[PPT] - Developing domestic bond markets: Why do we care and the role of PowerPoint Presentation

SLIDE 1

Developing domestic bond markets: Why do we care and the role of South-South cooperation

Ugo Panizza UNCTAD

Conference on Deepening Financial Sector Reforms and Regional Cooperation in South Asia New Delhi, November 2008

SLIDE 2

Outline

Why do we care?
Some facts about debt composition and

the development of domestic bond markets in developing countries

How do we build bigger bond markets?
Regional financial cooperation

SLIDE 3

Debt Composition Matters!

The “Economics 101” debt dynamics

equation tells us that the change in the stock

f debt is equal to the budget deficit
This equation can be used to decompose the

growth rate of the Debt-to-GDP ratio

DEFICIT DEBT DEBT

t t t

= −

−1

d g pb d i d + − − x = Δ )x ( π

SLIDE 4

Debt Composition Matters!

The “Economics 101” debt dynamics

equation tells us that the change in the stock

f debt is equal to the budget deficit
This equation can be used to decompose the

growth rate of the Debt-to-GDP ratio

SF DEFICIT DEBT DEBT

t t t

+ = −

−1

SF d g pb d i d + + − − x = Δ )x ( π

SLIDE 5

The Unexplained Part of Debt

Decomposition of Debt Growth in LAC7

12

12 24

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Percentage of GDP Inflation UNEXPLAINED PART Interest expenditure Primary balance GDP growth

Source: Campos, Jaimovich, and Panizza (2006).

SLIDE 6

The Unexplained Part of Debt

15
10
5

5 10 15 IND EAP ECA MNA LAC SSA

INFLATION GDP GROWTH UNEXPLAINED PART INTEREST EXPENDITURE PRIMARY DEFICIT

Source: Campos, Jaimovich, and Panizza (2006).

SLIDE 7

The Unexplained Part of Debt

What explains the “Unexplained part of

debt”

– Skeletons

Fiscal policy matters!

– Banking Crises – Balance Sheet Effects due to debt composition

SLIDE 8

Public Debt and Sovereign Rating (1995-2005)

Italy Jamaica Japan Israel Belgium Ghana Jordan Saudi Arabia Pakistan Egypt, Arab Rep. Mongolia Senegal Morocco Grenada Argentina Barbados Bolivia Panama Indonesia Bulgaria Portugal Cyprus Hungary Sweden Philippines Papua New Guinea Austria Tunisia Malta Denmark Ecuador India Benin Canada Finland Qatar Netherlands Spain France Uruguay Russian Federation Venezuela, RB United Kingdom Peru Croatia Brazil Poland South Africa Ireland Malaysia Trinidad and Tobago United States Iceland Belize Turkey Costa Rica Ukraine El Salvador Colombia Bahamas New Zealand Paraguay Germany Slovak Republic Mexico Switzerland Lithuania Bahrain Slovenia Norway Oman China Thailand Kazakhstan Guatemala Korea, Rep. Czech Republic Chile Australia Latvia Botswana Estonia Luxembourg 10 20 30 40 50 60 70 80 90 100 110

Public Debt as Percent of GDP Standard & Poor's Sovereign Rating

AAA B- BB- BBB- A- AA-

Source: Jaimovich and Panizza (2006) and Standard and Poor's Investment grade

Debt Composition Matters!

SLIDE 9

The international market is volatile…

J a n J u n N

v

A p r S e p F e b D e c M a y O c t M a r A u g J a n J u n N

v

A p r S e p F e b D e c M a y O c t M a r A u g J a n J u n N

v

A p r S e p F e b D e c M a y O c t M a r A u g J a n J u n N

v

A p r S e p F e b

SLIDE 10

The international market is volatile…

J a n J u n N

v

A p r S e p F e b D e c M a y O c t M a r A u g J a n J u n N

v

A p r S e p F e b D e c M a y O c t M a r A u g J a n J u n N

v

A p r S e p F e b D e c M a y O c t M a r A u g J a n J u n N

v

A p r S e p F e b J a n J u n N

v

A p r S e p F e b D e c M a y O c t M a r A u g J a n J u n N

v

A p r S e p F e b D e c M a y O c t M a r A u g J a n J u n N

v

A p r S e p F e b D e c M a y O c t M a r A u g J a n J u n N

v

A p r S e p F e b

100 200 300 400 500 600 700 12.10.07 11.11.07 11.12.07 10.01.08 09.02.08 10.03.08 09.04.08 09.05.08 08.06.08 08.07.08 07.08.08 06.09.08 06.10.08

