Conclusions

This study investigates the effects of the 1983 financial reform on the financing and investment behaviour of manufacturing establishments in Indonesia during the period 1981–88. The 1983 financial reform was part of an overall structural adjustment programme such as tax reform and trade reform; hence changes in the behaviour of manufacturing establishments may be attributed to other reforms as well as those in the financial sector. However, the study has tried to approach and identify the effects of the financial reform in many different ways.

The full sample of 2,970 manufacturing establishments has at least three years of positive output. Consequently, by the nature of the data, new entrants to the market after 1985 have been excluded. Clearly, as suggested by the literature, these young establishments are likely to face financial difficulties that have not been captured.

Secondly, the study has calculated descriptive statistics of profitability and financial structure for different categories of firms, both before and after liberalization. Those data suggest that smaller firms benefit disproportionately from enhanced access to external fundings after the reform, despite the increase in interest rates. There is a process of convergence of productivity levels among various categories of establishments, a feature that may suggest increasing economy-wide efficiency.

Thirdly, in order to explore analytically the way in which the financial reform may have affected these changes, an appropriate econometric method — the Generalized Method of Moments — is used to capture the dynamic structure of the model and compensate for the presence of general heteroskedasticity across firms over time. Observations with zero-investment level then had to be eliminated, reducing the sample size to 523 establishments. A full explanation of the econometric restrictions is provided in Chapter 3, section 3. However, the analysis of the differences between including and excluding zero-level investment suggests that the findings will be reinforced if an appropriate method is found to employ the full sample.

Introduction

The discussion in the previous chapter shows that Indonesian manufacturing establishments seem to have different access to credit according to their characteristics. Evidence also exists that the elimination of administered interest rates and credit ceilings has changed previously negative real interest rates to relatively high positive rates. Relying on recent theoretical and empirical studies on the link between financial market imperfections and real activity, this chapter will examine whether the deregulation of the banking system has resulted in any relaxation of financial constraints that firms face in their investment behaviour. In particular, this chapter will analyse whether different types of firms have different financing behaviour before and after the financial reform.

In order to analyse cross-sectional variations in financing and investment behaviour before and after the financial reform, establishment data for the manufacturing sector that are currently available in suitable form for the period 1981–88 only will be used. The 1981–84 period will be referred to as the “prederegulation” period on the assumption that changes instituted late in 1983 had insufficient time to affect real investment decisions until well into 1984, while 1985–88 will be referred to as the “post-deregulation” period. This dichotomization suggests a once-for-all regime shift that considerably exaggerates the reality. Rather, there was a fairly continuous process of deregulation of various aspects of the economy after mid-1983. Furthermore, the response of economic agents to these reforms took place fairly gradually. Nevertheless, for our purposes, the 1983 reforms were extremely significant for increasing levels of real interest rates, and reducing credit controls on individual banks. Dominant state banks were forced to act more autonomously and to base their lending decisions more on commercial criteria than had been the case before the reform.

Review of the Literature on Investment and Financial Constraints

Over the last decade, studies that link financial structure and investment behaviour have been put on firmer theoretical ground, borrowing heavily from the economics of information and incentives.

Introduction

During the 1980s, Indonesia undertook a series of structural reforms in response to its deteriorating economic situation especially in the market for Indonesia's primary export, petroleum products. It was recognized that high economic growth could not be sustained by export earnings alone, and that diversification from oil-related export was needed. The deregulation of the banking system removed control on interest rates and administratively determined credit ceilings were abolished. The devaluation of the rupiah and trade deregulation were part of the programme to stimulate economic growth and improve resource mobilization.

This chapter gives an overview of the Indonesian economy and discusses the process and effects of the financial liberalization. The reform in the financial sector should be examined in the context of the whole economic reform. Macro-economic and financial-sector indicators of 1981–88, which reflect the economic growth, capital accumulation, and financial deepening will be presented, as well as the behaviour of interest rates, and a brief review of the financial system in relation to the industrial policy. There is also an assessment on whether the dramatic switch in the regulatory regime generated any efficiency and growth benefits as predicted by financial repression literature (McKinnon 1973; Shaw 1973).

Macro-Economic Review and Economic Background to Deregulation

Since 1968 Indonesia has been having a high rate of growth, facilitated considerably by high oil prices in the 1970s and early 1980s. As an oil exporter, Indonesia experienced two major booms, in 1974–77 and 1979–82. The period of oil boom, which began with a quadrupling of oil prices in 1973 and continued with high prices until 1982, had profound effects on the Indonesian economy. Table 1.1 shows the growth of its gross domestic product (GDP) since the beginning of 1970. During the first period of the oil boom (1972–81), the average annual change was 8.1 per cent, a very high figure compared with other developing countries.

