23250 vol. 2 May 2002 , ina cr Marguerite S. Robinson The Microfinance Revolution Volume 2: Lessons from Indonesia © 2002 by the International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, NW, Washington, D.C. 20433 USA All rights reserved Manufactured in the United States of America First printing May 2002 The findings, interpretations, and conclusions expressed in this book are entirely those of the author and should not be attributed in any manner to Open Society Institute or to the World Bank, its affiliated organizations, or members of its Board of Executive Directors or the countries they represent Library of Congress Cataloging-in-Publication Data has been requested Edited, designed, and laid out by Communications Development Incorporated, Washington, D C. and San Francisco, California The Microfinance Revolution Volume 1: Sustainable Finance for the Poor Volume 2: Lessons from Indonesia Volume 3: The Emerging Industry Marguerite S. Robinson The World Bank, Washington, D.C. Open Society Institute, New York Praise for The Microfinance Revolution "This is volume one of three that Dr. Robinson is preparing for World Bank pub- lication. I especially liked three aspects of this tome: it makes a strong case for em- phasizing deposit mobilization in microfinance efforts; it does a thorough job of covering recent literature on this topic; and the discussion is enriched with anthro- pological perspectives that remind us that microfinance clients are complex people. Proponents of the new paradigm of development finance will warm to Robinson's treatment of interest rate policies, deposit mobilization, stress on sustainability, em- phasis on qualhty of services, and the profitability of providing mucrofinance if done correctly... I enjoyed reading volume 1 and look forward to chewing on volumes 2 and 3." -Dale WAdams, Professor ofAgricultural Economics, Emeritus, The Ohio State University; con- sultant in ruralfinance. From a review of volume I posted on Ohio State's online Development Fi- nance Network, 9 September 2001 "If you are looking for a book that can provide a global overview of the current mi- crofinance sector with a historic flavor from both a theoretical and practical perspec- tive, you have one place to go: Marguerite S. Robinson's new book, The Microfinance Revolution. Robinson's vast experiences in Asia and skllls as a financial anthropologist are well combined to provide a gourmet treat to a wide variety of readers including academics, nucrofinance practitioners, consultants, policy makers, and researchers. In short, it is a must read for all stakeholders in mucrofinance." -Geetha Nagarajan, Associate Editor, The MicroBanking Bulletin. From a review of vol- ume 1 in theAsian Development Bank's quarterly newsletter, Focal Point for Microfinance, September 2001, p. 8 "The book examines how the diverse demand for financial services.. .for the poor and low-mcome households and their enterprises .., can be met on a large scale and on a sus- tainable basis. [The author] does this in a stimulatmg manner by drawing from the basics of commercial microfinance. She combines the basics with her insights gained from years of field experience in microfinance and policy advice to polhcymakers in a number of developing countries.The result is a unique study.. .The book is a must for those who need to keep abreast of the changing landscape of microfinance.The readers of this book will, in my view, gain both insight and foresight." -NimalA. Fernando, Lead Rural Finance Specialist,Asian Development Bank " The Microfinance Revolution is a magnificent contribution to the theory and practice of international development. It is a much-needed wake-up call for economists who have long pooh-poohed the potential of microfinance institutions for promoting sav- ings and investment and alleviating poverty. Likewise, it will alert advocates of subsi- dized microfinance that the financial needs of the vast majority of the poor can be met by commercially based microlending." -David E. Bloom, ClarenceJames Gamble Professor of Economics and Demography, Harvard University "Dr. Robinson has written a magnificent work that provides a jolt of energy as well as wise guidance to the fledgling mucrofinance industry. This book will quickly be- come required reading for students and professionals in and around the mucrofinance industry, for donors and government agencies, and for investors.This is also the first book that, through thoughtful analysis, vivid images, and extensive research, wllE beck- on commercial bankers and the rest of the 'real world' to sit up and take interest in mucrofinance. It will thus be a potent force in fusing the small scale, donor-driven mi- crofinance of today with the formal financial systems of tomorrow-systems that will provide high-quality financial services on a permanent and ever increasing scale to mil- lions of poor households around the world." -Elizabeth Littlefield, Chief Executive Officer, Consultative Group to Assist the Poorest; Director, World Bank; andformer Managing Director,JP Morgan "Marguerite Robinson has produced a major work that will unquestionably lie at the very center of microfinance literature for many years to come. Dr. Robinson is umquely qualified, having spent many years living in tiny villages as an anthropolo- gist, seeing informal finance as it happens, and having spent many years advising top policymakers on how to design effective financial services for the poor, most notably in Indonesia with Bank Rakyat Indonesia projects. Her account of the paradigm shift in microfinance is both exhaustively researched and provocative. She has a wonderful ear for stories; her book is full of marvelous phrases, excerpts, and anecdotes from the world of poor people's finance, in addition to being a wellspring of quantitative doc- umentation for the trends about which she writes. Highly recommended!" -Robert Peck Christen, Senior Adviser, Consultative Group to Assist the Poorest;Academic Director, Microfinance Training Program, Naropa University, Boulder, Colorado "The Microfinance Revolution is an ambitious achievement that will be the definitive work on microfinance now and for some time to come. In clear, convincing, and often el- egant language, Marguerite Robinson gives us the fruits of her deep experience and painstaking research.This book provides the most complete statement existing on how mucrofinance arose, how it works, and why it matters. The Microfinance Revolution views mucrofinance from the commercial or financial systems perspective. Robinson sets mi- crofinance in its correct place as one important tool in the 'poverty alleviation tool- box: In so doing she dispels the fuzzy myths surrounding the image of microfinance as a panacea for poverty. Every microfinance professional wlll want a copy of this work as a comprehensive reference for the field. Every polhcymaker or donor will be remuss if he or she makes decisions about microfinance without first internalizing Dr. Robin- son's messages." -Elisabeth Rhyne, Senior Vice President,ACCI6N International;former Director, Office of Mi- aoenterprise Development, US.Agencyfor International Development; author, Mainstreamung Microfinance: How Lending to the Poor Began, Grew and Came of Age in Bolivia Praise for The Microfinance Revolution (continued) "The Microfinance Revolution is a tour de force remarkable both for the breadth of its vision and for the wealth of experience it captures. Dr. Robinson folds page after page of tellng information about real people and their financial behavior, and about real institutions and their achievements, into a vigorously argued-and sometimes con- troversial-synthesis. Anyone interested in financial services for poor people should read it." -Richard Rosenberg, SeniorAdviser, Consultative Group to Assist the Poorest "Marguerite Robinson's book succeeds admirably in presenting and analyzing the fun- damentals of microlending and mobilizing savings among the poor. In distilling the essence of microfinance, Dr. Robinson demonstrates with extraordinary clarity that the application of commercial principles to microfinance ensures the long-lasting ca- pacity of institutions to reach those previously excluded from financial services.This book combines the detailed, painstaking research of a noted scholar with the experi- ences of successful microfinance institutions around the globe, and provides a view of remarkable scope and exceptional weight. Dr. Robinson's work is not only an essen- tial contribution to our current understanding of microfinance, but also a key resource for laying out the future of this field." -Marna Otero, President and Chief Executive Officer, ACCI6N International "If you read Finance at the Frontier, published in 1991,you should read The Microfinance Revolution, published in 2001. If you did not read Finance at the Frontier and you seek an authoritative source about nucrofinance, you should still read The Microfinance Revolution. " -J.D. Von Pischke, President, Frontier Finance International; author, Finance at the Frontier "For more than 20 years Marguerite Robinson has been at the forefront of the 'mucro- finance revolution' she documents so lucidly and persuasively in thds book. She was deeply involved in the transformation and development of Bank Rakyat Indonesia's mi- crobanking (umt desa) system, now the largest mucrofinance mstitution in the world with more than 20 nullion cients.This book brings together the author's wealth of practice- based wisdom and draws on her experience of working with institutions all over the world. It is a valuable, important, and necessary addition to the library of anyone seri- ously interested in microfinance." -Graham A. N Wright, Programme Director, MicroSave-Africa; author, Microfinance Systems "Marguerite Robinson has written a wonderful book. Its declared aim is to make the case for large-scale commercial microfinance, a cause that Dr. Robinson champions with passion, logic, and plentiful examples from her years of experience. But in the process she sheds light on a host of important and contentious issues in microfinance, and the outcome is a work that will enormously enrich the debates it is bound to en- gender." -Stuart Rutheford, Chairman, SafeSave; author, The Poor and Their Money "Hardheaded yet warmhearted, Marguerite Robinson's compendium points a way to- ward including greater numbers in the world's wealth. Based on her sound and wide- ranging field experience, her investigations up and down official ladders, and her wide knowledge of theory in several disciplines, her work is provocative yet immensely prac- tical. Robinson's contribution shows how incentives and efficiency might finally take account of local power structures, human dignity, and reciprocity.The result is just the sort of guide that could help people who deal financially across continents, and across classes, to avoid the ideological excesses of the 20th century in the 21s". It is a remark- able bridging act." -Parker Shipton,Associate Professor ofAnthropology, Boston University; author, Bitter Money "Marguerite Robinson has spent 20 years at the cutting edge of microfinance. In this book Marguerite gives us a history lesson and a guide on how to build commercial finance that fits the needs of the world's poor majority. Policymakers, finance leaders, and anyone who wants to join this revolution in banking must read this book." -Nancy M. Barry, President, Women's World Banking "This book tells a long overdue story-that of commercial microfinance institutions. It highlights the world's most efficient rural microfinance institution, Bank Rakyat In- donesia's microbanking system. Marguerite Robinson provides extensive analysis of the remarkable traits that have made microbanking at BRI an unprecedented success. This program has achleved massive outreach to millions of low-income savers and bor- rowers. All this has been accomplished in the past decade without subsidies; in fact, it is a highly profitable operation. BRI's path-breaking achievements have often been overshadowed by other, overpublicized programs. The Microfinance Revolution is a timely publication that clearly demonstrates the tremendous potential embedded in well-designed microfinance programs." -Jacob Yaron, Senior Rural Finance Adviser, World Bank; author, Successful Rural Finan- cial Institutions "In the past five years the enormous promise of access to capital as an effective tool for the world's poor has erupted into the world's consciousness. But the facts have often come intertwined with myth and legend, until oft-repeated misinformation threat- ens today to debase the accomplishments of truth. In this fog Marguerite Robinson's book, The Microfinance Revolution, arrives as a beacon. In it she combines her exten- sive first-hand experience, gained initially in Asia and then around the world, with the intellectual rigor of the first-rate scholar she also is. The result is a rare, comprehen- sive look at mucrofinance that is long on analysis and short on sound bites. By asking the right questions and seeking the tough answers around the globe, she expands our understanding even though we in the field might from time to time squirm in our seats. In the process she has presented all of us who are seriously committed to the field-practitioners, policymakers, academics, public servants, and most of all, the poor of the world-a wonderful gift of intellect and expertise." -Michael Chu, Chair, Capital Markets; former President and Chief Executive Officer, ACCI6N International;former Chairman of the Board, BancoSol iBRD 31766 THAI ~~~~~~~~INDONESIA ' SELECTED CITIES AND TOWNS OWBO \ > L S IA X > 19 @0 PROVINCE HEADQUARTERS &D , 8 > R X _, t S J L v 2 c , NATIONAL CAPITAL Andaman j ; ex 9tc < < S PHI - - PROVINCE BOUNDARIES --INTERNATIONAL BOUNDARIES ISDI ACEB II JAWA BARAT 22 KAUMAANTANTIMUR That'land ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~2 SUMATERA UTARA 12 JAWA TENGAH 23 SULAWESI UTARA 9 2 D~~~~~~~RAU 13 0I YOGYAKEARTA 24 GORONTALO Sulu RIAUARCHIPEIAGOC 14 JAWA TIMUR 2 SULAWENA Sea ~~~~~~~~~~~5JIAMBI __ - - 1 6 BNALSA TENGGARA IIARAT 2276 SSULAWES TENGIGARA- - 6 3ENGKUW 17 NUSA TENGGARA TIMUR 28 MALUKU UTARA 7 SUMATERA SELATAN is TIMOR 29 MAIUKUJ 8L AMPUNG 19 KAUMANTAN BARAT 30 PAPUJA (IRLAN JAYA) Bando. 9BANGKA BEMNG 20 KAUWAMAN TENGAVi~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~9RAG8,RETTJG 8 ASMIBA TNGS AcehX 10 i'BANT5 | t A Y 5 BRUNEI jf j > /IAEN 21 KAUMANTAN SEIATAN Celebes I.15 8 K/;L1~r'~ - o ,>Ai ^14 Se a . I S PACIFIC OCEAN --mw A} SiB = B23 1 ~~~~~~~~~~~~~~q(r-d I Mono1 ] / 2 ~ ~ ~ APORE ~~ ~22 Mndo / Ni> T. (D AN OCEAN PrnfidA N 4 t 2 '-' - 20, , , , ,, I oRr20 'PaIe '.' s7ebIundoneg cotom opmrPlnkraayo Java Sea Ujung P27anndan,m < D s l @ -7 [ on th^s mop o'o not imply. on /be parf of 7ho WorS Bem p uBanda Ky -3 ocsopM.cc oa a rr 1 6 / FU - ESTIMOR Arazfura Sea "~Gulf of __ _ _ _ _ _ _ __ _ _ _ _ _ _ _ __ _ _ _ _ _ _ _Carpentaria 0 100 200 300 ADDOKm,, flBi -, - prdocod by,1 Il9Rp O8IQ .. Ol g ! The 1 W-rhi &kA S T A I T). b-1n6-o, colo-, dorooooDo, on8d o-y6 mi,,ifonoco 81-,0AU0,,R A L .noIh,, ,oop do -01 !.ply, 80th. pot of Th. Wold Book c,oo, my' jodg-do 00 th. IOQOII01t .O-y wYrwMy,o oo.y .odonn,ro ____________________________________________ 1~~~~~~~~~~~~~~~~~~20' FEBRUARY 2002 This book is dedicated to all those who have led the microfinance revolution around the world. I add a special, personal dedication to those in Indonesia who developed large, financially self-sufficient microfinance institutions. For the first time ir history, they made commercial microbanking available on a large scale to low-income people. Ah Wardhana Sugianto, in memoriam Kamardy Arief I Gusti Made Oka Sri Adnyani Oka About the author Marguerite S. Robinson is a social anthropologist and internationally recognized expert on microfinance. She received her B.A. and Ph.D. from Harvard University and served as professor of anthropology and dean of the College of Arts and Sciences at Brandeis University before jolmng the Harvard Institute for International Development, where she worked from 1978-2000. She has worked extensively in rural areas and among the urban poor in India, Sri Lanka, and Indonesia-where she served for many years as an adviser to the Mimistry of Finance and to Bank Rakyat Indonesia. She has also worked in other Asian countries and in Latin America and Africa, advising governrnents, banks, and donors, and is the author of many papers and books on development and microfmance. Contents Foreword Ira W Lieberman xxi Introduction Ali Wardhana xxv Preface xxxiii Acknowledgments xlv PART 3 COMMERCIAL MICROFINANCE IN INDONESIA 1 Overview 2 Chapter 8 An Introduction to Indonesia 18 The Javanese Wayang Shadow Theater 24 Indonesia's Environment, Demographics, Early History, and Struggle for Independence 25 The Sukarno Era, 1949-67 28 The Soeharto Era, 1967-98 30 The Javanese concept of power 33 Pancasila, the guiding principles of Indonesian government 33 The economy, 1966-96 34 The government, the military, and politics during the Soeharto period 40 Corruption and the growth of the conglomerates 45 Indonesia on its 50th birthday, 1995 46 The Indonesian Crisis and the Resignation of President Soeharto 47 The nature and extent of the crisis 48 xi The roots of the crisis 50 Indonesia in Transition 56 The economy and the financial system, 1998-99 57 Governance and politics, 1998-99 58 President AbdurrahmanWahid, 1999-2001 60 President Megawati Soekarnoputri 71 Democracy and the Messy State 76 Notes 78 Chapter 9 Rural Development and Rural Financial Institutions in Indonesia 82 Geographic and Demographic Diversity 86 Rural Development 88 Varieties of agriculture 88 Cultivation on Java in the early 20th century 89 The green revolution 90 Rural development during the Indonesian crisis 93 Developing Rural Financial Institutions 93 European background 95 The early Indonesian people's banks 96 Bank Perkreditan Rakyat (People's Credit Banks, or BPRs) 98 Rural Finance in the 1980s 99 Government Microfinance Initiatives in the 1990s 102 The 1992 Banking Law and BPRs 102 KUK and commercial banks 104 Levying corporations and wealthy individuals for funds for subsidized credit programs 105 "Left-behind" villages: INPRES Desa Tertinggal 105 Bank Indonesia, government ministries, and rural credit programs 106 Rural Finance in the 1990s 107 Developing the BPRs 109 Six examples of rural financial institutions and programs 115 Rural Financial Institutions in Indonesia in 2000: What Have We Learned? 136 Policies and politics 136 Financial intermediation 137 Rural financial institutions: public and private 138 Learning from experience 138 Stability 139 Notes 139 Chapter 10 Where the Microfinance Revolution Began: Bank Dagang Bali 144 Bank Dagang Bali: Formative Elements 147 Oka family history 147 The Okas as informal commercial lenders 148 Bank Pasar Umum 149 Bank Dagang Bali: Development and Performance, 1970-96 150 xii The Microfinance Revolution: Lessons from Indonesia Customer Relations, Organization, Products, and Services 155 Organization and management 156 Loan products 157 Savings products 157 Lotteries 158 Mobile savings teams 158 Public relations 159 Bank Dagang Bali's Savers 160 Low-income savers 161 Lower-middle- and middle-income savers 162 High-income savers 163 Notes 163 Chapter 11 How to Fail in Financing the Poor: Bank Rakyat Indonesia's Unit Desa System, 1970-83 166 Bank Rakyat Indonesia's History, 1895-1970 172 The Development of the Unit Desa System, 1970-83 175 BIMAS loans to rice farmers 180 Kredit Mini and Kredit Midi loans 184 Deposit mobilization in the unit desa system, 1970-83 186 Losses in the unit desa system, 1970-83 187 Why Did BIMAS Fail? 187 The program's goals were incompatible 188 BIMAS credit was tied to input packets 188 Other agencies selected BIMAS borrowers, but BRI had to collect the loans 189 BIMAS did not reach many poor rice farmers 189 Policies for loan forgiveness and rescheduling during crop failures were badly planned and encouraged corruption 190 BRI did not have the organization, human resources, or motivation to manage unit desas effectively 190 Successful agricultural credit programs require successful agriculture-but insecticides supplied in the BIMAS input packet caused severe crop destruction 191 Examples of BIMAS in Four Rice-growing Environments 194 Village G (East Java): BIMAS results in an ideal rice intensification environment 195 Village C (West Java): Most households benefit from rice intensification, but not necessarily from BIMAS 198 Village R (South Sulawesi): A village with large potential for rice intensification and low participation in BIMAS 200 Village P (South Sumatra):A village where nearly everything that could have been done wrong in BIMAS implementation was done wrong 202 Implications of BIMAS: Results in four villages 205 The End of the BIMAS Era 208 Notes 210 Contents xiii Chapter 12 Success in Microlending: The KUPEDES Credit Program, 1984-96 216 Indonesia's Enabling Conditions 219 Bank Rakyat Indonesia's New Approach to Microlending at the Unit Desas 221 Implementing KUPEDES 221 Microcredit: subsidized and commercial 222 Perception Gaps among Policymakers, Bureaucrats, andVillagers 224 Policymakers 225 Bureaucrats 226 Villagers 228 The Transition from BIMAS to KUPEDES 229 Policy issues 231 Three crucial decisions 232 Cutting back on credit subsidies 233 Starting the KUPEDES credit program 234 Basic Principles of KUPEDES 235 KUPEDES and unit desa reorganization 237 Selecting KUPEDES borrowers 238 Characteristics of the KUPEDES Loan Product 239 Loan purposes 239 Loan sizes 240 Interest rates 240 Loan terms 241 Implementation of the KUPEDES Credit Program 244 From application to collection 244 Measuring and managing delinquency 245 Outreach 246 KUPEDES Performance, 1984-96 252 Outreach and repayment history 254 Geographic coverage 255 Unit desa profitability 256 Notes 258 Chapter 13 Mobilizing Massive Savings: Bank Rakyat Indonesia's Unit Desas, 1984-96 262 Why Did BRI Emphasize Savings in Its Unit Desas? 265 To finance the demand for credit and enable institutional sustainability 265 To limit government risk 267 To encourage rural savings mobilization 267 Developing and Testing the New Savings Program 267 Early field research 268 The planning stage 269 The first SIMPEDES pilot project 270 The second-stage SIMPEDES pilot project 276 Expansion and Market Penetration of the New Savings Program 279 Preparing to expand the savings program,January-March 1986 280 xiv The Microfinance Revolution: Lessons from Indonesia Expanding the savings program to all unit desas, April-September 1986 291 Learning market penetration, 1987-89 293 Unit Desa Savings Products, 1996 296 SIMPEDES and SIMASKOT 297 TABANAS 297 Deposito Berjangka and giro accounts 298 The interest rate structure 298 Cost of funds 299 Lotteries 299 The transfer price 300 Performance in Savings Mobilization, 1984-96 301 Performance by instrument 302 Notes 304 Chapter 14 Institutional Development for Large-Scale Sustainable Microfinance: The Transformation of the Unit Desas, 1984-96 306 Old and New Cultures 309 Restructuring the Unit Desas: The Transition Process 311 From branch windows to profit centers 312 Changes in organization and management 313 Unit desa location 316 Marketing and public relations 319 Learning from mistakes 321 Organization and Management of the Unit Desas, 1996 322 At the head office 323 At the regional offices 327 At the branches 327 At the unit desas 328 At the village posts 331 The unit desa system and other bank divisions 331 Reporting Unit Desa Performance at the Unit, Branch, and Regional Levels 332 The unit development reports of two unit desas 333 The aggregated unit development reports of two branches 335 Unit performance in two regional offices 335 Staff Incentives and Training 337 Incentives 337 Training 339 Retention 342 Bank Rakyat Indonesia: Microfinance Outside the Unit Desa System 343 The Badan Kredit Desa 343 Pembinaan Peningkatan Pendapatan Petani-Nelayan Kecil 347 Microfinance at BRI's branches: comparing the BKDs and P4K 350 Microbanking in a Division of a Multipurpose Commercial Bank: Structural Issues 352 External dangers to sustainable microfinance 354 Contents xv Internal dangers to sustainable microfinance 355 Why Do Structural Issues Matter? 359 Notes 362 Chapter 15 Commercial Microfinance in Indonesia: Stability in Crisis, 1997-98 364 Indonesia's Financial Crisis 369 The collapse of the banking system 373 Bank reforms and corporate debt restructuring 375 Challenges ahead 380 The Stability of Microbanking during the Crisis 382 The Badan Kredit Desa, 1997-98 382 Bank Dagang Bali, 1996-2000 384 BRI's unit desa system, 1996-2000 388 The unit desas at the start of the 21st century 396 Commercial Microfinance in Indonesia:What Has Been Learned? 402 Commercial microfinance can be both economically and socially profitable 403 Stability in crisis 403 Notes 407 Appendix Rupiah-U.S. Dollar Exchange Rates, Consumer Prices, and Performance of Bank Rakyat Indonesia's Unit Desa System, December 1996-December 2000 410 Table of Contents for The Microfinance Revolution, Volume 1: Sustainable Finance for the Poor 414 Glossary and Acronyms 421 Bibliography 433 Index 451 Tables 8.1 Economic indicators for Indonesia, 1996-2000 35 9.1 Outstanding loans in Indonesia's financial system, 1985 100 9.2 Loans and savings in Indonesia's financial system, 1995 108 9.3 BPRs and BRI unit desas: number of units and clients, September 1998 110 9.4 BPRs and BRI unit desas: average loans and deposits, 1997 111 9.5 Loans and savings in five rural financial institutions and the PHBK program 116 9.6 Estimated earnings adjusted for subsidies and bad debt for 34 original BKKs/SK and 3 LKPs of NusaTenggara Barat, 1995 121 9.7 Viability indicators for Bank Shinta Daya and Mitra Karya, 1995 129 xvi The Microfinance Revolution: Lessons from Indonesia 9.8 Estimated subsidy dependence index and required interest rates to cover the program costs of the PHBK program, fiscal 1991-96 135 10.1 Bank Dagang Bali profit and loss statement, 1970-96 151 10.2 Bank Dagang Bali balance sheet, 1970-96 152 10.3 Bank Dagang Bali outstanding loans, 1970-96 152 10.4 Bank Dagang Bali savings, 1970-96 153 10.5 Size distribution of Bank Dagang Bali loans and savings, 1996 154 11.1 Features of BIMAS and Kredit Mini 185 11.2 Household borrowing in three Indonesian villages by source of the largest loan, 1980-81 195 11.3 BIMAS participation in four Indonesian villages, 1980-81 196 11.4 Evaluation of BIMAS in four Indonesian villages 206 12.1 A comparison of BIMAS and KUPEDES 220 12.2 Size distribution of KUPEDES loans at disbursement, 1995 241 12.3 Excerpts from responses to KUPEDES borrower survey, 1996 249 12.4 Number and value of KUPEDES loans, 1984-96 253 12.5 Loss ratios for KUPEDES loans, 1984-96 253 12.6 Geographic distribution of KUPEDES outstanding loans and unit desa deposits, 1996 255 12.7 Unit desa profits and losses, 1984-96 256 13.1 Unit desa savings in the Sukabumi pilot project, 31 October- 31 December 1984 274 13.2 The most important characteristic of SIMPEDES: responses of 144 SIMPEDES savers in the Sukabumi pilot project,January- February 1985 275 13.3 Savings mobilization in the second stage of the SIMPEDES pilot project,June-December 1985 277 13.4 The most important characteristic of SIMPEDES: responses of 76 SIMPEDES savers in the 12 new branches of the second- stage pilot project, September 1985 278 13.5 "Would you still save in SIMPEDES if the annual interest rate were 6 percent?": responses of 74 SIMPEDES savers in the 12 new branches of the second-stage pilot project, September 1985 279 13.6 Annual interest rates for unit desa savings instruments, September 1996 297 13.7 Estimated cost of savings mobilization in the unit desa system, 1996 299 13.8 Value of savings accounts by account type in the unit desas, 1984-96 302 13.9 Number of savings accounts by account type in the unit desas, 1984-96 303 14.1 Employment in the unit desa system by organizational level, 1996 325 14.2 Unit development reports of two unit desas, December 1996 334 14.3 Aggregated unit development reports of two branches, 1995-96 336 Contents xviI 14.4 Performance indicators for the unit desas of two regional offices, 1995-96 337 14.5 Curriculum of training centers for unit desa staff, 1996 340 14.6 Curriculum of training centers for unit desa branch supervisors, 1996 341 14.7 Performance of the Badan Kredit Desa, 1992-96 345 14.8 Indicators of financial self-sustainability for the unit desas, 1985,1990, and 1995 360 15.1 Performance indicators for the Badan Kredit Desa (BKD), 1996 to August 1998 383 15.2 Bank Dagang Bali profit and loss statement, 1996-2000 385 15.3 Bank Dagang Bali balance sheet, 1996-2000 386 15.4 Bank Dagang Bali savings, 1996, 1998, and 2000 387 15.5 Bank Dagang Bali outstanding loans, 1996,1998, and 2000 387 15.6 Unit desa savings and lending, 1996-2000 388 15.7 Unit desa pretax profits and returns on assets, 1996-2000 388 15.8 Value of unit desa savings by account type, 1996-2000 392 15.9 Number of unit desa savings accounts by account type, 1996-2000 392 Figures 11.1 Main reasons for the failure of the BIMAS credit program for rice farmers 170 11.2 Default rates for BIMAS rice cultivation loans, 1970-84 182 11.3 Amount of outstanding BIMAS rice cultivation loans, 1970-84 182 11.4 Number of outstanding BIMAS rice cultivation loans, 1970-84 183 11.5 Area covered under BIMAS rice cultivation loans, 1970-84 183 12.1 The evolution of microcredit at Bank Rakyat Indonesia, 1970-96 223 13.1 The evolution of microsavings in the unit desas, 1984-96 264 14.1 Restructuring unit desa organization and management 310 14.2 Number of unit desas, 1983-96 318 14.3 Bank Rakyat Indonesia's organizational structure, 1996 323 14.4 Government administrative levels and Bank Rakyat Indonesia's organizational levels, 1996 324 14.5 Organizational structure of the Business Unit Desa Division at Bank Rakyat Indonesia's head office, 1996 325 14.6 Orgamzational structure of a unit desa and its supervising branch, 1996 329 15.1 Exchange rates in Indonesia, December 1996-December 2000 371 15.2 Consumer price index in Indonesia, December 1996- December 2000 371 15.3 Value of unit desa loans and savings, December 1996- December 2000 389 15.4 Number of unit desa oustanding loans and savings accounts, December 1996-December 2000 389 15.5 Real value of unit desa loans and savings, 1984-2000 391 xviii The Microfinance Revolution: Lessons from Indonesia Boxes 1 Old and new cultures at Bank Rakyat Indonesia's unit desas 15 8.1 Excerpts from David C. Cole and Betty E Slade's Building a Modern Financial System: The Indonesian Experience 31 8.2 Excerpts from Ali Wardhana's "Overcoming the Current Economic Downturn" 51 8.3 Excerpts from Lloyd R. Kenward's "AssessingVulnerability to Financial Crisis: Evidence from Indonesia" 54 8.4 Excerpts from Thomas L. Friedman's "What a Mess!" 77 9.1 Excerpts from David C. Cole and Betty F. Slade's Building a Modern Financial System: The Indonesian Experience 103 9.2 Excerpts from Camilla Nestor's contribution to Ohio State University's online Development Finance Network, 2 February 1999 107 11.1 Agricultural loans in Java in the 1920s and 1930s: Excerpts from Thomas A. Fruin's The Provisional Manualfor the Credit Business of the General Popular Bank 176 12.1 Basic principles of KUPEDES 236 12.2 The KUPEDES prompt payment incentive 243 12.3 Measures of KUPEDES portfolio quality 247 13.1 Basic principles of unit desa savings mobilization 266 13.2 Excerpts from Bank Rakyat Indonesia's unit desa savings mobilization casebook 281 13.3 Excerpts from Klaus Maurer's "Bank Rakyat Indonesia (BRI) (Case Study)" 301 15.1 Excerps from Mark Baird's "Corporate Restructuring in Indonesia" 370 15.2 Excerpts from Klaus Maurer and Hans Dieter Seibel's "Agricultural Development Bank Reform: The Case of the Unit Banking System of Bank Rakyat Indonesia (BRI)" 376 Map 1 Indonesia viii Contents xix Foreword Occasionally one meets someone with deep expertise in her chosen field. But This seminal work rarely does one meet such a person who can also explain her views with equal ease to both other experts in the field and to other interested parties without prior offers readers a knowledge of the field, such as government policymakers, central bank gover- nors, or even members of the general public. Marguerite Robinson is such a per- richness and depth son, having acquired deep knowledge of microfinance over some 20 years. She has worked primarily in Indonesia, advising the government and helping to cre- on microfinance ate Bank Rakyat Indonesia's unit desa system, one of the world's most successful microfinance programs. But Dr. Robinson has also provided her expertise to pol- that have long icymakers and directors of microfinance institutions in many other countries, in- cluding Bolivia, China, India, Kenya,Tanzania, andVietnam-to name just a few. been needed Dr. Robinson came to microfinance with a rich academic and profession- al background as an anthropologist, having spent many years in villages in India, Indonesia, and Sri Lanka. She describes herself as a financial anthropol- ogist, given her umque credentials to understand both people-particularly poor people in remote villages or urban slums not normally served by financial in- stitutions-and financial markets, and how the two interact. Few people have come to microfinance with such tools of the trade, and Dr. Robinson has honed those tools with long stints in Indonesia and other countries studying, observ- ing, researching, teaching, writing, and practicing microfinance. Now Dr. Robinson has bundled all that knowledge, and the result is a sem- inal work on microfinance that offers readers a richness and depth about the field that have long been needed.This long overdue book, The Microfinance Rev- olution, consists of three volumes.The first focuses on the paradigm shift in mi- xxi crofinance, the second concentrates on microfinance in Indonesia, and the third (written with PeterJ. Fidler) looks at the global experience with microfinance and documents the move to commercially viable microfinance. The niicrofinance field is not short on information.There are scores of case studies on microfinance institutions; technical, financial, and practical guides to the field; and wonderful reports on savings, interest rates, client desertion and delinquency, supervision, audit, appraisal, planning, and management informa- tion systems for microfinance institutions. There are also works on the impact of microfinance on poverty and some selective works on theory. We have all the bits and pieces, but no one has really seamed it all together. No one has provided an overview of how the industry has developed and where it is head- This book contains ed.And no one has provided an overarching theory that supports these views- until now. Marguerite Robinson does all that and more.The third volume, The wonderful anecdotal Emerging Industry, provides a global view on microfinance in developing coun- tries (excluding the transition economies of Central and Eastern Europe and richness supported the former Soviet Union, which Dr. Robinson decided not to cover due to her lack of experience in the region).That volume also explores theory and by a wealth offacts, the evolution of thinking on this subject. This book also contains wonderful anecdotal richness on a variety of mi- figures, tables, notes, crofinance themes: on microfinance institutions, on the voices of microfinance clients, on savings, and on moneylenders, as well as a unique assessment of In- and citations donesia that makes up the second volume, Lessonsfrom Indonesia. This rich anec- dotal material is supported by a wealth of facts, figures, tables, notes, and citations reflecting Dr. Robinson's academic rigor, a rigor that has rarely been brought to this field. The book's detail and richness are spun into a fine web supporting the author's basic thesis-that a fundamental shift is occurring in microfinance, inexorably pushing the industry to focus on commercially viable microfinance.This thesis and a detailed explanation supporting it are the main subject of the first volume, Sus- tainable Financefor the Poor. Only by making this shift, says Dr. Robinson, can mi- crofinance fill the "absurd gap" between the demand for and supply of microfinance services.That gap is huge: at least 80 percent of the 900 million households in low- and lower-middle-income countries do not have access to formal financial services. Most microfinance institutions are nongovernmental organizations (NGOs), often providing an array of social services.They focus on microfinance as a so- cial intervention or a poverty alleviation tool.They see a dilemma between achiev- ing commercial viability and serving the poor. For the most part they are not viable financial institutions and do not mobilize domestic savings or raise com- mercial funds.And they are largely dependent on donors to subsidize their op- erations.Yet the microfinance industry barely scratches the surface of its market potential, and the industry as currently structured cannot meet this need. But increasingly, as spelled out in this book, commercially viable microfi- nance institutions are being established as banks or nonbank financial institu- tions.They operate from a financial systems perspective, and they see microfinance as filling an important niche in the financial system by providing financial xxii The Microfinance Revolution: Lessons from Indonesia services-for profit-to the working poor. The only way to close the absurd gap between demand and supply in microfinance is for microfinance institu- tions to mobilize savings, to raise capital commercially, and to service clients through extensive branch networks.This is increasingly the case in Latin Amer- ica, as illustrated by the book's analysis of Bolivia's BancoSol. It is also true for a few large microfinance institutions in Asia, such as Bangladesh's Association for Social Advancement. Bank Rakyat Indonesia's unit desa system best illus- trates the benefits of long-term adherence to commercial principles of micro- finance, which is why thls case is an important contribution of this book. Let me try to sum up what this work offers to readers: * A detailed overview of the development of microfinance over the past 20 The author's basic years. * A global view of microfinance in the developing world. thesis is that a * A thesis on the future path of microfinance. * A coherent theory about microfinance-why it works when so many other fundamental shift development interventions fail. * Exquisite detail on a number of important microfinance topics-such as in- is occurring in formal moneylending and savings. * An important study of Indonesia, with detailed analysis of Bank Rakyat In- microfinance, donesia. * Brief studies of many other microfinance institutions inAfrica,Asia, and Latin inexorably pushing America. the industry tofocus This book reflects Marguerite Robinson's longstanding experience in mi- crofinance. Readers will quickly understand that Dr. Robinson is one of the few on commercially people with deep knowledge in her chosen field-as well as the ability to con- vey that knowledge simply and clearly to a broad range of interested readers. viable microfinance Ira W Lieberman Former Chief Executive Officer, Consultative Group to Assist the Poorest, 1995-99 Senior Manager,World Bank Foreword xxiii Introduction We in Indonesia have a special, longstanding interest in the emerging microfi- We in Indonesia nance revolution, which has made it possible for large numbers of low-income people to access institutional financial services-often for the first time. Financial have a special, services that are widely available in rural areas and in low-income urban neigh- borhoods help the poor improve their financial security, allow them to take ad- longstanding vantage of business opportunities, and facilitate the growth of their enterprises. In Indonesia sustainable microfinance in the formal sector began in 1970 with interest in the the opening of Bank Dagang Bali (BDB), a private bank in Bali, and attained nationwide coverage with the 1984 restructuring of the unit desa, or local bank- emerging ing, system of the state-owned Bank Rakyat Indonesia (BRI). BRI's umt desa system is now the largest financially self-sufficient provider microfinance of sustainable microfinance in the developing world. Indonesia's approach to mi- crofinance-making it profitable, and so widely available-helped the country revolution reduce the incidence of poverty from about 40 percent of the population in the mid-1970s to about 11 percent in 1996. In 1997, when the East Asian economic crisis began and poverty in Indonesia started to rise, BRI's microfinance system helped poor people who had lost their jobs finance informal sector enterpris- es. It also gave them secure and convenient deposit facilities-especially impor- tant to poor people in times of crisis. Hindsight is, as we all know, a powerful analytical tool. In reviewing the re- structuring of BRI's microbanking system, one can identify a number of com- ponents that might better have been done differently. In the 1970s, for example, BRI opened more than 3,500 village units to channel subsidized governrnent cred- it to rice farmers through BIMAS, the credit component of Indonesia's massive xxv rice intensification program.As it turned out, the rice intensification program was highly successful, but its credit component was not.The long-term results ofBIMAS were similar to those found in many developing countries.The subsidized loans, being at below-market interest rates and so in demand by wealthier farmers, often did not reach poor farmers. Moreover, arrears and losses were high.The program was phased out in 1985. Meanwhile, BRI's unit desa system also tried to mobi- lize savings. However, since the government required that banks lend at 12 per- cent and pay 15 percent on most deposits, there was a negative incentive for the banks to mobilize savings-and the incentive structure worked well! During the 1970s and 1980s rural borrowers who qualified for loans larg- er than those available at the unit desas also had the option of obtaining sub- By the early 1 980s sidized government credit through bank branches in district capitals.The Small Investment Loan Program, known as KIK, and the Small Permanent Working we began to realize Capital Loan Program, known as KMKP, provided loans of up to 15 million rupiah ($36,145 in 1975 and $13,333 in 1985).But these programs also resulted that not only were in high arrears and large losses to both the banks and the government, and were eventually phased out. our subsidized credit By the early 1980s we began to realize that year after year, the subsidies and arrears of BIMAS, KIK, and KMKP were large, the programs were inefficient, programs not driving and the loans generally did not reach the intended borrowers. In brief, our ap- proach to local finance was ineffective and unsustainable. Not only were our rural development, subsidized credit programs not driving rural development, they were actually slowing it down! Having recognized the severe deficiencies of these programs, they were actually we decided in 1983 to begin a new program for rural finance based on prin- ciples of commercial finance. slowing it down! But in 1983, when the Indonesian governmnent began to implement a vari- ety of financial reforms, we did not have good models or examples-or even ap- proximate ones-from other, similarly positioned countries. In many ways Indonesia was a pioneer in implementing financial reforms, and the reform of the unit desa system is a prime example.When we decided to transform it into a commercial microbanking system, we could find no example of a financial institution in any developing country that provided microfinance profitably on a large scale. The development of commercial microbanking in BRI's unit desas can best be understood in the context of the broad set of economic reforms implemented by the Indonesian government. On the whole these reforms reflected a con- sistent intent to achieve three basic objectives: * To move toward a predominantly market-based financial system. * To provide effective protection, as needed, so that the general public could benefit from the services offered by the financial system. * To build a financial system that would support the stable, healthy growth of the national economy. To move effectively toward achieving these aims, in 1983 we began to intro- duce a series of far-reaching finance, tax, trade, and investment reforms. xxvi The Microfinance Revolution: Lessons from Indonesia The oil boom of the mid-1970s through the mid-1980s had been a mixed blessing for Indonesia. One economist, writing about oil-exporting countries, concluded that the boom left most economies no better off than they would have been if oil prices had stayed at 1972 levels in real terms. But unlike most oil exporters, Indonesia capitalized on its windfall oil revenues. Even when we had ample oil revenues, we looked ahead to days when we might not be so for- tunate. A critical element of Indonesia's development strategy has been to stimu- late rural development, rural incomes, and rural employment. Thus in the 1970s a large share of our oil wealth was invested in agriculture-especially ir- rigation and new rice technologies-and in infrastructure, education, and health. Much of this investment was in rural areas, where about 80 percent of A 1983 deregulation the population lived in the mid-1970s.This investment helped ensure that agri- culture and other rural industries would continue to support rural income growth made possible the and create employment-an essential part of the foundation for our econom- ic growth since the mid-1980s. transformation of It is important to understand that this was not "trickle down" growth. Our approach to economic growth incorporates some of the poorest groups in the BRl's unit desa economy. Our food supply, especially rice, depends on the increasing produc- tivity of small farmers-supported by the government's massive rural invest- systemfrom a ment. Our e4ort drive is based on the growth of firms that create jobs for low-skilled workers. Some of the country's largest industries-including con- channeling agentfor struction, transportation, retail trade, and other services-employ large num- bers of unskilled workers, especially in the informal sector.These service sectors targeted, subsidized are quick to respond to rapid growth in other sectors of the economy. As the incomes of poor people rose, their demand for banking services in- government loans to creased.The reform of BRI's microbanking system was undertaken in order to bring about a major increase in the availability of financial services-initially a profitablefinancial for the rural population and later for low-income urban residents as well. De- cisions to provide microbanking services dehvered at the subdistrict level intermediary throughout the country, to pay positive real interest rates for savings, and to charge loan rates sufficient to cover all costs and to earn a reasonable profit for the bank were consistent with our overall reform agenda. Financial reforms were extended to rural areas with the government's first major financial deregulation package, issued in 1983.That deregulation abol- ished credit ceilngs and permitted banks to set their own interest rates on most loans and deposits. This made possible the transformation of BRI's unit desa system from a channeling agent for targeted, subsidized government loans to a profitable financial intermediary providing small loans and deposit services to clients in rural areas throughout Indonesia. In 1989 BRI extended its mi- crobanking services to urban areas as well. When making the decision to reform the unit desas, we asked ourselves three questions. First, would there be local demand for credit at the interest rates need- ed for BRI to cover all its costs and earn a profit? We studied the demand for small loans in different areas and found it to be very large. Poor borrowers were Introduction xxvii paying much higher interest rates to local moneylenders, and it seemed that they would generally welcome the rates that BRI would charge. Second, would people place their savings in BRI's village units? We con- ducted studies in many parts of the country and found huge demand for sav- ings services if the deposit instruments and services were designed to meet the needs of poor savers. Third, with an eye on the government budget, we asked how long it would take for the restructured microbanking system to break even and begin to make a profit. Under the assumptions we used, we predicted that the sys- tem, which began in 1984, would break even in two years-which it did in just under two years. And it has been profitable every year since. The BRI reforms Our approach to reforming BRI was market-based: in BRI's thousands of local mnicrobanking units, performance-based cash awards and other incentives have enjoyed motivate staff to act as bankers. Unit personnel also required tralmng to change their behavior. Most important, unit staff had to learn about the markets they remarkable success. served. Responsibility for loan decisions had to be delegated from branch of- fices to village units, while regional offices had to de-emphasize their control- The system has minded approach and become more oriented toward promotion. In a large, complex institution like BRI, these changes took careful planning and imple- been profitable since mentation.The restructuring of BRI's unit desa system was a major institutional reform-and it succeeded. As a result savers have a secure outlet for their 1986 and without funds, on which they generally earn positive real returns, while borrowers with productive uses for small loans have access to credit on commercial terms. subsidy since 1987 The BRI reforms have enjoyed remarkable success.The umt desa system has a single loan product, KUPEDES, that offers loans of 25,000-25,000,000 rupiah ($3-$3,406 in 1999) for any productive purpose. Most KUPEDES loans carry an effective annual interest rate of about 32 percent if payments are made on time. Savings instruments offer a choice between different combina- tions of liquidity and returns-enabling depositors to combine the products in ways that best meet their needs. Unit desa deposits, a highly stable source of funds, finance all KUPEDES loans.The system has been profitable since 1986 and without subsidy since 1987. Contrary to much international experience with rural finance, KUPEDES has had very high repayment rates. In Indonesia we have found that a less regulat- ed economy, with widespread access to institutional finance at the local level, can open new opportunities to people previously excluded from full partici- pation in the country's economic growth. But in 1997 a severe financial and economic crisis developed that affected all EastAsian economies, fromThailand toJapan and the Republic of Korea. Indonesia's currency fell from 2,450 rupiah per U.S. dollar in June 1997,just before the cri- sis began, to about 17,000 at its weakest point in 1998. The rupiah then recov- ered to levels of 7,000-8,000 in the fourth quarter of 1998.At the end of 1999 there were 7,430 rupiah to the U.S. dollar. Indonesia's average annual inflation for 1998 was 57.6 percent-a sharp contrast to the 1980s, when annual inflation had stayed below 10 percent.,GDP, which had grown by more than 7 percent a year xxviii The Microfinance Revolution: Lessons from Indonesia for over a decade, grewjust 4.9 percent in 1997 and fell 13.7 percent in 1998. But in 1999 inflation dropped to 20.5 percent, while GDP rose to 0.2 percent. The economic meltdown that hit Indonesia-and one can hardly describe it differently-had multiple causes. Some were self-inflicted; others were ex- ternal. Among the external events I would list the sharp decline in the world oil price, a decline in prices for other primary product exports, and a serious drought in 1997. But to explain the severity of Indonesia's economic crisis rel- ative to that of our neighbors, we have to look at internal weaknesses. Let me highlight two. First, our financial institutions were encouraged to fund risky, unprofitable ventures. Government officials could and did direct loans to favored firms and activities. Loans were rarely subjected to even the most rudimentary econom- ic and financial analysis. Second, the involvement of well-connected parties in The economic many economuc activities led to a problem of moral hazard: in the presence of a perceived guarantee, implicit or explicit, there is little incentive to avoid risky meltdown that hit behavior. In addition, actions by the government and the central bank suggested that Indonesian banks would be protected from failure. Our foreign exchange Indonesia in regime also encouraged risky behavior that, after the depreciation of the ru- piah, resulted in unmanageable debt that effectively bankrupted a substantial 1997-and one can portion of our corporations. At this writing more than two years have passed since Indonesia's crisis began. hardly describe it While it may be too optimistic to say that the crisis has passed, much has been accomplished, and there is general consensus on what needs to be done to get dfferently-had our economy back on track.With assistance from the International Monetary Fund,World Bank,Asian Development Bank, and others, an economic reform multiple causes. Some program was introduced in 1998. Structural reforms are under way. Safety net policies to protect the poor have been given high priority.The weaknesses in were self-inflicted; the financial system have been clearly identified, a bank restructuring program is in process, and the legal and supervisory framework for the banking sector others were external is being strengthened. Emphasis is being placed on making our capital markets more transparent and better regulated. Many other reforms are also in process. Numerous policy measures must still be implemented, but my prediction is that the crisis will pass and growth will resume. In the 1980s and 1990s the rapidly growing Asian economies created a base of human and physical infra- structure, and that base remains intact. It is on this base that we will eventual- ly be able to resume rapid growth. While it has been important to identify our weaknesses in order to rebuild the Indonesian economy, it is also important to identify the institutions that remained strong throughout the crisis and to understand the reasons for their strength and stability. One of those institutions is related to the subject of this book: commercial, sustainable microfinance. In sharp contrast to the Indonesian banking sector generally, commercial microbanking at BRI's unit desa system continued its wide outreach, high re- payment rate, and profitability throughout 1997-99.The system remained sta- ble and profitable throughout the crisis. Deposits in the umt desas more than Introduction XXix doubled in rupiah terms, from 7.7 trillion rupiah ($3.2 billion) in June 1997 (the month before the crisis began) to 17.1 trillion rupiah ($2.3 billion) at the end of 1999. The number of savings accounts increased from 17.0 million in June 1997 to 24.2 million at the end of 1999. KUPEDES lending has remained stable. In June 1997 there was 4.3 tril- lion rupiah outstanding ($1.75 billion) in 2.5 million KUPEDES loans. By the end of 1999 the outstanding loan balance was 6.0 trillion rupiah ($802 mil- lion) in 2.5 million loans. The repayment rate, 98 percent in June 1997, was also 98 percent in December 1999. In 1998, the worst year for the Indonesian economy in the past three decades, pretax unit desa profits were 714 billion rupiah ($89 mlllion), while the pretax return on assets for the unit desa system In sharp contrast to was 4.9 percent. In 1999 pretax profits were 1.2 trillion rupiah ($160 million) and the pretax return on assets was 6.1 percent. the Indonesian BRI's microbanking system emphasizes understanding local markets and meeting the demand for financial services from low-income households and banking sector enterprises. It provides products and services designed to be appropriate for this market segment.We now know that the unit desas are so robust that they have generally, commercial withstood an extraordinary national economic and financial crisis.This strength in microbanking has helped to mitigate the effects of the crisis on the poor and microbanking at to improve the foundations for future economic development. The creation of BRI's unit desa system cannot be separated from Dr. Mar- BRI continued its guerite S. Robinson. She actively participated in developing the unit desas into what is now a strong, viable microbanking system that provides finan- wide outreach, high cial services to low-income people in rural and urban areas throughout In- donesia. To ensure that the system would function effectively for local repayment rate, and communities-consisting largely of small farmers and microentrepreneurs- Dr. Robinson visited many unit desas and the villages they served. She co- profitability ordinated research teams that surveyed the income flows and savings habits of local people, studied their need for capital and their demand for financial throughout the crisis services, and assessed opportunities for investment in the community.The stud- ies covered villages in Java, Sumatra, Kalimantan, Sulawesi, and other Indonesian islands, and resulted in ongoing recommendations to the Ministry of Finance and the BRI about unit desa instruments and services that would be appro- priate for local demand. When decisions were made to add new savings and loan products and ser- vices in the umt desa system, to open new units, or to expand unit desa oper- ations to urban neighborhoods, Dr. Robinson advised BRI, assisting with staff training and advising on the management and supervision of unit operations. She has often returned to the units to learn whether they function properly and to advise BRI on the development of its microbanking system. BRI's unit desa system has made great progress since 1984, rapidly becoming a financial institution capable of contributing to rural development and rural employment. It has also expanded to serve low-income urban areas.At the same time, the unit desas have a considerable way to go-and like many newly de- veloped financial institutions, they face problems of institutional development. xxX The Microfinance Revolution: Lessons from Indonesia Dr. Robinson deserves credit for her active role in creating the unit desas, not only at the initial stages of their restructuring but also during the entire period of their subsequent development. This book reflects her deep insight and thorough knowledge of BRI's unit desas. During the 1990s BRI's unit desa system received nearly 1,000 interna- tional visitors from more than 30 countries.The bank has had to create a sep- arate office to serve the many international visitors to the unit desas.A number of the visitors have also visited Bank Dagang Bali, well-known as the earliest bank to institute commercial microfinance, as well as some of Indonesia's other financial institutions that provide services at the village level on a commercial basis, such as the Badan Kredit Desas (Village Credit Organizations) ofJava and Madura. We are especially Many developing countries in Asia, Africa, and Latin America are at dif- ferent stages of learning about and implementing institutional commercial mi- pleased that our crofinance. This book documents Indonesia's experience with sustainable microfinance, explores the spread of commercial financial services to low-in- approach to sustainable come people in other countries, and analyzes the ideas that underlie both. Indonesia, which has played a leading role in the Non-Aligned Movement, microbanking is usefui is active in transferring technology and sharing experiences that lead to eco- nomic growth, equity, and stability in the developing world.We are especially for other developing pleased that our approach to sustainable microbanking-which has provided poor people in Indonesia with new opportunities for economic growth and countries financial security-is useful for the development of microfinance in other de- veloping countries. Ali Wardhana Minister of Finance, Government of Indonesia, 1968-83 Coordinating Minister for Economics, Finance, and Industry, Government of Indonesia, 1983-88 Economic Adviser, Government of Indonesia, 1988- Introduction xxxi Preface When I began life as a social anthropologist