Introduction

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

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

Review of the Literature on Investment and Financial Constraints

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