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Indonesia Company Law 1997 document sample
Indonesia Company Law 1997 document sample
1 Indonesia Saud Husnan1 1.1 Introduction The currency crisis that began in mid-1997 in Thailand spread quickly to Indonesia and the rest of Southeast Asia. Initially, Indonesia’s monetary authority tried to defend the domestic currency, the rupiah, by widening the intervention band, while maintaining its managed floating system. From 5 to 8 percent in June 1997, when the currency crisis hit Thailand, the band was widened to 12 percent on 11 July 1997 when the crisis started spilling over to Indonesia. After resisting pressure for a short period, the rupiah fell by 6 percent against the dollar on 21 July 1997, the biggest one-day fall in five years. Finally, the Indonesian monetary authority realized that the sys- tem could not cope with the continuing pressure on the currency, as the risk of losing all foreign exchange reserves to prop up the rupiah was too high. On 14 August 1997, the monetary authority decided to adopt a free floating exchange rate system. The currency fell further because of strong demand for dollars. As the rupiah weakened, nervous lenders refused to refinance maturing loans, investors cut down and then reversed the flow of funds, borrowers tried to obtain dollars before the rupiah fell further, and individuals joined the chase for dollars. At that time, several banks ran out of dollar notes. From Rp4,950 to the dollar at the end of December 1997, the exchange rate fell to more than Rp15,000 at the height of the crisis in June 1998, although it later stabilized at about Rp9,000. At that exchange rate, it is estimated that half of Indonesian corporations became technically insolvent. The crisis also exacerbated an already deepening political turmoil. The financial crisis devastated the Indonesian economy. In 1998, gross domestic product (GDP) contracted by 13 percent and the inflation 1 Associate Professor, Faculty of Economics, Gadsab Mada University, Yogyakarta, Indonesia. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Jarkata Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance. 2 Corporate Governance and Finance in East Asia, Vol. II rate reached 58.5 percent. All sectors, except utilities, posted negative growth. The construction sector was the worst hit, contracting by 36.5 percent, fol- lowed by finance (-26.6 percent) and trade (-18 percent). The scale of the financial crisis exposed weaknesses of the coun- try’s corporate sector. The highly concentrated and family-based ownership structure of corporate groups and companies resulted in a governance struc- ture where corporate decisions lie in the hands of controlling families. In many instances, these controlling families had political connections that allowed their companies to enjoy special privileges. Foreign creditors, no doubt, placed a high premium on these political connections in assessing the chances of being repaid. To facilitate even easier access to credit, the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. These banks were allowed to operate even if they violated minimum capital adequacy requirements. In this setup, short-term loans were used to finance long-term investments. Lending activities of affiliate banks that were not sufficiently backed by owners’ equity and the reliance by foreign lenders on the strength of politi- cal connections paved the way for risky investments. These were already contributing to high levels of nonperforming loans (NPLs) in the Indone- sian banking sector several years before the 1997 crisis erupted. On the other hand, prior to the financial crisis, the Indonesian economy seemed to be in generally good shape. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. However, the currency composition and term structure of corporate foreign indebtedness were causes for concern. Foreign debt reached more than $100 billion. Although as a percent of GDP the stock of outstanding foreign debt owed directly by the private sector was smaller than that of the Republic of Korea, Malaysia, or Thailand, this left the Indonesian economy extremely vulnerable. When the crisis hit the country, highly leveraged companies, particularly those with large foreign loans, were the ones most affected. This study reviews the Indonesian corporate sector’s historical de- velopment, regulatory framework, patterns of ownership and control, pat- terns of financing, and responses to the financial crisis. It analyzes the weak- nesses of corporate governance in Indonesia, how it has affected corporate financial performance and financing, and how it contributed to the crisis. The study also identifies family-based companies and corporate groups, and analyzes their importance to the corporate sector in Indonesia. Section 1.2 presents an overview of the Indonesian corporate sec- tor. Section 1.3 looks at patterns of corporate ownership and control, and Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. This section reports the results of an Asian Development Bank (ADB) survey on cor- porate management and control practices in Indonesian publicly listed companies.2 Section 1.4 analyzes corporate financing patterns. It also ex- amines the statistical relationship between corporate performance and cor- porate governance characteristics. Section 1.5 examines the corporate sector during the financial crisis in terms of its role, how it was affected by the crisis, and its response. Section 1.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indo- nesian corporate sector. 1.2 Overview of the Corporate Sector 1.2.1 Historical Development The marked permeability between the State and business in Indonesia goes back to the country’s struggle for independence. The Government became directly involved in industry as a result of the nationalization of Dutch- owned shipping firms and oil companies, in the course of the fight for na- tionhood from 1942 to 1950. Up until the mid-1960s, while Chinese and indigenous entrepreneurs ran some large businesses in trading, textiles, and tobacco industries, medium- and large-scale companies were dominated by state-run industrial concerns. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968, a gradual shift in public investment away from manufacturing took place. Subsequently, substantial volumes of private investment entered the scene. In the early 1970s, the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial devel- opment via import substitution. The industries that emerged were highly import-dependent and reliant on tariff protection. Despite the oil revenues, 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. However, only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). Not all items in the questionnaires were answered by the re- spondents. 4 Corporate Governance and Finance in East Asia, Vol. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. During this period, a distinct industrial elite started to emerge. These were families with strong links to the political elite of the New Order. In the 1980s, the Government shifted its industrial policy toward the promotion of labor-intensive exports. Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials. By 1987, exports of nonoil products (particularly tex- tiles and footwear, wood, and related products) had shares in total exports that were rapidly increasing. In 1992, the value of manufactured exports overtook the value of oil and gas exports for the first time. Partly as a result of various government policies, the Indonesian industrial sector was quite diverse. While most of the companies were small, produced consumer goods, and employed the bulk of the industrial labor force, there were also many rapidly growing large-scale companies and business groups or conglomerates, which dominated their respective sectoral outputs and markets. 1.2.2 The Capital Market The Government reactivated the stock exchange in 1977. A number of un- derwriters emerged, mostly nonbank financial institutions and stockbro- kers. But until the end of 1988, the number of firms quoted in the stock market was only 24. The equity market remained largely unappealing due to a number of factors. First, many founding owners of companies were reluctant to go public and dilute their corporate ownership. Generally speak- ing, the dilution of corporate ownership, even when new shareholders do not threaten the control exercised by the original owners, potentially sub- jects companies to greater regulatory scrutiny. Second, the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. Third, investors were reluctant to supply funds to the stock market because they did not know whom to trust and the mechanisms that could protect small investors and shareholders against expropriation by controlling shareholders were under- developed. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. Last, the Capital Market Execu- tive Agency and National Investment Trust tried to attract small investors to the stock market by setting prices and preferring small orders in initial public offerings (IPOs). But these proved counterproductive because they limited the potential for capital gains to prospective investors. Chapter 1: Indonesia 5 At the end of 1988, the liberalization of the banking industry al- lowed banks to determine lending rates for nonpriority loans. Thus, compa- nies could no longer enjoy low-interest credit from state banks. The Gov- ernment also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market, which were pre- viously constrained to 4 percent per day. The Government also allowed foreign investors to buy up to 49 percent of listed shares. Consequently, the number of listed companies in the stock exchange increased substantially, from 24 in 1988 to more than 300 in 1997. During this period, the capital market played an increasing role in raising long-term funds needed by the corporate sector. Conglomerates carried out 210 out of 257 IPOs, with a total value of Rp16.5 trillion. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned compa- nies (SOCs). Since 1977, six SOCs had issued equities in the market, with a total value of more than Rp8 trillion. However, to date, the controlling shareholder of these SOCs is still the State. 1.2.3 The Banking Sector Despite the development of the stock market, the banking sector has been and still is the major source of credit for the corporate sector. Through the years, the banking sector has undergone many reforms. However, the legal infrastructure that was supposed to guide the evolution of the banking sec- tor was not backed by effective enforcement. The initial banking sector reform was introduced in 1983. Interest rate regulations on state banks and credit ceilings in general were removed. The banking sector, which up to then was channeling oil revenues to prior- ity sectors, began to face competition. The dominance of state banks started to erode. However, priority credits still enjoyed subsidized interest rates and funding from the Central Bank. In 1988, more significant reforms were introduced. These included the opening of the banking industry to new entrants, reduced restrictions on foreign exchange transactions, and increased access of domestic banks to international financial markets. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. Partly as a result of these reforms, the number of private domes- tic banks increased. Table 1.1 shows that from 1994 to 1998, private domestic banks dominated the sector in terms of number and total as- sets. But in terms of assets per bank, state-owned banks were still among the biggest. 