in the 1960s, carrying out field work Over the years I in remote areas of developing countries in Asia, outsiders rarely visited the vil- lages where I lived. Those who did come, other than the occasional scientist, noticed that the were missionaries of various religions. Over the years I noticed that the few out- siders I encountered in the field were increasingly less likely to be missionar- few outsiders I ies-and more likely to be bankers.This gradual change was my first introduction to the then-embryonic microfinance revolution. encountered in The bankers who began showing up in small villages on their bicycles, mo- torcycles, or jeeps in the 1960s and 1970s were usually employees of local villages were less branches of state-owned banks.They came along with the green revolution.Their mission, as assigned by their governments and assorted international donors, was likely to be to find trustworthy villagers to whom they could provide credit. This, it was thought, would both help feed the population and increase rural economic growth. missionaries-and The bankers and the missionaries, who shared much of the same client pool, were curiously alike in some ways. Usually outsiders to the local community, both more likely to be tended to discover m the vlllages their own preconceptions, rather than the local realities and dynamics (a problem to which, of course, anthropologists are not im- bankers mune!). But many cared about helpmg poor people increase their incomes and improve thelr lives, and some were quite successful.They came with powerful ideas, found others already present, and often became catalysts for the cross-fertilization of thought and sometimes for the introduction of social and economic reforms. I watched from villages in different countries and continents as, over the decades, the balance switched from outsiders bringmg religion to outsiders bring- ing finance. Of course, those who lived in the villages already had both. As an xxxiii world began to develop commercial microfinance programs.Though the pro- grams differed, the underlying principles were similar. Gradually, a paradigm shift took place-from the delivery of government- or donor-subsidized credit to the development of sustainable financial intermediaries that capture local sav- ings, access commercial finance, and lend these funds to low-income borrow- ers at interest rates that enable full cost recovery and institutional self-sufficiency. The microfinance revolution developed in the 1980s (before it had a name) and came of age in the 1990s. It occurred when the many advances of previ- ous decades in market knowledge, lending methods, and savings mobilization were combined with a commercial approach to financial intermediation for low- income people, making financially sustainable formal sector microfinance pos- Gradually, a paradigm sible.This breakthrough-which also required the development of organizational structures and management resources capable of delivering microfinance ser- shift took place- vices profitably throughout an entire country-first occurred in Indonesia in the 1980s and then in Bolivia in the mid-1990s. from the delivery of Commercial microfinance is now found in many countries, where it is at different stages of development. In its most advanced form, in banks and other government- or donor- formal financial institutions, all microloans are fully financed by savings, com- mercial debt, for-profit investment, and retained earnings (in a variety of forms subsidized credit to the and combinations).As a result all savers and all creditworthy borrowers can be served, repeat borrowers can be accommodated as they expand their enterprises development of and qualify for larger loans, and many economically active poor people can be helped out of poverty. Industry standards for commercial microfinance began sustainable financial to develop in the 1990s.And in some countries intense competition has erupt- ed among commercial financial mstitutions aiming to attract the business of poor intermediaries clients. Nevertheless, in most developing countries the formal financial sector still does not serve microfinance cients.The traditional view-that it is neither im- portant nor profitable for institutions to provide commercial financial services to low-income people is still widely held.The microfinance revolution is still emerging. But it is probably irreversible: because there is massive unmet de- mand for microfinance, because it has been proven that this demand can be met profitably on a large scale, and because information about the profitability of financing the economically active poor has begun to be widely disseminated. Microfinance in the developed world is beyond the scope of this book. But many low-income people in industrial countries lack access to financial ser- vices, also with pervasive negative effects on society and the economy. Rich countries could learn many lessons on sustainable microfinance from developing countries. A number of people have asked whether, because this book is in three vol- umes, it is intended to be a reference book.While to some extent it can be used for reference, the book was not written primarily for that purpose. Rather, it is an analytical narrative on why and how capital is becoming democratized on a global scale for the first time in history. The reason the book is in three volumes is that it concerns a major revolution of our times. XXXVi The Microfinance Revolution: Lessons from Indonesia A reader who wants to learn about a particular microfinance institution- such as Bangladesh's Association for Social Advancement, Bolivia's BancoSol, or Mexico's Compartamos-can find these institutions in the indexes of these volumes and read about them. But the approach is not encyclopedic. The aim is not a comprehensive sunmmary of the institution, but an emphasis on its con- tributions (and in some cases lack thereof) to the microfinance revolution. Finance for the poor is a topic on which many opinions are held, usually passionately. This book wllU undoubtedly be controversial, as is intended. But microfinance is unusual.As in any emerging industry, debates are endemic. But in mucrofinance these debates are among people who work every day to in- crease the employment opportunities, incomes, and self-confidence of the poor.These are debates among good people. In presenting new data and analy- Financefor the poor ses and in reexamining long-held assumptions and conclusions, this book aims at stimulating constructive dialogue-in ways that will help financial institu- is a topic on which tions meet the demand for microfinance sustainably and soon. many opinions are What Is an Anthropologist Doing in Banking? held, usually During my first decade as an anthropologist, I conducted the kinds of research passionately. This I was taught at Harvard and Cambridge universities: studying the people of dif- ferent societies and recording, comparing, analyzing, writing, and teaching book will about their cultures and social structures.While the education I received was well suited for its multiple purposes, there was little in it to prepare me for the undoubtedly be fact that most of the people I would study would be poor-and in some cases starving, abused, and in bonded servitude. controversial, as is As part of extended field work in a very underdeveloped rural area in India, I had long conversations with many bonded laborers, members of "un- intended touchable" castes, and others among the desperately poor and disenfranchised. Once after a long discussion, I rose to leave a small group from whom I had been learning about their social and economic activities and their political environment.We had been sitting on the mud floor of a small, crowded, win- dowless house that provided only minimal protection from the driving rain of the monsoon. One of the men with whom I had been talking said to me,"We are pleased that you are interested in us, that you visit our houses, and that you sit and talk with us.We try to tell you whatever you want to know. But we would like to ask you a question.There is something that we cannot understand.We are sit- ting here in the mud because this is all that we have. Can you not see that we are cold and wet, and that we are poor and have nothing? But you are edu- cated and wealthy.Why do you want only to sit here and learn about our cus- toms? Why do you not also use your knowledge and resources to help us to have better lives and to improve our customs?" He was right. Since then, while continuing my anthropological research, I have worked on the social and economic development of the poor people in Preface XXXvii the societies I try to understand. Since 1979 I have worked simultaneously as an anthropologist and as a policy adviser to governments and financial institutions. As an anthropologist working on microfinance, I analyze local markets and their wider networks, the economic activities of their participants, and the na- ture and extent of the demand for financial services. My knowledge of local fi- nancial markets comes largely from those who participate in them: people of varying ages and both genders employed in a variety of occupations, from dif- ferent social, economic, religious, and political backgrounds. My anthropolog- ical training stands me in good stead here. I try to learn from whom, and at what cost, they obtain credit; how their credit options are linked with transactions in other markets; in what forms and for what purposes they save; and what they This bookfocuses like and dislike about their current methods of borrowing and saving. In the process it becomes possible to learn how informal credit markets, on how the demand government interventions, and bank programs work at the local level.The vest- ed interests that might oppose the development of institutional commercial nui- for microfinance crofinance in particular regions can be identified, and attention can be given to how such interests can be challenged, circumvented, or co-opted. It then be- can be met on comes feasible to design financial instruments and services appropriate for the social, political, and economic environment in general, and for the varied types a global scale of local demand in particular. As a policy adviser on microfinance, my role has been to learn the country's policy goals and its constraints, to provide infor- mation to decisionmakers about their country's microfinance demand and its relevance to development more broadly, and to suggest strategies to achieve pol- icy objectives, drawing on lessons from the country's financial markets and from international best practices in commercial microfinance. Plan of the Book This book focuses on how the demand for mucrofinance can be met on a glob- al scale. It documents the contributions of institutions and of people who have led the development of commercial finance for the poor, and it analyzes the principles on which the microfinance revolution is based.The book's intend- ed audience is diverse, including those with interests directly related to micro- finance, such as policymakers and other government officials, microfinance practitioners, social scientists, economists, bankers, and donors; those with more general interests in social and economic development and in the fundamen- tals of poverty reduction; and those drawn to difficult problems that can be solved only through an interdisciplnary approach. But this book is limited in a number of ways. Among these, no attempt is made to cover all the many types of financial institutions that provide some form of finance to the poor; emphasis is placed instead on the lessons from leading commercial nucrofinance providers. Second, it was not possible to cover all re- gions. For example, Eastern Europe, which has seen important growth in mi- crofinance since the breakup of the Soviet Union, is largely omitted from the xxxviii The Microfinance Revolution: Lessons from Indonesia discussion here. My impression is that microfinance in former centrally planned econouies is somewhat different from mucrofinance in most developing coun- tries, but I am not knowledgeable enough about transition economies to in- clude them in the discussion.Third, this is not a "how to" book for microfinance institutions on specifics such as operations, business planning, or financial analy- sis-though aspects of these topics are discussed, and references are provided to excellent sources on these subjects. Fourth, important as the topic is for poverty reduction and human rights, this book does not focus on gender issues. Many microcredit institutions have tar- geted poor women as clients and, as demonstrated in chapter 3 and elsewhere in the book, there is litde doubt that this approach has helped women and their fam- ilies increase their incomes and self-confidence. But this book is about large-scale Thefirst volume sustainable microfinance for all economically active poor people, women and men. Fifth, except for what clients of microfinance institutions tell us in their own considers the shift words, this book does not focus on the impact of microfinance on clients' house- holds or enterprises. Money is fungible, and the use of small loans and savings from subsidized is difficult to track accurately. Most impact studies on microfinance have deep methodological flaws, although breakthroughs are beginning and better knowl- microcredit to edge of the impact of financial services on the lives of the poor can be expected in coming decades. commercial Finally, except in the second volume-which provides extensive discussion on the development of microbanking in Indonesia-it has not been possible microfinance to provide the historical, macroeconomic, political, legal, and regulatory back- grounds for the development of microfinance institutions in the many coun- tries discussed. Because of these and other areas not discussed or covered in only a limit- ed way, I have called attention throughout the book to relevant works by mi- crofinance practitioners, bankers, financial analysts, economists, and others that will be helpful to readers pursumg in more depth specific components and analy- ses of the growing microfinance industry. Despite the book's omissions, I be- lieve it tells a critical story-one that is little known outside the microfinance industry.Writing this book brought to mind Charles Kindleberger's statement, "My thesis does not rest on small differences in quantities-or so I believe" (Kindleberger 1996 [1978], p. 5). There are difficulties in writing about a revolution in process. New ideas and practices spawn others. Realities change.Thus the emphasis here is on the principles and processes of the microfinance revolution. This book will soon be outdated as a current description of the state of microfinance-but not, it is hoped, as an analysis of the development and meaning of the microfinance revolution. The first volume: sustainable finance for the poor The book's first volume, which considers the shift from subsidized microcre- dit to commercial microfinance, has two parts. Part 1 (chapters 1-3),"The Par- adigm Shift in Microfinance," explores the reasons for the massive gap between Preface xxxix the low level of commercial microfinance generally available from financial in- stitutions and the extensive worldwide demand for such services among the poor. Chapter 1 explores the differences between the poverty lending approach to finance for the poor and the financial systems approach.The poverty lend- ing approach emphasizes lending to the poorest of the poor, while the finan- cial systems approach focuses on lending to the creditworthy among the economically active poor-people with the ability to use small loans and the willingness to repay them-and on voluntary savings mobilization. In this context a poverty alleviation toolbox is introduced. The tools in- clude food, employment, financial services, education, health care, infrastruc- Large-scale outreach ture, and the like. Credit is a powerful tool that is used effectively when it is made available to the creditworthy among the economically active poor. But is shown to depend other tools are required for the extremely poor, who have prior needs such as food, shelter, medicine, training, and employment. on institutional The focus then turns to the recent shift in microfinance from government- and donor-subsidized credit delivery programs to financially self-sufficient in- seif-sufficiencyfor stitutions providing commercial nucrofinance. The link between institutional self-sufficiency and large-scale outreach to low-income clients is examined; large- long-term viability scale outreach is shown to depend on institutional self-sufficiency for long-term viability. Chapter 2 introduces the emerging paradigm shift, considers how and why it is occurring, and discusses the implications of sustainable microfinance for social and economic development. In chapter 3 the focus shifts from insti- tutions to clients. Clients of microfinance programs in different countries pro- vide their views on the role that financial services have played in their economic activities, income growth, and household development.The voices of these clients show that microfinance helps them expand and diversify their enterprises, in- crease their incomes, raise their living standards and those of their families, and gain self-confidence. Their statements indicate strong underlying commonal- ities in microfinance demand across countries, economies, and institutions. Part 2 (chapters 4-7), "Theories of Local Finance: A Critique," reviews the theoretical background of microfinance. Four main streams of literature are analyzed. Chapter 4 considers supply-leading finance theory, its resulting subsidized credit programs, and the criticisms of this approach that have filled the literature for more than 20 years. Chapter 5 examines the imper- fect information paradigm and considers asymmetric information and moral hazard as these concepts have been applied to rural credit markets. The lit- erature on informal commercial credit markets and market interlinkages is reviewed in chapter 6, while that on the role of savings in microfinance is explored in chapter 7. These chapters share a common thread. They examine a variety of theo- ries and models that, when applied to microfinance markets, have impeded the development of formal sector commercial microfinance. The theorists' inten- tions were not to create obstacles to financing the poor, but that was often the xl The Microfinance Revolution: Lessons from Indonesia result.The theories are contrasted with the ways real microfinance markets work, and suggestions are offered for improving the theoretical framework for microfinance. The second volume: lessons from Indonesia Indonesia's exceptional accomplishments in microfinance are documented and analyzed in volume 2, which forms part 3 of the book ("The Indonesian Ex- perience," chapters 8-15). In one sense the Indonesian experience takes up a disproportionate amount of space in this book, partly because it is the exam- ple that I know best. But the choice of Indonesia for detailed examination, and particularly the long case study of Bank Rakyat Indonesia's (BRI's) mi- crobanking system, can be justified on other grounds. The second volume Indonesia is home to what is, to the best of my knowledge, the world's old- est commercial microfinance institution-the Badan Kredit Desas (BKDs), which documents and began in 1896. It is also home to Bank Dagang Bali (BDB), a private bank that opened in 1970 and is thought to be the world's oldest licensed, full-service analyzes Indonesias commercial bank providing continuous, profitable microfinance services on a substantial scale. And it is home to the world's largest fully self-sufficient mi- exceptional crofinance system: the microbanking division of BRI, which has operated profitably on a nationwide scale, without subsidy, since 1987. accomplishments In addition, it was possible to discuss here only one institution at consid- erable length and detail, and BRI's microbanking system is much less well known in microfinance internationally than some microfinance institutions in other countries that have been written about extensively. Emphasis is placed on the reasons the microfinance revolution emerged on a large scale in Indonesia, on the ways this occurred, and on the lessons for other countries. Chapters 8 and 9 present material on Indonesia's history, economy, and society (chapter 8) and on its rural development and rural financial mar- kets (chapter 9).These chapters provide the background for understanding why commercial microfinance developed in Indonesia nationwide, turning on its head the conventional wisdom of the time. Chapter 10 examines the history and performance of BDB. Chapters 11-15 document and analyze the remarkable restructuring of BRI's nation- wide local banking system from a government-subsidized credit program with high arrears and substantial losses during 1970-83 to a profitable, unsubsidized microbanking system beginning in 1984. The Indonesian section of the book, which was first written in early 1997, provides detailed material through 1996. It documents and analyzes the histo- ry of Indonesia's commercial microbanking over more than 25 years, a period when the country achieved unprecedented economic growth and massive so- cial and economic development. But in mid-1997 Indonesia was hit by its biggest economic, financial, and political crisis in three decades. The crisis that began in mid-1997 affected Southeast Asia and some East Asian countries, causing steep currency devaluations, plunging stocks, widespread bank failures and corpo- rate bankruptcies, loss of foreign investment, rising inflation, growing unem- Preface xli ployment, and increasing poverty throughout much of the region. For reasons discussed in chapter 8, Indonesia was hit hardest by the crisis. Given both the deadlines for this book and the importance of the post-1996 Indonesian material, certain compromises were adopted in writing part 3. Chapter 8 was revised to provide an introduction to Indonesia through 2000, and chapter 9 was updated with post-1996 material on rural finance. Chapters 10-14 analyze microbanking in Indonesia through 1996. But chapter 15, which concludes part 3, updates the microbanking material through 2000 and compares the 2000 results with those of 1996. Nearly everyone in Indonesia was affected by the crisis. Despite massive ef- forts by the government-aided by international agencies-to provide food, em- The Indonesian crisis ployment, and social safety nets, many low-income households faced very difficult times. Their purchasing power shrank substantially, many workers were laid off offers some basic as businesses closed or were retrenched, bank savings declined sharply in value, and some who had emerged from poverty slipped back under the poverty line. lessons about the Of crucial importance for this book is that as all this occurred and while the country's financial system collapsed, Indonesia's commercial microbanks re- extraordinary stability mained stable.They continued to serve mnllions of low-income households with- out any major interruption. In general these institutions saw the amount of rupiah that sustainable savings and the number of savings accounts increase considerably, loans held steady, repayments continued to be high, and the microbanks remained profitable. microfinance Thus the Indonesian crisis offers some basic lessons about the importance of microfinance to low-income households, and about the extraordinary sta- institutions can bility that sustainable microfinance institutions can maintain in a highly un- stable environment.Thus part 3 demonstrates how BRI's microbanking system maintain in a highly was transformed from a loss-making rural credit program to the world's largest sustainable microfinance system-and how it has continued to attain profitability unstable environment and wide outreach through good times and bad. The third volume: the emerging industry The book's third volume, in two parts, analyzes the emerging microfinance in- dustry, suggests a microfinance model for 2025, and discusses policy issues likely to be important for the microfinance industry over the next 25 years. Part 4,"Microfinance in Developing Countries:A GlobalView" (chapters 16-20), written with PeterJ. Fidler, analyzes the history and performance of selected institutions that have played key roles in the microfinance revolution- village banks, credit unions and cooperatives, NGOs, banks created by NGOs, commercial banks, central banks and bank superintendencies, microfinance net- works, international organizations and donors, and others. Its focus is on the creation and rapid spread of underlying principles and best practices of the new paradigm in varied institutional and country contexts in Asia, Latin America, and Africa, and on the further dissemination of these principles and practices. The microfinance revolution can be said to have reached a region when competitive institutions in the formal financial sector provide appropriately de- signed small loans and savings services (and in some cases other products as well), xiii The Microfinance Revolution: Lessons from Indonesia serve low-income clients efficiently, and price their products to cover all costs and risks-and when together these institutions provide financial services to a large share of the country's low-income households and enterprises. Chapter 16 offers a brief introduction to the history of microfinance as it developed in multiple regions.The contributions to miicrofinance made by non- bank financial mstitutions such as village banks, credit unions, and cooperatives- as well as the limitations of most of these institutions-are the focus of chapter 17. NGOs, along with regulated financial funds and companies (some of which are recent creations of NGOs that decided to expand microfinance outreach), are considered in chapter 18.The role of banks in microfinance is discussed in chapter 19, which highlights both the historical reluctance of most banks to enter microfinance and their growing interest in the market today. A few banks The third volume are selected for detailed discussion because of their special relevance for the de- velopment of the microfinance industry. analyzes the Chapter 20 explores the roles played in the development of commercial nii- crofinance by governments and international organizations, including inter- emerging microfinance national NGOs, foundations, networks, and donors. Emphasis is placed on three kinds of microfinance activities: information dissemination, banking laws and industry and suggests regulation and supervision of institutions providing microfinance, and capaci- ty-building initiatives that concentrate on tools, training of managers and staff, a microfinance model and institutional development.This chapter also focuses on the crucial partnerships being forged between governments and many kinds of organizations.Thus the for 2025 discussion concerns the roles played in microfinance by central banks, a donor consortium, multilateral and bilateral donors, an equity fund, an NGO, a non- profit charitable organization, a private microfinance rating company, a prac- titioner network, a training program, and an Internet list. Part 5, "The Twenty-first Century: Democratizing Capital" (chapters 21-22), analyzes the status of the microfinance revolution at the turn of the century and projects advances in the democratization of capital by 2025. A new model of institutional commercial microfinance is developed in chap- ter 21. Unlike earlier models also analyzed there, the commercial microfinance model assumes an arena in which competing formal sector institutions act as intermediaries, providing commercial loans and savings services to the eco- nomically active poor. In this model profitable microfinance institutions that are publicly regulated and supervised hold a sizable share of the microcredit mar- ket and a large share of the microsavings market. Organizational structures are streamlined for efficiency. Loan sizes are limited but savings, in any amount over a tiny minimum, are collected from the public-providing ample funding for loans and making savings mobilization cost-effective. Depending on the insti- tution, loan portfolios are also financed by commercial debt and investment. The model emphasizes horizontal links between formal and informal sectors in the same locality, as well as vertical links between local financial markets and actors in regional, national, and international arenas. The chapter ends with some thoughts on the microfinance industry in 2025. It projects a rapid advance in the market share of microcredit provided by reg- Preface xiiii ulated formal institutions, along with a substantial declne in the market share of informal moneylenders.This shift implies a much larger number of formal sector borrowers in 2025 relative to 2001, but not necessarily a major decrease in the number of moneylenders or their clients. As commercial miicrofinance develops into a competitive industry with funds to finance loans coming from capital markets, investments, and savings, the formal sector will lend more funds to far more microfinance clients.A substantial increase in the market share of nmcrosavings is also envisaged for formal sector mncrofinance institutions. The book concludes, in chapter 22, with a dliscussion of policy issues that are likely to be crucial for microfinance over the next 25 years.The focus is on the kinds of policy decisions that will probably engage governments, banks, non- "The bank is not bank financial institutions, donors, and others.The policy choices for the var- ious players are explored. a king, the bank There are many routes to large-scale, sustainable microfinance. Banks may enter the market. NGOs may become regulated, for-profit institutions.Village is a servant." banks may become linked with formal sector financial institutions. And some credit unions and cooperatives may decide to focus on niicrofinance. But the -A customer of focus here is on the basics that underlie the microfinance revolution and are common to all large-scale, profitable microfinance mstitutions.A macroeconomic Indonesia 's Bank and policy environment that permuts commercial financing and pricing enables institutional profitability and self-sufficiency. Institutional sustainability allows Dagang Bali financial services to be made widely available to the economically active poor over the long term. Profitablity engenders competition, which increases effi- ciency-improving the services available to low-income clients and lowering the costs they pay for them. What does all this mean for the poor people who become clients of these institutions? This is best explained by the clients themselves.A customer of In- donesia's Bank Dagang Bali for more than 20 years put it this way: I grew up poor and without education. I learned, though, that I could improve myself, and that the bank would help me. The president of Bank Dagang Bali is a great man.Why do I say that? Not because he is a bank president; there are many bank presidents. Because he knew that poor people fear banks, and he taught us not to be afraid. BDB taught us something important that we never knew before. BDB taught us that the bank is not a king, the bank is a servant. xliv The Microfinance Revolution: Lessons from Indonesia Acknowledgments During the years that I have been learning about microfinance, I have become greatly indebted to many people.This book draws on the help, insights, and guid- ance of many people in many parts of the world. It is not possible to mention all of them here, but I want to thank those who have helped in especially im- portant ways. First, I must record my debt to the thousands of men and women in vil- lages and low-income urban neighborhoods of developing countries who have answered my questions and taught me about their enterprises, their finances, and their lives. Most were poor in economic terms but rich in terms of wis- dom and social responsibility. My knowledge of mncrofinance is largely derived from them. Microfinance made an impression on me at an early age. My late father, Philip Van Doren Stern, wrote a story called The Greatest Gift that was made into a movie titled It's a Wonderful Life. The film, which I saw many times while grow- ing up, is about the owner (played by Jimmy Stewart) of a small-town build- ing and loan institution who fights the local establishment to provide financial services to the town's working poor. The movie's message seems to have sunk deep into my subconscious to emerge many years later. I first learned directly about the power of formal sector finance for the so- cial and economic development of low-income people from the late Burra Venkatappiah, who served at different times as deputy governor of the Reserve Bank of India (India's central bank) and chairman of the State Bank of India. As the driving force behind the famous 1954 All India Rural Credit Survey, he played a major role in the first nationwide study of rural credit and its relation xlv to economic and social development. The study found that government and cooperative credit together reached only about 6 percent of rural borrowers- mostly large farmers.As a result major changes were recommended in rural cred- it policy, laying the foundations for the country's long-term interest in providing finance to low-income borrowers. Much later the novelist Aubrey Menon, while being interviewed by the press, was asked what he considered the most important book written in India since independence. He rephed: "The 1954 All India Rural Credit Survey." I am much indebted to BurraVenkatappiah and his family for sharing with me their wisdom and their hospitality for a very long time. Among his many far-reaching contributions to the Indonesian economy, Professor AliWardhana-minister of finance from 1968-83, coordinating min- ister for economics, finance, and industry from 1983-88, and economic advis- er to the government since 1988-was primarily responsible for creating Indonesia's commercial microbanking system, the world's first large-scale sys- tem of sustainable microfinance. Ali Wardhana first played a crucial role in the economic reforms that resulted in extensive rural development in the 1970s and 1980s-and in the consequent emergence of millions of potential bank clients. He led the country's widespread financial reforms that began in 1983; among their results was a policy and regulatory environment in which com- mercial microbanking could be born and sustained. He then arranged the es- tablishment of Bank Rakyat Indonesia's (BRI's) nationwide commercial microbanking system, and he has watched over and guided its development ever since. Thus his introduction to this book is especially relevant. As Stephen Grenville, now deputy director of the Reserve Bank of Australia, said in 1994: "Not only was Pak Ali present at the creation of the Indonesian financial sec- tor as we know it, but he was midwife at its birth and its guardian as it grew up." I am deeply indebted to Pak Ali both for the privilege of having worked for him for so many years and for all that I have learned from him. I am also much indebted to Ibu Nani Gandabrata for her many years of assistance and kindness; through her example she has taught me much. I would like to express my gratitude to Drs. Radius Prawiro, for whom I worked when he was Indonesia's minister of finance (1983-88) and coordi- nating minister for the economy (1988-93), and who supported the develop- ment of microfinance in Indonesia throughout his long career in the cabinet. For many years I have been fortunate to have served as an adviser to BRI and to have had the opportunity to observe closely the development of its mi- crobanking system.To the thousands of BRI managers and staff-from the board of commissioners, president-director, and board of directors to the staff of the local bank units with whom I have interacted since 1979-I am indebted in a special way.They set the example for the development of sustainable microfi- nance on a nationwide scale. I have learned much from their achievements, as well as from the goals, strategies, tactics, and methods that lie behind BRI's suc- cess in microfinance. Kamardy Arief, former president-director of BRI (1983-92), provided long-term, active, committed leadership for the transformation of BRI's approach to banking for the poor. Djokosantoso Moeljono has been president- xlvi The Microfinance Revolution: Lessons from Indonesia director since 1994, and it was during his term that BRI's microbanking sys- tem emerged as a model of technology transfer among developing countries. A special acknowledgment must be made to the late Sugianto, BRI's man- aging director who was responsible for its unit desa (microbanking) system from the inception of its commercial approach to rmicrofinance in 1984 until his sud- den death in 1998. After the financial deregulation of 1983 made it possible, Sugianto (who hke many Indonesians used only one name) managed the tran- sition of the unit desa system from a network of banking units with high ar- rears, high losses, low savings, and low staff morale to the world's largest self-sufficient microbanking system. Sugianto once said to me, "You can suc- ceed in microfinance only if you love it." He did both.The unit desas now pro- vide financial services profitably to millions of poor people throughout the country, continuing even throughout the financial and economic crisis that began in 1997. I am much indebted to Sugianto for all that I learned from him for nearly two decades, and for his careful reading and helpful comments on chap- ters 1-14 of this book. His successor, Rustam Dachlan, who has managed the unit desas successfully at a time of great difficulty in Indonesia, has continued BRI's interest in the effort made in this book to document the development of BRI's microbanking system. From 1979-83 I coordinated with Donald R. Snodgrass the Development Program Implementation Studies (DPIS), an interdisciplinary study of In- donesian development programs conducted by the Harvard Institute for In- ternational Development (HIID) for the Indonesian Ministry of Finance. I had the privilege of coordinating the four-year DPIS study on Indonesia's rice in- tensification program, which resulted in recommendations to change the net- work of rural banks created to channel subsidized credit to rice farmers into a system of commercial financial intermediation. Many of the DPIS recom- mendations were accepted by the government and implemented by BRI. I am much indebted to the many people with whom I worked on that study. I am also grateful to the Center for Policy and Implementation Studies (CPIS) inJakarta, the Indonesian foundation that grew out of the DPIS project, and to the many people with whom I worked there.As coordinator of the CPIS local banking group, which provided assistance to BRI from 1983-90, I learned much from Ismah Afivan, Human Akil, Kwan Hwie Liong, R.J. Moermanto, Ilyas Saad, L. Hudi Sartono, Bambang Soelaksono, Sudarno Sumarto, and others. The CPIS also studied urban informal sector labor in Indonesia, and those studies helped me understand the demand for microfinance among the urban poor. From 1986-92 I served as coordinator of the CPIS informal sector group and worked closely with a number of CPIS research staff. Those whose work has been especially relevant to the issues considered here are Akhmadi, Sri Budiy- ati, Reno Dewina, Leni Dharmawan, Inca Juanita, the late Imanjuwono, Dewi Meiyani, Isono Sadoko, Kamala Chandrakirana (Nana) Soedjatmoko, and Dar- winaWismoyo, in addition to others from the CPIS mentioned above. I would also like to express my appreciation to Reitje Koentjoro for her long, contin- uing, kind assistance. Acknowledgments xlvii The research on which the Indonesian sections of the book are based was supported primarily by Indonesia's Ministry of Finance. The Ministry of Fi- nance and the coordinating minister for economy, finance, and industry pro- vided long-term support and provided me with extensive information on rural development, banking, and government policy. My work with BRI was also supported by BRI, the U.S. Agency for International Development (USAID), and the World Bank.All this generous support is acknowledged with gratitude. Much of what I have learned about successful mucrofinance has been gar- nered from years of discussions with I Gusti Made Oka, president-director of Bank Dagang Bali (BDB), and his wife Sri Adnyam Oka, and through obser- vation of their bank's operations. Putu Indra Suryatmaja provided extensive help explaining and helping me to document BDB's activities and performance. Kadek Edy Setiawan provided help with BDB's financial data. Chapter 10, on BDB's development, is based primarily on research that I carried out in 1994, sup- ported by USAID through its GEMINI Project (administered by Development Alternatives Inc. of Bethesda, Maryland) and by Calmeadow of Toronto. I am much indebted to all who helped me understand BDB's remarkable and pio- neering role in microfinance. From 1996-98 I served as coordinator of HIID's advisory project for BRI's International Visitors Program, funded by an agreement between BRI and USAID. I am indebted to BRI, USAID's Office of Microenterprise Develop- ment, the USAID mission in Jakarta, and those at BRI with whom I worked on this project: Soeseno As,Andi Ascarya,Widjojo Koesoemo, Siti Sundarl Na- sution,Tii Purwaningsih,Andrina Rivai, Iman Sarosa, andJarot Eko Winarno. This work broadened my perspective on the aspects of commercial mi- crobanking developed at BRI that are applicable directly or indirectly-to institutions in other countries. I learned much about microfinance from my work in the mud-1990s with the Reserve Bank of India, especially from R.V. Gupta, then deputy governor, andY S. P.Thorat, then additional chief general manager.This work was fund- ed by USAID through its India mission, its Office of Microenterprise Devel- opment, and the GEMINI Project; this support is gratefully acknowledged. On numerous trips to Bolivia I gained important information about mi- crofinance institutions and their clients from Francisco (Pancho) Otero, Her- mann Krutzfeldt, Maria-Elena Querejazu, and the many others with whom I have worked at BancoSol; from Eduardo Bazoberry and others at PRODEM; from Sergio Prudencio, with whom I worked at both institutions; and from man- agers and staff of other Bolivian microfinance institutions. My Bolivian work was supported partly by BancoSol and partly by USAID through its Bolivian mission and the GEMINI Project. Albert Kimanthi Mutua, C.Aleke-Dondo, and others with whom I worked at the Kenya Rural Enterprise Programme (K-REP) shared with me their ex- tensive experience on nmcrofinance and related institutional and policy issues. My work there was supported by the Ford Foundation.Jaime Aristotle Alhp, Do- xiviii The Microfinance Revolution: Lessons from Indonesia loresTorres, and others with whom I am now working at the CARD Bank (the Philippines) have helped me understand the opportunities, constraints, and in- ternal dynamics of NGO-created banks comnitted to financing microloans with voluntary savings. This work is being supported by Women's World Banking. Work with the Bank for the Poor inVietnam, sponsored by the Consulta- tive Group to Assist the Poorest, World Bank, and United Nations Develop- ment Programme; with the Bangladesh Mimstry of Finance and Bangladesh Bank, supported by the United Nations Educational, Scientific, and Cultural Organization; and with the Bank of Tanzania, supported by the bank and the World Bank, has provided important insights on how governments view the introduction of commercial microfinance.Work with financial institutions and government bodies in the Philippines and South Africa, funded by USAID; in East Africa, funded by the U.K. Department for International Development; and in China, funded by the Consultative Group to Assist the Poorest and the United Nations Development Programme, have broadened my perspective in this area.The support of these organizations is gratefully acknowledged. As a consultant to the U.S. Comptroller of the Currency on its effort to encourage bank use by people in the United States who are not participating in the formal financial sector, I had an opportunity to learn about the role of microfinance in industrial countries. I am grateful to Constance E. Dunham for making this possible, and for encouraging an ongoing comparison of lessons about financing the poor in both environments. Calmeadow, Ohio State University's online Development Finance Network, the Microfinance Training Program (first at the Economncs Institute and now at Naropa University in Boulder, Colorado), the Private Sector Initiatives Cor- poration (known as MicroRate), USAID's Office of Microenterprise Devel- opment, andWomen'sWorld Banking have provided assistance in various ways during the writing of this book, broadening my understanding of microfinance issues. I am especially indebted to Irene Arias-Hofman, Carlos Castello, Gregory C. Chen, Michael Chu, Michael Goldberg,Jennifer Isern, Elisabeth H. Rhyne, Laura 0. Robinson, Richard Rosenberg, Stuart Rutherford, Donald R. Snod- grass, and Jacob Yaron. Each read all or substantial parts of the manuscript and provided comments, corrections, criticisms, and improvements. I am also much indebted to Christopher P. A. Bennett, David E. Bloom, Robert Peck Chris- ten, James J. Fox, Mohini Malhotra,Joyita Mukherjee, and Maria Otero, who contributed to this book in many ways. My understanding of microfinance has been informed by the knowledge of these friends and colleagues, and enriched by their help. I would like to express my appreciation to many others who have contributed to my thinking about the role of microfinance in social and economic devel- opment. They include Dale W Adams, Nancy M. Barry, Lynn Bennett, Laksh- mi Reddy Bloom, John R. Bowen, Ernst A. Brugger, Barbara Calvin, Anita Campion, Catherine Mansell Carstens, Martha Alter Chen, Md. Shafiqual Haque Choudhury, Craig Churchill, Monique Cohen, David C. Cole, Martin Acknowledgments xlix Connell, Hernando de Soto, Deborah Drake, Cheng Enjieng, Todd Farring- ton, S. Malcolm Gillis, Claudio Gonzalez-Vega,Turabul Panjatan Hassan, Brig- it Helms, Richard M. Hook, Don E.JohnstonJr.,James R. Kern, Nathan Keyfitz, Klaas Kuiper, Dharma Kumar,Johan Leestemaker, Patricia Markovitch,Jonathan Morduch,Julia Paxton, Sayeeda Rahman,Ashok Rai, N.V Raja Reddy, the late Michael Roemer, Leo Schmit, Chiranjib Sen, Parker M. Shipton, Michael Simpson, Stephen Smith,Joseph J. Stern, the late Ann Dunham Sutoro, C. Peter Timmer, Norman T. Uphoff, Marzuki Usman, R. C. G.Varley, Robert C.Vogel, J. D.Von Pischke, and Damian von Stauffenberg. ACCION International, the MicroBanking Bulletin, and the MicroFinance Network provided information on countless occasions and steered me in many right directions. Scores of people contributed information and insights that were used in writing chapter 3 ("Voices of the Clients") and chapters 17-20 (which analyze the development of microfinance in institutions around the world).The assistance of all is most gratefully acknowledged. Carol Grotrian, Mary Ruggiero, and Flora Segundo provided extensive assistance in the preparation of the manuscript, and Jonathan Ramljak pro- vided exceptional help in overseeing its production.Jessica Roberts helped in multiple ways and prepared the bibliography and the glossary with much care and uncommon dedication. I am much indebted to all. Peter J. Fidler provided superb research assistance on all aspects of this book and co-wrote part 4. He has been invaluable in the effort to under- stand, untangle, clarify, document, and analyze the many issues discussed here, and I am much indebted to him. This book and its author owe an enormous debt to Ira W Lieberman. He supported the book from the start and played an extraordinary and continu- ing role in arranging for its financing, edcting, and publication-even as the book grew from one to three volumes.The help, encouragement, and support I have received from him is exceptional, and it is acknowledged with much gratitude. The book has received funding and support from the Consultative Group to Assist the Poorest, Ford Foundation, HIID, Open Society Institute, and World Bank. All this support is acknowledged with much appreciation. I am particularly grateful to have had Communications Development In- corporated as my editors. Paul Holtz and Bruce Ross-Larson provided superb editing at every stage, and I have learned a lot from both of them. I am also in- debted to Wendy Guyette, who laid out the chapters, and to Stephanie Ros- tron, who coordinated production, both with Communications Development. Deborah E. Patton compiled the index. I would also like to thank the publishers of the book, the World Bank and Open Society Institute. Paola Scalabrin of the World Bank's Office of the Pub- lisher served as project manager for the publication of the three volumes and played a crucial role throughout. I am indebted to her for help on a wide va- riety of matters. The three volumes of this book, especially the second one, are based primarily on work carried out for many years at HIID, and they draw on a number of my The Microfinance Revolution: Lessons from Indonesia earlier papers written at HIID. I am indebted to HIID for its support of my work generally, and for its support for the writing of these volumes. Members of my family have contributed to this book in a variety of ways, both direct and indirect, and I am most grateful for their help:Allan R. Robin- son, Sarah P. Robinson, Perrine Robinson-Geller, Laura 0. Robinson, Salva- tore A. d'Agostino, Eric B. Geller, and Peter Rosendorff. Once when I was at the Jakarta airport, about to leave for Boston, the im- migration officer challenged my embarkation card."It says here you are an an- thropologist," he said. "It also says you work for the Ministry of Finance.Which is it? It cannot be both!" It took some time to explain that both were correct. As an anthropologist who has been given the opportunity to serve as a policy adviser to finance ministries, central banks, and a variety of banks and other fi- nancial institutions in many parts of the world, I have been especially fortu- nate, and am most grateful. Acknowledgments Part -s Commercial Microfinance in Indonesia Indonesia was the first developing country to establish large-scale commercial microfinance systems. More than a hundred years ago the Badan Kredit Desa-village-owned banks now supervised by Bank Rakyat Indonesia (BRI)- began offering microloans commercially, and they contin- ue to do so today. Bank Dagang Bali, which opened in 1970, Indonesia was the is a private bank believed to be the oldest licensed bank in first developing a developing country specializing in commercial microfi- country to establish nance. Founded by a couple who had long experience in the informal sector and in informal moneylending, the large-scale bank provides savings and credit services and has been prof- commercial itable since the first year it opened. microfinance In 1983 the Indonesian government issued a major fi- systems. These nancial reform deregulating interest rates on most bank began in the late loans and savings accounts. At that time the Ministry of 19th century Finance decided that BRI, a state-owned commercial bank with a mandate to provide financial services in rural areas, would transform its 3,600 unit desas-bank outlets at the subdistrict level that served as channeling agents for the government's subsidized rural credit programs-into commercial microfinance intermediaries. And in 1984 BRI began transforming its loss-making unit desa system into what quickly became a profitable nationwide com- mercial microbanking system-now the largest in the world. 