Motivation for Encouraging Local Currency Bond Markets

2.1 Enhanced Financial Stability

As discussed in the introduction, one major conclusion from the 1997 Asian financial crisis was that the crisis may have been mitigated if the region was not so exceptionallydependent on bank lending for financial intermediation. Indeed, then-Chairman Alan Greenspan hypothesized as much in a well-known speech (Greenspan 1999), characterizing a well-functioning bond market as a potential “spare tire,” that might have allowed for continued intermediation and avoided economic turmoil even after banks had stopped lending in Thailand prior to the crisis.

Over time, the notion of bond markets as a spare tire has largely been discredited, as it has been widely observed that the development of successful banking sectors and domestic bond markets are complements, rather than substitutes. However, it is widely accepted that there is some truth to the idea that well-functioning bond markets can be better placed to provide some forms of intermediation. While banks are more adept at lending to smaller, more opaque firms, bond markets enjoy a comparative advantage in servicing larger, more established companies (Eichengreen 2006b). Indeed, if that were not the case, these markets would not have persisted in developed economies over time.

However, a more enduring lesson of the 1997 Asian financial crisis was the danger of exposure to currency risk. During that crisis, abrupt devaluations decimated the balance sheets of firms and financial institutions, as the value of revenue streams that were usually tied to domestic currencies plummeted relative to the hard currencies in which firm and bank liabilities were denominated, their balance sheet positions rapidly deteriorated. This experience taught the enduring lesson that external exposure to currency mismatches are a major source of vulnerability. The opportunity to issue in local currencies allows firms to avoid these mismatches and limit this vulnerability.² This desire to mitigate firm currency risk exposure remains one of the primary motivations for government intervention in support of the development of local currency bond markets in Asia (e.g., Kwon [2006]).

2.2 Achieving Economies of Scale

Another motivation for encouraging the development of local currency bond markets is in allowing them to reach transaction volumes sufficient to achieve economies of scale and reduce funding costs for issuing domestic firms. The size of the underlying economy plays a key role in the determination of the depth of local bond market activity.

One reason for bond markets to exhibit scale economies is that smaller markets can suffer from illiquidity. Asian bond markets, excluding Japan, are commonly regarded as less liquid than those in the US. While there are a number of alternative measures of liquidity, in practice these measures tend to be highly correlated (e.g. Jiang and McCauley [2004]). In response, we concentrate on bid-ask spreads in our analysis of Asian bond market liquidity as that measure is most widely available. However, as pointed out by Jiang and McCauley (2004), one should note that bid-ask spreads may be flawed indicators of liquidity in Asia, as government restrictions may constrain their magnitudes. In the presence of such restrictions, markets may adjust via the only mechanism available, namely through a decline in volume.

For example, Hale and Spiegel (2009) find that among non-financial firms in international bond markets there was a 35.3% increase in the probability of issuing in euro relative to preunion national currencies subsequent to the launch of the European Monetary Union (EMU). Presumably, that increase was attributable to the far greater size of the euro area economy relative to any of its national counterparts. This increased size implies that firms issuing in euro will attract more intense analyst coverage and face deeper markets than they did issuing in their national currencies prior to the advent of the euro. While the advent of the euro represented an unprecedented increase in the size of an underlying economy, it clearly suggests that scale economies play a role in the attractiveness of local currency bond markets.

Two features drive the perception that domestic Asian bond markets could achieve greater scale economies than those that they currently exhibit. The first is the perception that Asian domestic local currency bond markets are small relative to the size of their economies. While that conjecture is no longer as true as it used to be, thanks in large part to efforts made over the decade in promoting local currency bond market development in Asia, there is still a lot of heterogeneity within the region, with the result that this conjecture is still true for many countries within the region.

The second feature is that as a region Asia is running a large surplus with the rest of the world. The other side of this transaction is that the rest of this world finances this borrowing through the issuance of their own domestic bonds, with the result that both public and private agents in Asia have acquired large stocks of foreign bonds, particularly US Treasuries. There is a perception that instead of this pattern, capital could be profitably recycled within the region to local issuing firms. It has been argued for some time that the development of local currency bond markets could play a role in alleviating global imbalances, (e.g. Park and Rhee [2006]).

Although widely argued, the merits of this claim appear to be quite unclear. The argument appears to posit that US treasuries and Asian corporate bonds in domestic currencies are highly substitutable, so that reduced issuance of one would result in increased demand for the other. However, the period of rapid growth in global imbalances was also one with relatively low interest rates.

Some have argued that global interest rates were low over this period because of excessively-accommodative monetary policy. Taylor-rule based simulations indicate that the Federal Funds rate was below levels consistent with a 2% inflation target between 2003 and 2006, sometimes by as much as 200 basis points (e.g. White 2008). This might imply that Asian interest rates over this period were higher than they would have been under reduced global imbalances. However, at a minimum, it is clear that global credit conditions were easy during the period of high global imbalances, implying that the imbalances alone cannot be the source of low issuance volume in Asian domestic currency bond markets.

