Impact of the Global Financial Crisis

5.1 Asian Bond Market Performance During the Crisis

While the 2008–2009 financial crisis originated in the US, it quickly disrupted financial markets across the globe, including those in Asia. As volatility spread, Asian markets seized up along with their counterparts in the rest of the world. Asian bond funds exhibited increased bid-ask spreads, as markets became increasingly illiquid (Figure 10 [ PDF 39.1KB | 1 page ]).

An assessment of the performance of regional benchmarks over this period requires some sort of benchmark. One piece of evidence might be the relative severity of yield curve anomalies exhibited during the height of the crisis. As argued above, yield curves for lessdeveloped bond markets are likely to exhibit more severe anomalies. As a benchmark, we include the yield curves of both the US and Germany, as the financial turbulence in the US probably leaves it a poor benchmark despite that market's greater transaction volume.

The larger and more-developed local currency bond markets are shown for October 1, 2009 in Figure 11 [ PDF 16.8KB | 1 page ], along with those of the US and Germany. Emerging Asian bond markets are represented in Figure 12 [ PDF 16.8KB | 1 page ], again along with the US and German benchmarks, for the same date.

It can be seen that substantial deviations from a smoothed yield curve are displayed for all of the countries in Figure 11, including the US and Germany. However, the smaller local currency bond markets, Hong Kong and Singapore, exhibit substantial deviations from a smoothed yield curve. In contrast, the Chinese domestic currency market appears to be comparable to that of Germany, and closer to a smoothed curve than that of the US.

The emerging market country local currency bond markets exhibit much more aberrant behavior in Figure 12. In the wake of a general flight to quality, many of the economies shown exhibit higher yields at the short end, consistent with deteriorating borrowing conditions. In particular, the Vietnamese curve is actually inverted, with very high short-term rates that reflect steep premia on short-term borrowing during the crisis. However, most of the other curves also exhibit high short-term rates, reflective of decreased supply of shortterm funds.

It is difficult to say whether these pictures indicate that Asian government securities markets performed well over the course of the crisis. This period was a volatile one where investors' taste for emerging market paper of any kind was changing rapidly. As such, one would expect some anomalous behavior to appear in any market.

It is the case that as financial markets recovered worldwide, the yield curves did as well. As of 18 June 2009, for example, the Vietnamese yield curve was no longer inverted, although 1 year yields were the highest in the region.¹² At the short-end, yields recovered dramatically. For example, the 3-month Korean Treasury yield fell by 325 basis points to 2.3%, while the 3-month yield on US Treasuries fell 61.9 basis points over the same period.¹³

5.2 Reassessment of bond market promotion

It is clear that the current global financial crisis has affected our understanding of the role of financial markets in economic activity, and the role of bond markets in particular, in fundamental ways that are as yet incompletely understood. In this section, I raise some of these issues, although the answers are far less clear than the questions.

Some of the lessons of the crisis are apparent. One is that former Federal Reserve Chairman Greenspan's “spare tire” argument does not hold under sufficiently severe disruptions (Eichengreen 2007).¹⁴ Greenspan argued that a nation with a well-functioning bond market would be better placed to weather a financial storm, as its firms would be better able to rely on bond financing in the event that bank lending dried up. Moreover, they allow firms to borrow at longer maturities, which should be stabilizing for firms relative to borrowing at shorter maturities from banks.

However, as Eichengreen (2007) notes, there is no guarantee that bond markets will continue to function as the banking sector around collapses. In the US, bank lending seized up during the crisis precisely at the point when difficulties arose in using collateralized debt obligations as collateral. The lesson is that well-functioning bank and bond markets tend to go together, and the forces that lead to the disruption in one market are likely to spill over to the other market. This can be either due to a direct spillover, as in the above case where difficulties in bond markets actually reduce the value of collateral in the financial system available to support bank lending, or simply due to the fact that the deterioration in fundamentals that reduces activity in one market is also likely to reduce activity in the other.

The recent financial crisis also demonstrates that bond market characteristics can create new problems during financial disruptions. For example, the diversification achieved through bond markets is a welcome source of reduced idiosyncratic risk, but it weakens the incentives faced by creditors to gather information about their borrowers. This could lead to more imprudence in lending. Moreover, once a default does take place, the dispersion of credit claims leaves it more difficult to restructure debt obligations.

Other issues raised by the financial crisis remain unresolved. For example, many conclude that the recent global financial crisis revealed that the growth in financial intermediation going into the crisis period was excessive. Authors such as Rose and Spiegel (2009) find that those countries with the greatest leverage in financial institutions going into the crisis experienced the deepest downturns in economic performance and equity returns. However, much of the literature on the implications of the global financial crisis (e.g. Jang and Hyun [2009]), have concluded that the global crisis provides evidence of the “clear need” for wellfunctioning bond markets in Asia.

