Developing local currency bond markets in Asia

Park, Cyn-young Working Paper Developing local currency bond markets in Asia ADB Economics Working Paper Series, No. 495 Provided in Cooperation with: Asian Development Bank (ADB), Manila Suggested Citation: Park, Cyn-young (2016) : Developing local currency bond markets in Asia, ADB Economics Working Paper Series, No. 495, Asian Development Bank (ADB), Manila This Version is available at: https://hdl.handle.net/10419/169326 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/3.0/igo/ ASIAN DEVELOPMENT BANK ADB ECONOMICS WORKING PAPER SERIES NO. 495 August 2016 DEVELOPING LOCAL CURRENCY BOND MARKETS IN ASIA Cyn-Young Park  ADB Economics Working Paper Series Developing Local Currency Bond Markets in Asia Cyn-Young Park No. 495 | August 2016 Cyn-Young Park ([email protected]g) is director of Regional Cooperation and Integration Division in the Economic Research and Regional Cooperation Department of the Asian Development Bank. The author wishes to thank Pilar Dayag, Grendell Vie Magoncia, Ana Kristel Molina, and Mara Claire Tayag for their excellent research support. Creative Commons Attribution 3.0 IGO license (CC BY 3.0 IGO) © 2016 Asian Development Bank 6 ADB Avenue, Mandaluyong City, 1550 Metro Manila, Philippines Tel +63 2 632 4444; Fax +63 2 636 2444 www.adb.org Some rights reserved. Published in 2016. Printed in the Philippines. ISSN 2313-6537 (Print), 2313-6545 (e-ISSN) Publication Stock No. WPS168348-2 Cataloging-In-Publication Data Asian Development Bank. Developing local currency bond markets in Asia. Mandaluyong City, Philippines: Asian Development Bank, 2016. 1. Bond market.2. Financial integration.3. Local currency bonds.I. Asian Development Bank. The views expressed in this publication are those of the authors and do not necessarily reflect the views and policies of the Asian Development Bank (ADB) or its Board of Governors or the governments they represent. ADB does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. The mention of specific companies or products of manufacturers does not imply that they are endorsed or recommended by ADB in preference to others of a similar nature that are not mentioned. By making any designation of or reference to a particular territory or geographic area, or by using the term “country” in this document, ADB does not intend to make any judgments as to the legal or other status of any territory or area. This work is available under the Creative Commons Attribution 3.0 IGO license (CC BY 3.0 IGO) https://creativecommons.org/licenses/by/3.0/igo/. By using the content of this publication, you agree to be bound by the terms of this license. This CC license does not apply to non-ADB copyright materials in this publication. If the material is attributed to another source, please contact the copyright owner or publisher of that source for permission to reproduce it. ADB cannot be held liable for any claims that arise as a result of your use of the material. Attribution—In acknowledging ADB as the source, please be sure to include all of the following information: Author. Year of publication. Title of the material. © Asian Development Bank [and/or Publisher]. URL. Available under a CC BY 3.0 IGO license. Translations—Any translations you create should carry the following disclaimer: Originally published by the Asian Development Bank in English under the title [title] © [Year of publication] Asian Development Bank. All rights reserved. The quality of this translation and its coherence with the original text is the sole responsibility of the [translator]. The English original of this work is the only official version. Adaptations—Any adaptations you create should carry the following disclaimer: This is an adaptation of an original Work © Asian Development Bank [Year]. The views expressed here are those of the authors and do not necessarily reflect the views and policies of ADB or its Board of Governors or the governments they represent. ADB does not endorse this work or guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. Please contact [email protected] if you have questions or comments with respect to content, or if you wish to obtain copyright permission for your intended use that does not fall within these terms, or for permission to use the ADB logo. Notes: 1. In this publication, “$” refers to US dollars. 2. Corrigenda to ADB publications may be found at: http://www.adb.org/publications/corrigenda   CONTENTS TABLES AND FIGURES iv ABSTRACT v I. INTRODUCTION 1 II. REGIONAL INITIATIVES TO DEVELOP LOCAL CURRENCY BOND MARKETS 2 III. ASIA’S LOCAL CURRENCY BOND MARKETS: THEN AND NOW 3 A. Size and Depth 3 B. Market Maturity Profiles 7 C. Issuers and Investors 9 D. Secondary Market Liquidity and Trading 12 IV. DETERMINANTS OF LOCAL BOND MARKET DEVELOPMENT 14 A. Empirical Analysis 14 B. Empirical Results 17 V. THE CHALLENGES AHEAD 18 A. Size and Liquidity in Secondary Markets 19 B. Strengthening the Supportive Market Infrastructure 19 C. Broadening the Investor Base 20 D. Regional Integration 20 REFERENCES 21  TABLES AND FIGURES TABLES 1 Bond Market Development Timeline 2 2 Bonds Outstanding in Local Currency Debt Markets, 1995–2015 4 3 Depth of Local Currency Bond Markets, 1995–2015 4 4 Corporate Financing 6 5 Standard & Poor’s Sovereign Credit