ASIAN DEVELOPMENT BANK

PCR:INO 26194

PROJECT COMPLETION REPORT

ON THE

SECOND DEVELOPMENT FINANCE PROJECT (Loan 1223-INO)

IN

INDONESIA

April 2002

CURRENCY EQUIVALENTS Currency Unit – Rupiah (Rp)

At Appraisal At Project Completion

(5 Feb 1993) (1 July 2001) $1.00 = Rp2,067 Rp11,400 Rp1.00 = $0.0004838 $0.000088

ABBREVIATIONS ADB - Asian Development Bank ANDAL - environmental impact analysis BALI - Bank Bali BDNI - Bank Dagang Nasional Indonesia BI - Bank Indonesia BII - Bank Internasional Indonesia BNI - Bank Negara Indonesia CAMEL - capital adequacy, asset quality, management, earnings, and liquidity CAR - capital-adequacy ratio DANAMON - Bank Danamon Indonesia DFI - development finance institution DFL I - First Development Finance Loan DFL II - Second Development Finance Loan EXIM - Bank Ekspor Impor Indonesia FRN - floating rate note FSPL II - Second Financial Sector Program Loan FX - foreign currency GDP - gross domestic product IBRA - Indonesian Bank Restructuring Agency JSE - Jakarta Stock Exchange LDR - loan-to-deposit ratio Lippo - Lippo Bank LIBOR - London interbank offered rate NBFI - nonbank financial institution NIAGA - Bank Niaga NPL - nonperforming loan OCR - ordinary capital resources PANIN - Panin Bank PCR - project completion report PFI - participating financial intermediary PPFI - privately owned participating financial intermediary ROA - return on assets SBI - Sertifikat Bank Indonesia (Bank Indonesia Certificate) SPFI - state-owned participating financial intermediary

NOTES (i) The fiscal year (FY) of the Government ended on 31 March up to 31 March 2000.

Thereafter the fiscal year coincided with the calendar year. (ii) In this report, “$” refers to US dollars. (iii) Since August 1997 the exchange rate of the rupiah has been determined under a

floating system. (iv) An exchange rate of Rp11,400 to $1.00 has been used in this report.

CONTENTS

Page BASIC DATA I. PROJECT DESCRIPTION 1

A. History 1 B. Scope of Operations 2 C. Rationale for the Asian Development Bank Loan 3

II. IMPLEMENTATION 3

A. Economic and Financial Sector Developments 3 B. Lending Policies 4 C. Second Development Finance Loan Utilization Rate 5 D. Characteristics of Subloans 7 E. Implementation and Internal Operations of Subprojects 7 F. Operational Performance of Participating Financial Intermediaries 8 G. Financial Performance of Participating Financial Intermediaries 8 H. Financial Statements and Ratios 8 I. Covenant Compliance Status 9 J. Performance of the Borrower and the Participating Financial Intermediaries 9 K. Performance of the Asian Development Bank 10

III. EVALUATION 10

A. Loan Appraisal 10 B. Implementation 12

IV. CONCLUSION AND RECOMMENDATIONS 12

A. Conclusions and Assessment of Overall Project Performance 12 B. Lessons Learned 13 C. Recommendations 13

APPENDIXES 16-68

BASIC DATA

A. Loan Identification 1. Country Indonesia 2. Loan Number 1223-INO 3. Project Title Second Development Finance Loan 4. Borrower Republic of Indonesia

5. Executing Agency (i) Bank Negara Indonesia (ii) Bank Ekspor Impor Indonesia (iii) Bank Bali (iv) Bank Dagang Nasional Indonesia (v) Bank Danamon (vi) Bank International Indonesia (vii) Bank Niaga (viii) Lippo Bank (ix) Panin Bank

6. Amount of Loan $200.0 million 7. PCR Number PCR: INO 681 B. Loan Data 1. Appraisal - Date Started 26 January 1993 - Date Completed 05 February 1993 2. Loan Negotiations - Date Started 22 February 1993 - Date Completed 24 February 1993 3. Date of Board Approval 30 March 1993 4. Date of Loan Agreement 02 August 1993 5. Date of Loan Effectiveness - In Loan Agreement 02 November 1993 - Actual 14 March 1994 - Number of Extensions 2

6. Terminal Date for Commitments - In Loan Agreement 2 November 1996 - Actual 14 June 1998 - Number of Extensions 3

7. Closing Date

- In Loan Agreement 2 November 1997 - Actual 14 March 1999 - Number of Extensions 2 8. Terms of Loan - Interest Rate Variable (pool-based dollar facility) - Maturity 15 years - Grace Period 4 years - Repayment Terms Fixed type, 15 years, including 4-year grace period

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9. Terms of Relending to Participating Financial Intermediaries - Interest Rate Variable 6-monthly (ADB lending rate plus

0.5 percent) - Maturity 15 years - Grace Period 4 years - Free Limit $1 million initially, but increased to $3 million in

November 1995 10. Interest Rate for Subloans Based on prevailing market rates for dollar loans

11. Disbursements

- Amount Disbursed $75,439,040.35

- Amount Cancelled $124,560,959.65

C. Implementation Data

1. Number of Subloans by Participating Financial Intermediary

No. Amount Percent of ($ million) Loan Amount

Bank Dagang Nasional Indonesia 4 7.829 10.4 Lippo Bank 1 4.000 5.3 Bank Niaga 14 31.116 41.2 Bank Internasional Indonesia 8 12.572 16.7 Bank Bali 15 11.987 15.9 Bank Danamon Indonesia 8 7.935 10.5

Total 50 75.439 100.0

2. Sector Distribution of Subloans

No. Amount Percent of ($ million) Loan Amount

Agriculture, Forestry, and Fishing 6 9.365 12.4 Mining and Quarrying 4 5.161 6.8 Food Manufacturing and Processing 5 9.650 12.8 Textiles 17 23.730 31.5 Wood Products 3 1.084 1.4

Manufacture of Chemicals, Rubber, 11 14.089 18.7 and Plastic Products

Nonmetallic Mineral Products 3 9.360 12.4 Other Manufacturing 1 3.000 4.0

Total 50 75.439 100.0

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3. Size of Subloans

No. Amount Percent of ($ million) Loan Amount

Less than $0.5 million 16 4.694 6.2 Over $0.5 million-$1.5 million 11 10.473 13.9 Over $1.5 million-$3.0 million 21 52.272 69.3 Over $3.0 million-$5.0 million 2 8.000 10.6

Total 50 75.439 100.0

4. Geographic Distribution of Subloans

No. Amount Percent of ($ million) Loan Amount

Java 42 59.675 79.1 Sulawesi 1 1.522 2.0 Sumatra 4 8.168 10.8 Others 3 6.074 8.1

Total 50 75.439 100.0

5. Purpose of Subloans

No. Amount Percent of ($ million) Loan Amount

New 6 3.768 5.0 Expansion 42 70.919 94.0 Modernization 2 0.752 1.0

Total 50 75.439 100.0

6. Maturity of Subloans

No. Amount Percent of ($ million) Loan Amount

Up to 3 years 7 8.306 11.0 Over 3 to 5 years 32 43.900 58.2 Over 5 to 10 years 11 23.233 30.8

Total 50 75.439 100.0

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7. Subloans Above Free Limit

No. Amount Percent of ($ million) Loan Amount

Above free limit 2 8.000 10.6 Below free limit 48 67.439 89.4

Total 50 75.439 100.0

D. Data on Asian Development Bank Missions Name of Mission Dates No. of No. of Specialization Persons Person-Days of Members1

Fact-Finding 11-26 Nov 1992 2 32 i, r Appraisal 26 Jan- 5 55 i, h, s, r, p 5 Feb 1993 Inception 20-23 Apr 1993 4 13 r, s, t, w Review 10 Oct 1994 1 1 u 18 Oct 1994 1 1 u Special Review 8 Dec 1994 1 1 c Review 13 Feb 1995 1 1 u Portfolio Review 22 Mar 1995 2 2 i, u and Spring Cleaning Special Review 31 Mar 1995 2 2 c, k Review 1 Jun 1995 1 1 u 25 Nov- 23 Dec 1996 1 29 u 9, 12, 13 Jan 1998 1 3 u Desk Review 20 Apr 1998 1 1 u Project Completion 2 July- 2 71 d, v Report 25 Aug 2001 Total 25 213

1 a-director, b-resident representative, c-manager, d-sr. program officer, e-sr. economist, f-sr. project specialist, g-sr. control officer, h-sr. counsel, i-sr. investment officer, j-sr. economic advisor, k-sr. financial analyist, l-project implementation officer, m-counsel, n-financial analyst, o-HRD specialist, p-project economist, q-sr. project engineer, r-investment officer, s-environment specialist, t-control officer, u-program officer, v-staff consultant, w-sr. assistant

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E. Related Loans

Loan No. Date of Agreement Amount ($ million) BAPINDO I** 319 6 December 1977 30.0 BAPINDO II 834 23 October 1987 60.0 DFL I*** 981 23 November 1989 200.0

