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.