Development and Inclusion Program (Subprogram 2) (RRP INO 48207-002)

PROGRAM IMPACT ASSESSMENT ENHANCING THE REGULATORY FRAMEWORK OF FINANCIAL SECTOR DEVELOPMENT AND OVERSIGHT INDONESIA

I. Executive Overview

1. Problems in Indonesia’s financial sector continue to restrain the economy. GDP is stubbornly trending below target, and so is . As the macroeconomic conditions which often hinder credit growth have improved, structural issues in financial intermediation have come to seem a far more likely cause of poor capital market outcomes. This subprogram underwrites some necessary reforms.

The net quantifiable benefits of the initiatives being supported have been estimated at $5,865 million, and they are summarized in the table below. Output 1 contributes $169 million by enhancing financial system stability. The second output deepens markets, particularly in the area of Islamic , and it contributes $2,320 million. Output 3 will stimulate financial activity by extending the reach of the system to those most marginalized – women and small business contributing $3,376 million. The total cost to the economy is approximately $913 million. From this amount, approximately half of this is a cost to the industry through OJK’s levy. This approach shifts the burden from taxpayers to the industry and frees up fiscal space in the national budget. Other cost includes administrative cost to the government including operational costs of the Center for Financial Sector Policies, financial literacy outreach programs to women, micro and small-sized enterprises, implementation of best practices for Islamic finance and other institutional reforms.

Table 1: Costs and Benefits of Subprogram 2 Present Values in USD million* Output Benefits Costs Net Benefits 1 609 440 169 2 2620 300 2,320 3 3548 173 3,376 *Totals may disagree due to rounding Source: ADB Staff.

2. The subprogram includes measures to improve the efficiency of traditional markets but its dominant theme is one of growth through financial inclusion. Each of the outputs features actions which empower women and micro enterprises. Several other initiatives in output 1 deliver greater financial stability and will provide essential ballast for the financial system as it expands into relatively new domestic markets.

3. The gains generated by the subprogram accrue mainly as income streams to those who are newly enfranchised by reform. Financial stability initiatives are likely to have more diffuse benefits. By improving Indonesia’s reputation as a borrower in financial markets, they will reduce risk premia on debt and lower the cost of borrowing to Indonesian taxpayers and larger corporate borrowers. Most of the costs of the initiatives are administrative.

II. Development Problem and Constraints

4. Indonesia’s economy is growing steadily, but slowly, at around 4.9% per cent per annum. This is well below the rate of 8% which the government is targeting and which will be necessary to lift living standards for a growing population. 2

5. Financial intermediation is proving a major source of the shortfall in output. Credit extended by commercial is growing sluggishly at around 6.3% in real terms. Despite strong asset growth in recent years, Indonesia’s to GDP ratio, its ratio of financial system deposits relative to GDP, and the ratio of broad money to GDP, remain the lowest in ASEAN.

6. This situation owes more to weaknesses in the financial system than to monetary conditions. Indonesia is now enjoying significant monetary stimulus, following a fall in inflation from around 7.3% in mid-2015 to 3.5% and a commensurate easing in the key short-term government lending rate to around 4.75%.

7. Yet the engagement of Indonesians with their financial system remains weak. The prudential regulator, Otoritas Jasa Keuangan (OJK), estimates that around 203 million Indonesians lack access to financial services. The proportion of adults with accounts at financial institutions is around half the average for developing East Asia. Only 4.7% of the poor contribute to pensions, and life premia relative to GDP are around 25% below the average rate for developing East Asia.

8. Of the several reasons for disengagement with the financial sector, factors related to poverty are the most basic. Collateral requirements are prohibitive for poor people needing investment funding, and a lack of general literacy has meant that only 30% of the population is considered literate in the use of financial products.

9. But aspects of the financial system also contribute to disengagement. The market for Syariah finance, in particular, is significantly under-developed. Although Syariah-compliant banking assets have been growing more rapidly than in the conventional sector, the last twelve months have been quite weak, and asset growth in the Islamic banking sector has been near record lows. 1 In a structural sense, there is much that could be done. Despite the huge potential of Islamic finance, it is relatively underdeveloped. Syariah-compliant assets stand at only 5% of the nation’s banking assets. This pales in comparison to Malaysia which has over 20% Syariah- compliant banking assets.2

10. There is also a need for greater inclusion for enterprises which are smaller. Micro-sized firms produce around 40% of Indonesia’s GDP. However, they lack access to larger banks and so need the support of guarantee companies, firms and ratings facilities. These are all under-developed in Indonesia. For example, World data show that there is no private credit bureau coverage of adults in Indonesia, whereas the East Asia-Pacific average is around 14%.

