Abstract

A key policy prescription for fending off financial crises in emerging markets has been the development of local bond markets, and this strategy has been embraced by a number of policymakers and international organizations (see World Bank and IMF, 2001). From a macro-economic perspective, local bond markets could soften the impact of lost access to international capital markets or bank credit by providing an alternative source of funding.40 From a microeconomic perspective, they could help create a wider menu of instruments to deal with inherent currency and maturity mismatches in emerging markets (see Eichengreen and Hausmann, 1999: and HKMA, 2001).

A key policy prescription for fending off financial crises in emerging markets has been the development of local bond markets, and this strategy has been embraced by a number of policymakers and international organizations (see World Bank and IMF, 2001). From a macro-economic perspective, local bond markets could soften the impact of lost access to international capital markets or bank credit by providing an alternative source of funding.40 From a microeconomic perspective, they could help create a wider menu of instruments to deal with inherent currency and maturity mismatches in emerging markets (see Eichengreen and Hausmann, 1999: and HKMA, 2001).

In part as a result of the implementation of this policy prescription, emerging local bond markets have grown considerably over the past five years, and they are gradually becoming an alternative source of funding for both sovereigns and corporates. Also, as it becomes easier to invest across borders, local instruments are also attracting the interest of global fixed-income investors. In this chapter, we assess recent trends in emerging local bond markets. With particular attention to how they relate to global bond markets and international capital flows.

Size and Structure of Global Bond Markets

The size of global bond markets reached $43 trillion by the end of 2002, and overall the issuance of international bonds has expanded relative to domestic issuance. Indeed, international bonds constitute 20 percent of the global market, compared to 11 percent in 1997. Moreover, cross-border trading of bonds has become a key component of international capital flows (see Merrill Lynch, 2001). While such cross-border trading has affected emerging as well as mature markets, foreign participation in local emerging bond markets remains limited. Nonetheless, global bond fund managers have recently shifted their global benchmarks away from pure government indices, and are increasingly looking at investment opportunities in emerging bond markets (see Emerging Markets Investor, 2001).

Emerging bond markets have been growing faster than other bond markets, but so far they are just 6 percent of the global market (Table 5). Although foreign investors have tended to focus on foreign currency external debt issued by emerging markets, the size of the local bond markets is four times as large (i.e., $1,980 billion versus $512 billion of external bonded debt; see Table 5).

Table 5.

Size and Structure of the Global Bond Market in 2002

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Source: Staff estimates based on BIS Statistical Tables on Securities.

Since 2002 BIS has reclassified data on bonds issued by government agencies to public financial institutions and public corporate issuers as appropriate.

Includes bonds issued by governments, financial institutions, and corporates in international markets.

Euro area includes a total of 11 members of the euro zone, excluding Luxembourg.

The structure of emerging bond markets as a whole is similar to that of the mature markets, with around two-thirds of bonds issued by governments and financial institutions, and the rest distributed between corporate (around 10 percent) and international bonds (around 20 percent, Table 5). There are, however, some notable regional differences. While Latin American markets are dominated by domestic government and international bonds (47 and 39 percent of the total, respectively), Asian bond markets have a larger share of corporate bonds (18 percent; even larger than the 13 percent in the United States) and a relatively smaller share of international bonds. The rest of the emerging market universe is also dominated by government bonds, with 72 percent of the total market—a share comparable to that of the Japanese bond market.

Local Bond Markets as an Alternative Source of Funding

The rapid growth of emerging local bond markets over the last live years has been a natural outcome of financial crises. It also stems from the desire of governments, banks, and corporates to substitute domestic for external sources of finance to protect themselves against the on-off nature of access to international capital markets.

Until the mid-1990s, emerging local bond markets were generally underdeveloped, with restricted demand for fixed-income products, a limited supply of quality bond issues and inadequate market infrastructure. However, particularly in the period after the Asian crisis, many governments have made determined efforts to overcome these limitations. Nonetheless, there are regional differences in how rapidly the markets have developed. In Asia, the growth of local bond issuance has been driven by the need to recapitalize banking systems and more recently to finance expansionary fiscal policies. The lack of bank credit has also contributed to some increase in corporate bond issuance, not just in Asia but also in Latin America. In the latter region, the rapid growth of local institutional investors has driven the growth of local bond markets, together with large refinancing needs of the corporate sector in a difficult external environment. Finally, the buildup of institutions—such as debt management agencies—and the harmonization of regulations in the process of accession to the European Union have contributed to the growth of these markets in the Czech Republic, Hungary, and Poland—the so-called CE-3 countries.

A number of countries have made substantial progress in the development of government bond markets, but progress has been slower in corporate bond markets.41 While this has been the sequence of market development observed in many countries, there is nevertheless a risk that improved bond markets and debt management strategics could lead to excessive government debt issuance and crowding out of the corporate sector.

Government Bond Markets

While the increased issuance of government bonds has primarily reflected the financing of fiscal imbalances, there have been cases where governments have engaged in deliberate efforts to develop debt markets even without immediate fiscal needs. A large number of emerging markets have adopted debt management policies aimed at ensuring that “the government’s financing needs and its payment obligations are met at the lowest cost over the medium to long run, consistent with a prudent degree of risk” (see World Bank and IMF, 2001). A secondary but sometimes equally prominent objective has been the development of the bond market through a number of policy initiatives. These initiatives have included increasing market depth and transparency through preannounced and regular issuance programs, establishing benchmark issues and yield curves, improving market infrastructure, and developing a local investor base. In addition, some countries, such as Chile, Hong Kong SAR, and Singapore, have also made efforts to develop their bond markets even in the absence of explicit fiscal needs.

Increasing Market Depth and Establishing Benchmark Issues

Significant progress has been made in the development of local bond markets in Asia, with most progress concentrated in the government bond segment. In Thailand, for instance, the outstanding value of the total bond market has increased from 10 percent of GDP in 1996 to 37 percent of GDP by the end of 2002, with the largest increase in the government bond segment. The ministry of finance has established and announced a regular program for government bond and treasury hill issuance, with maturities ranging from 1 to 20 years. Similarly, the outstanding stock of government bonds increased by more than 10 percent of GDP in 1998 in both Korea and Malaysia (to 16.1 and 31.5 percent of GDP, respectively; see Table 6), and have continued to grow. Both markets continue to be dominated by corporate bonds, but governments have also made recent efforts to develop benchmark yield curves. Before 1998, market participants used three-year guaranteed corporate bonds as benchmarks in Korea, but since then the authorities have increased issuance and unified several issues into standardized treasury bonds that are currently issued up to 10-year maturities. Despite government efforts to develop a benchmark curve, market participants note that establishment of the curve in Malaysia has been complicated by the plurality of contenders for the title of “government bond” (see Moody’s, 2002).