APPENDIX I: DATA CONSTRUCTION

This appendix describes the procedure used to construct my data set, including the method used to construct annual capital stocks and stocks of debt that are not available in the original survey data.

Data Construction

The data has been taken from the annual surveys on manufacturing establishments conducted by the Central Bureau of Statistics since 1975. An additional data set, which proves to be very useful because it contains data on capital stocks and exports, is the 1986 Census of Manufacturing Establishments. The number of establishments in the annual survey varies from 8,300 establishments in 1975 to around 14,000 in 1988, and the 1986 census has 5,830 establishments with complete capital stock data.

I select a sample of firms from those two sources as follows. As there is no data available on financial sources prior to 1981, a sample period which runs from 1981 to 1988 is used. The 1981–88 survey data include 4,400 firms with complete data for at least three sequential years of output. The census data include 5,430 firms. Merging the 1981–88 survey with the 1986 census set brings the total number of firms to 3,192. I then construct a capital stock estimate by back-casting and forecasting the capital stocks, using the capital stock from the 1986 census data as a benchmark (see below for details). Leaving out establishments that have negative and zero capital stock and outliers, and keeping firms that have at least one year of positive investments, leaves us with 2,970 establishments (data set I). The frequency of each category of firms is given in Table 1 of this appendix. This data set is used to calculate the tables in Chapter 2 and the summary statistics in Chapter 4, section 4.

A very large number of firms report zero investment for many years. I am unable at this time to determine whether reporting of zero investment is in fact a non-response or represents a real observation of very low investment. I run a logit estimation of investment where it takes a value of 1 if investment is positive, and zero otherwise, the results of which are given in Table 2 of this appendix.

Introduction

The issue of whether the shift towards market-based credit policy has helped in directing credit to technically more efficient firms have been investigated in numerous studies. Do financial resources flow to more efficient firms after the removal of administrative controls in the financial market? Other things being equal, do more efficient firms receive more debt after liberalization that affect their capital structure? Is a higher proportion of investment carried out by firms that are more efficient, that is, firms with higher productivity?

This chapter investigates whether financial reform in Indonesia has indeed redirected credit towards more efficient firms, as suggested in financial repression literature. Firm-level efficiency is an interesting tool to compare market-based and government-directed allocation of credit. To explore this issue, an attempt is made to incorporate different measures of efficiency in explaining the distribution of credit and investment, before and after the reform. In particular, taking into account market structure issues, this chapter will explore a physical measure of efficiency derived from different specifications of frontier production functions. Whether a firm's technical efficiency plays a role in the allocation of credit, and whether its role changes before and after liberalization will be tested. It will also investigate whether there are specific characteristics of firms that can be identified as being potentially related to efficiency. The performance of measures of efficiency derived from the production function will also be compared with less structured measures of efficiency.

Literature Overview and the Measurement of Efficiency

How is efficiency measured? There are various concepts of efficiency available in the economic literature. The focus here will be on firm-specific technical efficiency, defined as how close a firm is to the production possibility frontier, given its quantity of capital and labour.

Farrell (1957) develops a method of measuring efficiency and characterizes the ways in which a production unit can be technically and allocatively inefficient.

Is there econometric evidence that liberalization has succeeded in relaxing financial constraints faced by individual establishments? This chapter investigates the issue by estimating a simple form of the investment function for the panel of individual establishments.

Introduction

Our basic theoretical view is that Indonesian manufacturing establishments increase their capital stock through investment in response to potential profitearning opportunities. Desired investment can be financed in a number of ways, the two most important being borrowing from the credit market and retention of cash flow (internal finance). If capital markets are perfect and taxes are absent, firms will be indifferent between various sources of funds. They will finance their investment at a constant marginal cost that is closely related to the risk-free market interest rate, and they will invest until the latter is equated with the expected marginal return to investment. In such a world, only the constant marginal cost of funds and rate of return to investment are important for the investment decision and the former should be closely related to the risk-free market interest rate.

However, even in perfect markets there will be constraints to borrowing because of asymmetric information, monitoring costs, and other factors, which make fixed-interest-rate lenders willing to lend a higher proportion of the costs of proposed investments only at increasing interest in order to compensate for the increased risk. The premium charged will depend on the value of the firm's assets that can be used as collateral. This is referred to in the literature as agency costs. Therefore, a negative association is expected between increasing divergence between average and marginal interest rates for individual borrower firms as the degree of financial leverage increases.

If markets are segmented so that some classes of firms have limited access to borrowing, they will be forced to rely on internally generated funds and may have to forego some desired investment because of financial constraints.