2 The Microfinance Revolution: Lessons from Indonesia These and other commercial microfinance institutions continue to operate profitably in Indonesia, reaching mil- lions of clients with small loans and savings services. And with decades of experience, such institutions offer many lessons that can be adapted by microfinance organizations in other parts of the world. The Indonesian institutions discussed here are important contributors to the microfi- In Indonesia it has nance revolution for another reason as well: in recent years been demonstrated they have demonstrated unmistakably that commercial li- unmistakably that crofinance institutions can be remarkably stable even in commercial times of extreme national crisis. The East Asian crisis hit Indonesia in 1997.The value of the rupiah plummeted, inflation mounted, and uneniploy- institutions can be ment, food shortages, and high prices led to social unrest remarkably stable in and violent outbreaks. By 1998 the foreign debt of com- times of extreme mercial banks reached about three times their equity, and national crisis loan losses increased dramatically because borrowers were unable (or in some cases unwilling) to make payments. Domestic loan losses increased as well, as corporations went bankrupt and the banking system melted down. President Soeharto was forced to resign after 32 years in office, and the country began a long and difficult effort to restore the economy, build a viable, transparent financial system, and un- dertake major political reforms. The process continues today-with mixed results and many obstacles remaining. Part 3 Commercial Microfinance in Indonesia-Overview 3 Yet an outsider with no knowledge of Indonesia who ex- amined the performance of BRI's unit desas during 1984-2001 would have no way of knowing that, beginning in 1997, the country had suddenly faced severe political in- stability, extensive economic hardship, and financial chaos.With giant banks and corporations collapsing all around them, the A century-old unit desas continued to increase their outreach, collect loans, tension-between mobilize savings, and remain profitable. Other commercial mi- rural credit subsidies crobanking institutions withstood the crisis as well. Part 3 (which contains all the chapters of volume 2) fo- and commercial cuses on how and why Indonesia developed large-scale microfinance--is sustainable banking systems, and is organized as follows. explored from its Chapter 8 provides an introduction to Indonesia's history, 19th century roots to economy, government, and politics. It then analyzes the its 21st century reasons for Indonesia's recent crisis, the crisis itself, and the issues attempts (through mid-2001) to restore broadly based eco- nomic growth and build a functioning democracy. Chapter 9 reviews the history of rural finance in Indonesia (and its antecedents in Europe) and examines the country's rural development and rural financial institutions.A centu- ry-old tension in Indonesian microfinance-between those who promote rural credit subsidies and those who foster in- dependent commercial financial institutions providing vol- untary savings and credit-is explored from its 19th century roots to its 21st century issues. In Indonesia large outreach 4 The Microfinance Revolution: Lessons from Indonesia and institutional profitability have been associated through- out only with a commercial approach to financial inter- mediation. Chapters 8 and 9 provide the background needed to understand the reasons that large-scale commercial mi- crofinance developed in Indonesia.The rest of volume 2 con- siders how and why this happened. Bank Dagang Bali (BDB), discussed in chapter 10, is the Bank Dagang Bali, oldest licensed general bank specializing in commercial a private bank, is microfinance that currently operates in a developing the oldest licensed country and without ever having received a subsidy. full-service bank Chapter 10 explores the history of BDB and its performance from 1970-96 (its 1997-2000 performance is discussed in specializing in chapter 15). The bank is best known for its knowledge of commercial microfinance clients and for its savings services, which are microfinance in a state of the art in microfinance. BDB is now a full-service developing country bank providing finance to large customers and corporate clients (many of whom were once the bank's poor clients) in addition to its microfinance customers. The development and growth of BRI's microbanking (unit desa) system are explored in chapters 1 1-15.The unit desa system was selected for detailed analysis here for three reasons. It is the world's largest financially self-sufficient microbanking system. It is the Indonesian microfinance in- stitution I know best, having advised on its development for more than 15 years starting in 1979.And it is much less well- Part 3 Commercial Microfinance in Indonesia-Overview 5 known internationally than some microfinance institutions in other countries that promote the poverty lending approach to microfinance. The BRI story should be understood by every government, donor, and financial institution making decisions about microfinance.The unit desas cannot-and should not-be cloned, but they offer many important Bank Rakyat lessons for the microfinance industry. Indonesia's unit Chapter 11 examines the unit desa system from its creation in 1970 to 1983, when the government decided to transform desa system IS the the units from channeling agents for subsidized rural credit world's largest programs to commercial financial intermediaries.The 1970-83 financially se!f- period was characterized by what BRI's President-Director sufficient Kamardy Arief (1983-92) called the unit desas' "old cul- microbanking ture" in sharp contrast to the "new culture" that resulted from system. This volume the fundamental institutional transformation initiated in 1984 shows how it got (see box 1 at the end of this section) .This "new culture" is de- there picted in chapters 12-15. Today's unit desas can be fully un- derstood only in the context of this transformation. The unit desa system was originally created to admin- ister the government's subsidized BIMAS credit program for rice cultivation; later many other smaller subsidized credit programs were added. BIMAS generally resulted in nega- tive outcomes for rice farmers, BRI, and the government. Chapter 11 analyzes the many reasons this program did not- and could not-work as planned.The lessons of this era are 6 The Microfinance Revolution: Lessons from Indonesia important because the transformation of the unit desa sys- tem occurred only after basic lessons about agricultural fi- nance had been learned the hard way. The reasons for Indonesia's failure with BIMAS may help other countries and financial institutions currently implementing similar pro- grams to understand why subsidized agricultural programs aimed at increasing production and raising the incomes of With giant banks poor farmers cannot achieve those goals.The failures of such and corporations programs are caused by intrinsic structural defects. Micro- collapsing all around finance outreach efforts must be based on fundamentally dif- them, BRl's unit ferent assumptions. Using the Indonesian example, this desas increased chapter shows why. Chapters 12-14 discuss, respectively, lending, savings, outreach, collected and organizational reforms in the unit desas from 1984-96. loans, mobilized Chapter 15 documents and analyzes the remarkable stabil- savings, and ity of the unit desas and other commercial microfinance or- remained profitable ganizations between 1997 and mid-2001, during the Indonesian crisis. Chapter 12 focuses on the financial sector reforms, pol- icy decisions, and other enabling conditions that made pos- sible the 1984 shift of BRI's unit desa system to a commercial microbanking intermediary. It analyzes BRI's achievements (and mistakes) in developing and implementing the unit desa credit program. And it examines the unit desas' credit per- formance and profitability from 1984-96. Part 3 Commercial Microfinance in Indonesia-Overview 7 Kredit Umum Pedesaan (KUPEDES), the unit desas' gen- eral purpose credit program introduced in 1984, provides loans to economically active poor and lower-middle-income individuals throughout Indonesia.The program is guided by the principle that institutional sustainability is required for large-scale outreach to low-income borrowers. KUPEDES Thefailures of provides loans to all creditworthy applicants for all productive subsidized rural purposes. Its interest rate is set to cover all unit desa costs and risks, and to return a profit to the system. credit programs are Loan decisions are based on evaluations by well-trained, caused by intrinsic experienced unit desa staff of borrowers' character (will- structural defects. ingness to repay) and of the viability and cash flows of their Using the enterprises (ability to repay). KUPEDES was designed Indonesian example specifically to meet the needs of low-income borrowers for (1970-83), chapter convenient bank locations, simple loan procedures, and 11 shows why flexible terms.Thus within the overall KUPEDES regula- tions, the loan purposes, maturities, and payment plans are customized for each borrower's needs. Repayment rates have been high for a number of reasons. Borrowers are selected based on their ability to use loans pro- ductively and on their ability and wilingness to repay them. Loans are provided in gradually increasing amounts, based on the borrower's repayment record and the creditworthiness of the enterprise for which the loan was taken. Borrowers are motivated to repay in order to retain their option to rebor- 8 The Microfinance Revolution: Lessons from Indonesia row on what are considered attractive ternis at reasonable cost. And unit staff treat clients with respect and courtesy. The unit desa system made a profit in 1986 and has been independent of subsidy since 1987. In 1996 the KUPEDES credit program had $1.7 billion in outstanding loans to 2.5 million borrowers and a long-term loss ratio of 2.2 percent. Ninety-five percent of the units were profitable, and the pre- Chapter 12focuses tax return on assets was 5.7 percent-substantially higher on thefinancial than typical banking industry averages in Indonesia and else- reforms and policies where.The crucial issue about profitability, however, has been that made possible BRI's use of unit desa profits to cover losses in the bank's the 1984 less successful divisions that serve wealthier borrowers with generally low repayment rates-a decision outside the con- transformation of the trol of the unit desa system. unit desas to a Chapter 13 documents the dramatic rise in savings mo- commercial bilization in BRI's unit desas from 1984-96. The units had microbanking only $18 million in savings at the time of the 1983 bank dereg- intermediary ulation. Low deposits were widely but wrongly attributed to an assumed lack of demand for financial savings instruments: it was believed that rural people were unable to save, unwilling to save in financial form, and did not trust banks. In fact, the problem was with the banks-which did not understand the nature or the extent of the demand for rural savings services- and with the government, whose regulations made it im- possible for banks to meet this demand profitably. Part 3 Commercial Microfinance in Indonesia-Overview 9 The unit desas' new savings program was developed in three phases. In 1984-85 extensive research was conduct- ed on the potential demand for unit desa savings and on products and services that would meet this demand; dur- ing this phase the new savings program was designed and tested in a two-stage pilot project.Then in 1986 the pro- The KUPEDES gram was expanded to all unit desas throughout Indone- loan product was sia. Finally, in 1987-89 methods were developed for market designed to meet the penetration. By 1989 all KUPEDES loans were funded by unit savings, as they have been ever since.The units subse- needs of low-income quently achieved increasing penetration of the Indonesian borrowers for market for rural savings and, with the opening of urban units convenient bank in 1989, urban savings in low-income neighborhoods. locations, simple Three main savings products offering different ratios of procedures, and liquidity and returns are available at all units, with some dif- flexible terms ferences between rural and urban units. Savers are permit- ted to have as many accounts as they want, enabling them to customize their use of the accounts to meet specific needs. In 1996 the unit desa system held locally mobilized savings of $3 billion in 16.1 million savings accounts. The principles of sustainable institutional microfinance carry with them a set of basic operational requirements. Chapter 14 shows that effective operations depend on an efficient organization and a microfinance-specific manage- ment structure. Such an organization does not arise in the 10 The Microfinanco Revolution: Lessons from Indonesia absence of the underpinning principles.Yet the principles can be put into operation on a large-scale, long-term basis only through appropriate institutional organization. How can the sequencing work in such a situation? This is a critical problem in microfinance, and one that is little understood.When BRI's unit desa system changed in 1984 from a loss-making channeling agent for govern- Chapter 13 ment credit subsidies into a commercial financial interme- documents the rise diary, it did not have an organizational structure that could in unit desa savings provide the prerequisites for institutional sustainability. mobilization-from Although microfinance can operate viably under a num- $18 million in ber of organizational structures, certain features of opera- 1983 (after more tions and management must be incorporated into the design of any financially self-sufficient microfinance in- than 10 years of termediary. For example, multiple components must be in collecting savings) to place to achieve the repayment rates of more than 95 per- $3 billion in 1996 cent needed for institutional sustainability. Among these components are effective, committed management; an ef- ficient, accountable, labor-intensive organization; simple, transparent accounting and reporting systems; appropriate staff training and performance-based incentives; decen- tralized authority for loan decisions; regular, meticulous in- ternal supervision; simple, suitable management information systems; and user-friendly products and services priced for institutional viability. Whatever its organizational struc- Part 3 Commercial Microfinance in Indonesia-Overview 11 ture, a sustainable microfinance institution must provide these elements. Chapter 14 focuses on the dynamics of organization- al development at BRI, specifically on the ways that the basic products of commercial microfinance-savings and credit-and their operating requirements drove the The ways in which changes in unit desa organization and management.The new savings and chapter also explores the organizational difficulties faced credit products drove by the unit desas in their role as the microbanking divi- sion of a full-service commercial bank. In addition, the major changes in chapter analyzes the performance of two large microfi- unit desa nance organizations administered (in different ways) by organization and BRI: the commercial Badan Kredit Desas (BKDs) and a management are heavily subsidized microcredit program known as P4K. explored in As would be expected, the two organizations have strik- chapter 14 ing differences in performance. Chapter 15 first examines the financial aspects of In- donesia's crisis, the collapse of the banking sector, and the government's subsequent bank restructuring efforts. It then turns to the stunning contrast that emerged during 1997-2001 between the banking sector generally and com- mercial microfinance, represented here by the BKDs, BDB, and the unit desas. During the crisis all three of these in- stitutions continued their wide outreach and profitability. The chapter also provides a more extensive analysis of unit 12 The Microfinance Revolution: Lessons from Indonesia desa performance from 1997-2000, followed by a mid- 2001 snapshot of their strengths and challenges. This final chapter of volume 2 addresses the reasons that commercial microbanking has remained stable during a fi- nancial crisis so severe that, as The Economist (18 July 1998) commented, Indonesia "would probably walk away with the prize for Asia's most desperate banking system."While there The stunning are differences among the three microfinance institutions contrast that discussed, the main reasons for their stability under crisis are emerged during the the same.These include: crisis-between the * Macroeconomic stabilization measures undertaken by the banking sector government with the support of the International Mon- etary Fund and other donors. generally and * The fact that most microbanking clients operate in the commercial domestic economy and were not directly affected by the microfinance-is the currency crisis. focus of chapter 15 * The experienced management, strong performance, and high liquidity of these institutions before the crisis. * Their well trained, motivated, and friendly staff. * The high value placed by borrowers on the option to re- borrow during the crisis. * The impetus for clients to save more and consume less in times of rising inflation and growing unemployment. * Savings moved from failing banks to trusted microfinance institutions. Part 3 Commercial Microfinance in Indonesia-Overview 13 * The decisions of these institutions to continue to make financial services available throughout the crisis. Indonesia offers four important lessons. Microfinance in- stitutions can be fully sustainable with large, nationwide out- reach over long periods. Commercial microfinance, following basic principles (see chapters 12-14), can be carried out by There are differences different types of financially self-sufficient institutions. Mi- among commercial crofinance can be profitable and stable even during severe microfinance crisis. And as a result, millions of low- and lower-middle- income savers and borrowers can improve their enterpris- institutions. But the es, increase their incomes, and gain self-confidence. Some main reasons for of these lessons (and others) are of course available from other their stability during countries. But these four are probably found in combina- crisis are the same tion only in Indonesia. 14 The Microfinance Revolution: Lessons from Indonesia Box 1 Old and new cultures at Bank Rakyat Indonesia's unit desas Old culture, 1970-83 New culture, 1984-present Overview Unit desas acted as channeling agents for the In June 1983 the government deregulated interest rates government's rural subsidized credit programs. on most loans and savings and encouraged restructuring The government set terms and ceilings for of the unit desa system. The government provided initial loans and interest rates for savings and loans funding for the KUPEDES loan program All decisions about unit desa products, services, pricing, and the like are made by BRI without government interference But the government has remained a strong supporter of the unit desa system and, when formulating financial policy, has consistently kept in mind the units' special contributions and requirements BRI managers and staff had little understanding of Since 1984 the units have provided commercial financial local markets or of the potential for microfinance. services for the economically active poor, the units' BRI saw the units as a loss-making activity that impedes profitability makes the system viable for the long term. "our real banking Hallmarks of the new culture include simplicity, transparency, professionalism, accountability, service, and knowledge of local markets Human resources Salaries of unit staff were much lower than those of Unit staff are on the same salary scale as the rest of the BRI branch staff. bank Unit staff were considered outside the BRI "family," were Unit staff are part of the BRI organization, included in corporate not treated as part of the corporate culture, events, and encouraged to act as, and regard themselves and were not viewed as bankers as, bankers There was no career track at BRI for unit staff Unit staff are on a BRI career track, based on performance, they can be promoted to BRI branches In addition, low-level branch staff can be promoted to serve at the units There was no specialized microfinance training for unit Extensive microfinance training is provided for unit staff and staff and their branch-level supervisors their supervisors, who are based at the bank's branches There were no performance-based incentives Unit staff receive significant cash incentives and formal recognition for good unit performance Unit managers had very limited authority Unit managers have considerable authority in loan approval and unit management Unit managers and staff had limited accountability There is strict accountability; unit managers and staff are held responsible for their financial decisions and for their unit's performance Part 3 Commercial Microfinance in Indonesia-Overview 15 Box 1 (continued) Organization and management Units were branch windows, and their transactions were Units are treated as individual profit centers, with each unit's posted as branch transactions. performance recorded and reported separately Unit performance reports were aggregated and incorporated A balance sheet and profit and loss statement are required into the balance sheet and profit and loss statement of each unit every month The unit desa system has its own of the supervising branch reporting system at the unit, branch, regional, and head office levels There was no unit desa division at the head office The unit desa division at the head office reports to a BRI and no unit desa section at regional offices managing director; regional offices have unit desa sections Supervision of the units was poor and irregular. Regular, intensive supervision of the units is conducted by supervisors from the branch and regional levels Thirty-two monthly reports were required from each Five monthly reports are required from each unit, providing unit, consuming a large amount of staff time but resulting more relevant information than was contained in the in little useful information 32 reports under the old system Products and pricing About 350 subsidized loan products were offered at One loan product and three basic savings/deposit products below-market interest rates One savings product was with generally positive rates of return are offered, with an provided, with an interest rate that was set below interest rate spread that enables unit profitability inflation and below the lending interest rate Interest payments on loans were transferred to KUPEDES interest is posted under unit assets and unit the supervisory branch Unit savings were also savings are posted under unit liabilities Units can save transferred to the branch, but interest to depositors was at or borrow from their supervising branch at the transfer paid by the unit price set by the head office Borrowers were selected primarily by government officials Borrowers are selected by well-trained unit staff, unit and committees. managers have the authority to approve most loans Profitability and outreach Arrears and defaults were high, as were government The units have been profitable every year since 1986 subsidies and unit desa losses. In 1983 there were and free of subsidy (except for technical assistance) since fewer than 500,000 outstanding loans, including many 1987. In 2000 the units had 2.7 million outstanding loans in default from previous years The number of savings in a portfolio of $816 million and $2 billion in savings accounts is not available, but at the time of the June in 26 million savings accounts 1983 financial deregulation the amount of unit savings was $18 million 16 The Microfinance Revolution: Lessons from Indonesia An Introduction to Indonesia The development of large-scale sustainable microfinance in Indonesia did not occur gradually, accidentally, or as a grassroots initiative; it was planned and implemented as an integral part of the country's economic develop- ment. Because Indonesia's achievements in microfinance can be understood only in a wider context, this chapter summarizes its history and economic development as background to the rest of volume 2. Only a brief account of Indonesia's rich and complex history can be given here, but references are provided throughout the chap- ter for readers who want to learn more about the coun- try's history, economy, politics, and culture. In preparation for the discussion of microbanking, the chapter that fol- lows completes the general background summary by 18 reviewing the history of Indonesia's rural development and rural fi- nancial institutions. This chapter begins with a discussion of early Indonesian histo- ry, the struggle for independence, and the post-independence era under Sukarno, who served as Indonesia's first president from 1949-67. By the mid-1960s, however, the Indonesian economy was in severe decline and Sukarno's political base had eroded. An attempted coup occurred on 30 September 1965; within hours Major-General Soeharto, head of the army's Strategic Reserve Command, took control of the army.The attempted coup-for which From 1970-96 responsibility is still in dispute-was followed by an army massacre of hundreds of thousands of communists and others whom the army Indonesia' economic blamed for the coup attempt. Soeharto emerged as the new national leader: executive power was transferred to him in March 1966, and growth averaged 7 he was appointed acting president in 1967 and president in 1968. percent a year, and The primary achievement of Soeharto's 32-year presidency was Indonesia's social and economic development under what was Soeharto' known as the New Order government. An extraordinary team of technocrats restored the economy and, as economics ministers, led government made it through three decades of remarkable growth with a strong em- phasis on equity. From 1970 to 1996 Indonesia's economic growth ry averaged 7 percent a year. During 1986-96 the country saw aver- achievements in age annual growth of nearly 8 percent, while average annual infla- tion stayed below 10 percent. poverty reduction Soeharto is widely credited with placing a high priority on poverty reduction, and his technocrats were able to help the poor increase their incomes and improve the quality of their lives.As a re- sult Soeharto won prestigious international prizes for Indonesia's achievements in food and agriculture, in family planning, and in pover- ty alleviation. But under the authoritarian New Order government the country remained politically underdeveloped, with Soeharto personally dominating all branches of the government, controlling the political opposition and the media, and ensuring that no healthy opposition-and no potentially powerful leaders-could emerge. By the 1990s the Soeharto family and a small group of their friends had become corrupt on a massive-and escalating-scale. In the process Soeharto had virtually stopped listening to his team of eco- nomics ministers. Many Indonesians became increasingly outspo- An Introduction to Indonesia 19 ken against Soeharto's authoritarian rule and the family's corrup- tion. Then in July 1997 a financial crisis erupted in Southeast Asia. In Indonesia the value of the rupiah plummeted, inflation mount- ed, corporations went bankrupt, banks closed, the financial system collapsed, and unemployment, food shortages, and high prices led to social unrest and violent outbreaks.The primary cause of the cri- sis was not the underlying economy, however, but the deep and grow- ing weaknesses in governance and in the financial system. Soeharto was forced to resign in May 1998; he was succeeded byVice Pres- Because of ident B.J. Habibie, his lifelong protege. In 1998 the International Monetary Fund (IMF) and other in- Soehartos ternational donors provided an emergency $42.3 billion soft loan authoritarian rule, financial aid package for Indonesia.The economy, which was at its lowest point of the crisis in 1998, improved gradually. Stabilization the country measures brought down inflation from 53.4 percent in 1998 to 20.5 percent in 1999 and 3.7 percent in 2000. remained politically Responding to mass demand after Soeharto's resignation, Presi- dent Habibie initiated a number of political reforms, including the abolition of restrictions on formmng political parties and the referen- wvith corruption dum that allowed the province ofEastTimor to vote overwhelmingly for independence from Indonesia. (After the vote, however, massive flourishing at the burning, looting, and killing of East Timorese were carried out by In- donesian militias with support from some of the military.) Immediate challenges were to improve governance, implement political reforms, strengthen the economy, rebuild the financial sys- tem, and maintain a safety net for the poor, whose numbers had in- creased during the crisis. But results were mixed. Inflation decreased substantially and economic growth improved. Some basic reforms were accomplished (such as freeing the media, a process begun by Habibie and completed by his successor, President Abdurrahman Wahid). But many of the country's old problems did not disappear, and new ones emerged. Indonesian general elections were held in June 1999-the first time in more than 40 years that the results of an election were not known beforehand. No party obtained a majority.The presidential election was held in October 1999, with Habibie and Megawati Soekarnoputri (Sukarno's daughter) as the front runners. Howev- er, the newly reformed People's Consultative Assembly elected Ab- 20 The Microfinance Revolution: Lessons from Indonesia durrahmanWahid as president and Megawati Soekarnoputri as vice president. Wahid was selected largely because he was a widely re- spected Muslim religious leader, known for his honesty, tolerance, and support for human rights. ButWahid is blind and had been weak- ened by strokes, and there was concern about whether he would be able to run the government. The challenges were formidable. CouldWahid build a coalition government from multiple newly formed parties with different views and priorities? Could the president control the army? Could the government resolve secessionist movements, restore the econ- Since independence omy and rebuild the financial system, and build the institutions needed for a viable democracy? Indonesia has had a The Soeharto family and cronies and their conglomerates, though weakened, remain wealthy and powerful. And many Soeharto sup- strong leader and a porters throughout the country remain active, in some cases work- weak state. JVen ing to create and maintain political instabilities. PresidentWahid failed in his effort to bring Soeharto to trial for corruption (the court dis- Soeharto resigned, missed the case, finding Soeharto too ill to stand trial). Wahid made some crucial reforms early in his administration: mak- the strong leader was ing the media fully independent, placing the military under civil- ian control, and holding some military officers accountable for g human rights abuses. And the economy showed improvement. In- state remained flation remained single digit and GDP growth, which was -13.0 per- cent in 1998 and 0.3 percent in 1999, reached 5.2 percent in 2000.' ButWahid was unable to consolidate power. He had neither the political backing nor the adrministrative skills needed to achieve sus- tained reforms. Political infighting, violence, bombings, secession- ist movements, ethnic and religious conflicts, and instabilities promoted by Soeharto supporters, Muslim fundamentalists, and others escalated. By early 2001 the rupiah was falling, the country's slow economic growth was faltering, and inflation was rising. Still constraining the economy were difficulties with the restructuring of massive corporate foreign and domestic debt, the crippled bank- ing system, and continuing large-scale corruption. Efforts to re- structure the corporate debt and to build an effective and accountable banking system, both needed for any significant growth in private investment, remained mired in political problems. Many of these prob- lems involve the Soeharto family and their friends. An Introduction to Indonesia 21 Meanwhile, the IMF and Indonesia's other donors had become dissatisfied with the glacial pace of agreed reforms and with grow- ing political instabilities. In December 2000 the IMF suspended dis- bursement of a $400 million tranche of its aid program, which remained suspended throughout the rest ofWahid's presidency. By April 2001,18 months after his election,Wahid had twice been censured by parliament. He was criticized for his government's lack of focus, coordination, and implementation; for the deterioration of the economy; for insufficient progress in legal, judicial, legislative, Indonesia is now banking, and other reforms; and for failing to curb corruption, re- solve secession issues, and bring former president Soeharto to jus- attempting to recover tice. Three months later, on 23 July 2001, President Wahid was impeached by the unanimous vote of the 591 members of the 700- from a major member People's Consultative Assembly who attended the session. economic,financial, He was replaced for the remainder of his five-year presidential term by Vice President Megawati Soekarnoputri. and political crisis The transition from the Soeharto era could not have been easy under any circumstances, but the economic, financial, and political and to build a crisis that began in 1997 made it especially difficult. And there will modern political undoubtedly be difficult times ahead. But Indonesia has many strengths. It has abundant resources: a large and educated labor state force, ample natural resources, a strategic location, an extensive in- frastructure, a large domestic market, and long experience with sustained economic growth and equity. As AliWardhana (1998b, p. 5) put it, "No one should doubt the severity of the current economic crisis.Yet neither should anyone underestimate our capacity to set our institutions right." 22 The Microfinance Revolution: Lessons from Indonesia Indonesia is perhaps the least understood of the world's major nations. Only an overview of selected aspects of this large, complex, and multiethnic coun- try is provided here. But even for a summary of Indonesia's social, economic, and political history, three underlying concepts are crucial: the role of the Ja- vanese wayang puppet theater and its teachings, the Javanese concept of power, and Pancasila-the five guiding principles of the Indonesian government. These concepts are considered here in the contexts where they are most di- rectly relevant to the discussion. In different ways, all are fundamental for an understanding of the events and processes explored here: the freedom struggle that culminated in a declaration of independence in 1945 and the formation of an independent nation in 1949, the country's economic development over the next half-century, its political dynamics, the economic and political crisis TheJavanese of the late 1990s, and Indonesia's current attempts to recover from that crisis and to build a modern political state. wayang shadow Wayang, orJavanese shadow theater, teaches central lessons about the con- duct of lhfe and about making choices-messages embodied in stories that peo- theater teaches ple learn from early childhood. Much ofJavanese philosophy is based in Hindu thought-not necessarily compatible with Western ideas-in which the cre- central lessons about ative and the destructive are the same principle, goodness cannot exist with- out evil, and opposition and complementarity are aspects of the same whole. conducting lfe and While most Javanese are Muslim,2 a strong underlay of earlier Hindu culture remains on Java, where most of Indonesia's population lives (and on Bali, making choices. where most of the population is Hindu). Three of the many lessons from the wayang are discussed below. One is that Current events are life is complex, duties conflict, and even ethical, honorable choices may lead to undesirable outcomes. Another is that whlle humans may accumulate ma- often interpreted terial goods, greed-especially among rulers-is unacceptable to the gods.The third is that a sovereign is legitimate only so long as he maintains the enlight- based on wayang ened characteristics required of a ruler and so long as he governs in the inter- est of his people. teachings Closely related is the Javanese concept of power-which is seen as an in- dependent, fixed entity that exists apart from its users and passes from one hold- er to another (Anderson 1990 [1972]).Thus the only way to gain power is to take it from someone else. Commoners can become kings if they acquire power. But to keep power, a ruler must demonstrate continuously that he still holds it. "The ruler must behave properly or his Power will ebb and vanish, and with it the good ordering and smoothness of the social system" (Ander- son 1990 [1972], p. 63). Pancasila, or the five guiding principles of the government-belief in one supreme being, Indonesian unity, humanitarianism, democracy by representative consensus, and social justice-was first proclaimed by Sukarno in a speech on 1 June 1945, two months before Indonesia declared its independence.As a national ideology, Pancasila is so all-encompassing that it provides an inclusiveness that can bind together many highly diverse groups. It also enables a powerful president to justify virtually any decision, and it can serve as an instrument of repression. An Introduction to Indonesia 23 Readers should keep these views in mind as the discussion below describes the rise and fall of both Sukarno and Soeharto, who between them ruled In- donesia for 50 years, as well as events of the post-Soeharto era and the rise of Sukarno's daughter, Megawati Soekarnoputri, who became Indonesia's presi- dent in 2001.3 The Javanese Wayang Shadow Theater Wayang, a traditional Indonesian puppet theater of multiple dimensions, in- corporates entertainment, art, spiritual teaching, and information and commentary "The ruler must on current events-all intricately interwoven.4 Extremely popular, especially on Java and Bali, the wayang both reflects and provides inputs into the wider light the minds and society. souls of his The trunks of banana trees that the puppets are inserted in subjects ... and are symbols of the world of man Man's spirit is the puppeteer, provide direction, symbol of truth and meaning. The screen's the unseen world above, responsibility, man's characters the wayangs, and the lamp's rays the Almighty example, and The audience is the all-perceiving wise man. -PakJaya, cited in Mulyono 1981, pp. 18-19 impartiality " Many wayang performances depict episodes from the Ramayana and the Mahabharata, ancient epics that came to Indonesia from India and were grad- ually adapted to local culture and society. The Ramayana, composed original- ly byValmiki in Sanskrit, tells the story of Rama, the prince of Ayodhya. One famous episode concerns the kidnapping of Sita, the wife of Rama-who is an avatar (incarnation) of Vishnu, part of the Hindu holy trinity of Brahma the Creator,Vishnu the Sustainer, and Siva the Destroyer. Sita is kidnapped by Ra- vana, the King of Alengka (Sri Lanka), and after many episodes is rescued by Rama's forces. One Javanese wayang performance5 highlights the role of Wibisana,6 the younger brother of King Rahwana.' Wibisana entreats Rahwana not to hold Sinta8 captive and not to make war on Rama,"who is a powerfuil, honest, noble- minded man of supernatural virtue" (Mulyono 1981, p. 72). Rahwana refuses to listen and banishes his younger brother.Wibisana then joins Rama's followers. The wayang performance centers on Wlbisana's choice. Serving one's country may mean betraying the truth, while serving the truth may mean betraying one's country. In the wayang the puppetmaster recites the following asWibisana's left foot touches the soil of Mangliawan, Rama's king- dom, while his right foot is still in contact with the soil of his native land: 24 The Microfinance Revolution: Lessons from Indonesia Stopping, he stands erect like a statue dressed with clothing. His heart is filled with confusion. The world grows dark in an instant.The flying birds fall to the ground, their feathers ruffled, their wings thrashing helplessly. The fish in the water float to the top and beat helplessly against the shore. In the words of the saying, not a leaf is stirring, for the wind itself is standing still. Wibisana is caught on the horns of a dilemma. "Eat the fruit of the simalaka- ma and your mother dies. Don't eat it, and your father dies.Walk forward and be wounded. Retreat and be torn to pieces. ..This is life." (Mulyono 1981, p. 74) Another episode from the Ramayana shown in wayang performances fo- Indonesia, with its cuses on the balance between the material and the spiritual, and on the prop- er way for a ruler to live.After many years as ruler, Rama set his life and kingdom strategic location in order. astride major Sri Rama did not leave worldly things behind until his children had replaced him on the throne. In the philosophy of the sealanes, has a rich wayang, man is advised to deal fully with the material side of life-only he is cautioned not to be greedy, and not to worship resource base possessions and rank, for worship belongs only to God. -Mulyono 1981, p. 149 including oil, natural In a third episode depicted in wayang performances, Rama teaches the prin- gas, minerals, timber, ciples of rule toWlblsana, who is eventually crowned King ofAlengka (Sri Lanka). The principles emphasize the duty of the king to give his subjects spirit, in- and primary energy spiration, and the means of earning their livelihood, to light their minds and souls, and to provide direction, responsibility, example, and impartialityThe ruler resources must be free of hatred and pettiness and must be solid, honest, and willing to reward those who serve the land and its people. "Every ruler who does not pos- sess these characteristics is a king without a crown, while every commoner who does is a crowned head in reality" (Mulyono 1981, pp. 136-37). Most Indonesians, including many non-Javanese, are familiar from child- hood with the teachings of the wayang shadow plays. This fact should be re- membered when considering Indonesian history (and current events)-because in Indonesia events are often interpreted and choices made in light of wayang teachings. Indonesia's Environment, Demographics, Early History, and Struggle for Independence The world's fourth most populous country, Indonesia lies between Asia and Aus- tralia on the world's largest archipelago, a strategic location on, and alongside, major sealanes from the Indian Ocean to the Pacific Ocean (see map of In- An Introduction to Indonesia 25 donesia). Divided into 23 provinces, 2 special regions, and 1 special capital city district, and covering 1.8 million square kilometers, the country comprises some 13,700 islands spread over a variety of ecological zones.A pluralistic country, in 2000 Indonesia had a population of 210 mnllion people from many cultur- al, linguistic, and ethnic backgrounds (World Bank 2002, World Development Re- port 2002). In 1999 about 60 percent of the population was rural, down from 78 percent in 1980 (World Bank 2001, World Development Report 2000/2001). But in densely populated Java and Bali, where most of the population lives, the distinction between rural and urban is not always clear. Indonesia is nearly 90 percent Muslim but is also home to Protestants, Roman Catholics, Hindus, Bud- dhists, and other religious minorities. Educating Although hundreds of languages are spoken, the nation's official language is Bahasa Indonesia (commonly called Indonesian in English), which is known Indonesians was not by nearly all Indonesians.The Malayan language has served as a lingua franca throughout the Indonesian-Malayan archipelago since the 15th century. Both a Dutch colonial present-day Bahasa Malaysia and Bahasa Indonesia, which are mutually intel- ligible, are modernized versions of the older Bahasa Melayu. Bahasa Indone- priority. At sia was proclaimed the official language of Indonesia in 1928, as part of the early independence struggle. The widespread acceptance of a national language in independence there this large, multilingual country was undoubtedly helped by the fact that the of- ficial language chosen was not thejavanese language of the dominant majority- were only 337 a lesson not learned in some other countries (India, for example).Among people 15 and older in 1998, 91 percent of men and 80 percent of women were re- higher education ported to be literate (World Bank 2001, World Development Report 2000/2001).9 The country's rich and diversified resource base includes oil, natural gas, graduates in a minerals, timber, and substantial primary energy resources. Indonesia is the world's largest exporter of liquefied natural gas. In addition to exploitation of natural population of 70 resources, the economy is based on manufacturing of consumer goods (tex- tiles, processed foods, garments, shoes, furniture) and intermediate goods (ply- million wood, cement, fertilizer), on agriculture and fishing (rice, cassava, maize, fish, and poultry and other animals for domestic consumption, and rubber, coffee, palm oil, spices, tea, cocoa, food, live animals, and fish for export), on trade, and on hotel and restaurant services.10 Early Indonesian history and culture (see Koentjaraningrat 1975b, 1985, and Fox 1980) were formed from a complex mix of influences from Chuna, India, Southeast Asia, and the Arabian peninsula. During the 15th century the Por- tuguese, Spanish, British, and Dutch fought for control of the Indonesian spice trade. By the 17th century the Dutch dominated the trade routes, and in the 18th and 19th centuries they occupied most of what is now Indonesia. Indonesia became administratively unified under Dutch colonial rule, which lasted until the Japanese occupation during World War II. The Dutch saw no need to bring significant numbers of Indonesians into government or to start preparing them to manage their own affairs. The 1930 census, the last before 26 The Microfinance Revolution: Lessons from Indonesia Indonesia's independence, showed there were 208,269 Dutch living in Indonesia.They ran virtually everything.. .M.S. Ricklefs in hls study A History of Modern Indonesia quotes Dutch governor- general B.C. de Jonge (1931-36) as saying, "We have ruled here for 300 years with the whip and the club, and we shall still be doing it for another 300 years." Education for the local people was also not high on the Dutch agenda, with the result that there were only a few hundred Indonesian college graduates out of a total population estimated at 70 million at the time of independence."1 -Masters 1999, p. 2 Independence was During the 1920s the Indonesian National Party (Partai Nationalis Indone- sia, or PNI) was organized by Sukarno-popularly known as Bung (brother) Karno, declared in 1945, later the country's first president-and six other founders. The PNI urged im- mediate independence. But the Netherlands strongly resisted the idea of Indonesian but the struggle to independence, and in 1929 Sukarno and many of his associates were imprisoned. Released in late 1931, in part because of protests by humanitarians in the Nether- gain it continued. In lands, Sukarno joined Mohammad Hatta and Soetan Sjahrir in forming a new party, the Indonesian National Education Party (Pendidikan Nasional Indone- 1949 Indonesia sia); the party's initials were intentionally kept the same as the previous independence party. Sukarno was imprisoned again in 1932 and then exiled to a remote fish- finally became a ing village in eastern Indonesia, where he remained until 1942. In 1940 Germany invaded Holland, and in 1942 Japan invaded Sumatra and unified republic with then Java. Sukarno became the nominal head of the Indonesian government under Japanese rule. He helped Indonesians when and as he could, but little Sukarno as could be done to mitigate the terrible hardship and suffering that the Japan- ese occupation brought to Indonesia. president InAugust 1945Japan surrendered to theAllies.Japan had promised to grant independence to Indonesia, but the promise was not kept and Japan handed Indonesia over to the Allies. However, during the short period between the Japanese surrender and the arrival of the Allied forces, Indonesia declared independence. A short procla- mation, written by Sukarno in Indonesian, stated: "We the people of Indone- sia hereby declare Indonesia's independence. Matters concerning the transfer of powers and other matters will be executed in an orderly manner and in the shortest time possible." Sukarno and Hatta signed the proclamation on behalf of the Indonesian people on 17 August 1945. But independence was not yet won. The Dutch returned almost immedi- ately, killing some 8,000 civilians in Jakarta by December 1945 (Neill 1973, p. 325). The Dutch tried several times to assassinate Sukarno, while the British (in Indonesia in the aftermath of the Japanese surrender) tried to arrest him. Over the next four years guerrilla warfare ensued in many parts ofJava as well as in Sumatra and Bali. Finally, on 27 December 1949 Indonesia became a fully independent state with Sukarno as its president and Hatta as its vice president. An Introduction to Indonesia 27 The Sukarno Era, 1949-67 Under President Sukarno Indonesia became a unified republic.'2 A constitu- tion was written and announced on 18 August 1945, the day after Sukarno and Hatta had proclaimed Indonesia's independence. Meant as a provisional con- stitution, it was short and general, but provided for a powerful presidency. Although the large majority of Indonesians are Muslim, the country was not established as an Islamic state. Sukarno's Pancasila was offered as a com- promise among groups with strongly different views on this and other issues. "The primary objective of this fuzzy doctrine is rooted in its first principle [be- lief in one supreme being] which aimed to undercut demands from the Mus- Sukarno' lim community for an Islamuc state" (Schwarz 1994, p. 10). Sukarno's presidency (1949-67) began with a period of parliamentary presidency began democracy. In 1950, when Indonesia became a fully independent state, a new constitution was adopted that mandated a parliamentary government, provid- with a period of ed detailed guarantees for human rights, instituted a system of checks and bal- ances for political institutions, and subordinated the military to civilian parliamentary leadership."3 In 1953 the government announced plans for general elections, which were held in 1955. More than 90 percent of the registered voters cast democracy. In 1959 ballots-in what turned out to be Indonesia's last democratic election until 1999. No party contesting the 1955 elections won a majority of the votes, and he switched to Sukarno continued as president with a coalition government. An election was also held in 1955 to elect delegates to the Constitutional 'guided Assembly (Konstituante), which was to draw up a permanent constitution. De- spite its diverse membership, the Constitutional Assembly was able to reach broad democracy "-in consensus on issues concerning human rights and safeguards against arbitrary use of power. But the delegates were polarized on some issues, most notably practice personal rule the debate over whether Indonesia should become an Islamic state. By then the economy had begun a sharp declne, a rebellion had occurred "reminiscent of inWest Sumatra,14 regional discontent withJakarta's leadership had grown, the military had become increasingly unhappy with parliamentary democracy, and Javanesefeudalism" a sense of crisis was forming. On 5 July 1959 Sukarno dissolved the Constitutional Assembly, abrogated the 1950 constitution with its division of powers and human rights protections, and decreed a return to the 1945 constitution (which remains in effect today). This ended the experiment in parliamentary democracy.What followed next was Sukarno's "Guided Democracy." Guided democracy, its title notwithstanding, meant in practice a return to a system of personal rule more reminiscent of Javanese feudalism than the chaotic democratic experiment of the 1950s.'In Guided Democracy,' Sukarno once said, with typical flair,'the key ingredient is leadership.The Guider. . . incorporates a spoonful of so-and so's opinions with a dash of such-and such, always taking care to incorporate a soupfon of the opposition. 28 The Microfinance Revolution: Lessons from Indonesia Then he cooks it and serves his final summation with "OK, now my dear brothers, it is like this and I hope you agree..." It's still democratic because everybody has given his comrnent.' -Schwarz 1994, pp. 16-17 Under Guided Democracy the influence of the Indonesian Communist Party (Partai Komunis Indonesia, or PKI) rose and became a source of serious con- cern to Islamic parties and to the military. Meanwhile, the military also became increasingly alarmed about political Islamic groups and their goal of Indone- sia as an Islamic state.The military expanded its operations under what had be- come known as the "the middle way," a doctrine formulated by Major General Abdul Haris Nasution in 1958. 15 According to the middle way the armed forces By the early 1960s were not only a military force, but also a socio-political force with a role in preventing national instability. Under Guided Democracy the military received the economy was in representation in the cabinet, civil service, and parliament. Later, under the mid- dle way, the military greatly expanded its role throughout the country. steep decline. And The Sukarno administration was based on an uneasy coalition of nation- alists, religious groups, and communists known as NASAKOM (Nasionalisme Sukarno-listening [nationalism], Agama [religion], Komunisme [communism]). An inherently unstable grouping, it began to rupture in the late 1950s and early 1960s. only to what he Sukarno, a political revolutionary, was little interested in economics. By the early 1960s the economy was in steep decline. Production and investment had wanted to hear- fallen sharply. Debt soared, real per capita income declined, the country was wracked by hyperinflation, and the agricultural sector could not produce lost touch with the enough food to feed the population. Export earnings declined sharply, the coun- try's net foreign exchange reserves were negative, and the budget deficit reached Indonesian people about half of government spending. Banks, choked with regulations and un- able to attract funds because of inflation that reached more than 600 percent, ceased most commercial lending. Most of the population was poor and get- ting poorer.16 Meanwhile, Sukarno had lost touch with the Indonesian people, listening only to those who said what he wanted to hear. "Dialogue died. The flow of opimon was now only from the top down.The sounding board for public opin- ion became an echo of the leader" Jones 1971, p. 248). Increasing antagonism between the PKI and the army, along with the growing economic problems and a narrowing of Sukarno's political base, led to a violent coup attempt in late 1965. Responsibility for the attempted coup is still in some dispute. Among the possible candidates are the PKI, some army officers, the U.S. Central Intelligence Agency, President Sukarno, then-Major General (later President) Soeharto, and others.'7 The coup attempt occurred the night of 30 September 1965, when leftist army troops murdered six army generals-members of the army's General Staff- as well as an aide, then buried them in an unused well injakarta. Soeharto, who led the army's Strategic Reserve Command (Kommando Strategis Angkatan Darat, or KOSTRAD), assumed control of the army by early morning 1 Oc- An Introduction to Indonesia 29 tober. The army blamed the PKI for the attempted coup. Along with youth, nationalist, and religious organizations that were encouraged to take part, the army massacred PKI members, followers, suspects, and others who were dis- liked by the attacking mobs.The victims included many ethnic Chinese, who were widely resented by indigenous Indonesians (pribum() because of their promi- nence in economic activities (box 8.1). The bloodbath that erupted on Java and Bali in October 1965 continued into 1966; an estimated 300,000-400,000 people were killed.8 The complex- ities of the attempted coup, and of the massacres that followed, have yet to be fully unraveled. Soeharto emerged from the havoc as the new national leader. Sukarno A violent coup was permitted to retain the title of president, but he was relieved of his pow- ers and prohibited from engaging in political activity until after the next elec- attempt occurred in tion. Executive power was transferred to Soeharto in March 1966; he was appointed acting president by the Provisional People's Consultative Assem- 1965,followed by a bly (Majelis Permusyawaratan Rakyat Sementara, or MPRS)'9 in 1967, and president in 1968. Sukarno, who never regained power, died in 1970. At the massacre that time of his death, about 60 percent of Indonesians lived below the poverty line. continued into The rest of this chapter considers Indonesian history since Soeharto assumed the presidency in 1967. It focuses first on the reasons for the country's impressive 1966. Soeharto and sustained economic development over three decades, then considers the reasons for the devastating economic, financial, and political crisis that began emerged as the new in1997; progress toward recovery; and early steps toward a workable political democracy. leader and soon became president The Soeharto Era, 1967-98 When Soeharto's New Order government took de facto control in March 1966, it inherited a fractured society and an economy in chaos.Thirty years later, in 1996, the IMF ranked Indonesia seventh in its list of emerging economies. Sim- ilarly, a 1997 World Bank report on Indonesia was titled "Indonesia: Sustain- ing High Growth and Equity."According to estimates for Indonesia made by the Bank in 1996: Economic growth is expected to remain at about 7.5 percent over the next few years, despite a declining contribution from the oil sector. Ongoing trade and industrial sector reforms should continue to open profitable areas for relatively labor- intensive export industries. -World Bank News, 4 April 1996, p. 6 In stark contrast, a July 1998 World Bank report on Indonesia, called "In- donesia in Crisis: A Macroeconomic Update," stated: 30 The Microfinance Revolution: Lessons from Indonesia Box 8.W Excerpts from David C. Cole and Betty F. Slade's Building a Modem Financial System: The Indonesian Experience A brief description of the evolution of the economic role of the ethnic Chinese business- men in Indonesia [is provided]. because many financial policies resulted from the over- whelming and very obvious economic success of many ethnic Chinese in Indonesia and their seeming domination of many aspects of economic activity In the early years of the New Order, Bruce Glassburner wrote It is the Chinese who pose the most difficult problem because of their vastly disproportionate share of economic power. The indigenous majority regard the power of the Chinese with suspicion, fear and hostility The indigenous The World Bank peoples typically regard the Chinese with derision for their devotion to trade, moneylending, banking, and manufacturing, while both resenting and envying the wealth and power which they enjoy Unfortunately, for the economic poli- observed in 1998 cymakers in the government, this dominance of Chinese entrepreneurship presents a major complication Policies which attempt to revitalize the private during the sector benefit the Chinese ethnic group relatively more than the indigenous majority, so far as direct effects are concerned Attempts to build an indige- nous entrepreneur group through subsidy and protection have not been nota- Indonesian crisis, bly successful (Glassburner, 1971, pp 181-82) "No country in In 1994 Schwarz...could affirm that the problem was influencing policymaking Indonesia's small, ethnic-Chinese business community dominates the private recent history has sector Many leading pnbumi [indigenous Indonesian] businessmen conclud- ed that the technocrats' deregulation measures [of the 1 980s and early 1 990s] ever suffered such a were specifically aimed at helping the ethnic-Chinese increase their dominance of the business world The fact that many of these same pnbumi business- men also benefited from the deregulations didn't blunt their resentment [pp dramatic reversal of 80-81] How did this important economic role of the Chinese come about? Glassburner fortune" (1971, p 9) attributes it to the legacy of the Dutch colonial regime which seems to have encouraged a "special economic and social position of the Chinese" [in addition,j the extensive system of Chinese schools was much more developed than those for Indonesi- an pnbumi children When the Dutch left Indonesia, the Chinese were the strongest economic force left However, they did not have political or military power in the new independent Indonesian state and were faced with building up new relationships. The Chinese have been suc- cessful since that time in joining with pnbuml businessmen in economic activities, includ- ing links with politicians, bureaucrats, and the military In the last two decades, a number of Chinese businessmen have joined forces with President Soeharto's emerging family interests This collaboration allowed the Chinese to get around the discriminatory practi- ces against them but, on the other hand, also provided the business skills and experience of the ethnic Chinese to a venture Foreign investors often preferred working with Chi- nese businessmen in Indonesia "because they were better equipped in terms of busi- ness experience, capital and technical know-how." Chinese firms have maintained close connections with Singapore and Hong Kong which have opened up opportunities for credit and trade and given them a distinct comparative advantage The ethnic Chinese, originally mainly in commercial, service, financial, and small in- dustrial sectors began to become more involved in larger manufacturing and industrial An Introduction to Indonesia 31 Box &1 (continued) activities However, many Chinese have remained in small-scale operations Soeharto remained close to powerful ethnic Chinese businessmen and involved them in most ma- jor investments with his family, friends and close colleagues Note Cole and Slade's account was published in 1996 During 1997 and 1998 many of the protests and riots that led to Soeharto's downfall targeted ethnic Chinese, who were widely seen as control- ling the nation's economy under Soeharto's protection and at the expense of indigenous Indonesians (pribuml) Source Cole and Slade 1996, pp 322-27 Injavanese culture, power is believed to Indonesia is in deep crisis. A country that achieved decades of exist as an entity rapid growth, stability, and poverty reduction, is now near economic collapse.Within the space of one year Indonesia has independent of its seen its currency fall in value by 80 percent, inflation soar to over 50 percent, the economy swing from rapid growth to users. The ruler has even more rapid contraction, unemployment climb rapidly, and the stock exchange lose much of its value. Foreign creditors have all the power-but withdrawn, investors have retreated. Capital and entrepreneurs have fled. Long standing defects in governance, earlier it can move to camouflaged by rapid growth, have now been unmasked as fatal flaws.. .No country in recent history, let alone one the size another holder of Indonesia, has ever suffered such a dramatic reversal of fortune. -World Bank 1998b, p.1 The World Bank was not alone in not anticipating the crisis. [A] study by Kaufmann, Mehrez, and Schmukler (1998) looked at various indicators of market expectations based on the Global Competitiveness Survey (GCS), McGraw-Hill Global Risk Service, and Moody's and Standard and Poor's (S&P) ratings. Only businessmen and local investors seem to have foreseen the crisis in Thailand and Korea, and to a lesser degree in Malaysia. No one predicted the crisis in Indonesia. -World Bank 1998a, p. 43 The reasons that the crisis was not anticipated, and the multiple warning signals that were not sufficiently heeded, are discussed later in the chapter. The exceptional achievements-and extraordinary regressions-that occurred during Soeharto's 32-year presidency are best viewed in the complex context in which they developed. Along with lessons from the wayang, two concepts 32 The Microfinance Revolution: Lessons from Indonesia are important for understanding Indonesia generally and the Soeharto era in particular: the Javanese concept of power, and Pancasila, the guiding principles of the Indonesian government. The Javanese concept of power Soeharto is Javanese, as was Sukarno and as are about 45 percent of Indone- sians. The Javanese concept of power is central to understanding Soeharto's presidency. BenedictAnderson's 1990 [1972] seminal work,"The Idea of Power in Javanese Culture," analyzes the differences between Western and Javanese concepts of power. InJavanese culture power is seen as a concrete entity that exists mdependent of its users.The total amount of power remains fixed, though its distribution may vary. "Power simply exists, and is not the product of or- Pancasila, the state ganization, wealth, weapons or anything else-indeed [it] precedes all of these and makes them what they are... Since all power derives from a single ideology, is so broad homogeneous source, power itself antecedes questions of good and evil... .Power is neither legitimate or illegitimate. Power is" (Anderson 1990 [1972], pp. that it can appeal to 22-23). As Schwarz (1994, p. 45) says, "The Javanese ruler does not have some of highly diverse the power, he has all of it. Power is a zero-sum game: to get it, you have to take it from someone else. There is no sense of broadening your scope of power by groups. It also seeking a mandate from your subjects." Soeharto saw the power he took from Sukarno as emanating from God, not enables a powerful from the Indonesian people.20 In this concept of power there is no scope for power sharing or for independence in the judiciary, legislature, political parties, or president tojustify media.Yet the traditional Javanese concept of power is not necessarily believed in by the many Indonesians outsideJava or, in the modern era, by manyjavanese. virtually any Pancasila, the guiding principles of Indonesian government decision Pancasila-belief in one supreme being, Indonesian unity, humanitarianism, democracy by representative consensus, and social justice-is a state ideology of great flexibility that can be (and has been) pulled, pushed, and stretched to cover just about any situation. Accordingly, and in contrast to the Javanese concept of power, there has been a wide gap between form and practice in Pancasila. In reality Indonesia is far from the ideal of Pancasila democracy. Not only is it not democratic in the Western liberal sense, it is not democratic in the Pancasila democracy sense either. The lmperative of"consensus at all costs" leaves Indonesians with little scope to disagree with official policy...The interesting thing about Indonesia's Pancasila democracy is that it includes many of the features of democratisation-secret balloting, universal adult suffrage, regular elections-but relatively few of the individual and group freedoms on the liberalisation agenda. It has, in other words, the form of (Western) democracy but not the content. -Schwarz 1994, pp. 292, 294 An Introduction to Indonesia 33 However, Soeharto strongly promoted acceptance of Pancasila principles, although not necessarily their implementation.The general principles of Pan- casila incorporate three important characteristics.They are so universal that they are widely agreed on and cannot easily be openly opposed.As the national ide- ology, they provide protection against specific ideologies or religious values that various groups advocate for adoption by the state. And their existence has al- lowed the government to control those it declared to be following anti-Pan- casila practices. An example of the second characteristic is that Soeharto, invoking the Pan- casila state ideology, was able to hold off militant Muslim munorities advocat- ing that Indonesia become an Islamic state, as well as those who argued for Real annual income exceptions for Muslims under Pancasila ideology. An example of the third is that under Soeharto's rule and the Pancasila doctrine of tolerance, ethnic and for the average religious conflicts were prevented where possible and controlled when they oc- curred. Negative examples of the third characteristic were common. Interfer- Indonesian was ence with political parties, "mysterious killngs" of alleged criminals without trial,21 control of the press, banning of books and plays, and the like were typ- nearlyfour times