Prescription for the Indonesian bond market

Prescription for the Indonesian bond market

By Thads Bentulan

HONG KONG (JP): There is a perfect reason why the writer is
playing doctor to the Indonesian bond market -- there exists no
rupiah government benchmark.

Now, this could not be a perfectly correct statement because
there actually exists a debt instrument called Sertifikat Bank
Indonesia (SBI) and still another called the bank
recapitalization (Recap) bond but I am going to demolish their
standing as possible useful benchmarks later.

If you scan the financial pages of any regional newspaper, any
listing of an Indonesia benchmark is invariably the missing.

Why is there a need for a benchmark? Benchmarks are so
important, that I am of the conclusion the Hong Kong Monetary
Authority sells treasury bills called exchange fund notes
primarily to establish benchmarks rather than to raise funds.
After all, Hong Kong perennially has surplus budgets; therefore,
it does not need to borrow.

A government benchmark is needed to give bond investors a
realistic and computable assessment of risk. Without a "risk-
free" reference parameter given by the sovereign, the relative
risk profile of ordinary entities like corporates or banks cannot
be quantified. If risk cannot be quantified, learned investors
may avoid the market altogether.

Around Asia, the government bond issuances are very high in
South Korea -- an OECD member -- comprising about 47 percent
relative to the gross domestic product (GDP). Indonesia's
government bonds attained 45 percent relative to GDP, while
Malaysian government bonds reach as high as 25 percent. These are
all 1999 figures.

In the corporate bond markets, Korean corporates raised about
25 percent relative to GDP, Indonesia corporates raised just 1
percent while Malaysian corporates raised 26 percent.

Last year, Korea issued about US$290 billion in domestic
currency debt, followed by China with $155 billion and Malaysia
with almost $70 billion. Indonesia issued around $12 billion in
local currency bonds.

Zeroing in on Indonesia, the government bonds are comprised of
36 percent in floating rate, mostly recap bonds, also about 36
percent in inflation-indexed bonds, and 21 percent in fixed rate
bonds.

Corporate issuers raised more than Rp 5 trillion ($523
million) in the first semester of 2000, which is not bad compared
to last year's Rp 2.2 trillion ($230 million).

Of the outstanding corporate issues in the market, about 37
percent are from the manufacturing sector, followed by the
financial sector which comprise 26 percent, then by the real
estate sector, and also the utilities sector with 16 percent
share each.

While profiling the bond investors in Indonesia is difficult,
this much we know: Pension funds hold only about 6 percent of
their portfolio in bonds way below the regulatory limit of 20
percent.

Insurance companies only carry about 4 percent in bonds.

Mutual funds are hard to pin down because a recently
introduction tax regulation necessitates a liquidation of the
investment very five years.

As for the banks who are the traditional bond investors
elsewhere in the world, they park their excess funds in the SBI,
which of course is a short-term instrument.

The first problem is the lack of a yield curve. Right off, the
absence of a yield curve tells you there is a problem with
Indonesian bond market.

The SBI is a short-term rupiah debt instrument issued by the
central bank, the Bank of Indonesia. With maturities ranging from
only one to three months these SBI provides a benchmark for the
shorter end of the yield curve. That is, the SBI is a useful
benchmark only for working capital loans but useless for bond
issues.

In addition to the benchmarking function, the primordial
function of government bonds, of course, is to provide long term
investment instruments for the investors with natural long term
liabilities. I am of course referring to insurance and pension
fund companies.

From the point of view of the government, the SBI is
fundamentally a monetary intervention instrument used to absorb
excess liquidity from the banking system when needed. But since
the government does not use the SBI to finance budget deficits
and government expenditure, by analogy, corporate borrowers
cannot use the SBI to benchmark their own capital expenditure
borrowings.

By the way, in the recent months, at times the SBI's yield are
higher than the longer term recap bonds, a seldom seen yield
curve inversion.