Indeed, if anything, one could argue that the low interest rates that prevailed during this period motivated increased appetite for more risky Asian securities, as global investors found themselves accepting greater and greater levels of risk to achieve some desired yield target. As such, the question seems rather to be whether local currency markets are sufficiently developed to provide a profitable channel for intermediation of the ample capital available for investment in the region.

Another motivation for encouraging the development of local currency bond markets is that current transaction volumes are inadequate to generate a desirable level of coverage by global rating agencies. It has long been understood (e.g. Park and Park [2003]) that successful development of Asian local currency bond markets would require the existence of both regionally specialized rating agencies, as well as rating activity from global firms. These rating agencies provide the analysis that investors require to feel secure about assessing the risks associated with foreign bond purchases, and the spreads required for issuance in the absence of their coverage may prove to be prohibitive to many potential issuing Asian firms. In response, Asian groups have actively encouraged additional coverage by both global and regional rating agencies.

However, many bond issuers in Asia are still not covered by these agencies. This immediately reduces the potential investor base for Asian issues, as many large Western institutional investors, such as pension funds, require that the bonds included in their portfolios be rated at some level by international credit rating agencies. This calls into question the wisdom of encouraging rating agencies solely at the regional level. These regional agencies are likely to encourage additional clients from the region itself, but may leave it difficult to attract foreign purchasers, as these institutions may not recognize the ratings generated by these regional agencies.

The superiority of global rating agencies over their national counterparts in Asia has also been questioned. On one hand, national rating agencies are supposed to have access to superior information concerning the underlying fundamentals of issuing firms. On the other hand, however, global rating agencies are supposed to enjoy superior international credibility, as they are generally considered to be more independent. A recent study by Ferri et al. (2009) sheds doubt on the superiority of global rating agencies in the Republic of Korea (Korea), as downgrades from a national ratings firm generated deeper negative responses on average than downgrades from its global affiliate counterparts.³

As such, the strategy that is likely to be best is one that encourages additional coverage by both regional and global agencies. While these two goals are in some sense contradictory, it is clear that requiring transparency at levels that facilitate rating agency coverage is likely to facilitate additional coverage by both forms of agencies.

2.3 Anomalies and imperfections in less-developed markets

There is widespread perception that less developed bond markets exhibit anomalies and other distortions in their yield curves. When well-behaved, bond yield curves can provide important information concerning the degree to which investors discount future payment streams. Yield curves have been shown to provide important information concerning agent's discount and expected inflation rates. For example, Gürkaynak, Sack, and Swanson (2005) demonstrate that bond yield curves are useful in gauging investors long-term inflation expectations, as long-term yields appear to respond to current data.

Distortions in yield curves can arise for a wide variety of reasons, including liquidity premia, hedging demand, demand for deliverability into futures contracts, desirability for use in repo markets, or differences in bid-ask spreads or non-synchronous quote times (Gürkaynak, Sack, and Wright 2007). These anomalies can be problematic for two reasons. First, they may make it difficult to garner information about the rate of discount. As bonds do not exist at all maturities, estimation of yield curves must entail some degree of interpolation across maturities. This smoothing process can introduce errors depending on the underlying causes of observed anomalies: Some might reflect actual differences in rates of discount, while others might reflect more market-based sources of heterogeneity, such as the aforementioned differences in bid-ask spreads, which may raise the yield on one bond substantially over another of close maturity. This inability to identify the true rate of discounting of bonds at various maturities can make it hard to gauge, for example, how well inflation expectations are anchored, and thereby hinder the ability of bond yields to be used in the pursuit of monetary policy.

Second, to the extent that anomalies reflect difficulties in settlement or other financial frictions, they represent additional costs of intermediating through the bond market at a given maturity. As such, these anomalies reflect the fact that it is more costly to conduct transactions at these maturities. Since mitigating risk often requires the ability to open and close positions at various maturities, these costs may discourage bond issuance not only at the maturities exhibiting the observed anomalies, but in the market exhibiting these anomalies as a whole.

However, it should be recognized that liquidity discrepancies are likely to lead to some lack of smoothness in even the most developed markets. In their estimation of the US Treasury yield curve from 1961 to 2006, Gürkaynak, Sack, and Wright (2007) find that while they can fit a curve that matches the data quite well using only six parameters, they still find maturities that are off their fitted curve, most notably at two and three year maturities. As such, some discrepancies of bond yields from values consistent with a smoothed curve should be considered normal, even for the bond markets of the most developed economies.