Total 290.0

** BAPINDO = Bank Pembangunan Indonesia (Indonesian Development Bank) *** DFL 1 = First Development Finance Loan.

I. PROJECT DESCRIPTION A. History 1. In March 1993, the Asian Development Bank (ADB) approved a $200 million loan, called the Second Development Finance Loan (DFL II), from ordinary capital resources (OCR) to the Republic of Indonesia. The First Development Finance Loan (DFL I), also of $200 million, approved in October 1989, had been implemented fairly satisfactorily.1 2. The project loan had two principal and two secondary objectives. The two principal objectives were to help develop the non-oil export-oriented manufacturing sector, and to improve the financial intermediation process. The two secondary objectives were to help develop the narrow securities market, and to strengthen the financial condition of the assisted enterprises. 3. The first principal objective of helping to develop the non-oil export-oriented manufacturing sector was to be achieved by providing DFL II with $200 million for financing the foreign currency component of such industries. At appraisal, it was considered that such industries in the private sector needed to be supported by long-term loans, preferably in foreign currency, and that such loans were in short supply owing to the continued short-term orientation of the financial system. At appraisal, the pipelines of export-oriented private manufacturing projects of the nine participating financial intermediaries (PFIs) indicated capital goods import requirements of $600 million. Additions to the pipelines during 1993-1995 were expected to further increase such import requirements. The Project, through the $200 million loan, provided the needed foreign currency for financing part of these investment requirements. About 100 subprojects with total fixed investment of about $700 million were expected to benefit from the Project. These were expected to have annual sales of around $700 million (over half from exports) and directly employ about 35,000 people. 4. The second principal objective of helping to improve the financial intermediation process was to be achieved through the involvement of nine PFIs. These were expected to provide a large branch network, allowing a wide selection of subprojects, encouraging institutional competition, and providing a wider choice of funding sources to borrowers. Seven of the nine PFIs were private PFIs (PPFIs) and were to provide strong private sector orientation to the Project. Two of the nine PFIs were state-owned PFIs (SPFIs). The mix of state banks and private banks was expected to draw on their various strengths: the large size and term-lending experience of the state banks and the efficiency, drive, and strong commercial orientation of the private banks. The inclusion of two of the better state banks was also expected to represent the state bank sector (which accounted for about half of the banking sector’s assets), help in institutional strengthening of these banks, and expose them to competition. The loan was also expected to instill stronger discipline in the PFIs by requiring them to comply with various financial covenants for continued participation under the Project. The PFIs were also required to observe strict accounting standards. 5. The first of the secondary objectives of helping to develop the narrow securities market was to be achieved by increasing the number of PFIs listed on the stock exchange. The PFIs were also expected to raise long-term rupiah funds from the market to make them more self-reliant in long-term funding, help reduce the short-term orientation of the financial system, and

1 The project completion report was circulated to the ADB Board in January 1996 (Doc. INO 23045).

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to stimulate the primary market for tradable debt instruments. The second of the secondary objectives of helping to strengthen the financial condition of the assisted enterprises was to be achieved by subjecting the assisted enterprises to some financial covenants and to stronger accounting and reporting requirements. 6. The Project was designed, as in the case of DFL I, as an umbrella credit line. The Government would relend the ADB loan in dollars to the nine PFIs – directly to two SPFIs and through Bank Indonesia (BI), the central bank, to the seven PPFIs. The PFIs in turn would onlend in dollars to eligible subprojects (i.e., manufacturing export enterprises in the private sector) for financing the foreign currency content of their investment costs. 7. For the first time in an ADB credit line to Indonesia, the proposed subloans were to be denominated in dollars with the foreign exchange risk being passed on to the subborrowers, so as to enhance market orientation in financial intermediation. The required export-orientation of the subprojects was to help subborrowers counteract the foreign exchange risk, and make the Project self-servicing in foreign currency. B. Scope of Operations

1. Participating Financial Intermediaries 8. The nine PFIs were: two SPFIs, namely, Bank Negara Indonesia (BNI) and Bank Ekspor Impor Indonesia (EXIM) and the seven PPFIs, namely, Bank Bali (BALI), Bank Dagang Nasional Indonesia (BDNI), Bank Danamon Indonesia (DANAMON), Bank Internasional Indonesia (BII), Bank Niaga (NIAGA), Lippo Bank (LIPPO), and Panin Bank (PANIN).

2. Performance Criteria 9. DFL II specified criteria for both initial eligibility and continued participation of PFIs in the loan (see Appendix 1 for details).

3. Major Terms and Conditions 10. The main loan terms and conditions were given in paras. 74 to 99 of the report and recommendation of the President (RRP) (RRP:INO 26194) as follows: (i) the loan in US dollars, from ADB’s OCR, would be repayable over 15 years, including a grace period of four years, and with a variable interest rate determined in accordance with the pool-based dollar facility (6.63 percent at appraisal); (ii) the Government would relend the proceeds, in dollars, to the PFIs for 15 years, including a grace period of four years, at ADB’s rate plus 0.5 percent (7.13 percent, at appraisal); and (iii) the loan proceeds would be onlent by the PFIs to subborrowers in dollars at interest rates reflecting market rates in Indonesia for dollar loans. The subloans, in the range of $0.1 million-$4.0 million, would be repayable to the PFIs within eight years, including a grace period not exceeding two years. The PFIs would recycle the subloan principal recoveries to eligible enterprises, pending repayment by the PFIs to the Government.

4. Asian Development Bank’s Relationships with other Lenders and

Participating Financial Intermediaries

11. The World Bank had a related project called the Financial Sector Development Project (FSDP) in place at the same time as this Project. It aimed to strengthen the five state

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commercial banks (SCBs)2 and the prudential banking regulations, and to improve the supervisory skills of BI. The FSDP consisted of an investment credit component of $300 million and a technical assistance component of $7 million. The FSDP’s objectives were not achieved as the competitiveness and efficiency of the SCBs did not improve significantly and their portfolios continued to be of poor quality. The other lenders to the FSDP were the local banks, mainly the PFIs, providing working capital for the subprojects. ADB’s relationships with the World Bank and PFIs were satisfactory. C. Rationale for the Asian Development Bank Loan 12. The rationale for the Project was that the expected increase in non-oil exports would help sustain imports essential for growth, reduce the current account deficit, and strengthen debt-service capability. The Project was also expected to serve as a vehicle to follow up the implementation of reforms under ADB’s Second Financial Sector Program Loan (FSPL II).3 The Indonesian economy was performing satisfactorily at the time of the approval of the Project in March 1993 (see para. 13 below). The timing of the Project was also considered appropriate as the country needed to develop an alternative source of foreign currency earnings, as against the traditional oil exports, to increase foreign currency earnings and reserves. Comments on project design and formulation are given in Chapter III (Evaluation).

II. IMPLEMENTATION

A. Economic and Financial Sector Developments 13. The economic and financial sector developments are detailed in Appendix 2. During the DFL II utilization period (March 1994 to March 1999), the Indonesian economy experienced upheavals. In the 1990s and up to the time of the financial crisis in the third quarter of 1997, overall GDP growth exceeded 7 percent a year. In this vibrant economic environment, external trade and the financial sector were liberalized. This led to large capital inflows and investment as the private sector resorted to borrowing, mainly over the short-term with rollover facilities, and at competitive interest rates, from external sources. As a result, external debt obligations relative to foreign reserves increased sharply. The outcome was that the rupiah came under speculation at the time of the financial crisis in Thailand, and its value dropped considerably.4 The huge depreciation led to the insolvency of many enterprises and this in turn adversely affected the operation of the financial sector. The result was a reversal of Indonesia’s development gains achieved over more than two decades. The most severe macroeconomic impact of the crisis was felt in the financial sector.

2 Bank Bumi Daya (BBD), Bank Dagang Negara (BDN), Bank Ekspor Impor Indonesia (EXIM), Bank Negara

Indonesia (BNI), and Bank Rakyat Indonesia (BRI). Two of these SCBs, namely, BNI and EXIM, were expected to participate under this Project but did not do so ultimately.

3 Ten policy actions pursued under FSPL II were: (i) compliance with BI’s prudential requirements on capital adequacy; (ii) new accounting standards for banks; (iii) implementation guidelines to make the laws on insurance and pension funds fully effective; (iv) reduction of BI’s liquidity credits as a ratio of other credits in the banking system; (v) setting up of a mechanism for developing a market-based interbank rate; (vi) separation of Jakarta Stock Exchange from the Capital Market Supervisory Agency (BAPEPAM); (vii) study of BAPEPAM’s human resources needs; (viii) elimination of restrictions on convertibility of bonds; (ix) issue of comprehensive guidelines for the establishment, operation, and regulation of investment funds; and (x) development of market-based benchmark short-term interest rates through the Sertifikat Bank Indonesia auctioning system.

4 Per one dollar, the value of the rupiah stood at about 2,400 in 1996; dropped to as much as 16,000 at the height of the financial crisis in June 1998; averaged about 8,000 in 1998 and 6,900 in 1999; and dropped again and stood at 11,400 on 1 July 2001.