Table 6.

Selected Emerging Local Bond Markets: Amounts Outstanding

(In percent of GDP)

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Sources: Bank for International Settlements; and IMF staff estimates.

China’s government local bond market has grown in a remarkably short period of time to become the largest in the region (excluding Japan). The total outstanding of treasury bonds reached 20 percent of GDP in 2001 and it declined somewhat in 2002, but the stock of tradable bonds has continued to rise. In 2001, the treasury added 15-year and 20-year bonds to the existing stock. The government has a quarterly issuance calendar, and around 50 institutions participate in the auctions. More recently, the authorities have announced that they may use the local bond market to finance the restructuring of the banking sector.

For governments that have consistently run fiscal surpluses, the development of the local bond market involves a series of costs, especially when there are few high-return uses for the funds raised. The Hong Kong SAR authorities nonetheless argue that public-good aspects of bond markets justify some degree of official involvement in their development—in particular those related to market infrastructure (see Yam, 2001), and the Singapore authorities appear to have been willing to incur costs related to the development of a government yield curve under the belief that the benefits of becoming a regional bond center dominate the implied costs.42

Both financial centers have undertaken explicit measures to help develop the market. The Hong Kong dollar bond market was one of the first domestic bond markets to develop in Asia, and it has grown from 13 percent of GDP in 1994 to 27 percent of GDP in 2002 (Table 6). The HKMA has established a government bond curve up to 10 years through the Exchange fund Notes and Bills program, but issuance is limited by the currency board arrangement and ample fiscal reserves. Given the limited size of the outstanding issues, some market participants argue that the interest rate swap curve constitutes a more liquid benchmark. Singapore has taken a much more proactive approach to develop the bond market and accelerated the issuance of Singapore Government Securities (SGS): the outstanding amount has doubled from 14 percent of GDP in 1997 to 36 percent of GDP in 2002. In August 1998, the Monetary Authority of Singapore began issuing 10-year SGS and in September 2001 it extended the yield curve to 15 years. Meanwhile, issue size has been increased to around 2.5 billion Singapore dollars (US$1.5 billion) and the monetary authority has conducted bond purchase operations to rechannel liquidity from small-size, off-the-run SGS issues into larger benchmark bonds. As a result of these efforts, in April 2001, Singapore became the first Asian country outside Japan to be included in J.P. Morgan’s Global Bond Index.

The growth and deepening of government bond markets in the CE-3 countries has been supported by strong institutional development, in particular by the early establishment of public debt management agencies. For example, the Government Debt Management Agency of Hungary (AKK) and the public debt department of Poland’s ministry of finance have pursued issuance strategies aimed at minimizing their exposure to foreign exchange and rollover risks,43 while developing local government bond markets. In the local market, Poland’s issuance strategy has been designed to increase the liquidity and extend the maturity of the treasury securities market, but it has also been required to adjust to budgetary pressures. Issuance of existing series of securities has been increased at the expense of the introduction of new series, the number of auctions has been reduced, and reverse auctions have been recently introduced to increase the size of key benchmark issues. Despite plans to lengthen the maturity structure of government securities, budgetary pressures and successive reductions in short-term interest rates led to an increase in the issuance of treasury bills in the second half of 2001, and the share of such instruments in total debt increased to 18 percent by the end of 2001 from 16 percent in December 2000. However, this was countered by the sovereign’s recent issuance of the first 20-year local bond from the region.

Hungary’s AKK has been instrumental to the development of a liquid government debt market and has recently focused its issuance strategy on smoothing the transition from a forint-denominated debt market to a euro-denominated debt market. The agency realizes that the separation of the external and domestic debt markets will become redundant with the adoption of the euro. As a result, market practices have been brought in line with those of the euro zone—including price calculations, quotations, and the use of annual coupon payments. The agency has also continued to lengthen the maturity of government debt and this has been reflected in the recent issuance of a 15-year forint-denominated bond.

The Czech Republic also extended the government local yield curve 15 years in January 2001. However, treasury bills with maturities of up to one year still form over one-half of the government debt, which increases rollover risk at a time when the deficit is about 5 percent of GDP.

In Latin America, Brazil had the largest and fastest growing government bond market until 2001: domestic public debt had grown from 33 percent of GDP in 1997 to 51 percent in 2001 (Table 6). By the end of 2001, the total amount of public debt amounted to $325 billion (65 percent of GDP), of which $270 billion corresponded to domestic bonds and $55 billion to external bonds. The authorities have undertaken a series of measures to improve the conduct of public debt management, but macroeconomic instability has hampered efforts to build up a benchmark yield curve. The main focus in terms of risk management has been the avoidance of refinancing risks. In this respect, the authorities have successfully extended the average maturity of the domestic debt—around 10 months in 1999 to 35 months at the end of 2001—and have achieved a smoother redemption profile, with the share of debt maturing in 12 months falling to 26 percent of the total by the end of 2001, compared with 53 percent in 1999. However, the objective of lower refinancing risk was achieved at the expense of higher market and credit risk, as investors required indexation to overnight interest rates and exchange rates to extend maturities. The resulting increase in indexed debt (see Box 2), combined with money and foreign exchange market pressures, has led to a complicated debt dynamics that was associated with a shortening of maturities by mid-2002. Indeed, as concerns about political developments intensified in the April-June 2002 period, the average maturity of the sovereign’s domestic debt fell from about 36 months in April to 32 months in September. Also, there was a sharp drop in the stock of domestic government debt toward the end of the year (Table 6), due to the substitution of external and central bank debt for domestic treasury debt. With the successful political transition in early 2003, the average maturity of the debt has started to recover somewhat.