ically justified as protecting the society from anti-Pancasila elements. higher in 1996 The economy, 1966-96 The New Order government is known for its rapid economic growth and de- than it was in 1970 velopment. During three decades of high growth the economy became diver- sified, as the country moved away from dependency on oil and developed an export-oriented manufacturing base. Major achievements in poverty reduction, agriculture, population control, and education brought international recogni- tion. Indonesia's population grew from 118 million in 1970 to 197 million in 1996. However, "real annual income for the average Indonesian was nearlyfour times higher in 1996 than it was in 1970" (Radelet 1999, p. 1). Between 1986 and 1996 real GDP grew by an average of 7.9 percent a year, increasing per capita incomes by nearly 80 percent. In 1996 per capita income reached $1,073 (in constant 1995 U.S. dollars; table 8.1).The focus here is on the growth of the economy from 1966-96; the crisis that began in 1997 and current reha- bilitation efforts are discussed later in the chapter and in chapter 15. Macroeconomic management and the technocrats. In 1966, as Soeharto's New Order government took power, the economy was paralyzed.The first priorities were to form a team of economic managers and to begin a process of economic restructuring.The new government introduced stabilization and rehabilitation policies, paying immediate attention to reducing inflation. Emphasis on devel- opment was next: increasing food production (especially rice), developing in- frastructure, strengthening the mining and manufacturing sectors, and encouraging foreign investment and export expansion (see Booth and McCawley 1981b). These policies were the work of a team of economics ministers that imi- tially had five members, though it later expanded.22 The team is known infor- mally as the "Berkeley mafia" (because many of its members were educated at 34 The Microfinance Revolution: Lessons from Indonesia Table 8.1 Economic indicators for Indonesia, 1996-2000 Indicator 1996 1997 1998 1999 2000 Exchange rate (rupiah/U.S. dollar, end of penod)a 2,383 4,650 8,025 7,085b 9,595 GDP growth (percent, at constant 1993 growth rates) 7 8 4 7 -13 0 0 3C 5 2C Annual inflation (percent, measured using consumer prices)a 8 0 6.2 53 4 20 5 3 7 GNP per capita Macroeconomic (constant 1995 U S dollars) 1,073 1,099 903 906 n a n a Not available policy in the 1980s a See appendix 1 for more details b The small discrepancy with tables 2 1 and 2 3 in volume 1 for the 1999 exchange rate occurs because more recent IMF data were used in this volume emphasized nonoil c Preliminary data from Biro Pusat Statistik (Indonesian Bureau of Statistics) Source IMF, International Financial Statistics, March 2001, World Bank data, Biro Pusat Statistik data exports. the University of California at Berkeley).Throughout, ProfessorWidjojo Ni- Manufactured goods tisastro has been the leader of the technocrats. ProfessorAliWardhana, Indonesia's longest-serving mmnster of finance, has served (among many other roles) as the rose from 2 percent leader in the development of Indonesia's financial system.This group of tech- nocrats has guided Indonesia's economy for more than 30 years. But as discussed of export value in later in this chapter, their influence had waned by the mid-1990s, when Pres- ident Soeharto had virtually stopped listemng to them. In the post-Soeharto 1980 to 53 percent era the senior technocrats have played important, though generally less public, roles. But despite their efforts, recent governments have allowed political pres- in 1993 sures to interfere with badly needed economic and financial reforms. The economic team first won the confidence of the country with its sta- bilization of the economy after the havoc of the mid-1960s.They won further respect, both at home and abroad, by effectively managing the economy through a series of oil booms and busts during the 1970s and 1980s, and by implementing far-reaching reforms in fiscal policy, foreign trade, and the financial sector beginning in the early 1980s. During the 1970s Indonesia's economy was heavily based on its rich nat- ural resources, especially oil and gas, copper, gold, tin, rubber, and palm oil. Ex- port revenues financed widespread infrastructure-roads, irrigation systems, ports, and schools-as well as massive health, family planning and education programs. "While there was clearly extensive waste and abuse, Indonesia managed its re- sources far better than most resource-abundant developing economies in the 1970s and 1980s" (Radelet 1999, p. 2). Agricultural output grew steadily be- ginning in the 1970s, supported by the government's investments in rural de- velopment, green revolution technology, and the relatively stable prices offered to rice farmers (see chapters 9 and 11). An Introduction to Indonesia 35 Three elements of macroeconomic management instituted by the New Order government in its early days guided the economy for decades.23 First, the gov- ernment required a balanced budget every year. This permitted the financial system to channel funds primarily to state and private enterprises that emphasized direct productive activities. It also prevented banks and the public from being forced to fund government deficits.While foreign borrowing was used to bal- ance resources and expenditures, the balanced budget rule enforced a budgetary discipline that protected the economy from deficit spending and inflationary excess.Although there were some off-budget expenditures, the balanced bud- get rule worked well for years. But by the latter part of the Soeharto era, the rule may have helped hide growing off-budget expenditures and increasing lack In the early 1 980s of transparency. Second, in what was considered a radical move at the time, the rupiah was the government made fully convertible in 1970.The open capital account placed a second ex- ternal constraint on monetary policy; it compelled the government to take rapid initiated a series of corrective action when external or internal developments threatened the bal- ance of payments. "The open capital account.. .ensures that any monetary mis- majorfinancial management will show up almost immediately in an outflow of foreign exchange. Thus convertibility imposed the discipline needed to deal with reforms to deregulate monetary pressures whenever these arose" (Wardhana 1998a, p. 128). Over time the government adopted an exchange rate mechanism that aimed at maintaimhg thefinancial sector the real international value of the rupiah by adjusting the rate to reflect move- ments in the domestic consumer price index relative to the international prices and promote a of its main trading partners. But by the mid-1990s a highly leveraged, risk-taking corporate sector and competitive economy foreign investors eager for Indonesian equity and debt could make use of the open capital account in ways that led to a substantial increase in private for- eign debt (Kenward 1999, p. 80). As discussed later, much of this debt was un- hedged and contributed significantly to the crisis in 1997. Third, the government instituted a relatively conservative borrowing pol- icy that lasted through the 1980s. For example, unlike many other oil-export- ing countries, Indonesia had a debt service ratio of only 15 percent in 1984, the year before an international collapse in oil prices (Wardhana 1998a).Thus effects on the Indonesian economy of the falling oil prices of 1985-86 could be cushioned by expanding international debt. But in the 1990s borrowing increased.A major source of the problem was the Soeharto family and friends, who used state banks to leverage funds from foreign banks for large, often nonviable, investment projects. By 1993 Indone- sia was ranked by the World Bank as the fourth largest debtor among devel- oping countries. Another important aspect of macroeconomic policy in the 1980s was the emphasis placed on the rapid increase of nonoil exports. In 1984 oil and gas revenues accounted for nearly three-quarters of Indonesia's dollar earnings from exports, but by 1989 manufactured exports accounted for nearly a third of ex- port earnings, while oil and gas contributed less than 40 percent of the total 36 The Microfinance Revolution: Lessons from Indonesia (Wardhana 1998a). Major exports include plywood, textiles, garments, shoes, toys, and furniture.24 Its large labor supply and relatively low wages give In- donesia a comparative advantage in labor-intensive products. In addition, most export industries are labor-intensive by government policy (although regula- tions and corruption have sometimes hindered implementation of this poli- cy). Manufactured exports grew by nearly 30 percent a year between 1986 and 1996.As a share of the value of exports, manufactured goods rose from 2 per- cent in 1980 to 53 percent in 1993 (World Bank 1997, World Development Re- port 1997). And the government increased efforts to deregulate the trade sector, sharply reducing multiple trade restrictions. It reduced and eventually removed numerous restrictions on foreign direct investment.And it adopted "a modern, simplified The newly tax system that removed low-income wage earners from the tax net, eliminat- ed, at least in principle, nearly all exemptions, and introduced the value added deregulatedfinancial tax" (Stern 2000, p. 2). system was to Financial reforms. In the early 1980s the government initiated a series of financial reforms to deregulate the financial sector and promote a competitive operate within the economy (see Wardhana 1994b, 1998a; Hanna 1994; McLeod 1994; Nasution 1994; Binhadi 1995; Cole and Slade 1996; and Stern 2000, forthcoming). prudential Some of the most important of the reforms are summarized below. The first reform, announced in June 1983, focused on deregulating cred- regulations. But this it. Credit ceilings were abolished. Liquidity credits from Bank Indonesia, the central bank, were reduced except for priority sectors. And banks were per- proved difficult to mitted to set their own interest rates on most loans and deposits.Among its other purposes, the June 1983 reform was crucial for the development of BRI's mi- implement, often crobanking system. In December 1987 a package of deregulation measures, known as PAKDES impossible I,25 was issued to activate and reform the stock market.Then in October 1988 a broad package of financial reforms, known as PAKTO 88,26 was announced; one of its most important aspects was its emphasis on competition, especially within the banking sector. PAKTO 88 opened new opportumties for finan- cial activity in rural areas. Restrictions on the operations of foreign banks were reduced. Requirements for opening new domestic banks were substantially eased. Banks wholly owned by Indonesian nationals were now permitted to open branches anywhere in Indonesia. And, in general, banks were given more au- tonomy and encouraged to expand their activities. Included among the provisions were a relaxation of requirements for open- ing branch offices and encouragements for banks to introduce new products. Reserve requirements were lowered from an average of 11 percent to a uni- form 2 percent on all deposits, reducing bank costs of intermediation. PAKTO 88 had a deep effect on the banking system. "The short-run impact of the PAKTO reforms was basically favorable.They had probably contributed to ac- celerating overall economic growth, without adversely affecting relative price stability and balance of payments equilibrium. In addition the banking system An Introduction to Indonesia 37 became more competitive and customer-oriented and was rapidly expanding both its facilities and services" (Cole and Slade 1996, p. 115). But in the longer term, the proliferation of banks that ensued, combined with the growing cor- ruption of wealthy and politically influential families and with inherent weak- nesses in the financial system, contributed to the financial crisis of the late 1990s (see chapter 15). Additional reforms followed, focusing on private securities markets, insur- ance, and promotion of instruments such as venture capital, leasing, and cred- it cards. PAKJAN,27 a January 1990 reform package, ended or cut back many of the subsidized credit programs that were administered by Bank Indonesia and channeled through state banks. Most of these liquidcty credit arrangements In 1970 about 60 were abolished except for those supporting food self-sufficiency and cooper- ative and small-scale enterprise development. In a political tradeoff, however, percent of PAKJAN also directed all domestic banks to allocate at least 20 percent of their loan portfolios to loans below 200 million rupiah (about $111,000 at that time).2s Indonesians lived But the growth of the financial system caused increasing concern about the need for better prudential regulation. In December 1990 the government pro- below the poverty vided for the privatization of the stock exchange, announced new regulations on loan loss provisioning, and required banks to adopt (over several years) the line. In 1996 the capital adequacy standards of the Basel Agreement. In the years that followed, the government's main priority for the financial system was to ensure that the figure was 11 newly deregulated system operated within appropriate prudential regulations. This effort included new measures of bank soundness and new laws on bank- percent ing, msurance, and pensions that were approved by parliament m the 1992 Bank- ing Law. Emphasis was also placed on restructuring bank management and operations so that banks could comply with the new regulations. Underlying the multiple, multiyear financial reforms was the overall goal of moving from the previous pattern of direct government control of the fi- nancial system to oversight of the system through prudential regulation.As dis- cussed later in the chapter and in chapter 15, however, effective implementation of the prudential regulations proved extremely difficult, often impossible, in the Indonesian political context of the 1990s. Poverty reduction and human resource development. Indonesia's rapid and sustained growth in these years made possible massive reduction in poverty, a remarkable achievement. In 1970 about 60 percent of Indonesians lived below the poverty line. By 1976 the portion of the population below the poverty line had declined to 40 percent (or nearly 54.2 million people)-and by 1996, to 11 percent (or 22.5 million people; Biro Pusat Statistik [Indonesian Bureau of Statistics] 1996, p. 570). Even during periods of financial difficulties, fiscal allocations and develop- ment expenditures for programs directly benefiting the poor were usually pro- tected. In addition, industrial development was carried out in a policy environment that emphasized the creation and expansion of labor-intensive in- dustries.The government was strongly committed to antipoverty programs and 38 The Microfinance Revolution: Lessons from Indonesia made special efforts to identify and help the poorest villages and the poorest people (see Haryono Suyono,"Indonesian Family Empowerment to Alleviate Poverty," Indonesia Times, 6 September 1997, p.7).As noted, average income in the poorest quintile of the population grew faster between 1976 and 1990 than average income for the entire population. And real annual income for the av- erage Indonesian was four times as high in 1996 than it had been in 1970. Indonesia also invested heavily in rural development. As discussed, a sub- stantial share of the oil wealth of the 1970s was invested in economic and so- cial infrastructure-much of it in rural areas, where more than 80 percent of the population lived at that time. Improvements in agriculture enabled Indonesia to become self-sufficient in rice and, despite a growing population, allowed per capita food consumption to grow, resulting in widespread improvements in nu- A substantial share trition and health. Family planning and primary education were made high priorities, and na- of the 1970s oil tionwide programs were effectively implemented beginning in the 1970s.Av- erage annual population growth fell from 2.3 percent a year during 1970-80 wealth was invested to 1.7 percent during 1990-97. The total fertility rate decreased from 4.3 in 1980 to 2.6 in 1996,29 while infant mortality (per 1,000 live births) plummeted in rural from 90 to 49 during the same period. Life expectancy at birth rose from 41 years in 1960 to 53 in 1980; by 1996, lfe expectancy was 63 years for men and infrastructure, 67 for women (World Bank 1982,1999). Education also expanded rapidly. Ninety-seven percent of the relevant age agriculture, group was in primary school in 1996 (compared with 71 percent in 1960 and 86 percent in 1977). And in 1996, 88 percent of both males and females education, and reached grade 5. Forty-two percent of the secondary school age cohort was enrolled in school that year (compared with 6 percent in 1960 and 21 percent health andfamily in 1977). By 1997 both females and males were expected to receive an aver- age of 10 years of formal schooling (World Bank, 1980,2000,2001). In the 1990s planning increasing priority was placed on tertiary education as well. Overall, the New Order government's macroeconomic policies and wide- ranging reforms achieved much over three decades, including substantial growth in GDP and per capita GNP, single-digit annual inflation from 1985-97, large increases in food supplies, dramatic nationwide successes in family planning and primary education, and a sharp reduction in poverty. Indonesia in relation to other emerging economies. Among the 15 lowest of the world's lower-middle-income economies in 1995, Indonesia (with $980) ranked eighth in GNP per capita.30 By far the most populated of the coun- tries, in 1985-95 Indonesia ranked first among the 15 in average per capita GNP growth (6.0 percent a year, compared with the median of 1.0 percent). In 1995 Indonesia had one of the highest average GNP growth rates (7.2 percent, com- pared with the median of 2.3 percent).The share of income held by the poor- est quintile of the population was highest in Indonesia and Egypt, both with 8.7 percent in 1995. Indonesia was at or near the median for all other economic and social indicators (World Bank 1997f, 1997g). An Introduction to Indonesia 39 Because of Indonesia's large population and its location in Asia, it is also useful to compare indicators for the eight Asian countries with low-income and lower-middle-income economies that in 1995 had populations of more than 50 million-in descending order of size of population: China, India, In- donesia, Pakistan, Bangladesh,Vietnam, the Philippines, and Thailand. Indone- sia, the third most populous but least densely populated of the eight countries, was above or near the median on all indicators. For the period 1985-95, In- donesia ranked third in average annual GNP per capita growth (afterThalland and China). It was third in 1995 GNP per capita (afterThailand and the Philip- pines). Among the eight countries, Indonesia was second highest in the share of income held by the poorest quintile in 1995 (8.7 percent), after Bangladesh The economics team (9.4 percent;World Bank 1997f, 1997g). was knownfor both Economic growth with equity. Indonesia made extraordinary progress in eco- nomic and social development between 1967 and 1996. Under the New Order vision and government, emphasis was placed simultaneously on raising economic growth and on reducing poverty; on improving agriculture and on increasing indus- caution-andfor try; on encouraging manufactured exports that are highly labor-intensive; on stimulating both public and private sectors; and on developing the country's decades of stable natural and human resources. The economics ministers worked as a team, drawing on a combination macroeconomic of caution and vision and a remarkable ability to learn from their mistakes, to implement tough policies, and to adapt to changing circumstances. Their management that stable and foresighted economic management was crucial for the country's development. enabled economic Since independence, however, Indonesia has been a country with a strong ruler and a weak state. As the economy grew it was also being undermned by growth with equity political forces discussed below.This intricate disconnect could not continue mdefinitely.The seeds of the recent crisis had long been germinating in Indonesian politics, even as the economy expanded year after year. The government, the military, and politics during the Soeharto period The Indonesian government operates under the original 1945 constitution which established a strong presidential form of government and a centralized admin- istrative structure, and mandated the principle of government by consensus.The cornerstone of the preamble to the constitution is the Pancasila. The discus- sion below refers to the Soeharto period. Events that occurred after his resig- nation in May 1998 are discussed later in this chapter and in chapter 15. The Indonesian military operates as both a mnlitary and a sociopolitical force under the doctrine of dwifungsi, or dual function-an outgrowth of the "mid- dle way" that developed under Sukarno's "Guided Democracy."31 An under- lying principle of the dual function concept is that national unity and political stability are preconditions for economic growth. The role of the military, broadly conceived, has been to protect political stability and actively to pre- vent its deterioration-an umbrella that has covered a wide range of activities. 40 The Microfinance Revolution: Lessons from Indonesia Under Soeharto, politics and the military were closely linked.A crucial as- pect of Soeharto's rule was his role as general, commander-in-chief, and pa- tron of the military.Another was his role in Golkar (golongan karya, or functional groups), the political arm of his regime. Golkar has been, in practice, controlled by the mlihtary-but both were controlled by Soeharto. The government. Under the constitution, the president, who serves as head of state and government, and the vice president are elected to five-year terms by the People's Consultative Assembly (Majelis Permusyawaratan Rakyat, or MPR). The MPR, which must meet at least once every five years, is also re- sponsible for reviewing and approving the government's broad policy goals.32 During the Soeharto era, MPR decisions were consistently made by (Soeharto- The military has a orchestrated) "'consensus.." Until the post-Soeharto reforms discussed later in this chapter, the 1,000- dualfunction: to member MPR consisted of the 500 members of the legislature and 500 rep- resentatives from the regions, from political organizations, and members of Golkar protect political from the armed forces.The 500-member legislative assembly, the Dewan Per- wakilan Rakyat (DPR), consisted of 425 elected members and 75 members ap- stability and to pointed by the president. The Indonesian judicial system administers three kinds of civil law: Shari'a, prevent its or Islamic law, for Muslims; a civil law based on Roman law for Europeans; and a collection of statutes, not yet codified, for other Asians such as ethnic Chi- deterioration-an nese and Indians.The same criminal law applies to all. As discussed below, however, a striking feature of Indonesian governance umbrella that has has been the wide gap between form and practice. Illustrating theJavanese con- cept of power, both the legislature and the judiciary were, in practice, under covered a wide range the direct control of President Soeharto, as was the MPR. An important, but often overlooked, aspect of governance in the Soehar- of activities to period was the substantially increased role Indonesia came to play in regional and international peacekeeping and cooperation. Under Soeharto, Indonesia became a strongly stabilizing force in Southeast Asia. During the more than 30 years of New Order government the country fought no international wars33- more than can be said for the others among the world's four most populous nations (China, India, and the United States). Moreover, Indonesia has played an important role in the Association of Southeast Asian Nations (ASEAN), in the development of the worldwide Non-Aligned Movement (NAM), and more recently in the Asia-Pacific Economic Cooperation (APEC) forum. The military. Under the doctrine of dwifungsi, or dual function, the armed forces (Angkatan Bersenjata Republik Indonesia, or Abri) play a major role at every level of society. From 1983 to 1998 between one-quarter and one-third of the seats in Soeharto's cabinets came from the military. Many village, sub- district (kecamatan), and district (kabupaten) heads were also from the military, as were many of the provincial governors who are appointed by the central government. An Introduction to Indonesia 41 Soeharto came from the army. He was born in 1921, the son of a village official in a poor village in Central Java. His parents, who divorced soon after he was born, both remarried.While growing up Soeharto moved among var- ious extended family households. He attended junior high school but had to leave because his family could not afford the expense. But he later attended a school inYogyakarta run by Muhammadiyah, a large Islamic organization, fin- ishing his studies when he was 18. Soeharto enlhsted in the Royal Netherlands Indies Army, but shortly afterwards the Dutch surrendered to the Japanese. He then enlisted in the Japanese-sponsored army of Indonesia; when the Japanese left Indonesia, he became an officer in the Indonesian revolutionary army. After independence Soeharto made his way up in the army and was eventually ap- Illustrating the pointed head of the army's Strategic Reserve Command-the base from which he assumed control of the army on 1 October 1965, following the attempted Javanese concept of coup. As president, Soeharto strongly supported the armed forces. power, Soeharto Soeharto came to power on the army's coattails and the repressive might of the army has been the single most important factor controlled the in undermining potential opponents throughout his tenure.The army has forcefully suppressed any number of legislature,judiciary, demonstrations ... But open shows of force are not really the New Order's style. Soeharto's-and the armed force's-objective is People's social control, not military control ... The military has tried to prevent unwanted political activity rather than rely on repression Consultative once that activity has appeared. Assembly, military, A second important feature of Soeharto's rule is his frequent and shrewd use of patronage to buy off critics particularly from within media, and Abri. . .As the New Order progressed so did the art of patronage. Revenues collected from Soeharto's close business associates in opposition parties sectors such as oil, construction, and agro-business-often washed through non-profit foundations-have enabled Soeharto to expand the distribution of patronage to potential critics in political, religious, and social circles. -Schwarz 1994, pp. 39-41 During the first half of the New Order government the army and Soeharto were practically synonymous (Schwarz 1994, p. 282). From the early 1980s on, however, the relationship grew more distant-especially in the 1990s with the escalating corruption of the Soeharto family and the rise of huge private wealth in corporate conglomerates. As the conglomerates grew in the 1990s, the influence of the armed forces (and the patronage it received) declined some- what. Nevertheless, Soeharto maintained control over the military, both through patronage and by continually shifting the appointments of its officers. The Indonesian military is not a monolith; its members hold a range of views. Some supported the preventive approach to political disruption as imple- 42 The Microfinance Revolution: Lessons from Indonesia mented, while others thought Soeharto took prevention too far. By the mnd- 1990s many members of the armed forces said they thought it was time for Soeharto to leave office (Schwarz 1994, ch. 10). Some, especially retired gen- erals, played an important role during the 1990s in criticizing Soeharto's ex- cesses and his growing unwllhngness to listen to others. As retired general Sayidiman Suryohadiproyo put it, "Soeharto no longer listens to anyone, not Abri nor anyone else.This is the danger we are facing" (quoted in Schwarz 1994, p. 284). The politics. During most of the Soeharto era Indonesia had a two-party political system-but both were opposition parties.What they were opposing was technically not a party but a government-sponsored coalition of groups, Indonesia was Golkar.34 Starting with an army-organized association of anticommunist func- tional groups known as Golkar, Soeharto announced in 1967 that Golkar micromanaged would become his parliamentary vehicle. The original groups soon lost their influence within the organization as Golkar came to be controlled by the mil- through a mixture of itary, with active support from the civil service and its civilian members. As Schwarz (1994, p. 31) comments, "The mass-based groups present at Golkar's top-down control, birth faded into insignificance,just as the masses disappeared from the politi- cal scene more generally." largesse, religious The military-backed Golkar quickly became the dominant political or- ganization in the country, also controlling the opposition parties.35 Seman- and ethnic tolerance, tics aside, Indonesia became essentially a one-party state. But the political power of Golkar was not held by the organization or by the army-it was held by military repression, Soeharto.36 From 1973 until after Soeharto's resignation 25 years later, only two other political parties were permitted. The United Development Party and economic (Partai Persatuan Pembangunan, or PPP) was formed in 1973 by the merg- er of four Islamic parties, and the Indonesian Democratic Party (Partai development Demokrasi Indonesia, or PDI) was formed the same year from five Christ- ian and nationalist minority parties. Several political groups (not parties) were also officially recognized. However, the political opposition was carefully controlled by Soeharto and Golkar. Until Soeharto's resignation the two opposition parties continued to serve largely as actors in the stage-managed general elections and MPR's pres- idential elections. Government officers and the military were required to vote for Golkar. Civilian voters were coerced, threatened, and paid to vote for Golkar-an approach that routinely produced the large majorities Golkar pre- dicted beforehand. The MPR, most of whose members were appointed or approved by Soe- harto, met every five years. Soeharto was elected seven times by unanumous ac- clamation, and his policies were routinely endorsed. As Juwono Sudarsono, minister of education in President Habibie's cabinet and minister of defense in President Abdurrahman Wahid's cabinet,37 put it, "Every five years 1,000 peo- ple met in a congress and there was not one who was brave enough to stand up and say, 'Enough"' (quoted in The New York Times, 13 June 1999, p. 3). An Introduction to Indonesia 43 Under Soeharto a large, complex, and pluralistic society was micromanaged through a carefully orchestrated mixture of top-down control, largesse, religious and ethmc tolerance, military repression, and economic development. Soeharto stood at the apex of the pyramid; his appointees sat in each of the key executive, legislative, and judicial branches of government. He dominated the cabinet and the state bureaucracy. He dominated the armed forces.. .He dominated the People's Consultative Assembly... He was the central figure in Golkar, the army-backed political movement, and had crippled the effectiveness of the two "opposition" political parties. He The Soehartos were dominated the judicial branch, weak as it was, and had stacked its key positions with long-time associates, all of them generals. involved in He appointed the men who sat in the Supreme Advisory Council... His writ extended into every department and into corruption "in every every state-run corporation; it reached down, if he chose, to every village. He wielded enormous power both because the 1945 form of state action Constitution confers enormous power on the president and because he was the dominant influence over the army, itself the that had an dominant force in society. In short, he had established himself as the paramount figure in a society in which deference to economic value." authority is deeply rooted. -Jenkins 1984, pp. 13-14 Indonesia was It has also been argued, however, that the authoritarian nature of Soehar- known to's political regime made possible many of the policles that promoted the coun- try's economic growth and development. internationally as a The [authoritarian] nature of the regime made possible kleptocracy macroeconomic policies marked by moderation and continuity, encouraging savings and investment. It also permitted policies that favored long-term development in regard to oil, agriculture, and industry, which, over time, and on balance, were beneficial economically and socially. -Bresnan 1993, pp. 292-93 But the strong leader-weak state syndrome required that the country's un- derdeveloped judicial, legislative, political, and financial systems stay that way. And no implementable process for succession to the presidency could be de- veloped while Soeharto remained president. "Mr. Suharto systematically neutered the most promising of his subordinates" (Seth Mydans in The New York Times, 6 May 2001, p.3).38 As Soeharto intensified his control, and as corruption mounted, cracks began to appear and then widen in the country's support for its president.This took place increasingly in the mulitary, in religious and ethnic groups, and among 44 The Microfinance Revolution: Lessons from Indonesia members of the media, students, intellectual leaders, civilian elites, and others. When the East Asian crisis hit Indonesia in 1997-sharply raising unemploy- ment, prices, and poverty-the growing dissatisfaction spread to ordinary peo- ple as well. Corruption and the growth of the conglomerates Corruption was an intrinsic part of Soeharto's rule. An outgrowth of the au- thoritarian nature of the regime and its lack of transparency and accountabil- ity, corruption took both public and private forms-though the distinction was often blurred.There was the vast private wealth amassed by the Soeharto fam- ily and their friends-through monopolies, subsidies, tax and credit benefits, and the like-at the expense of the state, of other firms, and of the Indonesian The 1 990s saw the people.The first family had major interests in virtually every sector of the econ- omy: oil and gas, shipping, banks, mmning, lumber, agroindustry, automobiles, rapid growth of huge toll roads, communications, and others.There was also massive funding for Golkar and its activities.These funds provided the means for the extensive patronage corporate that kept Soeharto in power. conglomerates owned The rise of the conglomerates. The 1980s and 1990s saw rapid growth of huge corporate conglomerates owned by the Soehartos and their friends, and by the Soehartos protected by the Soeharto regime. Closely related was the issue of the ethnic Chinese in the conglomerates. In return for their business skills, financial ex- and theirfriends perience, and investments in the first family's ventures, some ethnic Chinese were given the monopolies, subsidies, licenses, and other favors that enabled andprotected by the them to compete unfairly with most indigenous firms (see box 8.1). The scale of corruption was massive, pervasive, and continually escalating Soeharto regime (Bresnan 1993; Schwarz 1994; Cole and Slade 1996; The Economist, 30 March 1996,pp.41-42; The NewYork Times, 31 October 1997, p. C-7)."The [Soehar- to] regime was immersed in corrupt practices in the granting of licenses, lend- ing of funds, letting of contracts, and every other form of state action that had an economic value" (Bresnan 1993, p. 292). By the 1990s the soaring growth in the private wealth of the few favored families-combined with decades of inaction in domestic political develop- ment-raised, both domestically and internationally, increasing concerns about the country's economic and political stability. Because the domestic press and other media were controlled by the government, they were not permitted to report or comment directly on high-level corruption or on many aspects of domestic politics. Some members of the media, however, became masters at writing or speaking between the lines and expressing opinions through analo- gies. Some wayang puppetmasters used the foibles and heroics of ancient kings, queens, courtiers, warriors, and commoners to provide indirect com- mentary on the current scene. It was difficult for the government to object to a performance of Rama teaching the principles of rule toWibisana or other traditional wayang stories-and the messages being sent reached widespread popular audiences. An Introduction to Indonesia 45 The international media, however, increased their forthright criticisms of the Soeharto family and the conglomerates during the late 1980s and the 1990s. Articles critical of the Soeharto family and rule were banned in Indonesia dur- ing the 1970s and 1980s, but the ban became difficult to enforce during the 1990s (because there was so much criticism), and censorship relaxed somewhat. By 1997 there was hardly an international newspaper or political or econom- ic periodical that did not report high-level corruption in Indonesia. The in- ternational press referred to Soeharto's Indonesia as a kleptocracy (The Boston Globe, 2 June 1999, p. 26). The technocrats and the conglomerates. Struggles between the technocrats Soeharto was elected and the conglomerates occurred on numerous occasions, with Soeharto bal- ancing one against the other.The role of the technocrats in attempting to con- seven times by tain the conglomerates was widely recognized. As Bresnan (1993, p. 282) put it, "They [the technocrats] provided Soeharto with two essential ingredients acclamation. "Every to econonuc policy: the confidence of the international financial commumty, and policies and programs that produced demonstrable results." five years 1, 000 But powerful political and economic interests repeatedly sought to gain con- trol of financial institutions and resources. One of the most important contri- people met in a butions of the technocrats in the Indonesian government, often with support from international financial institutions, was to contain these special interests. congress and not one The technocrats were particularly skillful in maintaining their basic principles and using these to frustrate repeated attempts to circumvent financial controls was brave enough to and manipulate the financial system (Cole and Slade 1996, p. 355). While the technocrats tended to be able to get Soeharto's approval for their stand up and say policies in times of economic difficulty, ironically their influence diminished during periods when the economy was strong and financial resources were avail- 'Enough"' able for distribution.The technocrats managed to contain the conglomerates for many years. But in the mid-1990s the conglomerates' influence on Soe- harto surged, while that of the technocrats declined. Indonesia on its 50th birthday, 1995 At the time of its 50th birthday in 1995, Indonesia had accomplished much in a relatively short time and in a large and geographically diverse country with multiple languages, ethmc groups, religions, and cultural traditions. Sukarno had led the struggle for independence, unified the country, and put Indonesia on the world map. Until mid-1997 Soeharto presidency's produced strong eco- nomic growth, widespread development (including increased food production, education, health, and family planning), and a substantial decrease in poverty. The country's regional and international responsibilities had increased substantially, and Indonesia provided a stabilizing force in Southeast Asia. Yet at the 50th birthday celebration there were severe underlying problems and deep fissures in the political economy.The corruption of the Soeharto fam- ily and their friends, the president's control over the legislative and judicial branch- es, the political process, and the media, as well as the concerns-both at home 46 The Microfinance Revolution: Lessons from Indonesia and abroad-about presidential succession had led to increasing unease and mounting opposition to Soeharto. Indonesia had never seen a peaceful transi- tion in leadership. Power-sharing was not its strength, and there was little preparation for a transition to a new president. Whatever Indonesians as individuals might have thought about the Javanese concept of power, there was a growing view that, in any case, the Soeharto fam- ily was not behaving in a manner befitting a holder of power in Javanese cul- ture.A 1990 play about a fictional king and his four children who accumulated enormous wealth was closed by police order on its 1th day of playing to stand- ing-room audiences in Jakarta-because the government found it to be anti- Pancasila and a threat to security (Schwarz 1994, p. 232).The play, Suksesi, by Nano Riantlarno, ends with the following chorus: Some puppetmasters Don't show what can be obtained used the wayang to so that the people won't want it. The king always tries to keep his subjects provide indirect empty in heart, full in stomach, commentary on weak in desire, but strong in bones. current events. It was The king always tries to make sure that the people don't know dfficult to object to and those who know don't dare, Rama teaching the let alone act. And in consequence principles of rule all will be orderly and stable, orderly and stable...39 By the nation's 50th birthday in 1995, many in Indonesia thought that Soe- harto's continuing rule would not be in the interests of the Indonesian people. The Indonesian Crisis and the Resignation of President Soeharto It was in this context that the Southeast Asian crisis that began in July 1997 hit Indonesia.40 The Thai baht collapsed, the currencies of neighboring countries came under pressure, and a regional crisis with global ramifications developed rapidly. It soon extended well beyond Southeast Asia and became known as the East Asian crisis. Banks and corporations.. .borrow[ed] large amounts of international capital, much of it short-term, denominated in foreign currency, and unhedged. As time went on, this inflow of foreign capital tended to be used to finance poorer-quality An Introduction to Indonesia 47 investments. Although private sector expenditure and financing decisions led to the crisis, it was made worse by governance issues, notably government involvement in the private sector and lack of transparency in corporate and fiscal accounting and the provision of financial and economic data. Developments in the advanced economies, such as weak growth in Europe andJapan that left a shortage of attractive investment opportunities and kept interest rates low in those economies, also contributed to the buildup of the crisis. After the crisis erupted in Thailand with a series of speculative attacks on the The Thai baht baht, contagion spread rapidly to other economies in the region that seemed vulnerable to an erosion of competitiveness after collapsed, the the devaluation of the baht or were perceived by investors to have similar financial or macroeconomic problems. currencies of -IMF 1999e,p.1 neighboring The Indonesian crisis-which turned out to be the most severe in the region-erupted shortly after the collapse of the Thai baht.The primary cause countries came under of the crisis in Indonesia was not the underlying economy. It was the closely linked weaknesses in governance and in the financial system. pressure, and a The nature and extent of the crisis regional crisis with The value of the Indonesian rupiah plunged from 2,450 rupiah to the U.S. dol- lar at the end ofJune 1997 to 14,900 rupiah at the end ofJune 1998 (see ap- global ramifications pendix 1 and table 8.1). Most of Indonesia's corporations became technically bankrupt. Banks failed.And the financial system collapsed. Unemployment in- developed creased, and inflation was 53.4 percent for 1998. Even with its strong economnc base and long record of high economic growth, Indonesia could no longer at- tract foreign capital. GDP, which had grown on average by nearly 8 percent a year for a decade, grew by just 4.7 percent in 1997 and contracted by 13.0 per- cent in 1998. In addition to the financial crisis, in 1997 Indonesia faced its worst drought in 50 years.The resulting food shortages, hoarding of food by merchants, and soaring food prices occurred at a time when many farmers' incomes had fall- en sharply.A large portion of dwindling foreign reserves had to be used to im- port food, and food shortages continued into 1998. Riots over the high prices of food and other basic commodities broke out in various parts of the coun- try, often targeting ethnic Chinese. At the same time, there was a sharp decline in international oil prices. In addition, a major new environmental problem developed-one that was directly related to corruption issues. Huge forest fires, occurring during the drought in Sumatra and Kalimantan, resulted in massive haze that caused widespread air pollution, respiratory illness, ecological destruction, and economic hardship in Indonesia. These fires affected other parts of Southeast Asia as well, including 48 The Microfinance Revolution: Lessons from Indonesia Brunei, Malaysia, Papua New Guinea, the Philippines, Singapore, and Thailand (see Seth Mydans, The NewYork Times, 26 October 1997, international section, p. 3). Many of these fires had been set to clear land for large palm oil and in- dustrial pulpwood plantations. Indonesia's coffee, palm oil, cocoa, and rubber crops were harmed by the fires and the smoke, while the reduced sunlight that resulted slowed the growth of fruits and vegetables and decreased yields of maize and rice in the affected areas.These fires also "burrowed deep into vast peat bogs and seams of coal where experts say they may continue to smoulder for years" (The NewYork Times, 26 October 1997, mternational section, p. 3). In 1998 and 1999 new fires were set in Sumatra and Kalhmantan for the same purposes, again causing widespread devastation. The value of the Well-connected palm oil plantation owners and pulp-and- paper companies in Indonesia have continued clearing land by rupiah plungedfrom burning off vast tracts of jungle, seemingly immune to laws or punishment ... Indeed, the palm-oil producers, who have set 2,450 to the US. most of the fires, may be one of the few beneficiaries.They have cleared huge new areas for planting, and as the disaster has dollar inJune 1997 spread, palm-oil prices have risen sharply on the world market. -New York Times International Section, 28 August 1999, p. B2 to 14,900 inJune Shortly after the crisis began in mid-1997, unemployment and prices rose 1998 sharply. During 1997 and 1998 the government took steps to head off antici- pated reverses in poverty reduction. Public employment schemes were insti- tuted. The government guaranteed deposits in Indonesian banks. Government-subsidized credit schemes for small loans were expanded (with predictable results). An emergency $42.3 billion financial aid soft loan package for Indonesia was developed by the IMF,World Bank, Asian Development Bank, and sever- al bilateral contributors. The January 1998 IMF-supported economic reform program contained measures designed to eliminate cartels and monopolies, to remove subsidies and special privileges from some of the gigantic government- backed projects controlled by the country's wealthiest familles, and to increase transparency generally. But when the agreement was signed, there were wide- spread doubts throughout Indonesia about whether these measures could be implemented. Serious implementation problems and delays did occur, result- ing in postponed IMF payments on a number of occasions. Soeharto, becoming increasingly confrontational, strongly resisted reforms that would harm the business interests of his family and friends. But the IMF know little about the Indonesian economy and its institutions.This unfortu- nate combination exacerbated the already full-blown crisis in Indonesia. Soeharto had served six consecutive five-year terms as president when, in March 1998, he was "elected" to a seventh term. But the crisis continued to worsen, and it was increasingly believed that power, which Soeharto had held for so long, had deserted him.When the IMF agreement was signed, a picture An Introduction to Indonesia 49 of Soeharto and Michel Camdessus, managing director of the IMF, was wide- ly distributed through the Indonesian media.The picture showed Soeharto seat- ed, signing the agreement. Camdessus stood by his side, arms folded in front of him. This picture was widely interpreted in Indonesia as a sign that power had left Soeharto. (Some thought that Soeharto's power had come to him through his wife, IbuTien Soeharto, and that power had left him at her death in 1996). But by early 1998 it was widely agreed that Soeharto, although still president, no longer held power. In May 1998 corruption, the collapse of the financial system, soaring in- flation, sharply contracting GDP, capital flight, business closures, withdrawal of international investors, escalating poverty, the unresolved succession issue, and The IMF increasing violence and social disorder brought a crisis of confidence in the gov- ernment and forced Soeharto's resignation after 32 years in office. He resigned established a $42 on 21 May 1998 and was immediately succeeded by his longtime friend and protege,Vice President B. J. Habibie, a German-trained aeronautical engineer billion soft loan who had served as minister for research and technology from 1978-98. package that The roots of the crisis The economic, financial, and political components of Indonesia's economic mandated economic downturn were mutually reinforcing.The roots of the crisis ran deep. In an August 1998 speech Ah Wardhana, economic adviser to the govern- reforms. But serious ment and former long-term finance minister, put it this way:"Let me be quite blunt. Much of the economic crisis had its roots in the serious and fundamental implementation weaknesses of our financial system. Only after these have been tackled in a forth- right manner can we look forward to a serious and sustained recovery" (Ward- problems in reforms hana 1998b, p. 1). Wardhana's analysis of the basic weaknesses of the Indonesian financial sys- delayed tem is provided in box 8.2. "Our financial systems were encouraged to fund risky and unprofitable ventures. Government officials could, and did, direct loans disbursements to favored firms or activities" (Wardhana 1998b, p.2).As he shows, bureaucrat- ic interference, lending to favored firms, close links between banks and con- glomerates, and political pressure on bank regulators led to loans that were "rarely given even rudimentary economic and financial analysis." The result was a pat- tern of high-risk lending that was exacerbated by a widespread perception that banks were implicitly guaranteed by the government and by a rmispricing of foreign credits that contributed to the large capital inflows. Firms with sub- stantial foreign exchange exposure were vulnerable;"When we were forced to abandon our managed float, the depreciation of the rupiah created unmanageable debt burdens that effectively bankrupted a substantial portion of our corpora- tions" (Wardhana 1998b, p. 3). As the crisis unfolded, it became apparent that Indonesia had far more ex- ternal debt than had been publicly known-much of it owed by companies owned by the few wealthy, well-connected families discussed earlier. The for- eign debt of commercial banks had reached about three times the banks' eq- uity. Private corporations, banks among them, owed an estimated $68 billion 50 The Microfinance Revolution: Lessons from Indonesia Excerpts from Ali Wardhana's Box 8w2 "Overcoming the Current Economic Downturn" The economic meltdown, and one can hardly describe it differently, that has hit Indone- sia, had multiple causes. Some were self-inflicted, others were external...Let me be quite blunt much of the economic crisis had its roots in the serious and fundamental weak- nesses of our financial system Let me highlight only two First, our financial systems were encouraged to fund risky and unprofitable ven- tures In a banking system where state-owned banks play a significant role, bureaucratic interference is likely to be a serious problem Government officials could, and did, direct loans to favored firms or activities In addition the close links between banks and some of the conglomerates further reduced the likelihood that loans would be objectively evaluat- Iuch of the ed Even when government pressure was absent and when banks did not engage in in- tra-group lending, loans were rarely subjected to even the most rudimentary economic and financial analysis. In part, such analysis was handicapped by the absence of disclo- economic crisis had sure requirements and accounting standards that would allow analysts to make a reason- able estimate of risk And in part political pressure was exerted on bank regulators so that its roots in the they would not report some of the most flagrant violations of our banking laws In such a situation financial institutions fail in their most basic function to serve as an efficient intermediary, channeling savings to their most productive use. It is of course serious and true that all investments have associated risks But when savers, whether domestic or foreign, have no real capacity to evaluate the risks, the real cost of capital will be under- fundamental valued and the returns on investment overstated. As a result, scarce funds will be allocat- ed to low-return, high-risk activities Second, when neither investors nor lenders expect to bear the full cost of any fail- weaknesses of our ure, they will lower their guard against risky investments This is what is meant by the term "moral hazard " Moral hazard describes a situation where, in the presence of a per- financial system ceived implicit or explicit guarantee, there is little incentive to avoid risky behavior. It is true that the Government of Indonesia never extended any explicit guarantees against bank or corporate failures But it is also true that involvement of well-connected parties in many of our economic activities generated a feeling that, to quote a line from a popu- lar American movie, "failure was not an option here " Unfortunately, in the end, failure was very much an option here Actions by government and the central bank further en- couraged the belief that Indonesian banks would not be allowed to fail. Thus, when the government supported a recapitalization of Bank Duta in 1990, provided support to Bank Danamon to stem a bank run in 1991, and in 1994 made good the losses suffered by BAPINDO, it inadvertently suggested to all that banks would be protected from failure. As Paul Krugman recently noted, such implicit guarantees can trigger asset price inflation, reduce economic welfare, and ultimately make the financial system vulnerable to collapse 1 In a similar vein, our foreign exchange regime also encouraged risky behavior. Al- though Indonesia did not peg its exchange rate, as did some other Asian countries, we did maintain a managed float within a relatively narrow band Borrowers judged that the expected loss from currency depreciation was less than the cost of hedging their foreign borrowings For many years this proved to be correct The consequent mispricing of for- eign credits contributed to the very large capital inflows and created vulnerability for firms with substantial foreign exchange exposure. When we were forced to abandon our man- aged float, the depreciation of the rupiah created unmanageable debt burdens that effec- tively bankrupted a substantial portion of our corporations No one should doubt the severity of the current economic crisis Yet neither should anyone underestimate our capacity to set our institutions right The "Asian economic miracle" was not a mirage, it was real And many of the factors that allowed Indonesia An Introduction to Indonesia 51 Box 8.2 (continued) to grow by over 7% per annum for over a decade are still here. strong infrastructure, a well disciplined labor force, and ample natural resources These are the elements that will power our growth in the future But before that can happen we must rebuild our financial institutions so that they are capable of performing the functions that a modern economic state requires to mobilize capital and effectively channel it to its most productive use 1 Paul Krugman, 1998, "What Happened to Asia?" Unpublished research paper Source Wardhana 1998b. pp 1-3, 5-6 By early 1998 it was widely believed that Soeharto had in foreign debt in 1997, with more than half of it thought not to have been hedged. Under these circumstances the fall of the rupiah in 1997-98 led to mas- lost his power. In sive increases in foreign debt and debt service payments in rupiah terms, af- fecting the entire financial sector. By 1998 nonperforming loans (loans in May 1998 he default) accounted for about 70 percent of bank credit. Another factor contributing to the crisis was related to the sudden spurt resigned and was in the number of banks and bank branches that had followed the 1988 dereg- ulation liberalizing the creation of banks and bank branches. Excluding Peo- succeeded by Vice ple's Credit Banks (Bank Perkreditan Rakyat, or BPRs), the number of banks increased rapidly-from 129 in 1988 to 233 in 1994 (Cole and Slade, 1996, p. President Habibie 114).But there was a shortage of trained staff to supervise these banks.And even staff who had been trained were, de facto, often unable to supervise effective- ly (or even to obtain accurate information) because of the lack of transparen- cy at the banks, as well as the high-level political pressures on bank regulators to look the other way-as increasing numbers of banks provided loans to fa- vored firms and to their own conglomerates. This moral hazard problem was well known, but it was off lirmits for reform.Transparency requires accountability, high accounting standards, and accurate information about the financial con- ditions of banks and their debtors and creditors. Typically none of these was available at the banks. The problem was not that the weaknesses of the banking system were unknown. Rather the problem was the lack of political support for those who wanted to improve bank supervision and strengthen the economy's financial foundations.. .Bank licenses were often handed out to politically favored persons, further weakening supervision, and bank owners who were often industrialists, used their banks to lend to their own enterprises, often in violation of bank regulations. In the end, the economic/political interests controlling the banks were more 52 The Microfinance Revolution: Lessons from Indonesia powerful and better connected than the policy makers who were trying to shape policy in this area. -Stern 2000, p. 5 As noted, the Indonesian economic and financial crisis had been largely un- foreseen (although many had anticipated a possible political crisis arising from the growing concerns about corruption, civil rights, and succession issues). Lloyd R. Kenward, senior economist at the World Bank's Jakarta office (1994-98), analyzed the reasons for the Indonesian economic and financial crisis and "the warnings [that] were there,just below the surface" (1999, p. 71). He demon- strates that although the broadest macroeconomic indicators did not predict the crisis, extensive warning indicators of other kinds were recognized before Most of the huge the crisis (box 8.3). But as he shows, these warning signs tended to be viewed individually. Had they been analyzed collectively, they might have signaled the foreign debt (much likellhood of crisis before it occurred. Thus in 1996 and early 1997 the broad macroeconomic indicators for In- of it owed by the donesia were positive-robust economic growth, low and stable inflation, fis- cal accounts in surplus, adequate official foreign exchange reserves, and others. conglomerates) was But multiple warning signs had been identified, ranging from restraints on in- flation that were only temporary to weaknesses in the current account caused unhedged. With the by high international oil prices; from diluted deregulation packages to the coun- try's weak microeconomic