEs for privatization in accordance with the privatization strategy

Ministry of SOE

(accomplished)

MSOE to conduct IPOs for selected state-owned enterprises

2.2.6 DMO to establish system of primary dealership with underwriting and market making responsibilities in government debt securities

DMO

(accomplished)

DMO, in consultation with Bapepam-LK and Bank Indonesia, to review the operations of primary dealers to ensure they are carrying out underwriting and market making commitments, and two-way quote obligations

DMO to take measures to extend the scope of two-way quotations and to reduce the bid and offer spread

2.3 Improve overall market access, and reduce transaction costs

Bapepam-LK to develop ‘single point straight through processing’ to undertake consolidated post-trade processing

Bapepam-LK in consultation with Bank Indonesia to undertake a study on the feasibility of a single centralized custody or registry to consolidate all capital market depository activity under one entity. DMO in association with Bapepam-LK to request Bank Indonesia to allow nonbank primary dealers to participate in Bank Indonesia’s repurchasing window

46 Appendix 4

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009)

Bapepam-LK to improve the clearing and settlement infrastructure by requiring continuous net settlement

2.3.2 Bapepam-LK to require JSX to implement screen-based remote trading system

Bapepam-LK/JSX/SSX

(accomplished)

2.4.1 DMO to issue retail bonds

DMO

(accomplished)

2.4.2 Bapepam-LK to issue rules to enable the establishment of exchange traded funds

Bapepam-LK

(accomplished)

Bapepam-LK to require Exchange to issue listing rules for ETFs

Bapepam-LK to issue rules to enable the establishment of real estate investment trusts

2.4.3 MOF to issue Decree and Bapepam-LK to issue rules to facilitate the issuance of municipal bonds

MOF & Bapepam-LK

(accomplished)

MOF to monitor development of local government (municipal) bond markets

2.4.4 MOF to prepare draft bill to enable Government to issue sukuk (sharia-compliant bonds)

MOF/ DMO

(accomplished) Sukuk to be issued by the Government

2.4.5 Bapepam-LK to facilitate the development of sharia-based capital market by: (i) establishing a mechanism for effective cooperation and coordination between Bapepam-LK and the National Shariah Board; and (ii) adopting regulations to enable the issuance of sharia-based securities

Bapepam-LK

(accomplished)

Bapepam-LK to support the issuance of new sharia-compliant products

2.4 Develop new market products including hedging instruments

2.4.6 Bapepam-LK to submit draft amendments to Presidential Regulation 19/2005 to the Minister, MOF

Ministry of Finance / Bapepam-LK (accomplished)

Bapepam-LK to support development of appropriate

Appendix 4 47

A

ppendix 4 47

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009) to enable PT SMF to lend for long-term tenors (up to 10 years) in order to develop a critical mass of primary mortgage-backed receivables and develop and enhance the market for asset and mortgage-backed receivables

accounting standards by Indonesian Accounting Association to facilitate development of asset backed securities market

2.4.7 Bapepam-LK to require JSX to prepare and submit study on introduction of stock options and index-based options to Bapepam-LK

Bapepam-LK/JSX

(accomplished)

Bapepam-LK to require JSX to prepare and submit for approval rules and regulation for issuance and trading of stock options and index based options

DMO to coordinate with JSX to develop bond index futures contracts

2.4.8 Bapepam-LK to provide technical support to the Indonesian Accounting Association (IAA) to adopt accounting standards for the application of sharia principles in sharia-based capital market

Bapepam-LK/IAA

(accomplished)

2.5.1 Bapepam-LK to prepare draft amendments to the Pension Law to permit alternative payout options in addition to annunitization of defined contribution accumulation to address impediments to the development of the private pension industry

Bapepam-LK/ MOF

(accomplished)

Bapepam-LK to allow insurance companies to have diversified services portfolios

Bapepam-LK to undertake study on the possibility of liberalizing restrictions on investments by contractual savings institutions, including criteria for investments in foreign assets

2.5 Enhance performance of contractual savings industry

2.5.2 Bapepam-LK to prepare draft amendments to the Insurance Law to strengthen the legal basis for sharia based operations

Bapepam-LK

(accomplished)

MOF to submit bill to Parliament to strengthen the legal basis for sharia-based operations

48 Appendix 4

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009)

2.5.3 Bapepam-LK to prepare an assessment for the future development of public pensions and old age savings within the context of the National Social Security Law, leading to a road map

Bapepam-LK

(accomplished)

2.6.1 Merger of JSX and SSX to be approved by (i) Bapepam-LK and (ii) exchange shareholders

Bapepam-LK

(accomplished)

