Local Currency Bond Markets: the Challenge of Deteriorating - - PowerPoint PPT Presentation

Local Currency Bond Markets: the Challenge of Deteriorating Liquidity?

Government Bond Market: Peer Group Dialogue

Mike Williams mike.williams@mj-w.net

November 2014

The Questions

2

This presentation borrows heavily from work done within the Capital Markets Practice of the World Bank. The charts in Slides 3-5 are taken from the “2nd Annual Note on Recent Developments in Local Currency Bond Markets”, prepared by Official Institutions for the G20, August 2014

Some evidence – discussed below – that liquidity in local currency bond markets (LCBMs) is deteriorating

• Can we validate that?
• What are the determinants?
• What can or should we do about it?

The Context

3

The importance of LCBM development has long been recognised

• To debt managers for widening financing options and reducing risks
• To the wider economy for mobilising investment to support growth
• High on the policy agenda of IFIs and G20 – as well as individual countries

LCBMs have grown substantially – although pace slowed in recent years

6.1 7.3 8.3 9.2 9.3 44% 43% 42% 44% 42%

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 1 2 3 4 5 6 7 8 9 10 2009 2010 2011 2012 2013

EMEs LCBM USD tn

Local Local (% of GDP)

6.1 7.3 8.3 9.2 9.3 0.8 1.0 1.1 1.4 1.7 88% 88% 88% 87% 85%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 2 4 6 8 10 12 2009 2010 2011 2012 2013

LCBM Local v International USD tn

Local International Local (% of total)

397 388 562 910 868 683 52 36 55 70 91 35 43 55 72 72 73 40 511 500 706 1,126 1,051 765

2009 2010 2011 2012 2013 2014*

Corporate LC Issuance

USD bn

Asia Europe & Central Asia Latin America & Caribbean Middle East & North Africa Sub-Saharan Africa Total

Some other trends

4

LC issuance dominates FX issuance (In 2014 to May: ~60% of all EME bonds issued

(by government and corporates) have been in LC (slightly < 2013 average))

LC corporate debt issuance slowed in 2013; and LC government debt issuance increased only slightly

• Increase in USD issuance in some frontier markets (several now in EMBIG indices)
• Foreign investor participation in EME LCBMs has slowed (still historically high level
• JPM suggests 27% of stock - and IIF now expects some increased flow in 2015)

2,079 2,264 2,008 1,831 1,857 978 596 873 895 655 768 375 459 623 623 550 485 120 3,294 3,987 3,739 3,306 3,399 1,610

2009 2010 2011 2012 2013 2014*

Government LC Issuance

USD bn

Asia Europe & Central Asia Latin America & Caribbean Middle East & North Africa Sub-Saharan Africa Total

* to August 5

What is happening to liquidity?

5

Trading volumes of EME LCBs increasing in absolute terms. But:

• Trades as a proportion of the total outstanding stock (i.e. the turnover ratio) have

remained relatively stable, and at a low level compared with mature markets.

• Liquidity has worsened when measured by bid-ask spreads for 10-year government

bonds – widened significantly on average across several EMEs since 2010

0.5 0.6 0.6 0.4 0.4 0.6 0.8 0.7 0.5 0.5

• 0.1

0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2 4 6 8 10 12

2009 2010 2011 2012 2013 LC Outstanding EM Total Outstanding LC Turnover Total EM Turnover

Turnover Ratio (Trading Volume/Outstanding)

Source: EMTA; WBG Staff calculations

How typical are liquidity concerns?

6

Note also:

• Data uncertainties (from EMTA – survey based; also nominal not market values and

may include duplicates)

• Similar problems in advanced economies (recent RBS report, reported in FT July 7,

2014 “shows liquidity in the credit markets has declined ~70% since the crisis, and it is still falling….market depth, trading volumes and transaction costs [have all]

• worsened. The premium for illiquidity ..is at a record low …investors are not getting

paid to take liquidity risk.”) Turnover multiples low compared with outstanding, although vary with country:

• IMF expressed concern in April 2014 Global

Financial Stability Report. In many countries stock of non-resident holdings of LC gov debt is many times daily trading volumes

• Liquidity remains concentrated in

government debt instruments and in a handful of countries: 55 percent of total traded volumes in EME LC instruments were conducted in only 5 countries and 78 percent in ten countries in Q1 2014

More on spreads

7

Note:

• Focus on spread at 10 year point may give a misleading impression of

liquidity in EMEs? [Asian Bonds Online does not specify tenor]

• Bid-ask spreads difficult to measure directly – data rely on reporting banks
• Sharp rises in 2011 coincided with Eurozone crisis; and in 2013 with

expected US tapering – an opportunistic response to increased volatility?

