A diverse financial sector

A diverse financial sector

It was simply a coincidence that a two-day workshop on the
role of nonbank financial institutions was held in Jakarta as
jittery investors have rushed to redeem an estimated Rp 20
trillion (US$2.1 billion) in fixed-income mutual funds over the
past two weeks.

The workshop, co-organized by the World Bank and the finance
ministry, was timely as it reiterated the strategic importance of
developing nonbank financial institutions such as the mutual-fund
industry. The meeting of experts that ended on Tuesday also
analyzed the main challenges of diversifying the financial
industry away from too heavy dependence on banks.

The meeting warned that the financial industry was vulnerable
to future shocks because it was still heavily dominated by banks,
which account for over 80 percent of financial assets.

This domination by banks comes as the country is in urgent
need of investment in infrastructure and new production
facilities, which require long-term funding. But banks, by their
very nature, have never been and will never be a major source of
long-term funds.

Such nonbank financial institutions (NBFIs) as pension funds,
insurance companies, mutual funds, capital markets and
institutional investors must play a greater role in funding
investment, as they have access to long-term funds.

But as this small crisis that has hit the mutual fund industry
demonstrates, the development of NBFIs requires market
infrastructure, adequate supervision, excellent accounting
standards, reliable auditing procedures and a strong regulatory
framework.

In only two weeks the mutual fund industry lost over $2
billion as investors rushed to redeem their funds because of
concerns over the falling yields on government bonds, the main
underlying asset of fixed-income mutual funds, and a
misunderstanding about the method of pricing mutual funds (net
asset value).

It is natural for investors to shift from one investment
instrument to another to gain higher returns. Because the yields
on government bonds have declined as the central bank has raised
its benchmark interest rate to counter inflationary pressure
caused by the fuel price increases and the depreciation of the
rupiah, some investors have moved their funds to bank deposits
and other investment instruments.

But what turned an otherwise natural market development into a
small crisis was investor confusion over the pricing of their
fixed-income mutual funds. Many investors seemed to think that
because they invested in fixed-income mutual funds the net asset
value of their funds must be stable. They apparently were not
adequately educated by their fund managers to understand that
each mutual fund share (unit) represents the value of the stocks
or securities (bonds) in the portfolio.

Hence, the funds are priced on the basis of the prevailing
market value of their underlying assets. This is called
marked-to-market pricing, which is considered the fairest pricing
method. Since fixed-income mutual funds use government bonds as
their main underlying asset, their net value has declined as the
central bank has tightened its monetary stance.

But even the combined impact of declining bond yields and the
misunderstanding about the pricing of mutual funds would not have
caused such a massive redemption had the Capital Market
Supervisory Agency (Bapepam) learned from a similar crisis in the
mutual fund industry in 2003 and improved market infrastructure.

In November, 2003, when over Rp 30 trillion worth of fixed-
income funds were redeemed by jittery investors who misunderstood
the marked-to-market-pricing method, most market players urged
Bapepam to establish a standard repurchase agreement to help fund
managers cope with such rushes without having to sell their
investment instruments at large discounts to raise cash. A
repurchase agreement gives fund managers a provision to buy back
their investments at specific prices by specific dates.

However, due to the absence of such a safeguard fund managers
over the past two weeks have been forced to dump their bonds on
the secondary market to raise cash to pay back their fund
investors. The central bank did move to prevent an even worse
situation by entering the secondary market to buy Rp 4.3 trillion
of government bonds. But a similar crisis could recur if fund
managers cannot use repurchase agreements as a source of funds to
meet sudden demands for redemption.

Hopefully, this second crisis will jolt Bapepam to introduce
soon a master repurchase agreement to prevent mutual fund
managers from having to dump their bonds to raise funds.

Yet another message from the rush by investors to exit fixed-
income mutual funds over the past two weeks has been that,
besides market infrastructure, the development of NBFIs requires
an adequate education for investors to prevent unnecessary panic
during price fluctuations.