Guidance Note For Developing Government Local Currency Bond Markets

This guidance note was prepared by International Monetary Fund (IMF) and World Bank Group staff under a project undertaken with the support of grants from the Financial Sector Reform and Strengthening Initiative, (FIRST).The aim of the project was to deliver a report that provides emerging market and developing economies with guidance and a roadmap in developing their local currency bond markets (LCBMs). This note will also inform technical assistance missions in advising authorities on the formulation of policies to deepen LCBMs.

Abstract

This guidance note was prepared by International Monetary Fund (IMF) and World Bank Group staff under a project undertaken with the support of grants from the Financial Sector Reform and Strengthening Initiative, (FIRST).The aim of the project was to deliver a report that provides emerging market and developing economies with guidance and a roadmap in developing their local currency bond markets (LCBMs). This note will also inform technical assistance missions in advising authorities on the formulation of policies to deepen LCBMs.

Introduction

1. Local currency marketable debt as a share of total government debt has increased in emerging market and developing economies over the past decade. Better macroeconomic conditions and increased perception about the importance of developing domestic debt markets have created the conditions for this increase. For a selected sample of 44 emerging markets, the size of marketable government debt more than doubled since 2011 ($6.5 trillion to $13.5 trillion in 2019), with a significant increase in issuance of local currency debt during this period ($5.9 trillion to $12.1 trillion).3 Further, the local currency share of total government debt in emerging market and development economies increased from 18.9 percent in 2011 to 46.6 percent in 2019. However, despite considerable growth of local currency bond markets (LCBMs) in recent years, LCBMs in emerging market and developing economies continue to remain relatively underdeveloped compared with advanced economies, in which the local currency share of total government debt is about 95 percent.

2. Alongside growth in LCBMs, issuance policies have improved. Emerging market and developing economies have adopted new issuance policies and procedures as their government debt portfolios have grown, advisory efforts among international financial institutions (IFIs) and global and regional actors have increased, and knowledge sharing on debt management and debt management best practices have improved within the international community. In addition, progress has been observed in developing economies as primary market practices have become more transparent and more countries have started to issue benchmark securities.

3. Despite the observed progress, there is still significant scope for countries to further develop their LCBMs.4 Although many emerging market and developing economies have regularly promoted and adopted policies to develop their domestic markets for several years, different crises—for example, banking sector and macroeconomic dysfunctions in some countries have deterred LCBM improvements. In other cases, the lack of underlying enabling conditions or appropriate policies related to LCBM development has prevented further progress. Thus, it is important to understand the factors that are hindering the government LCBM development process so that appropriate measures and steps, targeted to the specific country, can be developed.

4. LCBM development can help to diversify government funding sources, safeguard sovereign portfolios from currency and maturity mismatches, and prevent or ameliorate financial crises in emerging markets (IMF 2002). In particular, Silva, and Velandia-Rubiano (2010) find that some emerging markets that shifted the composition of their public debt portfolios toward local currency debt issuance and improved their macroeconomic fundamentals avoided being buffeted by the global financial crisis. Along the same lines, Creehan (2015) argues that developing LCBMs can help insulate Asian emerging markets from volatility in global capital markets and associated capital outflows, as well as from exchange rate volatility that can lead to higher debt servicing costs for domestic borrowers in the event of a depreciating local currency. The funding challenges faced by many countries due to the COVID-19 pandemic is one more example of the importance of developing domestic debt markets to increase economic resilience.5

5. The Group of Twenty (G20) has also recognized the importance of LCBMs in improving the resilience of the domestic economy and financial systems. In November 2011, the G20 endorsed an action plan to support LCBM development. As part of this commitment, several multilateral institutions developed a diagnostic framework to identify general enabling conditions, key components, and constraints for successful LCBM development in emerging market and developing economies (IMF, World Bank, EBRD, and Organisation for Economic Co-operation and Development 2013). Also, IFIs have played a role in supporting domestic capital markets by issuing local currency bonds and setting up guarantee facilities.

6. The work presented in this guidance note brings together the large array of knowledge on this topic and is relevant to a variety of stakeholders. It systematizes the existing knowledge on the many issues related to the development of LCBMs and formulates a comprehensive approach to analyze them. Also, the guidance note provides a way to compile country experiences more easily, thereby facilitating the creation of a repository of information. This repository would be a powerful resource for country authorities who want to further develop their domestic debt markets and for technical assistance providers in this field. Technical assistance donors will also benefit because the guidance note can facilitate better implementation of recommendations and the monitoring of progress. Moreover, it will facilitate surveillance work by the IMF and World Bank teams, who can use the guidance note as a resource to identify relevant issues that need to be addressed to improve financial sector soundness and economic resilience.

7. The guidance note is organized as follows. The next section provides an overview of the literature and practical work done up to now in the area of LCBM development. The core of the guidance note is divided in two parts: Part I is the diagnostic element, which consists of an analytical framework to assess the level of market development. It discusses the enabling conditions necessary for LCBM development and presents a series of indicators to assess the level of development in six building blocks.6 Part II of the guidance note covers country experiences and discusses challenges and bottlenecks typically faced by emerging market and developing economies in their market development process. This section also offers guidance on how to overcome those challenges, backed by country cases where relevant. The final section concludes and suggests a roadmap on how to use the framework to implement LCBM development policies, considering the assessment from Part I and the challenges identified from Part II. The report also includes five appendixes. Appendix A describes selected case studies of successful market development experiences; appendix B presents the results from a survey sent to country authorities in 2019 to identify the main challenges they had faced in developing their domestic debt markets; appendix C presents three stylized cases that illustrate possible paths of reform for different levels of LCBM development; appendix D provides a brief discussion on the impacts of a deeper domestic debt markets on financial stability; and appendix E develops on the features and preconditions of a primary dealer system.

The Work on LCBM Development up to Now

8. Several studies have documented the key determinants of LCBM development. Burger and Warnock (2006) find that countries with stable inflation rates and strong creditor rights have more developed LCBMs and rely less on foreign currency denominated bonds. The results of Essers and others (2016) show that LCBM capitalization in selected African countries is negatively correlated with governments’ fiscal balance and relatively high inflation, and positively related to common law legal origins, quality of institutional setup, and strong democratic political systems. In a study on Asian emerging markets, Park (2017) presents evidence that better macroeconomic performance and stronger institutions help develop stronger LCBMs.

9. With regard to specific building blocks of LCBM development, Árvai and Heenan (2008) discuss the development of secondary markets for government securities and reach the following conclusions: (a) a commitment to achieving and maintaining a stable macroeconomic environment, especially prudent fiscal policy, should underpin market development, (b) a sound and transparent public debt management strategy supports secondary market activity, (c) a deep and diverse investor base is required, (d) poor market infrastructure leads to high transaction costs, slow order execution, and excessive operational risk, all of which inhibit trading, (e) secondary market growth is facilitated by effective monetary policy implementation, and (f) reforms should be sequenced to ensure a balanced development of all the structures supporting the secondary market.

10. Considering LCBMs’ integral role in sovereign debt portfolio management, Jonasson and Papaioannou (2018) maintain that LCBM development can be viewed in terms of three main stages with different priorities. In the initial stage, the focus should be on establishing a functioning primary market and creating the enabling conditions for secondary market development. In the deepening stage, where basic elements of the primary market and secondary market are established and functioning, the focus should be on improving liquidity on the secondary market. Finally, in the maturing stage, where elements of the market are, in general, well-functioning, the focus of policy makers should be on the development of sophisticated instruments and segments such as derivatives and making the market internationally competitive. Further, they maintain that the debt manager is in a key position to influence the development of the government securities market through the choice and design of instruments, issuance patterns, and its communication channels.