This raises the following question: if the global financial crisis revealed that intermediation worldwide was excessive, should Asian governments continue promoting increased bond market activity? In particular, how do we know that previous benchmarks that were used to assess the viability of the levels of activity in Asian markets, for example by comparing volumes in Asian bond markets to those in developed economies, were accurate?

One answer is that the difficulties associated with the run-up to the global financial crisis stemmed more from flaws in the financial system than from excessive intermediation volumes. However, some of the steps that have been advocated in response to these flaws may exacerbate the difficulties associated with the lack of scale economies in smaller Asian economies, as these efforts may increase the cost of intermediation. As a result, we may experience some declines in volumes in these markets, moving them even farther below levels associated with achieving viable economies of scale.

Another answer is that the importance of regional efforts has increased. As it becomes ever more difficult for individual country local currency bond markets to “go it alone,” the potential for welfare-improving outcomes from coordination at the regional level are enhanced. For example, the poor performance of rating agencies in classifying the underlying risk in securitized debt raises, rather than lowers, the demand for quality rating services. To the extent that quality services can be more readily provided through cooperation at the regional level, the crisis has raised the need for regional coordination rather than lowering it.

Finally, while financial markets generally exhibited excessive leverage going into the crisis, there is the countervailing fact that smaller countries appeared to exhibit greater disruptions during the global financial crisis, particularly those whose exchange rates were not credibly linked to one of the major world currencies. The global financial crisis therefore also underscores the importance of currency mismatch issues, one of the primary motivations for regional efforts in Asia to promote local currency bond markets.

5.3 Official responses to the Global Financial Crisis

A number of official responses to the global financial crisis have been released since the beginning of 2008. The regional policy changes with Asian efforts to promote bond market development are summarized in Table 5 [ PDF 70.2KB | 1 page ].

Following its May 2008 ASEAN+3 Ministers Meeting, it was announced that efforts were being made to strengthen financial cooperation in the region. The group reiterated its commitment to the multilateralization of the Chiang Mai Initiative (CMIM) under a selfmanaged reserve pooling arrangement in a single contractual agreement. The group raised the total size of the CMIM to US$ 80 billion. It also agreed to implement measures to facilitate monitoring and surveillance of economic and financial conditions under the Economic Review and Policy Dialogue and agreed to explore the role of the International Financial Institutions in providing information.

In efforts to promote the ABMI, the group endorsed the release of 2nd ABMI roadmap arguing for promotion of issuance and demand for local currency bonds and improvements in regulatory frameworks and institutional structures. The group also agreed to make periodic self-assessments of their progress to undertake voluntary efforts to promote the ABMI. A private sector group was also launched to discuss facilitating cross-border transactions.

The ASEAN+3 Finance Ministers met in Phuket, Thailand in a special meeting in February 2009 in response to the global financial crisis. At that meeting, the total size of swap arrangements under CMIM was increased from US$80 billion to US$ 120 billion. They also agreed to establish an independent regional surveillance unit to promote monitoring of economic conditions. Finally, the group called for an immediate and substantial capital increase for the Asian Development Bank.

The regular May ASEAN+3 meeting also included a number of notable announcements, both concerning addressing the current crisis and in terms of fostering development of regional financial markets. The group announced agreement on all of the main components of CMIM, including individual country contributions, borrowing limits, and surveillance mechanisms, with the scheme to be implemented before end of year. In addition, Hong Kong, China, was welcomed into CMIM.

The May ASEAN+3 Finance Ministers' Meeting also endorsed the establishment of a Credit Guarantee and Investment Mechanism (CGIM) as trust fund of the ADB with an initial capital outlay of $500 million to support private local currency bond issuance in region. Some details, such as the scope of coverage, leverage ratios and country limits were to be resolved by the 2010 meeting.

The group also agreed on the proposed provision of technical assistance from the ADB for cross-border bond issuance of Lao government debt in Thailand. The group took note of private sector efforts on cross-border transactions and settlements issues.

Overall, it is clear that the bulk of official responses to date have moved towards more regional cooperation and greater efforts to encourage local bond markets. However, not all policies remain unchanged. For example, the Basel Committee has changed its proposed treatment of securitized assets, such as collateralized debt obligations and asset-backed securities in response to the changed perception of the relative riskiness of securitized assets in the wake of the financial crisis (BIS 2009). Presumably, the crisis will lead to similar reassessments among the regional Asian groups.

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