Indexed Bonds

Indexed bonds are becoming more popular among investors and issuers in the mature markets, but they have a long history in inflation-prone emerging markets (see Merrill Lynch, 2002). The development of inflation-indexed (or inflation-linked, IL) bonds in the mature markets started with the introduction of IL Gilts in the United Kingdom in 1981, in response to highly volatile and negative real returns experienced by pension funds. A number of other mature markets for indexed bonds developed in the 1980s and 1990s, with the United States and France the latest to join in 1997 and 1998, respectively. However, IL bonds became popular in high inflation emerging markets during the 1970s, prompting a debate of the costs and benefits of such instruments that still continues.

The discussion of the costs and benefits of IL bonds indexation is usually focused on the macroeconomic consequences of indexation, but the issue also has important implications for financial markets. Proponents of IL bonds argue that they may lower the cost of funding for the government and that they provide information on inflation expectations and incentives for governments to keep inflation down. Detractors of IL bonds make the case that indexation of financial assets may spill over to labor markets and contribute to make inflation more persistent and costly. However, there is almost a consensus that IL bonds provide risk-sharing opportunities to investors and issuers alike, and that they contribute to complete asset markets in an efficient way. There is less agreement though on what role the government should have in the provision of such contracts, but a case can be made for the government to publish and coordinate the use of an IL unit of account to be used in such contracts (see, for instance, Campbell and Shiller, 1996).

Recent experiences in Latin America provide some useful insights on the costs and benefits of IL bonds, as well as on other aspects of indexation. In particular, they show that indexation could help deepen and lengthen both private and public bond markets, but that they need to be complemented with stable macroeconomic policies and capital market reforms that favor the creation of a large institutional investor base.

The creation of the Unidad de Fomento (UF), an indexed unit of account, together with the development of a strong institutional investor base, has played a central role in the development of the local Chilean bond markets. In particular, most corporate bonds in Chile are indexed to the UF, and this contributed to the recent growth of the corporate bond market, as well as to the long maturities achieved in local currency bonds. Local corporates generally issue bonds in two tranches, one of five to eight years, targeted to pension funds, and another of 20 years or more, targeted to insurance companies. Tight regulations on asset and liability management for insurance companies have generated demand for longdated paper, and issuers have gone up to 30 years. Analysts argue that, had it not been for the required use of the UF for many financial contracts and for the development of a UF-denominated government bond market, the fixed income market would have developed toward shorter-term, dollar-denominated securities (see Walker, 2002).

In Brazil, efforts to deindex the stock of domestic debt during the successful Real Plan of 1994–98 led to a relatively large share of fixed-rate debt (approximately 60 percent of the total) by mid-1997. However, increased instability in the wake of the 1998–99 financial crisis reduced drastically the share of fixed-rate bonds, and the authorities had to increase the supply of bonds indexed to the overnight interest rates and the U.S. dollar in order to reduce refinancing risk. Also, the authorities did not want to lock in high real interest rates or undo the deindexation (to inflation) achieved during the Real Plan. As a result, IL bonds have regained importance only gradually, and most of the rest of the financial system is indexed to overnight interest rates.1 Only recently a market for inflation-linked corporate bonds has reached volumes that are still a fraction (in terms of GDP) of those seen in Chile, in maturities of three to six years.

1 IL bonds were around 12 percent of total government debt in 2002, compared to 20 percent in the United Kingdom.

In contrast to Brazil, Chile has experienced a long period of government surpluses and has focused on building an external yield curve to serve as a benchmark for private issuance. Following what the authorities saw as an inadequate assessment of the fundamentals underlying Chilean corporate debt in the aftermath of the Asian crisis, they came to the view that the existence of sovereign external debt instruments would increase foreign investors’ research on the country’s fundamentals and would contribute to a more accurate pricing of corporate instruments in international markets. Also, the Chilean central bank has built a local yield curve in Unidades de Fomento (or UFs, a unit of account linked to the evolution of the CPI), and is currently trying to increase the issuance of peso-denominated debt. This process of nominalization of the central bank debt, aimed at improving the conduct of monetary policy since August 2001, has generated a number of transitional issues as investors get used to the change in numeraire. In particular, the change has disrupted the swap market and the pricing of long-term UF instruments with remaining maturities of less than one year. The authorities have stopped the issuance of UF-denominated debt of less than 360 days, and have successfully issued peso-denominated bonds up to five-year maturities. They hope to gradually continue to extend the peso curve, with the aim of having a coexistence of peso and UF instruments between two and five years, leaving the UF to continue to dominate the long end of the curve.

The main driver behind the growth of the local debt market in Mexico continues to be the federal government, which has financed moderate deficits exclusively in the domestic market since 1996. In the aftermath of the 1994–95 financial crisis, the authorities increased the average life of the stock of domestic debt from eight months in 1995 to 27 months in 2002, in part through the issuance of floating-rate bonds and inflation-indexed bonds. More recently, sustained macroeconomic stability and a low level of local government debt (at just over 12 percent of GDP in 2002; Table 6) has allowed the sovereign to increase substantially the issuance of fixed-rate peso-denominated debt. Issuance of three- and five-year instruments since the first half of 2000 and of 10-year instruments since July 2001 has allowed the sovereign to bring the share of fixed-rate debt to 26 percent of the total by the end of 2002. The authorities have also taken a number of steps to increase the liquidity of these benchmark instruments, by reopening existing issues and reducing the frequency of auctions. This has, in turn, contributed to a healthy growth of the corporate bond market in 2002–03.

Improving Market Infrastructure

A number of countries have improved their trading and clearing and settlement systems. In particular, the HKMA has recently focused on bringing an international dimension to this aspect of the local bond market. Following the buildup of a paperless clearing, settlement, and custodian system by the Central Money Markets Unit (CMU), and the introduction of a Real Time Gross Settlement (RTGS) payment system and a delivery-versus-payment system for securities in the mid-1990s, the HKMA linked up with Euroclear and Clearstream, as well as with other local markets—including Korea in 1999 and China in 2002. And more recently, it replicated the Hong Kong dollar infrastructure for the U.S. dollar, though use of the facility has so far been moderate.

