Bonds: Deserted measures in difficult times

Riyadi Suparno, The Jakarta Post, Jakarta

There were numerous important events that passed virtually unnoticed last week, overshadowed by news of fuel shortages and daily protests against the looming fuel price increases. One of these events was the issuance of government bonds.

The government issued Rp 1 trillion (US$100 million) in Treasury bonds last Tuesday and announced that it would soon issue $1 billion worth of bonds in the international market.

Now is not the ideal time to issue bonds, with high interest rates both internationally and domestically and the low appetite for bonds, especially among local investors.

The outcome of Tuesday's auction proved this. The bonds, which mature on Dec. 15, 2010, were priced to yield 15.1 percent -- one of the highest planned yields to date.

The lowest rate the government pays for its bonds stayed at about 9.5 percent.

It is clear that the consequence of this high yield will be a greater burden on future budgets, in terms of interest payments.

Earlier this year, the government canceled a few bond auctions, possibly because of high yields. So, why did the government go ahead with bond issue last week? The likeliest answer is that the government had no alternative for financing its budget deficit this year.

The government has budgeted a deficit of Rp 25.1 trillion this year, or 0.9 percent of gross domestic product (GDP), assuming the fuel subsidy does not exceed Rp 89.2 trillion.

Given the lack of appetite for government bonds in the domestic market, the government is correctly moving toward the issuance of bonds in the international market, with the hope of raising $1 billion.

According to Kahlil Rowter, head of economic and fixed income research at Mandiri Sekuritas, issuing bonds in the international market has some advantages. First, the overseas market has a huge amount of liquidity. In addition, Indonesian securities benefit from scarcity value; also, selling offshore adds to the country's foreign exchange reserves.

Selling offshore, however, carries risks as well, and the obvious risk is related to the fluctuation of foreign exchange rates.

Also, the international market will demand high yields for Indonesian bonds, which are currently rated as junk. Indonesia's sovereign debt is rated B2 by Moody's Investors Service, which is five levels below investment grade, and B+ by Standard & Poor's, four levels below investment grade. And news of the latest bombings in Bali will likely affect the appetite for Indonesian bonds among foreign investors.

Consequently, the cost of issuing bonds overseas is likely to go up, also considering the rising interest rates in the international market, particularly in the Untied States.

So, whether selling bonds in the international or the domestic market, the bottom line for the government will remain the same: building up the debt stock, which will burden future debt servicing.

As long as the government continues to run a budget deficit, issuing bonds will remain unavoidable since this is the best and fastest financing option available.

And the budget deficit will continue next year, totaling Rp 19.8 trillion, or 0.7 percent of GDP, with the fuel subsidy expected to remain at about Rp 68.5 trillion.

Unless the government and the House of Representatives agree to further cut the fuel subsidy, which would mean increasing fuel prices again, the government will have to dip into the bond market again next year.

But relying too much on the bond market, especially the domestic market, to finance the deficit has another danger: "crowding out" the private sector.

When a large chunk of liquidity is absorbed by the government via a bond issuance, private corporations are penalized with a much higher cost of borrowing, both through bonds and bank loans.

This danger of "crowding out" the private sector is minimized when the market has enough capacity and liquidity to absorb both sovereign and private sector debt.

However, our bond market is still far from mature. Liquidity, especially in the secondary market, is apparently drying up. And the biggest problem now is the lack of public confidence in bonds, especially following the massive public redemption of mutual funds.

Our bond market is "deserted" at best following the massive redemption. Old investors are packing up and leaving, and new investors are too frightened to enter.

The challenge now is how to develop the bond market to a level that allows both the government and the private sector to raise funds from the bond market to finance their needs.

This would require the market to have all the infrastructure in place, especially regulations to ensure price transparency, enough market players, a significant number of investors and most importantly sufficient liquidity.

When the market reaches this level, the government can enter the bond market not only to finance its deficit but also to finance certain infrastructure projects that require long-term financing support.

Local governments could also issue bonds to finance their needs, including infrastructure projects.

Equally, the private sector could raise funds by issuing bonds. And everyone would be happy. However, there is a long and winding road ahead before we arrive at that level.