With the Indonesian rupiah falling to a 17-year low against the US dollar in March, global investors are increasingly concerned about the ability of Indonesian companies to service their US-denominated debt. Foreign borrowing is worryingly high: private foreign debt has tripled in Indonesia since 2007 and represents 40% of Indonesian corporations’ total debt burden. In addition, local companies with foreign borrowings are also facing rising import costs.
Although Bank Indonesia, the country’s central bank, has introduced minimum FX hedging and foreign currency asset requirements for non-bank corporate borrowers, Indonesia’s large exposure to foreign currencies still causes concern. So how can Indonesian companies survive this situation?
In our opinion, the country’s reliance on foreign capital can lessen only with the development of a robust, complementary local currency domestic bond market. That nearly 40% of corporate debt financing comes from foreign currency borrowing suggests that Indonesia’s local market is unable to meet the financing needs of its corporations. Although Indonesia’s local currency corporate bond market grew from $2.8 billion in 1997 to $18 billion in 2014, the market size measured as a percentage of GDP has remained a constant 2%. In comparison, the average size of local currency corporate bond markets in emerging East Asia is 23% of GDP – making Indonesia’s market the second smallest in East Asia, behind only Vietnam.
How can Indonesia accelerate domestic bond market activity? By growing its local institutional investor base and encouraging institutional investors to deploy capital into the local bond market.
Growing institutional investor assets under management entails either mandating or encouraging more contributions into pension funds and retirement products. Indonesia’s low mandatory contribution rate has produced the lowest gross replacement rate (pension benefit as a percentage of individual lifetime average earnings) out of all East Asia/Pacific countries; at 14%, Indonesia’s replacement rate is significantly below the region’s average 44%.
This July, Indonesia will introduce a universal defined benefit pension system, which is expected to have a higher mandatory contribution rate and complement existing defined contribution pensions. Voluntary contributions and retirement planning can be encouraged through better financial education programmes; a staggering 81% of the Indonesian population is financially illiterate about pension funds.
Beyond growing institutional investor assets under management, Indonesia can relax pension and insurance fund portfolio requirements to make it easier to invest in corporate bonds. Because pension funds and insurance funds can only invest in bonds that meet certain standards, such as ratings requirements, they may over-allocate assets to bank deposits and government bonds.
Chile is an example of how institutional investor presence can accelerate capital market development. In the early 1980s, Chile replaced its under-funded pay-as-you-go pension system with a fully funded system. Over the next two decades, as pension fund assets grew at an average of 22% per year, corporate bond issuances grew at a similarly high average of 15% per year. This growth in corporate bond issuances is often attributed to the development of the pension system, which initially invested a large portion of its assets in fixed income.
A larger institutional investor base is critical to promoting local bond market activity and in turn, supporting Indonesia’s private sector. Indonesian companies are accessing foreign markets only for lack of alternatives: telecommunications operator PT Indosat, for instance, must refinance $55.8 million and Rp 2.2 trillion (approximately $167 million) of loans maturing this year and has publicly expressed a desire to reduce its foreign currency exposure. The question is, when will the Indonesian market be ready?
The World Economic Forum report, Accelerating Emerging Capital Markets Development: Corporate Bond Markets, is available here.
This article was originally published in The Wall Street Journal.
Authors: Michael Drexler is Senior Director, Head of Investor Industries, World Economic Forum and Giancarlo Bruno is Senior Director, Head of Financial Services Industries, World Economic Forum USA.
Image: A teller at Bank Indonesia counts out Rupiah bank notes at their headquarters in Jakarta October 27, 2014. REUTERS/Darren Whiteside