Bapepam-LK to: (i) monitor the implementation of the merger agreement between JSX and SSX; (ii) allow merged exchange to implement strategy to broaden ownership and strengthen governance; (iii) provide a framework for the establishment of alternative trading system and electronic communication network

2.6 Strengthen stock exchange governance

2.6.2 Bapepam-LK to prepare draft amendments to the Capital Market Law to enable (i) broader ownership of the merged stock exchange, and (ii) for-profit exchanges

Bapepam-LK

(accomplished)

MOF to submit draft amendments to the Capital Market Law to parliament, including provisions to enable (i) broader ownership of the merged stock exchange, and (ii) for-profit exchanges

2.6.3. New corporate law enacted to allow for (i) stock exchange, clearing and settlement institution to be owned by a single legal entity and (ii) par value for shares for public companies to be optional

Bapepam-LK

(accomplished)

2.7 Promote more conducive tax environment for capital markets development

2.7.1 MOF to facilitate parliamentary discussion on relevant provisions in draft amendments to tax laws to allow for more conducive tax environment for capital market development including:

MOF/DG Tax

(accomplished)

MOF to submit to parliament amendments to tax laws to address tax disincentives in sharia-

Appendix 4 49

A

ppendix 4 49

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009) (i) suspension/elimination of value-added tax on transfer of assets from originator to a special purpose vehicle for securitization purposes, and (ii) elimination of double taxation on repurchase agreements

based products

Government to study and consider full application of exempt- exempt- taxable tax treatment for pension funds

2.7.2 DG, TAX to submit draft government regulation to Minister of Finance to provide tax incentives for listed companies with a minimum public float of 40% of shares.

MOF

(accomplished)

Government to issue decree to provide tax incentives for (a) new listings on stock exchanges, and (b ) listed companies with a minimum public float of 40% of shares

(3) Improving market surveillance and investor protection

3.1.1 Bapepam-LK to propose appropriate regulatory structures and submit to Minister of Finance to provide it with enhanced financial flexibility and strengthened powers. The structure shall: (i) clarify the duty of confidentiality for officials and staff and attendant liability for breach of such duty, (ii) provide for enhanced accountability of officials and staff, (iii) provide for flexibility to Bapepam-LK in recruitment, including recruitment from the private sector, outside the civil service code

Bapepam-LK

(accomplished)

MOF to implement the regulatory framework that enhances Bapepam-LK’s financial autonomy and strengthens powers, including powers to recruit from the private sector

Bapepam-LK to strengthen and harmonize administrative sanctions across sectors to serve as an effective deterrent and to reduce incentives for regulatory arbitrage

3.1 Strengthen autonomy, accountability, and s powers of Bapepam-LK

3.1.2 Bapepam-LK to draft amendments to Capital Market, Pension and Insurance Laws to achieve greater compliance with international best practices and principles (IOSCO, IAIS, and OECD). The drafts shall: (i) strengthen protection of staff from legal harassment (immunity for official acts done in good faith),

Bapepam-LK

(accomplished)

MOF to submit draft amendments to the Capital Market, Pension And Insurance Laws to achieve greater compliance with international best practices and principles (IOSCO, IAIS and OECD) to parliament

50 Appendix 4

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009) (ii) require better governance by market participants, (iii) strengthen enforcement powers and clarify the power to impose administrative sanctions on any party which violates the law The draft amendments to the capital market law should include, in addition:

(i) power to obtain information on beneficial ownership

(ii) provisions to strengthen and clarify the ability to share information with foreign regulators in connection with cross-border securities fraud

3.1.3 Bapepam-LK to (i) establish an internal compliance bureau to strengthen governance, and (ii) to develop and adopt an internal code of conduct for officials and staff, including the duty of confidentiality, provide related training to officials and staff to ensure that they are aware of their responsibilities, and post the code on its website

Bapepam-LK

(accomplished)

Bapepam-LK to review and, where appropriate, consolidate rules, remove inconsistencies, and post rules and subsequent amendments on its website

3.2.1 Bapepam-LK to continue to enter into further bilateral MOUs with foreign securities regulators to strengthen information sharing

Bapepam-LK

(accomplished)

3.2 Promote International cooperation

3.2.2 Bapepam-LK to (i) conduct an assessment of its ability to meet benchmarks under the IOSCO multilateral MOU to enable it to share information with other signatories in connection with cross-border securities fraud (i.e., to become a signatory to Appendix A), and (ii) identify impediments to meeting such benchmarks, and become a signatory to Appendix B by indicating its commitment to IOSCO to address such impediments

Bapepam-LK

(accomplished)

Bapepam-LK to develop and implement IOSCO multilateral MOU action plan

3.3 Rationalize organization structure of Bapepam-LK

3.3.1 Bapepam-LK to develop a plan for a more effective organizational structure that incorporates a functional approach to addressing gaps in regulatory

