Policy Conclusions

The experience over the previous decade was one of rapid growth and development of local currency bond markets within the region. Moreover, while the advent of the global financial crisis has required that we reassess many of policy conclusions that were held going into the crisis, it appears that most of them remain intact, which leads to some notable conclusions.

First and foremost, the global financial crisis does not eliminate the merits of pursuing development of local currency bond markets. It is true that the crisis revealed many institutions to be overleveraged, suggesting that a reduction in overall issuance volumes worldwide might be desirable. It is also true that the experience also put paid to a strong form of former Chairman Greenspan's “spare tire” argument, as bond markets collapsed along with bank lending worldwide.

However, the crisis also demonstrated the perils of currency mismatch, particularly for smaller emerging market economies whose currencies were not credibly linked to one of the major world currencies. The primary motivation for encouraging the development of local currency bond markets was therefore strengthened by the crisis experience.

The crisis also supports the pursuit of initiatives at the regional level. First, the imperative of mitigating currency risk exposure among firms from smaller emerging market economies can only be satisfied through regional efforts. These economies are too small to achieve economies of scale in debt issuance in their domestic currencies, and their best prospect would be some kind of regional currency basket that would mitigate their exposure, although not eliminate it entirely. A viable arrangement for debt issuance of that form would only be feasible through coordination at the regional level.

Small movements towards monetary integration may have benign implications for the development of local currency bond markets. As Eichengreen (2006a) noted, one result of the path towards monetary integration in Europe was the increased issuance of European Currency Unit (ECU) bonds. The ECU was a basket of European community currencies that countries were encouraged to stabilize their currencies against beginning in 1979. While the bulk of transactions in Europe were still conducted in national currencies during this time, the development of the ECU bond market presents an alternative for Asia, as the adoption of a similar parallel currency Asian Currency Unit (ACU) might encourage increased local currency issuance within the region.

However, as a basket currency, creditors and issuers of ACU-denominated bonds would still be exposed to currency risk. One must therefore acknowledge that part of the observed growth in the ECU market may have been attributable to the mandate for countries to stabilize their exchange rates against the ECU, something that the ACU would lack in the absence of more dramatic monetary regime change in the region. As a result, it may be unrealistic to expect that the launch of an ACU in the absence of a commitment to further monetary integration in the region would result in the increased issuance volume observed in Europe.

Second, the effort to encourage greater coverage of private issues through the encouragement of regional ratings agencies -- while also ensuring that global ratings agencies remain active in the region -- is also of primary importance. While there were many disappointments with the performance of the ratings agencies during the crisis, particularly with respect to securitized assets, the problems illuminated that the need for quality ratings was stronger than previously believed, not weaker.

To some extent, the crisis supports the contention that increased official borrowing encourages, rather than crowds out, the issuing opportunities enjoyed by the private sector. Government issues appear to fill out volumes along the yield curve and reduce the severity of the anomalies discussed above. In particular, we saw bond markets with larger shares of domestic issues, such as that of China, exhibit less disruption during the height of the crisis. However, one should caution that much is not held equal in a cross-country context, and a more systematic study would be required to assess this question.

Among issues where reassessment is in order, one must include the conclusion that regional efforts over the decade to promote local currency bond issues were an unqualified success based on the astronomical growth in issues observed over this period. In retrospect, it is clear that a portion of these issues were motivated by an unhealthy and unrealistic appetite for risk in world financial markets. It is by no means certain that this healthy growth will be reversed, but the ultimate state of Asian local currency bond markets will only be known when markets return to tranquility; to date, the recovery in Korean 3-month Treasuries mirroring the performance of 3-month US treasuries over the same period signals that solid progress has been made in the region.

Another issue concerns the role of securitization. Led by revisions to Basel II, the current trend is away from regulatory encouragement as a vehicle for diversification, as we now have appreciation that it achieves this reduction in idiosyncratic risk only at the expense of increasing systematic risk exposure and opaqueness.