Ratings 11 6 Local Currency Bond Market Volatility Indicators 14 7 Multivariate Tests for Bond Market Development in Emerging Asia 15 8 Multivariate Tests for Corporate and Long-Term Local Currency Bonds Outstanding 16 FIGURES 1 Outstanding Local Currency Bonds by Sector, 2015 5 2 Local Currency Bond Sales in Emerging Asia Excluding India, 1995–2015 7 3 Maturity Profiles of Asian Local Currency Government Bonds, 2000–2015 8 4 Maturity Profiles of Asian Local Currency Corporate Bonds, 2000–2015 8 5 Corporate Bond Issuance by Sector in Global Emerging Markets 10 6 Corporate Bond Issuance by Sector in Emerging Asia 10 7 Credit Default Swap Spreads on Senior 5-year Debt 11 8 Foreign Holdings of Local Currency Government Bonds 12 9 Asian Government Bond BidAsk Price Spreads 13 10 Yield Volatility on 10-year Asian Government Bonds 13   ABSTRACT Local currency bond markets in emerging Asian economies have expanded dramatically since governments took steps to end the currency and maturity mismatches that savaged borrowers in the region’s financial crisis nearly 20 years ago. Encouraged in part by regional cooperation programs such as the Asian Bond Markets Initiative, the value of local currency government and corporate bond sales has grown fourfold in the past decade, helping to fund much-needed infrastructure development and protect businesses from global financial shocks. However, much more needs to be done to strengthen market infrastructure and institutions, address inconsistent policies and regulations, and enhance corporate governance. This paper presents evidence that better macroeconomic performance and stronger institutions help develop larger local currency bond markets and also create conditions for the growth in local currency sales of corporate debt and bonds with longer maturities. Regional integration can be stepped up to support the key determinants for developing efficient local currency bond markets in emerging Asia. Keywords: bond market, financial integration, local currency bonds JEL codes: G10, G11, G18  I. INTRODUCTION The development of local currency bond markets became a policy priority for many Asian economies following the region’s financial crisis nearly 2 decades ago. The crisis exposed the damage that using local currency assets to pay maturing foreign-denominated debt can wreak on private sector balance sheets. Relatively stable exchange rates before the 1997–1998 Asian crisis had encouraged firms to take short-term borrowings in foreign currency to fund long-term investments whose returns were tied to the value of their domestic currencies. Since such transactions often were loans from domestic banks, debt default led to massive bank failures during the crisis. In an effort to better channel regional savings for investment and prevent such risks from mounting again, finance ministers of the Association of Southeast Asian Nations (ASEAN) countries joined with the People’s Republic of China (PRC), Japan, and the Republic of Korea in 2003 to introduce the Asian Bond Markets Initiative (ABMI), aiming to develop efficient and liquid local currency bond markets in member countries. National policy efforts coupled with the regional initiatives of the ASEAN+3 focused on developing local debt markets to make bank-dominated financial systems more balanced, to reduce heavy reliance on foreign debts, and to mobilize the region’s excess savings more effectively for development finance. Many emerging Asian economies have seen local currency bond markets grow dramatically in the past 2 decades. Total outstanding local currency bonds in emerging Asia, including India, were about $10,228 billion as of December 2015, up from $2,568 billion in 2005. The main drivers of this growth have been the PRC and the Republic of Korea, but many ASEAN economies have also contributed. The PRC has the largest local currency bond market in emerging Asia, with bonds outstanding of $6,150 billion, followed by the Republic of Korea, with $1,720 billion in bonds outstanding. Asian local currency bonds have emerged as a new asset class in part because many traditional assets have lost their shine in the wake of the last global financial crisis. At the height of the crisis, in the last quarter of 2008, Asian local currency bond markets experienced the high volatility and low liquidity associated with large capital outflows. However, investors quickly regained confidence in emerging Asian economies on the back of their relatively strong growth performance, and the monetary easing and fiscal stimulus that occurred around the world. Fueled by favorable global liquidity conditions and regional initiatives, total local currency bond issuance has almost doubled since 2008. While progress in Asian local currency markets is remarkable, growth has not been universally strong. The growth in local currency bond markets across the region has been largely concentrated in government bonds, leaving room for substantial improvement for emerging Asia’s corporate borrowers. Hurdles to developing the market for local currency corporate bonds remain in the shape of market infrastructure and institutions, inconsistent policies and regulations, and—more broadly—in poor corporate governance. This paper reviews the advances made in developing local currency bond markets in