Bapepam-LK

(accomplished)

Subject to adoption of the proposed regulatory structure ,Bapepam-LK to

Appendix 4 51

A

ppendix 4 51

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009)

and supervisory oversight and harmonizing regulation and supervision

(i) centralize enforcement functions over all nonbank financial institutions and organize enforcement bureau along functional lines, and (ii) amend regulations to provide for a common licensing framework for the NBFS (e.g. governing persons are fit and proper, initial and ongoing risk based capital requirements, appointment of a compliance officer, for contractual savings/collective investment schemes – appointment of an independent custodian to hold client assets, appointment of a supervisory board/committee with audit/risk committee reporting to supervisory board/committee, independent auditor)

3.4 Enhance risk-based supervision of contractual savings industry

3.4.1 Bapepam-LK to review risk-based parameters used in the insurance industry with a view to strengthening risk-based supervision

Bapepam-LK

(accomplished)

Bapepam-LK to update risk-based parameters and minimum capital requirements in line with international best practices

Bapepam-LK to implement risk-based supervision of pension funds

3.5 Strengthen investor protection

3.5.1 Bapepam-LK to conduct a feasibility study on creating a securities market investor protection fund

Bapepam-LK

(accomplished)

Bapepam-LK and JSX to develop an implementation plan for a securities-market investor protection fund

52 Appendix 4

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009) 3.5.2 Bapepam-LK to strengthen regulation of collective investment schemes by (i) preparing draft amendments to the Capital Market Law to strengthen provisions governing conflicts of interest, and (ii) issuing regulations to cover: (a) advertising, performance, record keeping, disclosure, distribution and sales; (b) protection of unit holder rights and more equitable treatment of fund investors; (c) disclosure to unit holders; and (d) requirements for technical competence

Bapepam-LK

(accomplished)

MOF to submit amended draft Capital Markets Law to parliament

Bapepam-LK to establish facility to allow for submission, monitoring, and addressing of investor complaints

Bapepam-LK to issue rules and guidelines on asset valuation and disclosure rules on asset valuation and require the prospectus for each investment fund to disclose the valuation method that will be used

Bapepam-LK to:

(i) issue rules and guidelines for fund managers so they can use the independent valuation provided by licensed Bond Pricing Agency;

(ii) monitor implementation of net asset value calculations and disclosure

3.5.3 Bapepam-LK to issue new rules to improve the professionalism of mutual fund sales agents and representatives by imposing licensing, examination, and registration requirements

Bapepam-LK

(accomplished)

Bapepam-LK to review effectiveness of implementation of rules concerning mutual fund sales agents and representatives

Appendix 4 53

A

ppendix 4 53

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009)

3.5.4 Bapepam-LK to (i) issue rule to require securities companies to submit audited financial statements signed by commissioners and directors, and (ii) revise current rules governing licensing of securities company

Bapepam-LK

(accomplished)

(4) Strengthening governance and human resource capacity

4.1 Strengthen overall financial sector risk-management though better coordination

4.1.1 MOF and Bank Indonesia to establish the Financial System Stability Forum (FSSF) through a joint decree and to commence operations

MOF

(accomplished)

FSSF to develop Indonesian financial system architecture and financial sector early warning system

4.2 Strengthen the anti-money-laundering regime

4.2.1 PPATK to develop a systematic approach to addressing anti-money-laundering issues

4.2.2 Bapepam-LK to strengthen know-your-customer rules for nonbank financial institutions

PPATK

(accomplished)

Bapepam-LK

(accomplished)

Bapepam-LK and Indonesian Financial Transaction Reports and Analysis Centre (PPATK) to work with industry associations to develop systematic capacity-building approach for nonbank financial institutions to improve compliance with anti-money-laundering regulations

Bapepam-LK to develop and implement procedures and strengthen capacity for effective supervision of anti-money-laundering regulations

PPATK to prepare amendments to the anti-money-laundering law to comply with revised FATF

54 Appendix 4

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009) 40+9 recommendations and provide for a reorganization of PPATK, and confer upon it additional powers—including the ability to conduct preliminary investigations

4.3 Strengthen actuarial profession

4.3.1 Bapepam-LK to support PAI in pursuing programs to strengthen the insurance industry

Bapepam-LK

(accomplished)

Bapepam-LK and PAI to continue training programs and related efforts for the actuarial profession to further strengthen the insurance industry to reach international standards

4.4.1 Bapepam-LK to prepare and adopt a medium-term human resource development plan for staff in capital markets and nonbank financial institutions and to develop regulatory information and the research capability to meet current and future needs

Bapepam-LK

(accomplished)

Bapepam-LK research and training fully operational

4.4 Enhance industry skills and capacity for capital markets and contractual savings

4.4.2 Bapepam-LK to develop and adopt a plan of collaboration with universities to serve the research needs of the capital markets and nonbank financial institutions

Bapepam-LK

(accomplished)

Bapepam-LK to be collaborating with universities

4.4.3 MOF to commit sufficient resources to capacity building in the capital markets and nonbank financial institutions. Based on initial feasibility studies, $18 million over the 2008–2012 period will be allocated in the budget to support secondments, domestic and overseas scholarships, advanced and specialized training, a cooperative research program, support through academic institutions, including visiting professorships and other capacity building activities.