11. Jonasson, Papaioannou, and Williams (2019) discuss the main impediments in LCBM development and policies to overcome them, including macro or political instability; financial repression; low domestic savings; paucity of institutional investors; proliferation of government agencies issuing securities, fragmenting the market; unpredictable issuance policy; and absence of the required market infrastructure. Potential obstacles to the development of a domestic market depend on the country context (that is, the overall degree and stage of development). Each country must develop its own reform plan suited to its conditions, focusing on developing the credibility of the government as an issuer of securities and as a reliable policy maker; maintaining transparency to stakeholders; enhancing secondary market liquidity; and promoting a well-functioning money market, diversified investor base, and an appropriate regulatory infrastructure.

12. Since the early 2000s, the IMF and the World Bank have produced several reports to promote the development of LCBMs:

  • A handbook on policy issues, building blocks, and implementation considerations (World Bank and IMF 2001) that reflects the experiences and views of practitioners from the public and private sectors in the 1990s.

  • A joint pilot program to design relevant reform and capacity-building programs in 12 countries (World Bank 2007). The countries chosen were geographically and economically diverse7 and helped illustrate the challenges, obstacles, and progress in applying principles of LCBM development. This work provided practical insights to the many aspects of debt markets, including the six key building blocks already mentioned, and to the complex ways that they interact and react to policies and developments.

  • The Government Securities Market Development Toolkit for low-income countries to assess public debt market performance (World Bank 2014)8. The toolkit uses a rating system of 10 government securities market development key performance indicators and assesses the level of public debt management performance.

  • A stock-taking of recent global LCBM policy initiatives and regional/country implementation efforts and of examined trends in government and corporate LCBMs’ size, investor base, secondary market liquidity, and key drivers (IMF and World Bank 2018; IMF and World Bank 2020). Further, they presented key themes for developing LCBMs and discussed the roles that policy makers and multilateral development banks could play.

13. Many regional financial institutions have also produced reports on LCBM trends and development guidelines. The Asian Development Bank published a report in 2019 discussing trends in Association of South East Asian Nations (ASEAN)+3, which sets out good practices for developing LCBMs, drawing on regional experiences and lessons from the ASEAN+3 Bond Markets Forum. The report acknowledges that applying a one-size-fits-all approach to countries is not useful because of each market’s unique features.

14. Though the work described above is extensive, a more granular description of the underlying factors for market development and of the challenges faced by countries is missing. The analytical framework presented in this guidance note aims to close this gap.

Part I: Diagnostics

15. This section outlines a comprehensive and systematic framework to assess the level of domestic debt market development in a country. The following two components are discussed:

  • Enabling conditions, to highlight the important role that the broader environment plays in the implementation of policies in domestic debt market development.

  • Six building blocks, which use a set of indicators to measure the level of domestic government debt market development in each block. The six building blocks are money market, primary market, secondary market, investor base, financial market infrastructure, and legal and regulatory framework.

A. Enabling Conditions

16. Enabling conditions are fundamental for the effectiveness of agreed LCBM reform efforts and they broadly define a country’s development potential. To inform a better assessment of the building blocks for LCBM development, it is important to consider the nature of enabling conditions in the country being assessed. The state of the enabling conditions also can shape policy priorities and the sequencing of reforms. Nevertheless, even with less than satisfactory enabling conditions, strengthening of the basic functionalities in the LCBM building blocks can contribute to a virtuous cycle—such reforms will have a positive impact on macroeconomic discipline, which can contribute to further improving the enabling conditions themselves. For countries facing structural constraints, such as the size of the economy or the financial sector, there is a natural limit on domestic market development; securing stable, consistent financing from the domestic market could instead be the key objective. The most important enabling conditions that are conducive for domestic government debt market development are discussed below.

General macroeconomic conditions

17. Sound and stable macroeconomic conditions are crucial for the development of LCBMs. A stable macroeconomic environment anchors investor confidence, assuring investors that the value of their debt holdings will be preserved. A track record of good macroeconomic performance supported by a credible macroeconomic policy framework and overall commitment of the authorities will strengthen investor expectations. Mismanagement of the economy is often costly because past episodes of severe adverse events (that is, sovereign debt crisis/restructurings and banking sector crises) could have lingering impacts on investor confidence and significantly limit the progress of LCBM reform.

Financing needs of the government

18. The government’s funding needs form the basis of debt issuance. In most countries, the government’s fiscal requirements dictate the need to borrow, and the LCBM is one of the primary sources of this financing. However, in some lower-income countries, the availability of grants or long-term concessional borrowing might imply that the issuance of more expensive local debt is not advisable, if foreign currency risk is not a concern. In addition, there are a few examples of countries that have issued domestic debt for the sole purpose of developing a domestic market.

Structure of the economy

19. The size of the economy and domestic savings base (including the availability of contractual savings institutions) will have an impact on the absorption capacity of the bond market. For small economies, it may be challenging to build a liquid market. Furthermore, a low domestic savings rate, even for larger markets, may constrain the demand for interest-bearing financial assets, including that of government securities. The level of savings in a country is influenced by many factors, such as macroeconomic fundamentals, taxation policy, and pension systems. Domestic savings can also be allocated toward many competing factors (for example, domestic infrastructure assets), and the marketplace of such alternative assets should be considered when assessing this aspect of the structure of the economy.

20. Small economies may face more limitations when developing domestic markets; however, defining a minimum threshold for a local currency bond market to develop is difficult. Small sovereign issuers may face constraints on instrument consolidation and on the issuance of liquid benchmark bonds. These issuers also may face hurdles in mobilizing large volumes of money through cash management and in building a sufficient large cash buffer. They may be more vulnerable to larger concentration ratios of debt holdings with a few investors. Local investors may not be comfortable with holdings of single instruments in a large size and even with that they may not be willing to trade on the secondary market. The scope for attracting nonresident investors is limited because they typically expect large volumes in the overall market as well as in the instrument they purchase. Therefore, governments in these countries should assess carefully their capabilities and needs before heavily investing in costly infrastructures and building capacity for market development.

21. It is easier to issue local currency assets in a country with low levels of financial dollarization/euroization.9 Demand for local currency assets in the financial system would be supported when there is a small share of foreign currency deposits (and lending) in the banking system. This is further reinforced by a stable exchange rate and benign inflationary conditions that would preserve the value of local currency assets.

Fiscal and debt positions

22. Sound fiscal and debt positions support the development of LCBMs, particularly in the primary market. A high fiscal deficit can feed into an unsustainable debt trajectory, and fiscal risks stemming from contingent liabilities can add to debt-related vulnerabilities. Countries with large external financing needs, a high stock of public debt subject to market risks (for example, interest-rate refixing, refinancing and exchange rate risks), and an unsustainable fiscal position are likely more vulnerable. The size of the government’s borrowing needs and the risk of debt distress will affect the volume of net marketable domestic financing that the government is able to raise, the stability of this financing, and the pricing of the instruments. Easy availability of concessional external loans and reliance on nonmarketable domestic borrowings could constrain the growth of LCBMs. The erosion of investor confidence in countries with a history of sovereign debt defaults, including forced conversion or extension of domestic debt through financial repression measures, could affect significantly the prospects for LCBM development.