11. Gender represents another dimension of financial inclusion along which Indonesia needs to improve. Men are 50% more likely to have borrowed from a financial institution in the last year than women, and they are twice as likely to have a mortgage. OJK estimated in 2013 that around 25% were financially literate, compared with only 19% of women. 3 On most indicators monitored by the World Bank, Indonesian women have much less access to financial services and products than women elsewhere in East Asia.

1 Alwyini, F (2016), “Indonesia: Growing Dominance of Government Sukuk”, Islamic Finance News, December 2016. 2 Indonesia-Investments “Islamic Banking Industry Indonesia”, 6 November 2015. http://www.indonesia- investments.com/business/industries-sectors/islamic-banking/item6131? 3 Soetiono, M (2014) “Promoting Financial Literacy Through Life-Cycle”. 3

12. Mistrust of the banks also causes public detachment from the financial system. The World Economic Forum ranks Indonesia 69 th out of 138 countries in terms of the banks’ trustworthiness, and 72 nd in terms of their soundness. These placings contrast poorly with Indonesia’s overall competitiveness ranking of 41 st . Corruption, which is endemic in Indonesian corporate and political life, almost certainly explains some of this mistrust. Public perceptions of the banks have been marred in recent years by high-profile fraud scandals involving Bank Century, Bank Syariah Mandiri, Citbank Indonesia, Bank Mega and CIMB Niaga, among others. Complaints to the regulator by customers have been increasing and tend to focus on banking issues, particularly guarantees, credit restructuring issues and use of cards. 4

13. Unevenness in the performance of banks deepens skepticism about them. In aggregate, the system may be profitable and well capitalized. Net interest margins are certainly healthy at around 5.5%, and returns on assets are above those of ASEAN peers. System-level capital adequacy ratios of around 15% are also comfortable.5 Yet there is dispersion in the data underlying these aggregates, and the IMF has found that the smaller banks are significantly less robust than their larger competitors. 6 Not only does this discourage more financially literate Indonesians in their banking system, it creates concern among foreigners and so exacerbates financial stability concerns.

14. Better financial supervision and greater financial stability are pre-conditions for any in- roads into these problems. Yet in emerging or frontier markets, the relationship between financial stability and inclusion is complex, and reform can only succeed if it confronts the tension between them. From a consumer-savings perspective, the objectives are consistent enough: stability and a sound prudential framework are vital to securing the trust and inclusion of the poor, who cannot diversify their savings across providers. But from a lending perspective, the relationship between inclusion and stability is more difficult. Banks are more stable when their borrowers are sophisticated and creditworthy. Extending their franchise to those who do not meet these criteria for the sake of financial inclusion can be destabilizing.7

15. Indonesia’s approach to the problem is complicated by the volume of regulatory change now moving through the global financial system. Recent or ongoing international initiatives that affect Indonesia include various changes to risk management promulgated by the Basel Committee for Banking Supervision, new standards such as IFRS9, and regulations affecting dealings with US counterparties, under the Dodd-Frank Act. The implementation of these changes will all influence the terms on which banks can interact with more marginal users of the financial system. According to accounting firm EY, banks cite a lack of regulatory direction from OJK as a major problem in planning and improving their risk management systems.

16. Beyond questions of policy, there are issues of execution. Above all, the scale of supervision required in Indonesia is formidable. The banking sector’s control of over 74% of financial system assets suggests that scarce supervisory resources might be efficiently concentrated around banks.8 But the industry is more fragmented than the headline numbers

4 OJK, “Level of Consumer Complaints and Level of Public Awareness Increase”, 7 March, 2015. 5 OJK, (2016) “Indonesian Financial Services Sector Master Plan”, p24. 6 IMF (2016), “Indonesia: Selected Issues”, p.7. 7 See, for example, Sinha, A (2011) “Financial Sector Regulation and Implications for Growth” Paper presented by Anand Sinha, Deputy Governor, Reserve Bank of India, at the CAFRAL-BIS International Conference on Financial Sector Regulation for Growth, Equity and Financial Stability in the post-crisis world, Mumbai, 15–16 November 2011; M Kawai and E Prasad (2013) “New Paradigms for Financial Market Regulations: Emerging Market Perspectives” The Brookings Institution. 8 OJK (2016), op cit, p.26. 4 suggest. Indonesia has 118 commercial banks, 1800 rural banks, and 600,000 micro-finance institutions. 17. The challenges of simultaneously expanding and consolidating the financial system extend to insurance. These markets have been growing – albeit from a low base. As of mid-2015, there were 5 reinsurers, 35 reinsurance brokers, 50 life insurers, 79 P&C insurers, and 161 insurance brokers. 9 Although conditions in the industry have lately been buoyant, premium income growth has a history of volatility. Marketing and governance standards in the industry still lag better practice, and cost considerations have discouraged established players from educating and onboarding unserviced consumers at the periphery of the financial system.

