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 which I would like to highlight.  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.  They 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. 

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, although liquidity remains limited.  The region’s share of the global bond market has more than tripled from a mere 2.1% in 1996 to 6.7% at end-September 2009.  Government bonds represent about 70% of total bonds issued, while corporate bonds stand at 30%.  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. 

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.  They could also provide a better range of instruments for international investors wishing to invest in the region.  In this way, they could make an important contribution to the necessary rebalancing of growth.

References:

AsianBondsOnline

http://asianbondsonline.adb.org/

Eichengreen, Barry, and Pipat Luengnaruemitchai.  Why Doesn't Asia Have Bigger Bond Markets? 

NBER Working Paper No. 10576.  Issued in June 2004

http://www.nber.org/papers/w10576