Reviving the bond market

Reviving the bond market

The government seems confident macroeconomic and political
conditions next year will augur well for reopening the secondary
bond market, which has been lifeless since late-1997 when the
rupiah crashed and inflation spiraled out of control. Central
bank deputy governor Miranda Gultom confirmed on Monday Bank
Indonesia would begin allowing in February state and private
banks to trade treasury bonds which were issued this year to
finance the banks' recapitalization.

The government issued Rp 260 trillion (US$37.1 billion) in
treasury bonds between May and October to recapitalize state,
private and regional development banks, and repay liquidity
credits from the central bank. Another Rp 150 trillion in
treasury bonds will be floated early next year to recapitalize
several more state and private banks. But only about Rp 350
trillion of these bonds will be tradable; Rp 53.8 trillion worth
of index-linked bonds, which were issued to the central bank in
May to repay its liquidity credits, will remain in its vaults,
not seeing the light of day until they are redeemable 20 years
from now.

Allowing the T-bonds to be traded on the secondary market will
inject sorely needed liquidity into recapitalized banks, enabling
them to resume lending, which is the lifeblood of economic
activity. The recapitalized banks have so far been unable to
resume lending on a significant level, because their only real
liquidity is coming from the interest on the bonds.

The debt papers, prohibited from being traded, have simply
been sitting on their balance sheets as quasi capital to meet the
minimum capital adequacy ratio of 4 percent. Even without this
ban, however, no one would touch the debt instruments this year
given the volatile rupiah rate, persistently high interest rates
and adverse economic and political conditions.

In fact, seen from the structure and tenor of the bonds, the
debt instruments are marketable only if there is political
stability and improved macroeconomic conditions. The coupon rates
on the three types of bonds -- fixed-rate, floating-rate and
index-linked -- have been set at such levels that the instruments
will be attractive to investors only if there is low inflation
and a stable rupiah.

Anticipating analysts' concern that interest rates, which have
steadily declined since March, might skyrocket if the market was
suddenly flooded with unwanted debt papers, Gultom pledged the
central bank would seek to limit any negative impact by ensuring
orderly trading of the bonds.

Market stability could in fact be threatened if all bond-
holding banks decided to unload the bulk of their debt papers at
the same time, meaning bond yields would have to be jacked up to
attract buyers for such a massive offer. The central bank could
prevent sudden rises in interest rates by buying up the bonds,
but such a move would be a marked reversal of its tight monetary
policy, which has underpinned the steady decline in inflation and
the rupiah's recovery.

The central bank surely will have some say in the timing and
size of bond offers, because almost all of the bonds already
issued and those to be issued are owned by state and nationalized
banks and private banks in which the government is the majority
owner.

Provided the central bank can steadily lower interest rates,
which have now fallen to below 13 percent from as high as 35
percent early this year, and barring a new bout of volatility in
the rupiah, the market appears big enough to absorb gradually the
Rp 350 trillion worth of T-bonds, particularly if foreign capital
begins flowing into the country next year on the back of the
nascent economic recovery. A large portion of time deposits at
domestic banks, which totaled more than Rp 410 trillion as of
August, may shift to bonds if short-term interest rates continue
to fall.

However, raising funds is not the only objective of developing
the bond market, especially in Indonesia, where the capital
market still lacks depth. Currently, the market only has the
short-term benchmark interest rate -- Bank Indonesia's
certificates of deposit which are only available in one and
three-month terms. It is now nearly impossible to project the
cost of money a year from now, let alone set a benchmark to gauge
medium and long-term funds, the main type of financing used for
investment. The T-bonds will serve as a much-needed benchmark for
a medium and long-term yield curve.