18. Finally, there are underlying problems with the wholesale markets in which financial institutions operate. Indonesia’s ratio of liquid reserves to assets is quite high, partly because money markets are under-developed. There is a chronic need within the system for market infrastructure which allows banks to manage their risks and liquidity needs via repurchase agreements. There is also a need to remove red-tape and impose greater certainty over the direction of the industry.

III. Reform Program

19. The three outputs in this subprogram will collectively improve the quality of prudential supervision and lift financial inclusion. The first, ‘Regulatory Structure for Financial Stability Strengthened’, addresses the legal and regulatory infrastructure. The second, ‘Financial Market Deepened’ features a suite of reforms which improve a number of more established financial markets. Reforms in the third output, ‘Financial Inclusion Enhanced’, are designed primarily to make financial markets more accessible to their most marginal users.

20. Output 1 delivers a more robust legislative framework for prudential supervision and financial stability. Its most general provision is the development of the Financial Sector Master Plan. Collectively, the 134 reforms in the plan straddle most of the themes in the subprogram, and they are divided into four different themes: contributive, stable, inclusive, enabler.

21. The output includes several reforms which will deliver a more focused and independent regulator. This is a firm step toward better practice, and financial markets are likely to regard it as mitigation of systemic risk. It is reasonable to anticipate that some reduction of the risk premium on Indonesian debt will follow.

22. The measures in question include the transition to a funding model based on industry levies, and a $37million uplift in the overall level of that funding. The establishment of an autonomous funding model brings Indonesia closer to global better practice, and it reduces the potential exertion of influence on its operations by other arms of government.

23. The strengthening of the regulator’s fiscal position is buttressed by newly passed legislation which asserts OJK’s legal independence, while clarifying responsibilities and protocols during financial crisis management. In addition, the provisions offer essential personal legal protection for members of the Financial System Stability Committee (KSSK) in the proper exercise of their duties. This increases the likelihood that a systemic crisis in the Indonesian financial system would be efficiently managed, and so it will contribute to market confidence in the financial system.

9 KPMG, “Insurance in Indonesia: Opportunities in a Dynamic Market”. 5

24. The output also includes separate and more specific measures to improve the efficiency of the financial system. The development of the SPRINT licensing system will significantly reduce sale time for mutual funds through approved banks and similarly facilitate the licensing of bancassurance ventures – a sector which delivered around 36% of life premium in 2015. Chartered accountants can also reduce their startup time through the system to around 20 working days, lifting efficiency in the financial sector.

25. Output 2 is primarily designed to recognize a deepening of financial markets. Its signature reform is to Syariah financial markets, which have been suppressed by inequitable taxation. Tax in Indonesia is generated on the transfer of all real assets, and so it applies unevenly to Syariah and conventional financial transactions. The disparity effectively imposes a 15% tax on domestic Syariah securities, and it has reduced the appeal of a wide range of Syariah-compliant products, from saving and borrowing facilities, through to investment vehicles. The harmonization of the taxation treatment of Syariah products though this output has been complemented the reform with an implementation of the IFSB standards.

26. The benefits of deeper markets in Islamic products are complex. The main feature of the initiative – that is the fiscal cost of tax harmonization – is assumed to net off; that is, it is effectively a transfer from taxpayers to bondholders with no first-order efficiency dividend. Instead, a gain is expected to accrue as a result of the market becoming more accessible and attractive to marginalized users who need Islamic products but are discouraged by poor effective returns. The uplift in savings and investment should have positive long run implications for . The more complex benefits arise out of a deepening of the markets. Increasing the liquidity of both the government and corporate markets will improve liquidity and support the growth of non-bank financial service providers who have Islamic mandates.

27. A second objective of the output is to develop stronger and more uniform standards of corporate governance. OJK has taken a number of important steps in this regard by regulating corporations with respect to board remuneration, whistleblowing, and conflicts of interest. Although the benefits of these actions are hard to quantify, over the long term they should reduce funding costs by lowering the perceived risk around financial institutions. In a similar vein, the announcements in this output include improvements to OJK’s own governance.

28. Also included in the reforms adopted by OJK via this output channel is compliance with the ASEAN Corporate Governance Scorecard with respect to disclosure of gender diversity. The benefits of this action are again difficult to quantify. Apart from delivering more equitable employment outcomes over the long term, they improve prospects for promoting qualified women into positions where they will be better able to lift corporate productivity.

