The capital market versus the banking system

By I. Putu Gede Ary Suta

This is the second of two articles on the capital market and the government's privatization policy.

JAKARTA (JP): Some progress has been made in the development of the capital market despite weak government support. Between 1990 and 1997, the Capital Market Supervisory Agency (Bapepam) drafted sophisticated securities regulations that met international standards. Bapepam became one of the most open and transparent of government agencies. However, tax and banking policies were beyond Bapepam's authority and created a barrier to market development.

In addition to establishing an honest banking system, we should give priority to a dynamic capital market that will support stable economic growth. A number of measures must be taken:

* End Bad Banking: When companies can borrow from banks they control and when state banks supply funds to friends of government officials, it is easier to raise long-term funds by borrowing depositors' money from "friendly banks" than by a public offering of shares. State banks set a bad example and discourage sound banking practices, constituting a barrier to capital market development.

The United States has rigorous banking prohibitions against conflict-of-interest transactions, joint-ownership and "interlocking directorates". Except for a central bank and development banks, there is no justification for state banks. Government banks, including the banks in the restructuring program, should be privatized with control transferred to parties unaffiliated with borrowers.

* Encourage Equity Investment: Because, unlike bank deposits, the government does not guarantee equity investments and because return on equity is uncertain and dependent upon market forces, investors prefer government guaranteed bank deposits, especially when interest rates are high. Countries intent on developing capital markets provide incentives for the public to use equities for long-term savings. This calls for major policy changes:

* Limit Deposit Guarantees and Bank Interest Rates: Government guarantees on bank deposits must be limited and subject to interest rate restrictions. Otherwise, the government guarantee creates a "moral hazard" in which weak banks attract money by offering high interest rates, while discouraging investment in stocks and long-term bonds.

* Postpone Taxes for Retirement and Educational Funds: To compensate the risk and long-term nature of equity investments, many governments allow investors to save for retirement or their children's education in funds exempt from current taxation. Taxes are due only when profits are withdrawn. The country benefits from greater economic stability through equity financing.

* Encourage Public Companies: Strong incentives are needed to compensate for the cost of distributing equity in an undeveloped market. Some countries stimulate capital market development by lower taxation of public corporations. For example, a company with capital distributed to 5,000 domestic shareholders might be allowed a reduction on corporate taxes, compensated by higher taxes on nonpublic companies. To qualify for tax benefits, the public company must meet disclosure and corporate governance standards.

* Make Bapepam Independent: Bapepam has not been able to effectively exercise its enforcement powers because it is not free from political influence. Recent recommendations call for the transformation of Bapepam into an independent agency under the supervision of a board of commissioners, with similar safeguards as the United States' Security and Exchanges.

* Accelerate Privatization: The purpose of privatization is not to raise funds for the government, but rather to eliminate an inefficient system that fosters misuse of companies for political benefit. State-owned enterprises are often less efficient than private sector firms and are a drag on the economy and a source of corruption.

Despite commitments to the IMF, little progress has been made regarding privatization. Only six state-owned enterprises have sold shares to the public and in no case has more than 35 percent of the capital been distributed. There has been no true privatization resulting in transfer of control to the private sector.

Vested interests of directors, commissioners, employees and suppliers of state-owned enterprises oppose privatization. State banks and state-owned companies play a key role in the distribution of political favors.

Opponents of privatization contend that selling state-owned enterprises is only justified to finance economic recovery. However, many state-owned companies are unmarketable and the others, when profitable, are not easily sold at prices that would significantly help economic recovery.

Adversaries of privatization use false nationalism to argue against selling "national assets" to foreigners. They suggest privatization must be postponed until after economic recovery, at which time the idea may be forgotten.

The owners of state-owned enterprise are the people of Indonesia, not the government, and certainly not the directors, commissioners and employees. State-owned enterprises were created from taxes and it would be logical to return this money as a benefit to taxpayers.

Valuation of equities is not exact and is subject to opinion. It is unlikely that there will be consensus as to the "fair value" of shares of state-owned companies. Some other basis must be used.

It is possible to devise a system whereby privatization can raise funds to assist the government's finances during the recovery period, while avoiding the political traps of determining a "fair price" or sale to foreigners. This can be done by setting a reasonable price for the sale of shares to taxpayers who would be allowed to purchase some shares of state- owned companies every year and, within limits, use their purchase receipts to pay future taxes. In effect, the shares would be given to taxpayers who are, after all, the real owners. However, by advancing payment of taxes by a number of years, the public would finance the recovery budget.

Shares of state banks and state-owned securities companies, stores, industrial companies and other ventures that have competitors in the private sector should be entirely divested. Government firms that are uneconomical and have no strategic importance should be liquidated. State-owned companies with strategic importance and without private sector competition may be considered case-by-case.

Privatization must include the bank restructuring program that has resulted in the government subscribing to most of the capital of ailing banks. This subscription was accomplished by exchanging government bonds for shares. This program has serious flaws:

* Medium and long-term rupiah government bonds are not marketable at current rates in large quantities at a price close to par. Therefore, ailing banks have not received funds to finance recovery. If the bonds were to be sold at true market value --- less than par --- the banks would be decapitalized and the restructuring program would fail.

* The rupiah bonds are medium term with relatively high interest rates. This presents a cash flow problem for the budget.

To solve the problem, it is necessary to recapitalize the banks with bonds that can be resold in very large amounts on the international market. There is no such demand for rupiah bonds, but existing bonds could be substituted with marketable Brady bonds. Brady bonds are a type of government security issued by developing countries in financial difficulty, with a 30-year tenure, guaranteed by 30-year, zero-coupon U.S. Treasury bonds. Brady bonds have the largest international market for sovereign obligations of developing countries.

Since payment of the principal is 30 years in the future, and since dollar interest rates are generally less than equivalent rates in local currency, the Brady bond puts less stress on government budgets than alternative medium-term rupiah financing. By providing restructured banks with Brady bonds, these banks would be capitalized with usable funds and could finance Indonesian businesses and stimulate employment. Restructured banks could become profitable and the increased economic activity would improve tax receipts.

Privatization, banking reform and capital market development are linked. The key issue is the introduction of banking reforms prohibiting borrowers from controlling banks and limiting interest rates on guaranteed bank deposits.

To stimulate the capital market, fiscal incentives are needed. To remedy defects in the bank restructuring program, ailing banks should be re-privatized and Brady bonds should used as liquid assets for bank recovery.

The writer is a former chairman of the Capital Market Supervisory Agency (Bapepam).