6 Corporate Governance and Finance in East Asia, Vol. II Table 1.1 Growth of the Banking Sector, 1993-1999 Type of Bank 1993 1994 1995 1996 1997 1998 1999 State-Owned Banks Assets (Rp trillion) 100.6 104.5 122.6 141.3 201.9 304.8 391.5 Number of Banks 7 7 7 7 7 7 5 Foreign Banks Assets (Rp trillion) 7.9 9.2 12.3 15.8 37.8 51.1 66.4 Number of Banks 10 10 10 10 10 10 10 Joint Venture Banks Assets (Rp trillion) 11.8 14.3 17.9 19.8 37.4 47.6 35.9 Number of Banks 29 30 31 31 34 34 39 Regional Government Banks Assets (Rp trillion) 6.5 7.9 9.8 10.7 12.3 14.5 18.8 Number of Banks 27 27 27 27 27 27 27 Private National Banks Assets (Rp trillion) 88.2 113.8 147.5 200.9 248.7 351.9 291.6 Number of Banks 161 166 165 164 144 130 92 Total Assets (Rp trillion) 214.0 248.1 308.6 387.5 528.9 762.4 789.4 Number of Banks 234 240 240 239 222 208 173 Source: Bank Indonesia. Assets and liabilities were concentrated in the top 10 banks. In terms of assets, private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group), Bank Danamon (ranked 7th), and Bank International Indonesia (ranked 9th). The other banks among the top 10 were state banks. Among private domes- tic banks, the 10 largest were all affiliated with major business groups. Of these, BCA, Bank Danamon, and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Re- structuring Agency (IBRA), while BUN has been closed down by the Gov- ernment. Both BCA and BUN have shareholders linked to the former Presi- dent Suharto. The deregulation of the banking industry and the liberalization of the capital account created a variety of new sources of financing for the corporate sector. But the banking system proved incapable of performing its intermediation function. Because regulation was weak, banks could earn profits even when they did not gather and process information about risk. Chapter 1: Indonesia 7 Foreign and domestic banks defaulted on their responsibility of deciding where capital should go and ensuring that it was used in the most effective way. In effect, there was an explosion of credit for which the probability of repayment was based on little but blind faith in the sustainability of rapid growth and on the presumption that political connections were as good as government guarantees against bankruptcy of borrowers. 1.2.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs), initially from Japan and the Republic of Korea. But FDIs were only one form of foreign capital inflows to Indonesia. In the 1990s, there was a phenomenal growth in direct borrowings by Indonesian corporations. Until the onset of the crisis, foreign creditors were eager to provide financing to Indonesia, especially through bank loans. Between 1990 and 1996, Indonesia received capital inflows averaging about 4 per- cent of GDP. Although these inflows were not nearly as large as those re- ceived by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP), they still amounted to a large sum for the economy to absorb. From the mid-1980s until July 1997, when the financial crisis hit Indonesia, FDI flows were strong. Most FDIs came in through joint ven- tures with business groups having strong political connections. Net FDI flows increased to $5.59 billion in 1996, as shown in Table 1.2. Successive policy deregulation facilitated FDIs in various light manufacturing indus- tries, such as metal goods, textiles, and footwear. Increasingly, foreign in- vestment also had a strong presence in the services and infrastructure sec- tors. In 1994, the Government allowed foreign investors to own 100 percent of an Indonesian company, except in certain strategic sectors. Table 1.2 Foreign Capital Flows, 1990-1998 ($ billion) Type of Flows 1990 1991 1992 1993 1994 1995 1996 1997 1998 Net FDI 1.09 1.48 1.78 2.00 2.11 3.74 5.59 4.50 (0.40) Net Portfolio Investment (0.09) (0.01) (0.09) 1.81 3.88 4.10 5.01 (2.63) (1.88) Foreign Bank Loans — — — — — — 8.87 7.33 (13.15) — = not available. Source: IFS CD-ROM, IMF, September 2000; Joint BIS-IMF-OECD-World Bank Statistics on Exter- nal Debt, November 2000. 8 Corporate Governance and Finance in East Asia, Vol. II Up until the late 1980s, participation in the Indonesian stock mar- ket was exclusive to domestic investors. The Government relaxed this re- striction in 1988, allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. Consequently, foreign investors began to dominate daily trading, increasing the total trading value from Rp8 tril- lion in 1992 to Rp120.4 trillion in 1997. In September 1997, with the onset of the Asian crisis, the limit on foreign portfolio investment was removed and foreign investors were allowed to buy up to 100 percent of shares of a listed Indonesian company. Between 1989 and 1992, the average foreign ownership of listed companies was 21 percent. This increased to 30 percent by the end of 1993, but declined to an average of 25 percent during 1995- 1997. In the 1990s, foreign banks became a significant source of financ- ing for the corporate sector. By the end of 1997, more than 50 percent of total Indonesian private debt and 60 percent of total foreign exchange debt were owed to 175 foreign banks and other foreign financial institutions. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. Private borrowers preferred foreign loans since these were relatively cheaper, especially the short-term ones. From 1987 to 1996, the average borrowing rate for dollar loans was 9 per- cent, plus 4 percent for the depreciation of the rupiah. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. The private sector left foreign loans unhedged because the depreciation of the rupiah had never reached more than 4 percent annually since the 1986 de- valuation under the managed floating system. In November 1998, total cor- porate debt reached nearly $118 billion. Domestic corporate debt was about $50 billion equivalent, of which two thirds were rupiah-denominated. The external corporate debt owed to foreign commercial banks was $67 billion. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. 1.2.5 Growth and Financial Performance While it was obvious that the term structure and currency composition of debt suggested problems in the run-up to the crisis, an interesting question is whether standard measures of corporate profitability and performance also indicated the same. The following section looks at the growth and financial performance of the corporate sector. Due to data constraints, the analysis focuses only on publicly listed companies, state-owned companies (SOCs), and conglomerates. Chapter 1: Indonesia 9 Publicly Listed Companies Table 1.3 shows the growth and financial performance of Indonesian pub- licly listed companies. During 1992-1997, total sales of listed companies grew at an annual average rate of 31 percent, while total assets grew at 43 percent. Despite such rapid growth, publicly listed companies as a group contributed less than 10 percent to GDP, although the contribution increased over time. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996, but turned negative in 1997. The growth of listed companies was sustained by continuing investments. Table 1.3 Growth and Financial Performance of Publicly Listed Companies, 1992-1997 (percent) Item 1992 1993 1994 1995 1996 1997 Growth Indicators Sales Growth — 45.1 50.3 37.8 18.2 7.0 Share of Value Added in GDPa 3.7 4.6 6.0 6.9 7.0 6.4 Asset Growth — 48.5 64.8 37.1 33.8 31.9 Financial Indicators Debt-to-Equity Ratio 250.0 240.0 220.0 220.0 230.0 310.0 Return on Equity 12.6 12.5 12.0 11.3 10.7 1.1 Return on Assets 3.4 3.5 3.5 3.5 3.2 0.6 Asset Turnoverb 38.4 37.6 34.2 34.4 30.4 24.7 — = not available. Note: The number of firms is not identical for each year. In 1997, there were 204 firms; 1996, 248 firms; 1995, 246 firms; 1994, 250 firms; 1993, 226 firms, and 1992, 174 firms. a Value added was assumed to be 30 percent of total sales. b Asset turnover is defined as sales over assets. Source: JSX Monthly (several publications). Average return on equity (ROE) of listed firms was 11.8 percent between 1992 and 1996, but dropped to 1.1 percent in 1997 when the crisis began to buffet Indonesia. Return on assets (ROA) was also relatively sta- ble during 1992-1996, averaging 3.4 percent, but declined to 0.6 percent in 1997. Asset turnover was above 30 percent until 1996, but fell to 24.7 per- cent in 1997. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines, ranging from 220 to 250 percent between 1992 and 1996. When the crisis battered Indonesia in 1997, the average DER increased to 310 percent from 230 percent the 10 Corporate Governance and Finance in East Asia, Vol. II previous year. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. Overall, it appeared that the per- formance of listed companies was quite satisfactory prior to the crisis, al- though asset turnover was slow. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture; mining; basic industry and chemicals; miscella- neous industry; consumer goods; property, real estate, and building con- struction; infrastructure; finance; and trade, investment, and services. In terms of sales and asset levels in 1997, the dominant sector was the finance sector. However, in terms of growth of sales and assets, the mining sector ranked first, followed by agriculture (Table 1.4). In terms of share of value added to GDP, only two sectors (mining and finance) showed a consistently increasing trend from 1992. The finance sector’s contribution to GDP, mean- while, increased from 0.73 percent in 1992 to 1.64 percent in 1997. Table 1.5 presents the financial performance of listed companies by sector. From 1995, the mining sector had the lowest DER, indicating its reliance on equity to support growth. The finance; trade, investment, and services; and property, real estate, and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. For instance, when the property sector was booming during 1993-1997, the banks eagerly provided credit to property develop- ment companies. The same applied to the trade sector. Before the crisis, the mining sector had the highest ROE, averaging 21.3 percent between 1992 and 1996. But the sector’s ROE fluctuated a lot, due mainly to the domination of the International Nickel Company of Canada, which operated in nickel and copper mining in 1992 and 1993. During those years, the fluctuation in nickel and copper prices contributed to the oscillation of ROE. The consumer goods sector ranked second in terms of ROE, averaging 17.7 percent during 1992-1996. This sector was less affected by the crisis, still posting a positive but lower ROE, helped in part by the relatively strong demand for consumer goods. Also, the compa- nies in the sector did not operate with a high leverage. Meanwhile, the property sector was severely affected by the crisis, with ROE falling to -11.2 in 1997. When interest rates increased, ROE fell drastically because the sector had one of the highest DERs. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. ROA of all sectors dropped in 1997. Four sectors (basic industry and chemicals, miscellaneous industry, property, and trade) even posted Table 1.4 Growth Performance of Publicly Listed Companies by Sector, 1992-1997 (percent) Indicator/Sector 1992 1993 1994 1995 1996 1997 Sales Growth Agriculture — 155.0 (75.3) 51.4 58.5 45.2 Mining — 64.1 53.1 38.8 5.9 54.9 Basic Industry and Chemicals — 32.6 42.0 29.4 14.1 (11.4) Misc. Industry — 26.3 43.4 30.1 8.2 13.0 Consumer Goods Industry — 31.7 64.8 23.8 31.5 (8.4) Prop., Real Estate, and Bldg. Constn. — — (76.7) 24.7 6.0 (20.5) Infrastructure — — 26.5 24.7 6.5 9.9 Finance — 11.5 61.7 62.9 31.8 28.4 Trade, Investment, and Services — 95.4 40.8 54.4 21.6 (0.6) Asset Growth Agriculture — 103.5 66.1 44.9 119.7 112.8 Mining — 23.7 16.4 36.2 27.6 135.7 Basic Industry and Chemicals — 21.5 31.1 41.3 17.5 53.7 Misc. Industry — 13.0 67.2 17.2 28.9 59.0 Consumer Goods Industry — 68.8 59.5 35.8 22.1 0.9 Prop., Real Estate, and Bldg. Constn. — 62.1 92.1 32.3 25.9 8.0 Infrastructure — — 35.6 31.2 18.2 14.7 Finance — 39.6 83.8 41.9 43.6 24.4 Trade, Investment, and Services — 85.8 51.6 53.1 30.5 28.7 Net Profit Growth Agriculture — 50.0 133.3 71.4 133.3 92.9 Mining — (28.6) 340.0 77.3 (7.7) (27.8) Basic Industry and Chemicals — 25.2 16.9 51.7 (12.7) (113.5) Misc. Industry — 11.6 64.9 34.6 13.4 (149.5) Consumer Goods Industry — 51.6 123.4 28.6 49.6 (41.6) Prop., Real Estate, and Bldg. Constn. — 22.7 170.4 15.1 19.0 (192.0) Infrastructure — — 43.5 28.7 46.5 (11.3) Finance — 36.7 68.7 54.0 39.1 (41.7) Trade, Investment, and Services — 90.0 (82.8) 24.6 17.3 (203.2) Share of Value Added in GDP Agriculture 0.1 0.3 0.1 0.1 0.1 0.1 Mining 0.0 0.1 0.1 0.1 0.1 0.1 Basic Industry and Chemicals 0.8 0.9 1.0 1.1 1.1 0.8 Misc. Industry 1.1 1.2 1.5 1.6 1.5 1.5 Consumer Goods Industry 0.6 0.6 0.9 0.9 1.0 0.8 Prop., Real Estate, and Bldg. Constn. 0.1 1.3 0.3 0.3 0.3 0.2 Infrastructure 0.0 0.4 0.4 0.5 0.4 0.4 Finance 0.7 0.7 1.0 1.3 1.5 1.6 Trade, Investment, and Services 0.4 0.6 0.7 1.0 1.0 0.9 — = not available. Source: JSX Monthly (several publications). Table 1.5 Financial Performance of Publicly Listed Companies by Sector, 1992-1997 (percent) Indicator/Sector 1992 1993 1994 1995 1996 1997 Debt-to-Equity Agriculture 20.0 130.0 80.0 80.0 100.0 230.0 Mining 50.0 80.0 80.0 70.0 70.0 110.0 Basic Industry and Chemicals 110.0 100.0 100.0 100.0 110.0 190.0 Misc. Industry 120.0 130.0 120.0 150.0 160.0 220.0 Consumer Goods Industry 120.0 190.0 110.0 110.0 110.0 180.0 Prop., Real Estate, and Bldg. Constn. 