IMF Survey:What did you identify as the main requirements for developing corporate bond markets?
Ong: Experience across both mature and emerging market economies suggests that a set of key features must coexist for corporate debt markets to evolve and develop. Drawing on extensive research we had done for previous issues of the [IMF’s] Global Financial Stability Report, including insights we gained through meetings with policymakers and financial market participants, we identified certain common fundamental requirements—such as reliable market infrastructure, credible benchmark issues in the form of liquid securities with relatively low default risk, good corporate governance and transparency, and the maturing of domestic institutional investors. As for the benchmarking requirement, the low credit risk and high liquidity features of government securities can make them natural providers of benchmark interest rates. This, in turn, can facilitate issues of similar maturity terms by the private sector.
Luengnaruemitchai: Other aspects, including credit-risk pricing; government policies, such as taxes and issuance regulations; the role of foreign investors; and the sequencing of market reforms, have a less clear-cut impact on bond market development.
IMF Survey: What has driven the emergence of corporate bond markets over the past decade, and how have patterns of market development differed across regions?
Luengnaruemitchai: Institutional and policy factors have played a very important role in mature markets. In Europe, for example, the euro’s introduction at the beginning of 1999 acted as a catalyst for further corporate debt market development, with private debt issuance more than doubling to about $680 billion in 1999. European corporations took the opportunity to quickly set benchmarks with euro issues and diversify their liabilities away from the previous reliance on bank loans.
In some emerging markets, there was a necessary push for developing bond markets in the wake of financial crises. In Asia, a lack of bank financing and the need to restructure balance sheets provided an important impetus for corporate debt issuance. In Latin America, the rapid growth of local institutional investors, along with the corporate sector’s large refinancing needs in a difficult external environment, were key drivers.
Ong: Generally speaking, the implementation and sequencing of reforms are key for market development. But this is easier said than done. And, while a number of countries have made substantial headway in developing their government bond markets, corporate bond markets have been developing more slowly. There are various possible reasons for this, including a lack of liquidity in secondary markets, the absence of a meaningful investor base with developed credit assessment skills, and high costs of local issuance. Even in mature markets, such as the United States and Europe, where corporate bond markets are more developed, the majority of bond issues are still relatively illiquid.
IMF Survey:So what can be done to make even these mature markets more liquid—to stimulate secondary market trading?
Luengnaruemitchai: That’s a difficult question. Since different issues have different characteristics, the corporate bond market may not be as liquid as the government bond market, where the characteristics of issues of similar maturity are more uniform. In the United States and some mature European markets, the development and evolution of derivatives markets have also played an important role in deepening the corporate bond markets.
Ong: Of course, secondary market liquidity is worse in the case of most emerging markets, where only a few large corporations are able to issue bonds on a scale that is sufficient to create a market where investors can change their trading positions without moving the price against them. This problem is exacerbated by the underdevelopment of derivatives markets in some of these countries, which limits the ability of investors to hedge their exposures.
IMF Survey:Would you briefly explain the relationship between the development of government and corporate bond markets?
Luengnaruemitchai: Government debt securities provide a benchmark that plays a critical role in the development of domestic bond markets. While other liquid securities with relatively low default risk could also be used as benchmark issues, the low credit risk and high liquidity features of government securities have made them natural benchmarks for issues by private sector entities. The development of government bond markets can also have positive spillover effects for corporate bond markets—notably in that both markets can share the market infrastructure that is put in place, such as clearing and settlement systems, the primary market issuance process, and the data dissemination system. And development of government bond markets can cultivate an investor base that corporate bond markets could also tap.
IMF Survey:There has been considerable lack of consensus within the literature on the appropriate priority that should be given to securities market development within overall financial and economic development—particularly in less developed economies. Some believe that banks and securities markets have a complementary relationship in contributing positively to economic growth, while others support a “gradual approach,” focusing on developing and improving the functioning and regulation of banking sectors ahead of securities markets. What’s your view?
Ong: As the Asian crisis highlighted, a well-diversified financial system is clearly very important in that it would reduce vulnerability to systemic risk. An important condition for the smooth functioning of securities markets is the existence of good corporate governance and transparency to allow the credible pricing of securities. In underdeveloped markets, where information asymmetry is severe and the requisite institutional setting has not been established, banks may be able to provide more reliable intermediation services. If resources are scarce and, presumably, a banking system is already in place, the country would be better off focusing on strengthening the banking sector than spreading resources too thinly. In other words, priority should be given to making sure that the existing institutions operate in an environment where there is adequate infrastructure, and that the necessary legal and regulatory frameworks are in place.
It is important to keep in mind that when it comes to the sequencing of reforms, there is no set formula for all countries. This will depend on what the particular country has in place at the time, in terms of infrastructure, institutions, and regulatory framework.
IMF Survey:What prospects do you see for a regional approach to corporate bond market development—as in the establishment of the Asian Bond Funds [ABFs]?
Luengnaruemitchai: In some countries, which have yet to achieve minimum efficiencies of scale to develop well-functioning national markets, regional cooperation and cross-border investment may be able to help broaden and deepen local markets. Although it may still be too early to tell, the prospects for the regional approach in Asia seem promising, with the launch of the second Asian Bond Fund [ABF2] in December 2004. ABF2 is comprised of a Pan Asia Bond Index Fund, investing in sovereign and quasi-sovereign local currency-denominated bonds issued in eight Asian states’ markets— China, Hong Kong SAR, India, South Korea, Malaysia, the Philippines, Singapore, and Thailand—as well as eight national market funds. These national market funds each invest in sovereign and quasi-sovereign local currency-denominated bonds issued in their respective markets.
Ong: Ultimately, the aims of the ABF initiative are to raise investor awareness of Asian bonds as investment alternatives, improve the effectiveness of financial intermediation in Asia, promote new financial products and improve market infrastructure, and minimize regulatory hurdles in the individual national markets. In our view, the authorities in each country do have a role to play in market development, to the extent that they help establish the right environment for this to occur, or, as with the ABF initiative, help jump-start the process on a regional scale. The market mechanism should then be allowed to work without government interference, however, to ensure greater efficiency in the allocation of funds and to promote greater transparency.
Copies of IMF Working Paper No. 05/152, An Anatomy of Corporate Bond Markets: Growing Pains and Knowledge Gains, are available for $15.00 each from IMF Publication Services. See page 348 for ordering information. The full text of the paper is also available on the IMF’s website (http://www.imf.org).