Bank Indonesia officials and Acting Mayor of Banda Aceh Bakri Siddiq, third right, scan a quick response (QR) code during a celebration of the national QRIS week in Banda Aceh, Aceh on Aug 20, 2022. (Antara Photo/Irwansyah Putra)

Inflation and Financial Sector Deepening

BY :ADI BUDIARSO

SEPTEMBER 16, 2022

Amid a struggle with the Covid-19 pandemic, the global economy must face another challenge, inflation. For the United States, the recent hike in consumer prices has become a national crisis. The inflation rate in July reached 8.5 percent compared to the same month a year ago. A month earlier, US inflation reached 9.1 percent, the highest in the last 40 years. The United Kingdom also faces similar challenges. In July, the inflation rate reached 10.1 percent, the highest level for this country since 1982. The increased inflation occurring in many countries has penetrated various sectors, drastically reduced purchasing power, and brought about the threat of stagflation.

Nonetheless, the inflation in Indonesia is still under control. But, the inflation rate has also increased to 4.69 percent in August. The rising inflation rate is feared to hurt the economy. Therefore, is it matters to deepen the Indonesian financial sector? How critical is the finalization of an omnibus law on the financial industry, which is currently becoming one of the main agendas of the parliament?

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Deepening the financial sector may be negatively affected by the increase in inflation. The illustration can be explained as follows; When inflation is high and
persistent, the central bank may respond by raising its interest rate benchmark. Responding to that, banks will also increase their lending rates, which may trigger a reduction in the volume of bank credit to the private sector. As a result, bank credit can weaken, as indicated by the declining ratio of bank credit to the gross domestic product (GDP).

Over the years, the Indonesian credit intermediary role in supporting the economy has relied heavily on its banking performance, which means that a high inflation rate will limit the intermediary role of the financial sector. This is because total banking assets accounted for 79 percent of total assets in the financial industry.

The dominance of banks in providing resources in the Indonesian financial sector is indisputable. This makes the banking sector increase its overhead cost and, without difficulty, charge to the creditors. This might undesirably contribute to the ineffectiveness of resource allocation in support of the development plan.

The high inflation could unswervingly impact the non-banking financial sector, especially in lower-middle-income countries. For instance, high inflation will eventually push the real interest rate down or even become negative when the inflation is higher than the required rate of return.

The decline in actual returns has a more significant potential to occur in several non-bank financial sector instruments, such as pension funds and insurance. Furthermore, real returns on the stock market and bond market instruments may also decline. In other words, high inflation can hamper the deepening and development of the financial sector, both through banking and non-banking.

An Urgent Need for Financial Deepening

Eventually, Indonesia expects a lot from the financial sector's performance to finance economic recovery. This is the main reason economic development
requires deep and efficient financial sector support. The financial industry provides resources for economic activity. A deep financial sector will provide many alternative sources of financing for the economy.

The more alternative source of financing available, the cheaper the costs for the investment decision would be. For more than a decade, domestic savings have not been able to meet these needs. In fact, since 2011, the ratio of savings to GDP has continued to decline.

Indications of domestic investment need that savings have not met are reflected in the savings-investment gap, the value of which continues to increase. This phenomenon indicates that the role of financial sector intermediation has not been fully optimized. 

Simultaneously, Indonesia needs to increase its financial sector intermediation capacity to support the need for considerable funds to finance the National Economic Recovery Program (PEN). In 2020, the government must allow the reduction of the tax ratio up to 2 percent and raise more debt to fulfill the budget need amid increasing demand for productive investment.

Currently, the portrait of the depth of Indonesia's financial sector is not as desirable as expected. Several indicators commonly used to measure the depth of the financial industry are still relatively stagnant. One example is the ratio of bank credit to GDP, which is still in the range of 44 percent, much lower than peer countries such as Malaysia or Thailand, which have reached 134 percent and 160 percent, respectively.

Indonesia, until 2035 will still enjoy the demographic dividend, providing it with an abundant supply of young and productive workers. Thus, even though Indonesia's financial sector is still relatively shallow, the opportunity to deepen the financial sector is widely open. But, the effort to deepen the financial sector is not an easy task.

Several structural challenges await – apart from apparent high inflation. The first challenge comes from the low level of financial literacy. Currently, Indonesia's financial literacy index is still below the level of 40 percent. With relatively low financial literacy, the capacity for the financial sector to deepen will be minimal.

It can also be considered that there is another challenge which is the decline in public confidence in financial service institutions. This is a result of the rise of cases involving financial service institutions lately. These cases have incurred losses to the community, which are not small in number. As a result, people tend to resist financial services, especially non-banks, since the non-bank financial industry is still not optimally developed.

Apparently, given these challenges, efforts to deepen Indonesia's financial sector face a steep but not impossible road map. The current rising inflation should not
hinder efforts to deepen the financial sector. Because measures such as strengthening regulations, increasing literacy, protecting consumers/investors, expanding the consumer/investor base, and promoting multisector collaboration should be tracked in line with enhancing macroeconomic fundamentals as necessary to maintain financial system stability. When these things continue to be pursued, the goal of deepening the financial markets will soon be realized. Indonesia may strengthen its potential to become a financial center in the region.

Adi Budiarso is the head of the Center for Financial Sector Policy, Fiscal Policy Agency at the Ministry of Finance. Opinions are personal and do not reflect the opinions or policies of the institution where the author works.

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