Sat, 05 Apr 2003

IDM: The future for RI financial market

Kahlil Rowter, Head of Research, Mandiri Sekuritas

Despite having been forced to issue domestic securities (IGS- Indonesian Government Securities) a few years back, recent government initiative have yielded well.

Up and until the economic crisis in 1997 the government never had a plan to issue domestic debt. It mainly relied on foreign aid for most of its funding shortfall. But in 1998 the government had to issue two main types of IGS. The first was to pay for Bank Indonesia liquidity support (better know by its Indonesian acronym, BLBI), amounting to over Rp 200 trillion.

The second was to recapitalized banks whose loans were transferred to the Indonesian Banking Restructuring Agency (IBRA). This amounted to over Rp 400 trillion. The first IGS was never intended to be sold to the market while the latter was designed to be marketable. The purpose was for recapitalized banks to sell it and get funds they can then use to extend loans.

At the beginning trading volumes were very small. In part, interest rates were high at the time which means these bonds can only be sold at a loss; something recapitalized banks can afford to do.

Trading really picked up in 2001 when the monthly average reached close to Rp 6 trillion. In 2002 the monthly average rose close to Rp 10 trillion. With lower interest rates, these bonds can be sold without incurring too much loss. From the demand side investors were also looking for assets, preferably safe ones, they can place money into.

Whereas in the beginning trading mainly took place among banks in 2002 a significant change took place. Not only did trading volumes picked up significantly, but demand from mutual funds also took off. Mutual funds which before relied on institutional sponsors suddenly changed into mass-market retail.

And the size of fixed income fund which in early 2002 was around Rp 5 trillion grew to over Rp 37 trillion by December of the same year. The main driver was, of course, IGS funds. Just the top three IGS funds were recorded around Rp 26 trillion in December 2002, and the amount is sure to grown further since.

Seizing this opportunity, the government pushed ahead with the Government Securities Bill. This explicitly states that the government guarantees the timely payment of principal and coupon of debt securities it issues. This law significantly enhances the credibility of IGS. Therefore the next logical step was to cater to the market itself. That is why the government along with the central bank assisted by the Surabaya Stock Exchange formed a IGS working group tasked with finding a way to enhance IGS market. An initial step was to seek ways to increase liquidity and efficiency and transparency of the secondary market. Hence the formation of the Inter-dealer Market (IDM).

A key feature of efficiency is the way in which prices are formed. One of the best ways for this is through an auction mechanism, much like the way in which stock prices are formed in the Jakarta Stock Exchange. Another key feature is a level playing field in terms of risk. It was thus decided that a limited participation market needed to be established.

The major benefit of limited participation is that the same risk is faced by any particular participant vis a vis the others. Furthermore trading should be done on house or own-positions not that of clients whose credit risk varies and can be difficult to ascertain. Open participation can only by achieved by having an institution that can insure against settlement failure. Given the sizes of the transaction in this market no such institution can be envisaged.

Having an IDM does not curtail members trading outside the IDM platform as well among members and non-members. It is just that trading among IDM members is expected be the deepest and most liquid leading to the best prices. IDM members can certainly earn a margin when it trades with non-members -- the main incentive of becoming a member.

The next step was to select which institutions can participate. The basic criteria here is capital, which is the first input into any risk assessment exercise. The other less important factors include past participation in the market and so on. Thus 15 banks have been selected: Mandiri, BNI, BRI, BCA, Buana, Danamon, Lippo, Mega, Niaga, Panin, ABN Amro, Deutsche Bank, HSBC, Citibank, and Standard Chartered.

Certain large securities houses are also expected to apply. With their wider reach to non-bank end- investors, securities houses can help widen the reach of IGS trading.

Participants are not all recapitalized banks. Even more significant is that there are several foreign banks in the list. For these banks to participate they must have had headquarters approval. This underscores that trading is widespread, even among non-recapitalize banks. The participation of foreign banks signifies the return of confidence in domestic banking as well as debt markets. Granted their first major participation is in risk- free IGS. But this is a very good start.

Transparency is achieved by having the IDM transmit price on transacted deals to the market at large.

Besides increased liquidity, efficiency and transparency, a regular auction-based price making mechanism produces a vital benchmark. This is essential to set the basis for which the cost of other debt instruments can be set. And the implications of having such basis is profound.

Take bank loans or corporate bonds. One contributor to the crisis is the short-term nature of most investment horizons. This myopia can be traced to the absence of a credible long-term debt pricing benchmark in the past.

No more! Once the benchmark yield curve produced by the IDM price mechanism is accepted, one can easily pick a particular tenor along the curve to price a long-term debt. This will be the IGS yield at that particular maturity plus the appropriate spread due to the issuer's credit risk. Such method is routinely employed elsewhere. And now we can do so in Indonesia.

This should give more incentive for creditors to lend and for borrowers to calculate accurately their cost. In turn this will make project feasibility studies more credible. One can hope that this will help improve the investment climate in the country.

In most countries a benchmark yield curve along with a deep and liquid government securities market is the cornerstone of the entire financial market. It provides the basis for the creation of myriad forms of derivative products that caters to investors' need to speculate and hedge.

We can scarcely find a vibrant hedging market in Indonesia, which leaves investors in a naked position. This could all change should a hedging market, based on IGS liquidity and pricing benchmark, appears. In its way this development strengthens the domestic financial structure against shocks, both that originate from within the country and from outside.

Having a deep and liquid IGS market and, one day, its repo market, also permits that central bank to change its monetary operations mechanism into one which signals are given indirectly through changes in the IGS repo rate which is the way several central banks in developed countries are going.

This is a lot more efficient and cost-effective compared to the central bank dealing directly with outright monetary absorption or expansion.

Lastly, having a deep and liquid IGS secondary market prepares the ground for the government to issue debt in the future at the lowest cost and at minimum risk.

With so many benefits to be reaped, the formation of the IDM really opens the future for a more modern Indonesian financial market structure.