Source: Financial Times, “Beyond Brics” blog 6 Oct 2014, reporting Bloomberg data on generic 10-year LCGBs in 24 EMs Source: asianbondsonline.adb.org

5 10 15 20 25

2006 2007 2008 2009 2010 2011 2012 2013

LC Government Bonds: Bid-Ask Spread

CN HK KR MY PH SG TH

bps (selected Asian countries)

A Familiar Problem?

8

Many EMEs have been more successful in primary market than secondary market. Multiple causes

• Dominance of banks who are not natural holders of debt – and not interested

in longer-term debt

• Some growth in domestic investor base; but limited diversity (shortage of

mutual funds and other medium-term holders); longer-term funds often buy and hold

• Yield curve distortions <= regulatory or monetary policy requirements
• Limited availability of hedging instruments, poor price discovery, and

underdeveloped money market inhibits trading, except at shorter end - lack

• f interest in market making

But recent progress seems to have stalled – why?

What are the main determinants? 1: Supply Side

9

Rise in FX issuance

• Taking advantage of low interest rates and investors’ demand for yield (there is no

shortage of structural liquidity)

• But many of the new FX issuers have a limited domestic market anyway

Development of other finance sources

• Greater instrument fragmentation – e.g. Sukuk, PPPs
• Probably not significant in aggregate, but maybe in some countries at the margin; and

slows development of benchmarks (also occupies administrative resources)

Recent interest in sub-national government (SNG) bond issue

• Decentralization in many countries has given SNGs greater spending responsibilities,

revenue-raising authority, and the capacity to incur debt. Rapid urbanization requires large-scale infrastructure financing. Questions:

» Do SNG issues displace borrowing from banks or on-lending from central government? » SNG issues tend to be smaller, less liquid. Is it more difficult to build benchmarks? » Do SNG issues disrupt central government’s issuance schedule?

What are the main determinants? 2: Demand Side

10

Deleveraging of banks (whether on their own volition or driven by regulators) makes them less willing to make markets

• Evidence of falling inventories in AEs; and anecdotally in EMEs?
• Withdrawal of some market makers strengthens competitive position of
• thers => increased spreads?

Growth of buy-and-hold domestic investors

• Is maturity being lengthened at the cost of liquidity?

Change in the nature of foreign investors

• Longer term funds (pension funds, wealth funds, central banks) replacing

hedge funds. Reflects consolidation of EME bonds as an asset class, and publication of relevant indices

• Longer maturities, less trading?
• Low volatility encouraging perceptions of a benign environment. Increased

stability means less activity?

Does interest compression or do other macro factors inhibit trading?

Are there underlying trends in market liquidity?

(Other than recent changes in demand & supply)

11

How has liquidity behaved across the curve; are there specific instruments or segments where liquidity has substantially improved

• Does international focus on the 10-year segment mislead?
• Is the experience of changing bid-ask spreads even across the curve?
• Has development of benchmarks improved liquidity in those instruments, even if

declined for others?

There have been some setbacks in market making (withdrawal of some banks, wider spreads); but are EMEs generally better served now, in terms of:

• The availability of a market?
• Price transparency?

What is happening to the size of trades; is it easier to trade large volumes?.

• Asian data suggest that average trade sizes risen over time (but some fall in 2013)
• Trade sizes falling in some developed markets – linked with electronic trading

Has the growing use of government bonds as collateral (in repo markets, including by the central bank) improved liquidity?

In passing, some other observations!

12

Recent trends bring new risks

• Rise in US interest rates (implied by tapering or otherwise) leaves countries exposed

» where they have FX liabilities » to herd behaviour of foreign investors – pro-cyclical behaviour from large asset managers; unhedged carry traders responding to stress signals » to oligopolistic behaviour by intermediaries

• Exceptionally low volatility encourages perceptions of a benign environment

» Encourages risk taking by investors: but increased volatility risks flight to safety

• Country-specific problems (e.g. impact of China slow down on commodity exporters,

interest rate compression in many countries) in period of rising global risk aversion could intensify contagion across EMEs

All these factors emphasise continuing importance of LCBM development, and specifically importance of market liquidity

• Liquidity allows shocks to be absorbed without sharp change in prices
• Has implications for market development priorities

Some Questions for Discussion

13

Are the factors mentioned the right ones?

• Which have been most important in individual countries?
• Are there general lessons or is experience just too diverse?
• Is the focus on the largest countries (in part driven by data availability) unhelpful in

identifying the main drivers – or lessons?

Can we distinguish between recent impacts on supply and demand – many of which have been somewhat damaging to liquidity – from the potentially more helpful underlying trends? What does it tell us about market development priorities? For example:

• Role of benchmarks to concentrate available liquidity
• Investor diversity – not just aiming for buy-and-hold funds

» Recent Asian Bonds Online survey identified improved investor diversity as highest structural reform priority

• Importance of an efficient money market – supporting intermediaries and market

making (as well as monetary policy and wider debt management objectives)