150.0 150.0 140.0 170.0 180.0 190.0 Infrastructure 90.0 180.0 70.0 80.0 110.0 100.0 Finance 560.0 650.0 680.0 650.0 630.0 700.0 Trade, Investment, and Services 380.0 160.0 120.0 140.0 160.0 210.0 Return on Equity Agriculture 8.8 19.2 15.5 17.6 14.2 23.9 Mining 44.7 7.7 17.7 19.1 17.1 (5.8) Basic Industry and Chemicals 12.4 12.7 10.8 10.0 8.2 (4.0) Misc. Industry 13.2 10.6 9.3 8.4 7.1 (3.6) Consumer Goods Industry 15.7 18.7 18.7 17.1 18.3 7.8 Prop., Real Estate, and Bldg. Constn. 13.3 8.8 10.6 10.2 8.6 (11.2) Infrastructure 17.1 20.5 13.2 13.4 15.0 12.1 Finance 11.0 11.8 11.9 13.1 13.4 5.4 Trade, Investment, and Services 11.4 11.8 10.3 7.6 6.1 1.1 Return on Assets Agriculture 6.9 5.1 7.1 8.5 9.0 8.1 Mining 4.7 2.7 10.3 13.5 9.7 3.0 Basic Industry and Chemicals 5.5 5.7 5.1 5.5 4.1 (0.4) Misc. Industry 4.2 4.1 4.1 4.7 4.1 (1.3) Consumer Goods Industry 6.7 6.0 8.4 8.0 9.8 5.7 Prop., Real Estate, and Bldg. Constn. 4.2 3.2 4.5 3.9 3.7 (3.2) Infrastructure 8.7 7.3 7.7 7.6 9.4 7.3 Finance 1.3 1.2 1.1 1.2 1.2 0.6 Trade, Investment, and Services 38.2 39.1 4.4 3.6 3.2 (2.6) Asset Turnover Agriculture 382.8 479.7 71.4 74.7 53.9 36.8 Mining 26.4 35.0 46.0 46.9 38.9 25.6 Basic Industry and Chemicals 39.5 43.1 46.7 42.8 41.5 23.9 Misc. Industry 63.7 71.2 61.1 67.8 56.9 40.4 Consumer Goods Industry 111.0 86.6 89.4 81.5 87.8 79.8 Prop., Real Estate, and Bldg. Constn. 14.8 168.3 20.4 19.3 16.2 11.9 Infrastructure 73.9 38.3 35.7 33.9 30.6 29.3 Finance 17.5 14.0 12.3 14.1 13.0 13.4 Trade, Investment, and Services 66.0 69.4 64.5 65.1 60.6 46.8 Source: JSX Monthly (several publications). Chapter 1: Indonesia 13 negative ROA. Trade had the highest ROA of 39.1 percent in 1993, but dropped dramatically to 4.4 percent the following year. The finance and miscellaneous industry, and basic industry and chemicals sectors had rela- tively stable ROA before the crisis. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. State-Owned Companies At the end of 1995, there were 165 state-owned companies (SOCs)3 in Indonesia. SOCs actively operated in various sectors4 under the supervi- sion of “technical” departments. For instance, the Department of Finance supervised 30 SOCs, which collectively had the largest assets. The Depart- ment of Mining and Energy ranked first in terms of sales of SOCs under its control. This was due to large sales by the National Oil Company (Pertamina). Just like private companies, SOCs diversified into many businesses. By 1995, there were 58 SOCs with subsidiaries and affiliates. Taken to- gether, the subsidiaries and affiliates number 459 with total assets of Rp343.3 trillion. SOCs’ sales growth fluctuated during 1990-1996, registering an average annual rate of 10 percent. Similarly, growth of net profits and as- sets was erratic, averaging 24 and 31 percent, respectively, between 1993 and 1995. These growth rates were low compared to those for listed compa- nies during the same period. Assuming a fixed ratio of value added to sales, the SOCs’ value added as a percentage of GDP ranged from 6 to 8.7 percent. This was rela- tively high compared to the 3.7 to 7 percent for publicly listed companies. However, the ratio decreased from 8.7 percent in 1990 to 6 percent in 1996, indicating SOCs’ declining contribution to GDP. SOCs’ ROE ranged from 6.6 to 8.8 percent between 1992 and 1995 (Table 1.6), much lower than that of companies listed in the stock exchange. The DER was slightly higher than for listed companies, but it continuously declined from 370 percent in 1992 to 250 percent in 1995. ROA had been at high levels from 1992 to 1995, increasing from 21.1 percent in 1992 to 28.3 percent in 1995. Asset turnover rates were lower relative to those of publicly listed companies. While asset turnover rates of publicly listed 3 SOCs are those in which the State has at least a 51 percent equity interest. Six SOCs were listed in the Jakarta Stock Exchange. 4 The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies); banks (seven companies); insurance (11 companies); and finance company (four companies). 14 Corporate Governance and Finance in East Asia, Vol. II companies consistently declined over time, SOCs’ asset turnover rates showed a downward trend from 32.4 percent in 1992 to 28.6 percent in 1994, but climbed to 30.5 percent in 1995. Table 1.6 Growth and Financial Performance of State-Owned Companies, 1992-1995 (percent) Indicator 1992 1993 1994 1995 Growth Indicators Sales Growth — 16.4 (9.1) 25.1 Share of Value Added in GDPa 7.2 7.2 5.7 6.0 Assets Growth — 23.1 (2.6) 17.3 Financial Indicators Debt-to-Equity Ratio 370.0 310.0 260.0 250.0 Return on Equity 8.8 7.0 6.6 8.6 Return on Assets 21.1 24.1 28.0 28.3 Asset Turnoverb 32.4 30.7 28.6 30.5 — = not available. a Value added was assumed to be 30 percent of total sales. b Asset turnover is defined as sales over assets. Source: Indonesian Data Business Center. Conglomerates This study used available data on the top 300 conglomerates in Indonesia. In 1997, these conglomerates owned 9,766 business units, mostly private companies. Their total sales increased from Rp90.1 trillion in 1990 to Rp234 trillion in 1997. Assuming a constant ratio of value added to sales, the contribution of conglomerates to GDP increased from 12.8 percent in 1990 to 13.4 percent in 1994, but dropped to 11.2 percent in 1997 (Table 1.7). Table 1.7 Growth Performance of the Top 300 Conglomerates, 1990-1997 (percent) Item 1990 1991 1992 1993 1994 1995 1996 1997 Sales Growth — 17.1 19.4 16.7 16.2 18.1 12.5 3.0 Share of Value Added in GDPa 12.8 12.7 13.4 13.4 13.4 13.3 12.8 11.2 — = not available. a Value added was assumed to be 30 percent of total sales. Source: Indonesian Data Business Center. Chapter 1: Indonesia 15 1.2.6 Legal and Regulatory Framework During the 1990s, the Government promulgated a number of laws and regu- lations to protect investors. By international standards, however, the legal and regulatory framework of the corporate sector was far from adequate. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. The law replaced an earlier statute that was based on the Dutch system. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC), tasked with supervising the firm; and the board of directors (BOD), tasked to pro- vide direction to the company. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD. The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. The actual responsibilities of BOCs vary by company and are stipu- lated in the company’s charter. For instance, the decision to use certain company assets as collateral for bank credit might need BOC approval. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. This guards against shady intercompany dealings within a group of companies. For instance, a mem- ber company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. The law also holds the directors and commissioners jointly responsible for decisions made by the company. The BOC, as representative of shareholders, is the only shareholder mechanism for monitoring and controlling the BOD. If the BOC does not perform well, shareholders lose control. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting. The meeting decides on important issues, such as the appointment (or replacement) of directors, commission- ers, and the accountant. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the com- pany charter (articles of incorporation); acquisitions, mergers, and consoli- dations; and declaration of bankruptcy. The company charter details the issues that need shareholder meeting approval. In general, an approval needs the majority (50 percent plus one) vote, except in strategic issues stated in the law. For example, the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting, and the attendance should at least be two thirds of total shareholders. For mergers, 16 Corporate Governance and Finance in East Asia, Vol. II acquisitions, consolidations, and bankruptcy, the decision should be ap- proved by three fourths of the shareholders present, and the attendance should at least be three fourths of total shareholders. Because of such require- ments, some listed companies sell no more than a small proportion of shares to the public in order to retain the freedom of the founders to make strategic decisions. The law provides the following rights to or protection of share- holders: (i) access to regular and reliable information free of charge; (ii) proxy voting; (iii) proxy voting by mail; (iv) cumulative voting for direc- tors; (v) preemptive rights on new share issues; (vi) one share one vote; (vii) the right to call an emergency shareholders’ meeting; (viii) the right to make proposals at the shareholders’ meeting; (ix) mandatory shareholders’ approval of interested transactions; (x) mandatory shareholders’ approval of major transactions; (xi) mandatory disclosure of transactions by signifi- cant shareholders; (xii) mandatory disclosure of connected interests; (xiii) mandatory disclosure of nonfinancial information; (xiv) mandatory disclo- sure of intercompany affiliation such as affiliated lending or guarantees; (xv) mechanisms to resolve disputes between the company and sharehold- ers; (xvi) independence of auditing; (xvii) mandatory independent board committee; and (xviii) severe penalties for insider trading. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock ex- change, delineating the tasks and responsibilities of the Capital Market Su- pervisory Agency. It regulates the requirements of investment companies, securities companies, underwriters, brokers, investment managers, investment advisors, and other supporting agencies, such as custodian banks and the securities registration bureau. It also regulates reporting and auditing proce- dures, transparency requirements, insider trading (including market rigging and manipulation) investigation, and administrative and legal punishment. The law is supplemented by Government regulations, decrees of the finance minister, and guidelines promulgated by the head of capital market supervision. Examples in the area of corporate governance are guide- lines for situations that can potentially lead to conflicts of interest and for acquisitions of substantial shares of listed companies. An important rule is the requirement for independent shareholders’ approval for arrangements that might lead to conflicts of interest. Controlling shareholders have no vote on the matter. A tender offer is also required for acquisitions of up to 20 percent of listed shares. Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants, creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. The old bankruptcy law based on the Dutch system was biased in favor of debtors and made it almost impos- sible for creditors to seek court resolution when debtors defaulted. A new bankruptcy law was passed in August 1998. It aimed to protect creditors by providing easier and faster access to legal redress. Un- secured creditors could proceed against a debtor in default based on loan covenants and through the legal process of collection against the latter’s assets. A Commercial Court was also set up to deal with bankruptcy cases. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector. For instance, the Banking Law (1992), amended in October 1998, states that a bank is not allowed to provide credit without collateral. However, the col- lateral could take the form of nonphysical assets (e.g., the viability of a project). Banking regulations also set lending limits, net open positions, capital adequacy, etc. 1.3 Corporate Ownership and Control This section looks at the ownership structure of the corporate sector and reports the results of an ADB survey on corporate management and control of publicly listed companies. Discussions on corporate ownership cover listed companies and conglomerates. 1.3.1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study). The two most important elements of ownership structure are concentration and composition. Ownership concentration is usually measured by the propor- tion of shares owned by the top one, five, or 20 shareholders. It reveals characteristics of controlling shareholders, for instance, whether they are individuals, families, holding companies, or financial institutions. 18 Corporate Governance and Finance in East Asia, Vol. II Publicly Listed Companies Table 1.