emerging Asia, focusing in the next section on regional initiatives taken to develop local currency bond markets since the 1997–1998 Asian crisis. Section III provides an assessment of various dimensions of local currency bond market development. Section IV empirically investigates economic factors associated with expanding local currency bond markets and discusses their policy implications. Section V suggests key areas for further reforms and concludes that while Asian bond markets are growing at a healthy 2 | ADB Economics Working Paper Series No. 495 pace, careful and coordinated policies on market development and integration can help resolve significant variations in their efficiency across regions and difficulties on cross-border transactions. II. REGIONAL INITIATIVES TO DEVELOP LOCAL CURRENCY BOND MARKETS The experience of the Asian crisis of 1997–1998 gave rise to the establishment of regional institutions to safeguard financial stability and build economic and financial resilience. In this context, ASEAN+3 finance ministers introduced several initiatives for regional financial cooperation, including: (i) the Economic Review and Policy Dialogue (ERPD) process as a regional economic surveillance mechanism, (ii) the Chiang Mai Initiative (CMI) as a regional liquidity support facility, and (iii) the Asian Bond Markets Initiative (ABMI) to help develop local currency bond markets (Table 1). Table 1: Bond Market Development Timeline Year Initiatives 2003 Asian Bond Market Initiative (ABMI) is launched under ASEAN+3 to develop a liquid and wellfunctioning bond market. 2003 Asian Bond Fund 1 (ABF1) is launched by central banks of the Executives’ Meeting of East Asia and the Pacific (EMEAP) countries to invest pooled savings in the region’s (sovereign and quasisovereign) bond markets. 2004 ABMI launches AsianBondsOnline as a one-stop data and information portal for institutional investors, policy makers, and researchers participating in local currency debt markets. 2005 Asian Bond Fund 2 (ABF2) starts channeling investment into local currency bonds as a follow-up to ABF1. The primary goal is to reduce market barriers for investors and to improve liquidity in sovereign bond markets. 2008 ASEAN+3 ministers sign the New ABMI Road map to set up task forces to address specific issues in local bond market development. 2010 ASEAN+3 establishes the Asian Bond Market Forum (ABMF) as a platform to foster standardization of market practices and the harmonization of regulations relating to cross-border bond transactions in the region. 2010 The Credit Guarantee and Investment Facility (CGIF) started as a trust fund within the Asian Development Bank to provide guarantees for local currency corporate bonds issued in the region. 2013 ASEAN+3 establishes the Cross-Border Settlement Infrastructure Forum (CSIF) to discuss the preparation of a road map and an implementation plan for the improvement of regional crossborder settlement infrastructure. 2015 ABMF releases implementation guidelines for the ASEAN+3 Multi-Currency Bond Issuance Framework (AMBIF), which helps facilitate intraregional transactions through standardized bond and note issuance and investment processes. Sources: Levinger and Li (2014); ADB (2008, 2012, 2015). The 2008–2009 global financial crisis further demonstrated the need to strengthen regional financial cooperation. Visible progress has been made toward improving the ERPD, strengthening the CMI and its multilateralization, and creating the road map for the ABMI.1 The ABMI especially aims to “develop efficient and liquid bond markets in Asia to use Asian savings for Asian investments. As the ASEAN+3 Macroeconomic Research Office said in 2013, “the initiative would also contribute to the mitigation of currency and maturity mismatches in financing.”  1 The ERPD process has been enhanced and integrated into the multilateralized Chiang Mai Initiative framework (also known as the Chiang Mai Initiative Multilateralization, or CMIM) with its liquidity pool of $240 billion. A new surveillance unit, the ASEAN+3 Macroeconomic Research Office (AMRO), was established in Singapore in May 2011 to support the review and dialogue process and the initiative’s decision making. Developing Local Currency Bond Markets in Asia | 9  The maturity profiles of the corporate bond sectors present generally greater concentration on shorter end than those of the government sectors. The Indonesian and Vietnamese corporate sectors have issued proportionately large shares of short-term debts; corporate bonds of less than 5-year maturity account for 83.5% and 88.1% of their total corporate bonds outstanding, respectively. The maturity structure of most emerging Asian corporate debt markets has improved, but is still generally skewed toward short-term bonds. With the exception of Malaysia (29.3%), the Philippines (46.1%), and Singapore (49.6%), more than 60% of corporate bonds in all other emerging Asian economies have maturities of less than 5 years. Interestingly, corporate bonds sold in Hong Kong, China and Malaysia carry proportionately less short-term and more long-term maturities than their government bonds do. This may be related to many of the corporate issuers in the two economies being in the property development, energy, and infrastructure sectors, which