Relying on the market

Relying on the market

Kahlil Rowter
Head of Research
Mandiri Sekuritas
Jakarta

Next year, for the first time in the last four decades, the
Government of Indonesia will rely on bond issuance to finance its
budget deficit. To a lesser extent the same will also take place
this year. Despite its probable mild impact, the GOI need to put
in place several mechanisms to ensure this exercise is
successful.

In its revised 2003 budget, the government was being realistic
in accepting that the deficit will probably be larger than
expected. The deficit is expected to be 2 percent instead of 1.8
percent earlier expected. To a large extent the main reason will
be the lower nominal GDP growth, due to a significantly lower
inflation (down to 6 percent from 9 percent) while real GDP
growth will probably remain at 4 percent as expected. The nominal
deficit itself will increase about Rp 660 billion.

Nevertheless it is worth noting that one item in expenditure
that will increase significantly is fuel subsidy. The addition of
about Rp 13 trillion results from the increase in international
oil prices. The bulk of subsidy is borne by the central
government while the additional revenues must be shared with
regional governments. Therefore the central government bears the
brunt of international oil prices above the budget assumption.

More significant changes are taking place in the financing
part of the budget. The lower international aid disbursement plus
shortfall in privatization proceeds mean that domestic bank
financing, mainly in the form of government debt operations will
have to take up the balance.

In total domestic financing will increase by Rp 9.4 trillion,
the bulk of which comes from debt operations. Bond issuance will
be increased by Rp 4 trillion to Rp 11.7 trillion while the bond
buyback program has been scaled back by about Rp 4.2 trillion to
Rp 9.4 trillion. In total, therefore, government debt operation
will contribute about Rp 8.2 trillion or 87 percent of the
increase in domestic financing.

Next year, the amount of buyback will also be reduced to only
Rp 5.6 trillion. This plus the maturing government bonds
amounting to Rp 18.9 trillion will mean that the government has
to prepare at least Rp 24.5 trillion for debt operations. This is
why bond issuance is set at Rp 28 trillion, leaving the net
addition from domestic debt operations at Rp 3.5 trillion. Add to
this the planned international bond issuance of Rp 3.5 trillion
to come with total net increase in government debt of Rp 7
trillion.

Although the net amount of increase in debt appears small, it
should be noted that this represents a shift in debt strategy.
Whereas until this year the level of debt has actually decreased
due to smaller issuances compared to maturing amounts, in the
future this amount will either increase or at the most
maintained. Another change is the way in which debt level changes
are financed. Until now cash from outside debt operations has
been used to pay down the debt level.

But starting next year, due to pressure on revenues, maturing
bonds will be financed by new issuances. The debt operations unit
will, therefore, have to manage its cash flow internally. And,
despite its size, the net addition of Rp 3.5 trillion means that
for the first time debt operation will actually contribute to
budget revenue.

In the future foreign financing might still be constrained by
several factors, not the least of which is our own absorption
capacity. And should economic growth not pickup significantly,
tax revenues may not be able to sustain non-debt expenditure
requirements, let alone providing enough amounts to re-pay
maturing government bonds. Hence, the reliance on the market as a
source of re-financing for maturing bonds, naturally increases.

The government has probably realized this early on and has
prepared the primary as well as the secondary market well.
Enactment of the government bond and state finance laws certainly
adds to government debt credit strength. And the creation of the
association of bond dealer (HIMDASUN) along with its trading
platform have helped increase trading liquidity and price
efficiency as well as transparency. These measures go a long way
in enhancing the secondary market, which also positively impacts
the primary market, mainly because the HIMDASUN is effectively a
primary dealership group, although not called so.

This is made possible through having a liquid secondary market
among players with similar risks and building a relationship
among the group with Bank Indonesia as well as the Ministry of
Finance. Not less important is the network built between HIMDASUN
members and other players in the market. Although not yet acting
as underwriters HIMDASUN will help ensure that any bond issuance
will be successful, as long as it appeals to the market.

With a higher reliance on the market for its finance the
government needs to put more consideration on the market appetite
and put proper balance on this factor along with other
requirements such as the goal of reducing re-financing risk. One
way to do this would be to aim the buyback operations at those
bond series that are less liquid and not just focusing on series
that fall in certain maturity ranges.

Another would be to consider issuing shorter maturity series
and in the longer term filling in the yield curve with benchmark
issues. Having a more regularly scheduled auction for both the
buyback as well as new issuance will also add to market
certainty. It should be noted that having a more frequent auction
does not necessarily tie the government's hands in issuing or
buying back at pre-specified amounts. Therefore, this balances
degree of freedom with a more certain and regular market. It will
also impose discipline on the market as well as the government
itself, both of which increase efficiency.

Like or not, without much fanfare, the government is starting
to rely on the market for its funding needs. In the longer term
this should be codified into a broader program of funding through
the market and relying less on bilateral as well as multilateral
support. This shift entails a major requirement for revamping the
government's own debt as well as cash management systems and
operations. And most importantly, relying on the market means
catering to what the market wants.

This article is written in personal capacity