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997. On average, the five largest shareholders owned 68.9 percent of total outstanding shares. The percentage owned by each of the five largest shareholders was 48.6, 13.6, 3.9, 2, and 0.8, respectively. The pattern of ownership concentration changed little over this period. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia. This preserves the pro rata share of existing shareholders. When a company makes a rights issue, the controlling shareholders usually act as standby buyers. Table 1.8 Ownership Concentration of Publicly Listed Companies, 1993-1997 (percent) Shareholder Rank 1993 1994 1995 1996 1997 Average First Largest 50.5 48.1 47.9 48.5 48.2 48.6 Second Largest 16.6 13.7 14.1 12.0 11.6 13.6 Third Largest 3.0 3.9 4.0 4.2 4.4 3.9 Fourth Largest 2.1 2.0 1.9 1.8 2.1 2.0 Fifth Largest 0.5 0.6 0.8 1.0 1.2 0.8 Total 72.7 68.3 68.7 67.5 67.5 68.9 Source: The Indonesian Capital Market Directory. Table 1.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture, mining, consumer goods, and basic industry and chemicals sectors than in others. Meanwhile, ownership widely held by the general public is highest in the infrastructure and trans- portation sector (not shown in the table). This is because a few companies in the transportation sector issued high proportions of shares to the public. Zebra Nusantara (taxi services), for instance, issued 93.4 percent, Rig Ten- ders Indonesia (shipping services) issued 51.6 percent, and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.5 percent. Data from the Indonesian Capital Market Directory (various pub- lications) show that between 1993 and 1997, about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families. When a company goes public, the founder usually continues to own the majority of shares through a Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas). Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals. Table 1.9 Ownership Concentration of Publicly Listed Companies by Sector, 1997 (percent) First Second Third Fourth Fifth Sector Biggest Biggest Biggest Biggest Biggest Agriculture 54.5 15.6 2.5 1.3 1.1 Mining 58.9 9.4 1.4 0.7 0.6 Basic Industry and Chemicals 50.9 11.3 4.0 1.9 1.3 Misc. Industry 44.4 14.1 5.1 3.6 2.9 Consumer Goods Industry 54.9 13.2 1.5 0.1 0.1 Prop., Real Estate, and Bldg. Constn. 44.4 10.6 4.3 2.2 2.1 Infrastructure, Util., and Transportation 44.2 8.7 0.7 0.1 0.1 Finance 46.3 9.7 6.8 2.4 1.1 Trade, Investment, and Services 36.3 13.1 14.7 6.2 1.9 Average 48.2 11.6 4.4 2.1 1.2 Source: The Indonesian Capital Market Directory. This is confirmed in Claessens et al. (1999), which shows that in 1996, two thirds (67.1 percent) of Indonesian publicly listed companies were in family hands, and only 0.6 percent were widely held. In fact, Indo- nesia has the largest number of companies controlled by a single family. In terms of capitalization, the top family controls 16.6 percent of total market capitalization while the top 15 families control 61.7 percent of the market. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families. Claessens et al. (1999) also found, in a cross-country study, that the correlation between the share of the largest 15 families in total market capitalization, on the one hand, and the efficiency of the judicial system, the rule of law, and corruption, on the other, is strong. The findings suggest that the concentration of corporate control in the hands of few families is a major determinant of the evolution of an inefficient legal and judicial sys- tem, as well as the existence of corruption. Legal and regulatory develop- ments may have been impeded by the concentration of corporate wealth in 20 Corporate Governance and Finance in East Asia, Vol. II the small number of families and the tight links between companies and the Government. If the role of a limited number of families in the corporate sector is so large and the Government is heavily involved in and influenced by business, the legal system is less likely to evolve in a manner that pro- tects minority shareholders. The corruption and regulatory problems generated by high own- ership concentration by families in Indonesia are likely to overwhelm its benefits. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. Co- ordination is easier because informal communication channels exist. But these benefits are few and often dubious compared to the high costs of concentration. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988, foreign ownership increased to 21 per- cent. In 1993, it rose to 30 percent, but later declined and steadied at around 25 percent. In September 1997, the Government allowed foreign investors to buy up to 100 percent of listed shares. However, the onset of the crisis negated this development, resulting instead in a decline in the proportion of foreign investor ownership.5 Conglomerates Table 1.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment, ethnicity, political affiliation, and family origin. Among the top 300 conglomerates, most were established during the New Order Government, numbering 162 in 1988 and 170 in 1996. This may indicate that the New Order Government, with all its regulations, was able to create a favorable environment for business development. However, conglomerates established before 1969 dominated in terms of sales, ac- counting for 64 percent of total conglomerate sales in 1988-1996. In Indonesia, there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. Indigenous businesspeople include the Javanese, Sundanese, Batak, and Padang. The nonindigenous businesspeople are usually Chinese, Indian, or other ethnic groups. During 1988-1996, nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. From 193 in 1988, their number increased to 5 In 1997, the proportion of foreign ownership declined from 27.55 percent in August to 25.42 percent in December. Chapter 1: Indonesia 21 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates, 1988-1996 Item 1988 1989 1990 1991 1992 1993 1994 1995 1996 Number of Groups Year of Establishment Before 1946 13 13 13 13 13 12 12 11 10 1946-1968 125 125 123 120 118 122 122 120 120 1969 Forward 162 162 164 167 169 166 166 169 170 Ethnicity Mixed 86 83 80 76 76 71 69 71 68 Nonindigenous 193 196 196 199 198 201 205 204 204 Indigenous 21 21 24 25 26 28 26 25 28 Political Affiliation Nonofficial 260 259 260 260 262 263 262 260 259 Official-Related 40 41 41 40 38 37 38 40 41 Origin Family 176 175 171 174 172 171 172 177 175 Nonfamily 124 125 129 126 128 129 128 123 125 Sales (Rp trillion) Year of Establishment Before 1946 9.4 12.3 13.3 15.8 20.4 21.9 25.2 30.1 33.4 1946-1968 31.2 36.8 43.2 49.7 59.1 73.1 86.1 103.0 116.4 1969 Forward 23.2 28.4 33.6 40.0 46.5 52.1 59.8 68.9 77.4 Ethnicity Mixed 12.8 15.1 17.6 18.7 21.2 22.8 25.2 29.0 31.1 Nonindigenous 38.6 46.4 54.4 64.5 76.7 87.3 101.5 120.9 137.4 Indigenous 12.4 16.0 18.0 22.3 28.1 37.0 44.4 52.1 58.7 Political Affiliation Nonofficial 48.9 58.4 58.4 80.7 95.6 114.3 134.2 159.1 179.8 Official-Related 14.9 19.1 31.7 24.8 30.4 32.8 36.9 42.9 47.4 Origin Family 35.0 42.6 49.1 57.2 68.4 77.4 89.5 106.3 120.4 Nonfamily 28.8 34.9 41.0 48.3 57.6 69.7 81.6 95.7 106.8 Source: Indonesian Business Data Centre, Conglomeration Indonesia 1997. 204 in 1996. Their total sales also increased from Rp38.6 trillion in 1988 to Rp137.4 trillion in 1996, due to their “go public” activities. For instance, sales of the Bakrie group before it went public in 1990 were only Rp369.9 billion. In 1996, its sales reached Rp1.9 trillion, more than five times its 1988 level. Meanwhile, the number of mixed groups declined from 86 in 1988 to 68 in 1996. While they supplied 20.1 percent of total 22 Corporate Governance and Finance in East Asia, Vol. II sales in 1988, their contribution declined to 13.7 percent in 1996. The con- traction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. Conglomerates were also classified into nonofficial- and official- related groups. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). Most of the top 300 conglomerates were established by ordi- nary citizens. Only about 13 percent were formed by official or ex-official families, or have resulted from alliances between entrepreneurs and offi- cials. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim, Djuhar Soetanto, and Ibrahim Risyad of the Salim group. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo, Bambang Rijadi Soegomo, and Wisnu Suhardhono of Apac-Bhakti Karya. Average sales of official-related con- glomerates were substantially greater than nonoffficial-related ones dur- ing 1988-1996. In 1996, average sales of official-related conglomerates reached Rp1.2 trillion, compared with the less than Rp700 billion of a nonofficial-related conglomerate. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business prac- tices in the banking industry. Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. Prudential credit analysis tends to be ignored. The high NPLs accu- mulated by banks within official-related groups could be partly attributed to this practice. In November 1997, most of the 16 liquidated banks had violated the legal lending limit set by the central bank, Bank Indonesia. In 1997 and 1998, banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). In 1996, there were 175 groups that originated from a family busi- ness. Some of them later became public companies by listing in the stock market. But listed companies within conglomerates were few. The Salim group, for instance, which is the largest conglomerate in Indonesia, owns four groups with many subsidiaries and affiliate companies. Out of 174 companies, 117 are jointly owned by the family and 57 are owned by indi- vidual family members. But only a handful of these companies are listed in the market, including Indofood Sukses Makmur (food industry), Indocement Tunggal Prakarsa (cement industry), and Fast Food (restaurants). The Suharto family is the largest stockholder in Indonesia, collectively controlling Chapter 1: Indonesia 23 assets worth $24 billion (Claessens et al., 1999). The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children, as well as other relatives and business partners, many of whom, besides Suharto himself, served in some government function (see Figure 1.1). The Salim Group is also in part controlled by the Suharto family. The families retain control of the companies through ownership, management, or both. Although some groups employ professional man- agers, families mostly manage the groups and make strategic decisions themselves. The BOC chairperson often represents the controlling party of the company. He or she could either be the biggest shareholder, or someone very close to and trusted by the controlling shareholders. If the family members cannot actively manage the companies as directors, they maintain their position as commissioners. Although they are not actively involved in the daily operations of the companies, they still control the work of the directors. Some of the groups related to officials have a unique share owner- ship structure. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders. In so doing, the controlling shareholders are able to maintain their special rela- tionship with officials, and hence, continue receiving some kind of protec- tion and special treatment. Cross-Shareholdings Cross-shareholding is one way to enhance corporate control and occurs when a company down the chain of control has some shares in another company within the same chain. Indonesian law allows cross-shareholdings, with no restrictions. But it is difficult to obtain data on cross-shareholding among firms. It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms. In 1996, for instance, Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry). Both are listed companies and members of the Salim group. Cross-holdings between financial and nonfinancial firms poten- tially create more serious problems. This is because cross-owned banks had to consider not only their own interests, but those of the entire group. Cases in point are the Bank Papan Sejahtera and Bank Niaga, which were liquidated or recapitalized after being acquired by the Tirtamas group that owns a listed cement company, Semen Cibinong. While the source of the Figure 1.1 The Suharto Group Tirtamas 262 firms with Salim Group Usaha Mulia Group control over 20% (friend Soedono) (cousin Hasim) Cemen 21 firms with Cibinong control over 20% Sempati Air Hanurata Humpuss Group Bank Utamar Suharto Family Group Trias 18 firms 17 firms with Citra Lamoro Group with control Sentosa control over 20% (daughter Mbak Tutut) over 20% Bank Bimantara Group Bank Citra Persda Central TPI Yama Marga Tollroad (son Bambang) Bob Hasan Group Indomobil Andromed Tripolita (Mohamad Hasan) Mercu Buana Group 8 firms with Kabelindro Kiani 22 firms with (step brother Probo) Gatari control over 20% Murmi Sakti control over 20% 11 firms with control over 20% Source: Stijn Claessens, Simeon Djankov, and Kedaung Indah Kedaung Group Larry H. P. Lang, (Feb. 1999). Who Controls East (Agus Nursalim) Asian Corporations? Financial Economics Unit, 14 firms Financial Sector Practice Department, World Bank. with control over 20% Chapter 1: Indonesia 25 problem is inconclusive, one possibility is that legal lending limits had been violated. 