MOF

(accomplished)

MOF to commit incremental expenditures for capacity development in capital markets and nonbank financial institutions in line with its medium-term program

Appendix 4 55

A

ppendix 4 55

Purpose

Actions under Subprogram 1

(1 January 2006–September 2007)

Responsible Agency/ Status of Compliance

Indicative actions under Subprogram 2

(October 2007 – 2009) The Government is committed through its normal budgetary processes to make appropriate provisions for these human resources requirements

DMO = Debt Management Office, FATF = Financial Action Task Force, IAA = Indonesian Accounting Association, IAIS = International Association of Insurance Supervisors, IOSCO = International Organization of Securities Commissions, IPO = initial public offering, JSX = Jakarta Stock Exchange, MOF = Ministry of Finance, MOU = Memorandum of Understanding, MSOE = Ministry of State-Owned Enterprises, NBFS = nonbank financial sector, OECD = Organisation for Economic Co−operation and Development, PAI = Per Satuan Aktuaris Indonesia (Society of Actuaries of Indonesia) , PPATK = Pusat Pelaporan dan Analisis Transaksi Keauangan (Center for Financial Transaction Analysis and Reporting), Indonesian Financial Transaction Reports and Analysis Centre, SOE = state-owned enterprises, PT SMF = PT Sarana Multigriya Finansial (Secondary Mortgage Corporation), SSX = Surabaya Stock Exchange. a Bapepam-LK is the statutory regulator of the capital market and nonblank financial institutions under MOF and any successor agencies.

56 Appendix 4

Appendix 4 57

58 Appendix 4

Appendix 4 59

60 Appendix 4

Appendix 4 61

62 Appendix 5

LIST OF INELIGIBLE ITEMS

No withdrawals shall be made in respect of:

(i) expenditures for goods included in the following groups or subgroups of the United Nations Standard International Trade Classification, Revision 3 (SITC, Rev. 3), or any successor groups or subgroups under future revision to the SITC, as designated by ADB by notice to the Borrower:

Table A5: Ineligible Items

Chapter Heading Description of Items

112 Alcoholic beverages 121 Tobacco, unmanufactured; tobacco refuse 122 Tobacco, manufactures (whether or not containing tobacco substitute 525 Radioactive and associated material 667 Pearls, precious and semiprecious stones, unworked or worked 718 718.7 Nuclear reactors, and parts thereof, fuel elements (cartridges),

nonirridiated for nuclear reactors 728 728.43 Tobacco processing machinery 897 897.3 Jewelry of gold, silver or platinum-group metals (except watches and

watch cases) and goldsmiths’ or silversmiths’ wares (including set gems)971 Gold, nonmonetary (excluding gold ore and concentrates)

Source: United Nations (ii) expenditures in the currency of the Borrower or of goods supplied from the

territory of the Borrower; (iii) expenditures for goods supplied under a contract that any national or

international financing institution or agency will have financed or has agreed to finance, including any contract financed under any loan or grant from ADB;

(iv) expenditures for goods intended for a military or paramilitary purpose or for

luxury consumption; (v) expenditures for narcotics; (vi) expenditures for environmentally hazardous goods, the manufacture, use or

import of which is prohibited under the laws of the Borrower or international agreements to which the Borrower is a party [and any other goods designated as environmentally hazardous by agreement between the Borrower and ADB]; and

(vii) expenditures on account of any payment prohibited by the Borrower in

compliance with a decision of the United Nations Security Council taken under Chapter VII of the Charter of the United Nations.