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14. The reforms to liberalize the banking sector had encouraged the establishment of a large number of banks. In June 1997, the banking sector in Indonesia consisted of 238 commercial banks, but by mid-2001, 70 banks had been closed, 13 nationalized, and four of the seven state banks merged into a new giant state bank called Bank Mandiri. One of the two SPFIs, namely EXIM, had also been merged into Bank Mandiri and had ceased to be a separate entity. The other SPFI, namely BNI, had been restructured/recapitalized by the Government and continues to operate, albeit with portfolio problems.5 One of the seven PPFIs, namely BDNI (see Appendix 3), had been in liquidation since August 1998, as its financial condition was considered beyond redemption. Eleven private banks have been restructured/recapitalized by the Indonesian Bank Restructuring Agency (IBRA) including five PPFIs, namely LIPPO (see Appendix 4), NIAGA (see Appendix 5), BII (see Appendix 6), BALI (see Appendix 7), and DANAMON (see Appendix 8). All of them ran into financial distress at the time of the financial crisis due to foreign currency loans for domestic expenditure carrying currency risk exposure, and large loan exposures to affiliated companies and to large companies. The 11 restructured/recapitalized banks, including the five PPFIs, are now either fully or majority owned by the Government due to recapitalization and are no longer private banks. Further, despite restructuring and recapitalization, most of these banks, including the five PPFIs, continue to suffer from a large proportion of nonperforming loans (NPLs) in their portfolios and in some cases from capital inadequacy. Their financial condition continues to be fragile and they are not in a position to play any meaningful role in making new investment loans. Plans for divestment of government ownership are under development. Only PANIN, one of PPFIs, survived the financial crisis without government recapitalization as it was oriented toward small and medium enterprises and did not have too much currency risk exposure. B. Lending Policies 15. Learning from the lessons of the financial crisis in 1997, the existing PFIs have considerably improved and strengthened their lending policies. Prior to the financial crisis, the PFIs were engaged in imprudent lending policies such as providing foreign currency loans to finance domestic expenditure, including real estate development, thereby exposing themselves to currency risks6 and such as having large loan exposures to affiliated companies and relatively large companies. These imprudent lending practices led to many business failures and NPLs, and caused financial distress to PFIs and other banks. The PFIs no longer provide foreign currency loans to finance domestic expenditure and thereby have eliminated their exposure to currency risk. Further, any foreign currency loans to finance such expenditure are now given only after the PFIs have made adequate hedging arrangements. The PFIs have now also restricted large loan exposures to affiliated and relatively large companies to reduce the impact of any large increases in debt-service costs. 16. BI has also influenced more prudent banking by requiring banks to adhere to prudential regulations in terms of the capital-adequacy ratio (CAR),7 reserve requirement,8 legal lending

5 In December 2000, its loans classified as current came to only 75 percent and its nonperforming loans (NPLs) to

25 percent. 6 Prior to the financial crisis in the third quarter of 1997, the difference in the lending rates of the rupiah and the

dollar was about 10 percent. Given a depreciation rate of about 3 percent per annum of the rupiah at that time, borrowers had a net gain of about 7 percent per annum on dollar borrowings (of course, on the misplaced confidence on the continued strength of the rupiah at that time).

7 Capital to risk-weighted asset ratio of at least 8 percent. 8 Reserves of at least 5 percent on rupiah resources and 3 percent on foreign currency resources.

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limits,9 loan classification and provisioning,10 and loans-to-deposits ratio.11 Further, since June 1998, BI has required banks to publish summarized income statements and balance sheets, in the leading newspapers, on a quarterly basis, to ensure good governance in terms of better transparency and disclosure. BI has also undertaken staff training to strengthen its capacity to enforce prudential regulations. The banks, including the PFIs, are now focusing on credit risk management in line with lessons learned during the financial crisis. These policy improvements are positive developments. C. Second Development Finance Loan Utilization Rate 17. After ADB Board approval of DFL II in March 1993, the Loan and Project Agreements were signed in August 1993 and the loan was made effective in March 1994, four months after the date specified in the Loan Agreement of November 1993. Accordingly, the loan commitment date and loan closing dates were extended from November 1996 and November 1997 to March 1997 and March 1998, respectively. Due to slow utilization, the loan commitment closing date was extended for a second time to March 1998 and the loan closing date was extended for a second time to March 1999. The loan commitment closing date was extended for a third time to June 1998. In November 1995, ADB, at the request of the Government, relaxed some loan conditions to facilitate loan utilization as follows: (i) increased the free limit for each PFI from $1.0 million to $3.0 million; (ii) replaced the PFIs’ full report to ADB on capital adequacy and other performance criteria with BI’s compliance certificate; and (iii) allowed subloan projects to meet loan covenants on debt-equity and debt-service coverage two years from the start of operations. Despite these extensions in both the loan commitment and closing dates, and the relaxation of some loan conditions, the loan was used only up to $75.4 million. Thus, $124.6 million was cancelled, out of the loan amount of $200 million. 18. There were two principal reasons for the less than satisfactory utilization of DFL II. First, alternative sources of borrowings became available to the target group of subborrowers on increasingly competitive terms. The interest rate mechanism available for ADB’s public sector loans at the time of appraisal and approval of DFL II included the currency pool and the pool-based single currency mechanism. It was recognized at appraisal that the pool-based dollar mechanism used for DFL II faced interest rate competition from short-term lending based on the London interbank offered rate (LIBOR) that was available to many potential subborrowers directly from foreign sources, from branches of foreign banks operating in Indonesia, or from offshore funds raised by local banks. Nevertheless, the availability of longer-term loans under DFL II was expected to offset concerns regarding interest rate competition. During the loan commitment period, the average borrowing rate to PFIs from DFL II was marginally higher than typical LIBOR funding to PFIs.12 Even when the ADB rate was lower, subborrower expectations were for the more volatile LIBOR-based rates to decline and become more attractive in the future.

9 Loans to controlling shareholders not to exceed 30 percent of equity and to be reduced to 25 percent and 20

percent by 2002 and 2003, respectively; and loans to affiliated companies not to exceed 10 percent of equity. 10 Provisions to be made as follows: arrears up to 30 days—1 percent; up to 90 days—5 percent; up to 180 days—

15 percent; up to 270 days—50 percent; and over 270 days—100 percent. BI also required banks to reduce NPLs (interest and principal payments 90 days overdue) to 5 percent of loan portfolio gross of provisions by end-2001.

11 Loan-to-deposit ratio (LDR) to have a maximum range of 90-110 percent. 12 During the loan commitment period (i.e., 1994 to 1998), the yearly average borrowing rate under LIBOR plus (say)

1.25 percent markup came to 7.08 percent vis-à-vis ADB’s pool-based average rate of 7.31 percent during that period.

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19. Subsequent to loan approval in March 1993, developments in the region’s banking and capital markets further increased the competition for DFL II. From 1995, a number of local banks were increasingly able to access dollar funding on international markets that was highly competitive on interest rates, and substantially met the long-term maturity features offered by DFL II. For example, DANAMON, one of the PPFIs, raised offshore funds of $30 million in June 1995 and $100 million in November 1996, through the issue of floating rate notes (FRNs), which had a tenor of about five years (69 percent of DFL II subloans, by amount, had a maturity of less than five years) and at an average interest rate of about 5.25 percent plus 100 basis points, giving a total interest rate of about 6.25 percent, as against ADB’s pool-based average interest rate of about 7.31 percent to PFIs during that time. Also, BDNI raised $100 million on similar terms from FRN issuance in 1995. Although this alternate source of funding has ceased since the crisis, the PFIs had a strong incentive to fund potential borrowers from such sources in preference to DFL II. 20. Following approval of DFL II in March 1993, ADB introduced the more competitive LIBOR-based interest rate mechanism for development finance institution (DFI) loans in August 1994. This was not, however, automatically available on a retroactive basis to DFL II. Consideration was given to seeking Board approval to change to the new interest rate mechanism, but this was not pursued (see para. 38). Accordingly, DFL II became increasingly uncompetitive during a major portion of the loan commitment period and the interest rate issue, although identified, remained unresolved. 21. The second reason for slow utilization of DFL II was that the PFIs and subborrowers found ADB’s financial covenants (for example, 30 percent equity required from subborrowers and the need for subprojects to have maximum debt-equity ratios of 60:40 and minimum debt service coverage ratios of 1.25) and other requirements (for example, environmental impact reports) too time consuming for compliance. The combination of these two reasons dissuaded many potential subborrowers from using the ADB loan and they therefore sought alternative sources of credit. Also, some of the loan conditions were relaxed, as referred to earlier, only after about two years of the loan commitment period had already elapsed. Therefore, the relaxations did not have much impact on increasing loan utilization. 22. A further reason contributing to low loan utilization was the long delay encountered between the submission of subloan withdrawal applications and receipt of funds by the PFIs. The delay was as much as six months in some cases. That was the result of a subloan withdrawal application in respect of each subloan having to take a time-consuming route from the PFI—Ministry of Finance—Indonesia Resident Mission—ADB in Manila—BI, before receipt of funds by the PFI. In the interim, the PFIs had to provide bridging loans in local currency at interest rates higher than those of the subloans, which increased the cost of funds to the subborrower. 23. A further discouragement in attracting and retaining PFIs for DFL II was the series of financial and reporting covenants placed on the PFIs (see paras. 35 and 36). Most covenants were additional to the existing prudential and reporting requirements placed on banks by BI. The ADB covenants generally reflected previous experience in DFI lending where ADB was often a major lender to a DFI. However, DFL II was to be shared among nine PFIs, many of which were of a significant size prior to the crisis. Accordingly, the expected DFL II borrowing by individual PFIs would amount to no more than 2-3 percent of total assets in the case of most PFIs. Under these circumstances, it was not surprising that PFIs were reluctant to accept the burden of additional covenants imposed by DFL II.