1.3.2 Management and Internal Control A company’s internal organizational structure determines how sharehold- ers control management. The typical structure of a publicly listed company in Indonesia is shown in Figure 1.2. Shareholders are at the top of the organization, both controlling and minority. The BOD leads the company and makes strategic and operational decisions. The managers execute the BOD’s decisions and lead employees in their departments. As the owners’ representatives, the BOC supervises the work of directors. Therefore, the BOC has the right to obtain any information concerning the firm, seek an audience with directors, and, if necessary, request a shareholders’ meeting. This is based on the Dutch system. Figure 1.2 Typical Internal Organizational Structure of a Publicly Listed Company in Indonesia Shareholders Board of Board of Directors Commissioners M a n a g e r s Employees The succeeding discussions examine some aspects of the internal management and control system in practice in Indonesian listed compa- nies, including the boards, the directors, management and managerial com- pensation, role and protection of minority shareholders, and accounting and auditing procedures. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange. 26 Corporate Governance and Finance in East Asia, Vol. II Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independ- ent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the company’s founders. Table 1.11 Characteristics of the Board of Commissioners Number of Firms Questions Responded Presence of Independent Commissioners a. Yes 11 b. No 29 Basis for Electing the Board of Commissioners a. Professional expertise 23 b. Relationship with controlling shareholders 9 c. As founders of the company 9 Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM 10 b. Nominated by significant shareholders and confirmed by the AGM 22 c. Nominated and elected by shareholders during the AGM 7 Basis for Electing the Chairman of BOC a. Professional expertise 27 b. Shareholdings 7 c. As founders of the company 8 d. Relationship with controlling shareholders 8 Relationship between the Chairman and CEO a. Not related by blood or marriage 30 b. Related by blood or marriage 6 c. No answer 4 Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey. In most companies (22 out of 40), members of the BOC were nomi- nated by significant shareholders and confirmed at the annual general meet- ings (AGMs). A nominee that was not supported by significant shareholders Chapter 1: Indonesia 27 was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The ma- jority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is ob- tained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting di- rectors in 11 companies. Table 1.12 Characteristics of the Board of Directors Number of Firms Questions Responded Presence of Independent Directors a. Yes 10 b. No 30 Basis in Electing Board of Directors a. Professional expertise 29 b. Relationship with controlling shareholders 7 c. As founders 4 Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM 13 b. Nominated by significant shareholders and confirmed by the AGM 22 c. Nominated and elected by shareholders during the AGM 6 Basis in Electing the Chief Executive Officer a. Professional expertise 29 b. Shareholdings 3 c. As founders of the company 7 d. Relationship with controlling shareholders 8 Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey. Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling share- holders. 28 Corporate Governance and Finance in East Asia, Vol. II Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and partici- pates in strategic decision making. This indicates some overlapping func- tions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic de- cisions, may result in conflicts. However, since the BOC appoints mem- bers of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not hav- ing committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indone- sia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies Type of Committee BOD BOC Nomination Committee 5 1 Remuneration Committee 5 1 Auditing Committee 5 3 None 23 35 Total 38 40 Source: ADB Survey. Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies Chapter 1: Indonesia 29 provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 share- holders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), report- edly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quo- rum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., director’s fee) was rejected during the AGM. This is not surprising because management usually seeks prior ap- proval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have sub- stantially followed international accounting standards even prior to the fi- nancial crisis. Accounting authorities, however, can easily change accept- able accounting methods. After the crisis, for instance, the Indonesian Ac- countants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the associa- tion allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independ- ent auditor, which is usually an international audit company. Most compa- nies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM. 30 Corporate Governance and Finance in East Asia, Vol. II 1.3.3 External Control Control by Creditors The control of creditors over a debtor company rests on assets used as col- lateral for loans. Unsecured creditors resort to the legal process when prob- lems arise. Based on the ADB survey, each company was associated with an average of five creditors, the majority of which were banks. Some com- panies were associated with an excessively large number of creditors, reach- ing up to 30. Most of the companies have been dealing with their institu- tional creditors for less than three years. Although the banking law requires collateral for bank loans, some creditors did not enforce the requirement. Only 10 companies reported that they were required to provide collateral by all creditors. Twelve companies claimed having creditors that did not ask for collateral. Twenty-five out of 32 companies reported having renegotiated loans with creditors in the last five years, mostly after the Asian crisis. This indi- cates that many companies experienced serious difficulties in repaying debts as a result of the crisis. But most of these companies stated they would possibly borrow from the same creditors, indicating their relatively strong bargaining position. The majority of firms (22 out of 29) also said that creditors had no influence in management decision making. In 1998, the Bankruptcy Law was passed to protect creditors and the Commercial Court was set up to deal with bankruptcies. This paved the way for unsecured creditors to proceed against a debtor in default based on loan covenants and through the legal process of collection against the debt- or’s assets. However, enforcement of the law was a disappointment to those who hoped that it would put corporate restructuring and the settlement of corporate debts on a running start. Only 17 cases had been filed with the court by late November 1998. Just two companies had been declared bank- rupt, and three suits were dismissed by the Commercial Court. The Gov- ernment’s political will and support are still very much needed in order to set up a well functioning Commercial Court. Long and hard work is re- quired to restore creditors’ confidence in Indonesia’s legal system. The Market for Corporate Control Between 1992 and 1997, there were 40 cases of acquisition and takeover of Indonesian companies. Most of these, however, were internal acquisitions (i.e., acquisition of a company in the same group). Only five cases were Chapter 1: Indonesia 31 external acquisitions. A study by Connie Tjandra (1993) shows that inter- nal acquisitions were often initiated for tax shelter purposes. One famous takeover was Bank Papan Sejahtera, which was acquired by Yopie Wijaya in 1995. Wijaya and his friends bought shares of the bank on several occasions until they gained control. They then re- placed the BOD and later sold the bank, at a large profit, to Hashim Djojohadikusumo, the owner of Tirtamas group.6 In this case, the acquir- ing interest was apparently seeking economic profits. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo, who was acquiring his second commercial bank. However, the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. A more recent case was the acquisition by Nutricia (the fourth largest baby food firm in the world) of PT Sari Husada (another baby food firm) in 1998. The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. In these two latter cases, the acquir- ing parties were trying to obtain operating synergies because they had com- panies in the same industry. Control by the Government Government control could be in the form of state ownership, appointment of management, restrictions on market entry, or direct subsidies. Most Indone- sian state companies are 100 percent owned by the Government, except for publicly listed SOCs. State ownership for listed SOCs ranges from 25 to 35 percent. The Government appoints the BOD and BOC of these firms. Before the financial crisis, it was common for the Government to invest in certain private companies. For instance, with the minister’s ap- proval, a state-owned insurance company may invest its funds in a private firm. The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. This used to be a common practice in companies associated with the Suharto regime. In the massive restructuring of the banking sector that commenced after the crisis, the Government took over NPLs and put them under IBRA management. Since the NPLs reached up to Rp300 trillion, IBRA found itself tasked with managing large amounts of assets in the private sector. 6 Later in March 1999, the bank was liquidated. The bank was reported to have high NPLs and had broken the legal lending limit. 7 In April 1999, Bank Niaga was under a recapitalization program. 32 Corporate Governance and Finance in East Asia, Vol. II 1.4 Corporate Financing 1.4.1 Financial Market Instruments Prior to 1977, bank loans were the only instruments available to the corpo- rate sector for short term (working capital) or long term (investment) fi- nancing. Since then, new instruments have been introduced to the corporate sector, including bonds, stocks, and others offered by nonbank financial institutions or finance companies. Bank loans, however, remain the major financing instrument for the corporate sector. Bank Credit As shown in Table 1.14, bank credit surged from Rp122.9 trillion in 1992 to Rp487.4 trillion in 1998. Private national banks and state-owned banks were the biggest domestic creditors, jointly providing almost 90 percent of loans until 1997. Data from Bank Indonesia show that from 1994 to 1997, private national banks overtook state banks as the dominant credit source. From 34.4 percent in 1992, the share of private national banks in outstand- ing total loans increased to 44.6 percent in 1997. Table 1.14 Banking Sector Outstanding Loans, 1992-1999 (Rp trillion) Type of Bank 1992 1993 1994 1995 1996 1997 1998 1999 State-Owned Banks 68.2 71.5 80.0 93.5 108.9 153.3 220.7 112.3 Foreign Banks 9.3 14.7 18.4 24.2 27.6 48.6 66.7 50.0 Regional Govt Banks 3.0 3.6 4.2 5.2 6.5 7.5 6.6 6.8 Private National Banks 42.3 60.4 86.3 111.6 150.0 168.7 193.4 56.0 Total 122.9 150.3 188.9 234.6 292.9 378.1 487.4 225.1 Source: Bank Indonesia. Equities In 1977, when the Government reactivated the stock exchange, equities became available to the corporate sector. However, because of the restric- tions discussed below, this market was not well developed. When the Gov- ernment liberalized the banking industry at the end of 1988 (which allowed for higher interest rates), companies considered alternatives to bank loans. Chapter 1: Indonesia 33 Some companies went public, thus increasing the role of the capital market in raising long-term funds. In 1988, when foreign investors were not yet allowed to purchase listed shares, funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector. The ratio reached 8.