29. The output also includes reforms to insurance markets, which are as subject to problems of financial inclusion as are markets in banking. The natural constituency of wealthy, urban consumers is already well serviced by incumbents, while poorer regional markets are more difficult to access and supply.10 The low level of Indonesian participation in the life insurance market – premium volume relative to GDP is at the lower end of the ASEAN spectrum – has been addressed with more detailed monitoring of the industry’s progress.

30. Reforms in this area improve outcomes on gender, firstly by developing databases which track health insurance outcomes by gender and, secondly, by taking steps to increase the number of certified professional female actuaries.

10 KPMG, op. cit. p.1. 6

31. Reinsurance and insurance are also slated for improvement. Providers in the industry are generally optimistic about the trajectory of regulation. Seventy percent of respondents to a recent survey by accounting firm PwC recently reported that regulation will support the insurance sector. 11 Capital requirements are being stiffened, and OJK will be requiring that licensed entities create departments for risk management, underwriting and a licensed actuary. These actions will bolster confidence in the industry among both users and suppliers of funding.

32. That said, more remains to be done in the area of microinsurance. Data reported by KPMG suggest that microinsurance represents only 0.6% of premium being underwritten. OJK has targeted a rise in that figure to around 5%.

33. Output 2 also includes measures to boost Indonesia’s repurchase market. The lack of short-term money markets prevents banks from pricing liquidity accurately and it is conducive to the preservation of low-yielding funds. This cost is passed on to borrowers and is a partial explanation of high net interest margins an inefficiency in the banking sector. More efficient measures for managing liquidity are likely to improve the ability of banks to convert deposits into productive assets in the real sector of the economy. OJK’s initiatives in this regard are confined to improving accounting guidelines and to enforcing higher standards of market conduct. Their costs are low, and their benefits are difficult to quantify, as they represent a step toward better practice, rather than a full solution with a defined payoff.

34. Measures deliverable under output 3 are designed to lift awareness of, and confidence in, the financial system among marginalized Indonesians. Foremost among them is significant support for the expansion of the micro-finance sector. The Center for Micro Finance and Financial Inclusion (PROKSI) will provide a wide variety of services related to micro-finance. It will include training, rating (for both borrowers and lenders), technical assistance to government, as well as research and policy development forums. The Center’s activities are expected to draw participation from government, academic institutions, providers and a range of intermediaries, such as the post-office and approved pawn shops.

35. The product offering straddles micro-credit (borrowers with no collateral and borrowing horizons of less than a year), micro-saving ( with deposits of less than $1450) and micro- insurance (premia less than $3.62). OJK associates these market targets with the estimated 203 million Indonesians who subsist on incomes of less than $4.50 per day.

36. In addition, branchless banking has been extended significantly, with OJK having lifted the number of authorized banks from 4 to 16, covering 106,490 agents in 499 districts or cities. This measure means that agents will become more mobile, increasing financial inclusion and reducing cost pressures on banks. Other initiatives related to financial inclusion include the establishment of the National Council for Financial Inclusion and the associated National Strategy for Financial Inclusion. In announcing these initiatives, Indonesia’s President indicated a target of lifting the proportion of Indonesians with bank accounts from the current level of 36% to 75% by 2019. The initiative has six pillars: financial education, public financing facilities, financial information mapping, supportive regulations, distribution networks and intermediation facilities and consumer protection. 37. In tandem with the drive to improve the availability of products to marginal users of the financial system, OJK has intensified its drive to raise levels of financial literacy in target sections of the community. It has reached out to a wider constituency, focusing particularly on women and the visually impaired. Its actions with respect to literacy dovetail with separate initiatives through

11 PwC, “Indonesia Insurance Survey: 2016”, p.11. 7 the same output channel to survey the population more effectively in terms of financial literacy and to target those at the margins of the financial system.

38. Consumer protection is also accorded an elevated profile under the plan. Consumer complaints about financial service providers have been increasing in recent years partly, in OJK’s view, because of heightened awareness of consumer rights. OJK has now extended protections to investors in custodian banks and industries covered under the Securities Industry Protection Fund. Although costly to service, the fund will deliver benefits to an estimated 109 brokers and 19 custodian banks.

39. The financial sector master plan also has benefits which need to be separately registered under output 3. These include a rollout of regional financial access to around 45 local governments. This will increase the autonomy of those governments and allow them to fund infrastructure spending more efficiently. This improved access to capital markets supports the thrust of initiatives that are being funded under separate programs being sponsored by the ADB.