require longer-term financing. Extending the maturity profile of corporate bonds has been among the major long-term goals in many emerging Asian markets. Over the past decade or so, the mediumto long-term issuance of emerging Asian corporate bonds has increased. This trend continued with the onset of the global financial crisis and the subsequent low interest rate environment contributing to the extension of the maturity profile. A large amount of emerging Asian corporate bonds are due to mature in the next few years. C. Issuers and Investors A diverse and good-quality issuer base is an essential element of well-developed corporate bond markets. A sizable pool of quality companies is critical for expanding the market size. Major infrastructure companies and financial institutions are often the largest issuers in the early stage of bond market development, but the challenge is to increase the pool of quality issuers by encouraging successful companies in a variety of sectors to tap the bond market. This activity will support private sector growth and better protect the corporate sector from various economic shocks. Emerging markets have seen growth in both finance sector and nonfinance sector issuances over the past decade, even despite the effect of the crisis in 2008 (Tendulkar and Hancock 2014). In 2000, corporate bond issuances by the finance sector accounted for just 20% of total emerging market corporate sector issuances, increasing to 43% in 2007 (Figure 5). Between 2007 and 2013, finance sector issuance more than doubled, reaching $241 billion in 2013. However, nonfinance sector issuances grew by more than four times, reaching $692 billion in 2013. As a result, the share of finance sector bond sales declined to 23% in 2013. In emerging Asia, corporate bond issuances are also concentrated in the nonfinance sector, mostly the construction, mining, and utilities sectors (Figure 6). Financial services companies issued one-third of the corporate bonds sold in 2009–2013. The riskreturn profile of both government and corporate issuers in emerging Asia is also an important factor when promoting participation in local currency bond markets. Credit ratings represent the credit worthiness of the borrower, with a poor rating indicating high probability of default. Emerging Asian issuers, with their credit ratings steadily improving, offer relatively stable ratings and attractive yields compared to counterparts in other developing regions (Table 5). 10 | ADB Economics Working Paper Series No. 495 Figure 5: Corporate Bond Issuance by Sector in Global Emerging Markets (% of total) Source: Tendulkar and Hancock (2014). Figure 6: Corporate Bond Issuance by Sector in Emerging Asia (% of total, 2013) Source: Levinger and Li (2014). 0 10 20 30 40 50 60 70 80 90 100 2000 2007 2013 Finance Nonfinance Finance 33 Others 23 Telecoms 2 Transport 6 Construction and real estate 17 Mining and utilities 19 Developing Local Currency Bond Markets in Asia | 11  Table 5: Standard & Poor’s Sovereign Credit Ratings (local currency, long term) Economy as of Dec 2015 as of Dec 2000 Japan A+u AAA United States AA+u AAA Emerging Asia People’s Republic of China AABBB Hong Kong, China AAA A+ India BBB-u BBB Indonesia BB+ B Republic of Korea AAA Malaysia A A Philippines BBB BBB+ Singapore AAAu AAA Thailand AAViet Nam BBBB Note: For Viet Nam, the earliest rating is as of December 2002. A bond is considered investment grade if its credit rating is BBBor higher. Source: Bloomberg, L.P. Similarly, spreads on credit default swap (CDS) for emerging Asian issuers have narrowed over time (Figure 7). The CDS spreads indicate market sentiment about the riskiness of bond issues. The buyer (bondholder) pays a premium to the seller of the swap agreement for protection in the event of default. The premium, which is the CDS spread, is quoted in basis points per year of the contract’s notional amount and the payment is made quarterly. Higher CDS spreads represent higher default risks. The relatively stable and narrow CDS spreads for emerging Asian bond issuers since the end of the global financial crisis suggest favorable market sentiment for their risk conditions. Figure 7: Credit Default Swap Spreads on Senior 5-year Debt (midspread, basis points) HKG = Hong Kong, China; IND = India; INO = Indonesia; KOR = Republic of Korea; MAL = Malaysia; PHI = Philippines; PRC = People’s Republic of China; SIN = Singapore; THA = Thailand; VIE = Viet Nam. Note: A basis point is one hundredth of a percentage point. Based on monthly average spreads which represent changes in the cost of insuring debt against default. Data as of 20 May 2016. Source: AsianBondsOnline, ADB. 0 200 400 600 800 1,000 1,200 1,400 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 PRC HKG IND INO KOR MAL SIN THA VIE PHI 12 | ADB Economics Working Paper Series No. 495 The investor base for emerging Asian local currency bonds has broadened over time. Before the global financial crisis, most government bonds were bought by domestic banks. The growth of local institutional investors, such as pension funds and insurance companies, contributed significantly to the diversity of the investor base. The share of holdings in contractual savings and by other investors (including foreign investors) combined had increased to 65.9% of total