SLIDE 11

The case for innovative debt instruments

Innovative debt instruments can increase risk-

sharing and reduce vulnerabilities for the borrower

– Equity-like instruments

GDP indexed bonds
CAT bonds

– International bonds denominated in emerging market currencies

Single currency
In a basket of currencies

– Dedollarize official lending

SLIDE 12

Why doesn’t the market develop such financial innovations?

Coordination problems linked to the need of a “critical mass” and

standards for new instruments.

– Simultaneous issuance by many parties makes new instruments more appealing

Establishing a new asset class generates positive externalities.

– For financial instruments where payments are due contingent to certain conditions, it is crucial to have verifiable standards for whether those conditions are met.

For example, the market for credit default swaps took off as soon as the standards

for a “credit event” were properly defined and became broadly accepted

The highly competitive structure of financial markets.

– Private financial institutions are unable to maintain a monopoly over the provision of a new instrument

Signaling.

– Individual countries may fear that issuing innovative instruments is perceived as signs of weakness

Political economy

SLIDE 13

Outline

Why do we care?
Some facts about debt composition and

the development of domestic bond markets in developing countries

How do we build bigger bond markets?
Regional financial cooperation

SLIDE 14

Governments have been changing their debt structure…

0.0 0.1 0.2 0.3 0.4 0.5 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Debt to GDP Ratio Domestic Public Debt External Public Debt

Source: Panizza (2008)

SLIDE 15

…in all regions…

Source: Panizza (2008)

0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 EAP ECA LAC MNA SAS SSA All Countries

Share of Domestic Debt (weighted average)

1994 1999 2005

SLIDE 16

…and developing domestic bond markets

Size of the Domestic Bond Market (all developing countries)

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 % of GDP GOV

PRIV GOV

SLIDE 17

…and developing domestic bond markets

Size of the domestic bond market (Asian countries)

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 % of GDP

Private Government

SLIDE 18

…and developing domestic bond markets

Size of the domestic bond market (LAC countries)

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 % of GDP

Private Government

SLIDE 19

So, is everything well?

Not really!

SLIDE 20

Bond markets remain small and are dominated by the government

Domestic bond markets in developing and advanced economies (the data are for 2007)

0.00% 20.00% 40.00% 60.00% 80.00% 100.00% 120.00% 140.00% 160.00%

IND ASIA DEV LAC ECA

% of GDP

GOV PRIV

44% 62% 68% 71% 95%

SLIDE 21

They are also “sinful”…but less so in Asia

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1996 1997 1998 1999 2000 2001 2002 2003 Index of domestic original sin

Note : Original sin is measured as share of domestic debt which is short term, denominated in foreign currency, or indexed to prices or the interest rate. "Latin America" includes: Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela. "Asia" includes: China, India, Indonesia (from 1998), Korea, Malaysia, Philippines, and Thailand. "Other emerging markets" includes: Czech Republic, Israel, Hungary, Poland, Russia, and Turkey.

Domestic Original Sin in Emerging Regions

LAC Other EMs Asia

SLIDE 22

Maturities are lengthening…

Average Original Maturity

(Government Bonds) 2 4 6 8 10 12 14 16 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Years

Latin America Asia, larger economies Other Asia Central Europe IND

SLIDE 23

…but what is the “true” maturity of government bonds held by banks?

India

2 4 6 8 10 12 14 16 18

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Years

government bonds Average maturity of

SLIDE 24

…but what is the “true” maturity of government bonds held by banks?