foundations (banks and other corporations known collapse of the for structural weaknesses and risky behavior). And then there were Indonesia's euphemistically termed "issues of governance"-which commonly meant rupiah, the debt "corruption, cronyism, and nepotism." Had these and other trends been care- fully analyzed together, the possibility of an emerging crisis might have been became identified. Kenward also analyses the main indicators of the crisis that became clear unmanageable only with hindsight: the exchange rate risk, the extent of unhedged foreign ex- change positions, and personnel changes among high-level Indonesian officials that were "warnings to any government official who tried to enforce princi- ples of transparency and even-handedness in vital areas such as banking super- vision and privatisation. No matter how badly in need of reform, some areas were virtually untouchable" (p. 86).41 Readers who want to pursue in depth the reasons that the crisis was not predicted are referred to Furman and Stiglhtz (1998) for the Asian crisis gen- erally, and to Kenward (1999,2000) for the Indonesian crisis. Kenward also pro- vides lessons for practitioners "from the perspective of a macroeconomic practitioner close to the [Indonesian] instability as it was developing" (1999, p. 86).Among the types of lessons he presents are the Indonesian technocrats'pre- cept that "good times make for bad policies" (Kenward 1999, p. 86, quotes Ali Wardhana: "Reform is rarely if ever undertaken for its own sake"); the dangers of complacency, especially after decades of success; various ways in which mi- croeconomic weaknesses magnify macroeconomic shocks; and institutional prob- lems that can constrain prediction of a crisis. An Introduction to Indonesia 53 Box 83 Excerpts from Lloyd R. Kenward's "Assessing Vulnerability to Financial Crisis: Evidence from Indonesia" In 1967 per capita income in Indonesia was less than one-half that of India, Nigeria, or Bangladesh By mid 1997, it was five times that of Bangladesh, four times that of Nigeria and three and a half times that of India Virtually all of the country's social indicators had improved significantly, too. This was an extraordinary track record that put Indonesia in the top 10% of performers among developing countries Indicators that did not work... During the months and years before the financial cri- sis, virtually all of the broadest macro indicators were very reassuring . Economic growth was robust and driven by the private sector, inflation was low and quite stable, the fiscal "No matter how accounts were in surplus, the government was pre-paying large amounts of foreign debt, the growth of some monetary aggregates was high, but generally in line with inflation and strong, investment-led growth, foreign direct investment was strong; medium and badly in need of long-term debt service was declining in relation to exports (after allowance for debt pre- payments), official foreign exchange reserves looked adequate and were trending up- reform, some areas wards, and the deficit on current account of the balance of payments looked manageable The most controversial indicator in this context was external debt But even here, the overall situation was favorable.. .doubts arose only on examination of the breakdown be- were virtually tween public and private debt .Judging only on the broadest of criteria, the years imme- diately preceding the crisis were the best of macroeconomic times for Indonesia... [And] untouchable" if anything, the signals from sensitive, high-frequency (daily) financial market indicators were even more positive than the broadest macro indicators. Helpful Indicators. recognized wamings. [But some] analysts concluded [before the crisis began] that significant risks remained Inflation was being temporarily restrained by good luck on food prices and by delays in increasing certain administered prices the growth of monetary aggregates showed no clear tendency to decelerate Also, high inter- national oil prices (and probably data limitations) were masking weaknesses in the current account, dependence on potentially volatile short-term capital was increasing key non- tradeables (such as the property sector) were booming, and there were isolated signs of nervousness among foreign investors. The authorities even publicly acknowledged some of these indicators. [Kenward documents the recognition of each of these indica- tors before the onset of the crisis 1. While the macro data were giving off mixed signals at best, there was little doubt about the quality of structural policies. Many had been moving in the wrong direction for at least one year.. Recent deregulation packages had been weak and there was ample evidence that the deregulation drive-which had largely accounted for Indonesia's suc- cesses since 1986-had lost much of its momentum Moreover, issues of governance (the old euphemism for 'corruption, cronyism, and nepotism'. ) were drawing increasing levels of international attention Viewed individually, these slippages in structural policy seem unimportant But collec- tively, and considering the number of them, they raised the likelihood of crisis [There were] weak microeconomic foundations Indonesia's bank and non-bank corporate sec- tors have long been known for certain structural weaknesses and risky behaviour In the case of the banks, their fragile state was well-documented Indonesia's banking system would amplify any serious disturbance, spreading shockwaves throughout the economy, with destabilising feedback effects on the macroeconomy. Outside the banks, corporates were well known for their high leverage and risk-taking behavior. In many ways, there- fore, the Indonesian economy was badly positioned to absorb a major macroeconomic shock. Retrospective wamrngs. In addition to the warning signs documented above, there were a few signs of trouble that are only clear with the benefit of hindsight For example, 54 The Microfinance Revolution: Lessons from Indonesia Box 83 (continued) a standard measure of Indonesia's real effective exchange rate now suggests a modest appreciation for about two years before the onset of the crisis But the modestly appre- ciating trend (of only about 5% per annum, trough to peak) could not be spotted with any reliability until only a few months before the crisis broke, which was too late to be of much use. Another indicator that deserved more attention was the extent of unhedged foreign exchange positions, particularly among non-bank corporates that were borrowing directly off-shore and through banks on-shore With the full benefit of hindsight, there were several personnel changes among key Indonesian officials before July 1997 that constituted more subtle signs of trouble in the offing Individually, these incidents seemed to be of minor importance at the time But collectively and in retrospect they were warnings to any government official who tried to enforce principles of transparency and even-handedness in vital areas such as banking supervision and privatisation No matter how badly in need of reform, some areas were virtually untouchable None of the preceding discussion is intended to imply that the warning signs indicat- ed trouble of the order of magnitude of what eventually ensued Indeed the actual out- come exceeded the worst expectations Source Kenward 1999, pp 73-86 In the end Soeharto harmed not only the state, but also the economy he had built.Two overall commentaries on the Indonesian crisis are instructive. The Indonesian monetary crisis was triggered and exacerbated by the general collapse of financial prices in Southeast Asia. The breakdown in confidence and the disruption of normal financial flows within the region was not immediately recognised by Indonesian policy makers (nor by many others)... Indonesian banks attempted to replenish their reserves from sources offshore, but this time such funds were not available...'Normal' patterns of capital flows available to Indonesia since the early 70s, in the context of an open capital account and stable macroeconomic policies, had dried up. Domestic corporates also rushed into exchange markets to try to cover or hedge their foreign exchange obligations, and thus drove down the exchange rate. Panic by domestic individuals and businesses both drew from and fed back into foreign investors' panic, resulting in massive capital outflows from Indonesia and from the region. -Cole and Slade 1998, pp. 62-63 An Introduction to Indonesia 55 And: The macroeconomic framework constructed in the 1970s and 1980s may not have been entirely consistent but it served Indonesia well. But by the 1990s the structure of the economy had changed, new interests had emerged, and Indonesia had become more integrated with the rapidly growing world financial markets. At that time the old weaknesses of the macroeconomic framework, which had been mere annoyances early on, became serious liabilities.When the Asian crisis reached Indonesia, the macroeconomic framework proved too weak to Commercial banks' withstand the onslaught. -Stern 2000, p. 7 foreign debt reached The discussion below turns to the period from the end of the Soeharto era three times their in May 1998 to the early days of Megawati Soekarnputri's presidency, which began in July 2001. Soeharto's legacy, crucial for an understanding of Indone- equity. 70 percent of sia's current transitional period, includes three decades of extraordinary eco- nomic growth with equity and social development; a nation severely bank credit was in underdeveloped politically; a massive economic, financial, and political crisis- and the basic roots of the crisis themselves, many of them still deeply entrenched defaulted loans. The and very much alive. financial system Indonesia in Transition collapsed Many changes have taken place in Indonesia since the resignation of President Soeharto in May 1998. It is still too early to understand fully the dynamics, the complexities, and the horse trading of Indonesia in the post-Soeharto era.After Soeharto's resignation, immediate rehabilitation efforts focused mainly on im- proving governance, implementing political reforms, strengthening the econ- omy, rebuilding the financial system, and maintaining a safety net for the poor, whose numbers increased during the crisis. Results were mixed. Some reforms were accomplished that would have been unthinkable just a few years earlier. But many of the country's old problems did not disappear, some that had been buried resurfaced, and formidable new ones emerged. Discussion here focuses on some major events from mud-1998 through mid-2001, during the presidencies of B.J. Habibie (1998-99) and Abdurrah- manWahid (1999-2001). (See chapter 15 for discussion of efforts to restructure the financial system during this period).This account is followed by a brief discussion of the impeachment of President Abdurrahman Wahid by the People's Consultative Assembly (MPR), and the MPR's replacement ofWahid as president byVice President Megawati Soekarnoputri, Sukarno's daughter. These events occurred in July 2001, shortly before this volume went to press. 56 The Microfinance Revolution: Lessons from Indonesia The economy and the financial system, 1998-99 A set of economic and financial reforms was instituted as part of the econom- ic reform program financed by the IMF and other donors.These reforms in- cluded establishing a tight monetary policy to stem exchange rate depreciation, rescheduling banks' external debts, and establishing institutions to work out arrangements for the external debts of corporations. An Indonesian Bank Re- structuring Agency (IBRA) was created to restructure and recapitalize the banking industry (chapter 15). Monetary and banking reforms, along with the support from the IMF, helped the economy improve. The value of the rupiah relative to the U.S. dollar re- covered from 14,900 at the end ofJune 1998 to 8,025 in December 1998, and to 7,085 at the end of 1999 (see table 8.1 and appendix 1). Moreover, Indonesia A tight monetary (which is the only Asian member of the Organization of Petroleum Export- ing Countries, or OPEC) benefited from the soaring oil prices that began in policy, debt 1999. There was a significant turnaround in GDP growth-from -13.0 per- cent in 1998 to 0.3 percent in 1999. Inflation reached 78 percent at its high- rescheduling, and est point during 1998.Annual inflation was 53.4 percent for 1998 but dropped to 20.5 percent for 1999. IMF support helped As noted, Indonesia had an impressive record of poverty reduction during the Soeharto era-with the portion of the population below the poverty line the economy dropping from 60 percent in 1970 to 40 percent in 1976 to 11 percent in 1996 (Government of Indonesia 1996, p. 570). But during the crisis real wages and improve. But employment opportunities fell, and prices of food and other basic necessities rose. As a result some who had escaped poverty returned to it. In 1998 the share of economic recovery the population living on less than $1 a day was estimated at 20 percent. By the end of 1999, however, it had dropped to its pre-crisis, 1996 level of 11 percent has been slow, (but many "near-poor" people remain just slightly above the poverty level).And farmers who produce export crops (such as coffee, rubber, and palm oil) ben- largely for political efited from the booming export market that followed the fall of the rupiah. The government, with assistance from international donors, developed a reasons multipronged strategy for helping poor households during the crisis. Subsidized food, especially rice, was provided to many of the poor. Substantial employ- ment was created, much of it through labor-intensive public work programs. And social services, particularly for health and education, were preserved. The government instituted a "stay in school" campaign and provided scholarship pro- grams and block grants for schools. Social safety net programs were given high priority by the government and donors. But many of the country's problems remained intractable. Still constrain- ing the economy are difficulties with the restructuring of massive corporate foreign and domestic debt, the crippled banking system, and continuing large- scale corruption-exacerbated as before by the weak legal and judicial systems. Soeharto's family and cronies and their conglomerates, while weakened, are still wealthy and powerful. Many Soeharto supporters throughout the country re- main active, in some cases working to create and maintain political instabili- ties. Ethnic and religious tensions have grown, and separatist movements have An Introduction to Indonesia 57 accelerated. Investors have generally stayed away. The slow progress in In- donesia's economic recovery has been mainly a result of these and other relat- ed factors, rather than of weakness in the underlying economy. This volume went to press only a few months after President Megawati Soekarnoputri took office, and it is too early to know whether her government will be able to achieve significant economic improvement. Early indications of various kinds are dis- cussed later in the chapter. Governance and politics, 1998-99 Responding to mass demand after President Soeharto's resignation, President Habibie initiated a number of political reforms. Legislation concernung polit- Still constraining the ical parties and elections was revised, and restrictions on the formation of po- litical parties were abolished. General elections were held inJune 1999, and the economy are massive presidential election by the newly constituted MPR was held in October of the same year. Controls on the media were greatly relaxed. In another widely corporate debt, the publicized reform, Indonesia agreed to hold a referendum that would offer the province of East Timor a choice between independence and broad autonomy crippled banking within Indonesia. East Timor had been a Portuguese colony (covering half an island and surrounded by Indonesian territory) until it was annexed by Indonesia system, and large- in the mid-1970s. Issues of EastTimor's status and allegations of human rights abuses carried out there by other Indonesians and by the government had been scale corruption- in contention between Indonesia and many in the international community since East Timor first became part of Indonesia. exacerbated by the Under the Habibie reforms new political parties proliferated. Long restricted by a one-party state with just two powerless and tightly controlled opposition weak judicial system parties, Indonesians explored their new options, fielding 48 parties for the June 1999 general elections.The front runners were the incumbent, B.J. Habibie, a lifelong Soeharto prot&ge and supporter but also one of the mostWesternized of Indonesia's political leaders, and Megawati Soekarnoputri, Sukarno's daugh- ter and the most visible challenger to Soeharto while he was in office. Megawati had been able to mount an open opposition to Soeharto during the last years of his rule largely because she is the daughter of the country's founding pres- ident. Soeharto's ability to control her opposition was limited, although he ma- nipulated her removal from the officially recognized opposition party she led while he was president. She contested in the 1999 general elections as head of the Partai Demokrasi Indonesia-Perjuangan (Indonesian Democratic Party- Struggle, or PDI-P).42 PDI-P won a plurality with 34 percent of the 105 million valid ballets cast. Golkar, with President Habibie as its candidate, placed second with 22 percent of the vote. The remaining votes were divided among numerous parties, lead- ing to months of coalition-forming negotiations, payoffs, battles, and deals that paved the way to the October 1999 presidential vote. After decades of suppression, people spoke their minds during the campaigns. John Bresnan's comment in June 1999 about the forthcoming presidential elec- tions was widely repeated: "I think there is a lot of sense of irony that Golkar 58 The Microfinance Revolution: Lessons from Indonesia is seen as the status quo party but is headed by one of the most Westernized figures in Indonesian political history, whereas PDI-P, the party of reform, is led by a lady solidly rooted in the feudal past" (quoted in The New York Times, 22June 1999, p.A3). But a well-known political cormnentator,WitmarWitoe- lar, when asked about criticisms that Megawati nught not be smart or knowl- edgeable enough to become president, quipped,"We already have a rocket scientist as President and look where we are now" (quoted in The New York Times, 13 June 1999,p. 3). The 1999 presidential election was held under a reformed system in which a 700-member MPR was composed of the 462 members of the legislature elect- ed in the June 1999 general elections, 38 members of the legislature appoint- ed by the military, and 200 government-appointed MPR members from Responding to mass regional and minority groups. Megawati and Habibie remained the frontrun- ners. Habibie, while tainted by his long and close association with Soeharto, demand, President had brought about considerable reform in his short time as president. Megawati had no government experience (like nearly everyone in Indonesia outside Habibie abolished Golkar), but she is the daughter of the country's founding president, she had stood up to Soeharto, and she was (and is) popular with voters. restrictions on The newly constituted MPR convened injakarta in October 1999. It first rat- ified by consensus the landslide 30 August 1999 vote in which 87.5 percent of political parties, held the people of East Timor had voted for independence-a vote that had been fol- lowed by the worst massacre in Indonesia since 1965. Indonesian militias with ties general elections, and to the military opposed the independence of East Timor, resorting to burning, looting, and indiscriminate killings of EastTirmorese. More than 1,000 people were relaxed media killed, about 70 percent of East Timor's buildings were destroyed, and more than 200,000 East Timorese were forced into camps controlled by the militias in the controls Indonesian province ofWest Timor on the same island. Order was restored only with international intervention. East Timor became a Umted Nations protectorate temporarily, but it is in transition to become an independent nation. The MPR's next order of business was President's Habibie's formal ac- countability speech in which he reported on his presidency. After days of dis- cussion, the MPR voted by a close margin-just hours before the 20 October 1999 vote for the presidency-to reject the president's accountability speech (the first such event in the history of the republic).The rejection in effect ended Habible's candidacy for president, and he withdrew from the race. Then, in Indonesia's first democratic election since 1955 and its first trans- fer of power through a vote of democratically elected representatives, the MPR elected as president Abdurrahman Wahid-a widely respected moderate Mus- lim religious leader with a reputation for being tolerant and incorruptible.The long-time head of Indonesia's largest Muslim organization, Nahdlatul Ulama with more than 30 million members,Wahid was known for his attitudes of tol- erance and inclusion, for supporting human rights, and for championing the rights of non-Muslims, ethnic Chinese, and other rminorities. But he is nearly blind and had been weakened by strokes. Wahid (who is widely called by his nickname Gus Dur) received 373 votes to Megawati Soekarnoputri's 313. An Introduction to Indonesia 59 Wahid's Muslim-based Partai Kebangkitan Bangsa (PKB), or National Awak- ening Party, had received 13 percent of the popular vote in the June 1999 gen- eral elections. He had then supported Megawati's campaign, but broke with her in October and pushed ahead with a bid for the presidency. Few took his can- didacy seriously until the last moment when Habibie withdrew his candidacy and other parties added their support to that of the National Awakening Party to elect Wahid president as a compromise candidate. On 20 October 1999, as Wahid rose to take the oath of office, President Habibie, who had received a vote of no confidence in the same room just hours before, took the new president's arm and helped him to the podium.The next dayWahid nominated as vice pres- ident Megawati Soekarnoputri, who was elected after last-minute, closed-door The MPR held maneuvers convinced challengers from Golkar and the army to withdraw. President Habibie had served as president for 17 months.Too closely iden- presidential elections tified with the Soeharto regime to survive democratic elections, he neverthe- less brought more reform to Indonesia in his short time as president than many in 1999.It voted had thought possible. not to accept President Abdurrahman Wahid, 1999-2001 In October 1999 AbdurrahmanWahid became Indonesia's fourth president, elect- President Habibie' ed in large part because of his ethnic and religious tolerance; his long record of support for democracy, clean governance, and human rights; and his repu- accountability tation for honesty and incorruptibility. But, as president, Wahid soon became widely perceived also as mercurial, unfocused, and unorganized.Wahid him- speech, effectively selfjoked,"The Suharto era here was known as the 'New Order,' the post-Suhar- to era led by BJ. Habibie was known for being 'Out of Order,' and the Wahid ending his candidacy period is known as 'No Order," (The New York Times, 3 October 2000, p.A31). But, unlike his many widely quoted witticisms, this one was not a joke. Wahid had to build a multiparty coalition governrment-which had not been seen in Indonesia for over 40 years. His first cabinet (known informally as Gus Dur's mixmaster cabinet) was widely inclusive, although of course many of its members had little government experience. Concerns focused on whether the new coalition government could hold together the Indonesian nation, control the army, restore the economy, build a viable financial system, implement the new president's ideas of honesty and tolerance, and build the institutions need- ed for a viable democratic government. Unlike the economic crisis, which had not been predicted before its onset, by early 2000 it was widely anticipated thatWahid's new coalition government, riven by internal politcal rivalries, would not make substantial headway in meet- ing these extremely difficult and complex challenges.The predictions were cor- rect. But President Wahid made some crucial contributions to Indonesia-of which the most important was to move the country toward democracy in ways that, this time, may be irreversible. Wahid's 21 months as Indonesia's president are discussed first.Then three of the major issues that dominated that period are examined: bringing the Soe- hartos to justice, the secession issues, and the economy. 60 The Microfinance Revolution: Lessons from Indonesia Early reforms and obstacles. PresidentWahid made some crucial reforms early in his administration.The media, tightly controlled under Soeharto, had been liberalized by Habibie. But it was Wahid who made the media fully indepen- dent.Although the Indonesian press suffers from a shortage of trained journalists, it-and the other media-are now playing a major role in leading the way to new openness and transparency in the country. In one of his first acts after becoming president,Wahid placed the armed forces under civilian control (where they had been in the 1950s). He later sus- pended army chief GeneralWiranto (who had been Soeharto's last military com- mander, continuing under Habibie) from Wiranto's cabinet position as coordinating minister for political affairs and security. Along with four other high-ranking generals,Wiranto had been found at fault by an Indonesian gov- In Indonesia'first ernment panel and the United Nations for the violence and destruction in East Timor that followed the vote for independence there.Wiranto resigned his cab- transfer of power inet position in May 2000. Wahid also reshuffled military officers, promoting reformers. And he through a vote of pledged to hold the military accountable for past and present human right abuses. Indonesian investigators began questioning generals about the role democratically elected of the military in the burning, looting, and killing that took place in East Timor in 1999. In May 2000 a landmark human rights tribunal convicted representatives, the 24 Indonesian soldiers and one civilian of massacring 57 villagers during a 1999 operation mounted against rebels in the special region (daerah istime- MPR elected wa) of Aceh in northern Sumatra. But despite PresidentWahid's early reform efforts, many deeply entrenched Abdurrahman problems remained, and new ones arose rapidly.Wahid was unable to consol- idate power. Although he pushed hard for institutional reforms, he had neither Wahid as president the political backing nor the administrative skills to achieve significant progress in the desperately needed legal,judicial, legislative, financial, and other reforms. And the obstacles the new president faced were formidable. In sharp contrast to Mr. Suharto.. .Mr.Wahid's ability to enact his policies is dangerously limited. As he built his top-down structure of personal control, Mr. Suharto so eviscerated the nation's institutions that his successors have inherited a hollow and nearly useless bureaucracy."The government here is almost hydroponic," said aWestern diplomat-a floating structure with dangling, ineffectual roots." -Seth Mydans, The New York Times, 3 June 2000, pp.Al, 4 And Daniel S. Lev, an expert on Indonesia, put it this way: He [Wahid] is a president without the institution of the presidency. Every major administrative institution and political institution has essentially been destroyed, crushed.There is really nothing left to work with. It doesn't matter, in a sense, how good An Introduction to Indonesia 61 people are that you appoint because the institutions are devastated. There's corruption everywhere. -Quoted in The New York Times, 3 June 2000, p. A4 Under PresidentWahid, constitutional amendments were drafted in prepa- ration for presentation to the MPR in August 2000. Proposed amendments in- cluded direct presidential election, the creation of a two-house legislature, a system of judicial review, and decentralization of some powers to the provinces. But Wahid did not get far with these amendments. Political infighting, violence, bombings, growing secessionist movements, economic problems, and the in- stability promoted by Soeharto supporters, Muslim fundamentalists, and oth- Wahid, a respected ers took center stage.Wahid remarked,"even a hundred new presidents" won't solve Indonesia's problems (The New York Times, 30 April 2001, p.A8). moderate Muslim Constitutional amendments on governance, and institutional reforms gen- erally, were indefinitely postponed. Thus the viable institutions needed for religious leader, was long-term democratic governance were not yet under construction.Wahid was unable to gain sufficient power to bring about the democratic government of elected largely shared power in which he believes. The strong ruler had gone, but the weak state remained. because of his The president and the parliament. Wahid and Megawati were democrati- democratic views, cally elected as Indonesia's president and vice president. But Indonesia now also had a democratically elected parliament (Dewan Perwakilan Rakyat, or tolerance, and DPR)-and little experience on how the two branches of government could work together. Wahid's small National Awakening Party had little say in par- honesty. But he liament. Megawati's party, however had won a plurality in the general elec- tions and was well represented in parliament. But a rift grew between Wahid could not govern the and Megawati. As noted,Wahid's first cabinet was a broad coalition that represented com- country promises with multiple political parties. But political rivalries among cabinet members, combined with the lack of organization and focus of the president and the distance kept by the vice president, essentially paralyzed the govern- ment. In August 2000, parliament-which is dominated by the Indonesian De- mocratic Party (PDI-P; the vice president's party) and Golkar-demanded that Wahid improve his erratic and uncoordinated leadership. In response, Wahid formed a new cabinet composed mainly of people from his own Na- tional Awakening Party (which controls only about 11 percent of the seats in parliament) and from the military.This cabinet, he said, was composed of pro- fessionals who would concentrate on results, not politics. But, if anything, po- litical lines hardened. For example, despite PDI-P's power in parliament,Wahid did not appoint a single member of the PDI-P to his second cabinet. Megawati, officially in charge of cabinet affairs, did not attend the announcement of the new cabinet. By April 2001, 18 months after his election, Wahid had been twice cen- sured by parliament and had come under widespread criticism for arrogance, 62 The Microfinance Revolution: Lessons from Indonesia unpredictability and capricious leadership; for his government's lack of focus, coordination, and implementation; for legislative gridlock, the slow pace of re- forms, and insufficient emphasis on institution building. He was sharply criti- cized for failing to curb corruption, resolve secession issues, and prosecute key figures of the Soeharto regime, and for the deterioration of the economy (dis- cussed later in the chapter). At the beginning of 2001, a parliamentary investigative committee re- leased a report stating thatWahid had been aware that his personal masseur (also Wahid's spiritual adviser) had embezzled $3.7 million from a government agency. It also criticized the president for failing to declare a $2 million dona- tion from the Sultan of Brunei (which Wahid called a personal gift). But the panel found no proof that Wahid benefited personally from these transactions. "The government The president's supporters said that compared with Soeharto,Wahid's lapses are "like chickenfeed." But parliament found that Wahid had acted improperly in here is almost both cases. Parliament censuredWahid for misconduct in the two financial matters. But hydroponic-a it was widely agreed that the alleged corruption was not the real issue.The cor- ruption charge was simply the method used to express dissatisfaction withWahid's floating structure governance of Indonesia (or lack thereof). As Calvin Sims commented in The New York Times on 4 February 2001 (p.A10): with dangling, Behind the Indonesian Parliament's decision to censure President ineffectual roots" AbdurrahmanWahid for misconduct in two financial schemes last week, setting the stage for his impeachment, was widespread frustration with his erratic stewardship of the world's fourth largest population, which has been floundering.. .The corruption scandals were only the catalyst... For months there has been a growing sense of anger and despair that Mr.Wahid has failed to take the necessary steps to pull the country out of years of political and economic turmoil or end the separatist and religious violence that threaten to tear this archipelago apart. Parliament again censuredWahid in April 2001, this time for incompetence and corruption.The vote was overwhelmning: 363 to 52, with Wahid's defend- ers nearly all from his small National Awakening party. Impeachment proceedings (which can be initiated after two censures) could now legally take place. Al- though the military was now under civilian control, the army chief of staff, Gen- eral Endriartono Sutarto, warned the president not to dissolve parliament as a method of avoiding possible impeachment proceedings. In May 2001 Attorney General Marzuki Darusman, a widely respected for- mer director of the National Human Rights Commission, cleared President Wahid of any involvement in the corruption cases that had led to parliamen- tary censure. But only days later parliament voted 365-4 to convene a special session of the People's Consultative Assembly (MPR) to decide whether Pres- identWahid should be impeached. (In a cabinet shift the followmg month,Wahid An Introduction to Indonesia 63 replaced Marzuki Darusman as attorney general, citing failure in the prosecu- tion of former president Soeharto and his youngest son,Tommy Soeharto). The MPR special session was convened inJuly. Urged to resign,Wahid re- fused. He declared a state of emergency, but the military refused to carry out his order. On 23 July 2001 the MPR voted 591-0 to impeach Wahid and to replace him withVice President Megawati Soekarnoputri for the remainder of Wahid's five-year term which expires in 2004. Those in the 700-member MPR who opposed the impeachment boycotted the vote. The military sup- ported Megawati and protected the assembly building with tanks during the vote. Iromcally, Abdurrahman Wahid, the first Indonesian president to whom power was transferred democratically, also became Indonesia's first democrat- Wahid was unable ically impeached president. (Official impeachment procedures, starting with the first parliamentary censure, were carefully followed throughout). to gain sufficient Three of the most important issues that markedWahid's presidency are dis- cussed below. Each is presented simply as a snapshot of a situation at a partic- power to bring about ular point in time. But together they can provide some insight both into Indonesia during the 21 months ofWahid's presidency, and into the state of the the democratic nation that was entrusted to Megawatn Soekarnputri on 23 July 2001-the month following the celebration of the 1 00th anniversary of her father's birth. government of Taking on the Soehartos. PresidentWahid made a concerted effort to bring shared power in former president Soeharto to trial for corruption and abuse of power. But he was unable to do so. Shortly after taking office, Wahid sent a clear signal that which he believes (unlike former President Habibie), he intended broad anticorruption reforms. Charges were drawn up, and plans for Soeharto's trial were initiated.Wahid said that he would pardon the former president if he were convicted, provided that his illegally acquired wealth was returned to the nation.The pardon, however, would not extend to the Soeharto children (Soeharto's wife, Ibu Tien Soehar- to, had died in 1996). But in the process of moving toward trial, the govern- ment found that the Soehartos' cronies and loyalists remain strong, wealthy, and widespread in Indonesia. In early 2000 the government began to prepare the case against the for- mer president.Then in May, Soeharto was placed under house arrest "to smooth the investigation and in order to finish the case as scheduled," according to the attorney general, Marzuki Darusman (The New York Times, 30 May 2000, p.A3). But Soeharto's doctors said that he was too ill to stand trial. Although his trial was to begin on 31 August 2000, Soeharto did not appear in court; his doc- tors testified that he could not appear because of illness.The case was adjourned until September 14, and the attorney general and government prosecutors con- tinued with documentation and preparation.Then a spate of bombings rocked Jakarta. Bombs were set off at the attorney general's office (where work on the case was in preparation), at a crowded parking garage underneath the stock exchange (on the eve of the scheduled resumption of the trial), at Christian religious or- ganizations, and at other sites. It is widely believed that the bombings were car- 64 The Microfinance Revolution: Lessons from Indonesia ried out by Soeharto supporters in an attempt to derail the Soeharto trial and to undermine efforts to restore the stability of the government. By the end of September, the court dismissed the case against Soeharto on the grounds that he was too ll to stand trial. Meanwhile, in September 2000, in a reversal of a lower court decision, In- donesia's Supreme Court found Soeharto's youngest son, Hutomo Mandala Putra (known as Tommy), guilty of corruption in a multimnllion-dollar land deal. He was sentenced to 18 months in prison-the first conviction of any member of the family for graft. But Tommny disappeared. After two months he was found by security forces, but Tommny disappeared again. "He [Wahid] said... Tommy had slipped away while officers were checking with the palace on whether to arrest him. 'When the timing is right, he will be detained,' said Mr.Wahid" (The Wahid made a New York Times, 30 December 2000, p. A4). President Wahid publicly denounced Soeharto's youngest son as a crimi- strong effort to bring nal and also ordered his arrest in connection with the Jakarta bombings. But, the government was not successful in arrestingTommy in connection with the Soeharto to trialfor bombings, or in having him serve his prison term for corruption. The Wahid government continued its efforts to bring members of the Soeharto family to corruption and abuse court on corruption charges, but many Indonesians were highly skeptical that this would happen-and it did not. of power. But he In July 2001-just three days after Megawati Soekarnoputri took over as Indonesia's president-Syafiuddin Kartasasmita, the Supreme Court justice who was unable to do so had sentenced Tommy Soeharto to prison in the corruption case, was shot and killed in broad daylight by gunmen on motorcycles. According to the Jakar- ta police, two suspects were arrested and confessed. They said they had killed the justice under orders from Tommy Soeharto who had supplied the guns and paid them each 100 miUlion rupiah ($10,500) for the killing.Jakarta po- lice chief Sofyan Yacob accused Tommy Soeharto of masterminding the as- sassination, and the Jakarta police, assisted by National Police Headquarters, mounted a large-scale-but unsuccessful-search for the fugitive son of the former president. One of the men suspected of killing the justice was report- ed to have died in police custody. In a telling conmmentary on the state of Indonesian justice, a year after the Supreme Court's September 2000 conviction of Tommy Soeharto for corruption, the court overturned its own conviction. Seth Mydans, in an article called "If Tommy's so hard to find, justice is indeed blind," quoted Hendardi, chairman of the Indonesian Human Rights Association," Police officers are afraid that if they help catch Tommy, they could be killed." Mydans commented, "Did the message get through [to the court]?"And Anien Rais, speaker of parliament, said, "This spells disaster for the rule of law in Indonesia" (The New York Times, 4 October 2001, p. A4). But Indonesia's current president is the daughter of Sukarno-from whom Tommy's father, Soeharto, took power in 1966. Four months after Megawati Soekarnoputri became president,Tommy Soeharto was arrested (in a Jakarta mansion) and taken into custody by Jakarta police for al- legedly plotting the murder of Supreme Court Justice Syafiuddin Kartasasmi- An Introduction to Indonesia 65 ta.This arrest and the results that follow, which are far from certain, will be wide- ly viewed as a signal of power and direction in Indonesia. Can the center hold? AsWB.Yeats wrote in The Second Coming (1919),"Things fall apart; the center cannot hold."This was one of the most crucial issues that PresidentWahid faced (and that President Megawati now faces). The Indonesian nation, forged with so much struggle in the 20th century, faces multiple, escalating separatist movements at the start of the 21"t century. Recent surges of violence by secessionists in some provinces are thought to be assisted, in varying degrees, by Soeharto supporters intent on destabilizing the government. Ethnic and religious In Aceh, a special region in northern Sumatra that has rich oil and natur- al gas reserves, strongly Muslim secessionists have been fighting for an inde- rivalries, long pendent Islamic state for decades. Under the Soeharto government, the independence movement was repressed by the Indonesian military; 5,000 peo- controlled under the ple, mainly civilians, are estimated to have been killed in Aceh during the 1 990s (The New York Times, 17 September 2000, p. 9).The independence movement Soeharto regime, has become more overt, visible, and violent since Soeharto's resignation. Con- flict between the independence movement and the military has turned Aceh became openly into a "virtual war zone"(The New York Times, 11 November 2000, p.A3).Tens of thousands of Acehnese fled their villages for refugee camps. Despite an in- violent and ternationally brokered cease fire agreement between the Indonesian govern- ment and the Free Aceh Movement signed in Geneva on 2 June 2000, violence destabilizing has continued. In November 2000, PresidentWahid blamed the army and po- lice for escalating the violence onAceh and for 19 civilian deaths that occurred there. He said, "Acehnese people are my religious brothers. I want to ask [the top military and police officials involved] 'Since when are guns used in nego- tiations? If you are using guns, then please retire"' (The Boston Globe, 11 No- vember 2000, p. A15). In an attempt at compromise, the government offered Aceh increased au- tonomy and a larger share of the profits from its oil and gas supplies. President Wahid even agreed that a form of Islamic law could be imposed in Aceh, even though the Indonesian nation has never been an Islamic state. ButWahid ruled out independence for Aceh. However, many Acehnese say they will settle for nothing less than independence. A growing separatist movement exists in Papua (also known as Irian Jaya, located on the island of New Guinea)-which has giant copper and gold mines, vast timber resources, and offshore oil and gas.The indigenous Papuans of Irian Jaya have long aspired to independence from Indonesia. But Irian Jaya is re- source rich, and is the home of the Freeport mine, a subsidiary of Freeport- McMoran Copper & Gold, based in New Orleans (Louisiana, United States). This mine is Indonesia's biggest taxpayer and largest private employer. Since 1992 P.T. Freeport Indonesia has paid $1.5 billion in taxes, royalties, and divi- dends, as well as $160 million for regional development. (The Boston Sunday Globe, 10 September 2000, p. A23). 66 The Microfinance Revolution: Lessons from Indonesia Given the wealth and strategic locations of both Aceh and Irian Jaya, the Indonesian government is not prepared to consider independence for either province. Unlike the independence movement in East Timor, there is little in- ternational support for these independence movements because, if successful, they could destabilize the largest country in southeast Asia-and one that con- trols some of the world's most important shipping lanes. But it is an open question as to whether these conflicts can be resolved, es- pecially given the destabilizing aims of some Soeharto supporters and the dearth of functioning legal,judicial, and administrative institutions. In other areas ethnic and rehgious rivalries, long controlled under the Soe- harto regime, are now openly violent and highly visible. In the province of Cen- tral Kalimantan, anmmosity has existed for decades between the indigenous Dayaks Wahid accused and immigrants from other parts of Indonesia (mainly people from the island of Madura who were resettled in Kalimantan by the Indonesian government Soeharto supporters, as part of its transmigration program). But recently, the clashes between the two groups escalated into a campaign of ethnic terrorism, with the Dayaks trying some members of the to drive the Madurese from what they consider Dayak homeland. Security forces have made little attempt to stop the murders and violence (see The Boston Globe, military, and 27 February 2001, p.A9). But the future of Central Kalimantan is not the con- cern only of the Dayaks, the Madurese, and the government.Vast timber and Muslim extremists mining interests operating in Kalimantan, many connected with the Soehar- tos, are also major players in the provincial maelstrom. of using sectarian In West Timor, the defeated East Timorese militias-reorganized, rearmed, and tacitly backed by some Indonesian military units-continued to terrorize violence to create and harass the East Timorese refugees who fled or were forced into West Timor during the violence that followed East Timor's vote for independence (an es- political instability timated minimum of 50,000 refugees remained in the camps as of September 2001). But the East Timorese militias and their Indonesian military commanders were not brought to justice, and militia fighters continued to cross the border into EastTimor, attacking both EastTimorese civilians and United Nations peace- keepers stationed in East Timor. Only Eurico Guterres, the prominent militia leader widely believed to have been responsible for many of the worst crimes that took place during the East Timor massacre, was sentenced (on a charge of weapons possession)-to six months of house arrest. No one else-none of the other East Timorese militia leaders, none of the Indonesian officers who commanded them-has had to serve even a day in detention.. .Desperate to avert the creation of an international tribunal, Indonesia promised to conduct its own trials. The government formally agreed to share information with the new East Timorese administration and to provide witnesses and defendants for separate trials there. So far, both East Timorese and United Nations officials say, none of these promises have been kept... Former Defense Minister An Introduction to Indonesia 67 Juwono Sudarsono, in an interview, had little to say in defense of Indonesian justice. "The court system is in shambles," he said. In addition, President AbdurrahmanWahid is too engrossed in his own problems of political survival to push the issue and too dependent on the political support from the military to challenge it".. ."It's been a farce all along" said one United Nations official in Jakarta. -Seth Mydans, The New York Times, 16 May 2001, p.A4 In September 2000 the militias killed three United Nations aid workers who were working to repatriate East Timorese who were still in West Timor. For- Efforts to restructure eign workers then withdrew from West Timor. The Indonesian government pledged to disband the militias. But it did not (or could not) do so, and the mili- corporate debt and to tias remain active. In May 2001 a Jakarta court sentenced six militia members to prison terms, none of which exceeded 20 months, for the murders of the build an effective three United nations workers. and accountable This case apparently proceeded, unlike the others, because the victims were foreign United Nations employees. But the banking system Indonesian prosecutors did not seem to have their hearts in the case, declining to charge the men with murder or manslaughter remain mired in even though some of them admitted to stabbing the victims. "The sentences make a mockery of the international political problems community's insistence that justice be done in this horrific case" the United Nations High Commissioner for Refugees said. -Seth Mydans, The New York Times, 16 May 2001, p.A4 Meanwhile, religious pressures have been rising in Indonesia, with fights between Muslims and Christians becoming commonplace in some parts of the country.Wahid accused Soeharto supporters, some members of the mnlitary, and Muslim extremists of using sectarian violence to create political instabldity. Much of the violence between the religious groups has occurred in Maluku province in eastern Indonesia where it erupted in 1999 and then spread in 2000 to the island of Lombok, east of Bali.When military and police were sent to restore order, some of them divided along religious lines, each supporting local groups of his own religion.Jakarta has also seen numerous bombings of churches, restau- rants, and mghtclubs carried out by Muslim vigilante groups. Slow progress on economic andfinancial reform. Indonesia's progress in re- covering from the crisis has been slow. The widespread corruption and deep political uncertainties are major causes of the country's continuing economic problems.And President Wahid, who did not allocate high enough priority to the economy, made some poor choices in selecting his economic advisers.Yet, there has been encouraging economic progress on some important fronts. GDP growth reached 5.2 percent in 2000, representing an 18.5 percent turn- 68 The Microfinance Revolution: Lessons from Indonesia around in two years (see table 8.1). Inflation in 2000 was down to 3.7 percent. Oil prices stayed firm and there was strong external demand for Indonesian oil. And non-oil exports in 2000 were up substantially over 1999, reaching an all- time high (although their rate of growth was below that of their pre-1997 level). Mark Baird, the World Bank's country director for Indonesia remarked that in Indonesia, "you see a much healthier economy than you might expect read- ing reports overseas" (The New York Times, 1 November 2000, p.W1). However, many difficulties remained.At the end of December 2000 the ex- change rate was 9,595 rupiah to the U.S. dollar-compared with 7,085 at the end of 1999 (see table 8. 1).And by the end of March 2001 the rupiah had de- clined to 10,400 to the U.S. dollar.The rupiah continued to slide, with the ex- change rate at over 11,000 rupiah to the U.S. dollar from mid-April until July "The Indonesian 23 when President Wahid was impeached and President Megawati took office. By August 14 the rupiah had appreciated to 8,425 to the U.S. dollar, but by Bank Restructuring the end of October 2001 it had again dropped to 10,435. A huge foreign debt remains, estimated at over $150 billion, with debt ser- Agency is at the vice at over 20 percent despite multiple debt rescheduling agreements (Bar- clays Bank Country Report, 28 November 2000). Efforts to restructure the epicenter of a corporate debt and to build an effective and accountable banking system, both needed for any significant growth in private investment, remain mired in po- struggle over litical problems (chapter 15). Corporate governance remains a formidable chal- lenge. In Indonesia, corporations have long been accustomed to operating in Indonesia's economic a closed and collusive environment. Changing this corporate culture under pre- sent circumstances is extremely difficult. soul" The government assumed the bulk of recapitalizing the banking system, which is expected to amount to over 50 percent of GDP (see Barclays Bank Country Report, 28 November 2000); some estimates run as high as 80 per- cent of GDP (Tim Healy and Tom McCawley, in Asiaweek, 13 August 1999). But progress in restructuring the banking sector-through bank mergers, man- agement changes, loan collection efforts, and reschedulng of loans-has been slow, mainly because of continuing institutional weaknesses and political in- fighting. The Indonesian Bank RestructuringAgency (IBRA) was created in 1998 to reorganize the banking system and to manage the liquidation, mergers, re- structuring and recapitalization of faling banks. Its asset management unit was established to administer the bad loans of the banking system. It also plays a major role in restructuring corporate debt. IBRA's performance has been mixed.While some progress has been made, IBRA has often not been a match for the Soehartos and the conglomerates (chapter 15). [IBRA] has an impossible task and powerful opponents... [It] was created in 1998 to rescue a basket case of a banking system that included more than 200 poorly capitalized, opaque institutions burdened with billions of dollars in bad debt and usually owned by the debtors. IBRA today controls assets equal to 57 percent An Introduction to Indonesia 69 of GDP Meanwhile it has become an inefficient, less-than- competent, sometimes corrupt bureaucracy supported.. .by a weak central government... .IBRA is at the epicenter of a struggle over Indonesia's economic soul. On one side are the still-powerful forces of the old regime-Suharto's children and cronies. And on the other are economic reformers and activists who want retribution for the pain they see inflicted on the country by sweetheart deals and outright corruption. -Caragata 2001, p. 2 However, a new IBRA governance structure was adopted in 2000, mcluding During thefirst half appointment of a governing board composed of independent professionals. Some progress on restructuring banks and corporate debt has begun to occur. But a of 2001 the rupiah recent high-level IBRA appointment has raised some concerns because it is widely believed that the official is closely connected to the Soehartos-who fell steeply, economic have strong vested interests in IBRA's asset sales, bank privatization, corporate debt restructuring, and other actions. growthfaltered, Vast amounts of funds are idle ($45 blllion at the end of December 2000). At that time the average loan-to-deposit ratio of the banks was 36 percent (The inflation rose, and Nikkei Weekly, 5 February 2001). Some large banks have loan-to-asset ratios as low as 6 percent. Rather than lending, bankers have been keeping their funds dissatisfied donors in the central bank. In part this is because, in an effort to curb inflation, the central bank interest rate has been as high as 4 percent above the rates offered held back by commercial banks. Partly it is because bankers do not want to expand lend- ing at a time of high political risk. And partly it is because most of the larger disbursements banks have substantial funds in illiquid state bonds. There were also problems at Bank Indonesia, the central bank. In late 2000 the Supreme Audit Agency reported that during the financial crisis, nearly $9 billion ($17.2 billion at December 2000 exchange rates) provided in emergency loans to private-sector banks, many controlled by Soeharto cronies, had been diverted to unauthorized loans and other spending."The Supreme Audit Agency estimates that as much as 95 percent of the money may never be repaid. It blames Bank Indonesia for failing to track it. Much of the money went to banks con- trolled by Suharto cronies, and 59 percent was misspent, says the agency... If [the deficit] were all charged to the bank, it would go bankrupt" (Asiaweek, 22 De- cember 2000). Given the slow progress in restructuring public and private debt and in re- building the banking system, the continuing power of the Soeharto family and cronies, rampant corruption, the weak legal and judicial systems, regional un- rest, ethnic and religious tensions, and political uncertainties, foreign investors are generally staying away from Indonesia. In a now-famous interview with Dow Jones newswires in May 2000, then-coordmating minister for the economy Kwik Kian Gie said,"If I were a foreign investor, I wouldn't come to Indonesia.The law enforcement is not there, but not only that, the whole thing is so confus- ing."The minister may have been impolitic, but he was not wrong. 