THE CASE FOR AN ASIAN BOND MARKET

The need for an Asian bond market

The absence of a developed bond market in the region was one of the main factors behind the extreme volatility that precipitated the Asian financial crisis. The crisis itself spurred governments in the region to focus on bond market development. This has been one of the positive, constructive outcomes of the crisis, and this is the area in which most progress has been made.

Since the crisis, other important reasons for a stronger, deeper and broader debt market in the region have come to the fore. The strong current account performance of economies in the region has led to a very sizeable accumulation of reserves by the public sector. The total foreign exchange reserves of the major Asian economies generate quite strong investment demand for bonds.

On top of the demand from the public sector, private sector funds are increasingly diversifying into bond investment. Greater investor awareness has encouraged individual investors to think of bonds, instead of just sticking with deposits and equities. In addition, the population of the region is growing older. Not only are populations growing older, people are also living for longer. All of these considerations have led to greater attention to retirement planning and to an increase in the size of the pension fund portfolio. This has already added to the demand for bonds, and, as with public sector funds, this demand is likely to grow in the future.

But there is lack of a deep bond market in the emerging Asian economies and therefore much of the increased demand, from both the public and private sectors, has been satisfied by investments in bonds denominated in the major foreign currencies. Emerging Asia as a whole is now a large net exporter of portfolio capital.

The pattern of the flow of international funds in Asia has, for some time now and encouraged by financial liberalisation, been characterised by a two-way traffic of investment flows. In the one direction, there is the very substantial outflow to the industrialized economies. In the other direction, there is the inflow of private sector foreign funds. This recycling of funds brought benefits and risks. The greater presence of foreign funds, mostly in institutional form, and managed and serviced by highly versatile foreign financial intermediaries, in domestic financial markets in the region, no doubt, promoted financial sector development. Indeed, the overall efficiency, including the level of sophistication, of financial intermediation in the region has been substantially enhanced, contributing to economic growth and development. But it also presents considerable difficulty to monetary authorities in the region in the maintenance of monetary and financial stability.

In part, this is due to the differences in character between domestic and foreign savings. Those managing foreign savings are much less concerned about the long-term public interest than those managing domestic savings. Foreign savings are also much more sensitive to changes in market sentiment and shifts in domestic policies, and are more prone to reversals. While this imposes greater discipline on local authorities in pursuing prudent macro-economic policies, it also brings much higher volatility in the financial markets, to the extent of possibly creating systemic problems that Asian monetary authorities are ill-equipped to handle. Furthermore, the foreign financial intermediaries are usually not simply price takers, but a Òprice makerÓ with the power of pushing prices in a particular direction. The implications for the emerging markets are greater market volatility, greater tendency for overshooting, and consequently, greater challenges in maintaining monetary and financial stability. The problems are more intense for emerging economies with medium-sized financial markets that are large enough to attract foreign capital but not large enough to be immune from the manipulative or speculative plays that are, more often than not, associated with these fund flows.

The phenomenon was demonstrated in the recent mid-May episode of Asian stock market correction and the associated volatility in response to the reported withdrawal of foreign funds from the Asian market. This was a moderate episode that presented some threat to financial stability, and the markets were well able to take it. If the various measures introduced to strengthen financial systems after the Asian financial crisis had not been in place, and if Asian economies had not been in a recovery phase at this time, the impact of this volatility in fund flows could well have threatened monetary and financial stability in the region. Given the structural trends and the market dynamics associated with them, even with benign conditions and stronger financial systems, there is a danger that, as this recycling pattern grows larger, the risks to stability will increase. One way to address the above problems is to develop a regional bond market that is capable of recycling regional wealth in a more efficient and healthier manner, thus reducing the probability and the destabilising impact of any reversal of fund flows on the domestic financial markets.

Fostering regional bond market development

Fostering regional bond market development involves co-operation on a number of fronts among economies with very differing economic, political and cultural backgrounds. It is often said that the diversity of this region is a considerable obstacle to the kind of financial, economic and monetary co-operation that might be desirable. It is heartening that considerable progress has been made over the past few years, particularly among central banks. This co-operation has taken two forms: market development initiatives, which help promote the growth of a regional bond market, and infrastructural initiatives, which facilitate that growth.

A number of collaborative initiatives have been undertaken by central banks in the region to foster the development of both local and regional bond markets. The first of these is the APEC Initiative on the Development of Securitisation and Credit Guarantee Markets, which is being spearheaded by Hong Kong, Thailand and Korea and sponsored by the World Bank. The aim of this initiative is to address structural impediments to the development of bond markets and to provide an effective and immediate solution to the credit gap problem. The programmes under this initiative are making good progress.

A second cluster of initiatives, under the ASEAN+3 forum, involves a variety of studies known as the Asian Bond Market Initiative (ABMI) on issues such as new securitised debt instruments, issuance of debt by international financial institutions, regional credit guarantees and enhancement facilities, and the establishment of local and regional credit rating and credit enhancement agencies.

The third set of initiatives falls under EMEAP - the Executives¡¯ Meeting of East Asia-Pacific Central Banks - and takes the form of bond funds aimed at channelling a small portion of the very large official reserves held by the Asian economies into the region. The first of these funds - Asian Bond Fund I(ABF1) - was launched in June 2003 and is now fully invested in US dollar-denominated bonds issued by sovereign and quasi-sovereign issuers in the EMEAP economies. The EMEAP Central Banks are currently working on ABF2, which will invest in local currency-denominated Asian bonds.

These three sets of initiatives use differing approaches and a variety of tools. But they have common aims. One important aim is to identify - through individual studies, experience-sharing, and the practice of fund management - where obstacles exist and how best standards and practices can be harmonised to facilitate cross-border financial transactions within the region. A separate, but parallel consideration is the development of financial infrastructure. A number of studies have been carried out to explore the feasibility and desirability of establishing region-wide infrastructure, such as a regional rating agency and regional settlement and payment systems.

Effective financial infrastructure across the region is a precondition for debt market development within the region. A pragmatic approach is necessary, leveraging on existing infrastructure within each jurisdiction and creating a network of bilateral links between jurisdictions. Each jurisdiction will develop its own infrastructure and links according to needs, although the main lesson in this field is that it is better to be ahead of needs than behind.

Conclusion

Collectively and individually, central banks and governments are making good progress on a variety of initiatives aimed at reducing barriers, building infrastructure and encouraging interest in the market. In the end, however, there is only so much that the public sector can - or should - do, particularly in a region where there is traditionally not a lot of public debt. Central banks and governments have a responsibility to facilitate and promote development, and to provide an environment that is conducive to both supply (the issuers) and demand (investors). It is in the public interest that a healthy bond market should develop in our region. However, it is for the private sector to provide the great bulk of supply and demand. Happily, it appears that the private sector is playing its part with enthusiasm.