Asia needs better developed bond markets

Ever since the 1997 Asian Financial Crisis, the region has been saying that it needs better developed local currency bond markets. But while much progress has been, it is most certainly not sufficient.

When considering the issue of why Asia needs to have developed local-currency bond markets, it is necessary to place this question in the context of financial markets more generally. Local-currency bond markets are just one of the many markets that make up the financial system.

The ultimate objective of the financial system is to allocate the savings of those with surplus capital to those in need of capital to help achieve productive investment. In this way, financial markets enable economic agents to optimize their inter-temporal consumption over the course of their life. Financial markets also provide opportunities for managing risk.

Savers and investors have demonstrated a great variety of preferences for saving and investing, including different preferences regarding the short-term versus the long-term, high-risk versus low-risk. This is why over time our financial systems have developed a vast array of markets which offer a great variety of instruments and services. A short list of financial markets would include: bank financing; equity/stock markets; government bonds; corporate bonds; and foreign exchange markets which allow to economic agents to invest in foreign currencies. In this context, bond markets are usually medium- to long-term financial instruments (not short-term), and debt-based instruments (not equity).

Asian financial markets have traditionally been dominated by banks which have been the major providers of formal financial services. Stock markets and bond markets have been much less developed.

Why are Asia’s local-currency bond markets underdeveloped? In many countries, bank finance was used as an instrument of industrial policy, thereby distorting financial market development away from corporate bond markets. Also in many countries, governments did not create the necessary infrastructure which would support corporate bond market development – such infrastructure can be regarded as a public good. And lastly, government bond markets remained underdeveloped in most of developing Asia because generally prudent fiscal policy meant that there was little need for government bond financing.

The consequence of having bank-dominated financial sectors is that the Asia’s financial systems do not provide a wide range of financial services, as in the case of the developed OECD countries, although the situation is improving greatly. Savers have more limited investment options and similarly borrowers have more limited options for obtaining finance.

This has many adverse effects on Asia’s high saving and high investing countries, some of we will explore. Asia has two broad groups of savers, the corporate sector which is sitting on large amounts of corporate savings and the household sector which is “saving for ageing”. Each of these groups could gain greatly by having greater opportunities for investment, including in local currency bond markets. This would also be beneficial for borrowers in the region, for whom investment opportunities are enormous, especially in the infrastructure area.

The East Asian financial crisis of 1997 highlighted the costs of having underdeveloped local-currency corporate bond markets. In part because of this, many East Asian corporations took out short-term bank loans from foreign banks to help finance longer term investment projects.

These corporations suffered badly from the so-called “maturity mismatch” when refinancing these short-term loans was suddenly impossible because of the sudden and dramatic change in market sentiment towards East Asia. They also suffered from a currency mismatch when their currencies suddenly depreciated. That is, having borrowed in foreign currency for a local investment project, they were exposed the risk of exchange rate movement. In short, a local-currency corporate bond market would provide corporations with greater opportunity to obtain longer term financing for local projects, and thereby eliminate both the maturity and currency mismatches.

Governments in emerging Asia have recognized the importance of developing capital markets and local bond markets in particular. At the national level, efforts have included: removing policy distortions; enhancing market infrastructure to support the functioning of bond markets; strengthening the regulation and supervision of capital markets in accordance with international standards and practices; and developing government bond markets which can provide benchmarks for corporate bond markets.

Much progress has also been achieved through regional initiatives.

-- The Asian Bond Markets Initiative (ABMI) was launched by the ASEAN+3 finance ministers in August 2003, and has the objective of enhancing market infrastructure for local currency bonds and facilitating market access to a diverse issuer and investor base so that robust primary and liquid secondary markets are created in the region.

-- Together with technical support from the Asian Development Bank and driven by the East Asian central banks, two Asian Bond Funds, ABF1 and ABF2, were launched to promote the expansion of the local currency bond markets in East Asia.

