Lessons and Conclusions

Over the last decade domestic bond markets have developed considerably as an alternative form of financing with total bonds in all markets covered by the BIS reaching US$59.7 trillion in 2008 (BIS 2009). With a few exceptions, domestic bond markets remain dominated by government issuers and issues carrying long-term maturities. The trend to disintermediation has been accompanied and facilitated by: improvements in domestic bond trading and settlement infrastructure; the development of spot and forward foreign exchange markets; and the development of currency and interest rate derivatives markets (specifically cross-currency swaps and FRAs).¹⁰ Products in these markets facilitate risk management and risk transformation for the assets and liabilities held by investors and issuers, providing a means for avoiding the double mismatch problem (e.g., Tan, Karigane, and Yoshitomi 2001).

The expansion of both the scale and scope of bond markets offers considerable benefits to issuers by diversifying funding possibilities and creating opportunities to offer a range of products that better match the needs of investors. Generally, at the early stage of bond market development the aim is to simply facilitate the exchange of funds between domestic issuers and domestic investors. The next stage requires international participation. For non-resident investors and issuers to become involved in domestic markets they must have the means to manage and transform currency and interest rate risks associated with their foreign currency assets and liabilities. This implies having access to both foreign currency and interest rate derivatives and related cash-based hedging products. In the case of foreign bonds, issuers typically hedge the foreign exchange risk associated with the domestic issue via a currency swap into their home currency and then transform the cash-flows from the bond coupons to either fixed or floating via an interest rate swap (e.g., Worzala, Johnson, and Lizieri 1997). Ideally these transactions are undertaken simultaneously.

The presence of credit ratings and improvements in financial statement reporting has encouraged new issuance in international securities markets, with bonds outstanding now totaling US$23.8 trillion in all markets covered by the BIS in 2008. The internationalization of securities issuance offers both investors and issuers the opportunity to diversify currency risks, although international issues tend to be hedged to eliminate likely currency, interest rate, and occasionally credit risks. The recent development of these markets in the major financial centers in the Asia and Pacific region (especially Australia; Hong Kong, China; and Singapore) appears linked to the needs of international investors, such as sovereign and hedge funds with different risk appetites. Growth in international syndicated bank lending appears to have suffered as a consequence of this trend to disintermediated financing, especially since 2007, due to a combination of lenders experiencing difficulties in hedging credit risks and issuers being reluctant to borrow using volatile floating rate benchmarks such as the LIBOR. Therefore, syndicated loans outstanding in all markets covered by the BIS in 2008 fell to US$297 billion a level not seen since the late 1990s.

The development of foreign bond markets in a number of smaller financial centers outside of the US, UK, and Japan with different legal traditions and degrees of supporting financial market infrastructure, offers hope to other countries seeking to expand the scope of their domestic financial markets. Attention should be drawn to the development of these markets in economies as diverse as Australia and Switzerland. The development of these markets is more reflective of financial participants leveraging unique country-specific features, in conjunction with enabling legislation and the proactive involvement of government, rather than adhering to a rigid or predefined checklist of requirements.

Nonetheless, the desire by a government to develop its financial services sector into a world-class financial trading and investment center will be difficult without the proactive involvement of market participants. For example, Korea failed to develop a viable foreign bond trading and issuance market despite the best efforts of its policymakers, providing valuable lessons for others (Batten and Szilagyi 2007).

In conclusion the Asia and Pacific region, excluding Japan, Australia, and New Zealand, has benefited from recent developments in financial infrastructure and trading with it domestic bond markets now standing at US$4.3 trillion. However, given that this represents just 7.2% of the worldwide total, the region's bond markets remain underdeveloped—or at least offer scope for considerable further development—relative to the region's weight in the world economy. We suggest that development of foreign bond markets offers the best hope for the next stage of regional market development and refer to a number of critical features of these markets that emerge from the earlier analysis:

(a) There is a natural evolution to the sequence—and time it takes—for market forces to drive foreign bond and corporate bond market development.