India

2 4 6 8 10 12 14 16 18

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Years 10 20 30 40 50 60 70 80 (%)

Share of government bonds held by domestic banks (right axis) government bonds (left axis) Average maturity of

SLIDE 25

Outline

Why do we care?
Some facts about debt composition and

the development of domestic bond markets in developing countries

How do we build bigger bond markets?
Regional financial cooperation

SLIDE 26

How do we get bigger bond markets? A view from the market

An ADB survey found that market participants

want:

– More transparency

Pre and post trade information

– Publish a govt. bonds issue calendar and publish the outcome

f the auction
More intraday pricing transparency
More consistent secondary market pricing

– More hedging products

Better access to credit derivatives

– A larger and more diversified investor base

SIZE MATTERS!

SLIDE 27

How do we get bigger bond markets?

Evidence from cross-country regressions

Research* has shown that key factors

include:

– Good macro policies – Corporate governance – Good market infrastructure

These are like motherhood and apple pie..
...and EMs took important steps in this

direction.

But are these steps enough?

*Burger and Warnock (2003), Claessens Klingebiel and Schmukler (2003), Borensztein, Eichnegreen and Panizza (2006)

SLIDE 28

How do we get bigger bond markets?

Evidence from cross-country regressions

Borensztein Eichengreen and Panizza

showed that a relatively small set of variables explains:

– 70% of the difference in bond market development between LAC and the advanced economies – 90% of the difference in bond market development between Asia and the advanced economies

Can we just work on these variables and

catch up with the advanced economies?

SLIDE 29

How do we get bigger bond markets?

Evidence from cross-country regressions

Not Really

– Some variables are impossible to change

Legal origin

– Others are just proxies of economic development

GDP per capita

– Not so easy to change

One key variable is market size

– McCauley and Remolona (2000) suggest that a market capitalization of $100 billions is required for a deep and liquid bond market

Probably more now

– Few EMs meet this requirement

SLIDE 30

100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 1500 1600 1700 1800

Croatia Slovakia Lebanon Peru Russia Pakistan Chile Hong Kong SAR Colombia Philippines Hungary Argentina Indonesia Singapore Czech Republic South Africa Thailand Venezuela Poland Malaysia Taiwan Turkey Mexico India Brazil South Korea China

Billion USD

GOV PRIV

13 countries with cap above $100 billion

SLIDE 31

Country size matters

HRV SVK PER HUN PAK PHL SGP CHL COL CZE MYS HKG VEN THA ARG ZAF TWN IDN POL TUR MEX KOR IND BRA CHN

.2

.2 .4 .6 e( BM2GDP | X )

2
1

1 2 3 e( lgdp | X )

coef = .08405292, se = .03763301, t = 2.23

SLIDE 32

Summing up

Both market participants and economists

who run cross-country regressions think that size matters

Catch 22: the markets are small because

they are illiquid and they are illiquid because they are small

SLIDE 33

But how do you expand market size?

Institutional investors can help

– However, they help for size but not for liquidity – … and they can be raided

Don’t let people go outside (AKA capital

controls)?

– …mmm

Some countries are just not big enough and

financial integration across developing countries remains small

– Lack of liquidity seems to be the culprit in Asia (Garcia-Herrero, Yang, and Wooldridge, 2008)

Regional cooperation may help

SLIDE 34

Outline

Why do we care?
Some facts about debt composition and

the development of domestic bond markets in developing countries

How do we build bigger bond markets?
Regional financial cooperation

SLIDE 35

Regional financial cooperation The Asian experience

Crisis management

– Bilateral Swap Arrangement (BSA) under the Chiang Mai Initiative promoted by Asean+3

Still lacks surveillance and monitoring system and hence it is still

dependent from the IMF

Exchange rate cooperation and monetary integration

– The first objective is the development of a Asian Currency Unit (ACU)

So far, only research mostly promoted by ADB, ASEAN+3,
Development of regional bond markets

– The Asian Bond Market Initiative (ASEAN+3) – The Asian Bond Fund 1&2 (EMEAP) – Issue local currency bonds in the international market (ADB)

SLIDE 36

EMEAP (1991) 11 SEACEN (1996) 16 SEANZA (1956) 20 ASEAN (1967) 10 ASEAN+3 (1999) 13 APEC (1994) 21 ASEM (1997) 43 EAS (2005) 16 ACD (2002) 30 AUS