Appendix 6 63

SUBPROGRAM 2 1. The reforms under subprogram 2 are in line with the Government’s agenda for the financial system, in particular the capital market master plan, 2005–2009 and the annual financial sector policy package. Efforts will be concentrated on reforms to strengthen price information and discovery through bond trade reporting and on moving towards real time price information. This will be facilitated by the establishment of a bond pricing agency, expected by 2008. Subprogram 2 will enable prompt public disclosure of changes in beneficial ownership beyond 5% in the shareholding of any listed company. Secondary market liquidity will be further enhanced through better coordination between Bapepam-LK and Bank Indonesia, wider acceptance of the repurchase agreement, development of a centralized borrowing and lending program for government bonds, revised rules on short selling and margin trading, issuance of short-term T-bills of various maturities extended up to 1 year, market-making obligations being carried out by the primary dealers, and increased float and supply of securities through the privatization of selected state-owned enterprises. New products such as sharia-compliant government bonds (sukuks), municipal bonds, hedging instruments such as stock options and index-based options, and asset-backed securities will be developed and issued during the program period. 2. Insurance companies will be allowed to hold a more diversified services portfolio. The possibility of allowing the pension industry to invest in foreign assets will be examined. Proposed amendments to the Capital Market Law designed to demutualize the merged exchanges will be submitted to parliament. Amendments to the tax laws to address tax disincentives for financial instruments will also be considered by the parliament. 3. Market surveillance and investor protection will be enhanced under subprogram 2 through the implementation of the regulatory framework proposing greater financial and operational autonomy to Bapepam-LK. In parallel, proposed amendments to the Capital Market, Insurance and Pension Laws designed to achieve greater compliance with international standards will also be submitted to parliament for approval. Legal immunity will be provided to the staff of Bapepam-LK through these amendments. International cooperation will be enhanced when Bapepam-LK develops and implements the International Organization of Securities Commissions (IOSCO) MOU action plan. Bapepam-LK will also develop centralized enforcement functions over all nonbank financial institutions and organize an enforcement bureau along functional lines. Risk-based parameters and minimum capital requirements will be reviewed and updated in line with international standards for the insurance industry. The pension industry will also move towards a risk-based approach to supervision. Investor protection will be enhanced through an implementation plan for a securities market investor protection fund. Provisions governing conflict of interest will be strengthened through the proposed amendments to the Capital Market Law. Rules for using the new bond pricing agency quotes as the benchmark for valuation and pricing of collective investment schemes and units will be issued under subprogram 2. The Financial System Stability Forum, comprising Bank Indonesia, Bapepam-LK and LPS, will provide a platform for exchanging information and ideas, and coordinating regulatory and supervisory activities of the three member agencies. 4. Governance and human resource capacity in the nonbank financial sector will be enhanced under subprogram 2. Capacity for compliance with anti-money-laundering regulations by nonbank financial institutions will be strengthened. Amendments to the current anti-money-laundering law will be drafted to comply with revised FATF 40+9 recommendations, proving for reorganization of financial transactions reports and an analysis center. A medium-term capacity-building program to enhance the skills and staff of Bapepam-LK as well as the industry will be

64 Appendix 6

adopted and implemented under subprogram 2 with significant budgetary support from the Government and complemented by ADB technical assistance resources of $1,200,000 (Appendix 7). 5. The policy reforms under subprogram 2 are indicative and the scope and schedule of subprogram 2 will be modified as necessary, based on a review of the achievements under subprogram 1. This will provide flexibility in program design, as adjustments can be made on the basis of the results of subprogram 1 and changes in the external environment. Subprogram 2 will be subject to the approval of ADB’s Board of Directors.

Appendix 7 65

TECHNICAL ASSISTANCE A. Introduction 1. To support implementation of the Capital Market Development Program Cluster, the Republic of Indonesia asked the Asian Development Bank (ADB) to provide technical assistance (TA). A TA grant of $700,000 is included in the 2007 assistance program under ADB’s country strategy and program 2006–20091 for Indonesia. This will be supplemented by cofinancing support equivalent to not more than $500,000 from the Financial Sector Development Partnership Fund (FSDP)2 on a grant basis. B. Background and Issues 2. Capital Markets Supervisory Agency (Bapepam-LK). Financial sector regulation and supervision are under the authority of two supervisory authorities. Banks are regulated and supervised by the central bank, Bank Indonesia. The Capital Markets Supervisory Agency (Bapepam) was established in 1976 under Presidential Decree No. 52/1976 and given responsibility for the regulation and day-to-day supervision of capital markets in Indonesia. Bapepam is accountable to and reports to the Minister of Finance. The Ministry of Finance is responsible for development of high-level policy matters, with Bapepam having reasonable autonomy in relation to the conduct of investigations, inspections and other regulatory functions. In addition to Bapepam's role in regulating capital markets, the Commodities Futures Trading Regulatory Agency is responsible for regulating and supervising commodity futures trading and reports to the Minister of Trade. 3. In 2004, the Ministry of Finance prepared an action plan to improve the regulation and supervision of the nonbank financial sector. The insurance, pension, finance, and venture-capital companies were regulated by the Directorate General of Financial Institutions (DGFI) in the Ministry of Finance until 2005, when a presidential decree merging Bapepam and DGFI was passed. The merger of Bapepam and the DGFI into Bapepam-LK and the endorsement of a plan for continued improvements in the regulatory and supervisory structure of the newly created merged agency were a significant step toward strengthening supervision of financial services in the nonbank sector. The legal and regulatory framework for supervision will also be improved through amendments to the Capital Market, Pension and Insurance Laws. To increase the financial and operational autonomy of Bapepam-LK further changes to the regulatory framework and capacity building will be needed. Bapepam-LK has submitted a proposal to allow it to recruit staff directly from the general labor market rather than being limited to a pool of available civil servants. Salaries for Bapepam-LK staff are no longer tied to the general civil service pay scale, allowing the agency to compete more effectively for able recruits and to retain them. The Ministry of Finance has recently approved a tripling of Bapepam-LK salaries. To develop and motivate these staff, it will be crucial for Bapepam-LK to put in place a well-designed capacity-building program. 4. Capacity Building for Capital Market Development. The Program is predicated upon the development of a modern risk-based, supervision and regulatory framework for the capital markets and contractual savings industries. This framework will stress investor protection, market development, and system stability. This requires staff with graduate level education in