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24. For the above reasons, the two SPFIs, namely BNI and EXIM, decided in November 1995 not to proceed with participation under DFL II. At the same time, PANIN, one of the seven PPFIs, decided not to proceed with participation as it was mainly oriented toward lending to small and medium enterprises and found it difficult to identify export-oriented clients requiring foreign currency loans. Thus, only six PPFIs (BDNI, LIPPO, NIAGA, BII, BALI, and DANAMON) ultimately participated in DFL II out of the original nine PFIs. This reduction also contributed to the low utilization rate of DFL II. D. Characteristics of Subloans

25. A total of 50 subloans were financed by DFL II of which 48 subloans for $67.4 million or 89 percent by amount were below the free limit. Therefore, only two subloans for $8 million or 11 percent by amount were subjected to ADB’s detailed scrutiny and acceptance of the PFIs’ appraisal standards. By amount, 94 percent of the subloans were for expansion projects while 79 percent (90 percent under DFL I) were in the province of Java and the balance in other provinces such as Sumatra and Sulawesi, and in regions such as Bali and the small islands of Batam and Bangka. About 31 percent of the subloans, by value, financed the textile subsector, 19 percent benefited the chemical subsector, and 13 percent were extended to the food-based subsector. Nonmetallic minerals and agriculture-based subsectors accounted for 12 percent each. In regard to subloan maturity, 69 percent of subloans by amount were for less than five years and the balance of 31 percent for periods of between five and 10 years. The subloans were generally helpful in developing medium-sized firms into export-based enterprises as could be seen from the incremental export sales achieved by the subprojects. The details of procurement by the PFIs are given in Appendix 9. E. Implementation and Internal Operations of Subprojects 26. Data on subproject implementation and internal operations were not readily available from the PPFIs for two reasons: first, due to the general disarray of their operations as a result of the financial turmoil the PPFIs had encountered recently, transfer of NPLs to IBRA, and to recapitalization exercises; and second, the absence of computerized data systems, which caused delay in the collection of subproject data. Table A10.1 of Appendix 10 gives the subproject implementation indicators. 27. The project completion report (PCR) Mission visited 15 of the 50 subprojects (30 percent). They represented a sample of those in Java and in other provinces and regions and those of all the PPFIs. Apart from a palm-oil subproject,13 all the subprojects visited were profitable, and meeting debt-service obligations on time. All other subprojects were also reportedly completed by the time of the Mission. Most of the subprojects were completed within the estimated time and cost frameworks; only two subprojects had a delay of six months each, and one subproject had a cost escalation of about 289 percent (due to cost increases in machinery imports and building construction mainly due to the impact of the financial crisis), which accounted for the cost overrun average of 8.9 percent for all 15 subprojects of BALI. The Mission visited the projects related to the two subloans above the free limit that were approved by ADB and found them to be operating satisfactorily.

13 This palm-oil processing subproject was on Bangka island. Machinery installation has been stopped due to cost

escalations; restructuring by IBRA is under way.

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F. Operational Performance of Participating Financial Intermediaries 28. Details for this section for each PPFI are in Appendixes 3-8. G. Financial Performance of Participating Financial Intermediaries 29. The financial performance of the subprojects is analyzed in Table A10.2 of Appendix 10.

30. At the time of the PCR Mission, about 32 percent of the subprojects were underperforming against original estimates, but only 18 percent of the subprojects were in arrears. The main reason for the arrears was the increase in debt-servicing costs as a result of the rise in interest rates of their local currency borrowings at the time of the financial crisis. The arrears in respect of two subprojects were due to failure in making successful exports on account of intense international competition in the case of one subproject, and due to stoppage of machinery installation in respect of the other (i.e., the palm-oil subproject). The balance of 82 percent of the subprojects were profitable and meeting their debt service obligations on time. Only one subproject included in this category, i.e., that of LIPPO, had been rescheduled for two years due to the impact of the financial crisis, but was now making subloan repayments on time. 31. The socioeconomic indicators are given in Table A10.3 of Appendix 10. The 50 subprojects financed by DFL II made a total investment of Rp692.2 billion ($60.7 million), generated exports of Rp1,550.5 billion ($135.9 million) per annum, and created 10,669 new jobs at an incremental cost of Rp64.9 million ($5,690) per job. Despite the smaller than anticipated impact indicated earlier, the 50 subprojects financed under the loan are considered fairly satisfactory in terms of contribution to socioeconomic development. H. Financial Statements and Ratios 32. The details of the performance of the PPFIs are in Appendixes 3 to 8. Their latest key performance indicators as of 31 December 2000 are summarized in Table A10.4 of Appendix 10. Generally, the PFIs complied with ADB loan covenants, and adhered to BI’s prudential regulations, prior to the financial crisis. Therefore, their viability and sustainability were being strengthened slowly at that time and they continued to be eligible for participation under the Project. However, their viability and sustainability became questionable under the impact of the financial crisis. 33. Despite restructuring and recapitalization, the financial health of the remaining five PPFIs (i.e., LIPPO, NIAGA, BII, BALI, and DANAMON), remain fragile. As seen in Table A10.4 of Appendix 10, their portfolio qualities continue to be unsatisfactory. Loans classified as current ranged between 92 percent (DANAMON) and 67 percent (BALI) while the NPLs ranged between 8 percent (DANAMON) and 33 percent (BALI). ADB covenants required the loans classified as current to be at least 97 percent. None of the PPFIs met that requirement. BI required banks to increase the loans classified as current to at least 95 percent by December 2001. It is unlikely that any of the PPFIs will be able to meet that requirement. Following recapitalization, the CAR levels of four out of the five PPFIs (i.e., except BII) are well above the minimum of 8 percent as prescribed by BI and ADB. If the present unsettled economic conditions continue with high interest rates and volatile exchange rates, the NPLs are likely to increase, further eroding the CAR levels in the future. Because of continuing CAR problems of BII, it is at an advanced stage of being merged with the state-owned Bank Mandiri and would cease to exist as a PPFI in the future.

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34. All the five PPFIs are highly liquid at the moment as indicated by the low loan-to-deposit ratios (LDRs). This reflects a diminished portfolio size following the transfer of large numbers of NPLs to IBRA. Also, their deposit bases have generally continued to increase despite their poor financial health, reflecting the Government’s blanket guarantee given to all third-party depositors. In addition, the liquidity positions are high because of the lack of demand for loans in the present uncertain economic environment. BII’s liquidity level is less than the others as a large number of NPLs still remain in the portfolio without being transferred to IBRA for collection. Judging by the returns on assets (ROAs), none of the five PPFIs is operating efficiently. As against ADB’s minimum ROA requirement of at least 1.0 percent, only LIPPO met that requirement with a ROA of 1.1 percent in 2000. The ROAs of the others are well below that minimum requirement with BALI recording a negative ROA of about 11.87 percent in 2000. I. Covenant Compliance Status 35. The covenant compliance status of the six PPFIs is not satisfactory (see Appendix 11). The six PPFIs met the covenants in terms of submitting their annual audited accounts to ADB on time and making cash collections on DFL II portfolio of at least 80 percent. The other covenants were not fully met as follows: (i) two of the PPFIs (BDNI and BALI) did not disclose BI’s CAMEL reports to ADB on time; (ii) three of the six PPFIs did not issue bonds to raise long-term funds from the market; (iii) four of the six PPFIs did not submit their Long Form Audit Reports to ADB; and (iv) five of the six PPFIs delayed submitting their regular reports to ADB. 36. The five PPFIs (data not available on BDNI) also failed to meet the financial covenants (see Appendix 12) after the financial crisis, i.e., in 1997 to 2000. The status of compliance with financial covenants improved after they were restructured and recapitalized during 1999 and 2000, but none of them met all the financial covenants. As of 31 December 2000, none of the five PPFIs complied with the financial covenant that required loans classified as current to be at least 97 percent; other than LIPPO, the other four PPFIs (NIAGA, BII, BALI, and DANAMON) failed to comply with the covenant that required the ROA to be at least 1.0 percent; and BII also failed to meet the covenant that required the CAR level to be at least 8 percent. J. Performance of the Borrower and the Participating Financial Intermediaries 37. The performance of the Borrower and the PFIs was mixed. The Borrower made the loan effective without significant delay. The Borrower and the PPFIs requested extensions in loan closing dates for commitment and disbursement as well as changes in loan pricing, and in loan terms and conditions, on time, to facilitate greater loan utilization and attainment of objectives. The Borrower, however, failed to request the deletion of the two SPFIs and one PPFI, namely PANIN, from participation under the project at a very early stage of project implementation. That would have given the opportunity to the Borrower to replace them with other PFIs capable of contributing to greater loan utilization. The Borrower also failed to have the subloan reimbursement procedure expedited. The delay in the reimbursement, to some extent, was caused from the side of the Borrower. On the other hand, the imprudent banking policies of the PFIs led to their financial distress under the impact of the financial crisis. The PFIs also failed to comply with the financial covenants as indicated earlier. Such failures did not help achieve the project objectives of improving the financial intermediation process and capital market development.

