Indonesia is in the early phase of tapping the potential of capital markets to drive sustainable development and employment creation. The Indonesian government, with the assistance of the World Bank, is laying out the broad parameters of policy that can set the stage for greater private-sector activity.
To that end, a major focus of World Bank work under the umbrella of the Sustainable Finance Facility (SFF) and the Joint Capital Markets Program (J-CAP) more broadly has been support for reforms in the legal and regulatory framework, anchored by the preparation and implementation of the Financial Sector Omnibus Law (FSOL).
Signed into law on January 13, 2023, FSOL is an early milestone in Indonesia’s path toward an enabling environment for more vibrant capital markets. Some of the most crucial reforms in the law involve measures to improve long-term investor demand, particularly among institutional investors such as pension funds.
Indonesian capital markets are nascent, far behind its regional peers. Though its government bond markets are solid, private-sector activity is extremely limited. The corporate bond market, for example, is about 2.5 percent of GDP. Currently, equity markets are worth approximately 50 percent of GDP. To spur greater activity, long-term investor demand is critical, but the domestic investor base of pension funds, insurers, and other institutional investors remains very small. Pension funds amount to 6.4 percent of GDP, far below regional benchmarks such as Singapore (83.4 percent) and Hong Kong (48.5 percent).
Indeed, Indonesia’s financial system itself is relatively small and dominated by banks, which hold 78 percent of total assets. The country’s top ten banks hold 66 percent of total bank assets, and four state-owned banks dominate the sector. Islamic banking, which entails …., has grown quickly in recent years but remains small overall. At 31.4 percent, Indonesia’s credit-to-GDP ratio is well below peer countries. Though Indonesians save at a relatively high rate, the financial system does not channel those savings into productive endeavors.
These metrics are sobering but the path forward is relatively clear. The experience of higher income countries in the Asia-Pacific region suggests that a broadening and deepening of Indonesia’s financial system, including capital markets, will be essential if it is to break through the ceiling to become a middle-income country.
Precisely because Indonesia capital markets are underdeveloped across the board, the FSOL is a sprawling piece of legislation, designed to address almost all areas of weakness. The law contains 27 chapters, divided into 341 articles, that replace 17 previous laws governing the financial sector that were used for the past 30 years. Work supported by the SFF contributed to drafting of chapters in omnibus law to cover supply and demand side for financial assets – including capital, derivative, money, sustainable finance, pension fund, hedging, and carbon markets – as well as implementing regulations. That said, its scope is far wider than SFF-related work.
The changes that the FSOL includes to pension fund laws reflect an overall aim of strengthening long-term investor demand, especially for assets that bear on Indonesia’s sustainability goals and mobilizing savings for productive purposes. The work of the World Bank, supported by the SFF, goes beyond the financial sector law to include the overall design of the pension system, capacity building at regulators, and extensive technical advice.
For a mixture of reasons, Indonesian pension funds – normally the backbone of an institutional investor base – lack both skilled investment resources as well as an appropriate set of investible instruments that would be expected in a country with a high savings rate. Further, there is a shortage of willingness on the part of the funds to take on short-term volatility in the interest of increased long-term returns. These deficits, in turn, limit opportunities for local currency-based financing solutions that would improve Indonesia’s capital markets and limit exchange-rate risk.
Pension fund assets have grown marginally, but diversification of investments has unfortunately lessened. Pension system assets managed by the employment branch of the social security agency remain low at 8.7 percent of GDP, which reflects inconsistent contribution rates, underfunding, and management challenges. Only about a quarter of the labor force – 40 million people – contribute to pensions.
To properly implement the law, World Bank staff advised Indonesia on new investment regulations and risk management provisions for pension funds and on the introduction of default funds – life cycle pension funds – which encourage longer-term investment. The World Bank also worked with Indonesia on plans for pension fund taxation and digitalization.
The work is ongoing. The Indonesian Financial Services Authority, known by its acronym OJK, requested World Bank support for a review of its pension supervisory practice and advice on public communications strategies for pension reforms. The World Bank also facilitated a knowledge-sharing session around principles developed by the International Organization of Pension Supervisors (IOPS). One implementing regulation of the FSOL will involve harmonization of standards across the entire pension sector, to include both mandatory and voluntary elements, with an eye toward ensuring its contribution to social, fiscal, and financial sector development.
The implementing regulations for the FSOL total at least 70, with many relevant to the ability of Indonesia’s institutional investors to play a constructive role in more vibrant capital markets. A comprehensive law such as this one will demand further World Bank advice and technical assistance as Indonesia seeks to ensure that the law fulfills its potential for improving capital markets specifically, and financial markets more generally.