23. A lack of fiscal control can lead policy makers to deviate from sound market-based borrowing practices and affect investor confidence. For example, when there is a need to raise large amounts of financing and/or to contain borrowing costs over the short-term, the government may choose to exert control over interest rates, accumulate payment arrears, borrow directly from the central bank, or resort to nonmarket placement methods. Such noncompetitive placement methods may generate short-term cost savings at the expense of market development in the long run. Similarly, to save on near-term budgetary costs, the government may be tempted to primarily raise borrowings with short-term maturities, which impedes market development and creates additional refinancing risk concerns. The adherence to sound market practices is important because it generates a feedback loop—the adoption of sound practices in the primary market that are oriented toward market-based borrowing can instill fiscal discipline on the government, thus helping to keep its borrowing costs at tolerable levels.

Monetary and exchange rate conditions

24. Stable inflation, interest rates, and exchange rates reduce uncertainty for investors and enhance demand for government-marketable debt. Excessive interest rate volatility and inflationary pressures (which could also stem from the lack of monetary policy credibility) may lead to higher yields because investors require a premium for the unpredictability. Investors perceive excessively high and volatile nominal and real interest rates as unsustainable—this could induce uncertainty about debt sustainability, possible changes in the exchange rate regime, or an imposition of new forms of taxation and controls. In turn, this uncertainty reduces investor incentives to invest in local capital markets and long-term assets because it adversely affects expected profitability. Thus, stable monetary conditions allow the government to issue cheaper long-term debt, and to extend the maturity of the debt portfolio. High exchange-rate volatility along with a high pass-through rate are key deterrents for investor confidence, both domestic and foreign.10

25. Interest rate controls or other symptoms of financial repression are often seen as indicators of weak underlying monetary and fiscal conditions. Faced with limited fiscal space and high funding costs, the government might be tempted to resort to these practices. However, while these practices could save costs in the short-term, the government’s fiscal discipline could be compromised, fueling inflation expectations and exacerbating financing costs in the long-term; they might also distort market interest rates. The development of a market-based monetary policy framework (as discussed in the money market section) as well as the adoption of sound policies in the primary market could facilitate the exit from such practices.

Financial sector soundness

26. The country’s financial sector must be liquid and well-capitalized because it plays an important role as both investor and intermediary in the government debt market. The banking sector is an important part of the investor base in many countries, and typically it plays a critical intermediary role in LCBMs. The soundness of the financial sector is assessed typically by its capital adequacy, asset quality, earnings, and liquidity positions. Any risks of financial sector instability would hamper the capacity of the banking sector to play its role effectively.

Debt management capacity and operating procedures

27. Effective institutional arrangements for managing public debt is a key enabling condition for the development of LCBMs. Debt management responsibilities should be clearly defined in statute, and operating procedures should be stipulated in a Memorandum of Understanding between relevant institutions, if necessary. To implement a market-based approach to public debt management, the debt management entity should have trained staff, a supporting organizational structure, and the necessary resources to do so.

28. Although the debt management authority is not the only institution that may lead LCBM reforms, it is the best-placed to do so.11 The debt management entity typically has the mandate and the incentives to lead the development process for LCBMs. It is important to have in place a medium-term debt management strategy, an annual borrowing plan, an auction calendar, and a debt-reporting procedure (which requires sufficiently robust public debt-recording capacity).12 For countries with a high stock of nonmarketable debt, their debt strategy should also consider ways to move toward more marketable instruments over the medium-term.

29. The overall state of the enabling conditions will influence the pace at which progress in developing LCBMs can be achieved (figure I.1). The three markets (money, primary, and secondary) as well as the investor base are influenced by the enabling conditions, while the financial market infrastructure and the legal and regulatory environment are largely independent. In general, feedback loops from the building blocks also will facilitate progress in the enabling conditions, entrenching a virtuous cycle (for example, a strong primary market can help to promote fiscal discipline, and hence establish better sustainability in fiscal and debt positions).

Figure I.1.
Figure I.1.

Enabling Conditions and LCBM Building Blocks

Citation: Analytical Notes 2021, 001; 10.5089/9781513573922.064.A001

Source: IMF staff.Note: LCBM = local currency bond market.

Framework to Assess the Conduciveness of Enabling Conditions for Local Currency Bond Market Development

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B. Building Blocks of LCBM Development

Overview

30. Once an assessment of the enabling conditions is made, the LCBM framework can be used to assess the current stage of market development in individual countries and to facilitate the identification of key areas where reforms or policy measures are needed. The LCBM framework also enables countries to systematically monitor and assess progress in their LCBM development over time.

31. There are six building blocks that can be used to analyze the development of LCBMs in terms of their depth, liquidity, diversity, and resilience. The six building blocks are (a) the money market; (b) the primary market; (c) the secondary market; (d) the investor base (e) the financial market infrastructure (FMI); and (f) the legal and regulatory framework. The six building blocks are intuitively designed to provide focus on key reforms for the efficient functioning of LCBMs.

32. The framework uses a set of indicators that represent the key functionalities of each building block. For any country, each indicator is assessed from stage one to stage four, summarizing the level of functionality or stage of development in the particular building block. The indicators are ordered in a sequential manner, starting with more foundational measures and progressing in sophistication. A composite stage at the building-block level also can be calculated, which can help focus the proper sequencing of policy efforts across the six building blocks. The aim of benchmarking at the indicator and building-block level is to allow countries to identify peer countries that have overcome similar challenges, and to draw lessons from them to formulate an LCBM reform plan.

Determining the stage of development at the indicator level

33. There are two types of indicators: “outcome” indicators, which show the current state of the market vis-à-vis the building block; and “policy” indicators, which analyze the current policy and regulatory-associated practices employed by the authorities (both de jure and de facto). For most indicators, several binary (yes or no) questions are used to assess the extent to which sound policies and practices are implemented. Countries are rated as 1 (yes) or 0 (no) for each question, and the sum of the ratings determines the stage of the indicator. For several indicators (mostly those in the primary market), a specific question is asked, and the answer determines the stage of the indicator.13

Determining the composite stage at the building-block level

34. Four building blocks (the money market, primary market, secondary market, and the investor base) have outcome indicators and policy indicators. A composite stage can be calculated with an equal weighing for both the simple average of the assigned stages of outcome indicators and policy indicators.

35. Two building blocks (market infrastructure and legal and regulatory framework) have only policy indicators. A composite stage can be calculated with a simple average of the assigned stages of policy indicators.

The four stages of LCBM development

36. Four thresholds are proposed to represent the following stages of development in LCBMs:

  • Stage one, or the nascent stage, where the relevant indicator exhibits no functionality.

  • Stage two, or the developing stage, where the relevant indicator exhibits some functionality, but severe shortcomings exist.

  • Stage three, or the emerging stage, where basic elements of the indicator’s functionality are established.

  • Stage four, or the mature stage, where the indicator exhibits a considerable degree of functionality. This stage broadly corresponds to the levels/functionality in LCBMs of advanced economies.14

C. Building Block 1: Money Market

37. An efficient money market facilitates the implementation of monetary policy, strengthens monetary policy transmission, and provides a foundation for the maturity extension of government financing.15 Money markets are crucial for the short-term financing and inventory management of market makers in government securities, and for the liquidity management operations of commercial banks. In addition, they help create broader products, such as floating rate instruments, and hedging tools, such as derivatives. Derivatives (for example, interest rate swaps) can further facilitate the development of capital markets.

Outcome indicator

Well-functioning short-term securities and repo markets

38. A reliable short-term yield curve and active repo market16 provide the foundation for the issuance of long-term securities and the development of the secondary market. The reliability of the yield curve is underpinned by a deep and liquid money market that provides a foundation for many of the core areas of the government securities market.17 The treasury bill (T-bill) market is often the most liquid and important segment in the money market. T-bills are discount instruments issued by the government, generally at tenors of less than one year. Typically, they are regarded as the safest government instruments because of their short maturity. In addition, central banks sometimes rely on the T-bill market to conduct monetary policy operations. If that is the case, it is important that financial market participants understand the motives of T-bill issuances because lack of transparency and unclear or mixed signals may cause market distortions.