Many countries have also created a system of primary dealers, but some have not done it or do not even consider it necessary for the adequate functioning of the market. In Chile, for instance, bonds issued by the central bank are placed directly through a public auction in which banks and institutional investors can participate. As they have provided a stable source of demand for the securities, the authorities have not found it necessary to create a system of primary dealers (see Cifuentes, Desormeaux, and Gonzalez, 2002). However, the risks associated with the lack of primary dealers, in terms of undesirable pressures around key auction dates, were exemplified with Poland’s experience in early February 2002. According to market participants, the announcement by the Monetary Policy Committee that it intended to stop reducing interest rates (rates had been cut by more than 900 basis points in the previous 12 months), combined with the prospect of a sharp increase in bond issuance (to settle indebtedness problems with the pension funds) and a relative heavy amortization schedule, led a large number of foreign investors to close their positions in the live-year bonds; domestic investors then reportedly rapidly joined in the sale of five-year bonds. Traders in London argued that the lack of primary dealers made it difficult for the Polish authorities to gauge market sentiment in critical junctures. The authorities have been working on a primary dealer system but are rather skeptical as to how much better channels of communication with market participants would help in the management of key auctions.

Developing a Local Investor Base

In Asia, banks continue to be large players in local bond markets. Banks typically hold a large share of short-term government debt to meet liquidity requirements and they dominate the short end of the bond market. However, bond market issuance has recently outpaced the growth of banking sector liabilities in most Asian markets, reflecting an expansion and broadening of the investor base. Long-term institutional investors, such as life insurance companies, have attempted to increase the duration of their assets, and this has made them ready purchasers of longer maturity government securities. However, the asset needs of insurers are unlikely to be met only through government securities, as the yield on such instruments is insufficient to meet the guaranteed returns offered on life insurance products. Hence, in the current low rate environment, insurance companies have been forced to look for a yield pickup in corporate bonds or credit derivatives or to seek gains through more active trading.

The development of a local institutional investor base, as a result of pension system and capital market reforms, also contributes to the increasing depth and stability of local bond markets—especially in the CE-3 and Latin American bond markets. Pension funds hold around 10 percent of total government debt in Hungary, and a somewhat lower percentage in Poland; but they are a steadily growing and stable source of demand. In Latin America, where pension reform started even earlier than in central Europe, pension funds are major players in local bond markets. In Mexico, for instance, private pension funds hold one-fourth of local government bonds, and the percentage is even larger in Chile.—where assets under management are 55 percent of GDP (see Roldos, 2003).

Several emerging market countries have also developed a thriving domestic mutual fund industry. For instance, the mutual fund industry in Brazil has more than $150 billion (30 percent of GDP) in assets under management and is the largest holder of government securities together with the banking industry. The number of local mutual funds and their total funds under management has also increased rapidly in Thailand, where they have become important investors in the government bond market. The authorities have made interest income and capital gains from local-bond mutual funds tax exempt, and this has led to the development of more than 80 fixed-income mutual funds with total net asset value of $1.8 billion.

Retail investor demand for bonds has also grown in Asia, through, among other ways, direct sales of bonds through bank branches. In Thailand, retail investors have bought a large share of government bonds to take advantage of the yield pickup relative to bank deposits. Similarly the People’s Bank of China has just approved new rules to allow commercial banks to offer sales of interbank-traded government bonds to meet an increased demand from retail investors. Generally, government bonds have paid slightly higher coupons than the one-year savings deposit rates mandated by the central bank.

Foreign participation in local government bond markets has declined markedly since the Russian crisis of 1998, and, despite government efforts to develop bond markets and the removal of capital and exchange controls, foreign participation seems to be meaningful only in the CE-3 countries. The foreign investor base for local bonds in Hungary and Poland is relatively large, as “convergence plays,” which take advantage of the declining path of interest rates driven by the expected convergence of inflation rates to euro zone rates, continue to attract substantial foreign interest. Foreigners hold around 12 to 15 percent of total outstanding debt in both markets, but participants estimate that the percentage is closer to 30 to 40 percent when measured relative to total marketable debt or in terms of turnover. In Korea and Mexico, foreign holdings of local debt are around 2 to 3 percent of total outstanding stocks, but here also the figures appear to be an underestimate. Market participants attribute the even lower foreign participation in Brazilian and Chilean local securities markets to a number of factors. Despite the removal of most capital controls and the simplification of investment regulations, the existence of withholding taxes, the possibility of discretionary increases in other taxes—such as the Financial Operations Tax—and the use of indexation and non-standard pricing conventions deter foreigners from buying Brazilian local securities. Foreign investors have had limited interest in local Chilean bonds because of historically low interest rates and the widespread use of UF-denominated instruments.

Corporate Bond Markets

The authorities’ efforts to develop local bond markets, combined with the corporate sector efforts to diversify away from refinancing and foreign exchange risks, have contributed to an expansion also of local corporate bond markets in most emerging markets—with the exception perhaps of countries in central Europe, Despite this growth, access to local bond issuance has been restricted to top-tier corporates, and it is unclear whether the resilience and size of most of the markets are large enough to consider these markets a meaningful alternative source of funding. Also, in most cases increased local bond issuance has been a result of a favorable interest rate environment, which may be reversed if interest rates rise again.

Since 1997, corporate issuance of local bonds has far exceeded issuance on international markets (see Figure 2). Both Korea and Malaysia already had large corporate bond markets before the crises (11 and 21 percent of GDP in 1997, respectively; Table 6).44 The dearth of bank financing, as well as the need to restructure balance sheets, gave an additional impetus to these markets, and they more than doubled in size over the past five years. The Korean authorities supported the market through periods of rapid growth and instability after the 1997–98 crisis (see below), as the market struggled to develop a true corporate credit culture. Malaysia’s Securities Commission introduced a series of measures to streamline the capital-raising process, which, combined with the process of corporate restructuring, has supported further growth of an already deep corporate bond market. The cost of bond issuance has reportedly fallen below that of bank loans in Malaysia, and bond issuance has dominated bank lending as a source of funding since 1997 (see Moody’s, 2002).

Figure 2.
Figure 2.

Corporate Bond Issuance in Selected Emerging Markets

(In billions of U.S. dollars)

Sources: IMF staff estimates based on data from local central banks and securities com missions, as well as Capital Net and Bondware.Notes: Eastern Europe Includes Czech Republic and Hungary: Latin America includes Argentina, Brazil. Chile, and Mexico: Asia includes Korea, Malaysia, and Thailand.

