developing domestic bond markets: why do we care and the

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

South-South cooperation

Ugo PanizzaUNCTAD

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

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

Debt Composition Matters!

• The “Economics 101” debt dynamics equation tells us that the change in the stock of debt is equal to the budget deficit

• This equation can be used to decompose the growth rate of the Debt-to-GDP ratio

DEFICITDEBTDEBT ttt =− −1

dgpbdid +−−x=Δ )x( π


• The “Economics 101” debt dynamics equation tells us that the change in the stock of debt is equal to the budget deficit

• This equation can be used to decompose the growth rate of the Debt-to-GDP ratio

SFDEFICITDEBTDEBT ttt +=− −1

SFdgpbdid ++−−x=Δ )x( π

The Unexplained Part of Debt

Decomposition of Debt Growth in LAC7

-12

0

12

24

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Perc

enta

ge o

f GD

P

InflationUNEXPLAINED PARTInterest expenditurePrimary balanceGDP growth

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


-15

-10

-5

0

5

10

15

IND EAP ECA MNA LAC SSA

INFLATIONGDP GROWTHUNEXPLAINED PARTINTEREST EXPENDITUREPRIMARY DEFICIT

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


• What explains the “Unexplained part of debt”– Skeletons

• Fiscal policy matters!– Banking Crises– Balance Sheet Effects due to debt

composition

Public Debt and Sovereign Rating (1995-2005)

Italy

Jamaica

Japan

Israel

Belgium

Ghana

Jordan

Saudi Arabia

Pakistan

Egypt, Arab Rep.

MongoliaSenegal

Morocco

Grenada

Argentina

Barbados

Bolivia

Panama

Indonesia

Bulgaria

Portugal

Cyprus

Hungary

Sweden

Philippines

Papua New Guinea

Austria

Tunisia

Malta

Denmark

Ecuador

India

Benin

CanadaFinland

Qatar

Netherlands

SpainFrance

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 SalvadorColombia

Bahamas

New Zealand

Paraguay

Germany

Slovak RepublicMexico

Switzerland

Lithuania

Bahrain

Slovenia

Norway

OmanChinaThailand

Kazakhstan

Guatemala

Korea, Rep.Czech RepublicChile

Australia

Latvia

Botswana

Estonia

Luxembourg

0 10 20 30 40 50 60 70 80 90 100 110

Public Debt as Percent of GDP

Stan

dard

& P

oor's

Sov

erei

gn R

atin

g

AAA

B-

BB-

BBB-

A-

AA-

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

Investment grade


The international market is volatile…

Jan Jun

Nov

Apr

Sep

Feb

Dec

May

Oct

Mar

Aug

Jan Jun

Nov

Apr

Sep

Feb

Dec

May

Oct

Mar

Aug

Jan Jun

Nov

Apr

Sep

Feb

Dec

May

Oct

Mar

Aug

Jan Jun

Nov

Apr

Sep

Feb

The international market is volatile…

Jan Jun

Nov

Apr

Sep

Feb

Dec

May

Oct

Mar

Aug

Jan Jun

Nov

Apr

Sep

Feb

Dec

May

Oct

Mar

Aug

Jan Jun

Nov

Apr

Sep

Feb

Dec

May

Oct

Mar

Aug

Jan Jun

Nov

Apr

Sep

Feb

Jan Jun

Nov

Apr

Sep

Feb

Dec

May

Oct

Mar

Aug

Jan Jun

Nov

Apr

Sep

Feb

Dec

May

Oct

Mar

Aug

Jan Jun

Nov

Apr

Sep

Feb

Dec

May

Oct

Mar

Aug

Jan Jun

Nov

Apr

Sep

Feb

0

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

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

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

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

Deb

t to

GD

P R

atio

Domestic Public Debt

External Public Debt

Source: Panizza (2008)

…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

Shar

e of

Dom

estic

Deb

t (w

eigh

ted

aver

age)

19941999

2005

…and developing domestic bond marketsSize 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

% o

f GD

P

GOV

PRIV

GOV

…and developing domestic bond marketsSize 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

% o

f GD

P

Private

Government

…and developing domestic bond marketsSize 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

% o

f GD

P

Private

Government

So, is everything well?

• Not really!

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

% o

f GD

P

GOV

PRIV44%

62% 68% 71%

95%

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

Inde

x of

dom

estic

orig

inal

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

Maturities are lengthening…Average Original Maturity

(Government Bonds)

0

2

4

6

8

10

12

14

16

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

s Latin AmericaAsia, larger economiesOther AsiaCentral EuropeIND

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

India

0

2

4

6

8

10

12

14

16

18

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

s

government bondsAverage maturity of

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

India

0

2

4

6

8

10

12

14

16

18

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

s

0

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

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

of 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!

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)

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?

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

0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 1500 1600 1700 1800

CroatiaSlovakiaLebanon

PeruRussia

PakistanChile

Hong Kong SARColombia

PhilippinesHungary

ArgentinaIndonesiaSingapore

Czech RepublicSouth Africa

ThailandVenezuela

PolandMalaysia

TaiwanTurkeyMexico

IndiaBrazil

South KoreaChina

Billion USD

GOVPRIV

13 countries with cap above $100 billion

Country size matters

HRV

SVKPER

HUN

PAK

PHL

SGP

CHLCOL

CZE

MYS

HKG

VENTHA

ARG

ZAF

TWN

IDN

POL

TURMEX

KOR

IND

BRA

CHN

-.20

.2.4

.6e(

BM

2GD

P | X

)

-2 -1 0 1 2 3e( lgdp | X )

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

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

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

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)

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

The spaghetti bowl of Asian financial cooperation

ASEM

ASEAN+3

ASEAN

APEC

ACDSEANZA

EMEA

P

SEACEN

EAS

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

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 offinancial 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)

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 of dollar-denominated bonds

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

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

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

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?

(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

Marketcreation

Crowdingout

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

Where are they now?

0 200 400 600 800

IDN

PHL

MYS

THA

HKG

SNG

KOR

Million USD

InitialDec-07

June 2005

March 2007

April 2007

July 2005

April 2006

June 2005

August 2005

Source: Ma and Remolona (2008)

China11%

HK17%

Indonesia6%

Korea21%

Malaysia11%

Philippines5%

Singapore19%

Thailand10%

Allocation of PAIF

Is it enough?Securities issued by the 8 countries which are part of ABF1 and ABF2

(December 2007)

0

200

400

600

800

1000

1200

1400

1600

1800

2000

International Securities Domestic Securities

Bill

ion

USD

Initial size of ABF-1: $1 billion

Initial size of ABF-2: $2 billion

Current size of ABF-2: $3.2 billion

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

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

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

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

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

South-South cooperation

Ugo PanizzaUNCTAD

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

developing domestic bond markets: why do we care and the

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