GIVEN the changing global financial landscape and the unparalleled challenges faced by markets today, it has become increasingly imperative for post-crisis East Asia to develop sound, resilient debt markets in order to create greater balance in the overall financial architecture.
Although small by comparison to markets in ‘industrial’ countries, the East Asian bond market has a substantial presence in the bond markets of emerging market economies, representing approximately 55% of their combined market value.
Nevertheless, the need to enhance secondary market liquidity, and thus its efficiency is crucial to the viability of bond markets.
The major strand of financial literature measures market liquidity as the ability to generate volume, the flow of information into price and swifter trade execution – reflective of the depth and quality of market intermediation in the secondary market.
The secondary market is the market in which bonds are traded after they have been distributed as new issues, lasting right up until the maturity of the bonds.
There are several impediments however to the development of vigorous and vibrant secondary bond markets in East Asia.
The lack of an appropriate liquid benchmark yield curve and the absence of a critical mass of bonds (i.e. the relatively small issue size) tends to raise the transaction costs of trading.
Moreover, institutional holders, who form the backbone of the bond market, are “buy and hold” investors (representing “captive demand”) whose main objective is to avoid or minimize mismatches in the maturities of their assets and liabilities, thus creating little incentive for secondary market trading in bonds.
Other factors, such as a lack of market makers with access to liquidity support, also hamper bond market development.
Bond dealers run highly leveraged operations, and their inventories usually represent a certain multiple of their capital bases.
Dealers can be market makers only if they obtain liquidity through the repurchase market or the central bank rediscount window.
The secondary bond market also needs to be supported by an institutional infrastructure that includes, amongst other things, efficient clearing and settlement arrangements, credit-rating agencies and accommodative regulatory bodies.
Malaysia, Singapore, Hong Kong and Korea have well-established infrastructures with resonant, supportive regulatory framework in place.
Except in Malaysia and Thailand, there are no respected and prestigious rating agencies.
Likewise, except in Hong Kong, there are no market-based benchmarks that can guide market participants to price bonds in both the primary and the secondary markets.
In Malaysia's instance, the market has increasingly demonstrated growing liquidity, reflective of the development in the bond market.
Total turnover has increased over the years both in MGS (Malaysian Govt Securities) and PDS (Private Debt Securities).
Liquidity in public sector bonds has increased 2.5x since 2000, with the frequency of issues aimed at attaining a benchmark yield curve for the development of the capital market (Chart 1).
On the PDS front, the marked increase of issuances and diversity of bonds (i.e. advent of Islamic bonds) have enhanced market participation (Chart 2).
Concurrently, the introduction of repo instruments and more recently, the launch of Malaysia's inaugural Bond Futures, have also marked the depth of the Malaysian bond market.
The 5-year MGS Future (FMG5) is essentially a cash future contract, dealing in the more liquid 5-year MGS. In a move to enhance liquidity, the Derivatives Exchange has also appointed market makers comprising of local and foreign banks to generate interest and churn trading volumes.
The above initiatives, as well as the introduction of guidelines for Asset Backed Securities have enhanced market integrity and characterised a more transparent and well governed capital market.
Challenges moving forward to enhance liquidity for the Malaysian bond market include stimulating investor demand (i.e. tax incentives, smaller lot sizes thus increasing individual investor participation), creating accessibility to smaller investors (allowing a small percentage of issues to be taken up by small investors via accessible channels eg. ATMs), diversity of products (enhancing securitisation products, advent of derivative based products, conduits etc), lowering of issuing costs, augment market education as well as establishing a National Bond Fund to mobilize domestic and foreign capital more efficiently.
The coming decade promises to be the age of Asian bonds – the size of the East Asian bond market (excluding Hong Kong and Singapore) could grow to over US$1 trillion, net of redemptions, by year 2004.
The profile of the bond market is also likely to change dramatically, with the corporate sector leading the way (except in China, Indonesia and the Philippines), surpassing the government as the major issuer of bonds.
The projected rapid growth of the region's bond markets however is contingent upon the continuation of sound macroeconomic management, enhanced secondary market liquidity, investor participation and policy and institutional reform.
With these foundations firmly in place, the platform for sound debt capital markets will enhance competitiveness and sophistication in the increasingly robust and tumultuous world of financial markets.
l Next article will examine the prospects and challenges in Asset Backed Securities (ABS).
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