X X X X

BGD

X X

BRN

X X X X X X X

BTN

X

BUR

X X X X X X

CAN

X

CHL

X

CHN

X X X X X X X

FIJ

X X

HKG

X X X

IDN

X X X X X X X X X

IND

X X X X

IRN

X X

JPN

X X X X X X X

KHZ

X

KMR

X X X X X X

KOR

X X X X X X X X

KWT

X

LAO

X X X X X

MEX

X

MON

X X X X

MYS

X X X X X X X X X

NPL

X X

NZL

X X X X

OMN

X

PAK

X X X

PER

X

PHL

X X X X X X X X X

PNG

X X X

QAT

X

RUS

X X

SAU

X

SLA

X X X X X X X

SNG

X X X X X X X X X

TAJ

X

THA

X X X X X X X X

TWN

X X

UAE

X

USA

X

UZB

X

VNM

X X X X X X X

27 EU

X

9 DIFFERENT FORA

1956 SEANZA (20 COUNTRIES)
1966 SEACEN (16 COUNTRIES)
1967 ASEAN (10 COUNTRIES)
1991 EMEAP (11 COUNTRIES)
1994 APEC (21 COUNTRIES)
1997 ASEM (43 COUNTRIES)
1999 ASEAN+3
2002 ACD (30 COUNTRIES)
2005 EAS (16 COUNTRIES)

Too many players

Often without a permanent secretariat and sometimes with conflicting objectives

SLIDE 37

The spaghetti bowl of Asian financial cooperation

ASEM ASEAN+3 ASEAN APEC ACD SEANZA E M E A P SEACEN EAS

SLIDE 38

The Asian Bond Markets Initiative

AMBI was endorsed by ASEAN+3 finance

ministers at their meeting in Manila in August 2003

Set of working groups with the objective of:

– Promoting the creation of securitized debt instruments – Promoting the creation of credit guarantee mechanisms – Promoting the issuance of bonds denominated in local currency by non-residents – Strengthen rating Agencies and information dissemination

SLIDE 39

The Asian Bond Funds

Launched by EMEAP:

– Executive Meeting of East Asia Pacific Central Banks

11 CB: AUS, CHN, HKMA, IDN, JPN, KOR, MYS, NZA, PHL, SGP,

THA

The first time that central banks and monetary authorities

earmark part of their reserves for joint investment

– EMEAP worked with the IMF so that central bank holdings in bond funds qualify as international reserves

Motivation:
“A lesson learnt from the Asian financial crisis is the importance of

developing a deep and liquid domestic bond market to reduce corporate sector reliance on financing through short-term bank

borrowing. At the same time, part of the high savings in Asia, which

are mostly invested in assets of developed markets, have returned to the region in the form of bank lending and portfolio inflows. Such inflows tend to be volatile. Hence, to improve the efficiency of financial intermediation in Asia and to develop a source of long-term funding for Asian borrowers, the region needs to develop deep and liquid domestic bond markets” (EMEAP, 2006)

SLIDE 40

The Asian Bond Funds (ABF1)

Asian Bond Fund 1 (ABF1) initiative

– Launched at the EMEAP Meeting of June 2003

Objective:

– Catalyze the growth of Asian bond markets by allocating a portion of the reserves of regional central banks to the purchase of government and quasi- government securities

The initial $1 billion of investment was devoted

to Asian sovereign and quasi-sovereign issues

f dollar-denominated bonds

SLIDE 41

The Asian Bond Funds (ABF2)

Asian Bond Fund 2 (ABF2) initiative was

announced by EMEAP in December 2004

– Invest CB reserves in sovereign and quasi- sovereign bonds in local currency

Objectives

– Providing a low-cost and investment product in the form of passively managed index bond funds to broaden investor participation – Identifying impediments to bond market development in EMEAP economies and acting as catalyst for regulatory reforms and improvement in market infrastructure

SLIDE 42

The Asian Bond Funds (ABF2)

Two types of funds

– The Pan Asian Index Fund (PAIF) is a passively managed mutual fund (PAIF) operated by private sector managers and designed to track a Pan Asian index

The objective of the PAIF is to facilitate entry by retail

and institutional buyers

– Low cost (passively managed) – Increase liquidity (incentive to create a system of market makers)