40. Looking to longer term measures, the subprogram also contains efforts to increase Fintech. These reforms will require further supplementary measures to become fully effective, and their value is difficult to quantify at this point. Nevertheless, they are important as a means of keeping Indonesia aligned with global infrastructure developments, and they deserve the ADB’s support.

IV Benefits and Costs of the Reforms

41. The following table summarizes the main features of the reforms that the staff have identified for the Program in thematic terms. These benefits are not exhaustive, but provide an indication of the key aims.

Table 2: Summary of Economic Impact Enabling Outputs Name of reform Summary of economic impact Output 1 Output 2 Output 3 Financial stability reforms reduce perceived Financial Stability * * risk on securitized borrowing and reduce the cost of debt by around $400 million. Regulatory Reform of the OJK’s funding model and legal infrastructure * * status improve the regulatory infrastructure enhancements and contribute to financial system stability. A range of initiatives targeted at improving financial inclusion – particularly among Financial Inclusion * * * women – ensure lead to wealth accumulation of around $2,714 million. Market deepening initiatives extend the reach Market Deepening * * * of the financial system further into Islamic banking, Corporate governance standards for the Public Sector * corporate regulator have been improved, and Efficiency its funding model has been expanded. The reforms sponsor the rollout of branchless banking and will generate cost savings in Private sector financial institutions that are additional to * efficiency financial inclusion benefits. The subprogram also contains several initiatives that improve general corporate governance standards.

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Methodology

42. Many of the reforms deliver value by improving the efficiency of the financial system. Benefits generated in this way take the form of a lower interest rate to borrowers and, potentially, a higher rate of return to those who use the financial system for saving. This is true also of benefits generated by deeper financial inclusion. These accrue primarily as income to Indonesians who had previously interacted little, if at all, with the financial system.

43. Improvements to financial systems also have costs. Foremost among them are the costs of compliance by financial institutions. ‘Compliance’ in this context refers to both the economic costs of higher levels of capitalization, as well as the more essentially administrative costs of installing and maintaining infrastructure to comply with prudential requirements.

44. The reforms also entail public sector costs, though these are generally of a lower order. They typically include the employment costs of resourcing particular initiatives, and their incidence in the wider community depends primarily on the tax system and the government’s preference for tax-financing of spending over debt issuance.

45. Both costs and benefits that accrue over time are present valued. They are assumed to compound continuously and indefinitely, unless they have a natural termination date. Those that occur on a once-off basis are valued at their notional cost. For simplicity, benefits are assumed to have immediate effect, and there are no phase-in or ramp-up assumptions around them, though many are likely to take several years to become fully effective.

46. The calculations assume 13,320 Indonesian rupiah to the US dollar, a short-term official interest rate of 4.75%, a long-term interest rate (equal to the local currency government bond rate) of 7.57%, and the ADB’s social discount rate of 9%. All calculations are presented in real terms.

47. In some instances, it is not possible to separate the effects of different initiatives which have similar themes, and the analysis of such initiatives has been consolidated within the most appropriate output. Specifically, all benefits pertaining to financial stability are allocated to output 1, and all benefits related to financial inclusion (excepting Syariah finance), are presented in output 3.

48. Related to the problem of distinguishing between the effects of similar reforms is the risk of double-counting benefits. Target groups for financial inclusion may be reached by more than one initiative, and there is therefore a risk of exaggerating the benefits by aggregating the sum of individual measures targeting financial inclusion. For this reason, parameters for individual measures have been conservatively calibrated.

Benefits

49. Quantifiable benefits under output 1 have been present valued at $609 million.

50. The main contributing factor is the impact of financial stability. This is generated by a reduction in the default risk premium on domestic debt, and the calculations assume that only foreign holdings of domestic currency debt are relevant to this calculation.12

12 Reductions in debt premia on domestically held debt are less clearly a net wealth transfer to Indonesia. 9

51. There are numerous reasons for the risk premium on . One of the most important is that the rupiah is (episodically) very volatile, and there is a risk that a sharp depreciation will reduce the returns to foreign investors in their home currencies. Those investors demand a higher yield on rupiah-denominated securities in order to compensate them for this prospect.

52. A second, and closely related, source of the risk premium is sovereign default. Markets estimate that this has a 2.2% likelihood over the next year. By comparison, the US has an estimated default probability of only 0.3%. 13 The relative risk of default will therefore be a major contributing factor to the relatively high levels of Indonesian yields.

53. Measures which reduce the risk of either sharp rupiah depreciation or sovereign default are therefore likely to lower the cost of Indonesian debt and the cost of public sector borrowing. By lowering the likelihood of an expensive public sector bailout of the banking system, financial stability measures fit this description.