Hong Kong SAR and Singapore have encouraged statutory boards (quasi-government entities) and government-linked corporations to issue local currency bonds, but corporate bond issuance remains a small fraction of the market and is concentrated in high-quality issuers. Some foreign corporates have issued in Singapore after the country opened its market to foreign issuers in August 1998, and foreign banks regularly issue large amounts in the Hong Kong dollar market—usually swapping out the proceeds to foreign Currency. However, the volume of issuance by local corporates is still under 10 percent of the total, maturities remain around the five-year mark, and issuers rated lower than single A are rare.

Local corporate bond issuance has also increased in most Latin American countries, and has dominated international bond issuance since 1998 (see Figure 2). Latin corporates have increasingly looked at local markets to refinance external debts and reduce the cost of foreign exchange volatility (see Box 3). However, while Figure 2 shows a clear and growing substitution between domestic and external funding, the total amounts are still rather small—especially when compared with the size of local bond markets in Asia. Domestic corporate bond issuance is less than 1.5 percent of GDP in the major Latin America countries, with the exception of Chile (where issuance reached 4.6 percent of GDP in 2001), compared with 10 to 15 percent of GDP in Korea and Malaysia.

The corporate bond markets in Poland and Hungary are underdeveloped, in part due to the ability of the largest corporates to issue in the Eurobond market or fund themselves through their more highly rated foreign parents. In contrast, and despite a very recent development of the government bond markets, the Czech Republic has a more developed corporate bond market; still, most bonds are small and relatively illiquid (Euroweek, 2001). The Polish corporate bond market is dominated by short-term commercial paper that is distributed on the basis of private placements and has grown rapidly as a result of the fact that commercial paper is exempted from reserve requirements. The Hungarian corporate bond market has also struggled to take off for years, held up by abundant bank credit and some spectacular corporate defaults in the mid-1990s, but analysts are optimistic about the prospects for two reasons. First, several corporates have reached their credit limits with the banks and need an alternative source of finance. Second, the euro-forint market developed quickly in the second quarter of 2001, and this could widen the investor base for local bonds. Finally, the local corporate bond market has grown very rapidly in Russia since 2002, despite the lack of a well-developed government benchmark (see Box 4).

The development of local corporate bond markets is constrained by a variety of factors (see, for instance, Schinasi and Smith, 1998). Market participants highlight the lack of liquidity in secondary markets and of a meaningful investor base with developed credit assessment skills, as well as high costs of local issuance.

Low liquidity in secondary markets reflects such factors as the scale of local issuance, the characteristics of the instruments, and the nature of the investor base. In most emerging markets, only a few large corporates are able to issue bonds on sufficient scale that they create a market where investors can change their trading positions without moving the price against them. In addition, local instruments are not always transparent and hence are difficult to price. In Thailand, for instance, some bonds have complicated structures that may, say, switch from floating interest rates to fixed rates halfway through their term. In Brazil, long-term debentures are usually subject to repactuation clauses that allow for a renegotiation of the terms and conditions of the securities every year. The authorities are working with representatives of the private sector to agree on standard documentation for their bonds that would make them more homogeneous and improve their tradability.45

External Refinancing Risk in Latin America

The corporate sector in Latin America faced a heavier debt amortization schedule than the sovereign sector in 2002, and the same happened in 2003. As corporates usually take longer to recover access to international capital markets than sovereign borrowers, refinancing risks may be higher for the corporate sector under the current conditions in international markets. The increase in debt amortizations in the corporate sector, from $15 billion in 2001 to $18 billion in 2002 (see Table), is mostly due to an increase in $2.5 billion in the bond segment. In 2003, private sector amortization doubled that of the sovereign and public sectors.

A large fraction of the $4.8 billion of private sector bond amortizations in the second half of 2002 is accounted for by issues from Brazilian corporates and banks, and this contributed to the pressures in the foreign exchange market. However, Chile and Mexico concentrate the larger share of amortization of syndicated loans.

In this context, corporates have switched to local bond markets that have provided a cheaper avenue to refinance external debts coming due, especially in Brazil and Mexico.

Local corporate bond issuance in Mexico reached $3.3 billion in 2002 compared to $2 billion of private sector external bonds coming due in the year, as corporates took advantage of low domestic interest rates (see the Figures). Similarly, Brazilian corporates issued $3.2 billion of local corporate bonds, while the sector faced $4.8 billion in amortizations. Issuance of local bonds was down in Chile in 2002, but the decline was due to the fact that most large corporates took care of their refinancing needs the previous year.

Latin America: External Bond and Loan Amortizations

(In billions of U.S. dollars)

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Sources: Capital Data; and IMF staff estimates.
ch02ufig01

Brazil Domestic Federal Debt Composition

(In percent of total)

Source: IMF staff estimates.
ch02ufig02

Brazil and Mexico: Domestic Interest Rates

(In percent)

Source: Bloomberg L.P.

Although the cost of local issuance is in general lower than in international markets, regulatory and other factors have at times made it prohibitively costly to issue in the local market. For example, local investment banks estimate that the cost of placing debt in Chile’s local market is one-seventh of that paid for a placement in international markets (see Cifuentes, Desormeaux, and Gutierrez, 2002). The lower relative costs are attributed in part to the small size of Chilean issues (which makes it harder to absorb the large fixed cost of international issuance), to the fact that the local market is open all year round and is not restricted to the “windows of opportunity” provided by international markets, and to the continuously growing appetite of local institutional investors. In contrast, market participants note that bringing an issuer to market in Brazil is relatively expensive. The costs of local issuance, which include those associated with fiduciary agents, lawyers, registration, rating agencies, and bank fees, make it prohibitively expensive to issue debentures in amounts lower than 50 million reals ($20 million). The high costs are partly due to regulations that extend the underwriting process to 60 days, of which the Securities Commission authorization accounts for 30 days and requires that the price be established prior to the authorization request. Similarly, the cost of public issuance in Hong Kong SAR is estimated to be four times that of a private placement. A number of regulatory and cost obstacles make private placements the only profitable way to issue corporate bonds in Poland. For example, analysts noted that a prospectus has to be issued for each issue—ruling out medium-term notes programs—and that prospective issuers must wait a long time for the approval of the Polish Securities and Exchange Commission and must pay high fees to the National Depository of Securities.

