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.