1 ADB. 2006. Country Strategy and Program (2006-2009): Republic of Indonesia. Manila. 2 Contributor: Government of Luxembourg. Funding to be administered by ADB.

66 Appendix 7

actuarial science and finance and experience in regulatory practices and market surveillance in developed markets. Acquiring these skills is a pre-condition for success but a very major challenge over the medium term. 5. Implementation of the reforms supported under the Program and the extent of their effectiveness and sustainability depends not only on the availability of adequate capacity in Bapepam-LK, but also within capital market self regulatory organizations (SROs), and in the industry in general. Many of the skills required for effective regulation and supervision of capital markets (as well as effective compliance) are highly specialized and require significant on-the-job and advanced formal training. 6. In the short term, capacity-building support will be provided to Bapepam-LK under this associated TA. However, this support needs to be complemented by a medium- to long-term initiative to build up a critical mass of staff with relevant skills in Bapepam-LK and the industry in general. This should include support for: (i) scholarships for staff from Bapepam-LK and other capital market institutions for advanced degrees or other forms of training, and (ii) the establishment of local institutions focused on applied research and training tailored to the needs of Bapepam-LK and other capital market-related institutions as well as to industry more generally. 7. The importance of this capacity-building initiative is recognized by both the Government and the industry and discussions have been underway for some time among government agencies, industry associations, and local universities.3 The Program aims to support these efforts and lend momentum to them via the associated TA which will help meet immediate needs and allow for a systematic approach to medium- and longer-term efforts. 8. The Australian Agency for International Development (AusAID) is shortly to implement a technical assistance project under which change management and human resources experts will be engaged to help Bapepam-LK develop its human resources department and plans to move towards a more functional approach to regulation. This project is expected to complement policy actions within Bapepam-LK and to identify additional training requirements. 9. The TA associated with the Program will address immediate and short-term capacity-building needs and complement the change management assistance being provided by AusAID. The Government has agreed to commit, through its normal budgetary processes, appropriate provisions for human development to sustain capacity building over the medium to long term.4 C. The Technical Assistance 10. The TA will draw upon the findings of a human resources skills audit conducted by Bapepam-LK. It will provide capacity-building support in five main areas:

(i) establishment of a database and improvements to basic applied research skills in Bapepam-LK’s newly established research bureau;

3 For example, MOF has proposed the establishment of a Capital Markets Institute within the University of Indonesia. 4 A study was carried out under a previous TA project to broadly define a medium-term capacity-building program,

including the cost of carrying out the above exercise (ADB. 2002. Technical Assistance to the Government of Indonesia for Establishing a Financial Services Authority. Manila).

Appendix 7 67

(ii) external on-the-job training for Bapepam-LK staff through secondments with regulators in other jurisdictions;

(iii) short courses by local training institutions in collaboration with outside experts to develop the market surveillance and regulatory skills of Bapepam-LK staff;

(iv) curricula for training programs and standards for certification for professionals in fields related to capital markets (e.g., actuaries for general insurance and surveillance training for SRO staff); and

(v) an econometric model and related capacity to improve understanding of the vulnerabilities in the nonbank financial sector by the Financial System Stability Forum.

