Government bond market key to revival

Government bond market key to revival

By Larry Berger

JAKARTA (JP): This week's announcement of a draft law on bonds
is a laudable advance in Indonesia's long-running effort to build
an effective government bond market. If passed, the law will
allow the government to issue short-term treasury bonds, which
are urgently needed to finance future budget deficits.

Important as these measures are, they represent only one step
in the complex process of developing a robust bond market. To
ensure continued progress, the government needs to articulate a
holistic vision of how this market will work and lay out a series
of initiatives to establish all necessary laws, regulations, and
institutions.

A robust government bond market plays a vital role in any
emerging market by providing an important source of government
financing and supporting capital market development.

In Indonesia, there are also two urgent near-term reasons for
developing a liquid government bond market.

First, the government's budget deficit is projected to exceed
Rp 50 trillion this year, in part due to the burden of coupon
payments on Rp 430 trillion in bank restructuring bonds that have
been issued over the past two years.

To finance this budget gap, it is likely that the government
will need to issue yet more bonds.

However, without an active secondary market in which to trade,
these bonds are likely to be as illiquid as the original
restructuring bonds, thereby remaining stuck with their original
buyers.

Second, Indonesia's five largest banks hold more than 80
percent of the restructuring bonds, which account for a
significant percentage of these banks' total assets.

The lack of an active secondary market for trading bonds poses
serious liquidity problems for these banks. Meanwhile, the recent
spike in interest rates is pressuring bank margins.

Together, the illiquidity of the bond market and the attendant
earnings problems have the potential to create yet another
Indonesian banking crisis.

To better manage its fiscal burden and avert another round of
bank recapitalization, the government should pursue three key
policy initiatives: (1) dramatically increasing the pool of
domestic savings available to purchase bonds, (2) leveraging
international best practices to develop the mechanisms and
regulations for more efficient bond trading, and (3) articulating
a long-term debt management strategy.

A liquid and stable bond market requires a deep investor base
with a broad range of investment styles and objectives. In many
emerging market countries, pension schemes are the principal
providers of investment funds. Singapore, Malaysia and Chile
exemplify how fully funded pension schemes can create deep pools
of domestic savings.

In Indonesia, gross pension fund and insurance company
investment portfolios totaled less than Rp 50 trillion as of
year-end 1998-a pittance compared to the Rp430 trillion in bonds
already issued by the government. An active bond market would
require investment from a much broader pension scheme in
Indonesia, which in turn hinges on strong support from the key
economic ministries and the House of Representatives (DPR).

In developing the mechanisms and regulations to support bond
trading, the government can leverage on global standards for
emerging capital markets.

This will help ensure that the focus is on sustainable market
development rather than one-off initiatives.

And by adopting international best practices and standards,
the government can further integrate the domestic market with
international sources of capital.

Hong Kong and Singapore have pursued this strategy and reaped
substantial benefits.

In Indonesia, there are six specific steps that can be taken
now to comport with international best practices:

* establish a "securities issuance" calendar to announce all
planned debt issues over each 12-month period. This calendar,
which should be up-dated periodically and publicized widely,
should include the issue dates, principal amounts, coupon rates
and maturities.

* build a continuous yield curve of government securities. The
yield curve could initially include just a few key instruments,
such as short-term bills and notes with maturities of two, three
and five years.

* initiate an association of primary dealers including both
domestic and international securities firms.

* define and disseminate the rules. Regulations must be
developed, debated and distributed to all bond market
participants. These rules must define the responsibilities of the
Ministry of Finance, Bank Indonesia and the primary dealers'
association.

* create a repurchase agreement market facility through Bank
Indonesia. The success of a secondary bond market hinges on a
liquid "repo" facility.

* ensure a secure and scripless settlement system. Settling
government securities through Bank Indonesia must be safe,
efficient and transparent.

Finally, efforts to build a government bond market must be
part of a clear, long-term debt management strategy-particularly
for the bank restructuring bonds.

This strategy should address ways to lessen the refinancing
burden of these bonds, while contributing to the development of a
robust bond market.

These measures may include the restructuring of the
outstanding issues, or the early redemption of some issues by
replacing them with more tradable issues.

Additionally, debt management requires effective
communications-to promote the government's financial and economic
goals while bolstering market confidence.

In short, a robust government bond market will help develop
Indonesia's capital market while addressing the government's
immediate financing needs. With Rp 430 trillion in restructuring
bonds having been issued, the market urgently needs policies to
build an investor base, adopt international best practices and
articulate a debt management strategy.

The writer is a senior consultant with McKinsey & Company's
Jakarta Office.