Indonesia sold $3 billion of government bonds in late February: $1 billion of 5-year bonds and $2 billion of 10-year bonds. The bonds were priced at issue to yield 10.5 percent and 11.75 percent, which at the time represented new issue premia — the added inducement to attract buyers to new bond issues — of 110 basis points and 75 bp, respectively.
The bonds’ subsequent rally has more than eliminated the new issue premia. In the last week of March they were yielding 8.81 percent and 10.08 percent, respectively.
The rally is even more impressive in price terms. For the five-year bonds maturing in 2014, the new Indonesia 14s, the price is up nearly 7 percent to just over $106 for every $100 of face value of bonds. The price of the new Indonesia 19s, which mature in 2019, is up 10 percent to $109.50.
From the narrow historical perspective of the last month, our title seems wrong. In view of the last month’s price appreciation, potential investors may be thinking that the title should be “Indonesian Government US Dollar Bonds Are Too Expensive.”
A wider historical perspective, however, is needed to see the title’s truth. Consider the bonds of the Philippines, which has a similar Moody’s/S&P sovereign credit rating, “B1/BB-”, to Indonesia’s “Ba3/BB-”. Philippine 14s, the Philippine counterparts to the Indonesia 14s, currently yield about 5.15 percent. Philippine 19s yield about 6.92 percent. Bond investors evidently view Indonesia as much riskier than the Philippines judging by the three to four percent yield spread they require to take Indonesian 5-year or 10-year government risk over Philippine risk.
The perception that Indonesia is more risky than the Philippines is most evident in the cost of buying default insurance. If investors want to insure themselves against the risk of an Indonesian sovereign default they must pay $56,000 annually for every $1,000,000 of insurance on bonds that they buy. For the Philippines, this charge is only $36,000.
It was not always like this. Up until the Panic of 2008 erupted in September 2008, the cost of insuring against an Indonesian default was the same as insuring against a Philippine default.
From this historical perspective the question is: Did the Panic of 2008 so badly affect the Indonesian economy relative to that of the Philippines to warrant a permanently higher cost of default protection?
We do not think so. For many reasons we think Indonesian financial assets, including the cost of sovereign default protection, the rupiah and domestic interest rates, are more vulnerable during times like the Panic of 2008 than their Philippine counterparts.
A principal reason is Indonesia’s experience during the 1997-98 Asian financial crisis. We think that episode left a lasting, unfavorable impression on foreign and especially domestic investors about Bank Indonesia’s ability and commitment to stabilizing the rupiah. When panics do occur, even if they have nothing to do with Indonesia as was the case last year, lingering doubts about BI drive investors to hedge rupiah risk by buying dollars and contagion spreads to other assets.
Economists emphasize the importance of credibility for a central bank. A credible bank will find that its pronouncements carry more weight than those of a bank that lacks credibility. The mere mention of a policy change by a credible central bank can effect the desired change in peoples’ behavior without it actually having to implement the policy. Economists know less about how central banks acquire credibility. We know from BI’s experience since the Asian financial crisis that once credibility is lost it takes a long time to restore it.
BI is restoring its credibility. It has been active in the foreign exchange market to contain excessive volatility in the rupiah during periods of panic selling. Foreign exchange reserves declined by $5.5 billion in the fourth quarter of 2008, which we think was as a result of the central bank’s intervention to stabilize the rupiah-dollar exchange rate.
BI and the government also moved to reduce the economy’s vulnerability during periods of stress in global financial markets. BI data show that Indonesian corporations must roll over or repay $22.6 billion of debt this year. Under normal circumstances, the country’s $50 billion of forex reserves would be a sufficient buffer, but the authorities recognized that during panics they may not be. The authorities established a $4 billion contingency facility using contributions from the World Bank, the Asian Development Bank and the Japanese International Cooperation Agency. They also have moved to expand their bilateral swap arrangements, including a $6 billion arrangement with Japan that Indonesia may draw on without any conditions.
Indonesia will benefit from the reopening of global capital markets. Like the restoration of a central bank’s credibility, this will be a process, not an event. But the process has begun.
Indonesia and the Philippines have made successful forays into the global bond market this year. So have Korea’s policy banks. As the global capital market unfreezes, it will become easier for the debt of Indonesia’s corporations to be rolled over and/or repaid without dipping into the country’s forex reserves.
The relative increase in Indonesian sovereign bond credit spreads was a product of the Panic of 2008. As the panic fades, its side-effects will too. Indonesian bonds have gone up a lot in price. They’re going up even more.
Tim Condon is head of research at Wholesale Banking Asia at INGBank.