The Indonesian Bank Restructuring Agency (IBRA) which was
created following the 1997 currency crisis, acquired the non
performing loans of the ailing banks and issued about Rp 500
trillion ($52.3 billion) in bonds to pay these assets. These are
the so-called recapitalization bonds.

Of these recap bonds, some were 12 percent fixed rate five-
year bonds, some were 14 percent fixed rate 10-year bonds, and
there were 16 series of floating rate bonds with various
maturities ranging from due 2002 bonds to due 2009 bonds.

Why are these bonds unsuitable as benchmarks?

First, they were issued at par, instead of being priced
against the local bond markets.

Second, since there was no treasury auction such as those done
in the U.S., the value of these bonds are but nominal value,
therefore, they do not reflect the sovereign risk of Indonesia
from the viewpoint of the bonds investors.

Third, the banks under IBRA are holding these recap bonds in
their balance sheets as investments not as trading instruments,
therefore there is no secondary market liquidity.

Although these banks are now allowed to trade a maximum of 25
percent of their recap bonds, they hesitate to do so. Banks are
hesitant to trade these bonds because the interest rates are
picking up, therefore they have to be sold below par.

When that happens, the banks will suffer a capital loss
because the trading portfolio will be marked to market. In short,
by moving their recap bonds to the trading portfolio, banks are
risking another balance sheet loss problem.

Fourth, from the very start, the recap bonds were more of a
balance sheet cosmetic: That is, recap bonds were exchanged for
document-based non-performing loan assets rather than being
exchanged for cash from investors.

Fifth, together with the above points, the recap bonds were
never intended to be used a benchmark unlike in other countries
where governments aim for the twin goals of fund raising and
benchmarking.

When government regulations classify tax regimes based on the
type of investor, rather than the type of instrument, the
development of the debt market eventually suffers. This is the
case with Indonesia, especially regarding the classification of
on-shore and off-shore investors.

Indonesian offices of foreign banks are still not allowed to
issue long term rupiah bonds which again stifles debt market
development. This is unfortunate because foreign banks are often
highly capitalized to back up their rupiah liabilities.

Approval process is slow, which is not uncommon in Indonesia,
therefore the government should introduce the shelf approach to
bond issuances similar to Rule 415 in the U.S. This solution
eliminates the repeated approval process each time there is a
take down. In short, we solve the problem by bypassing it.

The medium term note programs established by a few Indonesian
conglomerates for overseas borrowing is a good model to follow.

Since there are no treasury auctions, there are no primary
markets or dealers to speak of. By setting up the systems of
regular treasury issuances, primary dealers can be appointed.

The lack of a yield curve, of course, creates pricing problems
for corporate bond issuers who eventually resort to curve
interpolation, which again, reduces the reliability of the risk
profile of the private entities as against the sovereign.

The lack of a government benchmark gives rise to too many
confusing proxy benchmarks which ultimately redounds to the
mispricing of corporate issuer risk.

The lack of a common clearing system for the both government
and private sector bonds can be solved by hiring consultants from
Euroclear or Cedel to implement one for Indonesia.

Leaning towards book-entry bonds, rather than physical
delivery of bonds, should be a primary goal of the local debt
market system. The government can take the lead role in this
endeavor.

Credit ratings are important and will surely follow the
development of the market.

Of course, taxation is important. If the intention is to
develop the local debt market, then tax incentives for debt
instruments should be used to pull investors away from other
securities. For example, capital gains taxes or final taxes can
be changed to favor bonds.

Altogether, the first step is for the government to provide
the necessary debt instruments that covers the entire range of
tenors. Once the tenors are established, the yield curve will
reflect the sovereign risk that will then encourage investors to
quantify corporate issuer risk.

The writer is a Hong Kong-based head of research of a market
research house and columnist for Manila-based BusinessWorld
newspaper. The above is based on his article in a Hong Kong
capital markets magazine (His email:
streetstrategist@hotmail.com.)