11. The TA will also provide focused support for the implementation of selected reforms under the Program. D. Cost and Financing 12. The TA is estimated to cost a total $1,500,000 equivalent, of which ADB will provide $700,000 to be financed from the ADB Technical Assistance Special Fund. A further $500,000 equivalent will be provided from the Financial Sector Development Partnership Fund on a grant basis and will be administered by ADB. The Government will provide the remaining $300,000 equivalent by providing counterpart staff and other support facilities (Table A7). E. Implementation Arrangements 13. Bapepam-LK will be the executing agency for the TA and the research bureau will serve as the main focal point. Bapepam-LK will provide office space, counterpart staff, and other services to the consultants. It will closely coordinate with other stakeholders involved in TA implementation. A capital markets capacity-building committee comprising representatives from Bapepam-LK and the MOF will be established to provide guidance on the allocation and use of training-related funds under the TA. In collaboration with the consultants and the local universities, the committee will help to develop curricula for training programs and standards for certification for professionals in capital market-related fields and will select degree and/or training programs and candidates that qualify for scholarship support. A project coordinator will provide general administrative support for TA implementation and will be responsible for overseeing the implementation of training programs in collaboration with the consultants and the capital markets capacity-building committee. The TA will be implemented over 24 months and is expected to commence in February 2008 and to be completed by January 2010. 14. The TA will involve a combination of international and national consultants to be engaged in response to requirements that will be identified during the course of implementation of the capacity-building exercise. It is expected that this will include: 28 person-months of international consultancy services focused on capital-market-related capacity building, course development, and establishment of professional standards and certification; and 24 person-months of domestic consultancy services focused on developing a database and basic applied research skills within Bapepam-LK’s newly established research bureau. Consultants will be engaged on an individual basis in accordance with ADB’s Guidelines on the Use of Consultants (2007, as amended from time to time), and other arrangements satisfactory to ADB for the engagement of domestic consultants. Outline terms of reference will be developed in consultation with relevant government counterparts. All consultants will submit an inception report detailing their draft work plan and schedule within 1 week of fielding and provide concise, regular updates to Bapepam-LK and ADB outlining progress and identifying implementation

68 Appendix 7

issues. Where appropriate, midterm, draft final, and final reports will also be submitted according to a schedule agreed with Bapepam-LK and ADB. All services, equipment, and material to support implementation of the TA will be procured by direct purchase in accordance with ADB's Procurement Guidelines (2007, as amended from time to time). Equipment will include computer hardware and software related to the database for Bapepam-LK. All equipment procured under the TA will be handed over to Bapepam-LK upon completion of the TA. Bapepam-LK will provide for dissemination of relevant TA outputs though its website.

Appendix 7 69

Table A7: Cost Estimates and Financing Plan ($'000)

Total Item Cost A. Asian Development Bank Financing 1. Consultants a. Remuneration and Per Diem i. International Consultants 330.00 ii. Domestic Consultants 100.00 b. International and Local Travel 35.00 c. Reports and Communications 2.00 2. Equipment 3.00 3. Training, Seminars, and Conferences a. Overseas Secondments (per diem and airfare)

130.00

b. Training Programs and Seminars i. Course materials 5.00 ii. Course fees for participants in pilot batches 20.00 4. Miscellaneous Administration and Support Costs 5.00 5. Contingencies 70.00 Subtotal (A) 700.00 B. FSDP Financing a 1. Consultants a. Remuneration and Per Diem i. International Consultants 230.00 b. International and Local Travel 35.00 c. Reports and Communications 2.00 2. Equipment 3.00 3. Training, Seminars, and Conferences a. Overseas Secondments (per diem and airfare)

130.00

b. Training Programs and Seminars i. Course materials 5.00 ii. Course fees for participants in pilot batches

20.00

4. Miscellaneous Administration and Support Costs

5.00

5. Contingencies 70.00 Subtotal (B) 500.00 C. Government Financing 1. Office Facilities 150.00 2. Remuneration and Per Diem of Counterpart Staff

150.00

Subtotal (C) 300.00 Total 1,500.00 FSDP = Financial Sector Development Partnership Fund a Funding to be administered by ADB. Source: Asian Development Bank estimates.

70 Appendix 8

SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY

A. Linkages to the Country Poverty Analysis

Is the sector identified as a national priority in country poverty analysis?

Yes

No

Is the sector identified as a national priority in country poverty partnership agreement?

Yes

No Contribution of the sector/subsector to reduce poverty in the Philippines: The Government has formulated a Medium-Term Development Plan (2005–2009), which focuses on poverty reduction through higher growth rates, job creation, and activities and investments to achieve the Millennium Development Goals. One of the five priority areas is achieving macroeconomic stability with fiscal sustainability and financial sector reforms. In addition, recognizing that macroeconomic and sector reforms will be vital to attracting greater private sector investments, the Government has begun to articulate a short- and medium-term reform agenda in the financial sector. Indonesia’s capital market master plan (2005–2009), and the Government’s annual financial sector policy package (2006 and 2007) are geared toward increasing the credibility and integrity of the Indonesian financial sector and enhancing the effectiveness of the regulation and supervision of the financial services in Indonesia. Stronger public finances will enable increases in social expenditure and investments. A strong, resilient, and more diversified financial sector will support growth and investments and indirectly contribute to poverty reduction. A financial sector that functions efficiently is vital to support enterprise development and job creation. B. Poverty Analysis Targeting Classification: General intervention What type of poverty analysis is needed? Because the Capital Market Development Program Cluster is a general intervention, no specific poverty analysis was undertaken, as the Asian Development Bank’s poverty assessment for Indonesia was recently concluded and this provides an in-depth analysis. The Program is anchored in the Government’s medium-term development plan, which has clear targets for poverty reduction based on overall growth targets for the economy. C. Participation Process