70 The Microfinance Revolution: Lessons from Indonesia Investors (domestic as well as foreign) were waiting to see whether Presi- dentWahid could estabhsh enough political authority to create a viable investment environment. But during the first half of 2001 the rupiah was falling steeply, the country's slow economic growth was faltering, and inflation was rising. The IMF and Indonesia's other donors had become dissatisfied with the glacial pace of agreed-upon reforms and with the growing political instabili- ties. In December 2000 the IMF suspended disbursement of a $400 million tranche of its aid program for Indonesia. And at the World Economic Forum in Davos, Switzerland in early 2001, Stanley Fischer, deputy director of the IMF, reported that the progress of structural reform in Indonesia had been very slow. In April 2001, the IMF again decided not to disburse the $400 million of sched- uled assistance which was held back throughout the rest ofWahid's presiden- Wahid declared a cy because of the views of the IMF and other donors that Indonesia had not complied with parts of the agreement. state of emergency In early 2001 Japan, Indonesia's largest donor, informed the Indonesian gov- ernment that its official development assistance to Indonesia would be reduced. but the military The World Bank and the Asian Development Bank stated similar intentions. TheWorld Bank announced that it would cut its annual loan to Indonesia from refused to respond. $1.2 billion to $400 mnllion. The Bank's vice president for East Asia and the Pacific,Jamal-ud-din-Kassum, said "Improved governance and progress on the He became reform program will be key determinants of future levels of assistance from the World Bank" (The Nikkei Weekly, 5 February 2001). Indonesia sfirst Indonesia under President Wahid. Indonesia's fourth president was a toler- democratically ant, libertarian, intellectual who encourages debate and believes strongly in democracy and its institutions. He understood that for Indonesia to become a impeached president well-functioning democratic state, transparency and powersharing would be re- quired. But Indonesia is still a neophyte in these areas.And the covert, but strong and well-financed, opposition to such reforms plays by its own rules. Because of the weak, corrupt legal system and judiciary, there are not only no accept- ed rules, but also few referees (those who attempt to provide justice, as Supreme Court Justice Syafiuddin Kartasasamita did, risk assassination). The president's low level of managerial and administrative skills, poor health, and lack of support in parliament, the country's lack of functioning in- stitutions, the strength and wealth of the Soeharto forces, the economic prob- lems, the secessionist movements, and the generally chaotic political scene combined to make it impossible forWahid to govern the country effectively. He was impeached in July 2001 in a democratic process, according the rule of law, at a time when the country needed to move on. President Megawati Soekarnoputri By vote of the People's Consultative Assembly (MPR), Megawati Soekarno- putri replaced former PresidentWahid in a peaceful transition of power on 23 July 2001. She is to serve as president until the 2004 general elections (she will be eligible to run for a five-year term as president at that time). However, An Introduction to Indonesia 71 Megawati faces the same difficult problems as Wahid did. Indonesia is a weak state, lacking basic government and civilian institutions, and it is riddled with corruption and special interests. But a strong ruler in the mold of the coun- try's first two presidents may no longer be acceptable to Indonesians. President Megawati is known as a conservative nationalist. It is widely ac- cepted in Indonesia that Megawati believes the power she now holds to be- long to her by destiny. She is the immovable object-stolid, silent, imperious-a puzzle to her countrymen even as she commands unrivaled popularity .. Her deep and dignified silences create a circle of awe Vice President around her .. Perhaps, some say this could only happen here, where Javanese culture reveres silence and where power is seen as a Megawati mysterious mantle that ... envelops a leader of its own accord. -Seth Mydans, The New York Times, 6 May 2001, p. 3 Soekarnoputri, But Megawati also commands the largest political party and the strongest Sukarno's daughter, political support from the people. And she is supported by the military. In the last few months of her vice presidency, whenWahid was concerned mainly with replacedformer his political survival, Megawati made crucial decisions to restore relations with the IMF-over the objection of the then-coordinating minister for the econ- President Wahid as omy. She adjusted and restructured the budget to bring it in line with the IMF- supported program, removed subsidies on fuel, and took other urgent actions. president in a In contrast to the MPR's decision about the presidency, the vice presidential election by the MPR was embroiled in bitter partisan politics.There were two peaceful transition leading candidates. One,AkbarTandjung, is closely associated with the Soeharto regime. At the time of the election he was the speaker of the Indonesian par- on 23July 2001 liament (DPR). He was also the leader of Golkar. The other candidate was Hamzah Haz, a conservative Muslim politician who had been a leader of the opposition to Megawati's candidacy for the presidency after the 1999 general elections, and who lost to her in the 1999 contest for vice president.The view he expressed then was that "Islam does not allow women to lead governments." In 2001 Hamzah, leader of the United Development Party (a Muslim party), won the election for vice president in the third round of a close race. The political infighting for the vice presidency prompted one political com- mentator, Chatrib Basri, to comment on a concept of power now emerging in Indonesia (quoted by Seth Mydans in The New York Times, 26 July 2001, p.A8): "What's most scary is to see how the elite aren't at all disturbed about what's going on. If there's been any profitable business in these last years [the post-Soe- harto times] it's been the business of buying and selling power." It is not that money was never before exchanged for power in Indonesia. But the image is different now, perhaps reflecting deeper changes under way. In the new image power is bought and sold. In the traditional image money flows from power. President Megawati's choices for her cabinet were widely praised both in Indonesia and internationally. "Much to the market's delight she chose people 72 The Microfinance Revolution: Lessons from Indonesia well-known and generally highly regarded in business circles to fill the key eco- nomics, finance and business posts" James Castle, Business Times, 10 August 2001). TheJakarta Post commented, "Megawati names rainbow cabinet... .Most key cab- inet posts, particularly in the economic arena, were given to professionals and bureaucrats, but there were enough seats left to placate the political factions and secure her the crucial support of the legislature" (10 August 2001). Only 4 cab- inet positions (out of 32) are held by members of the military. In Indonesia cabinets are named. Megawati named hers the Gotong Roy- ong Cabinet. Gotong royong is a phrase that is deeply imbedded in Indonesian consciousness. It refers to the ancient but continuing tradition of mutual help found in Indonesian villages-with the idea that everyone contributes to a pro- ject, and everyone benefits. It is widely accepted Economics andQfnance. With her strong cabinet appointments in economics that President and finance and her restoration of Indonesia's relations with the IMF, Presi- dent Megawati showed early indications of a serious intent to restore the econ- Megawati believes omy. Shortly after Megawati's first month in office, the government signed a new agreement preparing the way for resumption of a $5 billion IMF loan the power she now program and its long-delayed $400 million installment. The agreement in- cluded limiting the budget deficit and setting a timetable for selling or pri- holds to belong to vatizing failing corporations and banks. The Jakarta Post (24 August 2001) editorialized: her by destiny A new agreement with the IMF will.. .strengthen market confidence as it will greatly help smooth Indonesian relations with its creditors... One should not take lightly the good understanding shown on the part of foreign creditors, given the government's foreign debts of about $65 billion and corporate foreign debts of almost $70 billion...The hardest part of the job is for the government to demonstrate its real implementation capability in delivering on [its] promises.. .Learnmg from the bitter experiences and mistakes of the previous government, the Megawati administration should develop the kind of capability that reflects three fundamentals in the strategic interactions between people and government officials: accountability, transparency and predictability. The minister of finance in the Gotong Royong cabinet, Boediono, had pre- sented seven strategic points for stabilizing the Indonesian economy to an in- ternational Conference on Indonesia held in Tokyo on 30 March 2001:4 * Restoring Indonesia's battered self-confidence. * Reestablishing law and order. * Improving policy decisionnaking and implementation. * Normalizing the financial system. An Introduction to Indonesia 73 * Achieving true economic recovery, propelled by new Investments as well as a more productive use of existing resources and assets. * Maintaining macroeconomic balance. * Managing poverty and inequality. If these goals can be effectively implemented, Indonesia would be well on its way to recovery. It is too early to comment on the new government's progress toward its economic goals. But as is discussed below, it is worth not- ing that concerns are beginning to surface that little change appears to be under way and that the cabinet's economics team is running into the same difficul- ties faced by a variety of predecessors. Megawati made Other government priorities. In her Independence Day speech on 16 Au- strong cabinet gust 2001, President Megawati outlined a number of the government's prior- ities (see Seth Mydans, The New York Times, 17 August 2001, p.A8). Megawati appointments in emphasized national stability, human rights, and the need for fighting corrup- tion-about which she said, "Unlike in a feudalistic society, which doesn't con- economics and sider corruption a serious mistake, in a democratic society it is a big problem." She apologized for human rights abuses commnitted by the military in separatist finance and showed rebellions and said the military must reform itself. "We need to pay more at- tention to human rights.We need a security force which is effective, highly dis- indications of a ciplined, and under the control of the government." For the first time, Megawati acknowledged the independence of East serious intent to Timor, which she had opposed in 1999. But she ruled out independence for Aceh or Irian Jaya, encouraging them to "help build a new Indonesia." restore the economy Megawati also stated that the country's constitution (prepared in 1945 by her father, later abrogated, but reinstated by him in 1959) needs to be revised and updated. She proposed that an independent constitutional commission be established to seek the people's views on issues and then provide a compre- hensive draft of the amendment for review and enactment by the People's Con- sultative Assembly (MPR). MPR Speaker Amien Rais responded positively to this proposal, and discussion of the proposed commission is expected by the MPR. The issues now are whether President Megawati will be able to implement her government's priorities and achieve for Indonesia a balance between sta- bility and reform-while also controlling the military, reigning in the Soehar- tos, keeping the country united, maintaining the nation with the largest Muslim population in the world as a non-Islamic state (and managing Indonesia's re- sponse to issues resulting from the war in Afghanistan), building relations with the IMF and the international donor community, and holding her support in the legislature and with the people. These are difficult tasks and there are formudable obstacles. But Megawati has the support of most Indonesians, of the army, and of a majority in parlia- ment.The issue is political will.Three recent views lllustrate, in different ways, growing concerns about corruption, inertia, and lack of political will. 74 The Microfinance Revolution: Lessons from Indonesia It seems that the more things change, the more they stay the same. Corruption flourishes in new, inventive ways, there is no functioning structure to penalize wrongdoing, economic and legal reform is at a standstUll and businessmen are refusing to repay debts. Indeed, more than three years after Soeharto's downfall, there is little fundamental difference in how Indonesia's.. .people are being governed... It all adds up to a familiar gloomy picture. Megawati began her term in office with great promise by appointing well-regarded economics ministers. But the so- called "dream team" is already showing signs of paralysis- thanks in large part to a lack of political will on the part of the president ... Says former Attorney-General Marzuki But inertia is strong. Darusman... "The government is fast becoming immobilized because of inertia." "Corruption -John McBeth, Far Eastern Economic Review, 1 November 2001, pp. 17, 19 flourishes... there is Modern Indonesia is a crazy place. Incoherent, unprincipled and no functioning cymcal... It's not a good time for anyone with decency to be in government. structure to penalize -Sarwono Kusumaadmadja, a cabinet nmister in the Soeharto and Wahid governments, quoted by John McBeth, Far Eastern Eco- wrongdoing, nomic Review, 1 November 2001, pp 18-19 economic and legal Unlike Habibie and Abdurrahman Wahid], the new president [Megawati] possesses both the legitimacy and the power base reform is at a that are requisites for becoming an effective leader in the post- Soeharto era. But where is Megawati's politcal capital being used? standstill" Unfortunately, the answer is, towards no apparent end... If Megawati were to be more courageous and ask her followers to support her in making the hard decisions on economic reform and national security, her opponents would have a difficult time in maintaining the status quo of yesteryear. Megawati and her cabinet have the political capital to make a difference in Indonesia's future, but they should be mindful of the old adage, "Use it, or lose it." -JamesVan Zorge, TheJakarta Post, 19 November 2001 Although President Megawati is not known as a reformer, she has demon- strated courage and political skills under difficult circumstances. Megawati and her government have the political capital to make the hard decisions on the economy, to crack down on corruption, and to begin building the institutions Indonesia so desperately needs. But as of this writing in 2001, it is still too early to know whether the government will exercise the political will needed to meet these challenges effectively. An Introduction to Indonesia 75 Democracy and the Messy State Indonesia's future is well beyond the scope of this book, as well as beyond its author's crystal ball-reading abilities. But history may provide some perspec- tive. Sukarno led the independence struggle and unified the country. Soehar- to took over an economy in chaos and provided three decades of unprecedented economic growth and development.The vast corruption that permeated the country under Soeharto, along with the decades of arrested political develop- ment, were recognized and challenged by the same people who had grown up better fed and housed, healthier, and better educated because of the priorities and policies for economic development of Soeharto's New Order government Herfather built the and its economics ministers. President Habibie, Soeharto's protege, began the political reform process that President Wahid then broadened and deepened. Indonesian nation. The country's long-term commitment to its national goals of growth, eq- uity, and stability remain intact (although its goal of harmony seems more prob- It is much to be lematic). But Indonesia's history as a weak state with a strong ruler led, in the Soeharto era, to a system of governance characterized by pervasive corruption hoped that and a severe lack of transparency and accountability. Eventually the governance choked the development.The ensuing crisis was devastating.The transition from Megawati will build the Soeharto regime could not have been easy under any circumstances. But it has been especiaUy difficult because of the severe crisis that triggered the end the institutions that of the era. The political climate has provided a major impediment to the country's enable a strong much-needed institution building. The Soeharto forces are still able to evade justice, undermine reforms, and destabilize the country. And the dearth of ex- democratic state perienced national leaders is a direct Soeharto legacy. Confidence in the Indonesian economy has not returned, and few foreign investors are back.Viability has not been restored in the corporate sector. Se- vere difficulties stand in the way of restructuring the financial system-the out- come of which will affect the future distribution of wealth in Indonesia. In addition, the growing religious violence poses a threat to munority religions-and perhaps eventually to the choice made at the time of inde- pendence that Indonesia would not be an Islamic state. And the separatist movements provide dangers to the country's unity and to Southeast Asian stability. On the other side of the ledger, the transition from PresidentWahid to Pres- ident Megawati took place peacefully, lawfully, and democratically. Parliament is no longer a rubber stamp. International donors have begun to return. The milhtary is controlled by civilians (though to what extent the military is under control is an issue), and the role of the armed forces has been reduced.The press and other media are free to write and say what they see and what they believe. And on 30 August 2001 East Timor, a United Nations protectorate, elected its first government-in preparation for a transition to independent statehood in 2002. And the many East Timorese refugees remaiming in West Timor began to go home. 76 The Microfinanco Revolution: Lessons from Indonesia Box 8A Excerpts from Thomas L. Friedman's "What a Mess!" In the cold war we had authoritarian, democratic, and Communist states. Now we have authoritarian states (North Korea, Iraq), democratic states (America, France), democratiz- ing states (Poland, Chile, Hungary), failed states (Sierra Leone, Liberia) and messy states-namely Russia and Indonesia In messy states the old authority structure that allocated resources, enforced con- tracts, and collected taxes-President Suharto in Indonesia and the Communist Party in Russia-has broken down but has not been replaced by a new authority that can play the same role The result, in Indonesia and Russia, is rampant corruption and a fragmentation of power in which neither the army, the Parliament, the executive, nor the remnants of the old order have the strength to assert their will Messy states too big to fall, too mes- 'No one should sy to work That's why in messy states you never quite know-when arms are sold, people doubt the severity of murdered, or payoffs demanded-whether this is by design of those ostensibly in charge or because no one is in charge "In Suharto's time," said Witmar Witoelar, Indonesia's popular talk show host, "things were clear-you always knew who to pay and how long the current economic to wait Now you never know who's in charge Before people were being killed by the government Now they are killed because of no government " crisis. Yet neither Source Thomas L Friedman, "What a MessI" The New York Times, 3 October 2000, p A31 should anyone underestimate our These are among the many remarkable achievements that have occurred in the short period since Soeharto's resignation. And Indonesia continues to capacity to set our have abundant resources: human capital (including a large and educated labor force), ample natural resources, a highly strategic location, an extensive infra- institutions right" structure, a large domestic market, and long experience with sustained economic growth and development. In his strategy for the stabilization of the economy, Minister of Finance Boechono listed first the restoration of Indonesian self-confidence. Many In- donesians have suffered financially, physically, and emotionally in recent years. And some have lost pride and confidence in their country. Restoring self-con- fidence is a sine qua non for restoring the economy and addressing the na- tion's problems. Building responsible, accountable institutions that can take over the broad political and administrative functions previously performed by the military is the most difficult, the most pressing, and the most important challenge for Pres- ident Megawati Soekarnoputri. Her father built the Indonesian nation. It is much to be hoped that Megawati will build the institutions that enable a strong de- mocratic Indonesian state. Indonesia has become known internationally as a'messy state': "too big to fail, too messy to work" (box 8.4). But as Mulyono (1981, pp. 178-80) points out in his chapter entitled,"TheWayang: Messy but Loved Down the Centuries," wayang performances (with their "sometimes grotesque incongruities") have been teaching for thousands of years how truth is found beneath mess. An Introduction to Indonesia 77 There is no doubt that there are difficult and messy times still ahead. But with its extensive human and natural resources, it iS likely that Indonesia wil recover and move on.AsAliWardhana (1998b,p. 5) put it,"No one should doubt the severity of the current economic crisis.Yet neither should anyone under- estimate our capacity to set our institutions right." Notes 1.The 1999 and 2000 GDP growth data are preliminary figures from Biro Pusat Statistik (BPS), the Indonesian Bureau of Statistics. 2.Javanese refers to an ethnic and linguistic category of people who have tradi- tionally inhabited the central and eastern parts of the island of Java. Another group, the Sundanese, are found in the western part of the island. However, some Javanese live in other parts of Indonesia, while other munorities also live on Java (see Koent- jaraningrat 1985). 3. For discussion and analysis of Indonesia's history, society, and politics, see Raf- fles (1977 [1817]); Crawfurd (1993 [1820]); Soedjatmoko (1960,1967); Palmier (1960); Feith (1962);Soedjatmoko and others (1965);Shaplen (1969);Zamu'Ddmn (1970);McVey (1967); U.S. Central Intelligence Agency (1968);Anderson and McVey (1971); Neil (1973); Emmerson (1976); Anderson (1990); Jackson and Pye (1978); McDonald (1980);Jenkms (1984);Van Neil (1984);Robison (1986,1988,1990,1992, 1993);Crouch (1988 [1978]); Crouch and Hill (1992);Bresnan (1993);Mackie and Maclntyre (1993); Vatiklotis (1993); and Schwarz (1994). For discussion and biblhographic references, see Nell (1973) for Indonesia's environment and early history; Geertz (1963, 1984), Koentjaraningrat (1975a, 1975b, 1985), Fox (1980), andWhite (1983) for Indonesian culture and society; Anderson (1990), Bresnan (1993), and Schwarz (1994) for polit- ical history; and Booth and McCawley (1981a, 1981b), Cole and Slade (1996, 1998), Wardhana (1994b, 1997b, 1998a, 1998b), Prawiro (1998), Kenward (1999, 2000), and Stern (2000, forthcoming) for the economy and finance. For analysis of Indonesia in recent years, see also various articles by Seth Mydans in The New York Times (Mydans is bureau chief of the Times for Southeast Asia). 4. Not all wayang is performed with puppets, although this is its most common form.Wayang orang (human wayang) is enacted by people who play the roles of the wayang characters. 5.The names and episodes given here are those used inJavanese wayang perfor- mances of the Ramayana; they differ somewhat from those in theValniki Ramayana and from those used in India today. 6.Vlbhlshana in the Indian versions of the episode. 7. Ravana in the Indian versions. 8. Sita in the Indian versions. 9. In 1999, 14 percent of Indonesians age 15 and older were reported to be illit- erate (World Bank 2002, World Development Report 2002). But statistics based on cen- sus and survey data often use low standards to determine literacy and thus may overstate functional literacy. 10. Other agricultural products include cloves,coconuts, fruits and vegetables, peanuts, soybeans, sugarcane, sweet potatoes, tobacco, and goats, pigs, sheep, and cattle. Both fish- ing and fish farmung are common. 11. "At the time of independence in 1945 there were only 230 pribumi [indige- nous Indonesians] and 107 ethmc Chinese higher education graduates" (Cole and Slade 1996, p. 324). 78 The Microfinance Revolution: Lessons from Indonesia 12. See Schwarz (1994, chapter 1) for an excellent, succinct analysis of the ideol- ogy and pohtics of the Sukarno era.This section draws heavily on that chapter. 13. Indonesia's first (1945) constitution was superceded by its second constitution (1949), which was written following negotiations with the Dutch over a cease fire. The1949 constitution, considered tainted by Dutch influence, was replaced in 1950 by a third constitution written by Indonesians. In 1959 Sukarno abrogated the 1950 constitution and decreed a return to the 1945 constitution. 14. In 1958 a group of military officers set up a rebel government based in West Sumatra. "The Revolutionary Government of the Republic of Indonesia (PRRI) ... .did not seek to break up the Indonesian nation. Rather, its formation reflected the frus- tration of regional military commanders with the armed forces headquarters and the civilian political leadership in Jakarta, and their desire to see a new national govern- ment " (Schwarz 1994, p 13). Against the advice of the U.S. embassy in Jakarta, the rebel government received logistical and mnlitary aid from the U.S. Central Intelligence Agency (CIA), which was concerned that Sukarno was too close to the Indonesian communist party. 15.Jenkins (1984, p 2) points out that although the phrase "the middle way" is commonly attributed to Nasution, it was Professor Djokosutono who named the con- cept "the muddle way." 16. See Higgins (1968 ch. 3); Glassburner (1971); Mackie (1971); Booth and Mc- Cawley (1981b); and Arndt (1984) for analysis of the economuc situation during this period. For articles on many aspects of the Indonesian economy, see issues of Ekono- mi dan Keuangan Indonesia and Bulletin of Indonesian Economic Studies. 17. For various viewpoints about the controversy surrounding the attempted coup, its background, and its effects, see U.S. Central Intelligence Agency (1968);An- derson and McVey (1971); McDonald (1980); Crouch (1988 [1978]); Bresnan (1993); Schwarz (1994); Kahin and Kahin (1995); and Gardner (1997).A recently declassified official U.S. State Department history that describes U.S. policy on Indonesia in the mid-1960s states:"Gradually the [U.S.] embassy came to realize that Indonesia was un- dergoing a full-scale purge of PK.I. influence and that these killings were overlaid with longstanding and deep ethnic and religious conflicts." The history includes a 2 De- cember 1965 memorandum from Ambassador Marshall Green to the State Depart- ment supporting payment to a key civilian member of an organization known as Kap-Gestapu, which was involved in the campaign against the communists that was backed and coordinated by the army.The ambassador's memorandum commented,"The chances of detection or subsequent revelation of our support in this instance are as minimal as any black bag operation can be" (T7he NewYork Times, 28July 2001, p.A3). 18. Schwarz (1994, p.20) considers these the most credible estimates of the num- ber killed, noting that estimates of deaths range from less than 100,000 to more than 1 mnllhon.The Indonesian word amok (uncontrolled, berserk) is often used to charac- terize the events of these months. 19. Sementara, which means temporary, was added to the acronym MPR because the People's Consultative Assembly (MPR) was called to meet at a time when there had been long-postponed elections (McDonald 1980, p. 58).The People's Consulta- tive Assembly meets every five years to elect the president and approve basic policy. In practice, until after Soeharto's resignation in 1998, the MPR had a strong tenden- cy to elect the incumbent and rubber-stamp government policy. In this case "the MPRS was still dominated by Sukarno's appointees.. .but did Soeharto's bidding after hear- ing an unusually contrite Sukarno" (McDonald 1980, p.58). 20. Schwarz (1994, p.46) quotes a 1991 Soeharto statement:"I have always asked God to guide me in each of my tasks. And thank God, to this day...I have never felt that I have failed. And if people think I have been wrong, I think: Who is it who can An Introduction to Indonesia 79 rightfully gauge my mustakes?Who decides if something is wrong? I believe that what- ever I do, after I've asked for guidance and direction from God, that whatever the re- sults, these are the results of His Guidance." 21. "The police and other branches of the mulitary responded to a rise in the crime rate in 1983-85 by executing some 5,000 suspected criminals in various cities through- out Indonesia, all without benefit of trial. In many cases the bodies were dumped in public places to serve as a warning to the community. At the time the military vigor- ously denied responsibility for the wave of mysterious klllings, which was called petrus in Indonesian.. .But some years later, in his autobiography, Soeharto adnutted that pet rus had been a government-sponsored operation from the start" (Schwarz 1994, p. 249). 22. See Bresnan (1993, ch. 3), Cole and Slade (1996), and Stern (forthcoming) for discussion of the technocrats and their role in Indonesia. 23.This section draws fromWardhana 1994b, 1997b, 1998a; Cole and Slade 1996; Prawiro 1998; and Stern 2000, forthcoming. I am grateful to Joseph J. Stern, an expert on the Indonesian economy, for his help in providing econonuc data for this chapter. 24. By 1994 Indonesia was the world's 3'' largest exporter of footwear in the world (after Italy and China), 11 ' largest exporter of garments, 12 h largest exporter of tex- tile fibers, and 13th largest exporter of furniture. 25. PAKDES I is an acronym for Paket 23 December 1987. 26. Paket October 1988. 27. Paket January 1990. 28. See discussion of Kredit Usaha Kecil (KUK) in chapter 9. In April 1997 the requirement was changed to 22.5 percent of the loan portfolio or 25 percent of net bank credit expansion. 29. The number of children that would be born to a woman if she were to live to the end of her childbearing years and bear children in accordance with current age- specific fertility rates (World Bank 1997f). 30.The 1996 GNP per capita of the 15 countries ranged from $770 for Lesotho to $1,390 for Ecuador.The remaining countries (from lowest per capita GNP to high- est) were Egypt, Bolivia, Macedonia FYR, Moldova, Uzbekistan, Indonesia, the Philip- pines, Morocco, Syria, Papua New Guinea, Bulgaria, Kazakhstan, and Guatemala. 31. See Jenkins (1984), Crouch (1988), and Schwarz (1994) for discussion of the role of the military in Indonesia. 32.The MPR is also the only body that can amend the constitution. 33. There were, however, numerous instances of guerrilla fighting within In- donesia, often generated by regional independence movements (as in Aceh, East Timor, and Irian Jaya), with varying degrees of military involvement.There were also guerrilla engagements across neighboring country borders, as in Papua New Guinea 34. Techmcally the joint secretariat of the Golkar functional groups is a govern- ment-sponsored coalition of groups such as agricultural workers, factory workers, women, youth, and businesspeople. 35. In 1993 Soeharto arranged for Information Minister Harmoko to became the first civilian Golkar leader, but Golkar was stlll controlled by the mlitary. 36. For'discussion of Indonesia's political economy, see Bresnan 1993 and Schwarz 1994; see also Cole and Slade 1996, ch. 10. 37. Upon Soeharto's resignation in May 1998 he was succeeded by B.J. Habible, the vice president. In 1999 general elections were held andWahid was elected presi- dent by the MPR. 38. The former president spells his name Soeharto, and this is the spelling nor- mally used in Indonesia. The foreign press, however, often uses the spelling Suharto. 39. See Schwarz (1994, ch. 6) for discussion of this play, the third in a trilogy, and the context in which it was ordered closed. 80 The Microfinance Revolution: Lessons from Indonesia 40. For analysis of the crisis in Indonesia see Wardhana (1998b); Cole and Slade (1998);World Bank (1998b); Radelet (1999); Kenward (1999,2000); and Stern (2000). For discussion of the East Asian crisis more broadly, see World Bank (1998a); Furman and Stiglitz (1998); IMF (1999c, 1999d, 1999e); Lane (1999); Lane and others (1999); Radelet and Sachs (1998,1999); Stiglitz andYusuf (2001). 41. Furman and Stiglitz (1998, p. 71) argue that while countries would do well to improve transparency, this does not inoculate them against a crisis. "In the case of Indonesia, there is a plausible case that... the crisis may have been due to the expecta- tion that corruption was going to be reduced.A substantial fraction of the profits and value of many companies. ..may have been based on their political connections to the Suharto regime and the favors that followed from them. The worrisome news in the fall of 1997 was not that this corruption and nepotism existed. Rather, it was that these connections or favors might dry up, either because of the increased transparency promised by the reforms or because of the increased likelihood that Suharto's regime would end because of his poor health or political vulnerabilhty.The costs of this openness for many investors-rather than corrupt practices by the government-may have played a role in the large outflow of capital that was the central feature of the crisis." 42. Megawati's earlier party was the PDI.When Soeharto realized that she was at- tracting attention and support as head of PDI, he had her removed as party leader. She then formed PDI-P; the P for Perjuangan (struggle) symbolizes the struggle against the Soeharto regime. 43."The International Conference on Indonesia: Strategy for the Stabilization of the Indonesian Economy and its Sustainable Development in the Future," at Mita Kaigisho, Tokyo, 30 March 2001. An Introduction to Indonesia 81 Q Rural Development and Rural Financial Institutions in Indonesia Located on the world's largest archipelago, Indonesia is home to more than 200 million people and hundreds of eth- nic groups, most of whom live in rural areas. The country encompasses a large variety of environments ranging from dense tropical rainforests to terraced rice paddies to tiny islands of coral reef. Its rural areas contain a rich variety of natural resources, including oil, natural gas, and an abun- dance of minerals. The main food crop is rice-grown in irrigated wetlands, drylands, swamps, and even jungles where small plots of land are burned and cultivated in ro- tation. Other food crops-maize, cassava, vegetables, and fruits-are cultivated on rainfed lands, while plantation agriculture, a legacy of the Dutch colonial era, produces ex- port crops such as palm oil, rubber, coffee, tea, and the spices for which the Indonesian islands are famous. With its 82 thousands of islands, the country also has a large supply of fish, although the industry is not fully developed. This chapter examines Indonesia's rural development and its cen- tury-old history of rural financial institutions.The country is home to the world's largest sustainable rmicrofinance system and many local commercial microfinance institutions. But a long-standing tension prevails between those who promote massive rural credit subsidies and those who foster independent commercial financial institutions. A similar tension exists between supporters of member-based financial cooperatives and those who advocate publicly or privately owned rural Indonesia is home to financial organizations that serve the public. Examples are provided of these and other recurrent themes in Indonesia's rural finance. the worlds largest The green revolution came to Indonesia in the 1970s, making pos- sible major gains in the production of rice and other food crops.The financially seW- government invested much of its oil wealth in rural areas, developing sufficient infrastructure, agriculture, and human capital. New methods of rice cul- tivation brought higher yields and multiple cropping that at first ben- microbanking system efited mainly rural elites with valuable irrigated ricelands. But soon the benefits reached smaller farmers as well, and the increased labor re- and many smaller quirements of multiple cropping offset labor displacements caused by commercial new cultivation techniques. Eventually the commercialization of agri- culture and growing off- farm employment opportunities brought sub- microfinance stantial production growth, rapidly increasing monetization, and rising per capita incomes to rural areas. By the early 1990s many areas of rural institutions Indonesia had gained substantially from the green revolution. But considerable rural poverty remained, as did significant regional and local disparities in income distribution and employment opportunities. Rice production in Indonesia increased from 22 million tons of dry unhulled rice in 1976 to 50 million tons in 1996.As incomes rose, so did per capita rice consumption and food consumption generally. In addition, massive investments in education, health, and family planning improved nutrition and health and increased awareness, skills, and ex- pectations. Roads and communication facilities opened up inter-island travel and migration. Middle- and upper-income rural households gen- erally prospered, especially in irrigated lowland regions. Many less de- veloped rural areas also saw economic growth and increasing employment opportunities, though to a lesser extent. But inhabitants of poorer regions, especially on some eastern islands, had fewer op- portunities for development. Rural Development and Rural Financial Institutions in Indonesia 83 Until the late 1980s rural Indonesia was served by few commercial banks other than the unit desas of Bank Rakyat Indonesia (BRI). There were, however, many commercial financial institutions in rural areas, usually owned by provincial or local governments. But these institutions typically operated on a relatively small scale. In the late 1980s banking deregulation led to a substantial increase in the number of banks and bank branches in the country. Some of these operated in rural areas, but usually only in well-developed regions. The market share (in value of outstanding loans) of rural financial In Indonesia a institutions in the financial system hardly varied between 1985 and 1995-it was about 2.5 percent in 1985 and about 2.1 percent in century-old tension 1995. In 1995 the unit desas, which are examined in chapters 11-15, accounted for 48 percent of the number of loans in microfinance exists between those institutions, 63 percent of the value of outstanding microcredit, 76 who promote rural percent of the number of savings accounts, and 81 percent of the value of savings. credit subsidies and The subsidized credit programs implemented by commercial banks and funded by the government and donors generally suffer from high those who foster costs and high arrears.They often do not reach the poor-or reach independent them in ways that do not suit borrowers' needs. And the programs are not sustainable.Worse, they deflect attention (and adaptation) from commercialfinancial Indonesia's long history of commercial, viable microfinance in rural financial institutions, some private banks, and the unit desas. institutions This chapter examines both commercial and subsidized rural fi- nancial institutions and programs. First the century-long develop- ment of Indonesia's commercially oriented People's Credit Banks (Bank Perkreditan Rakyat, or BPRs) is reviewed. This is followed by discussion of rural finance in the 1980s, government initiatives in the 1990s, and development of the BPRs after the 1992 Bank- ing Law. Finally, the chapter analyzes six very different rural finan- cial institutions and programs using data from 1995-98. These organizations-four BPRs (public and private), a Grameen Bank replicator, and a large subsidized credit program linking banks and self-help groups-illustrate well the range of approaches to micro- finance in Indonesia-and their results-as well as the current dilemmas and recurrent themes in Indonesian rural finance. The first three BPRs discussed (two public and one private) are sustainable financial intermediaries that serve both poor and non- 84 The Microfinance Revolution: Lessons from Indonesia poor clients.The fourth BPR, as it operates in one district, provides a classic example of how corruption, politicization, and lack of ac- countability can prevent profitable commercial microfinance while putting poor savers' money at risk.The highly subsidized Grameen replicator offers a rigid, targeted rmicrocredit program in a province that already has hundreds of experienced BPRs offering flexible mi- crofinance programs. As a result the replicator has low capital, low outreach, and 39 percent financial self-sufficiency in 1995 (Seibel and Parhusip 1998, p. 15).The subsidized program linking banks and self-help groups-a large, unnecessarily complicated, inefficient Commercialization program with layers of intermediaries-attained substantial outreach but at very high cost (in fiscal 1995/96 the annual effective inter- of agriculture and est rate would have had to have been 277 percent to fund full pro- gram costs). Moreover, borrowers paid high annual effective interest of-farm employment rates-typically more than 100 percent and in some areas up to 450 resulted in percent. In 1997 the start of the economic crisis and a severe drought caused production growth, substantial hardship in many rural areas.Agricultural growth fell to less in than 1 percent in 1997, a sharp decline from the 3 percent growth of creasing 1996. Marginal areas and poor people were hit particularly hard by monetization, and the drought and the crisis, as employment decreased and prices rose. Social safety net programns were crucial for the rural poor, yet in many rising rural per cases were inadequate. There was considerable variation in food se- curity by province and district, with some provinces facing severe food capita incomes shortages. But the 1998/99 and 1999/2000 rice harvests were good, and production of other food crops improved as well. In addition, es- pecially on some of the Outer Islands where the rural economy is dom- inated by export crops such as palm oil, coffee, and rubber, the plunging rupiah resulted in increased exports and substantial incomes for farmers. But as discussed in chapter 8, as of mid-2001 economic and political difficulties continue in Indonesia. Yet even as Indonesia's financial system collapsed during the cri- sis, the leading commercial microfinance institutions-a number of the BPR systems, BRI's unit desas, and Bank Dagang Bali-remained liq- uid, profitable, and stable. Together these institutions serve about half the county's households-providing a powerful lesson about the sta- bility of sustainable microfinance institutions even in times of severe economic, financial, and political crisis. Rural Development and Rural Financial Institutions in Indonesia 85 In 1976, 80 percent of Indonesia's 136 million people lived in rural areas (World Bank, World Development Report 1980).Although there has since been a substantial increase in the urban population, much of it due to rural-urban rmigration, the country remains predominantly rural. In 1999,60 percent of In- donesia's 207 million people lived in areas classified as rural (World Bank, World Development Report 2000/200 1). But there are substantial differences among the many Indonesian islands, and rural conditions vary considerably. For example, the 1995 population density onJava-where 59 percent of the country's pop- ulation lived on 7 percent of its land-was 900 per square kilometer. In Irian Jaya (now Papua)-where 1 percent of the population lived on 22 percent of the country's land-population density was 8 per square kilometer (Govern- Massive investments ment of Indonesia 1996, p.47). Infrastructure, agriculture, communications, ed- ucation, health, and the like tend to be more developed in rural Java and Balh in agriculture, and less developed in rural Papua, NusaTenggara, and Kalhmantan. Parts of Suma- tra and Sulawesi fall along different points of this continuum. education, health, andfamily planning Geographic and Demographic Diversity improved nutrition There is enormous geographic variation in the Indonesia archipelago. The country has mountains, hills, plateaus, plains, rivers, lakes, and volcanos. It has trop- and health and ical ramforests, swamplands, savanna, elevated coral reefs, areas of intensive irri- gated agriculture on rich alluvial soils, and places where little grows on dry, increased awareness, leached-out earth. Indonesia is rich in natural resources, with oil and natural gas, tin, coal, bauxite, nickel, gold, silver, manganese, copper, and other minerals. skills, and Asian land vertebrates are found in the western islands of Sumatra,Java, Bali, and Kalimantan, which had land connections to the continent when the Sunda expectations shelf, part of the Asian continental shelf, was largely exposed during the Pleis- tocene period. Similarly,Australian animals moved overland into IrianJaya and other eastern Indonesian islands when much of the Sahul shelf, part of the Aus- tralian continental shelf, was exposed. Alfred Russel Wallace, the British natu- ralist who explored Indonesia in the mid-19th century, found that a line drawn through the Makassar and Lombok Straits (east of Ball and west of Sulawesi) marked the division between Asian andAustralian fauna. It was later found that Asian and Australian fauna coexist in a transitional area in the central Indone- sian islands' around Sulawesi, the largest of a group of islands that lies between the two great shelves. Rainfall is highest in the western part of the country and decreases toward the east; the typical range is from more than 200 inches a year to less than 40 inches.The country's rural population is concentrated in areas where there is recent or continuing volcanic activity.Young volcanic soils are highly fertile and permit the growth of the dense rural populations found in Java and Bali. Stated on Indonesia's national emblem are the words binneka tunggal ika (diverse but united).The country is home to several hundred ethnic groups, most with mutually unintelligible languages.Java is populated by a Javanese 86 The Microfinance Revolution: Lessons from Indonesia majority, a large minority of Sundanese primarily in WestJava, and several small- er ethnic minorities. Moving from west to east across the archipelago, small ethnic groups and small speech communities become more pronounced until in Irian Jaya there are small bands with separate languages spoken by fewer than 100 people (Koentjaraningrat 1975b, p. 54). But except for some elderly people, nearly all Indonesians now speak the national language, Ba- hasa Indonesia. Indonesia is heavily Islamic, with Muslims making up nearly 90 percent of the population; the largest minorities are Protestant, Roman Catholic, Hindu, and Buddhist. In studying the cultures of Indonesia, Koentjaraningrat (1975b, pp. 57-60) placed the hundreds of ethnic cultures into four general categories: 6 rural microfinance * Small groups of isolated peoples whose livelihoods are based on shifting cul- tivation, found mainly in the smaller eastern islands and in Irian Jaya. institutions are used * Interior peoples whose livelihoods are based on swidden2 or irrigated agri- culture, with rice as the main crop. These groups live in village communi- to illustrate the ties and interact with people in nearby administrative towns. Examples are found in North Sumatra, Central Sulawesi, and the eastern islands. range of approaches * Coastal peoples who cultivate rice as their main crop.This is a heterogeneous mix of maritime peoples descended from Malays, Javanese, South Indians, and results in Arabs, Persians, Portuguese, English, Dutch, and Chinese. * Interior settlements of people whose subsistence is based on wet rice agri- Indonesian rural culture.These village communities, characterized by significant social strat- ification, are located most notably in Java and Bali. Elaborate agrarian-based finance royal courts developed in some of these areas.TheJavanese gentry have dom- inated Indonesia's government and development since independence. However, many changes have occurred since Koentjaraningrat's 1975 clas- sification. The opening of road travel throughout Indonesia, rural-urban mi- gration, inter-island mugration, the green revolution, the growth of overseas employment opportunities, and the explosion of infrastructure, communica- tions, and education have changed the country greatly. Koentjaraningrat's cat- egories remain relevant and important for understanding Indonesia, but the dynamics of these groupings are shifting. As James J. Fox (The Independent Monthly, 17-19 February 1990, p. 18) put it in a discussion ofJava: But, in truth,Java is a single settlement.What makes it a single settlement is its incredible flow of traffic. The Dutch left the island with a peasant population very much tied to the land in separate subsistence-oriented villages. But over the last 20 years Mitsubishi and Mercedes Benz have managed to open up the vllUages; Mitsubishi with its mini-van, the Colt, that could- and did-reach the most isolated villages, and then Mercedes with huge buses that take passengers across the island in less than a day. Rural Development and Rural Financial Institutions in Indonesia 87 Rural Development Given its geographic and cultural variety, it is not surprising that many types of agriculture are found throughout the Indonesian archipelago.The country supports a vast range of food types and other agricultural products. Varieties of agriculture The main rice supply comes from sawah (irrigated riceland) agriculture. Sawah is a field that is meant to be flooded; it is surrounded by a small dike, and if it is on the mountainside, the slopes must 1hen thefinancial be terraced. Sometimes the flooding is left to the rains, but the result of this procedure is unpredictable, for rainfall might be system collapsed too much, too Iltde, or poorly timed. Usually ditches or bamboo pipes lead water to the sawah from a nearby stream. during the crisis, -Nell 1973, p. 43 BRls unit desas, Sawah, which refers to wet-field cultivation on irrigated rice fields, regardless of the source or quality of irrigation, is the environment in which most rice is BDB, and many grown in much of Java, Madura, Bali, and Lombok, parts of Sumatra and Su- lawesi, and in scattered parts of other areas. People's Credit Estate (plantation) agriculture was introduced to Indonesia by its Dutch col- onizers. Plantation crops include palm oil, rubber, sugarcane, tobacco, coffee, Banks (BPRs) tea, and spices.These crops are grown on large estates but most are also culti- vated by smaliholders. Depending on the crop, plantations are found in both remained profitable highlands and lowlands. Timber production is concentrated in the Outer Is- lands (outside Java and Bali). and stable Another type of cultivation is known as tegalan (dryland) agriculture; this refers to land that is normally continuously cropped but is not irrigated. Rice, maize, cassava, sweet potatoes, peanuts, soybeans, vegetables, and fruits are common in rain- fed agriculture. Pekarangan (mixed garden) cultivation is usually found in small house- hold or village plots. In ladang (or swidden) agriculture, an ancient technique, a small forest area is burned and rainfed crops are grown in the ashes.The cultivat- ed area is productive for a few years but then yields declne rapidly and the cul- tivator moves on, burning a new plot on which to plant yams and other root crops, rice, and other crops. After some years the original plot is often cultivated again, and the cycle begins anew. Ladang cultivation is common in parts of Sumatra, Kali- mantan, Sulawesi, and Maluku and other eastern islands. In 1995,23.9 percent of the country's land was in estate cultivation, 19.6 percent was in ladang, 16.5 per- cent was in wooded areas, and 14.6 percent was in sawah. The rest was used for housing and other purposes (Government of Indonesia 1996, p. 151). Rice, the primary staple food of Indonesia, is grown on irrigated wetlands, on drylands, in swamps, in garden areas, and in shifting ladang cultivation. An- imal husbandry is common, especially for goats, cows, buffalo, poultry, and (in non-Muslim areas) pigs. Fish come from both salt and fresh waters and from 88 The Microfinance Revolution: Lessons from Indonesia fish cultivation in brackish water ponds, fresh water ponds, cages, and flooded sawah fields.3 Shrimp cultivation has also been developed in recent years. Cultivation on Java in the early 20th century Thomas A. Fruin, president of the AlgemeeneVolkscredietbank (AVB), a pre- cursor of BRI, wrote an extraordinary manual for the AVB in 1935. The Pro- visional Manualfor the Credit Business of the General Popular Banke was based on decades of work that had brought Fruin and others into close contact with In- donesian farmers.The AVB and its predecessor, the Volkscredietwezen (Popu- lar Credit System) early credit institutions established in Indonesia by the Dutch colornal administration to provide banking services to indigenous Indonesians- are discussed in chapter 11. What is of interest here is the analysis of indige- OnJava in 1995, nous farming in Indonesia that Fruin constructed to learn how best to provide and recover loans from different kinds of farmers. Many of the inputs into the 59 percent of manual came from articles by Fruin and others in the monthly journal Volks- credietwezen, published under several names beginmning in 1913, but from 1931 Indonesia's on known as Volkscredietwezen. Many of today's rural banks could learn from Fruin's section on types of population lived on loans in indigenous farming on Java (Fruin 1994 [1935], p. 132). He begins: 7 percent of its land. If one examines the credit business of any former popular credit bank one is often struck by the large measure of uniformity In IrianJaya 1 revealed; this is due to the fact that no more than one or two different types of loans can be found. Further study then reveals percent of the that exactly the same types were used by many similar institutions. In other words, insufficient account was taken of the different population lived on kinds of agriculture within a region or of the differences between regions. If this situation is to be improved, each local 22 percent of the office will have to investigate, district by district, what the normal types of farming are. It is not therefore sufficient to know land what the principal crops are in the region, to consult monthly figures on planting and harvesting of each crop, to have some idea about the kinds of fruit trees which are grown, about trade or about employment; one must consider farming as an organic whole, i.e. find out how crop rotation operates in particular types of farming, how large such a farm has to be to support the farmer and hls family, which crops are intended for sale, which exclusively for food and which for both, and in the latter case in what proportions they are divided, whether and to what extent such a business usually derives cash income from horticultural and orchard produce, whether cottage industries or coolie work normally provide additional income, and so on. The KUPEDES loan instrument, created much later for BRI's unit desas, reflects Fruin's lessons. KUPEDES provides loans in a wide range of amounts, Rural Development and Rural Financial Institutions in Indonesia 89 offering 36 combinations of repayment and maturity options so that borrow- ers can select loans appropriate for their particular needs. In the 1920s and 1930s Fruin painstakingly analyzed different types of farm- ing from the viewpoint of credit extension (see chapter 11). These included cycles of rice cultivation on irrigated wetlands and on higher-elevation rain- fed drylands, crop rotations of rice and secondary crops such as maize, cassava, and vegetables, and cultivation of both cash crops such as tobacco and coffee and of crops that may be for subsistence or for sale (rice, cassava, fruits). Although Fruin's purpose was to examine farming in order to establish credit procedures, much can also be learned from his manual about the various types of farming and the marketing of farm produce that were then common in different areas The main rice ofJava.While there have been considerable changes in farming in Java (and else- where in Indonesia) as a result of the green revolution, Fruin's principles of agri- supply comes from cultural credit and many of his observations aboutJavanese agriculture remain relevant today. irrigated ricelands. The green revolution But rice is also In the mid-1960s international agricultural research began to demonstrate that new high-yielding technology could significantly increase agricultural grown on rainfed productivity. Based on high-yielding seed varieties, substantial growth in the use of chemical fertilizers, insecticides, new cultivation and management tech- drylands, in swamps, niques, expanding irrigation, and in some cases new agricultural machinery, the green revolution resulted in a large-scale shift to commercial cultivation of food- and inforest areas grains in many developing countries. In Indonesia-as in most countries-the results varied by region, by crop, and by farmers' access to land, water, labor, using shifting credit, and marketing facilities. cultivation Cultivation patterns. The green revolution made possible major gains in the production of rice and other food crops. Increases in rice production have come from both intensification, primarily on Java and Bali, and extensification, pri- marily on some of the Outer Islands. Increases in rice production from inten- sification have come from higher yields and increased cropping intensity (two or three crops a year instead of one). Other areas that have achieved significant rice intensification are North, West, and South Sumatra and South Sulawesi. In 1996 average yields in sawah paddy production were 54 quintals4 of dry un- hulled paddy (gabah) per hectare on Java and 40 quintals per hectare off Java, with a range in average quintals per hectare from 28 in Irian Jaya and East Timor to 55 in EastJava. For Indonesia as a whole the average yield for sawah paddy production was 47 quintals of gabah per hectare, while the average yield for dryland paddy cultivation was 22 quintals of gabah per hectare (Government of Indonesia 1996, pp. 164-65). In contrast to intensification, rice extensification occurs by bringing new lands under cultivation. Beginning in the 1970s, far more new land was culti- vated with rice off Java than on Java. But much of the land used to extensify rice cultivation outside Java is only marginally suitable for rice growing (see 90 The Microtinance Revolution: Lessons from Indonesia chapter 11), andJava produces more than 60 percent of the country's rice. Over- all, rice production in Indonesia increased from 22 million tons of gabah in 1976 (when the population was 136 million) to 50 million tons in 1996 (when the population was 197 million). But the demand for rice increased faster than the population.As incomes rose, so did per capita rice consumption. Most of those whose main diet had been cassava or maize switched to rice when they could afford to do so. In 1996 Indonesia produced 17 mnllion tons of cassava, of which 55 percent came from Java, and 9 million tons of dry loose maize, of which 61 percent came from Java (Government of Indonesia 1996, pp. 166-67). ThusJava remains Indonesia's principal source of rice and other staple food crops.The Outer Islands contribute much of the country's export crops, such as palm oil, coffee, rubber, and timber, as well as oil, natural gas, and minerals. The green revolution Results. The effects of the green revolution in Indonesia, especially for rural significantly Java, have been much debated (see Mannmng 1987). During the 1970s many so- cial scientists reported that the commercialization of agriculture onJava was caus- increasedfood ing increasing inequalities among the rural population (Penny and Singarimbun 1973; Collier and others 1974; Budhi-santoso 1975; Hinkson 1975; Sinaga and production. But the Collier 1975; White 1976, 1979; Palmer 1977b; Gordon 1978; Hart and Sisler 1978; Sinaga 1978; Sayogyo 1982 [1973]). It was argued that: results varied by * The benefits of the new agricultural technologies reached primarily large farmers' access to farmers who had access to irrigation, credit, and high-yielding inputs ap- propriate for well-irrigated sawah. land, water, labor, * The new methods, especially for weeding, harvesting, and rice hulling, low- ered costs for cultivators but decreased employment opportunities for laborers credit, and markets (Collier and others 1974; Collier, Soentoro, Hidayat, andYuliati 1982; Bud- hisantoso 1975; Sinaga and Collier 1975; Singarimbun 1976; Sinaga and oth- ers 1977; Collier 1978; Sinaga 1978; Manning 1987, ch. 4). * Rural elites and urban residents were consolidating the fragmented lands that poor farmers could no longer afford to cultivate. * New agricultural methods and changing forms of labor contracts weakened the patron-client and communal ties believed to demonstrate Geertz's (1963) concept of a cultural norm of"shared poverty" (Collier and others 1974; Bud- hisantoso 1975; Ruttan and Binswanger 1978; Collier 1981; Hart 1986a, 1986c; Manning 1987, ch. 5).5 In addition, attention was drawn to the increasing replacement of cottage industry products by manufactured goods. There is some truth to all these statements. But the dismal picture of in- creasing income inequality, poverty, and polarization portrayed in much of the literature of the 1970s and early 1980s was oversimplified and did not provide an accurate representation of rural realities.6 Thus while the new methods for cultivating rice benefited the rural elites earlier and more extensively than was the case for small farmers, some farmers with small plots also gained from the higher yields and multiple cropping made Rural Development and Rural Financial Institutions in Indonesia 91 possible by the new technologies. In addition, the increased labor requirements of multiple crops offset much of the labor displacement and employment dis- tribution problems caused by the new cultivation techniques and labor contracts. The government's extensive investment of oil wealth in rural areas in the 1970s-in agriculture, infrastructure (irrigation, roads, markets), health, fami- ly planning, and education-had generally succeeded, by the 1980s, in improving agriculture, creating employment, and raising rural incomes. But the distribu- tion of these benefits varied considerably by region, locality, social and economic status, occupation, and gender. Increasing employment generation included both off-farm work in rural areas (trade, construction, food processing, services) and employment opportunities for rural workers in urban areas (both in informal Although large petty trade, transportation, construction, and small-scale manufacturing, and in then-emerging formal sector labor-intensive export activities). farmers often control Although large farmers often control more irrigated riceland (sawah) than they own, sawah is generally not concentrated in large holdings.This outcome more irrigated is probably due to the multiple employment activities that enabled many small farmers to retain their lands, and to the better education and increasing investment riceland (sawah) opportunities available to large farmers who were able to diversify their eco- nomic investments. than they own, Most middle- and upper-income rural households have prospered, especial- ly in the irrigated lowland regions ofJava, Bali, and Sulawesi.Two or three crops sawah is generally a year are now normally cultivated in these regions, creating additional employ- ment. In 1996 agriculture accounted for just 17 percent of GDP, yet employed not concentrated in 44 percent of the Indonesian workforce (Government of Indonesia 1996, p. 45). Yields have increased considerably, and crops are frequently sold in bulk for cash. large holdings Widespread improvements in roads and related growth in transportation- popularly called the "Colt revolution"7-m combination with the greater em- ployment opportunities generated by labor-intensive exports, expanded income sources beyond the village. This, in turn, increased remittances and transfers of funds to rural areas. Overall, irrigated lowland villages saw economic growth and increasing mon- etization, much higher crop yields, added employment opportunities for the many landless, an emerging pattern of multiple income sources (including new off-farm activities in manufacturing, services, and trade), and higher mobility (see Keyfitz 1985 and Fox 1990 for accounts of the rapid development of two East Java villages over time).8 Many less developed rural areas were similarly characterized, though to a lesser extent, by economrc growth, rising employment opportunities, multiple income sources, and increasing monetization. But the inhabitants of poorer re- gions, especially in parts of Kalimantan and some eastern islands, had fewer op- portunities for development.9 In 1996 the rural population below the poverty line varied across provinces from 3.5 percent (Bali) to 33.1 percent (East Timor) (Government of Indonesia 1996, p. 574). 