The structure of the financial industry may also limit the growth of the local corporate bond market. Analysts note that the CE-3 countries have little intermediary capacity to underwrite corporate bonds, as the large, foreign-owned banks have little incentive to devote capital to such activity in the local market, and the local banks and brokerages typically lack the resources to do it. Also, banks in Thailand appeared reluctant to underwrite bond issuance because they feared competition from the bond market, while banks in Hong Kong SAR, eager to take advantage of the fees involved in the process, have begun to underwrite bonds. In Brazil, “firm underwriting” procedures are used by the local banks as a tool to compete with the foreign banks.46 According to international investment banks operating in Brazil, local banks’ willingness to adopt the more expensive underwriting procedure is partly explained by their appetite for credit risk, different risk management strategies compared with foreign-owned institutions, and the not-so-solid “Chinese walls” between their investment bank and asset management arms, which allow them to place some of the issuance with the pension and mutual funds under their control.

Local Corporate Bond Market in Russia

In 2002, the ruble-denominated corporate bond market in Russia was the fastest growing local corporate bond market in the emerging markets universe. The total value of all outstanding bonds (excluding the nonmarket issues) more than doubled, increasing from Rb25 billion ($0.8 billion) as of end-2001 to Rb63 billion ($2 billion) as of end-2002. This surge in corporate bond issuance was due to a combination of factors, including the favorable interest rate environment, both globally and domestically; high ruble liquidity on the back of strong petrodollar inflows; and the dearth of bank financing. In contrast with the previous year, the majority of corporate issuers in 2002 were medium and small-size firms from nonresource sectors. As a result, the industry structure of the ruble bond market became more diverse than that of the Russian corporate eurobond market, with oil and gas companies accounting for only about 40 percent of the total market capitalization. In contrast, the much larger corporate euro bond market, with the total value of all outstanding bonds at around $7 billion, is represented mainly by the top-tier companies from the oil and gas sector.

The 1998 crisis provided an impetus for the development of the local corporate bond market by significantly weakening the domestic banking system and shutting off Russian companies from external financing sources. During 1999–2000, the ‘veksel’ market was the only other form of financing available to local companies besides their accrued earnings. A ‘veksel’ is similar to commercial paper but, unlike a standard commercial paper, its legal status is not well-defined and, unlike a corporate bond, it does not have to be registered with the Securities Commission. As of mid-2002, the capitalization of the veksel market reportedly stood at around $10 billion, significantly exceeding that of the corporate bond market. On the other hand, Russian banks remained small and undercapitalized and often lacking expertise to lend to companies directly. The main problem faced by banks in Russia is the lack of long-term funding. Since most Russians still prefer to keep their savings in dollars and “under the mattress,” most ruble deposits are short-term corporate deposits, rather than longer-term retail money. Also, unlike bonds, bank loans often require posting a collateral and are on average 2 to 3 percentage points more expensive than bonds. As a result, Russian companies prefer bonds to bank loans and similarly, most local banks prefer to have exposure to corporate credit risk via tradable securities rather than loans. Separately, the small size of the local government bond market (less than 5 percent of GDP) and the low level of borrowing by the sovereign created room for a rapid expansion of the corporate bond market (in contrast to the “crowding out” phenomenon in Poland and Hungary).

However, the collapse of the GKO/OFZ market following the 1998 sovereign default left local corporates without a meaningful local currency denominated benchmark. Many floating-rate corporate bonds issued in 2000–01 had their coupon rates tied either to some GKO/OFZ portfolio or to the central bank’s refinancing rate or to a liquid sub-sovereign or corporate bond rate. However, high volatility and unpredictability of reference rates eventually forced issuers to switch to fixed-rate bonds. Thus, in the second half of 2002, a three-year bond with a fixed-rate semiannual coupon and embedded put options at 12-month intervals became the most widely used instrument.

The Russian corporate bond market is gradually becoming more mature, with issue sizes increasing, tenors lengthening, and put options being used less frequently. According to local sources, the average “investment period” of the ruble corporate bonds increased from 123 days as of end-2001 to 440 days at end-2002, where “investment period” is defined as the time to the first put option expiration date or to maturity, depending on which yield (yield-to-put option expiration or yield-to-maturity) is the highest. In contrast, the longest-dated Russian corporate eurobond is currently the one issued by Gazprom in February 2003, which matures in March 2013, At the same time, the average yield on a ruble corporate bond with the investment period of one year fell from 21.1 percent as of end-2001 to 15.8 percent as of end-2002, on the back of a continued decline in government bond yields and also partly due to a relative shortage of corporate paper, compared to the abundant banking sector liquidity.

However, along with positive developments, the Russian corporate bond market continues to experience “growing pains” stemming from regulatory inefficiencies and a weak credit information infrastructure similar to that encountered in many other emerging market countries. For example, the existence of a 0.8 percent bond registration fee is reportedly the main reason for a widespread use of bonds with put options and variable-rate coupons, where the coupon rate is determined unilaterally by the issuer and announced shortly before the put option expiration date. These instruments, which appear to be similar to the Brazilian long-term debentures with repactuacion clauses, are nontransparent and difficult to price. According to analysts, the proposed reduction of the bond registration fee to 0.2 percent would reduce incentives for Russian companies to use these instruments and could also help accelerate the conversion of the “veksel” market into the corporate bond market. Weak “credit culture” is another problem. S&P and Moody’s recently introduced a national scale of credit ratings for Russian companies, but so far awarded such ratings to only a handful of issuers, and the correspondence between ratings and corporate bond spreads remains weak. Meanwhile, the rapid expansion of the market led to a perceived deterioration of the average credit quality of corporate issuers, with more medium and small-size companies tapping the market in 2002 compared to 2001. Some market participants believe that a deterioration in the pool of issuers, combined with the continued decline in spreads, suggests that pricing may not be entirely efficient and that the credit risk assessment capabilities of investors may have to be strengthened.