government bonds in Indonesia, 63.7% in the Republic of Korea, 68.5% in Malaysia, and 81.0% in Thailand at the end of 2015. That compared to figures for the respective countries of 63.4%, 51.5%, 64.9%, and 72.7% 5 years earlier. Emerging Asian local currency bonds have attracted foreign investors for their relatively good riskreturn profiles. Emerging Asian bonds offer attractive yields on the back of the region’s robust economic performance following the global financial crisis and gains from ongoing and anticipated currency appreciation. The share of foreign holdings in government bonds has now reached nearly 40% in Indonesia, more than 30% in Malaysia, about 14% in Thailand, and over 10% in the Republic of Korea (Figure 8). Figure 8: Foreign Holdings of Local Currency Government Bonds (% of total) Source: AsianBondsOnline, ADB. Emerging Asian local currency bond markets have attracted growing interest from emerging market bond funds and global institutional investors like pension and insurance agencies. As foreign investors become increasingly more comfortable with the credit profiles of emerging Asian issuers, global bond flows will likely channel more global savings into the region’s local currency bond markets. D. Secondary Market Liquidity and Trading The growth in the size of local currency bond markets has not translated automatically to a significant improvement in market liquidity. Although secondary market liquidity and trading have been improving in several emerging Asian markets, liquidity varies significantly across the region’s local currency bond markets, depending on their overall size, turnover, issuance, and investor bases. Liquidity is a multidimensional concept and can be measured in terms of market tightness, depth and resilience (Bank of International Settlements 1999). Tightness, often measured by the bidask spreads, refers to “how far transaction prices (bid or ask prices) diverge from the mid-market price.” Depth, shown 0 5 10 15 20 25 30 35 40 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar - 16 Indonesia Republic of Korea Malaysia Thailand Developing Local Currency Bond Markets in Asia | 13  as the average turnover ratio or bond yield volatility, refers to “either the volume of trades possible without affecting prevailing market prices, or the amount of orders on the order books of market-makers at a given time.” Resilience can be defined as either “the speed with which price fluctuations resulting from trades are dissipated, or the speed with which imbalances of order flows are adjusted.” However, data on secondary market liquidity and trading is scarce. For example, bidask spreads for particular corporate bonds are not readily available or publicly accessible. Similarly, data on turnover ratios and dealer inventories of corporate bonds is very limited. Where data is available in emerging Asian markets, liquidity appears to be improving. Government bond markets are also more liquid than corporate bond markets. Emerging Asian government bond market liquidity can be characterized as moderately improving because their bidask spreads have narrowed and yield volatility has declined (Figures 9 and 10). Liquidity in the corporate bond markets is relatively poor, with turnover ratios being much lower than for government bonds and even having deteriorated since 2005 (Table 6). Figure 9: Asian Government Bond BidAsk Price Spreads (average over period, basis points) HKG = Hong Kong, China; INO = Indonesia; KOR = Republic of Korea; MAL = Malaysia; PHI = Philippines; PRC = People’s Republic of China; SIN = Singapore; THA = Thailand; VIE = Viet Nam. Source: AsianBondsOnline, ADB. Figure 10: Yield Volatility on 10-year Asian Government Bonds (standard deviation) HKG = Hong Kong, China; IND = India; INO = Indonesia; KOR = Republic of Korea; MAL = Malaysia; PHI = Philippines; PRC = People’s Republic of China; SIN = Singapore; THA = Thailand; VIE = Viet Nam; JPN = Japan; US = United States. Source: Bloomberg, L.P. 0 5 10 15 20 25 30 PRC HKG INO KOR MAL PHI SIN THA VIE 2004–2006 2009–2011 2013–2015 0.0 0.5 1.0 1.5 2.0 2.5 3.0 PRC HKG IND INO KOR MAL PHI SIN THA VIE JPN USA 2007–2009 2010–2012 2013–2015 14 | ADB Economics Working Paper Series No. 495 Table 6: Local Currency Bond Market Volatility Indicators Economy Trade Volume ($ billion) Turnover Ratio 2015 2005 2015 2005 Government Corporate Government Corporate Government Corporate Government Corporate PRC 2,476.69 447.12 214.19 40.11 0.63 0.29 0.27 0.73 HKG 71.14 13.75 246.31 2.29 0.61 0.16 15.15 0.03 INO 53.72 2.96 6.21 0.42 0.52 0.16 0.15 0.07 JPN 10,395.57 36.98 7,402.82 130.00 1.24 0.06 1.19 0.18 KOR 413.05 97.80 270.02 57.14 0.59 0.10 0.69 0.16 MAL 38.38 5.60 19.51 7.42 0.27 0.05 0.32 0.17 PHI 39.07 … 12.19 … 0.49 … 0.30 … SIN 34.61 … 29.84 … 0.47 … 0.62 … THA 126.50 5.47 22.10 0.56 0.62 0.08 0.35 0.04 … = data not available; HKG = Hong Kong, China; INO = Indonesia; JPN = Japan; KOR = Republic of Korea; MAL = Malaysia; PHI = Philippines; PRC = People’s Republic of China; SIN = Singapore; THA = Thailand. Source: AsianBondsOnline, ADB. https://asianbondsonline.adb.org/regional/data.php IV. DETERMINANTS OF LOCAL BOND MARKET DEVELOPMENT A. Empirical Analysis Empirical work to explore which economic variables help develop local currency bond markets in Asia is