10 Special programs, public and private, were instituted to reach the "left behind" (tertinggal people and villages. Even in Java some poor villages remain left behind. In the mid-1980s I talked 92 The Microfinance Revolution: Lessons from Indonesia with a man who worked in Jakarta as a laborer for a microenterprise that sort- ed and sold recyclable waste purchased from ragpickers. From this work he was able to send about $20 a month to his family in a poor Central Java village. I asked him what was the main difference between living in the city and living in his village. He answered without hesitation, "In Jakarta I can eat every day and as much as I want. I can eat until I burst. In the village I might eat today but I won't know today if I will eat tomorrow." Rural development during the Indonesian crisis In 1997 the economic crisis, along with the devastating drought, eroded and in some cases erased gains that had been made in rural development. Particu- larly hard hit were marginal areas and the poor. The social safety net programs Employment was discussed in chapter 8 were crucial for the rural poor, but many of the poor were not reached, were not adequately provided for, or were not reached at the generated by the time of greatest need.As a result the number of people below the poverty line increased from 11 percent in 1996 to an estimated 20 percent in 1998. Some labor requirements of rice eaters switched back to cassava, maize, and sweet potatoes. Prices rose, em- ployment dropped, some children left school, health care and medicine were multiple crops and not always available or affordable, and the gap between prevailing conditions and people's expectations widened. rural off-farm work, But the 1998/99 and 1999/2000 rice harvests were good, and production of other food crops-maize, cassava, soybeans, potatoes, and peanuts-improved and by opportunities as well. In addition, especially in some outer islands where the rural economy is dominated by export crops such as palm oil, rubber, and coffee, the precipitous for rural labor in fall of the rupiah resulted in increased exports and substantial incomes for farm- ers. By the end of 1999 the percentage of people below the poverty line was back urban areas to the pre-crisis 1996 level of 11 percent. Overall, the impact of the crisis on the poor was generally more severe in urban areas than in the countryside. Even with the substantial difficulties Indonesia faces as of mid-2001, there is no question that its rural poor have made strong gains over the past three decades. Although some rural inhabitants are still below the poverty line, most have benefited from more diverse employment opportunities, increased real in- comes, and better nutrition, health, education, and housing. Huge governmnent investment in rural areas during the Soeharto era-in agricultural technology, infrastructure, education, health and family planning, communications, and food processing and other off-farm rural activities-laid a firm foundation for continuing development. When Indonesia achieves the political stability and will to implement needed economic and financial reforms, these rural assets can serve as a springboard for future development. Developing Rural Financial Institutions Indonesia has a long history of rural financial institutions, dating to the late 19th century when the early Volksbank (People's Bank) and Afdeelingsbank (Dis- Rural Development and Rural Financial Institutions in Indonesia 93 trict Bank) were introduced by the Dutch colonial admimstration. After inde- pendence, different kinds of rural financial institutions continued and many new ones were developed, variously called rural banks, village banks, market banks, people's banks, and the like.The generic term for these small local banks is Bank Perkreditan Rakyat (People's Credit Bank, or BPR), but as will be discussed, this term has multiple meanings. BPRs are small independent rural financial institutions, widely scattered. Many offer both savings and credit facilities. Until recently, with the publica- tion of Steinwand (2001), relatively little had been published about most of them-with the exception of the Badan Kredit Kecamatan (BKK) of Central Java and the Badan Kredit Desa (BKD) of Java and Madura, and a few other Some villages well-known systems.This chapter and others in this book (chapters 11, 14, and 17) explore selected Indonesian BPRs. Readers interested in more in-depth remain poor. As one study of Indonesia's nearly 9,000 People's Credit Banks are referred to Stein- wand (2001), which begins with the BPRs' European antecedents in earlier cen- man said, "In turies and traces their development in Indonesia from their beginmngs during the Dutch colonial period up to the current Indonesian crisis.11 Jakarta I can eat In addition to the BPRs and BRI's unit desas, Indonesia's rural areas have long had ubiquitous rotating savings and credit associations (ROSCAs) as well every day and as as nonrotating associations (ASCAs) and other forms of savings and loan asso- ciations. But most of these informal associations have had limited outreach. In- much as I want. In formal commercial moneylenders provided most of the credit in rural areas. And most rural Indonesians kept most of their savings at home. In the second my village I won't half of the 1980s, however, things began to change. In analyzing the development of mucrofinance in rural Indonesia, certain know today if I will recurrent themes emerge in both colonial and Indonesian contexts. These themes underlie much of the discussion throughout volume 2. (Most are also eat tomorrow" relevant, in various ways, to mucrofinance in other countries, as discussed in vol- ume 3.) * Policies andpolitics. Indonesia has a century of experience with different kinds of unsubsidized, profitable microfinance institutions. Many different kinds of People's Credit Banks have been developed without assistance from donor agencies (donors have been involved only on rare occasions). Initial funding came from wealthy individuals or local governments. Equity was created from retained earnings. But Indonesia also has a history of large-scale subsidized rural credit programs. A long-standing tension has continued, generation after generation, between supporters and opponents of credit subsidies (see Schmit 1991).There is a similar dynamic between those who support mem- ber-based cooperatives and those who advocate nonmember-based financial institutions. Examples are provided here of the same political tensions in dif- ferent periods-tensions that have resulted in both policy oscilations over time and simultaneous implementation of contradictory policies. Generally the ten- dency has been for the Ministry of Finance and the National Development Planning Board (Badan Perencanaan Pembangunan Nasional, or BAPPENAS) 94 The Microfinance Revolution: Lessons from Indonesia to support commercial microfinance, while the Ministries of Cooperatives and Agriculture have frequently advocated subsidized credit programs channeled through village cooperatives. Both sides were powerful, and both approach- es reached every Indonesian village. (It should be remembered that injavanese philosophy, opposites are part of the same whole.) * Financial intermediation. Many People's Credit Banks have been (and are) fi- nancial intermediaries, not microcredit institutions. Loans are generally fi- nanced from savings and equity, and in some cases with commercial bank loans. From the beginning of the People's Credit Banks in the 19,h century, there has been a strong view in Indonesia that self-sufficient financial inter- mediaries work better than rmicrocredit programs. * Ruralfinancial institutions: public and private. Most of Indonesia's commercial The impact of the People's Credit Banks, as well as BRI's unit desas, are public enterprises, pro- viding a sharp contrast to the currently dominant international view that po- recent crisis on the tentially self-sufficient microfinance institutions are best located in the private sector. The Indonesian experience has demonstrated that commer- poor was generally cial mucrofinance can flourish in both sectors. * Learningfrom experience. There has been a long history in Indonesia that, when more severe in urban institutions do not work well, lessons are learned and new models are de- veloped-whether it be conversion from cooperative to noncooperative banks areas than in the during the colonial era or the BRI unit desas' transformation from subsi- dized credit delivery to commercial financial intermediation toward the countryside end of the 20h century. Examples are provided throughout this volume. These themes are as relevant for Indonesia today as they were a century ago. But as will be discussed, much has been accomplished in the interim. European background European banking began more than 500 years ago in Italy with the provision of credit to the aristocracy and the church, and with payment services for long- distance trade. But the Italhan banks did not provide financial intermediation. Between 1490 and 1520 German and Swiss banks developed into financial in- termediaries and took the lead in European finance.As Bergier (1979, quoted by Steinwand 2001, p. 49) put it, "The Italians had given banking its name and its instruments.The Germans gave it its place in the economy and society." By the 181' century the development of microbanking had begun. The structural changes from an agricultural based society to an industrial one and the rapid demographic growth after the end of the extended European wars (1618-1648) led to a tremendous increase in poverty in Europe. One response was the establishment of various forms of microfinance institutions during the 18th and 19th centuries...Their common goals were to fight poverty and to release the poor from the grasp of the moneylenders.They can be grouped into four categories: credit- Rural Development and Rural Financial Institutions in Indonesia 95 focused charity funds.. .community based funds which started with donated funds but developed over time into fully fledged commercial intermediaries; savings banks...and the cooperative banks. -Steinwand 2001, p. 51 Indonesia's early people's banks and district banks were introduced by the Dutch at the end of the 19th century.The founders of these banks were direct- ly influenced by the growth of riicrofinance institutions in 19th century Europe. A few examples of the European antecedents will be useful (for further discus- sion see Steinwand 2001, chapter 3). One was the Irish loan funds started in 1720 In Indonesia there byJonathan Swift, author of Gulliver' Travels, which provided small loans to poor traders (see Hollis and Sweetman 1997,1998 and Steinwand 2001).This model has been a strong was widely copied by other wealthy individuals, and by 1840 the loan funds reached about 20 percent of Irish households. 12 Another model was the savings viewfor over 100 banks that began in Germany in 1778 and spread to many European countries in the early 19th century. As Tilly (1994, p. 305) comments: "The chief motive years that se!f- [for the development of the savings banks] was to encourage thrift and economic self-dependence among the poorer segments of the population. ..and not the mo- sufficient financial bilization of financial resources to finance investment." A third important influence was the cooperative banks that began in two intermediaries serve regions of Germany in about 1850. Schultze-Delitzsch started his first credit association, mainly urban-based, in the northeast of the country, and Freidrich the poor better than Raiffeissen began his first savings and loan association, mainly rural-based, in the southeast.The two models had somewhat different approaches.Among the microcredit programs differences, the Schultze-Delitzsch model incorporated limited liability for members (to attract deposits from clients who were not poor), whereas in the Raiffeisen model members' liability was not limited. Another difference is il- lustrated by Wolff (1893, p. 64; quoted in Steinwand 2001, p. 56): "Schultze- Delitzsche throughout put the lender's interest foremost, Raiffelsen the borrower's." It was Raiffeisen's approach to cooperatives that eventually became the model for most European cooperative banks.13 In the Netherlands the first savings banks were established in 1817 with the explicit aim of assisting low-income people. But these banks were not effec- tive in reaching poor clients (Steinwand 2001, p. 59). In the 1880s, however, an agricultural crisis led to the formation of a Netherlands government com- mission to advise on improvements for the agricultural sector. The commis- sion recommended establishing local cooperative banks modeled on the German Ralffeisen banks.The first such bank in the Netherlands was officially opened in 1897, and the banks, which eventually became known as Rabobanks, mul- tiplied. By 1920 there were some 1,250 Rabobanks in the Netherlands.14 The early Indonesian people's banks The Dutch colonial administrators in Indonesia introduced various forms of People's Credit Banks beginning in 1895.The establishment of a series of banks 96 The Microfinance Revolution: Lessons from Indonesia that eventually became Bank Rakyat Indonesia (BRI) began that year (see chap- ter 11). But it was not only BRI that was developed by Dutch colonial offi- cials; many district banks and lumbung desas (iterally "village granaries," but known as paddy banks) were begun at about the same time in Java and Madura. The original plan was to construct a cooperative rural banking system in Indone- sia based on the Raiffeisen model.The lumbung desas would form the village- level credit cooperatives, and the district banks would become the second tier of the cooperative structure. District banks. Seventy-one district banks disbursed an average of 755 loans in 1926. Data for 1929 show that nonperforming loans (loans in default) in the district banks were 3 percent of the amount of outstanding loans.15 More The Indonesian than half of the district banks' deposits were from (predominantly European) time deposits in 1913, but by 1926 time deposits had declined to 23 percent experience of total deposits, while 55 percent of the banks' deposits came from (mainly Indonesian) savings accounts (Steinwand 2001, pp. 73-83). demonstrates that These financial intermediaries soon became financally self-sufficient. In 1911 there were 75 district banks, of which 67 (89 percent) were subsidized. But by commercial 1926 only 6 of 90 banks (7 percent) were subsidized (Suharto 1996, quoted in Steinwand 2001, p. 80). microfinance can Lumbung desas. By 1910 there were 12,542 lumbung desas in Java and Madu- flourish in both ra; the number gradually declined to 5,451 by 1940.The original lumbung desas were supposed to be funded by members' donations paid at the end of the Mus- public and private lim fasting month. But this approach did not work well, and a modified sys- tem was introduced that did not follow the Ralffelsen model so closely. The sectors modified lumbung desas were not strictly member-based: they had external fi- nancing as well as members' contributions, and grew much faster and performed better than those developed using the earlier model. Originally the lumbung desas provided (and collected) loans in paddy.Their main purpose was to level out seasonal fluctuations in rice supply. But by the early 1900s some of the lumbung desas in the more developed regions ofJava began to lend and collect loans in cash.As a result of this development, in 1904 the colonial administration introduced bank desas (village banks) operating on a currency basis. The lumbung desas achieved wide and deep outreach in Java and Madura but did not work well in many outer islands where paddy farming was less im- portant. By 1918 there were no lumbung desas outside Java and Madura. But in 1926 the lumbung desas reached nearly 1.3 mullion borrowers, 16 percent of the approximately 8 million households inJava and Madura.The loans pro- vided by the lumbung desas were short, small, and profitable. However, outstanding loans as a share of total lumbung desa assets were 27 percent in 1913, and only 2 percent in 1926. "Thus 98 percent of the Lum- bung Desas' funds were idle and were not used for making loans to villagers! Of course, such a low rate of investment was only possible because the Lum- Rural Development and Rural Financial Institutions in Indonesia 97 bung Desas were owned by the villages and funded to 99% by equity" (Stein- wand 2001, p. 91).The source of the lumbung desas' equity was retained earn- ings. Because paddy stored for a number of years deteriorates in quality (and sometimes in quantity, as it can be eaten by rats), the lumbung desas sold most of their paddy stock and deposited the funds in the district banks. Bank desas. When the bank desas opened in 1904 and began lending in cash, there was considerable demand for these loans. The main sources of the bank desas' startup funds were the government, district banks, local lumbung desas, and repayable villagers' shares. In 1926,4,754 bank desas onJava and Madu- ra had 941,000 borrowers, and outstanding loans were equal to 56 percent of Large-scale total assets (down from 74 percent in 1913 because the banks' equity had grown faster than their loan portfolios; Steinwand 2001, p. 97). Default rates were gen- microcredit began in erally low, averaging about 1 percent, and overhead costs were minimal because the banks operated through the offices or residences of the heads of the vil- the 1 8th century with lages where they were based. These bank desas were highly profitable. During the first two decades of the 20th century they yielded an average 50-58 per- the Irish loanfunds cent annual net return on the average outstandmg loan amount (Steinwand 2001, pp. 96-97).16 started in 1720 by The Bank Desas were fully initiated by the government and Jonathan Swift, funded with external resources. Hence their establishment finally marked the end of .. [the] idea to establish a cooperative author of Gulliver's system based on Raiffeisen's self-help principles at the village level. . .During the following decades plans to transform the Bank Travels Desas and the district banks into a two tier cooperative system surged from time to time among the colonial officials, however they were never realized. -Steinwand 2001, pp. 92-93 In 1907 the lumbung desas and the bank desas were regulated under a de- cree for Badan Kredit Desas (BKDs).These regulations were modified several times until 1929; the 1929 version is still valid (see chapter 14). Bank Perkreditan Rakyat (People's Credit Banks, or BPRs) The term Bank Perkreditan Rakyat (BPR) was introduced by Bank Indone- sia in 1978 as a generic term for people's banks.The term includes the village- owned BKDs (the lumbung desas and the bank desas), the Lembaga Dana dan Kredit Pedesaan (LDKPs, rural financial institutions owned by provincial, dis- trict, or subdistrict governments, often in combination, or by villages), and other small financial institutions variously called People's Credit Banks, rural banks, village banks, market banks, cooperative banks, and others. Such institutions vary widely in ownership, activities, legal status, supervision, management, and size. After the 1988 financial reforms of PAKTO 88, new secondary banks were es- tablished; these were also called BPRs. PAKTO 88 stipulated that BPRs meet 98 The Microfinance Revolution: Lessons from Indonesia certain requirements, including paid-up capital or savings of 50 million rupi- ah ($28,885 in 1988). Existing BPRs were given two years to fulfill the new requirements. But in 1989 the PAKMAR reform package extended indefinitely the time limit for preexisting BPRs to meet the new regulations, essentially grandfathering them from the PAKTO 88 requirements. However, the Banking Law of 1992, which recognized only two types of regulated banks (commercial banks and BPRs serving the rural population), in effect reversed PAKMAR in this regard, stating that rural financial institutions are required to meet the BPR criteria. But following the crisis of the late 1990s, the requirements for rural financial organizations to meet BPR regulations were substantially changed. As a result the future status of rural financial organizations that are not licensed BPRs re- People's Credit mains unresolved (see the discussion later in this chapter). Today the term BPR has two primary meanings. It refers to rural finan- Banks were cial institutions that meet the criteria specified in the 1992 Banking Law (li- censed BPRs). But it is also used for the nearly 9,000 People's Credit Banks of introduced in all kinds that exist today in Indonesia (generic BPRs), most of which do not meet the new criteria.At independence, Indonesia had several thousand small Indonesia by rural financial institutions, but the district banks had been merged in 1934 into the AlgemeeneVolkscredietbank (General Popular Bank), a precursor of BRI Dutch colonial (see chapter 11). By 1966 there were more than 4,000 bank desas and nearly 2,700 lumbung desas, according to the central bank (in later Bank Indonesia administrators in the statistics these institutions were grouped together under the category BKDs). The LDKPs, however, were not included in central bank statistics until after late 1 9th century the 1988 financial reforms. The LDKPs developed further during the 1970s and 1980s.The BKDs (which are discussed in chapter 14, as they are supervised by BRI) continued to pro- vide financial services to many villages in Java and Madura, but they were not permitted to serve other areas of the country or to open new units.This is gen- erally attributed to the fact that the village-owned BKDs, although they do not operate as originally planned on the basis of Raiffeisen self-help principles, are relatively autonomous.The rural financial institutions favored by President Soe- harto were those under direct government control: the BRI unit desas, the LDKPs under provincial government authority, and the state-controlled (subsidized and loss-making) village cooperative system (Koperasi Unit Desa, or KUD). Some of Indonesia's People's Credit Banks perform exceptionally well. Oth- ers perform poorly, and many are in between. But BPRs that do not perform well have generally been allowed to die out. This is a lesson that still needs to be learned in many other countries. Rural Finance in the 1980s In 1985 BRI's unit desas accounted for about 1.0 percent of the value of out- standing loans in the Indonesian financial system; all other rural financial in- Rural Development and Rural Financial Institutions in Indonesia 99 Table 9.1 Outstanding loans in Indonesia's financial system, 1985 Amount Share of Type of Billions of Millions of financial system financial institution rupiah U.S. dollars (percent) Banks 22,933 0 20,384 9 96 83 Bank Indonesia (direct credits) 964 0 856 9 4 07 State banks 15,145 0 13,462 2 63 95 Other commercial banks 4,1060 3,6498 17 34 Foreign banks 1,073 0 953 8 4 53 From 1900-20, Development banks 6400 5689 2 70 Savings banks 1,005.0 893.3 4 24 early village banks Nonbank financial institutions 162 0 144 0 0 68 Rural financial institutions 589 1 523 6 2 49 onJava and Madura BRI unit desas 229 0 203 6 0 97 Secondary banks 214 3 190 5 0 90 earned an average Bank Pasar 1930 171 6 081__ Village banks 19 0 16 9 0 08 annual net return of Paddy banks 2 3 2 0 0 01 Pawnshops 64.8 57 6 0 27 50-58 percent of Other rural nonbank financial institutions 81 0 72 0 0 34 BKKs, KURKs, and so on 31 0 27 6 0 13 KUDs 500 444 021 the average Total credit outstanding 23,684 1 21,052 5 1000 outstanding loan Note BRI stands for Bank Rakyat Indonesia BKK stands for Badan Kredit Kecamatan, or Subdistrict Credit Organization (Central Java) KURK stands for Kredit Untuk Rakyat Kecil, or People's Small Enterprise Credit Institution (East Java) KUD stands for Koperasi Unit Desa, or Village Cooperative amount Unit Source Bank Indonesia data, World Bank 1987 stitutions accounted for about 1.5 percent (table 9.1).These other institutions included secondary banks, government-owned pawnshops, regional credit pro- grams under provincial government supervision, privately owned financial in- stitutions, village cooperatives, and various kinds of village credit organizations. Although there were many active rural financial institutions, their outreach was typically small. Thus only 2.5 percent ($524 mullion) of the value of outstanding loans in the country's financial system in 1985 ($21 billion) was provided through rural financial institutions-although 75 percent of the country's population lived in rural areas.Another 0.7 percent of the value of outstanding loans ($144 mil- lion) came from nonbank financial institutions.The other 97 percent of the value of outstanding loans in 1985 was in banks. In 1983 only 17 percent of agricultural households received government credit (Agricultural Census of Indonesia 1983),17 primarily through BRI's 100 The Microfinance Revolution: Lessons from Indonesia BIMAS, the government-subsidized rural credit program provided at the unit desas. Rural borrowers who were able to qualify for the larger loans available in urban bank branches could obtain subsidized credit in district (kabupaten) cap- itals.The KIK (Kredit Investasi Kecil, or Small Investment Loan) and KMKP (Kredit Modal Kerja Permenen, or Small Permanent Working Capital Loan) programs offered subsidized loans up to 15 million rupiah ($13,333 in 1985). But very few rural households were eligible for these and for the other subsi- dized programs for larger loans sponsored by Bank Indonesia."8 And minimum loan sizes at standard commercial banks were prohibitive for nearly all rural dwellers. Most rural credit to low-income households was through the informal sec- People' Credit tor. Typical monthly effective interest rates charged by informal commercial lenders-professional moneylenders, commodity suppliers, traders, landlords- Banks that do not to low-income borrowers in rural Indonesia ranged from about 10 percent to more than 60 percent.'9 Daily or weekly loans, when calculated as effective perform well have monthly rates, ranged from about 10 percent to more than 1,500 percent (see chapter 1, box 1.1).Yet in 1985 inflation was just 4.5 percent.The highest-in- generally been terest loans tended to go to the lowest-income borrowers because these bor- rowers had little bargaining power and few or no other options, and because allowed to die out- smaller loans are usually more expensive for lenders than larger ones.20 Loans were often obtamed at low or no financial cost from relatives, friends, a lesson that many or rotating savings and credit associations (ROSCAs, called arisan in Indonesian). But as discussed in chapter 6, such credit may entail nonfinancial costs and is countries still need typically provided only for emergencies, special occasions, or relatively small loans. These loans are frequently not fungible and are often inappropriate (in amount, to learn timing, or option to reborrow) for working or investment capital. Rural savings facilities were scarce except for BPRs and some credit co- operatives. Most rural people kept their cash savings in the house and in ROSCAs. Savings in gold, crops, animals, raw materials, and finished goods were common. Most commercial banks did not collect voluntary savings from rural areas, and especially not from poor people. Interest rates at state banks were reg- ulated by the government, and with annual effective interest on loans set at 12 percent and interest on most savings accounts set at 15 percent, collecting sav- ings was unprofitable. Even at BRI, after a decade of offering savings accounts nationwide through the unit desa system, savings at the units totaled only $18 million at the time of the June 1983 financial deregulation. But by the end of the 1980s the transformed, commercialized units had $471 million in savings. The defining moments for microfinance in the 1980s were, first, the 1983 financial deregulation, which made it possible for banks to set their own in- terest rates on most loans and savings accounts; and, second, PAKTO 88 (and reform packages that followed), which substantially liberalized restrictions on opening new domestic banks and bank branches and encouraged autonomy and competition in the banking sector. Some effects were immediate. For ex- ample, shortly after PAKTO 88 was issued Bank Dagang Bali opened branch- Rural Development and Rural Financial Institutions in Indonesia 101 es in many areas of Bali where the bank had previously served clients through a de facto mobile banking service (because it had not been permitted to open branches; see chapter 10).As discussed in chapter 8, PAKTO 88 had long-range effects, both positive and negative, on the banking sector. It also had important effects on the development of BPRs, considered later in this chapter. Government Microfinance Initiatives in the 1990s By the early and mid-1990s new government initiatives and presidential in- structions on microfinance in rural areas were thick on the ground.At one end The 1983financial of the continuum was the Banking Law of 1992, which defined banks, their roles, and their supervision, and which aimed at strengthening the banking in- deregulation that dustry, including banking for low-income people.At the other end were a wide variety of politically motivated credit programs-ranging from an effort to pro- allowed banks to set vide massive numbers of highly subsidized $9 loans with an additional grant of less than $1, to a directed credit program through which Indonesian banks interest rates on were required to allocate 20 percent of their loan portfolios to loans of up to 200 million rupiah ($105,000 in 1990) for small enterprises.The impetus for most loans and many of the credit programs of the mid-1990s-which emphasized with con- siderable fanfare their importance for indigenous Indonesians (pribuml)-was savings accounts was mixed. It stemmed from a government priority to provide finance to low-in- come indigenous Indonesians, from the need to maintain rural elites' active sup- a defining moment port for Golkar (it being correctly assumed that rural elites would receive a substantial share of the banks' directed credit), and from attempts to deflect at- for microbanking tention from the growing wealth and corruption of the conglomerates and to defuse rising resentment against ethnic Chinese. The 1992 Banking Law and BPRs The 1992 Banking Law had been in preparation since the early 1980s but had been repeatedly delayed because of interagency disagreements (especially be- tween the Ministry of Finance and Bank Indonesia) about basic issues.A com- promise version mediated by the leading technocrats was submitted to Parliament in 1991, and the law was passed in 1992.Among other issues, the Banking Law defined banks, set limits on bank supervisors, specified the extent of special- ization by banks, and delineated the role of and supervision for very small banks (see Cole and Slade 1996). The law recognized two types of regulated banks: general banks (bank umum) with paid-in capital of 10 billion rupiah ($4.8 million in 1992) and Peo- ple's Credit Banks (BPRs) serving the rural population as well as low-income people and small and microenterprises in urban areas, with a minimum capi- tal requirement of 50 million rupiah ($24,250 in 1992). Mariyanto Danoesputro, then managing director of Bank Indonesia, said in 1997 that "the objective of BPR is to modernize the rural population and to help free the small people from the moneylenders" (quoted in Steinwand 2001, p. 161). 102 The Microfinance Revolution: Lessons from Indonesia Box 9.1 Excerpts from David C. Cole and Betty F. Slade's Building a Modem Financial System: The Indonesian Experience With the existence of nearly 8,000 rural financial institutions at the time the Banking Law was being examined, it was necessary to give consideration to their special require- ments These financial institutions had different types of ownership, size, activities, legal status, and supervision For example, some only gave loans but did not collect deposits PAKTO, 1988 did not deal directly with these institutions, but instead authorized the li- censing of BPRs The BPR had to be either a limited liability company, a regional govern- ment enterprise or a cooperative, and it had to have paid-up capital or basic and compul- sory savings (as the case warranted) of at least Rp 50 million Existing BPRs were given two years to adjust to the new regulations Following PAKTO it became clear that the failure to consider the special aspects of The 1992 Banking the other types of rural institutions and the implicit requirement that these institutions must adhere to the BPR rules was not in the best interests of rural finance In March Law defined banks 1989 (the PAKMAR package), the time limit for existing BPRs to adjust was made indefin- ite, I e they were grandfathered-given the status of old-style (grandfathered) BPRs Thus there were the old BPRs and the new BPRs By the time the Banking Law passed and their roles. It parliament there were 848 new BPRs, including a few that transformed from other status to the new BRP status aimed at The 1992 Banking Law defined BPRs as banks which are permitted to accept de- posits only in the form of time deposits, savings, and/or other of similar types BPRs in- cluded all banks other than general banks, therefore the BPR category included both the strengthening the grandfathered rural financial institutions and all the newly licensed BPRs Article 58 recog- nized the existence of rural financial organizations, and basically gave flexibility to the gov- banking industry, ernment to set rules for the change of status of LPDs, BKDs, BKKs, BKPDs or other or- ganizations similar to BPRs But it was clear that PAKMAR had been reversed rural financial institutions would have to meet BPR requirements [But in 1999 the effects of including banking the crisis resulted in significant changes in requirements for rural financial organizations with regard to meeting BPR requirements) for low-income Source Cole and Slade 1996, p 129 people The Banking Law limited the BPRs "in terms of location, function and portfolio composition. They are precluded from taking demand deposits and participating in the payments system. Their main role is to take time and sav- ings deposits and to extend credit" (Cole and Slade 1996, pp. 128-30; see also Sukarno 2000 and Steinwand 2001).The changing status of the BPRs during the late 1980s and early 1990s is summarized in box 9.1. Although the Banking Law stated that rural financial institutions are required to meet BPR criteria, the crisis and the collapse of the Indonesian financial sys- tem in 1998 caused changes in Bank Indonesia's views and in government pol- icy. The crisis provided a strong incentive for Bank Indonesia to reduce the number of financial institutions under its supervision. In 1999 new regulations increased capital requirements for opening new BPRs or branches by 10 times, to 500 mnllion ruplah.Adjusting for inflation, the new capital requirement was more than three times the previous requirement (Steinwand 2001, p. 181; see also Timberg 2000, p. 18). Rural Development and Rural Financial Institutions in Indonesia 103 Assuming that the [1999] regulatory framework for BPR. . .does not undergo substantial changes... .it is very likely that the... two- fold banking system consisting of commercial banks and BPR will develop into a three-fold system with large commercial banks, new medium sized BPR that work on a provincial level and operate an extensive network of branches and service posts, and the small unit-bank BPR as well as the LDKP and BKD at the bottom level. -Steinwand 2001, p. 182 KUK and commercial banks "The objective of In 1990 the government introduced a new directed credit program called Kredit Usaha Kecil (Small Business Credit, or KUK; see Martokoesoemo 1993; BPR is to McGuire, Conroy, and Thapa 1998; Ravicz 1998;Timberg 2000; and Steinwand 2001). All Indonesian banks were required to lend at least 20 percent of their modernize the rural volume of credit to small enterprises. However, the maximum loan size was 200 million rupiah ($105,000 in 1990); in 1997 the maximum was raised to 350 population and to million rupiah ($75,000 at the end of 1997). Banks could meet the KUK loan quota in three ways: direct lending to en- helpfree the small terprises, lending to BPRs or banks that would onlend to small enterprises, or by issuing Surat Berhaga Pasar Uang (SBPU-KUK), a special money market peoplefrom the instrument. Most commercial banks do not have extensive branch networks, and they had little experience making loans of this size; most of their loans were moneylenders" much larger. Thus the banks often tried to channel their KUK funds through other institutions, typically BPRs.The Association of Indonesian National Pri- vate Banks and the Association of Indonesian Rural Banks jointly created a foun- dation to receive funds from commercial banks and to onlend to BPRs, funded by a 1 percent spread between the rates at which the foundation received and lent funds. But many BPRs could not absorb all the KUK funds supplied by commer- cial banks, and a substantial amount of these finds went to the interbank money market rather than to small businesses.Another problem was that the large KUK funds discouraged BPRs from mobilizing savings. In theory KUK loans had no minimum and were supposed to be made available for small enterprises. In prac- tice these loans rarely reached poor clients, though they did reach some small and medium-size enterprises. But many banks filled their KUK quotas by financing cars and housing rather than small enterprises (Martokoesoemo 1993, p. 108). During the crisis the obligation for banks to provide KUK loans was sus- pended, and KUK lending declined rapidly from 65,890 billion rupiah in fis- cal 1998 to 38,171 billion rupiah in fiscal 1999 (Steinwand 2001, p. 179). In December 1998 nonperforming KUK loans (loans in default) were 23 percent of outstanding KUK loans (Timberg 2000, p. 21)-a very high default rate by microfinance standards, but much lower than Indonesian commercial banks' nonperforming loans as of the same date (officially 59 percent of outstanding loans, but widely believed to have been considerably higher). 104 The Micrafinance Revolution: Lessons from Indonesia Levying corporations and wealthy individuals for funds for subsidized credit programs A 1994 Ministry of Finance regulation and a 1995 presidential instruction re- quired state-owned enterprises (including banks) to use 5 percent of their prof- its to support small and medium-size enterprises and to reduce poverty (the Badan Usaha Milik Negara, or state-owned enterprise, policy; see McGuire, Conroy, andThapa 1998; Meyer 1998; Ravicz 1998; and Steinwand 2001).The levy, which was outside the tax system, was collected and administered by a foun- dation created by President Soeharto. In addition, private corporations and in- dividuals with annual incomes above 100 million rupiah ($43,328 in 1995) were required to donate 2 percent of their profits or income to the Soeharto foun- dation to be used for poverty reduction. Half of these funds were to be used Indonesian banks for loans to low-income people at low interest rates, usually 6 percent a year. The other half was used for poverty-related training and research (30 percent) were required to lend and for support of the state-owned cooperative credit insurance company (20 percent). at least 20 percent The Prosperous Family Program, implemented by the National Family Plan- mng Coordinating Board (Badan Koordinasi Keluarga Berencana Nasional, or of their credit BKKBN) through its village outlets, was a major recipient of these funds. Known as Tabungan Kesejahteraan Rakyat (Savings for a Prosperous Family, or volume to small TAKESRA) and Kredit Usaha untuk Kesejahteraan Rakyat (Credit for a Pros- perous Family, or KUKESRA), the program operates through women's groups. enterprises-up to When a group is established, each woman receives a grant of less than $1. Poor women receive initial loans of $9 at a highly subsidized 6 percent annual ef- loans of $105, 000. fective interest rate; 10 percent of the payments are returned to borrowers who repay the loans.The program received about 500 million rupiah during its first But the poor were year of operation ($210 million in 1996). By mid-1997 nearly 10 million households were reported to have participated in this program. The Prosper- rarely reached ous Family Program was not expected to cover the cost of its loans (and in any case had little experience collecting loans). The National Family Planning Coordinating Board has built a vast infra- structure throughout Indonesia and enjoys a well-deserved international rep- utation for its role in substantially reducing Indonesia's population growth rate since the 1970s. But its Prosperous Family Program, a large, hlghly publicized, unsustainable microfinance program, emphasized short-term political priori- ties at the expense of viable microfinance development. In addition, its large- scale delivery of highly subsidized credit put the program in unfair competition with the BPRs and BRI's unit desas, which provide loans to much the same market at commercial interest rates. This is just one of many examples of op- posing microcredit policies and approaches being implemented simultaneous- ly in the same villages during the mid-1990s. "Left-behind" villages: INPRES Desa Tertinggal A 1993 presidential instruction created the INPRES DesaTertinggal (IDT) pro- gram for backward (literally, "left-behind") villages (see McGuire, Conroy, and Rural Development and Rural Financial Institutions in Indonesia 105 Thapa 1998, Seibel and Parhusip 1998, and Parhusip and Seibel 2000). Coor- dinated by the National Development Planning Board (Badan Perencanaan Pem- bangunan Nasional, or BAPPENAS), the program provided $600 million over three years (1994-97) for about 28,000 rural villages identified as being espe- cially poor-about one-third of the country's villages. Most are located on the Outer Islands, and the program represents an effort by the government to re- dress long-standing regional inequalities. The program provides funds for de- veloping physical infrastructure, for income-generating activities of poor people organized into self-help groups, and for personnel (teachers, social workers, and others) who help these groups. Each of the program's villages received 20 nrldhon rupiah ($9,100 at the end A political strategy of 1994) for the income-generating component. These finds were provided as grants to the self-help groups, which then make loans to group members in a developed that revolving credit scheme. Each group decides the terms on which the loans are made; the groups are not required to set interest rates that cover costs. By mid- emphasized visible 1997 about 3.3 million people had participated in the program, with an average loan of $85 (McGuire, Conroy, andThapa 1998, p. 158). Ismawan (2000, p. 4) re- (but not viable) ports that as of February 2000 Bina Swadaya (Self-Reliance Development Foun- dation), which helps groups lnk with banks in many parts of Indonesia, had creditfor poor consulted and held policy discussions with about 100,000 IDT self-help groups. A 1995 evaluation concluded, however, that the IDT program had multi- indigenous ple problems, including the role played by facilitators without backgrounds in commercial or production activities, the development of business plans that had Indonesians, little potential for profit, and-once again-an emphasis on short-term polit- ical gains derived from highly publicized disbursement of loans to the poor rather undermining than on professional program design and implementation (Seibel and Parhusip 1998, pp. 3-4). commercial Bank Indonesia, government ministries, and rural credit programs microfinance Bank Indonesia and several ministries have been involved in rural credit pro- jects and programs in different ways. Bank Indonesia implements the govern- ment's Microcredit Project as well as the Linking Banks with Self Help Groups Program, a subsidized credit program partly funded by the German Agency for Technical Cooperation (Gesellschaft ftir Technische Zusammenarbeit, or GTZ) .21 The central bank's main role in microfinance, however, is to provide subsidized liquidity credits channeled through the banking system (see chap- ter 12). Major recipients of Bank Indonesia credit subsidies include government- sponsored village cooperatives (Koperasi Unit Desas, or KUDs) which, while important for state ideology, have a long history of defaults and mismanage- ment; and Kredit Usaha Tani (Credit for Farm Enterprises, or KUT), a Min- istry of Agriculture program channeled through BRI's branches (but not through the unit desa system), also with a poor repayment record. As noted, the Indonesian government is not a monolith when it comes to cred- it subsidies. But with the rise of the conglomerates in the early and mid-1990s, the massively increasing crony capitalism, and the growing resentment against eth- 106 The Microfinance Revolution: Lessons from Indonesia Box 92 Excerpts from Camilla Nestor's contribution to Ohio State University's online Development Finance Network, 2 February 1999 I've become increasingly dismayed with the mounds of subsidized credit the Indonesian government, the World Bank, and UNDP (among others) are pumping into Indonesian vil- lages, ostensibly as a response to the economic crisis Within the past four months, dis- tortions have emerged in the rural credit markets-cheap credit has begun to squeeze lo- cal financial service providers who must charge a market interest rate to survive If this continues, the risk of failure for BPRs (rural banks) and other rural financial institutions will be compounded-subsidized competition on top of an economic crisis If RFIs [rural fin- ancial institutions] stumble as a result of the subsidized loan programs, where will people save? And where will they borrow once the subsidized projects end? Furthermore, there's the risk of devaluing the term "loan " If these government/donor subsidized credit The government projects, which charge 0%-20% interest per year, have no enforceable repayment re- quirements and no penalties for default, people will consider the loan a gift. views charging Perhaps [this occurs] because donors cave into pressure from the government, which views charging market interest rates on micro-loans "harmful" to the poor, and po- litically unwise market Interest rates We know that 1) directed credit most often ends up in the hands of those with con- nections to the distributors, rather than with the worthiest clients, 2) loan programs with on micro-loans vague repayment terms and subsidized interest rates are unlikely to see very impressive repayment rates, and 3) subsidized credit eventually dies-the donors cannot keep inject- " t h ing such vast amounts of money Why perpetuate this? harmful to the Source Camilla Nestor, 2 February 1999 poor and politically nic Chmnese, a political strategy was adopted that emphasized visible (if not viable) unwuse" benefits to poor indigenous Indonesians. During the 1990s rural credit subsidies increased to massive proportions, as illustrated in a February 1999 letter to Ohio State University's Development Finance Network from the Indonesia project man- ager of Catholic Relief Services (box 9.2). Catholic Relief Services is active in nucrocredit development in Indonesia and other developing countries. Rural Finance in the 1990s Following PAKTO 88, the 1988 deregulation package that liberalized the banking sector, and the 1992 Banking Law, new banks and bank branches pro- liferated rapidly. By 1998 there were 222 commercial banks in Indonesia: 130 private national banks with 3,976 offices and a 46 percent share of the total as- sets of commercial banks; 7 state-owned banks with 1,602 offices (excluding the unit desas) and 40 percent of conimercial bank assets; 58 foreign and joint venture banks with 121 offices and 13 percent of assets; and 27 Regional De- velopment Banks (Bank Pembangunan Daerah, or BPDs) with 555 offices and 2 percent of assets (Stemwand 2001, pp. 147-48).22 The number of BPDs and state-owned banks did not change between 1987 and 1998, but the number of private banks doubled, from 64 to 130, and the number of foreign and joint venture banks more than quintupled, from 11 to 58. Rural Development and Rural Financial Institutions in Indonesia 107 Table 9.2 Loans and savings in Indonesia's financial system, 1995 Savings Credit Number of Amount Number Amount savings Type of Number Billions of Millions of of loans Billions of Millions of accounts financial institution of units rupiah U.S. dollars (thousands) rupiah U.S. dollars (thousands) Microfinance institutions 12,843 5,077 2,203 4,712 7,423 3,220 19,084 BPRs and secondary banks 1,948 1,566 679 1,232 1,226 532 2,969 LDKPs 1,978 224 97 261 118 51 456 BKDs 5,345a 93 40 955 63 27 1,176 BRI unit desas 3,482b 3,194 1,386 2,264 6,016 2,610 14,483 Commercial banks 240 234,611 101,783 91,168 214,764 93,173 49,904 Total 13,083 239,688 103,986 95,880 222,187 96,393 68,988 Note BPR stands for Bank Perkreditan Rakyat (People's Credit Bank, excluding here the LDKP and BKD) LDKP stands for Lembaga Dana dan Keuangan Pedesaan (Rural Fund and Credit Institution) BKD stands for Badan Kredit Desa (Village Credit Organization) BRI stands for Bank Rakyat Indonesia a Only 4,806 BKDs were active in 1995 b Table 12 7, based on BRI data, shows 3,512 unit desas at the end of 1995 The figure in this table probably came from an earlier month in 1995 Source Adapted from Seibel and Parhusip 1998, table 1 3, and Parhusip and Selbel 2000, table 7 3 By the mid-1990s the rural financial sector had also expanded consider- ably. Indonesia was home to a plethora of financial institutions operating in rural areas, some old and some new (those opened after PAKTO 88).These includ- ed state-owned and private commercial bank branches; provincial government banks; credit organizations owned by provincial, district, and subdistrict gov- ernments and by vlllages; cooperatives; licensed BPRs, old and new, public and private; and thousands of generic BPRs. But many of the new BPRs had been opened inumediately after PAKTO 88, and their owners and managers often had little banking experience. The values and numbers of loans and deposit accounts in Indonesia's com- mercial banks and microfinance institutions at the end of 1995 are shown in table 9.2.Although data for the microfinance institutions are often of poor qual- ity, the general picture is clear. Comparison with table 9.1, which provides 1985 data on loans in the financial system and in rural financial institutions, is use- ful. Between 1985 and 1995 average annual inflation (GDP deflator) was 8.8 percent (World Bank 1997). In 1985 outstanding loans in the financial system totaled 23,684 billion rupiah ($21.1 billion); in 1995 the total was 239,688 bil- lion rupiah ($104.0 billion). Tables 9.1 and 9.2-which are derived from different studies and different sources-are not directly comparable.23 Still, they show that the value of out- standing loans in rural financial institutions (including BRI's unit desa system) as a percentage of total loans in the financial system hardly varied between 1985 108 The Microfinance Revolution: Lessons from Indonesia and 1995-it was about 2.5 percent in 1985 and about 2.1 percent in 1995. The other 98 percent or so was in banks.Table 9.2 also shows that in 1995 mi- crofinance institutions had about 5 percent of the number of loans in the fi- nancial system, 28 percent of the number of savings accounts, and 3 percent of the value of savings. Data are not available, however, on commercial banks' share of outstand- ing rural loans or microloans, or of small savings accounts. These shares likely increased somewhat between 1985 and 1995, but there is no way of knowing how significant that increase might be. Table 9.2 also enables comparison ofBRI's 3,482 unut desas with 9,271 other (heavily rural) nmicrofinance institutions in 1995.With only 27 percent of the aggregate number of units in these mncrofinance istitutions, the unit desas dom- The value of loans inated with 48 percent of the total number of loans, 63 percent of the value of outstanding loans, 76 percent of the number of savings accounts, and 81 per- in ruralfinancial cent of the value of savings. institutions as a Developing the BPRs After PAKTO 88 and the passage of the 1992 Banking Law, indigenous In- share of total loans donesians were encouraged to open BPRs. Most of the BPRs that opened after 1988 are privately owned and financed commercially from local resources: sav- in the financial ings, commercial debt (mainly from KUK loans during most of the 1990s), and equity. But in 1999 Bank Indonesia allocated concessional lines of credit to the system was 2.5 BPRs. In September 1998 there were 8,699 generic BPRs, reaching 5.6 million percent in 1985 and clients. Table 9.3 shows the number of units and clients for the 1,576 private licensed BPRs, for an estimated 2,317 local-government-owned LDKPs (in- 2. 