-- Since 2008, ASEAN+3 countries have cooperated to establish an Asian Bond Market Forum as a common platform for regional bond market integration.

-- ASEAN+3, with an ADB contribution, has established the Credit Guarantee and Investment Facility to provide credit enhancement for investment grade companies seeking to issue local currency bonds.

Thanks to domestic reforms and collective regional efforts, emerging East Asia’s bond market has come a long way since the Asian financial crisis in terms of market depth, and regulatory and market infrastructure, in particular:

-- the local currency (LCY) bond market of emerging East Asia (EEA) has risen from approximately $1 trillion in 2001 to $6.5 trillion as of end 2012. EEA is defined as China, Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Thailand and Viet Nam.

-- total LCY bonds outstanding in EEA at the end of September 2011 were approximately 8.1% of the global bond market against 2.1% in 1996.

-- the domestic corporate bond market has been the growth driver for the EEA LCY bond market as a whole over the past few years -- but it still only accounts for about a third of total bonds outstanding in the region.

-- the largest LCY bond market in EEA is in China with $3.4 trillion in bonds outstanding at end 2011.

-- notwithstanding the impressive development of emerging East Asia’s bond markets, most corporate bond markets in Asia remain underdeveloped and small compared to the region’s equity markets, with the major exception of Korea. But while corporate bond markets are growing fast in China, most issuers are government-owned entities.

-- Korea, Malaysia, and Thailand had the most liquid government bond markets – as measured by quarterly turnover ratios – at the end of 2011. But overall, liquidity remains limited. The most important structural issue holding back liquidity in EEA is the need to increase investor diversity.

Overall, despite the impressive progress in developing bond markets, Asian financial systems are still dominated by the banking system, whose share relative share declined only moderately from 54.5 per cent in 2005 to 50 per cent in 2010.

As Asia now looks beyond the current Global Financial Crisis, its new challenge is to rebalance its economies away from excessive reliance on US and EU export markets towards more domestically- and regionally-driven growth. Better developed local currency bond markets could facilitate the mobilization of Asian savings for Asian investment, especially in infrastructure, for which the deficits in many countries are enormous.

Asian capital markets have the potential to become a major financial hub – if they were more integrated. But Asia’s surplus savings are still mainly invested outside the region. Asian policy makers prefer to "outsource" their long-term savings to the advanced markets. Currently, many Asian capital markets remain relatively small and fragmented and lack the liquidity and capacity to compete globally. By integrating, they would be able to strengthen financial intermediation and build the capacity to channel the large amounts of regional savings into productive investments in the region.

Clearly, there are significant impediments to the further development of Asia’s capital markets, including capital controls, different stages of economic and financial development, fear of domestic markets being overwhelmed by foreign competition, non-uniform taxation, legal and regulatory frameworks, and relatively small institutional investor bases in countries such as Indonesia and the Philippines.

At the same time, foreign holdings of local currency debt in EEA have significantly increased in recent years. Investors have been putting their money to work in emerging East Asia since the early 1990s, but the flows have picked up pace in recent years because of low interest rates and slow or negative economic growth in developed economies while emerging East Asia has enjoyed high growth rates and appreciating currencies. In Indonesia, for example, overseas investors held 33% of outstanding government bonds at the end 2012, while foreign holdings of Malaysian government bonds had reached 28.5% of the total at the end of September 2012.

While foreign investor interest in Asian bond markets is a welcome sign, it does raise the risk of asset price bubbles, said the Asian Development Bank’s latest Asia Bond Monitor.

“Emerging East Asia is much more resilient than it used to be but governments still need to be careful that the surge in capital inflows doesn’t fuel excessive rises in asset prices and that they are prepared for a possible reversal in the flows when the economies of the US and Europe pick up again,” said Thiam Hee Ng, Senior Economist in ADB’s Office of Regional Economic Integration.

Author

John West
Executive Director
Asian Century Institute
www.asiancenturyinstitute.com