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