limited due to the relatively short history of sales of such debt. Bae (2012) investigated various determinants including macroeconomic, institutional, and capital controls for markets in 43 countries and suggested that the degree of economic development as measured by GDP per capita is the most important factor. Bae (2012) also found that fiscal balance, interest rate, domestic credit provided by banks, and the existence of a well-developed government bond market matter for the development of corporate bond markets. Burger and Warnock (2006) analyzed economic factors associated with local currency bond development using comprehensive data from private and public issuances from 49 countries, placed both at home and abroad. Their main findings suggested that policies and laws matter: stable inflation rates and strong creditor rights lead to more developed local currency bond markets and less reliance on foreign currency-denominated bonds. This section offers empirical analysis on economic factors associated with local currency bond market development in emerging Asia. Tables 7 and 8 report regression results for the determinants. Table 7 shows the effects of economic factors on (i) the size of local currency bond market measured by the ratio of the local currency bonds outstanding to GDP and (ii) the share of local currency bonds in emerging Asian economies’ debt markets combined (which comprise bonds denominated in local and foreign currencies). To investigate which economic factors matter for corporate and long-term bond market developments more specifically, separate analyses were undertaken for those segments of the local currency bond markets (Table 8). In both analyses, the influence of inflation, rule of law, the fiscal balance (in percent of GDP), and economic size (as measured by the log of GDP) was examined. Developing Local Currency Bond Markets in Asia | 15  Other control variables that may affect local currency bond market development, such as bank lending, sovereign credit rating, and exchange rate volatility were included. In both tables, even-numbered columns present results from full regressions, including the control variables. Table 7: Multivariate Tests for Bond Market Development in Emerging Asia LCY Bonds Outstanding % of GDP LCY Bonds % of total bonds (1) (2) (3) (4) Constant -32.521*** -43.865*** 60.238*** 39.929*** ( 5.731) ( 7.602) ( 3.752) ( 4.012) Inflation -0.483*** -0.864*** -0.004 0.123 ( 0.15) ( 0.274) ( 0.153) ( 0.151) Fiscal balance -0.013 0.044 0.072 -0.145 ( 0.193) (0.196) ( 0.122) ( 0.108) Rule of law 1.017*** 0.810*** -0.039 -0.476*** ( 0.062) ( 0.093) ( 0.039) ( 0.05) ln (GDP) 4.709*** 3.583*** 4.890*** 0.889* ( 0.777) ( 0.938) ( 0.487) ( 0.507) ln (Bank lending) 1.135** 2.523*** ( 0.455) ( 0.238) Sovereign credit rating 1.753*** 3.899*** ( 0.518) ( 0.293) Forex volatility 1.314*0.447 ( 0.645) ( 0.501) Number of observations 732 628 597 556 Adjusted R2 0.339 0.392 0.156 0.373 *** = significant at 1%, ** = significant at 5%, * = significant at 10%, GDP = gross domestic product, LCY = local currency. Notes: 1. Based on quarterly panel data of 10 emerging Asian economies covering Q1 1996–Q4 2015. Emerging Asia includes the People’s Republic of China; Hong Kong, China; India; Indonesia; Republic of Korea; Malaysia; the Philippines; Singapore; Thailand; and Viet Nam. 2. Local currency bonds outstanding as a percentage of total bonds refers to local currency bond outstanding as share of the sum of local currency and foreign currency-denominated bonds. 3. Rule of law refers to World Governance Indicators’ rule of law estimate, which captures the perception of agents’ confidence in and accordance with the rules of society, including the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. The rule of law estimate was converted to a scale of 0 to 100, with higher value denoting better perception or confidence. 4. Fiscal balance as a percentage of GDP is used. A positive fiscal balance denotes fiscal surplus. 5. Bank lending refers to following—Financial Institution Loans (PRC); Authorized Institutions: Loans and Advances to Customers (Hong Kong, China); Commercial Bank: Domestic Credit (India); Commercial Banks: Loans to Deposit Ratio: Total Credit to Third Party (Indonesia); Loans of Commercial and Specialized Banks (Republic of Korea); Commercial Banks: Loans and Advances (Malaysia); Loans: Universal Commercial Bank (Net of Reverse Repurchase Agreement) (Philippines); Domestic Banking Unit: Loans and Advances (Singapore); Commercial Bank: Loans (Assets) (Thailand); Banking Institutions: Claims on Private Sector (Viet Nam). 6. Sovereign credit rating is based on historical S&P credit rating on sovereign long-term local currency bonds. S&P credit rating is transformed such that higher value denotes higher rating. 7. Forex volatility is based on the coefficient of variation of economy’s foreign exchange rate against the US dollar. 8. Robust standard errors in parentheses. Source: Author’s calculations based on data from Bank of International Settlements; CEIC Database; Haver Analytics; various issues of the Asian Development Outlook, ADB; World Governance Indicators; World Development Indicators, World Bank; and national sources. 