39. Repo markets play various roles in the LCBM. The use of repo transactions in central bank market operations is a good starting point to catalyze the market development process.18 Liquidity in the interdealer market would strongly support market-making activities of dealers, particularly in inventory management.19 Repo markets also could strengthen the capacity of banks and other institutional investors to adjust their liquidity positions, and invest in longer-term government securities and help to support dealer activities in the primary market. As repo markets develop, interbank and/or interdealer transactions would tend to increase and the reliance on central bank operations would tend to fall. The size of the haircut20 applied to government securities, including illiquid ones, should not be set at a high level nor deviate significantly from that imposed on central bank securities (where relevant) as it could dampen the incentives for repo activity. The active use of repos by market players is an indication of an advanced stage in the money market.

Policy indicators

A monetary policy operating framework supportive of LCBM development

40. The operating framework of monetary policy has a significant effect on money market development. The monetary policy framework reflects the development stage of money markets and defines the central bank’s involvement in them—the more extensively interest rates are used as operational targets to guide monetary policy, the more active money markets tend to be and the higher the propensity of central banks to develop this market segment.21 As the transition to a market-based framework entails costs in the form of higher interest expenses, which might result in central bank negative capital positions, authorities need to be mindful of these associated costs and take relevant steps to address them.22 A market-based operating framework requires liquidity management across the whole banking sector. Any excess liquidity in the banking system, if not properly managed by the central bank,23 could reduce the need for banks to actively manage their liquidity and undermine any incentives to trade in the money market.

Monetary policy operations supportive of LCBM development

41. Open market operations are integral to the functioning of money markets. Direct policy instruments (particularly interest rate controls), are harmful to market development. High levels of reserve requirements, which are typical under a reserve monetary targeting framework, could distort the price discovery function in money markets by putting downward pressures on market interest rates.24 In banking systems that hold high levels of excess reserves, the absence of remuneration at market rates also can adversely affect price discovery. In general, the use of marketable securities in liquidity absorption operations is more conducive to market development than the use of non-marketable term deposits (see box I.1). The use of competitive price auctions indicates that securities are issued at market rates (and thus more likely to be traded in the secondary market).

Transparency of market information

42. Transparency can be assessed by the publication of short-term reference rates, other than the policy rate. Because short-term reference rates are the basis for pricing a broad range of products in capital markets, it is important to ensure their reliability as reference rates. In general, transaction-based reference rates are more reliable than quote-based rates, particularly if the quotes are indicative.25 Information on market pricing is necessary to construct a reliable short-term yield curve, and information on trading volumes is helpful to enhance transparency and facilitate the broadening of the investor base. This information could include pre-trade information and market quotes on the T-bill and repo market. Timeliness is key—if the publication of market prices is delayed, their usefulness declines. Ideally, market pricing should be published daily (that is, by the end of the business day), while trading volumes should be published at least monthly. In general, the local banking/market association, or in some cases the central bank, is best placed to publish such reference rates. Appropriate measures should be in place to ensure the reliability of reference interest rates.

Instruments for Central Bank Monetary Policy Operations

The marketable instruments used by central banks for liquidity absorption operations vary across countries. While many central banks have begun to use repo transactions for liquidity management purposes, the issuance of government treasury securities and central bank securities for monetary policy purposes is rather common. A 2013 survey by the IMF (covering 125 countries) indicates that 34 percent of economies issue securities for monetary policy operations. Central banks in Latin America tend to use treasury securities, while those in East Asia and Eastern Europe tend to use central bank securities. In Africa, the evidence is mixed. Notwithstanding the type of instrument used, the coordination between the central bank and government is critical to avoid debt fragmentation, unnecessary competition, yield curve distortions, and additional costs.

Optimal instruments should be determined depending on individual circumstances. While the use of both instruments has pros and cons, key considerations guiding their usage should include

The stock of treasury securities available in the market.

The ability of central banks to use treasury securities for monetary operations would largely be dependent on the size of the stock of marketable treasury securities available. Some central banks have arrangements with the government to issue or borrow government securities for monetary policy purposes. In this case, the central bank can use reverse repo transactions with the central government without relying on new issuances of treasury securities (as practiced in many advanced economies).

Market fragmentation.

The use of treasury securities is generally more conducive to market development because it can avoid market fragmentation. Where central bank securities are used, the negative consequences of issuing two similar instruments should be minimized, such as through a separation of maturities (that is, central bank securities are issued short term and treasury securities are issued at longer maturities) and a harmonization in the design of securities and the method of auction. In practice, the separation of maturities could be costly for countries at an early stage of market development, where investor demand is concentrated in short-term securities. Fragmentation could be significant for countries where sterilization needs may be large and where the maturities of central bank securities are expanded to the medium term. Price distortions may also develop with pricing abnormalities for identical securities issued by the central bank and the government.

Autonomy of central bank operations.

The use of central bank securities is more straightforward in terms of maintaining the autonomy of central bank operations. The use of treasury securities (new issuances), the proceeds of which are sterilized by being held in the central bank, requires a carefully designed arrangement between the two institutions to ensure the central bank’s discretion regarding the size and timing of issuances. For countries without the legal and institutional arrangements to prevent direct central bank financing of the government, the use of treasury securities could further blur the line between government financing and central bank market operations. Often, the proceeds from treasury bills issued by the government to accommodate the central bank’s monetary policy purposes are deposited in a sterilization account and have separate reporting and accounting lines from fiscal policy treasury instruments.

Cost considerations.

In practice, sterilization costs are usually reflected in central banks’ balance sheets, regardless of the instruments used. If treasury securities are used, and the central bank typically pays market interest rates to the government (on the positive cash balance in the government account), the impact on central bank net income positions would then be exactly the same as in the case where central bank securities are used. Sterilization costs are ultimately borne by the government. In most countries, the profits of the central bank are transferred to the government, after allowing for adequate reserves, and any lower profits or losses of the central bank would reduce present or future revenue, or both, of the government.

Debt considerations.

New issuances of government securities for the use of central bank operations would increase the level of gross public sector debt (although public sector debt net of the deposits at the central bank will be unchanged), while central bank securities (liabilities) are usually not considered as public sector debt.

The legal framework for repurchase transactions

43. Written master agreements and their enforceability are crucial for the development of repo markets. Written master agreements, such as the Global Master Repurchase Agreement and the Master Repurchase Agreement , have been developed to provide legally robust contractual documentation for repurchase agreement transactions (that is, repos).26 To be fully enforceable, such agreements will, in many countries, require supportive legislation, in particular to recognize the ownership right over the collateral as well as the right of the non-defaulting party of close-out netting in the event of an insolvency-related default.27 Such legislation avoids instances where a court refuses to acknowledge the transfer of title to the collateral, and recharacterizes the repo as a collateralized loan, with the risk that the holder of the collateral has no more rights than other creditors in a bankruptcy, or invalidates netting.28

44. A non-distortive tax framework is important. A tax framework for repo transactions could be distortionary if it is structured based on the legal structure of the repo (sale and repurchase) rather than its economic substance (collateralized borrowing). It is desirable to treat income and gains from, and the costs of, repo transactions as interest income and expenses, respectively, rather than as giving rise to capital gains and losses, and also to ensure transaction amounts are free from withholding tax. Also, transaction taxes on repos are not helpful in developing repo markets. Box I.2 summarizes the key tax considerations relating to repo transactions.

