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.