Capital market development lacks guidance

Lin Che Wei, Director and Founder, Independent Research & Advisory, Jakarta

Indonesia was the last of five countries to emerge from the Asian financial crisis. One of the main reasons for Indonesia's prolonged crisis was the massive banking failure, which in turn was due to the poor banking supervision and poor lending practices among Indonesian banks.

The big question we must answer is whether strengthening the regulations on Indonesian banks is sufficient to address these issues. Or should we focus on the creation of a capital market so the corporate world will have alternative financing? We believe with proper regulatory and supervisory guidance, a capital market would provide a more efficient way to allocate resources and accelerate economic development.

Does the government's post-IMF white paper answer the issue of direction and strategic positioning of the Indonesian capital market amid the changing landscape of the global financial sector? In simple language -- how should the Indonesian capital market be positioned to play a more significant role in supporting economic growth, as well as meeting the challenges of globalization?

Does the white paper address the issue of overdependence on banks in financial intermediation and underdeveloped capital markets, which has been recognized as one of the serious problems that triggered the Asian financial crisis? What steps have been taken by the government to reduce this overdependence on banks?

From the white paper we can conclude that, unlike the banking sector, the development of the corporate bond market takes a backseat in the post-IMF economic program.

It seems that Indonesia is not making a sufficient effort to develop the corporate bond market to complement bank loans as a source of financing. The white paper has addressed the banking issue quite thoroughly with six policy measures, including: improvement of banking regulations and supervision to fully comply with the Basel Accord core principle, rigorous enforcement of prudential regulations, a certification program for bank supervisors and examiners, the divestment of banks under IBRA and a strengthening of the governance of state banks.

We notice that in terms of capital market development, the post-IMF white paper addresses six areas, namely: the restructuring of securities companies to strengthen financial and operational capabilities; the restructuring of the stock exchange to anticipate market liberalization and globalization; strengthening of the regulation and supervision of mutual funds; improvements in good corporate governances; introduction of new stock market products, including asset-backed securities, sharia products and option; and finally, the reorganization of the Capital Market Supervisory Agency (Bapepam) to strengthen its regulatory, supervisory and legal enforcement roles.

However, none of these six capital market policies addresses the issue of capital market structure.

Admittedly the development of a domestic bond market faces huge constraints, such as: the limited number of high quality issuers who can economically issue bonds; poor legal, informational and judicial infrastructure and a poor corporate governance record; relatively low demand for corporate bonds due to rudimentary domestic institutional investors; a huge amount of deficit, which means the government is "crowding out" the private sector in borrowing from the public.

However, these factors are not a good excuse for not making an effort to establish a domestic bond market. The recent issuance of government bonds and the increased trading volume in these instruments are evidence that there is an appetite for bonds. A low loan to deposit ratio is further evidence that banks are not efficient and effective in reviving the real sector.

In addition, a rapid growth in assets under the management of the mutual funds industry in Indonesia and the huge need for funding from quality corporate entities provide an excellent opportunity to establish a liquid domestic bond market.

Without a clear strategy to develop the corporate bond market, the public might interpret the primary reason for the establishment of the government bond market to be the government's needs to finance its deficit rather than to provide a benchmark for corporate issuers. The government is more focused on how to solve its financing problems rather than reestablishing alternative financing for the private sector to revive the economy.

Sadly, nothing is being mentioned about the development of the bond market. In order to facilitate the securing of credits, we have to strive to create a high degree of liquidity to minimize market risk. The improvement of domestic bond markets is very crucial in this regard. At the moment the development of the corporate bond market is left purely to market forces without proper guidance or support from the government.

Without an adequate regulatory and supervisory framework, the issuance of corporate bonds could be disastrous, as corporations might issue bonds recklessly, leaving investors to again bear the brunt. Unlike bank loans where the depositors are protected by a government guarantee (or deposit insurance in the future), in the case of banking failures public investors have to bear the risks of their investment decisions. Due to a lack of information, weak legal infrastructure and a poor corporate governance record, bond investors face a huge risk in investing.

The government should try to improve the legal infrastructure, corporate disclosure and the enforcement of good corporate governance to protect bond holders if the government wants to ensure the development of a healthy bond market.

On the other hand, the regulators are also faced with a problem of creating a sufficient pool of reputable private firms that can periodically issue a large amount of corporate bonds. Too many regulations might prevent corporates from issuing bonds and instead opt for bank loans. This is dilemmatic as corporates might be tempted to raise financing in a less-regulated sector, be it the capital market or through bank loans.

To get a well-balanced financial system it is important that improvements in banking supervision be followed by an increase in the regulation and supervision of bond issuances. Despite a huge demand for bond instruments, both from issuers as well as investors, the white paper does not put sufficient emphasis on the legal, judicial and informational infrastructures to support the development of adequate corporate bond markets.

The fear that corporate bonds might "cannibalize" bank loans probably explains the lack of emphasis on corporate bonds.

It is important to recognize that corporate bonds are complimentary to bank loans for financing economic development. Bank loans have a limited source of financing due to the short- term nature of banks' liabilities, which are mainly short-term saving accounts and time deposits. This means the banks' ability to finance long-term projects without having maturity mismatches in their assets and liabilities is limited.

This is the area where the capital market can play a substantial role for financial stability. On the other hand, banks will continue to be more efficient in providing short-term working capital for the corporate sector.