Key Tax Treatment Considerations for Repos

  • Ensure that both the transfer and return of the securities are disregarded for the seller to avoid taxable gains/losses from otherwise being realized by the seller.

  • Treat as interest (or equivalent) the amount by which the agreed repurchase price exceeds the amount of the initial sale to better align the tax treatment with the substance of the repo transaction.

  • Ensure taxation of third-party (such as rehypothecation or reuse) transactions for the buyer.

Clarify the tax law treatment of manufactured payments, which could otherwise be treated as equivalent to the receipt and payment of interest on the securities.

45. The legal framework should provide the necessary operational flexibility when managing a repo portfolio. It is important that the legal framework allows for different types of repo transactions involving the right of substitution—in which sellers of the security may or may not have the right to retrieve the security and substitute it with another of equal quality and value during the term of the repo. Similarly, the legal framework should allow the rehypothecation of collateral—in which buyers can reuse the securities received as collateral in separate transactions. If the underlying legal framework for repos lacks such flexibility (for example, the collateral is blocked to the benefit of the buyer of the securities), the potential benefits of repo could be significantly reduced.29

Framework for the Money Market

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D. Building Block 2: Primary Market

46. The primary government bond market lays the foundation for the LCBM. The primary market provides the domestic financing to the government. Through this market, the debt manager implements the debt management strategy and establishes the relationship with market participants. Through the ability of the debt manager to directly influence several variables, such as the definition of the debt instrument, the auction calendar, and issuance procedures, the primary market is the most direct channel available to the debt manager to affect the market positively. The primary market also provides a regular opportunity for two-way communications between the issuer and market participants. Thus, primary market policies have a fundamental role in promoting the development of the domestic market.

Outcome indicators

Marketable domestic debt as a share of central government total debt

47. The share of marketable domestic debt to central government total debt is a proxy for the degree of reliance on domestic market borrowing/financing.30 A larger share of marketable domestic debt issued in local currency, compared with total debt, is associated with more advanced stages of primary market development. This is reflected in a relatively smaller share of external debt to total domestic debt. Although some economies issue foreign currency debt in the domestic market, their inability to issue adequate volume of local currency debt may reflect the underdeveloped stage of the LCBM.

Stability of domestic market financing

48. The stability of domestic market financing is defined as a stable overall demand for government securities, as often captured by the bid-to-cover ratio. Persistent oversubscription of securities offered signals healthy demand and is associated with advanced stages of primary market development. However, in some emerging market and developing economies, primary dealer obligations related to minimum auction participation and the presence of large captive investors may result in persistently high bids to cover ratios and mask true underlying demand.

Average maturity of government debt

49. A central government debt portfolio that shows a predominance of medium- to long-term security issuance is prima facie evidence of a more mature investor base. An increased share of medium- and long-term marketable securities in the central government debt portfolio typically is associated with more advanced stages of primary market development. As the market develops, average maturity can be increased by the issuance of long-term instruments.

Issuance across the yield curve

50. The yield curve is used as a basis for bond pricing and, thus, investor decisions. A yield curve that is relatively long, with adequate liquidity distributed across benchmark (reference) maturities typically is associated with advanced stages of primary market development.31

Policy indicators

Market-based pricing

51. The adoption of market-based pricing in auctions signals an adherence to transparency and noninterventionist policies. When bond prices are determined by the issuer rather than cleared at market rates, and when those prices are not consistent with fundamentals, the true value of the security cannot be ascertained in the primary market and the attractiveness of securities for investors diminishes significantly.32 Lower investor demand could result in pressures for monetary financing from the central bank. Market-based pricing is fundamental to extend maturities of debt, establish a yield curve, and develop the secondary market. In advanced stage primary markets, the issuer is a price-taker.

Market-based placement mechanisms

52. The use of market-based issuance mechanisms signals a commitment to greater transparency.33 Issuance on a tap basis or private placements may not facilitate price discovery, when compared with issuance by syndications and auctions.34 Advanced primary markets in advanced economies use auctions as the dominant issuance mechanism; however, syndications could be useful for new maturities or new type of instruments.

Predictability and transparency of issuance

53. Predictability in the timing of issuance in primary markets enhances transparency and gives investors and intermediaries time to prepare their balance sheets. This predictability is important for long-term maturities, where the market risk is greater. Rates at which medium- and long-term government debt may have been contracted bilaterally can have a material impact on bond valuations. The transparency of issuance volume and characteristics of individual instruments also helps reduce uncertainty for investors. Primary markets at advanced stages would, in normal times, publish and adhere to at least a quarterly issuance calendar, including details on issuance volumes and the terms of individual instruments, particularly the tenors.

Government cash flow forecasts

54. The ability to produce reliable forecasts of the government’s cash flow is critical for predictable and transparent issuance. A well-developed cash management function in the government allows delinking bond issuance with temporary cash shortfalls, enabling adherence with the issuance calendar and enhancing predictability for investors. Debt management authorities should have access to a reliable forecast of the government’s future cash positions. This forecast should be updated frequently; the longer the forecast period, the more supportive it is for predictable and transparent issuance.

Transparency of auction results

55. The transparency of auction results is crucial for market transparency. Auction results with information on bid and accepted amounts; cut-off price; and the minimum, average, and maximum prices (yields) of accepted bids should be disseminated as widely as possible on the day of the auction. More advanced stages of primary market development often are associated with greater transparency and a tighter timeframe in the announcement of auction results.

Transparency of communication between the authorities and market participants

56. The transparency of communication between the authorities and market participants reduces uncertainty for investors and helps to facilitate their participation in the primary and secondary markets. This transparency requires that the authorities disseminate to the market information that can affect the pricing of government bonds, including fiscal information, debt portfolio risk indicators, the debt management strategy, and the annual borrowing plan. Regular communication between the authorities and market participants should provide a two-way dialogue on market conditions, leading to a better understanding of the supply and demand factors that can improve the execution of the issuance program.

Fragmentatio n

57. A proliferation of debt instruments creates distortions in primary market bond prices and reduces secondary market liquidity.35 The central government should coordinate the issuance of its own debt and its guaranteed marketable debt issued by other entities. In case the central bank issues debt, the government and the central bank should minimize fragmentation by differentiating tenors and avoid entering the market around the same time. The central government should avoid the issuance of nonmarketable debt for financing purposes, with the possible exception of small volumes for the retail sector.

Benchmark bonds

58. Benchmark bonds36 aim to increase the size of individual securities at key tenors, thereby fostering liquidity and helping to establish a yield curve. Developing a benchmark yield curve is an important objective for countries that want to develop a liquid secondary market. Although the benefits and costs of developing a benchmark yield curve are difficult to quantify, the benefits—such as the increased market competition, reduced liquidity premium, and positive externalities to the broader financial sector—tend to outweigh the costs. As the market develops, there are more regular re-openings of existing lines of securities in key maturity segments. Typically, advanced markets have benchmark bond policies that target certain amounts at key maturities, such that the size is large enough to develop a secondary market yield curve. Developing the policies in close consultation with market participants is good practice.

Cash and debt management

59. Cash management plays a critical role in establishing transparent and predictable issuance practices as well as in controlling refinancing risks. In several markets (including in advanced countries), the government holds a certain level of cash buffer and/or uses various instruments (for example, short-term securities, repo, deposits) to reduce cash flow volatility and manage refinancing risks.37 The increased size of individual securities from benchmark bonds creates higher rollover risks, which can be mitigated by having flexibility in pre-financing, the maintenance of proceeds, and the use of liability management operations (for example, buybacks and switches).