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K. Performance of the Asian Development Bank 38. ADB sent a total of 11 missions for the administration and review of DFL II. All these missions made efforts to facilitate greater loan utilization. They identified and discussed with the Government and PFIs at an early stage of loan commitment period the two main issues, i.e., the interest rate issue and ADB’s loan conditions that were adversely affecting loan utilization. At that stage, ADB should have acted on the Government and PFI request and converted DFL II from a pool–based dollar loan into a market-based loan to make it more competitive with commercial sources and to contribute to effective utilization of the loan. But that was not done, presumably, for two reasons. First, because that conversion necessitated ADB Board approval which entailed a lengthy and time-consuming procedure. Second, ADB expected the loans from commercial sources to become more expensive than ADB’s pool-based interest rate in the future and hence no action was taken. However, loans from commercial sources did not become more expensive than ADB’s pool-based interest rate. Thus, the interest rate issue continued to be unresolved and hence contributed to the low utilization rate of DFL II. The relaxation of loan conditions made in November 1995 did not help increase loan utilization as it was made too late during the loan commitment period to have a significant impact on loan utilization.

III. EVALUATION A. Loan Appraisal 39. The objectives and rationale for the Project were satisfactory. However, the Project design had shortcomings that prevented the achievement of the twin objectives of developing a non-oil based export industry and improving the financial intermediation process. These are detailed below. 40. The pricing mechanism was flawed. The interest rate should have been market-based rather than ADB’s standard single currency pool-based, to have made the ADB loan competitive with commercial rates. While ADB did not have a market-based facility available at the time of loan approval, it was introduced for DFI loans in 1994. This could have been introduced for DFL II at that time, albeit at the extra effort of a separate Board paper for this purpose. It appeared that potential subborrowers preferred cheaper interest rates from commercial sources to longer maturities under the ADB loan. At the time of project approval in March 1993, the relending rate of the ADB loan was 7.13 percent. However, during the loan commitment period (i.e., from 1994 to 1998), the yearly average borrowing rate under LIBOR plus (say) 1.25 percent markup came to 7.08 percent vis-à-vis ADB’s pool-based average rate of 7.31 percent during that period. 41. While endeavoring to develop private sector enterprises and PPFIs, DFL II introduced too many traditional DFI-type terms, conditions, and controls (para. 21), which constrained the quick approval and dispensing of credit as needed by private sector enterprises. The long time taken to comply with these conditions led to delays in project implementation, and to missed opportunities in export markets. The excessive use of terms, conditions, and controls to achieve project goals proved unsuccessful. Hence, potential subborrowers looked for alternative sources of financial assistance with less rigorous conditions. 42. The time-consuming subloan reimbursement procedure set up under DFL II increased the cost of funds to the subborrower. This cost factor also dissuaded potential subborrowers.

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43. The PFIs should have been selected using a more rigorous analytical process in terms of participation interest. That would have eliminated the two SPFIs and PANIN from participation at the appraisal stage and enabled their replacement with more suitable PFIs. 44. Thus, the principal objective of the Project in terms of financing about 100 subprojects, with the attendant socioeconomic benefits, as estimated at appraisal, was not achieved. 45. The policy framework and management of the PFIs should have also been subjected to more rigorous analysis and interpretation at appraisal. That would have shown the flawed policy and management decisions of PFIs in their general operations, particularly in providing foreign currency loans to borrowers that had no means of managing the currency risk involved, and in providing large loans to affiliated companies. Those factors ultimately led to the financial distress of eight of the nine PFIs until government bailout and recapitalization, and ultimate ownership by Government. Thus, the second of the principal objectives of helping to improve the financial intermediation process was not achieved either. 46. The first of the secondary objectives of contributing to develop the narrow securities market was partially achieved. Three of the six PPFIs raised long-term funds through the issue of bonds. As required, BNI listed on the Jakarta Stock Exchange in July 1996, but EXIM failed to do so. The second of the secondary objectives of strengthening the financial conditions of the assisted subprojects was partly met as most of the successful subprojects (about 70 percent) subjected themselves to stronger financial discipline, accounting, and reporting requirements. They were profitable; maintained sound financial positions in terms of equity, debt/equity ratios, and debt-service coverage ratios; met debt-service obligations on time; had their annual accounts audited on time and submitted them to the respective PFIs on time; and met their reporting requirements to the respective PFIs on time. 47. The Appraisal Mission recognized the interest rate issue (para. 103 of the RRP), as follows: (i) ADB’s relending rate at that time (7.13 percent including the Government markup of 0.50 percentage points) was higher than the prevailing dollar-deposit rates of 5.5-7.0 percent paid by the SPFIs, and just comparable with the rates of 7.0-7.5 percent paid on dollar deposits by the PPFIs; and (ii) the margins of lending rates of 4.0-5.0 percent on dollar loans in Indonesia were higher than the margins of 2.5-4.0 percent on dollar on-lending of PFIs. 48. Further, the average 12-month (the longest term available) dollar LIBOR rate, at the time of project appraisal in March 1993, was 3.606 percent and plus (say) 1.25 percent markup, the LIBOR rate at project appraisal for the PFI would have been about 4.856 percent. However, the Appraisal Mission appeared to conclude that these attractive interest rates of commercial sources could be overcome by: (i) the attractiveness of long-term maturities being made available under the ADB loan; and (ii) the expectations that the six-monthly variations in interest rates over the long term under the ADB loan would be lower than the variations in floating rates based on LIBOR. 49. However, the Appraisal Mission’s expectations were not realized during project implementation. The interest rates for commercial loans based on LIBOR were generally slightly less or comparable to those of ADB’s pool-based loan during project implementation. Potential subborrowers were not willing to pay a marginally higher interest rate and face more rigorous conditions for the benefit of accessing longer-term maturities under DFL II. That was the primary reason for the very low loan utilization rate of DFL II.

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50. The Appraisal Mission also felt that any significant fall in dollar lending rates could squeeze lending margins to a point that made the ADB loan unattractive to the PFIs and jeopardize loan utilization. While that was considered a risk to loan utilization, any significant fall in dollar lending rates in Indonesia in the near term was discounted by the Appraisal Mission, given the shortage of foreign currency resources in the country. However, the difference in the margins between the dollar loans and dollar on-lending rates of PFIs that prevailed at the time of the appraisal continued during the loan commitment period and that was sufficient to jeopardize loan utilization, even without a significant fall in dollar lending rates. B. Implementation 51. Project implementation was not satisfactory. The loan was used only up to $75.4 million and the balance of $124.6 million was cancelled. The Government and ADB took steps to increase loan utilization by: (i) extending the loan closing date for commitment three times for about two years and the loan closing date for disbursement two times for about one and half years; and (ii) relaxing some of the loan conditions in November 1995. These changes, however, did not help increase loan utilization. The relaxation of the loan conditions took place too late to have significant impact—i.e., after about two years of the loan commitment period had expired. By this stage, there was increasing availability of alternative funding for up to five years maturity under the FRN issues by PFIs. The nonparticipation of the two SPFIs and one of the PPFIs, namely PANIN, was another reason for the low loan utilization rate. The nonresolution of the interest rate issue by ADB, however, appeared to be the primary contributory factor in the low loan utilization rate of DFL II. 52. Although the five PPFIs have now been restructured and recapitalized, all are in a fragile financial condition as they continue to have poor quality portfolios and some have capital inadequacy. Therefore, their sustainability depends on the return of business confidence and on the general improvement in the economy. 53. On the development of the narrow securities market aspect, the following should be noted: (i) three of the six PPFIs issued bonds and raised long-term funds for lending and thereby increased their term-lending resources, and reduced their liquidity mismatch positions to some extent; and (ii) as required, one of the two SPFIs, namely BNI, listed on the Jakarta Stock Exchange, but EXIM did not do so. Further, the 10 policy actions under FSPL II (para. 43 of RRP and referred to earlier), were implemented satisfactorily and the second tranche was released in 1994, i.e., during the loan utilization period of DFL II. 54. On the other hand, about 70 percent of the subprojects financed under the ADB loan are operating satisfactorily. Since all of them are export-oriented, they are generally protected from major changes in the exchange rate.

IV. CONCLUSIONS AND RECOMMENDATIONS

A. Conclusions and Assessment of Overall Project Performance 55. The Project had the right objectives and rationale. However, those objectives could not be achieved due to serious shortcomings in project design. Therefore, the overall assessment is that the Project was unsuccessful. The details of this assessment in terms of relevance, efficacy, efficiency, sustainability, and institutional development and other impacts are detailed in Appendix 13, and the rating assessment is given in Table A13.5 of Appendix 13.

