Bonds: Deserted measures in difficult times

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.