Framework for the Primary Market

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E. Building Block 3: Secondary Market

60. The secondary market provides a cost-efficient and secure platform for market participants to trade securities in a fair and transparent manner. The market structure should involve a sufficient number of intermediaries that trade a non-negligible volume of government securities, with standard pricing and during agreed times. These, in turn, should provide wholesale investors with several options to buy and sell their securities at short notice and at reasonable cost. In broader terms, the secondary market provides liquidity for government securities that leads to term transformation, allowing investors to hold longer maturities than that of their liabilities on the assumption that liquidity will be available in the secondary market. The secondary market also provides a pricing reference for the sovereign—contributing to price discovery on the sovereign’s new borrowing costs and for non-sovereign borrowers. Typically, a mature stage of LCBM development is characterized by healthy secondary market activity across the yield curve during normal times.

Outcome indicator

Market liquidity and depth

61. Market liquidity and depth enable reliable price discovery. Market liquidity can be measured by the turnover ratio, average transaction size, and bid-ask spreads. A bond market is considered liquid when bond trades of reasonable size can be executed in the secondary market (measured by the turnover ratio of government securities). A market is considered deep when there are significant orders at tight spreads, and large trades (buy and sell) have a limited impact on market prices. In deep markets, trades can be executed at low costs and tight bid-ask spreads.42 Secondary markets in advanced stages of development tend to have a high turnover ratio, large transaction sizes, tight bid-ask spreads, and instruments traded across the yield curve.

Policy indicators

Pre- and post-trade transparency

62. Market transparency, in the form of price quotes and market transactions, improves secondary market liquidity. Transparency can be measured through the availability of pre- and post-trade information. At advanced stages of market development, pre-trade executable price quoting and post-trade information on prices and volumes are available in a consistent and timely manner.

Market-making duties

63. Countries with a relatively developed financial system could adopt a primary dealers (PDs) system43 to enhance secondary market liquidity. It is important to emphasize that a PDs system is not a precondition for a liquid secondary market. Liquid secondary markets can develop without a PDs system, while secondary markets may remain illiquid in case of inefficient or premature PDs systems. Nevertheless, if the preconditions for the implementation of a PDs system are met, a carefully designed PDs system can contribute to increase secondary market liquidity. The key obligations for PDs include providing two-way quotes for a certain number of hours per day within a predefined spread and associated trading volume.44 Although the obligation for the two-way quotes usually is based on firm prices, indicative quotes may be used to provide flexibility to PDs during the initial phase when the price discovery process is still evolving. Another obligation could be a minimum level of trading turnover over a certain period. PDs should be regularly evaluated, and nonperformers potentially replaced with new entrants in the PDs system.45

Market-making privileges

64. Privileges afforded to PDs normally include exclusive access to auctions and liability management operations, access to non-competitive auctions in the primary market, and access to securities and cash-lending facilities. Special privileges such as access to central bank credit lines could be provided in the early stages of development of a PDs system, although care should be taken so that such arrangements do not conflict with market development or monetary and debt management objectives. The privileges of PDs should be proportionate to the obligations to maintain incentives to participate in the PDs system.

Trading environment

65. An enabling trading environment helps to improve the efficiency of secondary market transactions. In addition to the repo market, the interest rate derivatives market (that is, interest rate swaps and interest rate futures) and the ability to short-sell securities help dealers manage risks related to market-making activities.46 Electronic trading platforms (ETPs) also help to increase market transparency and strengthen the surveillance over securities transactions. Conditions discussed in other building blocks also affect secondary markets.47

Framework for the Secondary Market

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F. Building Block 4: Investor Base

66. A deep and diversified investor base ensures demand for government securities, strengthening the resilience of the market in times of market stress. The development of a diverse investor base comprising agents with different investment horizons and risk-return preferences, particularly institutional investors, allows the government to spread risk in its debt portfolio and helps to extend the yield curve. The absolute size of the domestic financial sector largely defines the domestic absorption capacity for government bonds, and the structure of the financial sector can have a significant impact on market liquidity.

Outcome indicators

Market participants

67. The investor base significantly affects the pace and degree of development of the money market, the primary market, and the secondary market. Commercial banks usually play a major role in developing countries, typically as dominant investors for government bonds and as intermediaries for government bond trading. The size of the banking sector relative to the economy broadly defines its absorption capacity for government securities. The structure of the banking sector has a large impact on trading activities in the money and secondary markets, where a highly concentrated banking sector can undermine banks’ incentives to trade.49 Nonbank investors bring different risk-return preferences and investment horizons to the government bond market when compared with different risk-return preferences and investment horizons from commercial banks. Typically, pension funds and insurance companies prefer longer-dated assets to match their longer-dated liabilities, largely determining the ability of the government to issue longer-dated securities and thereby facilitate the extension of the yield curve. Meanwhile, money-market mutual funds generally prefer shorter-dated securities. Hedge funds also are important market players in some government bond markets, though these intermediaries normally emerge at a later stage of development; they contribute to market liquidity, via their more active trading. A developed investor base would have a deep and diverse range of bank and nonbank participants.

Investor relationship management

68. Active investor relationship management is useful to strengthen the investor base.50 An understanding of the risk/return profile and the constraints of key investors provides a sound basis for matching issuances to potential demand and helps reduce the costs of funding in normal times. It also helps the government to maintain market access in times of stress. In advanced markets, there is a mutually beneficial two-way flow of communication between the authorities and market participants.

Domestic institutional investors

69. The diversification of the investor base is a priority for many countries. Tax, accounting, and regulatory frameworks should be consistent with the objective of developing the institutional investor base (see Building Block 6 for further discussion). Collective investment schemes (CIS; for example, investment funds) are useful to encourage retail investor participation while avoiding the extensive use of dedicated products, which can create market fragmentation. Public pension reforms can contribute to enhancing national savings, though such reforms should be formulated taking into account broader considerations. Markets in advanced stages typically have a supportive policy environment for the development of domestic institutional investors.

Direct financing from the central bank

70. Central bank lending to the government is harmful to the development of LCBMs.51 Several established practices prevent monetary financing: the legislative prohibition of all forms of monetary financing; the legislative imposition of limits of purpose and duration of temporary cash advances; the legislative prohibition of central bank participation in the primary market;52 and the disclosure of central bank holdings of government securities. Monetary financing tends to occur when the financing needs of government bonds exceed the absorption capacity of domestic and foreign bond investors. Aside from distorting price discovery (and secondary market development), monetary financing has adverse effects on inflation and the external position, and it undermines investor confidence in the government. Markets that are more advanced do not rely on central bank monetary financing for financing government.

Foreign investors

71. The participation of nonresident investors can enhance the investor base but should be subject to careful monitoring and robust safeguards. Nonresident investors add different investment perspectives to the LCBM, often increasing secondary market liquidity; however, they are more sensitive to global market conditions and could amplify market volatility. Authorities will need to weigh the trade-offs related to the participation of nonresident investors in the domestic government bond market. Nonresident investors typically invest in more mature or large markets53 because they usually demand sufficient market liquidity, hedging instruments, investor-friendly foreign exchange administrative procedures, and predictable tax frameworks (see Building Block 6 for further discussion). In addition, the inclusion of domestic bonds in global indices indicates that the market is well-developed and attractive to foreign investors.