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B. Lessons Learned 56. Three lessons can be learned from this Project, relating to project design, project implementation, and subloan reimbursement procedure, as detailed below. 57. Project Design. As far as possible, ADB should not mix private sector-related lending practices with those of the traditional DFI-type lending such as the subloan conditions prescribed for the subborrowers/subprojects and the loan conditions prescribed for PFIs. First, the pricing of ADB’s private sector-related loans should be competitive with those of commercial sources, and second, ADB loan conditions and controls should be kept to the bare minimum. Otherwise, private sector banks and subborrowers will seek alternative sources of finance, as happened under this project. The numerous loan conditions and controls should be replaced by specific guidelines, which should be properly laid down and well explained, up front, to all participating parties. Thereafter, the project should be allowed to proceed in accordance with existing practices and market conditions. For example, the responsibility for proper appraisal and monitoring of subprojects should be placed with the PFIs in accordance with their internal policies and procedures, while the proper supervision of the PFIs should be left to BI in accordance with its prudential regulations. Steps, of course, should be taken by ADB to strengthen the project appraisal and monitoring capability of the PFIs and the prudential regulations enforcement capability of the BI. Thereafter, the proper enforcement of these capabilities should be followed up by regular ADB missions. Once the BI’s prudential regulations regime meets acceptable standards and its capacity for their enforcement is adequately strengthened, the need for additional financial covenants for both subprojects and PFIs is reduced. 58. Project Implementation. ADB should respond quickly with necessary changes in terms and conditions as requested by the Government and PFIs during project implementation. As discussed above, ADB left the interest rate issue unresolved, although the Government and the PFIs requested a change from ADB’s pool-based interest rate to a market-based interest rate, at a very early stage in project implementation. Had that been done at an early stage, loan utilization and attainment of project objectives would have been much greater. The extensions made in the dates for loan commitment and closing, and the relaxations made in some loan conditions, were largely ineffective in achieving these aims. 59. Subloan Reimbursement Procedure. The long and time-consuming subloan reimbursement procedure increased the cost of funds to the private sector subborrower. Such increased costs, in turn, reduced the competitiveness of the export-oriented subprojects. Therefore, ADB should take steps to shorten that procedure as much as possible. C. Recommendations

1. Project-Related Recommendations 60. ADB should take the following steps:

(i) procure data on subloans, subprojects, PPFIs, and those required for subproject monitoring and evaluation included in the International Computerized Banking System (ICBS) now being installed by banks, including the five PPFIs that would facilitate the storage and quick retrieval of data essential for ADB work;

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(ii) reduce the long and time-consuming subloan reimbursement procedure. One way to do this would be to adopt ADB’s present Imprest Account System;

(iii) persuade IBRA to expedite collections on the four subloans of BDNI with a total

outstanding amount of $6.9 million as of 31 July 1998, and ensure that the proceeds are handed over to the Government without delay;

(iv) ensure that the five PPFIs comply with ADB’s financial covenants now being

breached. Also, ensure that BI enforces its prudential regulations effectively to develop a sound and sustainable banking system for Indonesia. This could be achieved by, for example: ADB providing technical assistance for staff training, to strengthen the capacity of BI to enforce its prudential regulations; through regular monitoring by ADB of BI’s supervisory reports on PFIs and taking appropriate action; and requiring the annual independent audit reports of PFIs to have separate sections outlining their performance in meeting the various prudential regulations as prescribed by BI;

(v) discuss with the Government a time-bound plan for it to (i) divest its shares in

the five PPFIs so that they can revert to private ownership and management and (ii) ensure the operational efficiency of the five PPFIs; and

(vi) follow up the present proposal to merge one of the five PPFIs, namely, BII with

Bank Mandiri to ensure that loan collections on BII’s outstanding subloans are made on time and their proceeds handed over to the Government.

2. Asian Development Bank-Related Recommendations

61. The following measures are proposed:

(i) ADB should ensure that private sector-related loans are competitive with those from commercial sources. In this connection, the introduction by ADB of market-based loans for DFIs in 1994, and LIBOR-based loan products in 2001, represent important improvements. In Indonesia, any future ADB lending should seek to (a) reduce the markup given to the Government to 0.25 percent from the present 0.50 percent to make the cost of ADB loans more competitive; and (b) reduce to the bare minimum the DFI-type lending conditions and controls in respect of PFIs and subprojects and replace them with specific guidelines. These specific guidelines should be properly laid down and well explained to all participating parties;

(ii) if changes in any ADB loans terms and conditions are needed, such changes

should be comprehensive and be made at an early stage of project implementation in order to have maximum impact on loan utilization and attainment of objectives;

(iii) ADB should support measures to improve and strengthen the present

Bankruptcy Law in Indonesia. Defects in the present law are stalling corporate restructuring and sale of assets by IBRA. This, in turn, is slowing down corporate and bank recovery;

15

(iv) strengthen ADB staff capability in banking sector policy analysis and interpretation. The financial distress of banks at the time of the financial crisis was caused mainly by imprudent banking policies and inadequate management, which were not properly identified, analyzed, and interpreted at appraisal; and

(v) ADB should continue support to the Government to improve the nonbank

financial sector and capital markets (including the bond markets), as alternative sources of term-finance for private investment.

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LIST OF APPENDIXES

Number Title

Page

Cited on (page, para.)

1 Performance Criteria for Participating Financial Intermediaries

16 2,9

2 Economic and Financial Sector Developments

17 3,13

3 Overview of Bank Dagang Nasional Indonesia

21 4,14; 8,28; 8,32

4 Overview of Lippo Bank

25 4,14; 8,28; 8,32

5 Overview of Bank Niaga

30 4,14; 8,28; 8,32

6 Overview of Bank Internasional Indonesia

37 4,14; 8,28; 8,32

7 Overview of Bank Bali

44 4,14; 8,28; 8,32

8 Overview of Bank Danamon Indonesia

51 7,25

9 Details of Procurement by All Participating Financial Intermediaries

58 4,14; 8,28; 8,32

10 Implementation, Financial Performance, and Socioeconomic Indicators of Subprojects, and Performance Indicators of Participating Financial Intermediaries

59 8,33

11 Compliance with Loan Covenants

61 9,35

12 Summary of Compliance with Financial Covenants

63 9,36

13 Assessment of Overall Project Performance

65 12,33

Appendix 1

17

PERFORMANCE CRITERIA FOR PARTICIPATING FINANCIAL INTERMEDIARIES

1. The Second Development Finance Loan (DFL II) specified criteria for both initial eligibility and continued participation of participating financial intermediaries (PFIs) in the loan. The PFIs needed to comply with covenants for soundness, capital adequacy, risk exposure, profitability, loan recovery, and asset quality. The criteria had been based on Asian Development Bank’s experience with the First Development Finance Loan (DFL I), the prevailing conditions in Indonesia, and the need to promote the establishment of a strong and efficient banking system. 2. The PFIs were required to meet the following qualifying criteria, by 31 December 1992, for inclusion under the Project: (i) qualified as a foreign exchange bank;1 (ii) listed on the Jakarta Stock Exchange (JSE) (not applicable to state banks); (iii) rated sound based on the CAMEL2 rating system of Bank Indonesia (BI); and (iv) have a capital-adequacy ratio (CAR) of at least 5 percent using BI criteria. 3. To be eligible for continued participation in the Project, a PFI had to: (i) continue to be a foreign exchange bank; (ii) continue to be listed on the JSE (in the case of the state-owned participating financial intermediaries [SPFIs], the Government needed to take all necessary measures to satisfy the listing requirements of JSE by the end of 1996, provide ADB with annual written reports describing such measures, and consult with ADB in 1996 or an earlier date concerning the program of listing each of the SPFIs); (iii) continue to be rated sound, based on BI’s CAMEL rating system; (iv) achieve a CAR, as per BI criteria, of at least 7 percent from 31 March 1993 and at least 8 percent from 31 December 1993; (v) reduce single-loan exposure and group-loan exposure to below BI’s prescribed limits by 31 December 1994 and keep the exposure within BI’s limits thereafter; (vi) achieve an annual post-tax return on average assets of at least 1.0 percent from 1994; (vii) achieve an annual cash collection ratio on its DFL II portfolio of at least 80 percent; and (viii) maintain earning assets classified as current, using BI criteria, of at least 95 percent for 1993, improving to at least 97 percent from 1995.

1 A foreign exchange bank is a bank licensed by Bank Indonesia to deal in foreign exchange. 2 The CAMEL system is used by BI to rate banks on the basis of evaluation of capital adequacy (C), asset

quality (A), management (M), earnings (E), and liquidity (L).

