The integration of banks, capital markets, state budget a good start

The integration of banks, capital markets, state budget a good start

Kahlil Rowter, Head of Research, Mandiri Sekuritas, Jakarta

The linkage among the banking industry, the capital market and
the government budget has moved from merely influencing each
other to a tightly integrated one. The government bond market
performs the role of the transmission mechanism that passes on
changes in one part to the others. A proper comprehension of this
context is essential for players as well as regulators.

Anyone who went through Economics 101 will remember the
Keynesian system whereby interest rate is the tool through which
changes in the real sector affect the financial sector, and vice
versa. This framework, in various forms, exists in all economies
including Indonesia's. What is different this time, however, is
the speed and magnitude of adjustments that changes in one sector
induces in the other.

Certainly, it is a simplification to characterize the
financial sector as merely influenced by interest rates and
pretend that the various sub-sectors behave the same towards
changes in interest rates. Yet to some extend all players in the
financial sector do respond to changes in interest rates, and
this variable is the primary driver in this sector. And it its
way interest rates also clears the various sub-sectors in the
overall financial sector.

What has strengthened the transmission mechanism in the
Indonesian financial sector? The answer is the thriving
government bond market. A recent case aptly illustrates this. The
government bond market became very active due to various
institutional enhancements and declining short-term interest
rates. This is because government bonds became alternative
instruments for investor to place their funds in lieu of very low
yielding time deposits.

And the main thrust came not from institutional but individual
investor. The main vehicle for this move was through government
bond-based mutual funds. This particular segment of the financial
market grew from almost nothing at the beginning of 2002 to
almost Rp70 trillion in the 3rd quarter of 2003.

Strong demand stemming from these funds, at least until mid
2003, resulted in prices of various government bond series to
soar. As a consequence yields plummeted. So much so that for a
certain period government bonds with maturities over a year was
yielding lower that 1 month SBI. But the honeymoon did not last
long.

In the 3rd quarter of 2003 the central bank began to voice
concerns that a few funds were sold with guaranteed return, which
in turn meant that these products resembled time deposits. A
related concern was that certain related banks had a buyback
guaranteed with the funds. Both impinged on the prudential
banking regulatory framework, hence the warning that these banks
cease offering such products. Added to this was the unclear
taxation regime of mutual funds and its unit holders.

Both resulted in a massive selling pressure from funds that
only a few months earlier were the prime mover in the market. And
still later was the developing story with regard to marking-to-
market which it turned out was far from clear. Although the
massive selling pressure has largely subsided, the price to be
paid for this lesson is steep. Mandiri Sekuritas Government Bond
Index which at its height rang at over 103 recently saw a level
of 98.5, or a loss of almost 450 basis points.

Besides the obvious loss to investors, what ramifications does
this event have? For one, the government as an issuer of
securities had a very favorable reception and lower cost when
issuing at the height of the buying spree. Conversely, a recent
auction of T-bonds (Nov. 4, 2003) resulted in 12.92 percent
yield. And this occurred when SBI was at very low levels! The
lesson here is that movements in the bond market directly impact
the government budget.

Banks that booked gains during the height of the bond market
also benefits from market movements. In short what happens in the
government bond market directly affects the rest of the financial
sector. It is also true that the bond market is not immune from
influence. When banks, especially recapitalized ones, sell their
government bonds prices will certainly fall. A similar influence
is also exerted whenever the government buys back or issues
securities.

With the rise in government bond yield, albeit temporarily,
the cost of issuing corporate bonds rises commensurately. This
could make funding through the market more expensive next year,
compared to borrowing from banks. Therefore corporations in
search for loans could line up for bank loans. Such was not the
case in 2003 when bond issuance was less costly than bank loans.
Again this shows that what takes place in the bond market affects
the bank loan market which directly affects activities in the
real sector.

Adjustments in the regulatory and policy framework become
important when the transmission mechanism undergoes such a
development. Whereas before misalignments or policy sequencing
lags can corrects itself or at the very least tolerated to some
degree, this luxury has now evaporated. Even a small
uncoordinated policy changes can have significant impact. And in
the sector where signaling is as important as the policy itself,
even a misdirected comment -- to be retracted later -- can
seriously affect the policy path in the future, let alone the
behavioral changes that take place in the interim.

What is needed, therefore, is a coherent strategy that
encompasses the financial sector as a whole. Such strategy has as
its necessary condition the harmonious coordination among the
various policy making agencies. It should provide enough guidance
without restricting the imagination and contingencies that will
most certainly occur. If a grand strategy is not in place or will
take long to conceive, as a second best interim solution the
various policy agencies should be aware of the impact their own
initiatives can have on other parts of the system. Such effects
should be communicated to the other agencies so they can in turn
prepare for these eventualities.

One essential ingredient to this strategy would be to see
which parts are still missing from a complete and modern
financial sector. For example, most modern financial sector has a
re-purchase (repo) mechanism whereby an institution can sell
their long-term bonds with the promise to buy it back at a
certain date in the future.

This provides liquidity in the short term. If the terms are
standardized enough these repos can then be sold to other
parties, effectively creating a short-term market for long-term
instruments. Government bonds are considered to have minimal
credit risk which lends itself naturally for a thriving repo
market. If these bonds are widely distributed among banks, the
repo market can in fact become the basis for the central bank's
open market operations, achieved by the central bank becoming a
player in the market.

Should it want to increase liquidity, the easiest way would be
to lower the repo rate inducing banks to sell their bonds (in a
repo arrangement) to the central bank, hence acquiring liquidity.
And the reverse to drain liquidity.

There are a host of other short-term and longer-term issues
that needs to be considered. But the essential element remains
the awareness that the transmission mechanism among sub-sectors
in the financial sector and the sector itself with the real
sector is robust. Ignore this at your own peril.

This article is a personal view