Buy-and-hold investors

72. A “buy-and-hold” investor base entails important trade-offs for market development. A strong presence of buy-and-hold institutional investors (for example, pensions funds and insurance companies) could serve as a reliable source of funding for long-term investment, thereby contributing to the resilience of the debt market. However, excessive reliance on buy-and-hold investors, especially through captive investors, can severely constrain secondary market activity and negatively affect further diversification of the investor base. Although buy-and-hold strategies could arise from several factors, including structural ones,54 legal and regulatory frameworks (that is, tax, accounting, bank, and financial institution regulations) could be important contributors. Examples of these aspects include an unfavorable tax treatment of secondary sales (for example, on gains attributable to accrued interest), withholding taxes for institutional investors and transaction taxes, the lack of transparency in valuation rules, and reference rates for mark-to-market valuations that are not clearly defined in the regulatory framework.55 Excessively high liquidity regulations on banks as well as investment requirements for pension funds and insurance companies also could encourage buy-and-hold behavior.56 Markets in advanced stages of development typically have an environment that mitigates buy-and-hold behaviors.

Framework for Investor Base

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G. Building Block 5: Financial Market Infrastructure

73. Efficient FMI facilitates the smooth flow and settlement of transactions in the money market and the primary and secondary markets, strengthens investor confidence, and stimulates the pace of market expansion. The state of development and functioning of the custodial and settlement infrastructure is a major determinant of systemic risk. Absent a sound securities settlement infrastructure, a market may be exposed to considerable systemic risks. The failure of one party to settle a large transaction may thus lead to a series of subsequent failures.

74. Systems used to settle, and clear financial market transactions should be safe, cost-efficient, and convenient to use. The financial market infrastructure should have a clear legal basis, provide delivery versus payment (DVP), be subject to regulatory oversight, and have the necessary capacity to process trading volumes within the chosen settlement cycle. At advanced stages, FMI can facilitate the smooth flow of transactions for different categories of investors with high certainty and low costs. In the future, new financial technologies (fintech) could play a relevant role in increasing efficiency and reducing risks for issuers and market players. It is important for debt managers to monitor the developments in these technologies.

Performance indicators

FMI technology platforms

75. Electronic systems improve efficiency and reduce risks. Core FMI systems include government securities issuance systems,57 security registers, real-time gross settlement (RTGS) payment systems, central securities depositories (CSDs), and security settlement systems. Interconnectivity among the core systems is critical. Modern systems support electronic payments, fast and efficient low-risk settlement for high volumes of transactions, and straight-through processing between the core systems. They improve transparency in the market, support the monitoring of anti-money-laundering compliance, and provide an opportunity to establish cross-border links. In a small financial market, partial manual and electronic systems may be more cost effective and efficient. A pragmatic assessment of cost and benefits based on the constraints of the market size is necessary.

Dematerialized securities

76. Dematerialized securities increase “asset safety” and support settlement efficiency.58 Dematerialized securities are held as credit balances on securities accounts and they are typically kept in the form of electronic records. If issued under well-designed legal frameworks, dematerialized securities are secure and verifiable, unlike physical securities, which must be held in a secure place and ownership is difficult to prove if they are lost or stolen. Dematerialized securities are a prerequisite for effective clearing and settlement systems.

Clearing and settlement risk (for a central securities depository [CSD] and/or central counterparty clearing house)

77. FMI framework should minimize counterparty and market risk during clearing and settlement. Building on the supportive legislation for dematerialization of securities, counterparty credit risk can be limited when the “finality” (that is, the definitive character) of payments and transfers of dematerialized securities is protected by law, notwithstanding bankruptcy and other laws,59 and the CSD system supports simultaneous security delivery versus payment. Also, the CSD and/or central counterparty clearing house (CCP) should have an electronic link to the central bank’s RTGS to facilitate DVP with final security transfer against the final RTGS cash settlement. The CCP could further reduce counterparty and market risks, but this risk reduction depends on the robustness and nature of the CCP settlement guarantee, its ability to call on financial resources, and the legal capacity to enforce settlement in case of participant default. Market risk can be contained by reducing the time between trade execution and settlement finality (for example, real-time intraday trading and same-day settlement).60 The more frequent the DVP model 2 (DVP2) or model 3 (DVP3) netting intraday, the lower the market risk exposure to the netting arrangement.

Governance and access policies of CSD and/or CCP systems

78. Sound governance and access policies strengthen the credibility and functionality of FMI. The owner and operator of the CSD and/or CCP should have a sound reputation; clearly defined roles and functions, including the legal mandate to develop the system that supports the development of the LCBM; and, the financial capacity to operate and invest in system development and absorb adverse financial and business shocks. The supervisory agency should ensure the accountability of these systems, and framework for supervision and oversight could be assessed against the principles for FMI.61 The fee structure should be on a cost recovery basis so that the system could be developed consistent with the public interest. The CSD and/or CCP should have fair and open participation criteria that protects both themselves and the participants. Their access policies should be harmonized with financial market law and regulations, and they should not preclude any sound financial institution and investors. A direct and/or indirect remote CSD membership also is useful for diversifying the investor base. Nonresidents investing through a regional or global CSD may have a different risk-return profile from those investing through the domestic CSD. The owner and operator of the CSD and/or CCP would need to be subject to supervision and the oversight of regulators.

Market segmentation

79. If multiple CSDs and/or CCPs exist, market segmentation should be minimized. Key issues include (a) the high costs and inefficient transfer of securities between the systems; (b) different access rules between the systems, and (c) different settlement models (that is, RTGS [DVP1] or netting models [DVP2 and DVP3]). These factors add additional costs and create inefficiency, limiting the potential for secondary market development. In addition, these factors can make the repo market unviable, which has happened in some countries.

FMI liquidity support

80. FMI should provide collateralization functionality. Once the market and legal framework exists, FMI should enable participants to liquidate government securities by offering low-risk, intraday settlement for an outright sale; intraday and overnight repo functionality consistent with a written master repurchase agreement; and an intraday collateralized lending arrangement.62 Inefficient FMI could increase the costs of repo transactions compared to similar unsecured interbank transactions, undermining the potential advantage of repos in minimizing counterparty risks.

Transparency (of data and information)

81. FMI should have the legal power and capacity to collect and publicly release data regarding transactions and categories of holders of securities. An electronic registry and CSD can extract information on transaction activity by security, security type, and security holdings by sector. This information also can be published electronically daily. Such information needs to be published in an aggregate form either by CSD and/or CCP systems operators or the authorities, which is a basis for establishing transparency in the primary market, secondary market, and money market. Information on the categories of holders of government securities also may be released.

Framework for Financial Market Infrastructure

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H. Building Block 6: Legal and Regulatory Framework

82. A country’s legal and regulatory framework affects the structure, functioning, and development of LCBMs.70 When the government is the borrower and issuer of securities, legislation and other legal instruments (such as a fiscal agency agreement between the government and the central bank) provide for the ability of the government to borrow and they provide the authorization of different government entities to operate in these markets, including the role that the central bank undertakes as an agent of the government. At the level of intermediaries and investors, rules and regulations shape the organization of the primary and secondary markets in government securities and influence the roles of different types of market participants.

83. Like any other securities market, the legal and regulatory framework for government securities should aim at maintaining fair, efficient, and transparent markets.71 To do this, the frameworks should define and enforce fair trading practices, penalize deviations from those practices (such as market manipulation and insider trading), and ensure investor protection through adequate rules for depository intermediaries to protect the holdings of investors.

84. Achieving these goals depends on effective enforcement. Effective enforcement is in turn a function of the robustness of the regulatory and supervisory framework, the overall quality of the regulator and supervisor, and the resources and independence of the regulator and supervisor. This can be a major challenge, especially for emerging market and developing economies. The legal and regulatory framework for FMI and CIS as well as tax issues should be reviewed together with the related discussions in the other building blocks.72

Policy indicators

Borrowing authority73

85. A government’s borrowing activities require a legal basis. The legal framework should clarify the roles and responsibilities of the debt management entities.74 The stipulation in law of the objectives of developing domestic debt markets facilitates the efforts to develop those markets. Several debt management operations (such as liability management operations) might require additional legal provisions, which should, for instance, allow for the implementation of a primary dealer system. Ideally, the periodic preparation and publishing of a medium-term debt management strategy should be part of the law, which should help to facilitate coordination between the debt management authorities and the fiscal and monetary authorities.