Appendix 2

18

ECONOMIC AND FINANCIAL SECTOR DEVELOPMENTS

1. Economic Environment 1. During the Second Development Finance Loan (DFL II) utilization period (March 1994 to March 1999), the Indonesian economy experienced considerable upheavals. In the 1990s and up to the time of the financial crisis in the third quarter of 1997, overall gross domestic product (GDP) growth exceeded 7 percent a year. Further, the contribution of non-oil and non-gas manufacturing to aggregate GDP came to as much as one quarter of GDP by 1996 and thereby surpassed that of agriculture. Likewise, the services sector, including finance, grew rapidly. 2. In this vibrant economic environment, external trade and the financial sector were liberalized considerably. This led to large capital inflows and investment as the private sector resorted to borrowing, mainly over the short-term and with rollover facilities, and at competitive interest rates, from external sources. As a result, external debt obligations relative to foreign reserves increased sharply. The outcome was that the rupiah came under intense speculation at the time of the financial crisis in Thailand, and its value dropped considerably.1 The substantial depreciation led to the insolvency of many enterprises and this in turn adversely affected the operation of the financial sector. 3. The result was a severe reversal of Indonesia’s development gains achieved over more than two decades. Prudent macroeconomic management, however, restored macroeconomic stability by the third quarter of 1998. Overall GDP grew by 3-4 percent annually in the first six months of 2000, after 0.2 percent growth in 1999 and severe contraction of 13.2 percent in 1998. Although investments contracted for the second consecutive year in 1999, growth was positive in early 2000, following the pickup in exports. Continued increases in investment are crucial for sustaining and broadening the recovery. 4. Macroeconomic stability set the stage for recovery. Year-on-year inflation at the end of 1999 was only 1.9 percent compared with 78 percent at the end of 1998, and averaged 3.8 percent in 2000 and was 9.3 percent at the end of that year. A tight monetary policy, together with declining food prices and rupiah appreciation, caused a sharp drop in inflation in 1999.The rupiah, however, continued to be volatile and it weakened sharply in the second quarter of 2000, reflecting market anxiety over delayed reforms and a deteriorating political situation. Low inflation had permitted interest rates to fall close to precrisis levels,2 but the weakening of the rupiah undercut this positive trend. Business confidence remains low due to the volatility of the rupiah and uncertainties in the banking sector.

1 Per one US dollar, the value of the rupiah stood at about 2,400 in 1996; dropped to as much as 16,000 at

the height of the financial crisis in June 1998; averaged about 8,000 in 1998 and 6,900 in 1999; and dropped again and stood at 11,400 on 1 July 2001.

2 The interest rates of commercial banks for investment loans averaged 16.4 percent in 1996; after the financial crisis they increased to averages of 17.3 percent in 1997, 23.1 percent in 1998, and 22.9 percent in 1999 and stood at about 18.5-19.0 percent on 1 July 2001.

Appendix 2

19

2. Financial Sector Developments 5. Structural reforms are needed to rebuild investor confidence and sustain the recovery. The most severe macroeconomic impact of the crisis had been felt in the financial sector. The previous reforms to liberalize the banking sector had encouraged the establishment of a large number of banks. In June 1997, the banking sector in Indonesia consisted of 238 commercial banks, but by mid-2001, 70 banks had been closed, 13 nationalized, and four of the seven state banks merged into a new giant state bank called Bank Mandiri. One of the two SPFIs, namely Bank Ekspor Impor Indonesia (EXIM), had also been merged into Bank Mandiri and had ceased to be a separate entity. The other SPFI, namely Bank Negara Indonesia (BNI), had been restructured/recapitalized by the Government and continues to operate, albeit with portfolio problems.3 One of the seven PPFIs, namely Bank Dagang Nasional Indonesia (see Appendix 3), had been in the process of liquidation since August 1998, as its financial condition was considered beyond redemption. To support restructuring of banks and corporate debt, the Government had issued bonds valued at Rp645 trillion ($56.5 billion) for deposit guarantee and recapitalization. 6. The Indonesian Bank Restructuring Agency (IBRA), a unit under the Finance Ministry set up in January 1998, has been mandated the task of restructuring and selling assets.4 IBRA has restructured/recapitalized 11 relatively large private banks, including five PPFIs, namely, Lippo Bank (see Appendix 4), Bank Niaga (see Appendix 5), Bank Internasional Indonesia (see Appendix 6), Bank Bali (see Appendix 7), and Bank Danamon Indonesia (see Appendix 8). All of them ran into financial distress at the time of the financial crisis due to foreign exchange loans for domestic expenditure that carried currency risk exposure, and large loan exposures to affiliated companies and to large companies. These became nonperforming loans (NPLs) as the borrowers could not repay them at the hugely depreciated values of the rupiah and the highly increased interest rates prevailing at the time of the financial crisis. The increased NPLs forced the banks to set aside large amounts for bad-debt provisions, which drove them from profitable to loss-incurring situations. Additionally, the banks, including the five PPFIs, also ran into liquidity mismatch positions and could not meet obligations to depositors. The sixth PPFI, namely Panin Bank, survived the financial crisis and did not have to be restructured/recapitalized. This was for two reasons. First, its lending was more oriented toward small and medium enterprises with relatively small loans, for example, to domestic market-oriented producers (household goods, shoes, garments, handicrafts) and to local traders (rice, sugar, vegetables) whose-debt service costs did not increase as much as those of the relatively large companies at the time of the financial crisis. Second, it did not provide loans in foreign exchange to finance domestic expenditure and thereby did not expose itself to currency risks. 7. The 11 restructured/recapitalized banks, including the five PPFIs, are now either fully or majority owned by the Government due to the recapitalization. Therefore, they are no longer private banks until the Government decides to divest, for which there are

3 In December 2000, its loans classified as current came to only 75 percent and NPLs, 25 percent. 4 The new Government placed IBRA under the State Minister for State Enterprises with effect from 14

August 2001, to ensure synergy between the asset sales of both institutions.

Appendix 2

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no firm plans at present.5 Further, despite the restructuring and recapitalization, most of these banks, including the five PPFIs, continue to suffer from a large proportion of NPLs in their portfolios and in some cases from capital inadequacy. Their financial conditions continue to be fragile and they are not in a position to play any meaningful role in making new investment loans. Similarly, the state-owned Bank Mandiri, into which most of the state banks were merged, is also going through a period of consolidation. Therefore, that bank will also need some time before it can play a similar role. In the circumstances, there is a serious vacuum in the supply of term-finance for industrial development. Thus, an urgent need exists to get the banking system bank on operating track to begin making new investment loans and helping sustain the economic recovery. 8. The financial crisis has had a serious negative impact on the private sector, due to the sector’s substantial foreign exchange exposure prior to the crisis and the weak financial system. The large exchange rate depreciation caused private external debt to balloon, and this debt shock was quickly transmitted to the domestic banking system. Corporate debt restructuring is therefore urgently needed to restore the battered private sector to sound health. On the other hand, the further development of small and medium enterprises, which did not suffer as much as the larger companies at the time of the financial crisis due to their relatively smaller debt burdens, continues to be constrained by various factors. These are the need to borrow at relatively high interest rates from the informal credit market; excessive licensing, registration, and regulatory requirements at both central and provincial government levels; continuing operation of large monopolies and state-owned enterprises; and the slow progress of privatization. 9. Over the last 10 years, much has been done to strengthen prudential regulations and banking supervision, and the central bank has now become an independent entity. However, the financial distress suffered by the financial sector at the time of the financial crisis showed that some of the past reforms have either been inadequate, delayed, or not properly sequenced. For example, Bank Indonesia’s prudential regulations and its capability for their strict enforcement should have been put in place firmly prior to the liberalization of the banking sector. Similarly, a strong supervisory capability should have been put in place to supervise the external borrowings of banks and companies as well as lending foreign exchange loans to finance domestic expenditure without proper hedging arrangements. 10. Had these been done before bank liberalization, the impact of the financial crisis on the banking system would have been less severe. Some banking reforms have been introduced recently to improve transparency through better disclosure, while an anti-money laundering bill is due to be considered by Parliament. Bank Indonesia is also taking steps to further strengthen bank supervision through training, forward-looking risk analysis of banks, and setting up early warning systems to anticipate problems of banks. 11. However, further financial sector reforms are needed, first, to reduce the overdependence on the banking system, second, to reduce mismatch liquidity positions, and third, to overcome the present vacuum in the supply of term-finance for industrial development. Therefore, appropriate policies are needed to develop alternative sources of investment capital for the private sector, for example, through the development of

5 Plans are under way for IBRA to divest 40 percent of its 70 percent stake in Bank Central Asia (BCA), the

country’s largest retail bank. A 10 percent stake has already been sold through a public offering, while the sale of the 30 percent balance is held up pending assessment of bids from strategic partners.

Appendix 2

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nonbank financial institutions (NBFIs). NBFIs currently play a very small role in the economy. There is also considerable scope to expand the role of the capital markets, particularly to help long-term resource mobilization. Other needed reforms are in the following respects: (i) reform of the Bankruptcy Law to declare bankrupt uncooperative debtors and to facilitate restructuring of corporate debt and sale of assets by IBRA at a faster rate; (ii) divestment of government shares in the recapitalized banks to enable them to revert to private ownership and management; and (iii) reform of the cumbersome internal procedures and complex decision-making process of IBRA to facilitate quicker sale of assets. It controls about Rp600 trillion (about $53 billion) in assets taken over from debtors. So far, it has sold less than 20 percent of those assets. Accelerated debt restructuring and sale of assets are considered essential to get the corporate sector back into business and thereby help sustain the economic recovery.