1 percent in 1995 cluding those that are licensed BPRs),24 and for the 4,806 active vlllage-owned BKDs. To provide a more complete picture of Indonesian microbanking, the table also shows data for BRI's unit desas. Steinwand (2001, p. 188) notes the well-known difficulties of collecting data for thousands of small, independent BPRs and the "notorious inconsistency of BPR statistics." But he has made an important contribution by collecting and analyzing much previously unpublished data. In tables 9.3 and 9.4 licensed BPRs that are privately owned are shown sep- arately from those that are publicly owned (mainly former LDKPs). These ta- bles are based on Steinwand's tables and therefore reflect his data organization. Because he was interested in comparing public and private BPRs and most of the licensed BPRs are privately owned, Steinwand used the larger data set of generic BPRs for his comparison. In his tables he separated the private BPRs from the public LDKPs and BKDs, and he included former LDKPs that are now licensed BPRs in the LDKP category (see table 9.3). In 1998 the 2,262 licensed BPRs, private and public, had $175 million in outstanding loans, $56 million in savings, and $83 million in time deposits (Stein- wand 2001, p. 190). Among the three BPR categories (private BPRs, the LDKPs, and the BKDs), private BPRs had the fewest active units (1,576) but Rural Development and Rural Financial Institutions in Indonesia 109 Table 9.3 BPRs and BRI unit desas: number of units and clients, September 1998 Active units Clients Share of total Share of total Institution Number (percent) Numbera (percent) BPR systems 8,699 70 5,615,215 26 Private licensed BPRs 1,576 13 3,107,612 14 LDKPsb 2,31 7c 18 1,700,000c 8 BKDs 4,806 39 807,603 4 BRI unit desas 3,703 30 16,050,000 74 Among microfinance Total 12,402 100 21,665,215 100 institutions, BRIs Note BPR stands for Bank Perkreditan Rakyat (People's Credit Bank, excluding here the LDKP and BKD), LDKP stands for Lembaga Dana dan Keuangan Pedesaan (Rural Fund and Credit Institution) BKD stands for Badan Kredit Desa (Village Credit Organization) BRI stands for Bank Rakyat unit desas had 63 Indonesia. a For the BPRs Steinwand uses the number of savers for the number of clients because every borrower has a savings account For the unit desas, the author's calculations estimate the number of percent of the value clients from the number of savings accounts All borrowers in unit desas also have savings accounts, but since individuals may have more than one, the number of savings accounts is larger than the number of savers (clients) BRI does not track the number of savers, only the number of accounts In of outstanding loans September 1998 there were 21 4 million savings accounts in the unit desas Estimating that roughly a quarter of the savers had two accounts, this would leave 16,050,000 savers (clients) b Includes former LDKPs that are now licensed BPRs and 81 percent of c Estimated Source Steinwand 2001, table VI 2, BRI unit desa monthly report for September 1998 the value of savings in 1995 the most clients (3.1 million) in September 1998 (table 9.4).Private BPRs also had the most assets ($308 million, compared with $91 million for the LDKPs and $28 million for the BKDs; Steinwand 2001, p. 230).25 The BPRs and BRI's unit desas. BRI's unit desas, with 30 percent of the combined number of BPR and BRI bank units, had 74 percent of the total clients. Private BPRs, with 13 percent of the units, had 14 percent of the clients. But the public LDKPs and BKDs, with 57 percent of the units, had only 12 percent of the clients.While tables 9.2 (for 1995) and 9.3 (for 1998) are drawn from different sources and are not directly comparable, they indicate clearly that during the crisis years the unit desa system retained its dominant position in microfinance. But tables 9.3 and 9.4 also show that the generic BPRs had, in aggregate, substantial numbers of small loans and savings accounts during the crisis. As at the unit desas, BPR savings increased during the crisis, and the BPRs were able to place the funds in high-yieldmg commercial bank deposits. Non- performing loans at the BPRs and at the unit desas did not increase significant- ly. The BPR and unit desa figures are not always comparable, however. For example, the village-owned BKDs, still operating under 1929 regulations, are lim- ited in their writeoffi; thus their default rate includes substantial bad debt accu- 110 The Microfinance Revolution: Lessons from Indonesia Table 9.4 BPRs and BRI unit desas: average loans and deposits, 1997 Average Average Average outstanding loan savings balance time deposit Percentage Percentage Percentage Rupiah of GNP Rupiah of GNP Rupiah of GNP Institution (thousands) per capita (thousands) per capita (thousands) per capita Private licensed BPRs 1,338 26 141 30 8,165 158 LDKPs LPNs 582 11 77 1.5 2,182 42 LPDs 535 10 130 2 5 2,204 43 BKKs/CJ 424 8 134 3 0 4,026 78 BKDs 142 3 14 03 27 05 BRI unit desas 1,791 35 424 80 8,739 169 Note In June 1997, just before the crisis began, the exchange rate for rupiah was 2,450 to the U S dollar, but by December 1997 the rupiah had fallen to 4,650 to the U S dollar Percentage of GNP per capita ($1,110 in 1997) is calculated based on the year-end exchange rate BPR stands for Bank Perkreditan Rakyat (People's Credit Bank, excluding here the LDKP and BKD) LDKP stands for Lembaga Dana dan Keuangan Pedesaan (Rural Fund and Credit Institution) LPN stands for Lumbung Pitih Nagari (People's Credit Bank, West Sumatra) LPD stands for Lembaga Perkreditan Desa (Rural Credit Organization, Bali) BKK/CJ stands for Badan Kredit Kecamatan/Central Java (Subdistrict Credit Organization) BKD stands for Badan Kredit Desa (Village Credit Organization) BRI stands for Bank Rakyat Indonesia Source Steinwand 2001, table VI-3, BRI unit desa monthly report for December 1997, World Bank 1997g, author's calculations based on Steinwand and BRI data mulated from the past. But BRI's unit desas have an automatic system for writ- ing off bad debt (chapter 12). None of the three BPR systems (private BPRs, the LDKPs, and the BKDs) has an adequate loan loss reserve policy. Underprovisioning for loan losses by the BPRs disguises their real position and prevents timely adjustments for fu- ture lending. In contrast, BRI's unit desas provision according to Bank Indonesia regulations, follow international accounting practices, and are required to have regular audits. BPRs: public and private. Indonesia's nearly 9,000 generic BPRs can be analyzed based on their age, legal status, and ownership. First, old and new BPRs can be differentiated depending on whether they were opened before or after PAKTO 88 (October 1988). Second, BPRs are defined by their legal status. Licensed BPRs, most of which opened after 1988, meet Banking Law criteria and other subsequent regulations. The third distinction is between public and private BPRs. Most licensed BPRs are privately owned, though a number of publicly owned former LDKPs are also licensed BPRs. The public unlicensed BPRs are officially considered in transition to becoming licensed BPRs. Private BPRs are a heterogeneous group with many kinds of owners, in- cluding individual investors, limited companies of investors, commercial banks, Rural Development and Rural Financial institutions in Indonesia 11 industry groups, and NGOs.These BPRs tend to be clustered in well-developed areas with intense competition (Jakarta, Surabaya,Yogyakarta, Bali), while pub- lic BPRs operate in rural areas in many parts of the country, typically allocat- ed by subdistrict. Steinwand (2001, ch. 6) points out some important differences between pri- vate and public BPRs: * Competition. Private BPRs compete with one another. Public BPRs gener- ally do not compete because of their separate locations (although they may have other competitors, especially BRI's unit desas). * Savings. Public BPRs mobilize more savings at a lower cost than do private 8, 699 generic BPRs.This pattern is attributed to greater trust by communities, related to implicit or explicit government deposit guarantees. BPRs continued to . Loans. Public BPRs have smaller average loans and lower default rates than do private BPRs (see table 9.4). Steinwand suggests that since public serve 5.6 million BPRs have a lower cost of savings than the private BPRs, they are gen- erally able to charge lower interest rates on loans and make lower-risk in- clients in 1998-as vestments. In addition, fierce competition among private BPRs in Java and Bali has led to high defaults (see chapters 18 and 19 for discussion of how the country's intense competition among institutions providing microcredit in Bolivia and other Latin American countries in the late 1990s also resulted in high financial system defaults). * Commercial bank links. Licensed BPRs, most of which are private, are super- collapsed vised by Bank Indonesia. Private licensed BPRs have no formal links with commercial banks (except for BPRs owned by commercial banks). But many have deposit accounts at commercial banks, and some have loans.And some BPRs have formed BPR networks. In contrast, public BPRs have close links, both financial and supervisory, with commercial banks. "The public BPR are better supervised both by the formal supervisory agencies as well as by informal control mechanisms compared to their private counterparts" (Stein- wand 2001, p. 267). * Profitability. Public BPRs are more profitable than private ones, but because many BPRs do not adequately provision for loan losses and do not under- go regular audits, reported profits are often not adjusted for loan loss provi- sions and writeoffs or for inflation. This makes it difficult to obtain a true picture of BPR profitability (see Ravicz 1998).As Steinwand (2001, p.292) shows, unadjusted figures indicate that in 1997 the average returns on assets for private licensed BPRs was 1.0 percent; for the three main systems of pub- lic LDKPs, 4-6 percent; and for the village-owned BKDs, 10 percent. Un- adjusted figures also indicated a return on equity in 1998 of 5 percent for private BPRs, compared with 17-34 percent for the three public LDKP sys- tems and 11 percent for the BKDs. But Steinwand (pp. 249,251) comments: In absence of more audited data, we calculated a "reserve- adjusted ROA [return on assets]" under the assumption that 112 The Microfinance Revolution: Lessons from Indonesia collateral value is zero and that all adjustments have to be made within one year... Under this "worst case scenario" the adjusted ROA of all BPR [groups] would be negative, however those of the BPR unit banks [private licensed BPRs] would be more than twice as low as those of the other BPR systems: -15% for the BPR umt banks; -7% for the LPN; -2% for the LPD; -3% for the BKK; and -6% for the BKD. The real situation is likely to fall somewhere between the reported fig- ures and the worst case scenario. It is of course different for different insti- tutions, and is further complicated by regulations on writeoffs. Moreover, these are 1997 figures. By the end of 1997 Indonesia was in the midst of its The public BPRs, worst crisis in three decades. Steinwand (p. 293) concludes: "The public LDKP are the most successful as a group, have BPR system and ... outperform. . . the private ones, a finding quite in contrast to mainstream thinking which clearly favors private [microfinance institu- higher savings, lower tions]."These results raise some interesting issues and questions. default rates, deeper The private BPRs are new, primarily urban or semiurban, heterogeneous in ownership, generally not well supervised, without strong links to commercial outreach, and higher banks, and they often have relatively little banking experience, at least at the start. In contrast, public BPRs tend to be more experienced and more trust- profits than the ed; they are rural; owned by provincial, district, and subdistrict governments or by villages; and are supervised by commercial banks. As a group the pub- newer private BPRs lic BPRs have higher savings, lower default rates (though still high compared with the unit desas), deeper outreach, and higher profits than the private BPRs. But the three LDKP systems used as examples in many of Steinwand's comparisons with the private licensed BPRs (primarily because of the rela- tively reliable data available for the LDKP systems) are among the best LDKPs in Indonesia. The Lembaga Perkreditan Desa (LPD) of Bali is widely con- sidered the best LDKP system in Indonesia, and the Badan Kredit Kecamatan of Central Java (BKK/CJ) is generally considered the second best (see Stein- wand 2001, pp. 292-93). Had the three systems been compared with the best of the private BPRs, the results might have been somewhat different.The of- ficially licensed BPRs (both public and private) have a wide range of per- formance, and some are in the process of upgrading. As Timberg (2000, pp. 21, 25) notes: It is reported [in December 1998] that 45% of BPRs are not healthy or almost healthy... The BPRs, though generally in better shape than the commercial banks, need to go through a parallel process of closing some BPRs and restructuring others ... Further, there is a need for a tightening of procedures and lessening of costs and a more aggressive marketing Rural Development and Rural Financial Institutions in Indonesia 113 orientation. Upgrading management is already occurring as networks of BPRs put out standard management packages- just like a franchisor. I visited one bank, taken over by a private chain, which had moved from 95% NPL [non-performing loans] to under 5% in one year. It is also worth noting that many public BPRs operate in quasi-monopo- listic environments. Yet private BPRs, generally operating in areas of high competition, have higher assets and wider outreach than public ones. In 1998, with only 18 percent of the number of BPR units (8,699), private licensed BPRs served 3.1 million clients, or 55 percent of the number of BPR clients (see table Many public BPRs 9.3). Private BPRs, not born with linkages like their public counterparts, are are quasi- developing links-both with commercial banks and with other BPRs.And pri- vate BPRs are learning to operate in an intensely competitive environment- monopolies. Yet which is likely to be where the future of mucrofinance lies (see chapter 21). The public LDKPs and BKDs had smaller average loans and savings balances private BPRs, than the private BPRs (see table 9.4). But this would be expected because, un- like public BPRs-which are typically dispersed to cover as many rural subdistricts generally operating as possible-private BPRs tend to cluster in relatively well-developed areas, many of them urban and semiurban.Yet with an average outstanding loan of 1.3 rrul- in highly competitive lion rupiah in 1997 ($288 at the end of 1997, or 26 percent of per capita GNP) and an average savings balance of 141,000 rupiah ($30, or 3 percent of per capi- areas, have on ta GNP), private BPRs appear to be providing financial services to low-income segments of the developed areas in which they operate. average higher assets Private BPRs serve better-off clients as well; their time deposit accounts had an average balance of $1,756 in 1997 (158 percent of GNP per capita). and wider outreach The fixed deposits increase the size of the average savings account, making it possible for private BPRs to serve small savers profitably.The fixed deposit ac- counts also make available substantial funds for lending, enabling the wider out- reach that private BPRs have achieved relative to public BPRs.26 There are important lessons here. First, both public and private microfinance institutions can be financially self-sufficient. Second, as Steinwand (2001, pp. 250, 324) shows, the BPRs are more likely to be self-sufficient if they are fi- nancial intermediaries, funding loans with savings.Third, over time, public BPRs that performed badly died out. The same is likely to happen to private BPRs (if donors do not interfere); in another decade it is possible that private BPRs that survive will be substantially improved. The crucial point is that as a group the generic BPRs, like BRI's umt desas- and in sharp contrast to commercial banks-survived the Indonesian crisis, main- taining outreach, liquidity, and in some cases profitability. The public and private BPRs, the state-owned BRI unit desas, and the private Bank Dagang Bali together demonstrate unmistakably that commercial microfinance-in very different kinds of institutions-can be extremely stable even in times of ex- ceptional economic, financial, and political crisis. 114 The Microfinance Revolution: Lessons from Indonesia Six examples of rural financial institutions and programs Six quite different rural niicrofinance institutions, projects, and programs are dis- cussed below to lllustrate the varied trends of the 1990s discussed above and the range in performance (table 9.5). These examples were selected based on the quality of available data and on geographic and program diversity. BRI's unit desas are not considered here because they are exarmined in detail in later chapters. The oldest of the BPRs, the Badan Kredit Desas (BKDs), and the Income Gen- erating Program for Small Farmers and Fishermen (Pembinaan Peningkatan Pen- dapatan Petani-Nelayan Kecil, or P4K) are also not discussed here because they are supervised or administered through BRI's branches and are discussed in chap- ter 14. The well-known LDKP system, the Lembaga Perkreditan Desa (LPD) of Bali, is examined in chapter 17 as a part of an analysis of village banks. As a group the The organizations discussed below include three public LDKPs, a licensed private BPR, a Grameen Bank replication project that receives funding from generic BPRs, like the Grameen Trust Fund and from an Indonesian state bank, and a large gov- ernment- and donor-sponsored program linking banks and self-help groups. the BRI unit These organizations vary considerably in age and size, and also in the envi- ronments in which they operate ranging from Sumatra in the west to Nusa desas-and in Tenggara Barat in the east. For each I have used the most recently published information I could find (varying from 1995 to 1998). It should be noted, how- sharp contrast to ever, that the data are of uneven quality and depth, and that there are some- times inconsistencies among sources for the same institution. In addition, types commercial banks- of information and definitions of indicators vary by organization. Published information is not yet available on how most of the organiza- maintained outreach tions discussed in this section were affected by the Indonesian crisis. But given Steinwand's (2001) assessment that BPR systems generally survived quite well and profitability during the crisis years (as well as corroborating evidence from BRI's unit desas and Bank Dagang Bali), it seems likely that the first two of the LDKP systems during the recent and the private BPR considered here would have weathered the crisis to vary- ing degrees. However, the third LDKP and the two programs discussed had se- Indonesian crisis rious problems-conceptual, financial, structural, or political (and in some cases all four)-even before the crisis. An early microfinance pioneer: the Badan Kredit Kecamatan of CentralJava (BKK/CJ). The oldest, best-known, and best-documented of the six organi- zations is the Badan Kredit Kecamatan of Central Java (BKK/CJ), an LDKP system owned by the provincial government of Central Java and administered through rural credit organizations located at the subdistrict level (Gadway, Gaway, and Sardi 1991; Patten and Rosengard 1991; Gonzalez-Vega and Chaves 1993; Mosley 1996; Riedinger 1994; Chaves and Gonzalez-Vega 1996; Meyer 1998; Steinwand 2001). CentralJava, along with neighboring D.I.Yogyakarta, is a world-renowned center ofJavanese culture and traditions. CentralJava is a densely populated area with 30 million people; in 1995 the province had 911 people per square kilo- meter. It is a fertile, rice-producing area with well-developed irrigation and in- Rural Development and Rural Financial Institutions in Indonesia 115 Table 9.5 Loans and savings in five rural financial institutions and the PHBK program Typical Value of effective Province; Number out- monthly Value institutional of standing interest Adjusted Adjusted Number of Nare, status; out- loans rate on Type arrears default of savings year of year standing (U.S. loans of rate rate savings (U.S. data started loans dollars) (percent) loans (percent) (percent) accounts dollars)a BKK/CJ, CentralJava;LDKP - 104 million 2-11 Individual - 127 - 71 million 1998 owned by in the 204 (1997) in the 204 provincial, district, BKKs/CJ BKKs/CJ and subdistrict that had that had governments, BPR BPR 1970 licenses licenses BKK/SK, South Kalimantan, 34,518 3 4 3 9-16 0 Individual 5 gb,c 3 5b,c _ 427,357 1995 LDKP owned million and group by provincial government, 1985 LKP (four Nusa Tenggara 4,148 312,963 8 3 Individual 20 Oc.d 5 5c.d d 28,249 LKPs in Barat, LDKP one owned by district), provincial 1995 government; 1989 Bank Shinta D I Yogyakarta, 12,656 2 1 million 23 Group and 3 5e 2 oe 30,340 22 million Daya, 1995 private licensed individual BPR 1970 Mitra Karya, East Java, 255 31,899 2 5f Group 2 oe 1 oe 1,125 5,329 1995 Grameen groups compul- replicator with 1,078 sory project, loans to savings 1993 1,125 only members PHBK, 16 provinces, 6,800 5 5 million9 4-35 Group 5 7e,h Estimated - 895,345 1996 project providing group below 4 compul- technical assist- loans percente sory ance to banks, savings NGOs, and only borrower groups; 1989 116 The Microfinance Revolution: Lessons from Indonesia Table 9.5 (continued) - Not available Note BKK stands for Badan Kredit Kecamatan (Subdistrict Credit Organization) of Central Java (CJ) or South Kalimantan (SK) LDKP stands for Lembaga Dana dan Keuangan Pedesaan (a publicly owned Rural Fund and Credit Institution) LKP stands for Lumbung Kredit Pedesaan (Rural Credit Organization) PHBK stands for Program Hubungan dan Kelompok Swadaya Masyarakat (Program to Link Banks and Self-help Groups) a Compulsory and voluntary combined except where noted b Calculated only for the 34 original BKKs c Calculated by dividing the volume of loans in arrears and in default by the volume of outstanding loans The volume of loans in arrears is defined as the percentage of loan volume in arrears net of previous year's defaults All loans more than 90 days overdue are considered to be in default (Ravicz 1998, p 35) d Average for three LKP units The fourth LKP unit studied had adjusted arrears of 78 percent in 1993, but data for this unit were not available for 1994 or 1995 e The arrears rate is not defined but probably refers to loan payments more than 30 days overdue The default rate is also not defined, but in accordance with Indonesian bank regulations, it would refer to loans more than 90 days overdue f Compulsory savings were not included in the interest rate calculation, had they been included, the effective interest rate would be higher g Total loan volume for fiscal 1995/96 h Arrears are defined as the volume of payments one day late or more as a percentage of the volume of outstanding loans Source Ravicz 1998, McGuire, Conroy, and Thapa 1998, Seibel and Parhusip 1998, Parhusip and Seibel 2000, Steinwand 2001 frastructure. Central Java also has other food crops, commercial crops, and in- dustries (including tourism), and is well known for its art and handicrafts. The early years. The BKK/CJ began in 1970 as a project of the CentralJava provincial government and by 1975,486 BKKs/CJ had been established-cov- ering all but 6 of the province's 492 subdistricts.The BKK/CJ is owned by the provincial government (50 percent), district governments (35 percent), and Provincial Development Bank (Bank Pembangunan Daerah, or BPD; 15 per- cent).27 Each subdistrict unit was capitalized by an initial loan ($2,400 in 1972) from the provincial government, with a maturity of 3-5 years at an interest rate of 1 percent a month. Although the BKKs/CJ operate under the Central Java provincial gov- ernment, each is locally administered and financially autonomous. "This has en- sured consistency of overall system policies, standards, and procedures, and at the same time maintained local accountability and incentives based on local per- formance" (Patten and Rosengard 1991, p. 28). Starting in the early 1970s the BKKs/CJ provided small, short-term indi- vidual loans to rural households and collected compulsory deposits from bor- rowers. Loan maturities ranged from 22 days to six months, with several repayment options varying from daily installments to seasonal repayments. Ef- fective monthly interest rates ranged from 2.2-10.8 percent depending on the type of loan; the shorter the loan maturity and repayment intervals were, the higher the interest rates were (Patten and Rosengard 1991, p. 27; Steinwand 2001, p. 134). Loans were financed by retained earnings, local government loans, and compulsory savings. Retained earnings and current profits grew from 34 percent of funding in 1975 to 62 percent in 1985. But during the 1970s the BKKs/CJ also channeled government-subsidized loans, and BKKs/CJ with a high incidence of these loans showed high losses. Rural Development and Rural Financial Institutions in Indonesia 117 The losses, combined with corruption and mismanagement, resulted in clo- sure or severely curtailed operations in one-third of the BKKs/CJ by the early 1980s (Riedinger 1994, p. 306). In 1979 the U.S.Agency for International Development (USAID) began pro- vidmng technical and financial assistance for the BKKs/CJ (the first time that any of Indonesia's BPRs had received external support). The USAID-supported Provincial Area Development Project helped rehabilitate the system, recapitalize bankrupt BKKs/CJ, and provide training in management and bookkeeping.The project also helped the BKK/CJ system upgrade from a project to a Badan Usaha Milik Daerah (BUMD), or provincial government-owned enterprise, in 1981. Important lending principles of the BKKs/CJ-short-term working cap- The average ital loans, interest rates that cover all costs and risks and enable a profit, char- acter-based lending to individual borrowers, and incentives to management and outstanding loan at staff-were adapted by BRI in 1983 when the unit desas' new KUPEDES lend- ing program was designed (see chapter 12). CentralJava's The BKK/CJ as a provincial government enterprise. In 1981 the BKK/CJ sys- tem began a period of growth. Larger BKKs/CJ opened village posts to increase BKKs (subdistrict their outreach.The village posts, which are open once a week and operate in village halls, disburse loans and collect savings and loan installments, but they credit organizations) do not have authority to make loan decisions.There were about 4,000 BKK/CJ village posts in 1999 (Steinwand 2001, p. 202). was 8 percent of per In 1984 the ministry of finance granted the BKKs/CJ perrnission to col- lect savings from the public. But the BKKs/CJ were slow to mobilize savings capita GNP in because of the widespread view that the rural population could not or would not save in financial institutions (see chapter 13). By 1987, however, the suc- 1997 cess of the BRI unit desa voluntary savings mobilization program, especially its fully liquid SIMPEDES instrument, had become known in Central Java.That year the BKKs/CJ began offering a similar voluntary savings product called Tabungan Masyarakat Pedesaan, rural people's saving (TAMADES). But in sharp contrast to SIMPEDES,TAMADES grew slowly-even in the same vil- lages where SIMPEDES grew rapidly.There were two reasons for the slow growth ofTAMADES. Unlike BRI's unit desas, the BKKs/CJ required compulsory savings from borrowers. Mandatory savings typically discourage borrowers from placing voluntary savings in the same financial institution (see chapter 7). It is no co- incidence that early results showed that 75 percent ofTAMEDES savers were not BKK/CJ borrowers-although the savers fit the profile of potential BKK/CJ clients (Patten and Rosengard 1991, p. 39). The second reason for the slow growth ofTAMADES was that there was little incentive for the BKKs/CJ to market savings aggressively-because of the government's large directed credit program (KUK) that began in 1990.To ful- fill its KUK obligations to provide 20 percent of its loan portfolio to small busi- nesses, the state-owned Bank Ekspor-Impor Indonesia provided the BKKs/CJ with $34 million, far more than the system could safely absorb at the time.28 As a result the BKKs became overly liquid and deposited more than 60 per- 118 The Microfinance Revolution: Lessons from Indonesia cent of their funds at the CentralJava Provincial Development Bank (BPD; see Gonzalez-Vega and Chaves 1993 and Steinwand 2001). Over time, however, the BKKs/CJ invested a large part of these funds by increasing their loan portfolios.And the BKKs/CJ became more active in sav- ings mobilization. Steinwand (2001, p. 204) shows that by September 1998 an average BKK/CJ with a BPR license had $50,828 in outstanding loans and $34,653 in savings and deposits (80 percent in savings29 and 20 percent in fixed deposits).Thus 68 percent of the average loan portfolio was covered by savings and deposits; other sources of funds were retained earnings and bank loans. At the end of 1998 there were 512 BKKs/CJ, of which 204 had BPR licenses and were supervised by Bank Indonesia.The other 308 had applied for licenses and continued to be supervised by the BPD. BKK loans are As of 1997, the BKKs/CJ-both those that were licensed BPRs and those that were not-provided small loans and collected small deposits (with larger financed by savings, fixed deposit accounts raising the average account size).As percentages of 1997 per capita GNP ($1,110), the average outstanding loan at the BKKs/CJ was 8 retained earnings, percent, while the average savings balance was just 3 percent.The average time deposit balance was 78 percent (see table 9.5). and bank loans Nonperforming loans were 13 percent in 1997. The BKKs, like other BPRs, do not provision sufficiently for loan losses. Therefore, as discussed above, profitability is difficult to ascertain.30 Based on unadjusted figures for 1997, the return on assets for the BKK/CJ system was 4 percent and the return on equity was 21 percent. According to Steinwand's (2001, p. 249) worst-case re- serve-adjusted calculations, however, the 1997 return on assets would have been -3 percent. But with 512 BKKs and about 4,000 village posts in 1999, and with aver- age outstanding loans and savings balances below 10 percent of GNP per capi- ta, the BKKs/CJ-one of the best BPR systems in Indonesia-provide financial services to many low-income people throughout Central Java. Learningfrom the BKK/CJ. There is much to be learned from the BKK/CJ, which began in 1970, the same year as BRI's unit desa system. Over time, each learned from the other's successes and failures (and from its own). Not surprisingly, many of the lessons from the two systems are the same, as can be seen in the discussion of the unit desas in chapters 11-15, and many are complementary. In addition, many of these lessons reinforce the experiences of the private Bank Dagang Bali, which also began in 1970 (chapter 10). All underscore the fun- damental principles of commercial microfinance discussed in volume 1. Basic lessons from the history of the BKKs/CJ include: * Small, short-term individual loans to rural households can be provided by rural credit organizations owned by local governments at interest rates that cover costs and risks and enable profitability. * Such organizations can be managed with low operating costs, and can be suc- cessful even if open only one day a week. * Loans can be financed by retained earnings, savings, and commercial bank loans. Rural Development and Rural Financial Institutions in Indonesia 119 * Loans should have a range of maturities and repayment options suitable for the community. * Providing subsidized loans to borrowers leads to losses and can eventually result in unit closure or severe retrenchment. * Training and incentives for management and staff are essential. * Large external injections of liquidity discourage voluntary savings mobilization. * Small voluntary savings accounts can be cross-subsidized with larger time deposits. * Emphasis should be placed on appropriate loan loss provisioning and bad debt writeoff, a remaining problem at the BKKs/CJ. * Donors that support institutional capacity building for critical needs get max- With 512 BKKs imum return on their investments. * Links between microfinance institutions and local governments and banks and about 4, 000 can be advantageous for both in a variety of ways. village posts, many Adapting the BKK model to a different environment: the Badan Kredit Ke- poor people camatan of South Kalimantan (BKK/SK). The South Kalimantan BKK pro- gram, modeled on the one in Central Java, began in 1985 (Gonzalez-Vega and throughout Central Chaves 1993; Chaves and Gonzalez-Vega 1996; Ravicz 1998; Steinwand 2001). The two institutions are unrelated, however. The BKK/SK is owned by the Java have easy access provincial government of South Kalimantan and supervised by South Kali- mantan's Provincial Development Bank (BPD). The account below draws to credit and savings heavily on R. Marisol Ravicz's excellent paper, "Searching for Sustainable Mi- crofinance: A Review of Five Indonesian Initiatives" (1998). services South Kalimantan, located northeast of Central Java, has an ethnically het- erogeneous population of 2.9 million people, with only 79 people per square kilometer in 1995. Known as "the province of 1,000 rivers," much local trans- portation in South Kalimantan is by water; in many areas roads and other in- frastructure are not well developed. South Kalimantan, with its estate agriculture and forest areas, produces such export commodities as timber, rubber, rattan, and palm oil. Development of the BKK/SK. South Kalimantan's BKKs began in 1985 with modest facilities and capital endowment grants of about $5,000 each.3" The first 16 BKKs/SK were financed by USAID; the South Kalimantan provin- cial government then financed 94 BKKs/SK. Although their loan portfolios are not subsidized, the BKKs/SK are provided with indirect and in-kind subsidies. The province provides training and supervision, and provincial and district gov- ernments often provide office equipment, motorcycles, and bicycles (Ravicz 1998, p. 32). After the 1992 Banking Law was passed, the provincial government obtained BPR licenses for 20 of its 34 then-existing BKKs-which were exempt from the 1992 regulation that deposit-taking institutions opened after 1992 must ei- ther meet the minimum capital requirement or become cooperatives. But nei- ther of these two alternatives for new BKKs was acceptable to the South 120 The Microfinance Revolution: Lessons from Indonesia Table 9.6 Estimated earnings adjusted for subsidies and bad debt for 34 original BKKs/SK and 3 LKPs of Nusa Tenggara Barat, 1995 (percent) Eamings measure BKKs,SK IKPs Adjusted real return on assets 1 5 -5 2 Adjusted real return on equity 12 0 -2.8 Estimated subsidy dependence indexa 0 24 Current annual interest rate 64b 160 Annual interest rate required to cover all costs (including obtaining a market return on equity) 64 198 Note BKKI/SK stands for Badan Kredit Kecamatan (Subdistrict Credit Organization) of South Kalimantan Large external LKP stands for Lumbung Kredit Pedesaan (Rural Credit Organization) of Nusa Tenggara Barat a The percentage increase in the interest rate required for the institution to operate without subsidies (including obtaining a market return on equity) injections of b " BKK interest rates vary by loan size and repayment frequency This interest rate is for one of BKK's most common loans-a four month loan with a 2 5 percent per month flat interest rate, payable in monthly installments, with a 5 percent forced savings requirement Five percent was selected for the liquidity discourage savings requirement because some BKKs require a 10 percent savings component while others require none " lRavicz 1998, p 37) Source Ravicz 1998, pp 37, 48 voluntary savings Kalimantan BPD.Therefore the provincial government stopped creating BKKs mobilization and began instead to build Institutions for Small Enterprise Finance (Lemba- ga Pembiayaan Usaha Kecil, or LPUKs).The one difference between BKKs and LPUKs, an important one, is that the older BKKs are permitted to accept de- posits (both voluntary and compulsory), while the newer LPUKs are not. By 1995 there were 76 LPUKs in addition to the original 34 BKKs-one in each of the province's 109 subdistricts and one additional unit (table 9.6). Following Ravicz (1998), here the 110 BKKs and LPUKs are referred to col- lectively as BKKs/SK except when the two categories are compared. The BKK/SK system is supervised by the district branches of the South Kahman- tan Provincial Development Bank (BPD). The early 1990s were difficult for the BKKs/SJ. At the same time as the system was expanding with its new LPUKs, the BKKs/SJ faced political de- mands to lend in inappropriate ways."It appears that political pressures on lend- ing policy in 1992 (caused by the election in that year) led to unprecedented arrears in 1993" (Ravicz 1998, p. 36). Loans in default at the 34 original BKKs, adjusted for defaulted loans not written off in previous years, were 23 percent of total loan volume in 1993; loans in arrears fewer than 90 days were 27 percent (Ravicz 1998, pp 35-36). But as discussed below, performance improved rapidly and the 34 original BKKs "did not require subsidies to operate profitably in 1994 and 1995, and could have paid equity holders a satisfactory return" (Ravicz 1998, p. 37). Informa- tion is not available about the defaults, profitabdity, or sustainability of the LPUKs. The BKKs/SK are each staffed by three to six employees. Staff training is emphasized, and a performance-based incentive system has been developed under which managers and staff share 18.2 percent of their BKK/SK's nominal prof- Rural Development and Rural Financial Institutions in Indonesia 121 its.The incentive is provided in bonuses and through a welfare fund. In 1995 each employee at the average BKK/SK received 669,000 rupiah ($290), equiv- alent to 1.6-5.4 months of salary (Ravicz 1998, p.34). BKK/SK managers are generally active, and the BPD provides regular supervision. In theory, the BPD makes all policy decisions for the BKKs... .including the types of savings and lending products units can offer, the terms [of] those instruments, how they should provision for bad debt, when they should write off loans, what their underwriting and loan servicing procedures should be, whom they should hire, how they should train staff, etc. In The first 16 South practice, individual unit managers frequently assume at least minor levels of discretion with regard to many of these policies. The Kalimantan BKKs BPD has one full-time supervisor for every 8.5 BKK units. Supervisors visit units from one to four times per month. werefinanced by -Ravicz 1998, pp. 32-33 USAID, and the Interest rates for loans range from a low of 3.5 percent a month on a de- climnng balance basis with no savings requirement (equivalent to 51 percent a provincial year) to a high of 1 percent a week on the original loan balance with a 10 per- cent savings requirement (about 196 percent a year on a declining balance basis). government then The most frequently quoted rate is a 2.5 percent flat rate a month, with a 10 percent compulsory savings requirement at the 34 original BKKs/SK, but no financed 94 others - mandatory savings at the newer LPUKs. For a four-month loan on these terms, the effective interest rate is about 3.9 percent a month, or 59 percent a an exemplary use of year, assuming no compulsory savings requirement. For the original BKKs/SK that require compulsory savings, the effective interest rate is 4.5 percent a donorfunds month, or 70 percent a year (Ravicz 1998, p. 33). Loan maturities, which vary by unit, range from 10 weeks to 18 months; repayment schedules range from weekly to monthly. Until 1995 all loans were made to individuals. But that year a pilot project in lending to self-help groups was started in one BKK/SK as an effort to reduce transaction costs. This ex- periment in group lending was influenced by the Program to Link Banks and Self-Help Groups (Program Hubungan Bank dan Kelompok Swadaya Masyarakat, or PHBK, discussed later in this chapter). But before the initial pilot project was completed and evaluated, other BKKs/SK adopted the idea. Ravicz (1998) re- ports that 59 self-help groups received loans from BKKs/SK in 1995. The BKKs/SK provide loans to "'channeling groups that simply pass loan funds down to their members and pass up repayments.The groups do not attempt to act as financial intermediaries, and there are no NGOs involved in the process" (p. 33). Loan sizes in the BKK/SK system range from $21-428, but the ranges are different in different BKKs/SK. In 1995 the BKK/SK system had $3.4 million outstanding in more than 34,500 loans (see table 9.5).32 In 1995 the average loan was 10 percent of GDP per capita (Ravicz 1998, p. ix). Savings in the 34 original BKKs was $427,000 in 1995. 122 The Microfinance Revolution: Lessons from Indonesia The amount of loans in arrears by more than 90 days was 26 percent of the value of outstanding loans in 1995. But since the units do not write off bad loans, Ravicz (1998, p. 35) recalculated the arrears rate to simulate arrears and default rates that would have been reported if the institution had written off 100 percent of its loans in default each year. Calculated in that way, and with all loans overdue more than 90 days considered to be in default, 5.9 percent of net outstanding loans were in arrears and 3.5 percent of loans were in default. Ravicz (1998, pp. 36-37) also calculated the real return on average assets for the 34 original BKKs, adjusted for subsidies and bad debt.Although the ad- justed return on assets was -20.9 for 1993, it was 0.5 percent for 1994 and 1.5 percent for 1995. The subsidy dependence index (the percentage increase in the interest rate "The higher the required for an institution to be fully self-supporting, including a market rate of return to equity holders) for the 34 BKKs was 118 in 1993. But the index share of savings to for the 34 BKKs was 0 in both 1994 and 1995 (see table 9.6).Thus in aggre- gate the 34 BKKs were financially self-sufficient in both 1994 and 1995. Op- total assets [in erating in a province with only 79 people per square kilometer (in 1995), the BKKs/SK face little competition.Their main competitors are BRI's unit desas BPRs], thefaster and informal moneylenders. the growth, the The only other major source of financing available to BKK clients is loans provided by cooperative leaders. These individuals use higher the their position in the cooperatives to function as private moneylenders.The rate they charge (20 percent flat per month) profitability, and the is about three times as high as the highest rate BKK units charge. -Ravicz 1998, p. 42 better the loan Learningfrom the BKK/SK. Only half as old as the BKK/CJ system, the performance" BKK/SK has already demonstrated many of the same lessons as its CentralJava counterpart.The first four lessons from the BKK/CJ, above, concern basic is- sues of commercial niicrofinance in rural areas. These fundamental principles are embedded in the BKK/SK as well. In addition, the importance of training and incentive systems in both BKK systems emerges clearly, as does the con- tinuing need in both systems for appropriate loan loss provisioning and bad debt writeoff. For both BKK/CJ and BKK/SK, a donor (USAID in both cases) played an important early role in building capacity; for the BKK/SK this involved fi- nancing the first of the BKK units. But in both cases the provincial govern- ment has played the leading role in developing and supervising the BKKs. Both systems went through difficult times, largely for political reasons, and through subsequent recovery periods. But in 1995 both BKK systems were at or close to financial self sufficiency, and both had widespread outreach in their provinces. In addition, both had average loan sizes that are very small relative to per capita GNP. One specific lesson from the BKK/SK is how the South Kalimantan provincial government adapted a system developed under the very different con- Rural Development and Rural Financial Institutions in Indonesia 123 ditions of Central Java. Both systems have BKKs in nearly every subdistrict. But as noted, there are vast differences between South Kalimantan and CentralJava in population density and infrastructure development, as well as in other as- pects of their environments, that affect the provision of financial services to the rural population.33 Some differences between the two BKK systems that are likely related to their different environments are: * While the BKKs/CJ have developed a huge network of village posts, this approach has not been adopted for the BKKs/SK.Village posts would like- ly not be cost-effective for many sparsely populated areas of South Kalimantan. The challenge is in . Unlike the BKKs/CJ, the BKKs/SK began lending to self-help groups in 1995, based on the PHBK model (although the PHBK program had not yet adapting the basic begun in South Kalimantan). But this form of lending had just begun at the BKKs/SK when Ravicz was there in 1995, and information on the perfor- principles of mance of the group loans is not available. And the BKKs/SK did not wait until their pilot project was completed and evaluated before expanding their commercial self-help group lending to multiple BKKs/SK. Elsewhere in the country, the PHBK program developed into a large, complicated, and high-cost program microfinance to providing credit and training. The BKKs/SK, however, opted for a pared- down version of the PHBK model. If the BKKs/SK can extricate the lend- diferent ing methodology from the rest of the high-cost PHBK program-as was done on Java by the private BPR Bank Shinta Daya, discussed below-they might environments find the self-help group lending methodology useful in South Kalimantan's sparsely populated environment, where BKK/SK staff travel long distances on poor roads. * Perhaps the most critical problem for most BKKs/SK (the newer LPUKs) is that they are not permitted to mobilize savings. Lending growth is slow because of lack of funds, and of course these BKKs/SK cannot meet the de- mand for savings services in their subdistricts. The BPD is aware that the BKK/SKs have few staff and limited supervision, serve large areas, and har- bor substantial opportunities for theft and corruption.These factors may dis- courage the provincial government from changing the status of some LPUKs. But other provinces have moved toward solving the problem of savings in new institutions by establishing them as licensed BPRs or as what Ravicz calls "nominal cooperatives" (see the discussion below of the Lumbung Kredit Pedesaan of NusaTenggara Timur). Savings remains an unresolved prob- lem for the LPULKs of South Kalimantan. Because data are not available on the performance of the LPUKs alone, it is not possible to assess the differ- ent levels of outreach and profitability of the 34 original BKKs and the 76 LPUKs. But Steinwand's (2001, p. 324) general comment about BPRs is like- ly to be relevant: "The long term performance of the BPR is closely linked to their capacity of savings mobilization.The higher the share of savings [to] total assets the faster the growth, the higher the profitability, and the better the loan performance." 124 The Microfinance Revolution: Lessons from Indonesia Indonesia is a large country with many environments. What works at the local level in rural areas in Central Java may not work as well in South Kali- mantan, and vice versa.Thus the central government left the detailed decisions about unlicensed BPRs to their respective BPDs."The central government. . .left enough scope for the provincial governments to follow their own LDPK pol- icy, as the different approaches of the BKK of South Kalimantan, LPD of Bali, and LKP [Lumbung Kredit Pedesaan] of NTB [Nusa Tenggara Barat] have proven" (Steinwand 2001, p. 217). But there is no question that important lessons about commercial micro- finance can be, and are, passed from one BPR to another. The challenge is in adapting the basic principles to different environments. Some cooperative "hen basic principles are lacking: Lumbung Kredit Pedesaan (LKP) of Nusa Tenggara Barat. The Rural Credit Organizations (LKPs) of NusaTenggara Barat leaders are also in eastern Indonesia are owned by the provincial government of Nusa Teng- gara Barat and supervised by the Provincial Development Bank (BPD). Rav- private icz (1998, pp. 43-51) analyzes the 1995 performance of the four LKPs in Dompu District (see tables 9.5 and 9.6). Like the two BKK systems discussed above, moneylenders, these Rural Credit Organizations are public LDPKs. Nusa Tengarra Barat is a poor province with an ethnically and religious- charging aflat ly diverse population of 3.6 million; in 1995 it had 181 people per square kilo- meter. NusaTengarra Barat is generally dry (although there is variation in rainfall monthly interest rate within the province) and has few commercially valuable natural resources and little industry. In some areas, especially Lombok, irrigated wet rice is culti- of 20 percent (an vated. But much of the province's population relies on fishing or dryland sub- sistence agriculture (sorghum, mnllet, mungbeans, cassava, sweet potatoes, annual effective rate yams, and the like).Among Indonesia's provinces, NusaTengarra Barat has one of the highest percentages of population below the poverty line (18 percent of 1, 600 percent) in 1996).3 The Dompu District LKPs were subject to political pressures and were gen- erally not well supervised. With one exception, they also appear not to have been well managed. Compared with the BKK systems of CentralJava and South Kalimantan, Dompu District's LKPs had low transparency and higher defaults and arrears. Although they had higher interest rates on loans than the BKKs, the Dompu LKPs were much further from financial self-sufficiency than the other two systems. Ravicz (1998, p. 50) commented,"The units [LKPs] are heav- ily influenced by the expertise and honesty of their management. For exam- ple, one unit was driven to the brink of insolvency through corrupt management practices... Further.. .the units are owned by the NTB provincial government and controlled by the provincial development bank. It appears likely that both of these entities have objectives for the units beyond profitability, growth, and client service." Development of Nusa Tenggara Barat's LKPs. Introduced in 1989, the LKPs are located in subdistrict capitals in a relatively poor province. In 1995 Dompu District's four LKPs covered 34 of the 45 villages in their subdistricts Rural Development and Rural Financial Institutions in Indonesia 125 (76 percent), but the two other subdistricts in the district were not served by LKPs. Dompu's LKPs were all established before 1992 and so were exempt from the government's regulations on LKPs opened after that year. Nevertheless, in 1995 the BPD was planning to convert two of the four LKPs mto licensed BPRs. For the other two, the BPD plan was "to comply with the letter of the law by nominally declaring the units to be cooperatives and redefining voluntary sav- ings as 'required members savings"' (Ravicz 1998, p. 51).The BPD also planned to open two other LKPs as nominal cooperatives in the two unserved Dompu subdistricts. Dompu's LKPs offer one loan product that is common to many BPR sys- The Rural Credit tems: a 12-week loan to individual borrowers repayable in 12 equal weekly in- stallments.The first installment represents the interest due on the loan, the second Organizations is a compulsory savings payment, and the final 10 installments repay the capi- tal. Assuming that the compulsory savings and the interest earned on the sav- (LKPs) of a Nusa ings are paid to the borrower at the end of the loan period, as is supposed to happen, Ravicz (1998) calculated the monthly effective interest rate to be 8.3 Tenggara Barat percent and the annual effective rate to be 160 percent (compared with 59-70 percent at the BKKs/SK). district were subject In 1995 loan sizes ranged from $21-214. One voluntary savings instrument is offered, a demand deposit with an unlimited number of withdrawals and a to political pressures, 10 percent annual interest rate. Compulsory savings, required to obtain loans, also pay 10 percent interest a year. poorly supervised, In 1995 the outstanding portfolio in the four LKPs was $313,000 in about 4,150 loans (see table 9.5).The largest LKP had 47 percent of the value of out- and in some cases standing loans and the smallest had 4 percent. Savings (voluntary and compul- sory) were $28,000 in 1995. corrupt Ravicz (1998, p. 46) notes, however, that "income statements and balance sheets provided by the BPD contain some apparent errors, omissions, and in- consistencies."The problems were not only at the BPD. "The Dompu district branch of the BPD has one full-time supervisor to oversee the four LKPs in its district.Two of these units are within walking distance of the BPD branch. Despite the fact that the supervisor oversees only four units, one unit manag- er was able to effectively bankrupt his unit by making fraudulent loans and em- bezzling funds" (Ravicz 1998, p. 43). The LKPs receive endowment grants and in-kind gifts and subsidies, in- cluding supervision by the BPD. Like the two LDKPs discussed, the LKPs do not provision adequately for loan losses and do not write off bad debt. Adjusting for subsidies, bad debt, and inflation, Ravicz found that three of the LKPs had average arrears (payments overdue 30 days or more) of 20 per- cent of outstanding loans in 1995.The fourth LKP had had the highest adjusted arrears in 1993-78 percent. But although this LKP continued to operate, data on its performance in subsequent years could not be obtained. Excluding the fourth LKP, adjusted loans in default (in arrears 90 days or more) averaged 5.5 percent in 1995. 126 The Microfinance Revolution: Lessons from Indonesia The adjusted real return on average assets for the three LKPs was -5.2 per- cent in 1995, and the adjusted real return on average equity was -2.8 percent (see table 9.6).These returns would have been lower had the LKP with the miss- ing data been included. Based on the three LKPs, "in 1995, the program would have had to charge a 198 percent annual interest rate to completely eliminate all program subsidies and pay liability and equity holders a market return on their investments" (Ravicz 1998, p. 48; see table 9.6). There were, however, substantial differences in performance among the LKPs.The best-performing LKP maintained consistently low default rates over the three years examined and in 1995 had an adjusted real return on assets of 4.9 percent, an adjusted real return on equity of 11.9 percent, and a subsidy depen- dence index of -4 percent.Thls LKP "could have provided an adjusted real re- Good management turn to equity holders of from 3 to 12 percent since 1993" (Ravicz 1998,p. 48). The LKPs report almost no institutional competition for borrowers, but they matters. Even in a compete with the BRI unit desas for savings. Like the BKKs/SK, LKPs report that "cooperative leaders use their position in the cooperative system to function as politicized, corrupt private moneylenders, charging a 20 percent flat monthly interest rate (equiva- lent to 1,600 percent per year on a declimng balance basis)" (Ravicz 1998, p. 51). environment, a good Learningfrom the LKPs. Although the data cover only the four LKPs of one district, much can be learned: manager can * Politicization is typically incompatible with accountable supervision and with generate good results profitable commercial microfinance institutions. * When owners and managers lack expertise and honesty, the institutions they manage are likely to be unsound, and their clients poorly served. * Lack of transparency occurs when owners, managers, and staff are not held accountable for their decisions and actions. * High defaults and arrears put poor savers' money at risk. * Inefficiency and corruption can lead to high interest rates on loans, unnec- essarily penalizing borrowers. * Appropriate products are necessary but insufficient for success in mi- crolending (and in savings).The LKP loan product (except for its interest rate) is similar to loan products in BPRs all over Indonesia.Where it is implemented well, this product can serve as a basis for a sustainable loan program with wide outreach. But when the institution is not properly managed, a loan program using the same product can show unsatisfactory performance. * Good management matters. Even in a poor region, and in a BPR system marked by politicization and corruption, a good manager can generate con- sistently good results in a particular unit. A licensed private BPR: serving the poor profitably at Bank Shinta Daya inJava. Bank Shinta Daya is in D.I.Yogyakarta, a special region of Indonesia (D.I. stands for Daerah Istimewa, which means "Exceptional Region"). Border- ing the province of Central Java toward the southeast, D.I.Yogyakarta holds a Rural Development and Rural Financial Institutions in Indonesia 127 special status as a sultanate in the Republic of Indonesia.Yogyakarta is small and densely populated (916 people per square kilometer in 1995); its area and its population are one-tenth those of Central Java. ButYogyakarta is a cultural and intellectual center and former capital of Indonesia. It is world renowned for its history, art, music, dance, ancient Hindu and Buddhist temples and statues, and its kraton, the palace compound of the sultans ofYogyakarta. Like Central Java, Yogyakarta has both wet rice and dryland cultivation and has well-developed irrigation and infrastructure. Bank Shinta Daya was founded inYogyakarta in 1970 as a limited liability company. A rural bank, it was established with private investment and funded its expansion from retained earnings.The account below is based on Seibel and At Bank Shinta Parhusip (1998) and Parhusip and Selbel (2000), unusual papers that analyze types of data rarely available for microfinance institutions. Daya 71 percent of Development of Bank Shinta Daya as a private rural bank. For its first 20 years Bank Shinta Daya mobilized savings and lent to individual clients, poor and loans made to poor nonpoor. In 1989 the bank began to participate in Bank Indonesia's Program to Link Banks and Self-Help Groups (PHBK), and by the end of 1995 Bank borrowers were Shinta Daya provided financial services through 310 groups with 7,750 mem- bers.At that point the bank had a total of more than 30,000 savers (with 43,000 through se!f-help accounts) and more than 12,500 borrowers (see table 9.5). It is important to note, especially in light of the costly PHBK program discussed below, that: groups. But 71 After an expensive and ultimately abortive attempt of working percent of poor through a local NGO as a financial intermediary, Bank Shinta Daya decided to seek out its own savings and credit groups which savers were are ubiquitous in Indonesia.The bank has set up a special group lending department, hired its own field workers, some of them individuals former NGO staff, and trains its own groups of the poor in group management, bookkeeping, savings mobilization and financial management. -Seibel and Parhusip 1998, p. 9 Bank Shinta Daya classifies most of its savers and borrowers as poor, but it has far more poor savers than poor borrowers. In 1995, 25,752 savers (85 per- cent of total savers) and 8,782 borrowers (69 percent of total borrowers) were poor. That poor savers outnumbered poor borrowers nearly three to one sup- ports data from other Indonesian microfinance institutions (and from other parts of the world) that more poor people want to save than borrow at any given time (see chapters 10 and 13; see Rutherford 2000; and Wright 2001).Among the nonpoor this pattern is less pronounced: Bank Shinta Daya's 4,588 non- poor savers do not greatly outnumber it 3,874 nonpoor borrowers. An especially interesting finding is that among poor borrowers, 2,582 (29 percent) were individual borrowers and 6,200 (71 percent) were from self-help groups. But exactly the opposite pattern held for poor savers: 18,352 (71 per- cent) were individual savers and 7,400 (29 percent) were from self-help groups. 128 The Microfinance Revolution: Lessons from Indonesia Table 9.7 Viability indicators for Bank Shinta Daya and Mitra Karya, 1995 (percent) Indicator Bank Shinta Daya Mitra Karya Average annual interest rate on deposits 15 2 10 0 Annual effective interest rate to borrowers 27 4 30 0 Average cost of outside funds 16.5 3.5 Financial self-sufficiency 96 0 39.0 Source Parhusip and Seibel 2000, p 171 Individual and These data also suggest what has been shown elsewhere: savers value confi- group methodologies dentiality and prefer to save as individuals rather than through groups (see chap- ter 7). were both profitable At Bank Shinta Daya the average annual effective interest rate charged to borrowers in 1995 was 27.4 percent-a long way from the 160 percent charged at Bank Shinta at the Nusa Tenggara Barat LPKs that year (and the 198 percent the LPKs would have had to charge to become profitable). Bank Shinta Daya's default rate was Daya. But the 2 percent.The average annual interest rate paid to depositors was 15.2 percent. Savings of $2.2 million represented 105 percent of the $2.1 million in outstanding individual loans in 1995.The bank's net worth at the end of 1995 was $215,000, with 36 percent in capital and 64 percent in retained earnings. Net profit was $27,426. methodology Seibel and Parhusip (1998,p. 16) calculate that the bank was 96 percent financially self-sufficient (table 9.7). accountedfor 94 As noted, Selbel and Parhusip provide information rarely available for mi- crofinance institutions. This includes a comparison of the outreach and prof- percent of the profits itability of Bank Shinta Daya's individual and group methodologies. Their findings show that group loans and group savings were of only minor impor- tance in 1995: 97 percent of the value of the bank's deposits came from indi- vidual clients, and 89 percent of the value of outstanding loans was in loans to individual borrowers.Although Siebel and Parhusip found that the individual and group methodologies were both profitable to the bank in 1995, the indi- vidual methodology accounted for 94 percent of profits. The group technology is thus found by Bank Shinta Daya to be viable as such, but adds little to the bank's overall viability. Why then does the bank engage in business with small groups? The bank's management explains this with future expectations. By providing financial services to group members with microenterprise activities, it contributes to their growth.As the members' microenterprises grow, so will their business with the bank. -Seibel and Parhusip 1998, pp. 16-17 Rural Development and Rural Financial Institutions in Indonesia 129 Learningfrom Bank Shinta Daya. In addition to the basic principles for com- mercial mucrofinance mentioned above for other institutions, Bank Shinta Daya's performance offers important lessons: * Licensed private BPRs can reach the poor sustainably (as can public BPRs of all types). * Savers, both poor and nonpoor, will save in licensed private BPRs if the BPRs demonstrate that they are trustworthy. * The poor are far more likely to use the bank's savings facilities than its cred- it services.The nonpoor are somewhat more likely than the poor to be bor- rowers. Mitra Karya, a . Although most savers are poor (89 percent), most of the value of the savings is from the nonpoor (thus raising the average account size and making it pos- Grameen replicator sible for the bank to collect savings profitably while also serving the poor). * Bank Shinta Daya, which operates its own group lending department, pro- in EastJava, had an vides both loans and voluntary savings services to self-help groups profitably (in contrast to the high-cost PHBK program discussed below). average cost offunds . Self-help groups can deepen credit markets, increasing poor people's access to commercial loans. of 3.5 percent and * Both individual and group methodologies are profitable at Bank Shinta Daya. But 94 percent of the bank's profit is from its individual methodology. was 39 percent . Bank Shinta Daya provides support for the view that BPRs that serve as fi- nancial intermediaries are more profitable and achieve higher outreach than financially se!f- those that do not mobilize voluntary savings from the public. sufficient. Its Missing the point: Mitra Karya of East Java, a Grameen Bank replicator. outreach was low The information on Mitra Karya here is drawn from Seibel and Parhusip (1998) and Parhusip and Seibel (2000).The Mitra Karya Grameen replication project is in East Java-the largest in area of the provinces on Java. In 1995 the population of East Java was 33.8 million, with 706 people per square kilome- ter. EastJava is well known as the home of earlyJavanese kingdoms, culminatmg in the Majapahit kingom-a Hindu court culture in the 14th century with an empire that stretched from parts of mainland Southeast Asia in the west to set- tlements on Irian Jaya in the east (covering a larger area than present-day In- donesia). Today East Java combines well-developed infrastructure and highly intensified agriculture (irrigated rice with two or three harvests a year, as well as many other crops) with major industrial and commercial businesses centered around Surabaya, Indonesia's second largest city after Jakarta. Development of Mitra Karya. Mitra Karya was established as a replication pro- ject in 1993 with funding from the Grameen Trust Fund and the state-owned Bank Negara Indonesia. The project is implemented by the Research Cent