54. The exact magnitude of the reduction in the risk premium that might flow from the measures in the subprogram is subject to some uncertainty, and it will vary over time. Assuming conservatively that the sum of the measures in the program reduces the required yield on domestic currency government debt held offshore by just 10 basis points on average, there is a present valued wealth transfer to Indonesia of $555 million. This is a benefit which accrues to Indonesian taxpayers.

55. The benefits of shorter licensing periods under the SPRINT initiative are assumed to total $53million. For accountants, the gains of shorter licensing periods can be approximated as the increase in the value that is generated by being able to work longer in their initial year. To calculate this benefit, assume that around 5% of the profession is replaced in any year. Supposing the total number of licensed accountants to be 10,000, 14 the number of new entrants subject to licensing delays each year is 500. Average wages in this industry are around $14,000 pa. If each accountant shortens their licensing period by 34% of a working year, they unlock an annual flow of income of approximately $2.4 million in aggregate. The total benefit for this reform can then be derived by assuming that efficiency gains in the banks which accrue from faster SPRINT licensing are of the same magnitude.

56. The major benefit under output 2 is assumed to be an uplift in investment in Syariah products. The reform of tax arrangements pertaining to Syariah finance deserves special mention. Gains are assumed to occur strictly as a result of the increasing profitability of products, and tax transfers on outstanding products are assumed to generate no net benefit, even though progressivity in the tax system should ensure some second-order transfers in favor of the poor.

57. Quantifiable gains are defined by the returns on an uplift in the amount of corporate sukuk on issue. Corporate sukuk are assumed to increase in volume until the ratio of their outstanding to total corporate bond issuance is equal to the ratio of Islamic, to conventional, banking assets in Malaysia. The underlying assumptions is that the harmonization of the tax code and the adoption of IFSB standards will encourage this new issuance. Much of it is likely to be beneficially held by those who are currently under-banked by reasoning of needing Islamic securities in their

13 Deutsche Bank, https://www.dbresearch.com/servlet/reweb2.ReWEB?rwnode=DBR_INTERNET_EN- PROD$NAVIGATION&rwobj=CDS.calias&rwsite=DBR_INTERNET_EN-PROD. 14 A slightly dated study puts the number of accountants at 8,600. See Utami et al (2011) “Professional Accounting Education in Indonesia: Evidence on Competence and Professional Commitment “, Asian Journal of Business and Accounting, 4(2), 93 ‐118. 10 portfolios. On the assumption that sukuk return a risk-free rate equal to the current government bond rate under the reconfigured market, the discounted values of the flows is $2.620 billion.

58. The risks around this assessment are balanced. On the one hand, the market may require more than the current round of regulatory initiatives in order to reach the gains that have been defined. On the other, the success of Islamic finance in corporate securities may generate positive externalities in contiguous markets, such as insurance and funds management. These are difficult to measure and have not been factored in. The deepening of the market in Islamic securities also has positive, though difficult-to-model, implications for market liquidity and risk management in the industry.

59. The benefits of financial inclusion – except those arising under Islamic finance – are the principal benefit of output 3 , and they have been estimated at $3,549 15 . They cannot be estimated precisely, but plausible scenarios offer perspective. The tables below show the benefit to increased financial inclusion across different broad product types, for various different rates of return, and on varying assumptions about product uptake. The total benefit is the sum of the central cases from each scenario. All figures are in USD million.

Table 3: Benefit Calculation for Financial Inclusion Saving Low Medium High Low 34 68 137 Medium 72 145 289 High 110 221 442

Borrowing Low Medium High Low 764 1,145 1,527 Medium 1,617 2,426 3,234 High 2,471 3,706 4,941

Insurance Low Medium High Low 43 68 85 Medium 90 144 180 High 138 220 275

60. The savings table reports the results of different rates of uplift in savings under alternative scenarios about real returns. The columns present alternative sizes for the uplift, while the rows represent potential rates of return on those savings. The calculations assume from recent public targets that reforms generate an extra 49 million accounts, with average deposit sizes ranging between $5, $10 and $20 (the columns of the matrix). The returns scenarios consist of: a low- return scenario, in which deposits are assumed to earn the short-term risk-free real interest rate of 1.26%; a high-return scenario, which assumes the current real long-term interest rate of around

15 Totals may not agree due to rounding. 11

4.1%; and, a medium-return scenario, which assumes the mid-point of the other two returns. All cash-values are present-valued income streams which are assumed (for conservatism) not to be reinvested.