The investor base for ruble corporate bonds is not sufficiendy diverse and remains heavily dominated by local banks. According to local market sources, its current structure is as follows: 45 to 50 percent, Moscow based banks (most of which are also the underwriters); 20 to 25 percent, regional banks; 20 percent, insurance companies and nongovernment pension funds; and 10 percent, other (including about 3 percent, retail investors). The top 20 banks are also the main liquidity providers in the secondary bond market, deriving part of their trading income from buying/selling corporate bonds, while most of the medium and smaller-size banks typically hold bonds to maturity. Regional banks that have relatively expensive liabilities typically seek higher-yielding paper. Foreign investors can invest in ruble denominated corporate bonds using N-accounts (rubles are not freely convertible into foreign exchange) and K-accounts (rubles are freely convertible into the foreign exchange for coupon payments). Although until recently foreign investors remained on the sidelines, their participation in some recent primary placements was notable. Asset management companies that invest on behalf of mutual funds are currently not allowed to participate in primary bond placements because the mutual fund regulations explicitly prohibit their managers from investing in securities that do not have a history of quotes. Some buy-side market participants note that a relaxation of this restriction would significantly increase their interest in the domestic corporate bond market.

Note: This box was prepared by Anna llyina.

The lack of a stable and large institutional investor base, and/or restrictions on their asset holdings, is also seen as a major constraint on market development. Although some countries in Asia have started to develop privately managed pension funds, it takes time for these institutions to accumulate the funds and to have an impact in the market (see IMF, 2001; and Moody’s, 2001). In Malaysia, life insurance companies are important players in fixed-income markets, but they cannot invest more than 15 percent of their portfolio in unsecured bonds and loans, and they can only invest in highly rated corporate bonds. Similarly, restrictions on the use of derivatives in the CE-3 and Latin American countries’ pension funds have limited the funds’ appetite for fixed-income products, as they cannot hedge interest rate risks.

Some market participants note that most emerging local bond markets lack sophistication in credit risk assessments and that the full development of a credit culture is still some way off. For instance, they note that many investors in Asia treat quasi-government issues almost on an equal footing with the sovereign and that they price local issues on the basis of name recognition, without a deeper analysis of credit fundamentals. However, the degree of sophistication in the pricing of corporate bonds is relatively high in Chile, and it is gradually improving in Brazil. Local rating agencies have achieved a relatively high degree of professionalism in Chile, reflecting more than 20 years of experience in the market and the important presence of the major international rating agencies. In Brazil, market participants complain that there is not enough price discrimination and that the mutual funds buy the bonds by name recognition, without pricing adequately company fundamentals or the existence of guarantees or other enhancements. Nevertheless, participants see the fact that most issuers are obtaining two rating—rather than only one, as required by the regulations—as a sign that the market is gradually maturing.

Korea’s experience provides an interesting illustration of the potential role of the corporate bond market as an alternative source of funding, as well as of the problems that may arise when guarantees distort price discovery. As the supply of bank credit dried up in the aftermath of the financial crisis of 1997–98, bond issuance increased substantially, operating to some degree as an alternative source of funding. However, issuance was concentrated in the Big Five chaebol, which were also owners of the largest investment trust companies (ITCs), the main investors in corporate bonds. The collapse of the third largest chaebol led to a run on the ITCs and the associated sell-off in the bond market forced the authorities to restrict redemptions and provide liquidity support to the bond market. Moreover, the surge of bond financing in 1998 led to a wave of refinancing in 2000–2001 that, combined with the removal of guarantees and the introduction of mark-to-market in the ITCs, prompted further governmental support of the market through the creation of a bond stabilization fund and official guarantees. A key support measure expired at the end of 2001 as planned, and the authorities are phasing out other support for the corporate bond market over time.

Finally, in several emerging markets the major obstacle to the growth of corporate bond markets is the crowding out by government bond issuance. In Brazil, for instance, government securities offer domestic investors low credit risk, ample secondary market liquidity, high yields, and—in many cases—protection against exchange rate, inflation, and interest rate risks through indexed bonds. Hence, only strong local corporates willing to pay rates in excess of 20 percent on three-year bonds are able to bid for domestic investors’ money given the formidable competition posed by the government. These issuers are concentrated in highly rated companies from the telecommunications, utilities, and natural resources industries. In many cases, corporate bonds had to be enhanced with guarantees to become attractive enough to investors. Similarly, the abundant supply of government paper in the CE-3 countries also crowds out private issuance. The inverted yield curve in Hungary and Poland is also a hindrance to corporate bond demand, as investors who can get 10 percent risk-free returns on government paper have little incentive to seek out credit yield pickup in medium-term corporate bonds.

Secondary Markets and the Role of Foreign Investors

The increasing importance of local bond markets can also be seen in the evolution of secondary market activity, as measured by trading volumes. According to EMTA’s debt trading volume survey, local market volumes reached almost half of total debt volumes in 2002,47 followed by 35 percent in Eurobonds and 15 percent in Brady bonds (see Table 7). While trading volume in external debt instruments fell in 2002 to less than half its 1997 level, trading volume in domestic instruments held up and has recovered to its pie-Asian crisis level. The overall declining trend, as well as the high regional and country variation, is mostly due to the string of crises and to the role played by foreign investors, who are considered critical to the market’s liquidity and direction (see, for instance, Deutsche Bank, 2000). Analysts note, however, that governments’ efforts to develop the markets have focused more on the primary market than on the transparency and efficiency of the secondary markets; and that transaction taxes, as well as underdeveloped repurchase (repo) and derivatives markets, limit secondary market activities.

Table 7.

Emerging Market Debt Trading Volume Survey

(In millions of US dollars)

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Source: Emerging Markets Trade Association.

Regional totals are based on the countries in this table and, hence, do not include all countries in the region.

All other countries of the survey not in this table.

Notes: External instruments include Brady Bonds, Non-Brady Bonds, and Eurobonds. Loans and Debt Options & Warrants categories of the survey are not included in local instruments or external instruments. However, these categories are in the totals by countries, regions and overall.

