Indonesian banks facing a bloodbath - Brief Article

Business Asia, Feb 11, 2000 by Will Dempster

It is crunch time for the Indonesian Government's expensive bank recapitalisation program.

Between now and March some of the 500 trillion rupiah (US$70 billion) in bonds the government issued to save embattled banks will hit the secondary market and there is every indication that it could be a financial bloodbath.

The government issued the bonds to recapitalise the banking sector but rather than trying to sell the bonds, it gave them to the banks in exchange for an equity stake.

This means that although the banks are recapitalised on paper, they do not have any cash with which to resume lending, which is the real key to both a banking sector and broader recovery.

Besides the modest income banks will receive in coupon payments on the bonds, banks have no other source of cash flow. So the plan is for them to sell the bonds.

The most obvious question is: Who is going to buy bonds?

Why would an investor buy the bonds of a government that owes US$84.1 billion in foreign debt, hundreds of trillions of rupiah in domestic debt and is about to deliver a budget with a deficit at 5 per cent of GDP which will have to be externally funded?

Given investors' likely reluctance to buy the bonds and given banks' desperate need to raise cash by selling the bonds, it is almost inconceivable that investors will pay full price for the bonds.

This will create several problems. Firstly, it means that banks' financial positions will not be as strong as they look on paper.

Presently, Bank Indonesia deems a bank healthy if its capital adequacy ratio (CAR) is 4 per cent or higher -- so just enough bonds were issued to lift banks' CARs to 4 per cent.

If banks sell the bonds for below face value then their CARs could slide.

Secondly, because the cash the banks raise through the bond sales will be less than the bonds' face value, the banks will have far less cash to lend than they had hoped for, thus slowing lending growth.

Finally, with so many bonds hitting the market, interest rates could rise. Bank Indonesia has worked hard to lower rates over the past 18 months and has managed to lower benchmark 1-month rates from 70 per cent to about 11 per cent.

But Bank Indonesia uses market mechanisms (a weekly auction) to set rates, so competition from bonds could cause rates to spike, thus making it even harder for banks to lend the cash they raise through the sale of bonds.

To be sure, not all of the 500 trillion rupiah of bonds will be for sale. In fact, Bank Indonesia estimates that about only 10 per cent will be sold.

In short, the scenario could easily look something like this: Banks sell bonds but for less than face value, thus reducing their financial health and placing constraints on their ability to lend.

As these bonds hit the market they drive up interest rates, further harming banks' lending prospects and casting a shadow over a broader recovery.

And as if things are not already bad enough for the government, by some estimates it may still have to issue as much as another 200 trillion rupiah to complete the recapitalisation.

With such challenges ahead, there is a very real chance the government is getting itself even further in debt for a program that at every turn looks more and more likely to fail.

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