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares, but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. It gradually increased again starting in 1991, shooting up to 18.7 percent in 1997. Overall, the stock market has gained a bigger role in corporate sector financing (Table 1.15). Table 1.15 Value of Stocks Issued and Stock Market Capitalization, 1992-1999 (Rp trillion) Item 1992 1993 1994 1995 1996 1997 1998 1999 Stocks Issued Outstanding 11.2 16.1 26.5 35.4 50.0 70.9 76.0 206.7 (As % of Outstanding Bank Credit) 9.1 10.7 14.0 15.1 17.1 18.7 15.6 91.8 Market Capitalization 48.6 123.4 207.6 310.9 406.6 301.5 333.6 859.5 Source: Bank Indonesia. Financing by Finance Companies Finance companies first emerged at the end of 1980, offering services such as leasing, factoring, credit cards, and consumer credit. They were not, however, allowed to accept deposit accounts from the public. Prior to 1995, the activities of finance companies were not covered by regulations on pru- dential practices in the banking sector (e.g., legal lending limit, capital ad- equacy ratio, and net open position). Most banks therefore set up subsidi- ary finance companies to circumvent banking regulations. During the 1990s, finance companies were increasingly used as channels for the inflow of foreign loans. In 1995, the Government issued regulations to supervise and pro- mote prudential practices in finance companies, i.e., limiting loans to a maxi- mum of 15 times equity and foreign loans to five times the equity. The ratio of funds raised by finance companies to credit disbursed by the banking sec- tor has been increasing from about 5 percent in 1992 to 13 percent in 1996. 34 Corporate Governance and Finance in East Asia, Vol. II Commercial Papers Commercial papers, which are unsecured negotiable promissory notes with a maximum maturity of 270 days, have been popular in Indonesia since 1990. While banks had some exposure to these instruments, they were not rated by a rating agency. Thus in November 1995, Bank Indonesia prohib- ited banks from underwriting issues of commercial papers but allowed them to act as paying agents. Banks could invest only in commercial papers that were rated by the Indonesian Rating Agency (which was set up only in 1995 to rate debt instruments), otherwise it would be classified as a loss in the banks’ books. 1.4.2 Patterns of Corporate Financing Table 1.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis. In the second half of the 1980s, publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings), averaging 26.5 percent and 36.8 percent, respectively. This is in contrast to the lower share of borrow- ings during the same period. In terms of composition, short-term borrow- ings were greater than long-term debts, at 81 percent of total borrowings. Table 1.16 Financing Patterns of Publicly Listed Nonfinancial Companies, 1986-1996 (percent) Financing Source 1986-1990 1991-1996 1986-1996 Internal 36.8 16.0 17.3 Borrowings 17.3 39.3 37.9 Short-Term 14.0 16.7 16.5 Long-Term 3.2 22.6 21.4 Debentures/Equity 26.5 23.3 23.5 Debentures — (0.1) (0.1) Equity 26.5 23.4 23.6 Trade Credit 11.8 8.4 8.6 Others 7.6 13.0 12.6 Total 100.0 100.0 100.0 — = not available. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases, PACAP Research Center, 1996. Chapter 1: Indonesia 35 In the 1990s, the pattern changed. Corporate debts grew over time, rising from Rp54.4 trillion in 1993 to Rp112.9 trillion in 1996. This amount doubled in 1997, reaching Rp229.2 trillion. Of the various financing sources, corporate debts accounted for 39.3 percent during 1991-1996, with long- term debts increasing rapidly. These liabilities grew significantly because corporate expansion was largely financed by debt. Many companies suffered big losses in 1997 due to their high ex- posure to dollar loans. For instance, Indofood registered losses of almost Rp1.2 trillion (mostly foreign exchange losses), while Semen Cibinong’s losses reached Rp2.9 trillion. Two telecommunications companies, Indosat and Telekom, also suffered from foreign exchange losses but managed to post profits of Rp0.6 trillion and Rp1.1 trillion, respectively. All companies in the cement industry suffered from foreign exchange losses, except Se- men Gresik (an SOC), which managed to post significant profits due to low exposure to dollar-denominated loans. Hence, the corporate sector’s high leverage, as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997, was due largely to a rapid rise in long-term debts, which was masked by the rapid growth in investments. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms. Bank loans also surged when the banking sector was liberalized in 1988. 1.4.3 Corporate Financing and Ownership Concentration It has been suggested, in the context of Indonesia and some other countries, that ownership concentration may be associated with heightened risk-taking by companies. Large shareholders are inclined to undertake risky projects in- tended to generate high returns using borrowed funds. They also do not want to dilute corporate control and are more likely to finance growth with debt. Table 1.17 compares the DER of listed firms by degree of owner- ship concentration. The results indicate that firms with higher ownership concentration tend to have a higher DER. The analysis of ownership pat- terns in Section 3 indicated that founders (the controlling party) or the five biggest owners held at least 50 percent of total shares. Most corporate char- ters require commissioners to approve debt issues or sign debt agreements. 36 Corporate Governance and Finance in East Asia, Vol. II However, since commissioners represent the controlling party, decisions on debt are made with the implicit endorsement of owners. Controlling parties rely on external financing to maintain their equity share and, ultimately, to maintain control of the company. Table 1.17 DER of Listed Companies by Degree of Ownership Concentration (percent) DER of Firms with High DER of Firms with Low Item Ownership Concentration Ownership Concentration Mean 699.0 351.0 Standard Deviation 1,358.0 386.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. The test of the difference between the two means found the t-value of 1.56 signifi- cant at the 10 percent level. Source: Author’s estimates. 1.5 The Corporate Sector in the Financial Crisis 1.5.1 Causes of the Financial Crisis Many intertwined factors led to the crisis. This section highlights those that were seen to have contributed significantly to the crisis in Indonesia: inad- equacy of the regulatory framework under the financial liberalization, heavy reliance of companies on bank credits to finance investments, and high ownership concentration among families with political affiliation. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. The availability of bank credit brought by the rapid rise in the number of banks and the free capital flow system led to a credit boom. Between 1987 and 1996, the private sector borrowed heavily in unhedged dollars. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. In addition, the free capital flow system allowed private companies to borrow dollars offshore without any restriction. As a result, the borrowings swelled, aided Chapter 1: Indonesia 37 by the lack of an existing mechanism to supervise and monitor foreign transactions. The removal of entry barriers in the banking sector caused the number of private national banks to soar from only 65 in 1988 to 144 in 1997. The supervising agency was caught unprepared. A director at Bank Indonesia revealed that in 1995, the level of corporations’ foreign debt could not even be ascertained. It was doubly difficult to exercise supervision when groups with political clout owned the banks. Conglomerates that had difficulty in getting loans (i.e., those with high DERs) established their own banks. The banks served as a “cashier” that provided easy credit to nonfinancial compa- nies within the group. This often led to the violation of prudential credit management practices. It also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers. They were, after all, only created to serve the companies to which they lent. As a result, large amounts of credit were directed to the companies within the group, and the negative net open position (short posi- tion in dollars) continuously rose to precarious levels. The Government later specified the legal lending limit and the net open position that banks had to follow. However, to circumvent these banking regulations, conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. It was only in 1995 that some regulations on the activities of finance companies were contemplated. It is not known if these regulations had an effect on nonbank intermediaries. Heavy Reliance on Bank Credits to Finance Investments Companies relied heavily on bank loans to finance rapid corporate expan- sion because internal financing was insufficient and the capital market was not developed. There was also a smaller demand for equity compared to external debt financing since controlling shareholders preferred the latter to maintain their control of the companies. In the process, many firms became highly leveraged. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. The large supply of foreign funds, averaging about 4 percent of GDP, did finance many viable ventures. However, substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections. A lot of short-term foreign funds were used to finance long-term investment projects. Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans. 38 Corporate Governance and Finance in East Asia, Vol. II By mid-1997, $35 billion of Indonesia’s foreign debt owed to pri- vate foreign banks was about to mature in less than one year. In early 1998, total private sector foreign debt stood at $72.5 billion, of which $64.5 bil- lion was owed directly by corporations. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families, there was also almost universal confidence that the eco- nomic growth would continue indefinitely. Corporations were certain that they could roll over short-term loans when these fell due, as they had done so in the years before the crisis. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. The ultimate control of the corpo- rate sector rests in the hands of a small number of families who own groups of companies. Families retain control by keeping the majority percentage of outstanding shares. They ensure that commissioners represent their in- terests and maintain close relationships with the chairperson. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership, and in the process maintain control of the company. They enhance their control over companies through cross-shareholdings, by set- ting up their own banks, and investing shares among nonfinancial compa- nies within the group and in other groups’ companies. Collusion between big businesses and the political elite was wide- spread in Indonesia. This was often the case in the banking industry, where private banks are usually in the hands of big businesses, politicians, or both. In many cases, banks did not lend on the basis of the soundness of the project, but on the basis of who the borrower was. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. This fact was usually not dis- closed in financial statements, partly because they used nominee accounts to register ownership rather than set up a holding company. Family-con- trolled corporations were generally structured as a complicated web of af- filiates and associated companies. Projects involving massive capital investments and long-term op- erating deals (in telecommunications, toll roads, and power generation) re- quire huge capital. Since the Government could not afford to undertake these projects, contracts were granted to the private sector, most often to people who were close to the ruling regime. Chapter 1: Indonesia 39 1.5.