61. To give an example which should also assist with the ‘borrowing’ and ‘insurance’ tables, the central case of $145 million in the saving table has been calculated by multiplying an assumed extra per capita saving of $10 (the ‘medium’ column) by 49million (the estimated number of extra savers) and 2.67% (the ‘medium’ return scenario given by the middle row of the table). Dividing this product of three numbers by the discount rate gives a present value of $145million. Varying the size of the return and the size of the saving gives the other elements in the table.

62. A similar set of scenarios is developed for borrowing , which accrues to smaller borrowers and women. OJK expects the banks to allocate 20% of their book to SMEs by 2018. The calculations are built around different rates of achievement of that objective, from the existing base of around 10%. For conservatism, they assume no growth in lending from 2016. The ‘low’, ‘medium’ and ‘high’ scenarios are associated with proportions of lending to SMEs of 12%, 13% and 14% respectively. The benefits on this uplift are assumed to have the same alternative returns as those in the preceding table. Because these loans are to new and inexperienced borrowers, 10% are assumed to be defective and pay no interest. Again, for the purposes of illustration, the central forecast is given as 90% (by reason of a 10% impaired loan rate) of a 3% uplift in commercial bank credit (the ‘medium’ column) and a medium return scenario of 2.67% (the ‘medium’ row). This is present valued at 9%. The amount generated in this way represents an uplift in value added from the funding of new projects.

63. The initiatives around financial inclusion for insurance have been developed from OJK’s target of 5% of GWP on insurance, which translates into $691 million. The columns represent different rates of realization around that target: the ‘low’ assumption is that 50% of OJK’s target is achieved; the ‘medium’ assumption is 80% of target rate; and, the high assumption is 100%. The different returns to insurance, which once again define the rows of the matrix, are assumed to be the same as for banking.

64. Efforts to improve branchless banking are also important, since they reduce the costs of employing bankers. Assuming that the average wage of frontline bankers is around $14,000, it is possible to evaluate the benefits by assuming an efficiency dividend to the banking sector of 5% from giving employees greater mobility. Because the reform has generated 106,490 jobs, the present value of that efficiency dividend is $834 million. Additional spillover benefits from financial inclusion associated with this initiative are subsumed in paragraph 59.

Costs

65. There are relatively few costs to this sub-program. Most of the changes involve administrative actions by government, and they do not generate transfers or costs on a macroeconomic scale. They total $911 million.

66. In output 1 , the main cost is the price of the increase in annual levies to fund OJK. This is the difference between levies collected in 2015 and 2016 when OJK became fiscally autonomous. They are assumed to be $37 million per year, which has a present value of $411 million.

67. The Center for Financial Sector Policies will also impose costs on government. On the assumption of an increase of 50 staff in the directorate and an average wage of $30,000, the 12 present value of the cost of the Center is $16 million. A further $5 million has been added to this figure for the development, implementation and monitoring of the consolidated Financial Sector Master Plan and another $2 million to operationalize and monitor financial inclusion initiatives through the National Council.

68. SPRINT licensing technology in output 1 is assumed to have a cost of approximately $1.8 million to the public sector. The cost is a once-off development expense and does not require present valuation. It assumes the employment of 130 staff or contractors for a period of one-year at an average annual wage of around $14,000. Assuming similar costs of compliance for the private sector returns a total cost for the initiative of $3.7 million.

69. Within output 2 , some expenses were incurred in preparation for the rollout of tax harmonization and compliance with the IFSB. These are one-off – that is, undiscounted – expenses, and they have been estimated at $60 million. In addition, the development of infrastructure for issuing corporate sukuk on a larger scale will be expensive. Assuming 250 highly permanent skilled staff are required across a number of areas of financial specializations generates a further additional cost (present valued) of $83 million.

70. There are also likely to have been costs to the private sector associated with corporate governance initiatives in the output. The ‘comply or explain’ provisions and the introduction of whistleblower systems are likely to place a very significant compliance burden on industry. These reforms are very difficult to cost, but if the implied increase in full-time employment is as little as 1000 across all industries to which they apply then, at an average wage of $14,000, the present value of the cost is $157 million.

71. In output 3 , literacy initiatives are the main expense. Producing and disseminating mandatory training materials in Indonesia’s schools will be significant. The estimates include $50million for these costs, as well as a further $10 million for other outreach initiatives, such as the development of a mobile phone application.

72. Research initiatives will also be expensive. While focus group research is unlikely to be expensive for the subprogram, the costs of extending data collection on financial inclusion may be material. A figure of $15 million has been allocated.

73. Regional financial access will also entail costs. Building the autonomy of regional governments will require training, staffing and infrastructure at a cost of around $67 million. This is the present value of the wages of 200 staff.