It is difficult to both accelerate the speed of foreign bond market development and regulate for the risks associated with domestic development. For example, on average the largest markets outside the US first issued bonds between 1984–1989. Thus, we recommend a step-by-step approach, which establishes: technical infrastructure (e.g., trading and settlement systems for bond trading and adequate benchmark bonds to enable corporate bond pricing); sufficient market access by investors and issuers (and the legal apparatus to support this); and the presence of additional products in other market segments (such as interest rate and exchange rate derivatives) to enable risk management and risk transformation. With respect to the last category, the importance of FRAs and swaps for managing interest rate and currency risks cannot be understated, although there must also be sufficient depth in spot and forward foreign exchange markets to ensure that exchange rate distortions are minimized. Deep, liquid and diverse products crossing a host of derivative and cash-based markets are necessary to ensure low cost arbitrage and enabling risk transformation. One key aspect of countries with developed bond markets (e.g., Australia, Japan, and Switzerland) was deep foreign exchange and derivatives markets, and the inability to offset risk via deep derivatives markets may account for limited foreign bond market development in Korea.

Over-the-counter products, especially swap and FRAs are now well established with standardized supporting legal documentation and settlement procedures. Thus, these products would be the easiest to introduce into a market with the possibilities of related exchange traded products (e.g., interest rate futures) undertaken later on as markets unfold. Invariably, developing products for risk management requires international participation in domestic financial markets by foreign banks and financial institutions, regulatory changes to accommodate derivatives trading, and the removal of capital control restrictions (Forbes 2005).

Eichengreen and Luengnaruemitchai (2004) highlighted several obstacles for the development of bond markets within the Asia and Pacific region including the slow development of private debt markets and the need to simultaneously reform other supporting aspects to financial markets. Such reforms include: creating bankruptcy legislation; reducing corruption reduction; creating reliable securities market regulation; eliminating or reducing capital controls so there is free movement of currency; and adopting international accounting standards. In addition there are necessary regulatory reforms linked to improving corporate governance (e.g., Nestor and Thompson 1999; Thompson 1999; Thompson and Poon 2000; Jiang and McCauley 2004; Park and Park 2005). All of these reforms are important and are difficult to achieve not just in one decade but several. Importantly, while risk management and trading skills may be imported to help kick-start a local development agenda, bringing about a comprehensive shift in business attitudes to risk management will require a much longer term investment in training local employees.

(b) Government consultation with industry is crucial to the development of foreign bond markets.

One should not underestimate the commitment required from industry, and financial intermediaries in particular, to support the markets in their embryonic stage. The presence of foreign institutions with existing skills in these areas is also a vital ingredient to this process. A noteworthy example of the cooperation between industry and government arose when the governments of Australia and New Zealand withdrew from their respective bond markets in the period before 2008 due to the presence of ongoing fiscal surpluses. The governments and industries agreed to the use of the use of high credit quality foreign bonds as substitutes for repo transactions to avoid liquidity and related benchmark pricing issues. The presence of foreign bonds also offered local pension funds the ability to buy the long dated securities necessary to manage new asset-liability matching regulations, international accounting standards, and risk-based regulations for insurance companies (Blommestein 2007). Blommestein argued that this will lead to a long-term demand for very long (20–30 years) and ultra long (30+ years) term bonds, and foreign bond issuers will likely meet this investment demand.

(c) Not all financial risk can be managed through government intervention.

Some risk can be avoided through appropriate accounting and risk management standards set by government. However, the human proclivity to gamble is difficult, if not impossible, to control or eliminate, as the losses suffered by traders in the most sophisticated financial firms can attest. This further emphasizes the need for consultation with industry in any development agenda.

(d) An ordering of issuance helped build confidence at the nascent stage of foreign bond market development

Almost without exception as foreign bond markets developed the highest credit quality issuers or sovereigns issued first, followed by quality banks and some multinationals (see Table 5 [ PDF 57.1KB | 1 page ]). The foreign bond market appeared to require an order of issuance. This particular order seems linked to the need for intermediaries to guide pricing (e.g., through benchmark bonds at long maturities) and related issues.

Although the presence of enabling infrastructure is important it does not guarantee that corporate and foreign bond markets will develop. It appears the right mix of issuer supply and investor demand is also needed to reach a take-off point for market development.

(e) There is an ongoing need to maintain liquidity in all markets, and especially so for benchmark bonds.

Risk-free benchmarks remain an integral and necessary part of the corporate bond market for pricing and hedging purposes. The theoretical and practical aspect of this concerns trading and risk management based upon credit spreads, where the risk free government bond is the benchmark. Thus, it is critical that governments (and local central banks) recognize the need to maintain adequate liquidity irrespective of fiscal requirements. Alternatively, in the absence of these governments can formally state that high quality foreign bonds are credit substitutes, as in the cases of Australia and New Zealand.

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