The Asian crisis brought that region’s trading volumes in local instruments to one-third of the pre-crisis levels, but they have recovered to more than twice their 1996 level, outstripping the increase in stocks outstanding. Trading volumes have grown sharply in Korea, with the introduction of mark-to-market regulations, a system of over-the-counter inter-dealer brokers, increased foreign participation, and availability of hedging instruments—in particular, the rapid growth in the three-year Korean treasury bond futures contract.48 Similarly, secondary market activity has increased in Malaysia, despite the existence of capital controls and some structural problems—such as the lack of mark-to-market regulations (see Deutsche (see Deutsche Bank, 2001b). Another constraint to the development of secondary market activity is the underdevelopment of repo markets. In Thailand, for instance, all repo transactions are done bilaterally with the Bank of Thailand, as private repo transactions are subject to a gross transactions tax that makes them prohibitively expensive. This tax has also prevented the establishment of a short-term interbank rate that would serve as the basis for the swap market. Foreign participation has remained low, as a result of these structural weaknesses and—more important—because of the low interest rate environment. Reflecting the easing of global monetary conditions and local financial policies, yield curves in most Asian countries shifted down and steepened during 2001 (see Figure 3). Short-term interest rates fell to under the 2 percent level in Hong Kong SAR, Singapore, and Thailand by the end of the year, while longer-term rates were supported in part by active government efforts to extend the duration of bond issues and market participants’ expectations of interest rate increases. In 2002 and the first half of 2003, yield curves continued to shift downward and flattened in an almost deflationary environment for the region (see Figure 3).

Figure 3.
Figure 3.

Selected Countries Domestic Yield Curves1

(In percent)

Source: Bloomberg L.P.1 June 2003 data are at the beginning of June.

Despite having one of the largest stock of outstanding domestic government bonds, China’s secondary markets are quite illiquid, reflecting the existing segmentation across investors, instruments, and trading mechanisms. There are two separate markets for bond trading: the stock exchange and the interbank market. Since 1997 banks have been banned from the stock exchange and trade solely in the interbank market. Until recently, individual investors were allowed to trade only in the stock exchange, while securities houses and investment funds were allowed to trade in both markets.

The crises in some countries caused a collapse in secondary market activity in European local bond markets, while trading of external instruments recovered to precrisis levels in 2001. For example, nonresident investors were holding about one-third of Russian treasury domestic securities (with a value of around $20 billion) by mid-1998 (see IMF, 1998a), and the losses incurred in the aftermath of the devaluation of the ruble and default have meant that they have stayed out of that market—and perhaps out of several other local bond markets. Similarly, foreign holdings of Turkish domestic securities were around 10 to 15 percent by mid-2000 (a percentage similar to that of the Mexican crisis), when pressures in the treasury bill market began, but they have declined markedly after the November 1999 sell-off.

Increased issuance and foreign participation contributed to very rapid growth in secondary market trading in the CE-3 countries. Most foreign investors engaged in “convergence plays” are “real money”—that is, institutional investor funds from western Europe that have a positive long-term view on the region and take unhedged positions in medium-term local currency government bonds in order to capture the gains from declines in local interest rates and exchange rate appreciations that are viewed as likely to occur as these countries near access to the European Union.49 Although the exposure to the domestic bond markets is not a one-way bet, especially after the widening of the exchange tale band of the Hungarian forint in May 2001 and the recent volatility of the Polish zloty, real money investors have a long-term view and do not seem to worry much about short-term foreign exchange rate fluctuations. Leveraged investors, such as hedge funds and the proprietary trading desks of the major banks, have a much smaller presence that tends to increase in periods of high volatility. Market participants see the large ratio of real to leveraged money as providing stability to the foreign investor base in the CE-3 local debt markets, but the hedging behavior of institutional investors and other features of the investor base have at times been a source of instability. For instance, the tendency of investors to dynamically hedge timing periods of increased exchange rate volatility has sometimes led to “snowballing effects.” This was seen in Poland by mid-2001, when weak local market conditions combined with increased hedging by foreign holders of zloty-denominated bonds to lead to a sell-off in the local foreign exchange market. Also, the sharp flattening and downward shift of local market yield curves in 2002–03 has reduced the attractiveness of convergence plays (Figure 3).50

Trading volumes in Latin American local instruments increased 68 percent in 2001, with growth in volumes of Mexican instruments dominating the decline of those from Argentina and Brazil. Trading volumes in all three local markets declined in 2002, following Argentina’s default in December 2001. Still, trading in Mexican local instruments accounts for more than half of the local emerging market universe according to the EMTA survey—a reflection of the appeal of Mexican debt for crossover investors, among other factors. This fact gives credence to market participants’ view that the role of foreign investors in the Mexican market is larger than that suggested by official estimates of foreign holdings of local bonds.51 Also, trading volumes in the Mexican local market have increased as a result of the relative increase in fixed-rate bonds,52 while the opposite has occurred in the Brazilian local markets. Liquidity in the latter market has also been hampered by the bank debit tax (the CPMF).

Conclusion

Emerging local bond markets are gradually but steadily becoming an alternative source of funding for sovereigns and, to a lesser extent, corporate borrowers. To some degree, existing corporate bond markets served as an alternative source of finance in Hong Kong SAR, Korea, and Malaysia after the 1997–98 financial crises. Progress in these and other markets over the last five years has meant that these markets are likely to buffer the impact of future disruptions in other financial markets. The rapid growth of local corporate bond issuance in Latin America is substituting for the reduced access to international capital markets, but mostly for top-tier corporates. Analysts hope that the strong growth in private pension funds, combined with the support of more transparent government benchmarks and better corporate governance and transparency, may extend the benefits of corporate bond markets to lower-tier credits.

Progress in the development of secondary markets is somewhat less satisfactory, and some market participants are concerned that a reversal of the interest rate cycle might lead to excessive adjustments in bond prices, especially in those markets where hedging instruments are unavailable or highly illiquid. Despite improved liquidity, uncertainties on EU accession and large fiscal deficits could still generate periods of market turbulence in the CE-3 countries. Foreign participation continues to be relatively large in these markets and has so far contributed to a deepening of secondary markets. Increased crossover interest in local bonds has been seen only in liquid markets with plain vanilla 5- or 10-year fixed-rate bonds. A large share of indexed securities has kept foreigners away from local Latin bond markets, but things seem to be gradually improving in Chile and Mexico.

Recent Developments and Policy Issues
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