16 | ADB Economics Working Paper Series No. 495 Table 8: Multivariate Tests for Corporate and Long-Term Local Currency Bonds Outstanding Corporate Bonds (% of total local currency bonds) Long-Term Bonds (% of total local currency bonds) (1) (2) (3) (4) Constant –46.777*** –63.453*** –49.612*** –37.233*** ( 3.204) ( 4.15) ( 10.524) ( 12.649) Inflation –0.247** –0.612*** –0.403*** –0.319*** ( 0.113) ( 0.151) ( 0.121) ( 0.123) Fiscal balance 0.096 0.024 0.124 0.088 ( 0.105) ( 0.107) ( 0.08) ( 0.083) Rule of law 1.151*** 1.052*** 1.269*** 1.730*** ( 0.034) ( 0.051) ( 0.2) ( 0.222) ln (GDP) 2.827*** 0.464 –0.612 6.937*** ( 0.424) ( 0.511) ( 0.818) ( 2.487) ln (Bank lending) 2.115*** –7.912*** ( 0.249) ( 1.952) Sovereign credit rating 1.353*** 0.839** ( 0.282) ( 0.383) Forex volatility 0.540 –0.140 ( 0.51) ( 0.44) Number of observations 708 619 455 455 Adjusted R2 0.670 0.708 0.609 0.629 *** = significant at 1%, ** = significant at 5%, * = significant at 10%, GDP = gross domestic product, LCY = local currency. Notes: 1. Based on quarterly panel data of 10 emerging Asian economies covering Q1 1996–Q4 2015. Emerging Asia includes the People’s Republic of China; Hong Kong, China; India; Indonesia; Republic of Korea; Malaysia; the Philippines; Singapore; Thailand; and Viet Nam. 2. Local currency bonds outstanding as a percentage of total bonds refers to local currency bond outstanding as share of the sum of local currency and foreign currency-denominated bonds. 3. Rule of law refers to World Governance Indicators’ rule of law estimate, which captures the perception of agents’ confidence in and accordance with the rules of society, including the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. The rule of law estimate was converted to a scale of 0 to 100, with higher value denoting better perception or confidence. 4. Fiscal balance as a percentage of GDP is used. A positive fiscal balance denotes fiscal surplus. 5. Bank lending refers to following—Financial Institution Loans (PRC); Authorized Institutions: Loans and Advances to Customers (Hong Kong, China); Commercial Bank: Domestic Credit (India); Commercial Banks: Loans to Deposit Ratio: Total Credit to Third Party (Indonesia); Loans of Commercial and Specialized Banks (Republic of Korea); Commercial Banks: Loans and Advances (Malaysia); Loans: Universal Commercial Bank (Net of Reverse Repurchase Agreement) (Philippines); Domestic Banking Unit: Loans and Advances (Singapore); Commercial Bank: Loans (Assets) (Thailand); Banking Institutions: Claims on Private Sector (Viet Nam). 6. Sovereign credit rating is based on historical S&P credit rating on sovereign long-term local currency bonds. S&P credit rating is transformed such that higher value denotes higher rating. 7. Forex volatility is based on the coefficient of variation of economy’s foreign exchange rate against the US dollar. 8. Robust standard errors in parentheses. Source: Author’s calculations based on data from Bank of International Settlements; CEIC Database; Haver Analytics; various issues of the Asian Development Outlook, ADB; World Governance Indicators; World Development Indicators, World Bank; and national sources. Developing Local Currency Bond Markets in Asia | 17  B. Empirical Results The regression results in Table 7 provide evidence that better macroeconomic performance (GDP) contributes to the development of local currency bond markets in terms of sizes and their relative shares of bond markets as a whole. Inflation significantly hinders the overall size of local currency bond markets, but has no significant effect on the share of domestic debt markets that are denominated in local currencies. This may also reflect that low inflation (perhaps effective monetary policy) encourages local currency bond issuance. The results suggest that in addition to the role of macroeconomic policies, economies with stronger institutions (rule of law) have larger local currency bond markets in terms of share of GDP. This finding is consistent with earlier empirical studies. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998) show that better institutions can lead to larger and deeper capital markets and allow firms to make greater use of external finance. Bank lending and sovereign credit rating are also important factors for local currency bond market development. An increase in bank lending suggests an increase in demand for debt financing, and hence positive for local currency bond issuance. Improved sovereign credit rating also positively influences local currency bond market development. Especially, when bank lending and sovereign credit rating are controlled, the rule of law’s effect on the share of local currency bonds in total bonds turns negative, suggesting that it also exerts considerable effect on foreign currency-denominated bonds. While exchange rate volatility shows up significantly positive, it may reflect the positive influence of improvements in macroeconomic management based on increasingly flexible and market-based exchange rate regimes. Table 8 presents results showing the effects of economic factors on corporate and long-term bond markets separately. The results suggest that the determinants of corporate bond market development are similar to those of local currency bonds; namely, the economies with better macroeconomic performance and stronger rule of law have larger corporate bond