Nevertheless, even the most developed countries appear to show declining yield curve anomalies with bond market development. Gürkaynak, Sack, and Wright (2007) show that yields on US securities at a wide variety of maturities exhibit declining yield curve anomalies, in the form of observed errors in yield curve estimation, over time. They argue that increased market activity and liquidity is one possible explanation for their observed decline in these pricing anomalies. In particular, they point out that their estimations do worse in the immediate aftermath of the global financial turmoil experienced in the fall of 1998.

Yield curve anomalies also appear to arise during temporary episodes of financial turbulence. These anomalies are likely to reflect the lack of liquidity in issues at specific maturities. For example, Gürkaynak, Sack, and Wright (2007) find increases in liquidity premia of on-the-run 10 year US Treasury yields relative to synthetic off-the-run Treasury securities with comparable maturity dates and coupons during episodes of financial turmoil, such as the 1987 stock market crash and fall 1998 seizing up of financial markets following the Russian ruble crisis.

Even among developed economy bond markets we see evidence that increased depth and liquidity in domestic bond markets can reduce the magnitude and incidence of anomalies. For example, Ehrmann et al. (2007) examine the case of bond markets in the euro area before and after the advent of the EMU. They find that the advent of the euro led to substantial convergence of levels and co-movements of yields across these markets, suggesting that investors tended to treat the euro-area bond market as closer to a single market, notwithstanding the differences in perceived default risk among euro area member countries. Indeed, Manganelli and Wolswijk (2007) find evidence that heterogeneity in pricing of government bond yields after the launch of the euro was attributable to differences in bond credit ratings, which are supposed to be based solely on default risk. As such, it appears that net of default risk, and differences associated with legal regimes, the euro area was treated as a single local currency bond market after the launch of the monetary union.⁴

To the extent that investors treated issues in euro as a single market subsequent to the launch of the monetary union, we would expect bond markets in Europe to exhibit increased depth and liquidity after the launch of the currency union. The advent of the euro therefore provides us with a natural experiment concerning the impact of increased bond market depth and liquidity on the prevalence of anomalies, such as those displayed in deviations from smooth estimated yield curves.

Evidence consistent with this conjecture is provided in Figure 1 [ PDF 27KB | 1 page ], which is taken from Ehrmann et al. (2007). They estimated yield curves for Italy and France in 1995 and 2005, i.e. before and after the launch of the EMU. Prior to the launch of the EMU, Italian bond yields of similar maturities traded more than 100 basis points apart. They attributed these differences to wide discrepancies in liquidity and other security characteristics in the pre- EMU Italian bond market. However, the yield curves for 2005, subsequent to the launch of the EMU, suggest a deeper, more liquid, and more efficient Italian bond market.

Moreover, these discrepancies are far larger for the pre-EMU Italian bond market than for the French bond market. Prior to the launch of the EMU, the French bond market, which was already deeper and more developed in 1995 than its Italian counterpart, only displays one maturity far removed from the yield curve estimate. This suggests that even prior to the advent of the euro the French bond market was deep enough to avoid a substantial number of bonds removed from its smoothed yield curve.

This evidence from the euro area demonstrates that the primary path to removing bond market inefficiencies is achieving the optimal scale necessary for sufficient liquidity, as well as deeper analyst coverage. However, it is important to remember that the advent of the euro brought other changes as well, most notably greater credibility for “Italian” monetary policy, but also greater credibility on the fiscal side because of the constraints faced under the growth and stability pact, which limited euro area governments to fiscal deficits less than 3% of gross domestic product (GDP), except in exceptional circumstances. Finally, other changes happened as well, including harmonization of financial standards within the European Union, which raised the quality of financial regulatory standards in Italy.

The European example therefore provides a lesson for the development of Asian local currency bond markets. While additional liberalizations makes it incorrect to attribute all of the declines in observed anomalies in euro area bond markets to scale economies with the increased volume of euro area issuance, we can conclude that the combination of increased market depth, superior macroeconomic policies, and improved financial regulatory conditions provided a desirable cocktail of policy changes that led to marked improvements in the observed conditions in these markets.

Given the efforts made in encouraging the development of Asian local currency bond markets, and the general consensus that these efforts have been successful to date in a number of countries in the region, it is natural to expect that we would observe a decline in the yield curve anomalies discussed above over the time period where these efforts were taking place. That appears to be the case, as evidence by the fitted Korean yield curves in Figure 2 [ PDF 25.2KB | 1 page ].⁵ It can be seen that at the launch of the ABMI in 2003, discussed in more detail below, the Korean government securities yield curve exhibited a number of anomalies, including a notable inversion at the 2-year horizon. Four years later, this was replaced by a relatively smooth upward-sloping yield curve. Most currently, despite the financial turbulence experienced in that country, the Korean yield curve fails to exhibit any inversions, although the medium maturities deviate substantially from levels that would be consistent with a smooth fitted yield curve.

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