Appendix 3

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OVERVIEW OF BANK DAGANG NASIONAL INDONESIA A. Background

1. Brief History and Ownership 1. Bank Dagang Nasional Indonesia (BDNI) was established in 1945. At appraisal, it was majority owned by the Nursalim family (80 percent) and considered financially sound. BDNI’s operations were frozen in August 1998 and it is now in the process of being liquidated.

2. Scope of Operations 2. BDNI was a commercial bank providing the usual commercial banking services such as short-term finance, trade-related activities, and deposit-taking facilities. It had also begun to provide term-finance for industry. B. Implementation of the Subprojects 1. Characteristics of Subloans 3. BDNI gave four subloans for a total of $7.8 million. The characteristics of the subloans are given in Table A3. The bulk of the subloans were given for expansion projects (87 percent), while subloans above the free limit (3.0 million) comprised 51 percent and those below that limit comprised 49 percent. As for maturity, 64 percent of the subloans had a maturity of five years and above, while the balance of 36 percent had a maturity of less than five years. The majority of the subprojects were located in Sumatra (64 percent) and the balance of 36 percent in Java. The food manufacturing and processing subsector had the most subprojects, in value, (51 percent), followed by the nonmetallic minerals subsector (30 percent), the agriculture, forestry, and fishing subsector (13 percent), and the wood and wood products subsector (6 percent). 2. Operations of the Subprojects a. Implementation Status 4. Two subloans, one for a shrimp-processing plant and the other for wood processing, have been implemented satisfactorily and without any time and cost overruns. The implementation of the third subloan for a palm-oil processing plant has been stopped due to cost increases since the financial crisis. It is now being restructured by the Indonesian Bank Restructuring Agency (IBRA) but no date has been fixed for recommencement of implementation. No information is available on the performance of the fourth subloan for a ceramic factory. b. Financial and Economic Performance of the Subprojects 5. The two subloans that have been successfully implemented were operating satisfactorily. The shrimp-processing subproject provided additional employment for 2,400 persons at an incremental cost of Rp16 million per job, generated incremental exports of Rp660 billion per annum, and had a loan balance of about $3.5 million as of 31 July 1998. The wood-processing subproject provided employment for 100 additional

Appendix 3

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persons at an incremental cost of Rp200 million per job, generated incremental exports of Rp40 billion per annum, and is said to have fully repaid the subloan in July 2000 (it had a loan balance of $389,000 as of 31 July 1998). The implementation of the subloan for the palm-oil processing plant has been stopped (it had a loan balance of $931,000 as of 31 July 1998). Information on the fourth subloan is not available (it had a loan balance of $2.1 million as of 31 July 1998). The total amount outstanding in respect of the four subloans was $6.9 million as of 31July 1998. 6. Through an agreement signed between IBRA and the shareholders of the four subprojects, dated 21 September 1998, all the shareholders have acknowledged their respective debts and have given promissory notes for those debts. They have also agreed to give assets of their holding companies to IBRA for sale and subsequent settlement of the promissory notes. At present, the shareholders are yet to give such assets to IBRA for sale. The Asset Management Investment (AMI) and Asset Management Credit (AMC) units of IBRA are making efforts to collect the outstanding amounts of the four subloans and hand over the proceeds to the Government.

c. Procurement 7. BDNI followed Asian Development Bank procedures and guidelines in procurement. All four subprojects adopted the reasonable competitive bidding method by comparing alternative quotations prior to selection of the procurement source. By origin, the suppliers were Germany (30 percent), US (26 percent), Sweden and Denmark (12 percent each), Malaysia and Thailand (7 percent each), and Japan and Indonesia (3 percent each). C. Institutional Performance of Bank Dagang Nasional Indonesia 8. BDNI suffered under the impact of the financial crisis. That was due to a combination of factors such as inadequate management, imprudent lending policies of giving foreign currency loans to non-exporters and giving large loans to related group borrowers, rising interest costs (the interest rates went up to as much as 70 percent at the height of the crisis) that pushed up the cost of debt servicing, runs on deposits, and lack of liquidity. 9. BDNI’s banking license has now been cancelled by Bank Indonesia. IBRA is in the process of selling its assets, collecting loans, paying off third-party depositors using the Government’s blanket deposit guarantee scheme (all the third-party depositors have now been fully paid off), closing down offices, and reducing staff and expenses.

24Appendix 3

Characteristic No. Amount Percent

A. PurposeNew 1 1.019 13.02 Expansion 3 6.810 86.98 Balancing, Modernization, and Replacement (BMR) - - -

Total 4 7.829 100.00

B. SizeLess than $0.5 million 1 0.450 5.75 Over $0.5 million-$1.5 million 1 1.019 13.02 Over $1.5 million-$3.0 million 1 2.360 30.14 Over $3.0 million-$5.0 million 1 4.000 51.09 Over $5.0 million - -

Total 4 7.829 100.00

C. MaturityLess than 3 years - - -Over 3 to 5 years 2 2.810 35.89 Over 5 to 10 years 2 5.019 64.11 Over 10 years - - -

Total 4 7.829 100.00

D. LocationJava 2 2.810 35.89 Kalimantan - - -Sulawesi - - -Sumatra 2 5.019 64.11

Total 4 7.829 100.00

E. IndustryAgriculture, Forestry, and Fishing 1 1.019 13.02 Mining and Quarrying - - -Food Manufacturing and Processing 1 4.000 51.09 Textiles - - -Wood and Wood Products 1 0.450 5.75 Paper and Paper Products - - -Chemicals - - -Nonmetallic Minerals 1 2.360 30.14

Total 4 7.829 100.00

Source: PCR Mission

Table A3: Characteristics of Subprojects of Bank Dagang Nasional Indonesia ($ million)

Appendix 4

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OVERVIEW OF LIPPO BANK A. Background

1. History, Ownership, Management and Organization

1. Lippo Bank (LIPPO) was established in 1949 as a private bank. At appraisal, it was majority owned by the Lippo Group (67 percent), other shareholders (22 percent), and public (11 percent). LIPPO was affected adversely by the impact of the financial crisis due to imprudent banking policies and increased debt-servicing costs of many of its borrowers. This led to its recapitalization in June 1999 with present ownership consisting of the Indonesian Bank Restructuring Agency (IBRA) (59 percent), public (34 percent), and Lippo Group (7 percent). IBRA placed bonds worth Rp7.7 trillion and shareholders Rp3.6 trillion for the recapitalization. It has now become a majority government-owned bank until IBRA divestment, for which a definite date has not been fixed. 2. LIPPO is managed by a board of directors under the supervision of a 12-member (three members at appraisal) board of commissioners, which sets policies. LIPPO has a staff of about 6,557 (6,500 at appraisal) servicing the head office in Jakarta and 363 branches (190 at appraisal) including one overseas branch in the Cook Islands (the three branches in the Philippines, Viet Nam, and Malaysia have now been closed). It has a joint-venture bank with the Japanese called the Tokai Lippo Bank in Indonesia, which is said to be operating satisfactorily. LIPPO has undergone consolidation and is operating more efficiently now judging by the fact that a much larger branch network is still being managed by almost the same number of staff as at appraisal. LIPPO has been modernized with the introduction of computerization, electronic banking, and credit card operations. It has also engaged ING Barings to introduce best practices to improve its quality and competitiveness.

2. Scope of Operations 3. LIPPO is mainly a commercial bank and provides export-import finance, working capital, foreign exchange operations, and credit card services. It also provides term finance for industry with emphasis on small and medium enterprises. B. Implementation of Subprojects

1. Lending Policies and Procedures 4. LIPPO is continuing with its policy of lending mainly to small and medium enterprises. It has begun to adopt more prudent banking policies and stopped giving foreign exchange loans to non-exporters and loans to related large business groups. The board is committed to good profitability and aims to achieve a return on assets (ROA) of at least 1.5 percent. The accounting and auditing systems are well established and follow generally accepted principles and procedures. Its accounts for year ending 31 December 2000 were audited within three months of closing. LIPPO adheres to Bank Indonesia (BI) prudential requirements in terms of capital-adequacy ratio (CAR), minimum reserve requirement, legal lending limits, loan classification and provisioning, and loan-to-deposit ratio (LDR).

Appendix 4

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5. Loan authorization has been decentralized for quicker loan dispensing. The branches can now lend up to Rp100million-150 million (Rp50 million at appraisal) to any one client. Any excess needs to be approved by the credit committee. Loan approval, monitoring and control procedures have been standardized in a set of operating manuals and are considered satisfactory. Loans are now subject to strict risk management analysis.

2. Characteristics of Subloans 6. LIPPO utilized only $4.0 million under the Second Development Finance Loan (DFL II) for one subloan of $4.0 million in February 1998 for a glass manufacturing subproject located in Jakarta. The term was for eight years. The full amount was disbursed. The subloan was above the free limit of $3.0 million and for an expansion project. The characteristics of the subproject are given in Table A4.1.

3. Operations of Subprojects

a. Implementation Status of Subprojects 7. The subproject was implemented within the projected cost and time frames.

b. Performance of Subprojects 8. The operations of the subproject were affected adversely by the financial crisis due to increased cost of servicing a large local currency debt. For this reason, the subloan was also restructured in 2000 and its maturity period extended, by one year, fro