Beyond the lessons of the crisis, a number of other policy conclusions are worth mentioning: First, it remains of primary importance that countries maintain macroeconomic stability and the financial infrastructure needed for successful intermediation in their domestic market. On the macro policy side, it has been well-documented that emerging market economies that exhibit macroeconomic stability are more successful in developing their domestic financial markets, (e.g. Burger and Warnock [2007]).

It is also important to develop a robust and safe domestic financial system. Such a system would allow firms to issue offshore, as well as in foreign currencies. Many market imperfections in Asian markets are self-induced. For example, withholding taxes and legal constraints combine to segment markets from global capital (Jiang and McCauley 2004). These policy-induced distortions raise the cost of intermediation through local bond markets, and drive issuers to alternative financial instruments or to alternative jurisdictions.

Countries may also expand their domestic financial depth by encouraging foreign borrowers to issue domestically in local currency. Asian markets are already making headwinds along these lines, such as in the Korean “Arirang” bond market, which reached the size of US$2.7 billion in 2006 (Batten and Skilagyi 2007).¹⁵ Attracting foreign issuers may be a desirable way to encourage increased volume in the domestic market.

First, there is a logical disconnect in the notion that the capital surpluses built up in Asia are somehow available for “recycling” by domestic Asian borrowers. The buildup of capital is a result of large current account surpluses, the financing of which requires a net surplus of external lending. However, if a portion of this foreign borrowing can be channeled to domestic local currency bond markets, it can play a positive role in increasing domestic currency issue volumes to levels sufficient to achieve economies of scale. Indeed, as noted by Hoschka (2005a), the presence of highly rated multinational corporations may actually “crowd in” local issuance, because they are likely to be experienced in raising capital through this channel and will deepen the markets for their domestic counterparts. This deepening also increases the visibility of domestic issuers, potentially increasing their coverage and further reducing their issuance costs. Moreover, firms that raise funds locally with the intent of swapping these funds into other currencies may contribute to the development of crosscurrency swap markets, which are desirable for local issuers that issue abroad and desire to hedge these issues to avoid exposure to currency mismatches.

A successful program of encouraging local currency issues by foreigners would require achieving a certain degree of liberalization. Hoschka (2005b) argues that a primary source of foreign issuance is through the multilateral development banks. However, these institutions typically require compliance with conditions, such as exemption from withholding taxes, exemption from domestic rating requirements, access to a broad set of potential investors, including insurance and pension funds, risk weightings in line with BIS guidelines, and eligibility to meet financial institution reserve requirements, similar to the status enjoyed by government securities.

Attracting foreign investors will require a number of enhancements to domestic bond markets that should improve their performance overall. Asian nations will need to continue to make progress in regional harmonization of regulatory standards. This is the motivation for the promotion of “Asian Bond Standards,” within the region. However, prevailing regulatory standards remain quite heterogeneous. Asian nations will also need to develop access to hedging instruments, such as currency swaps and forward contracts, to encourage foreign investors to acquiring Asian domestic bonds (Park and Park 2003).

Finally, it must be recognized that one of the primary forces limiting the development of Asian bond markets is that the large current account surpluses enjoyed by Asian nations are financed in large part through offshore bond issuance. Global firms from outside the region find willing holders of their paper in Asia as these investors attempt to park their export proceeds in safe instruments yielding competitive returns. Given these imbalances, potential borrowers within the Asian region find themselves in competition with foreign bond issuers. If trade were more balanced, there would be less excess demand for credit from the rest of the world, and the borrowing terms faced by Asian issuers would be enhanced, holding all else equal.

Of course, all need not be held equal. Domestic issuers would respond to these enhanced terms by issuing more debt, some of it presumably on domestic markets. As a group, this would increase the volume of issues in these domestic markets and to some extent alleviate their economies of scale issues. Admittedly, the level of response is unclear, as Asian firms may alternatively choose to issue their paper abroad. Still, it appears certain that the fact that Asia as a region is running a large current account surplus and holding a large share of debt issued outside the region in its portfolio is not a coincidence.

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