74. The cost of the PROKSI initiative add to the costs of government. An annual budget for 50 staff has been applied. With an average annual wage rate of $30,000, the resource requirement implies a present valued cost of $17 million.

75. The Fintech initiatives will also impose costs on the taxpayer. These are expected to be modest and one-off, at around $5 million.

76. Finally, output 3 has a self-regulatory reserve fund for the securities industry. Imposing a funding cost equal to the government bond rate returns a present value of $9.2 million. This may be slightly aggressive, since the cost of capital for the institutions concerned will be higher than the risk free rate. 13

Table 4: Summary These are summary costs and benefits of the major policy initiatives under Subprogram 2. They include observations on some of the less readily quantifiable effects. Full descriptions of the initiatives are contained in the policy matrix for the Program . Channel of Effect Impact on the Sector/Economy Estimated benefits, beneficiaries and benefactors General Specific Short to medium Term Long Run Enhanced financial Reductions in debt Reductions in fiscal deficit and Gradual pass-through of lower debt costs Benefits are likely to total around $555million and will stability service costs lower tax requirements to the corporate sector is the main be distributed via the tax system, since lower debt (output 1) benefit. Stronger outcomes in growth and service costs reduce tax requirements. Longer run employment, commensurate with the benefits from higher economic growth are likely to be reduction in credit costs, are expected. diffuse, and shared across the entire economy.

Market • Increased depth Improvements in financial Longer term benefits from deeper Syariah Poor households are the main beneficiaries of the Deepening in Syariah inclusion. Greater returns to markets are considerable. Related financial inclusion initiatives under output 2. Returns (output 2) markets those who are currently markets, such as mutual funds and are sponsored by taxpayers via foregone government • Clearer legal underbanked. insurance will likely benefit from having revenue. Immediate benefits accrue to investors as the arrangements in deeper portfolios. harmonization of rules and tax rates inspires new issue repo markets and generates returns Preconditions Long run benefits to a strong Fintech • Repo arrangements are likely to benefit customers of for Fintech sector are considerable. P2P lending reduces the costs of intermediation and banks. Effective repo markets allow more profitable management of reserves. The development of a market facilitates borrowing among agents which in repurchase agreements would also improve financial might not otherwise be able to stability by enabling liquidity risk management. These benefits are difficult to quantify. Financial Better access to Higher returns to more Stronger economic growth and higher Women and smaller business are likely to be the Inclusion savings and marginal users of the financial employment outcomes are likely as a main beneficiaries of the financial literacy and (output 3) investment system, including micro result of the mobilization of under-utilized financial inclusion initiatives. Within the SME sector, products for enterprises, women and the resources. A more uniform distribution of the Government is targeting the maritime and marginalized users poor. income and better performance on fisheries sectors. of the financial measures of gender equality are also system probable. Public Sector • Improved funding • Higher costs to shareholders • Strong funding and governance models There is an implied transfer in the change to OJK’s Efficiency of OJK and of supervised institutions; for the regulator enhance its reputation funding model from taxpayers to shareholders and (output 1) enhanced • More efficient delivery of and contribute to financial stability. customers of supervised institutions. governance; financial services to users of They also increase its capacity to arrangements the system. Cost savings to deliver against its mandate. SPRINT initiatives impose an initial cost on taxpayers • Better service financial institutions and • Better financial services lift disposable and shareholders of licensed entities which comply provision via the their customers. income and are conducive to financial with the regime. Longer term benefits are to SPRINT offering; inclusion. shareholders. 14

• More effective co- • The Center for Financial • The Center for Financial Sector ordination on Sector Policies will impose Practice will enhance productivity in the The Center for Financial Sector Policies is an financial stability costs on the taxpayer, but private sector and contribute to intergenerational transfer between taxpayers. The matters improve private sector financial sector efficiency. cost of establishing the Center should be offset with interaction with government lower bond yields in the long run, as the reforms take in matters of policy effect. Private sector • Branchless • Branchless banking will In the long run, higher standards of Some costs to branchless banks do occur to banks in efficiency banking; generate higher wage corporate governance will result in better the extension of their franchise. However, this should • Higher standards income for agents. It will reputations for Indonesian firms and lower be outweighed by higher returns. of corporate also facilitate financial borrowing costs. This enriches investment governance in all inclusion and reduce the opportunities. Returns to better corporate governance practices are sectors costs of servicing difficult likely to be widely shared. Corporations incur a markets substantial cost, but returns accrue in the form of • New governance standards lower borrowing costs over the long run. will enhance corporate integrity, raise productivity and lower corruption.