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1.18 shows that growth in most sectors significantly fell in 1997. This continued in 1998, when all sectors, except utilities, posted negative growth rates. The construction sector was the worst hit, followed by the finance and trade sectors. Table 1.18 GDP Growth by Sector, 1996-1999 (percent) Sector 1996 1997 1998 1999 Agriculture, Livestock, Forestry, and Fisheries 3.1 1.0 (0.7) 2.1 Mining and Quarrying 6.3 2.1 (2.8) (1.7) Manufacturing 11.6 5.3 (11.4) 2.6 Electricity, Gas, and Water Supply 13.6 12.4 2.6 8.2 Construction 12.8 7.4 (36.5) (1.6) Trade, Hotels, and Restaurants 8.2 5.8 (18.0) (0.4) Transport and Communications 8.7 7.0 (15.1) (0.7) Financial, Real Estate, and Business Services 6.0 5.9 (26.6) (8.1) Other Services 3.4 3.6 (3.8) 1.8 GDP 7.8 4.7 (13.0) 0.3 Source: Central Bureau of Statistics (Biro Pusat Statistik, BPS). The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.24 trillion for the first six months of 1998; 53 compa- nies reported negative equity of Rp6.58 trillion (meaning their losses were greater than the paid-up capital); and 128 companies reported a total loss of Rp46.52 trillion. Only 86 companies reported profits. Using the financial statements as of 30 June 1998 of 161 publicly listed companies, DER and ROE were calculated per sector, as shown in Table 1.19. The average DER was found to be 1,370 percent, much higher than the 307 percent registered in December 1997. Sectors with lower ROE generally had higher DER. The consumer goods industry reported the low- est ROE, followed by property, real estate, and building construction. Most sectors showed significant increases in leverage, indicating a rapid rise in 40 Corporate Governance and Finance in East Asia, Vol. II Table 1.19 DER and ROE of Publicly Listed Companies by Sector, 1996-1998 (percent) DER ROE a Sector 1996 1997 1998 1996 1997 1998a Agriculture 104.0 234.0 186.0 14.2 23.9 12.8 Mining 65.0 108.0 72.0 17.1 (5.8) 36.5 Basic Industry 111.0 193.0 635.0 8.2 (4.0) (78.1) Miscellaneous Industry 158.0 219.0 1,097.0 7.1 (3.6) (115.4) Consumer Goods Industry 108.0 177.0 2,271.0 18.3 7.8 (373.4) Property 177.0 191.0 864.0 8.6 (11.2) (264.6) Infrastructure 105.0 97.0 92.0 15.0 12.1 30.2 Finance 631.0 697.0 1,395.0 13.4 5.4 (6.7) Trade/Services 163.0 205.0 2,625.0 6.1 1.1 (92.0) Average 229.0 307.0 1,370.0 10.7 1.1 (124.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity. a Actual data for 1st semester only, but annualized to approximate full year values. Source: JSX Monthly, several publications. rupiah values of dollar-denominated debts due to the weakening of the lo- cal currency and the rapid decline in equity because of losses. The huge losses suffered by most companies were caused by three factors. First, losses in operation were due to declines in sales and increases in the cost of imported inputs. Second, interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999. Third, foreign exchange losses came about with the use of unhedged foreign debt. Impact on the Banking Sector Table 1.20 reveals that the banking sector’s ROE decreased significantly in 1997. Mostly suffering from a liquidity squeeze, private banks posted nega- tive ROEs in the same year. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits, small foreign banks enjoyed the highest profits. As the rupiah weakened and interest rates increased, the NPL ratio rose to 25.5 percent in April 1998, from only 8.8 percent in 1996. This figure further increased to 47.7 percent in July 1998, as shown in Table 1.21. Financial and banking analysts estimate that by September 1998, the NPL ratio had reached more than 60 percent, and would have kept on in- creasing if interest rates had not declined. Chapter 1: Indonesia 41 Table 1.20 ROE of the Banking Sector, 1992-1997 (percent) Type of Bank 1992 1993 1994 1995 1996 1997 State-Owned Banks 7.06 15.84 14.73 7.25 8.28 5.89 Foreign Banks 20.34 27.72 30.69 22.2 27.15 20.86 Joint Venture Banks 16.91 16.47 14.37 8.81 11.30 5.39 Regional Development Banks 21.45 20.07 19.44 13.67 13.09 11.43 Private National Banks 21.45 13.12 15.24 8.50 10.09 (11.38) Total — 15.07 15.70 9.68 11.24 (4.20) — = not available. Source: The National Banking Association. Table 1.21 Nonperforming Loans by Type of Bank, 1996-1998 (Rp trillion) Private Regional Foreign and State-Owned National Development Joint Venture Item Banks Banks Banks Banks Total Total Loans Dec 1996 — — — — 331.3 July 1997 140.1 179.8 9.2 32.2 361.3 Dec 1997 198.1 187.5 10.8 48.7 445.0 July 1998 274.2 222.2 14.6 106.7 622.7 NPLs Dec 1996 — — — — 29.1 July 1997 19.3 8.6 1.1 1.5 30.5 Dec 1997 22.0 6.5 1.2 2.2 31.9 July 1998 129.6 128.6 1.9 37.0 297.2 NPL Ratio (%) Dec 1996 — — — — 8.8 July 1997 13.8 4.8 11.9 4.7 8.4 Dec 1997 11.1 3.5 11.1 4.5 7.2 July 1998 47.3 57.9 13.0 34.7 47.7 — = not available. Source: Infobank, July No. 227/1998 and October No. 230/1998. State-owned banks initially had the highest NPL ratio. In July 1998, however, private national banks overtook State-owned banks when their NPL ratio jumped to 57.9 percent. The high and increasing NPLs, coupled with negative spreads (deposit rate was higher than the credit rate), put pressure on the banking sector. 42 Corporate Governance and Finance in East Asia, Vol. II 1.5.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997, the Government and private sector formed a committee to help corporates deal with the crisis, particularly in terms of debt resolu- tion. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. Corporate debt accounted for 46.7 percent ($64.6 billion) of Indone- sia’s total external debt in March 1998. In addition, the corporate sector had more than Rp600 trillion ($75 billion at Rp8,000/$1) in debt from domestic commercial banks. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring), about 80 percent of which was private. More than two thirds of private debt was short-term and the average maturity of all private debt was estimated to be only 18 months. In June 1998, IBRA was formed to offer Mexican-style resolution for private sector foreign debt. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. However, by mid-Sep- tember 1998, none of the 2,000 eligible firms had signed up for the scheme. Aside from being described as overly complicated, few companies were in a position to resume interest payments. Thus, the scheme failed. On 9 September 1998, the committee launched the Jakarta Initia- tive, a more comprehensive scheme to tackle domestic and foreign corpo- rate debt. The scheme encourages negotiation between creditors and debt- ors, assembling the legal and policy framework to facilitate corporate re- structuring. One premise of the initiative was that creditors should agree to a standstill for a certain period (creditors would desist from exercising their claims on a distressed company’s assets) to allow debtors to operate nor- mally after obtaining fresh financing. Since September 1998, a number of prominent companies, such as Garuda (a national flag carrier), Astra International (automotive), and Ciputra (property business), have been subject to restructuring deals under the ini- tiative. In November, Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1.2 billion debt. By end-November, the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2.4 trillion of domes- tic debt and $6.7 billion of foreign exchange debt. While the process of restructuring was in progress, companies were not servicing their debts. Another option that companies could take under the Jakarta Initia- tive was debt restructuring via debt-to-equity swaps. Unfortunately, only a Chapter 1: Indonesia 43 few companies reached agreement with their creditors on this. Astra Inter- national (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. In the banking industry, Bank Bali agreed on a debt-to-equity swap with its creditor, Standard Chartered, un- der which the latter would become one of the bank’s shareholders. Bank Niaga also negotiated with some of its creditors, i.e., Rabobank and Citibank, for equity infusion. Meanwhile, some companies attempted to restructure their busi- nesses on their own. When credit from the banking sector became unavail- able and interest rates increased significantly, the companies’ financial per- formance deteriorated, forcing them to cut costs, lay off workers, consoli- date business units, and sell noncore businesses or nonoperating assets. For instance, Astra International, a publicly listed company operating in the automotive industry, focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors, plantations, mining, and mining equipment. Some listed companies with relatively “rich” shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). Bankruptcy Reform The Bankruptcy Law was passed in August 1998, aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of com- mercial disputes. Qualified professionals from the private sector will act as receivers and administrators in the management of estates of companies in bankruptcy or reorganization. Procedural rules are also being introduced to ensure certainty and transparency in the proceedings, especially in prevent- ing unjustifiable delays in the adjudication of bankruptcy. Protection against insider and fraudulent transactions taken by a debtor prior to the adjudica- tion of bankruptcy will be enhanced. Moreover, limitations will be im- posed on the ability of secured creditors to foreclose on their collateral during bankruptcy proceedings (as is provided for in the bankruptcy laws of most other countries), with the requirement that adequate compensation and protection will be provided to such creditors during that period. A Commercial Court was set up to handle corporate restructuring and debt settlements, as well as general commercial disputes. Debtors, who fail to reach agreements with creditors in out-of-court workouts under the Jakarta Initiative or fail to gain the requisite creditor support for the workout plan can resort to the Commercial Court. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process 44 Corporate Governance and Finance in East Asia, Vol. II to achieve liquidation of the company. In the longer term, it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system. The significance of a sound bankruptcy system cannot be un- derstated as it provides a backdrop for negotiations in the workout and re- structuring process against which parties often gauge their legal rights. However, the Court’s early record has been a disappointment, with only 17 cases filed as of November 1998. The Court has also declared only two companies bankrupt. The bias in favor of debtors has retarded the pace of corporate restructuring. Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. To push bankruptcy reforms, legislation against corruption, collu- sion, and nepotism (anti-KNN) was signed in 1999. There will be changes in the implementation of the bankruptcy law, including procedures for han- dling operational issues and processing bankruptcy cases. The Government, in consultation with IMF and the World Bank, is also reviewing the Bank- ruptcy Law. Capital Market Reform In the capital market, the Capital Market Supervisory Agency allows compa- nies to offer additional shares directly to the public. Previously, companies were allowed to sell shares only by issuing stock rights. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. However, since the market reflects the condition of the economy, the measure had only a minimal impact. The Government has also been concerned with the issue of capital controls. Realizing that they undermine investors’ confidence, the Govern- ment did not impose restrictions nor did it attempt to regulate capital flows. Rather, the monitoring system for foreign exchange transactions will be strengthened to improve transparency and better assess the credit exposure of the corporate and banking sectors. Banking Sector Reforms The Government’s banking sector reform strategy is focused on (i) govern- ment-assisted recapitalization programs for potentially viable private banks; (ii) the resolution of nonviable private banks; (iii) the merger, reform, and recapitalization of state banks; (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia; and (v) a strength- ened banking supervision system. Chapter 1: Indonesia 45 In 1997, the Government established IBRA to supervise problem banks. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. To obtain a clearer picture of the banking sector, the Government required banks to be audited by international external auditors. In October 1998, Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. A new central banking law, providing Bank Indonesia with substan- tially enhanced autonomy, was enacted in 1999. The Bank Indonesia 21st package includes recapitalization, improve- ment of rules and prudential regulations, and follow-up action on bank re- structuring. Bank Indonesia has announced a recapitalization program for potentially viable private banks. Banks deemed ineligible for recapitalization will be closed, merged, or sold (after transferring NPLs to the AMU). How- ever, depositors will be fully protected by the Government. Liquidity sup- port given to troubled banks should be repaid in four years. The four state banks (BDN, BEII, BBD, and Bapindo) will be merged into one bank named Bank Mandiri. The merger process will be finished within two years. Other Regulatory Reforms To push corporate restructuring further, the Government has drafted a regu- lation providing tax neutrality for mergers and removing other tax disin- centives for restructuring. It has also drafted regulations to remove obsta- cles for converting debt to equity. The importance of this legislation may need to be emphasized. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. In particular, it is doubt- ful whether pure holding companies are able to enter into swaps. To over- come these problems, regulations will need to be issued to permit debt-to- equity swaps in the context of corporate restructuring plans. 1.6 Summary, Conclusions, and Recommendations 1.6.1 Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family busi- nesses. Some 175 groups that originated from family businesses controlled 46 Corporate Governance and Finance in East Asia, Vol. II 53 percent of total assets of the top 300 Indonesian conglomerates. How- ever, not all of the conglomerate-affiliated companies are publicly listed. Among those listed in the Jakarta Stock Exchange, the majority remains family-controlled. On average, families control 67.1 percent of publicly listed companies in Indonesia, while a single family controlled 16.6 per- cent of the total stock market capitalization in 1996 and the top 15 families controlled 61.7 percent. These figures show the extent of power wielded over the corporate sector by a small number of families. The restructuring and resolution of financial distress may, how- ever, put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government. The financial crisis created opportu- nities for addressing the inefficiencies in the legal and judicial system that supported corruption. Financing Patterns Controlling shareholders opted to use debts to finance expansion, allowing them to maintain their equity shares and, thus, retain ownership control of companies. As a result, corporate debts grew over time. Rapid growth in investments masked the corporate sector’s increasing leverage. Companies preferred to borrow in dollars because interest rates of foreign loans were lower than for domestic loans and the exchange rate was relatively stable. But because foreign creditors were reluctant to lend long term, Indonesian companies borrowed short term. Foreign creditors, mean- while, lacked the information necessary to allow them to assess projects’ risks and chances for success. Companies relied heavily on bank credit. However, banks were unwilling to provide credit to highly leveraged companies. Therefore, when barriers to entry in the banking sector were lifted, conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups. These banks also obtained cheap offshore funds. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. When the Government regulated the legal lending limit and the net open position of banks, conglomerates set up finance compa- nies to bring in cheap foreign loans as these companies were not adequately regulated. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. On the one hand, this financing pattern supports the claim that family-based controlling share- holders relied on excessive borrowing to finance corporate expansion Chapter 1: Indonesia 47 without diluting their control. On the other hand, it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. Impact of the Financial Crisis Prior to the crisis, the corporate sector was in quite good shape in terms of growth and profitability. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. Sales of conglomerates as well as those of publicly listed companies were increasing, although at a declining rate. Net profits of publicly listed com- panies had consistently been growing at an average rate of 20 percent each year. When the crisis hit Indonesia, the highly leveraged companies, par- ticularly those with large short-term foreign loans, were the most adversely affected. Total profits of publicly listed companies dropped to Rp3.1 tril- lion in 1997 from Rp13.21 trillion in 1996, and registered a net loss of Rp39.24 trillion in the first half of 1998. DER increased to 307 percent in 1997 and further surged to 1,370 percent in 1998. ROE dropped from 1.1 percent in 1997 to -124.1 percent in 1998; the consumer goods industry was the worst hit, followed by the property sector. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts, the high domestic interest rates that prevailed from 1998, and the rapid decline in equity due to losses. The financial crisis led to the closure of several dozen banks. As the rupiah weakened and interest rates increased, NPLs rose and capital adequacy ratios fell. At the height of the crisis, Bank Indonesia extended emergency loans to many banks, financed by issuing nearly $80 billion worth of bank restructuring bonds. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. The Government and the private sector responded with measures to mitigate the negative effects. The Government introduced reforms to improve bankruptcy procedures, facilitate debt restructuring, and strengthen prudential regula- tions and supervision of the financial sector. To restructure the corporate sector, the Government initiated cor- porate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). Meanwhile, corporate-initiated debt restructuring 48 Corporate Governance and Finance in East Asia, Vol. II measures included internal business restructuring (e.g., cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. 1.6.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study. Specific recommendations include protecting the rights of minority shareholders, improving the legal and regulatory framework for bank supervision, and protecting creditors’ rights. Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all share- holders, but inadequate protection to minority shareholders from the domi- nance of large shareholders. In particular, minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprof- itable projects financed by unhedged foreign currency debts. If the role of a limited number of families in the corporate sector is so large and the Gov- ernment is either heavily involved in or influenced by business, the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. The Corporate Law should be reviewed and amended in the con- text of pervasive control by large shareholders. Amendments should in- clude (i) empowering minority shareholders by raising the majority per- centage of votes required on critical corporate decisions and mandating minimum representation of minority shareholders on the board; (ii) delin- eating the functions of the board of directors and commissioners; and (iii) strengthening transparency and disclosure requirements. Most companies claim to have adopted international standards of accounting and auditing procedures, but it is not clear whether in practice these standards are in place. The Government should ensure that all laws and regulations are ef- fectively enforced. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector, the regulatory environment was not prepared to supervise the increasing number of banks and nonbank Chapter 1: Indonesia 49 financial institutions. In the first place, the banking regulatory framework was inadequate in regulating banks’ dealings with affiliated nonfinancial companies. The ownership of banks (including finance companies) by share- holders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. Consequently, most of banks’ NPLs resulted from credit to companies within the same group. The regula- tory framework was also weak in supervising and monitoring foreign trans- actions. When finance companies were used to channel offshore loans in lieu of commercial banks, the Government lost monitoring and control pow- ers over foreign fund flows. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent cir- cumvention of prudential regulations. One way is to set limits on lending activities by banks to affiliated nonfinancial companies, with necessary le- gal sanctions for violations. The Government should also continue strengthening the monitor- ing system for foreign exchange transactions. Banks should be required to provide data on such transactions and charged penalties for noncompli- ance. The tendency of foreign creditors to lend short term is a problem that must be confronted once private capital flows to Indonesia recover. Be- cause foreign creditors are faced with more information asymmetries than domestic creditors, it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. Protecting Creditors’ Rights To protect creditors’ rights, a new bankruptcy law was passed in the after- math of the crisis and a Commercial Court was set up to deal with bank- ruptcy cases. However, the Court has been slow and ineffective in process- ing bankruptcy suits. Further, in contrast to the Republic of Korea and Thai- land, the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. Because these banks are neither easily convinced nor compelled to submit their claims to the juris- diction of Indonesian commercial and bankruptcy courts, it has been diffi- cult to implement standstills, orderly restructuring, recapitalization, and liquidation of corporate assets. With credit being coursed through the domestic banking system rather than directly to numerous local corporations, the Republic of Korea and Thailand were more successful in getting foreign creditors to collec- tively solve their problems during the crisis. This is a significant factor in 50 Corporate Governance and Finance in East Asia, Vol. II explaining the greater depth of the crisis in Indonesia, despite the smaller level of capital inflows (as a percentage of GDP). The Bankruptcy Law should thus be reinforced and creative means should be introduced to avoid a prolonged and costly paralysis of corporate activity and financing. Only when creditors have the confidence that their rights are protected will they resume financing companies. Chapter 1: Indonesia 51 References ADB Programs Department (East). 1996. Indonesia: Sustaining Manufactured Export Growth. Manuscript. Bank Indonesia, Economic and Financial Statistics, various publications. Claessens, Stijn, Simeon Djankov, and Larry H. P. Lang. 1999. Who Controls East Asian Corporations? Financial Economics Unit, Financial Sector Practice Department, World Bank. Conny Tjandra Rahardja. 1995. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. Unpublished thesis MM- UGM, Yogyakarta. Delhaise, P. F. 1998. Asia in Crisis: The Implosion of the Banking and Finance System. John Wiley and Sons. Forest, Jonathan, Michael Krill, and Richard Turtil. 1999. Indonesia: An Emerg- ing Market. Working Paper #58, Center for International Business Education and Research, University of Maryland, Maryland. Indonesian Business Data Centre. 1997. Conglomeration Indonesia: Regenera- tion and Transformation into World Class Corporate Entities. Indonesian Business Data Centre. 1998. The Private Debt Anatomy. Indonesian Central Bureau of Statistics. 1996. Large and Medium Manufacturing Statistics. Institute for Economic and Financial Research. Indonesian Capital Market Di- rectory 1992-1998. Jakarta Stock Exchange. JSX Monthly Statistics, various publications. Keasey, K., and M. Wright. 1997. Corporate Governance: Responsibilities, Risks, and Remuneration. John Wiley and Sons. Embassy of Indonesia. 1995. Economy of Indonesia. Embassy of Indonesia Homepage. Letter of Intent of the Government of Indonesia to the IMF, 14 May 1999. The Economist Intelligence Unit. Indonesia Country Profile, various publica- tions. The Economist Intelligence Unit. Indonesia Country Report, various publica- tions.
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