markets. High inflation in particular not only discourages the growth in sales of local currency bonds, it also tends to discourage the expansion of issues with longer maturities. Both bank lending and improvements in sovereign credit ratings help encourage corporate bond sales in local currencies. Surprisingly, exchange rate volatility does not seem to matter so much for the development of the markets for local currency bonds that are either corporate or sold with long-term maturities. However, this finding is consistent with literature pointing to the importance of macroeconomic management and policy-setting conditions in the development of local currency bond markets. As many emerging market economies adopt more flexible exchange rate regimes, exchange rate volatility alone does not seem to discourage local currency bond market development. The main difference is the effect of bank lending on the percentage of local currency bonds that are sold with long-term maturities. This may reflect the effect of credit constraints on local currency bond market development. If short-term bank loans are easily available, demand for long-term bonds tends to decrease in emerging market economies. Our results are largely consistent with literature that highlights the importance of macroeconomic performance and institutional strength for local currency bond market development. This literature includes Bae (2012), Burger and Warnock (2006), and La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998). Countries with better macroeconomic performance and stronger 18 | ADB Economics Working Paper Series No. 495 institutions tend to develop larger local currency bond markets and also create conditions for the growth in local currency sales of corporate debt and bonds with longer maturities. The results suggest that there is significant room and leverage for policy makers to encourage local currency bond market development in emerging market economies. As Burger and Warnock (2006) suggest, the results also support the relationship between bond market and banking sector development. That is, bank lending is positively associated with local currency bond market development, except the long-term segment. V. THE CHALLENGES AHEAD Emerging Asia has come a long way in building local currency bond markets, but significant variations remain in development across the region. While the bond markets of Hong Kong, China; the Republic of Korea; and Singapore are relatively well developed and liquid, markets in the PRC, India, Indonesia, Malaysia and Thailand are still in the early stages of development. Although the PRC and India have the largest local currency bond markets, in terms of market depth and liquidity, they fall short of potential. Bond issuance data also shows variations in sectoral diversity, issuing volume, and consistency. Bond markets in the PRC and India also remain relatively less open to foreign investors despite being much larger than those in Indonesia, the Republic of Korea, Malaysia, and Thailand. Rapid growth in bond markets has helped diversify the sources of corporate financing in the region, but more needs to be done to enable the private sector to obtain funding from a broader range of sources without increasing vulnerability to shocks. The region’s demographic changes and substantial needs for infrastructure and urban development also suggest long-term funding needs will only increase. Asia’s investment needs for infrastructure are indeed substantial—as much as $8 trillion in the 10 years to 2020 (ADB and ADBI 2009). Fiscal spending alone would not be sufficient to address the funding gap. Robust local capital markets are essential to diversify the sources of funding necessary to support long-term investments and sustain emerging Asia’s high growth rates. However, structural impediments to growth in corporate bond markets remain. The rapid growth of emerging Asia’s corporate bond markets has been an outcome of regional initiatives to build financial resilience and reduce currency mismatches in the postcrisis period. The first step was to establish well-functioning government bond markets. In doing so, many economies encouraged sales of locally rated or unrated debt to encourage the use of bond markets. For example, the CGIF provides guarantees for debt sold by firms that would otherwise be constrained in securing long-term funding through local bond markets. Another example is Thailand’s Securities and Exchange Commission, which began to allow the sale of unrated bonds to accredited investors. Many local currency bond markets have also seen substantial progress in market infrastructure, including much-improved settlement and clearing systems. Local agencies for regulatory, supervisory, and enforcement functions covering issuers and investors play an important role. The regulatory framework should cover (i) the issuance procedures to reduce cost and simplify the issuance and approval process, (ii) the licensing structure to better define the role of intermediaries and their functions, (iii) an investment framework for nonbank institutional investors to invest in corporate bonds, (iv) the establishment of over-the-counter trading, custody and settlement mechanisms, and price reporting for corporate bonds, and (v) credit rating requirements.