Is there a stakeholder analysis? Yes No Is there a participation strategy? Yes No D. Gender Development

Strategy to maximize impacts on women: As a policy-based Program, the focus is on gender-neutral reforms to strengthen the financial sector. The reforms are designed to strengthen regulation and supervision as well to diversify the sector, and to benefit men and women alike. Has an output been prepared? Yes No

Appendix 8 71

E. Social Safeguards and other Social Risks

Item Significant/ Not Significant/ None

Strategy to Address Issues

Plan Required

Resettlement

Significant

Not significant

None

Full

Short

None Affordability Significant

Not significant

None

Yes

No

Labor Significant

Not significant

None

Yes

No

Indigenous Peoples

Significant

Not significant

None

Yes

No

Other Risks and/or Vulnerabilities

Significant

Not significant

None

Yes

No

72 Appendix 9

ENVIRONMENTAL ASSESSMENT OF THE POLICY MATRIX A. Introduction 1. The proposed Capital Market Development Program Cluster supports the Government’s reform agenda for the financial sector, with a focus on development of capital markets. The policy measures include a set of reforms to promote the diversification of financial channels by enhancing the growth and development of the capital markets. The Program is a program cluster with two subprograms. Subprogram 2 is expected to be ready for Asian Development Bank (ADB) Board consideration about 18 months after subprogram 1. This environmental assessment report examines the environmental impacts of the policy component of the Program. B. Description of the Policy Interventions 2. The reform agenda is structured around the following policy outcomes, which form the basis of four components for the proposed Program:

(i) enhancing information disclosure and price discovery, (ii) promoting deeper and more liquid financial markets, (iii) improving market surveillance and investor protection, and (iv) strengthening governance and human resource capacity.

3. The Program is embedded in the Government’s medium-term reform agenda and the two-tranche structure will provide the Government with the flexibility to adjust the program and its speed of implementation according to country developments.

Table A9: Environmental Assessment of the Policy Interventions

Policy Area Economic and Social

Outcome Environmental

Impact Mitigation Measures

1. Enhanced information disclosure and improved price discovery

• Reduction in bid/offer spreads for bonds

None

None needed

2. Deeper and more liquid financial markets • Benchmark for 3-, 5-, 7-, 10-

15- and 20-year bonds created through domestic debt swaps/ consolidation

• T-Bills issued for maturities ranging from 12 months down to 1 month.

• Increased number of new products issued

• A doubling of the number of individual holders of market securities, equity and government bonds from 2005 to 2009.

• Issuance of retail bonds on a sustained basis

• Increase in number of listed companies by 15% to 400

• Increase in number of IPOs-

None None None None None None None

None needed

Appendix 9 73

Policy Area Economic and Social Outcome

Environmental Impact

Mitigation Measures

percentage of IPOs to market captilization increased by 1.5–2% per year

• Increase in issues of corporate securities from Rp68 trillion in 2006 to Rp100 trillion in 2009, an increase of 47%

None

3. Improved market surveillance and investor protection • Increased compliance with

IOSCO Principles • Investor protection fund set

up in 2008 • Jakarta Stock Exchange

and Surabaya Stock Exchange merged in 2008

None Under the CMDPC, ADB funds will not be used to finance investments in infrastructure, or used as a financial intermediary to channel ADB funds to infrastructure projects.

None needed

4. Improved governance and human resource capacity in market institutions • Ministry of Finance decree

issued to establish and operationalize the Financial System Stability Forum

• Strengthened insurance companies with increase in capital and full implementation of risk-based capital framework. Risk-based supervision introduced for private pension industry

• Regulation and rules issued to strengthen Know-your-customer medium-term plan to develop regulatory information and research capabilities implemented

None None needed

ADB = Asian Development Bank, CMDPC = Capital Market Development Program Cluster, IOSCO= International Organization of Securities Commission, IPO = initial public offering. C. Environmental Management Plan 4. An environmental management plan is not required. D. Conclusion 5. On the basis of this assessment, the Program is classified as environment category C.