» Asian investors tend to be of the buy and hold type

– Diversification (a basket of countries provide better diversification than a single country)

– A series of 8 national funds

The 8 funds aim at increasing the liquidity in the various

domestic markets and promote integration across the markets

SLIDE 43

The Asian Bond Funds (ABF2)

The initial allocation is $ 2 billion

– $1 billion for the PAIF and $1billion for the 8 national funds

Two phases
Phase 1: investment in ABF2 funds confined

to EMEAP

– Started in December 2004, funding was completed in April 2005

EMEAP investments are held through a BIS investment

vehicle, this facilitates their use as international reserves

Phase 2: Funds are offered to the public

SLIDE 44

The Asian Bond Funds (ABF2)

So far, the focus has been on sovereign

– Will there be the need for and ABF3 or will positive externalities be enough?

SLIDE 45

(a detour on the interaction between corporate and government bond markets)

Market creation

– Benchmark curve – Minimum size required for developing trading infrastructures

…or crowding out?
No clear empirical evidence

– Probably an inverted U

Market creation Crowding

ut

SLIDE 46

Where are they now?

The Pan-Asian fund started in July 2005

with USD 1 billion and at the end of June 2008 had assets for USD 1.76 billion

As of December 2007, 7 of the 8 individual

funds had been launched

– They had total assets of approximately USD 1.4 billion

SLIDE 47

Where are they now?

200 400 600 800 IDN PHL MYS THA HKG SNG KOR Million USD Initial Dec-07

June 2005

March 2007 April 2007

July 2005 April 2006 June 2005 August 2005

Source: Ma and Remolona (2008)

SLIDE 48

China 11% HK 17% Indonesia 6% Korea 21% Malaysia 11% Philippines 5% Singapore 19% Thailand 10%

Allocation of PAIF

SLIDE 49

Is it enough?

Securities issued by the 8 countries which are part of ABF1 and ABF2 (December 2007)

200 400 600 800 1000 1200 1400 1600 1800 2000

International Securities Domestic Securities

Billion USD

Initial size of ABF-1: $1 billion Initial size of ABF-2: $2 billion Current size of ABF-2: $3.2 billion

SLIDE 50

Is it enough?

Size, is clearly not the key factor

– Moreover, central banks don’t trade much, so the funds are not likely to add liquidity – Moreover, ABF-I invests in dollar- denominated sovereign bonds and ABF-II invests in local-currency sovereign bonds

But these are the most developed segments of the

market

SLIDE 51

So, what are they key factors?

Learning by doing

– Find out what the real impediment are by trying to do it – Catalytic role

Establish a benchmark
Provide an example for the private sector
Strengthen creditors' rights

– Improve and harmonize corporate governance and transparency

Reduce constraints to market entry

– Common rules on the access of non-resident to the local bond market

Several countries were forced to liberalize access to their market

– No restrictions on the operation of foreign exchange futures markets – Develop derivative and hedging instruments

SLIDE 52

So, what are they key factors?

Establish common regulations

– Law harmonization – Similar supervisory structures – Homogenous tax treatment and market structure – Regional cooperation in supervision and information and data sharing

Increase market transparency

– Standardized and harmonized documentation – Improve data compilation and reporting – Improve price disclosure mechanisms – Common methodology to establish credit ratings

So that an A- rating from a Indonesian rating agency means the same thing

as an A- rating from a Korean rating agency

– Similar benchmark curves

A network linking 8 markets may provide further impetus to regional

integration

– Create similar and integrated clearing and payment systems

SLIDE 53

Unintended consequence

These are all measures aimed at reducing differences

across local markets

All these steps are equivalent to promoting capital

account liberalization

– both de facto and de jure

This is not bad or good per se

– But, we are usually told that the right sequencing is to strengthen the domestic financial system and then open the capital account – Here, we are opening the capital account in order to strengthen the financial system

This part of the “collateral benefit” view of capital account

liberalization

– But do we have evidence supporting this collateral benefit view

There is also the exchange rate issue

SLIDE 54

Developing domestic bond markets: Why do we care and the role of South-South cooperation

Ugo Panizza UNCTAD

Conference on Deepening Financial Sector Reforms and Regional Cooperation in South Asia New Delhi, November 2008