Market regulation and enforcement

86. Market regulation and enforcement mitigates the risk of unfair trading practices such as market manipulation, front-running, and collusion. These practices tend to distort price formation in the government bond market and undermine investor confidence. Market regulations should be backed by adequate enforcement capacity and the expertise to monitor trading activities and enforce market conduct rules.

Investor protection

87. Investor rights over securities should be safeguarded. The segregation and identification of customer assets in the books of depositaries is vital for maintaining investor confidence in market intermediaries. It should prevent them from using customer assets for proprietary trading or other self-financing activities without the consent of the customer. Also, it supports the orderly return of customer assets in case of default of a depositary intermediary. The competent authority should regularly oversee compliance and take prompt corrective measures when needed.

Collective investment schemes

88. A robust legal and regulatory framework is the key to developing CISs (for example, mutual funds, investment funds). Because CISs are typically marketed to retail investors, it is particularly important to ensure investor protection. CIS operators must act in the best interests of clients—there should be minimum standards for the eligibility, governance, and operational conduct of a CIS operator, including rules governing the CIS operator’s legal form and structure as well as the segregation and protection of customer assets. Disclosure and periodic mark-to-market valuation for security holdings play an important role in providing the relevant information to investors on a timely basis. The net asset value of the CIS determines the purchase price that investors would pay when investing, as well as the sales price they would receive when liquidating. Valuation methods of CISs should be properly regulated and disclosed to potential investors.75

Legal framework for taxation

89. Tax impediments to LCBM development should be identified and, when possible, removed. Tax frameworks are a key determinant of investment decisions and liquidity in LCBMs; therefore, the tax treatment of primary and secondary market transactions for government securities should be clear and reasonable.76 This typically requires the careful design and implementation of suitable provisions in the tax law affecting both the supply side (that is, the tax treatment of government securities) and the demand side (that is, the effective and efficient alignment of tax treatment between key institutional investor groups). Box I.3 summarizes the objectives of these supply side and demand side provisions.77

Supply-Side and Demand-Side Tax Provisions

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Framework for Legal and Regulatory Framework

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I. Using the Framework

90. The questions and indicators in the framework described above allows for a comprehensive assessment of the stage of development of a country’s LCBM. With answers to all the questions in each building block, it is possible to aggregate the answers and determine the development stage of the specific building block. Although assigning specific weights to each indicator may make sense in some cases, the framework at this stage assumes a simple average to arrive at the development stage of each building block.78

91. A comparison across building blocks for a given country would help identify gaps in the market developing process, which would provide clues to where policy priorities should rest. After the stages for each indicator have been determined, it will be possible to evaluate whether any or some of the building blocks are lagging the others. This assessment will help define the building blocks that deserve more attention and prioritization in designing reforms.

92. A comparison can also be made relative to other countries. Once a number of countries are evaluated using this framework, and a more robust set of country data and experiences is established, it will be possible to evaluate the stages of development for each indicator for countries similar to the one being evaluated.79 This assessment should provide useful inputs to determine areas for improvement, lessons learned from other countries’ experience, and policy recommendations.

Part II: Country Experiences: Common Challenges and Possible Remedies

93. The framework outlined in the previous section provides a path for country authorities to guide LCBM reform. The indicators identified in the framework represent key features associated with best practice measures for the effective functioning of the six building blocks.

94. In practice, however, countries often face challenges that prevent them from adopting these best practices. These constraints can originate in factors within the same building block or reflect the conditions in other building blocks. The identified building blocks do not work in isolation, and the proper functioning of each one often depends on the stage of development of the others.

95. Given the interconnected nature of the building blocks, progress (or lack thereof) within each building block is likely to affect the scope for progress in other building blocks. Some building blocks are more foundational than others, thus tending to determine the scope for improvement in other building blocks. For example, FMI and the legal and regulatory framework are foundational elements that would, to a great extent, dictate the composition of the investor base and the structure of the three markets (money, primary, and secondary). The investor base may pose structural, long-term constraints, if underdeveloped. The development of the secondary market, to a large extent, reflects the outcome of conditions in all the other building blocks. Feedback loops between the building blocks, as well as with the enabling conditions, further reinforce the relationships between them, as shown in figure II.1.

Figure II.1.
Figure II.1.

Building Blocks and Interlinkages in Local Currency Bond Markets

Citation: Analytical Notes 2021, 001; 10.5089/9781513573922.064.A001

Source: IMF staff.

96. This section aims to identify constraints commonly faced by countries, and to provide broad guidance on how to overcome them. These common challenges are drawn from the IMF and World Bank’s extensive experience in providing technical assistance in this area, and they are corroborated by the LCBM survey that sheds further light on countries’ concerns (the results of the survey are summarized in appendix B). The challenges presented here are illustrative and in no way exhaustive. They are grouped by building block and reflect the issues raised by the indicators described in the framework. If available, country examples are provided to point to the experience of successes in resolving these challenges. A few specific cases are discussed at greater length in appendix A. It is important to take the circumstances of individual countries into account, and to tailor the design of policies appropriately.

A. Building Block 1: Money Market

97. Many emerging market and developing economies financial systems display structural excess liquidity, concentrated or fragmented banking systems, a lack of instruments, and inadequate market infrastructure, all of which impede the development of the money market. These, as well as other challenges, are discussed further in the following sections.

Difficulties in moving to a market-based monetary framework due to limited fiscal space

98. An underdeveloped money market may reflect the lack of a market-based operating framework for central bank monetary policy operations. It is challenging for some countries to adopt a market-based framework because of limited fiscal space, which could lead to fiscal dominance and financial repression (for example, the imposition of interest rate controls). A shift to a market-based framework entails higher costs (for example, where higher interest rates paid by the central bank could lead to a negative capital position) that are borne ultimately by the government.

Possible remedies
  • Create sufficient fiscal space to allow for market-based monetary policy (for example, India, see appendix A).

  • Seek a high-level commitment between the government and the central bank to move to a market-based framework, clearly recognizing both benefits and costs.

  • Provide support to the central bank if balance sheet rigidities constrain the deployment of market-based monetary policy operations.

  • Coordinate with reforms to adopt market-based pricing in the primary market.

Lack of appropriate instruments to conduct monetary policy

99. The choice of instruments for monetary policy operations requires careful consideration of the trade-offs between the potential market fragmentation and the autonomy of monetary policy operations in the political context of individual countries.

Possible remedies
  • Determine the appropriate marketable instruments including government securities, considering the availability of instruments, the potential market fragmentation, the operational independence of the central bank, and the coordination between the central bank and the government. Establish operational capability for identified instruments.

  • Where sufficient government securities are available in the market, start using repo transactions for central bank market operations and gradually increase the use of them to foster the development of the repo market (for example, Brazil, see appendix A).

Structural excess liquidity in the banking system that discourages trading in the money market

100. A sustained period of excess liquidity in the banking system in many countries has undermined bank incentives to manage liquidity and trade in the money market. If banking sector liquidity is not properly managed, and even under a market-based framework (inflation targeting or exchange rate targeting framework), central banks could have many unremunerated excess reserve balances (which reduce banks’ incentives to manage liquidity).

Possible remedies
  • Strengthen the central bank’s liquidity management capacity. The central bank should develop tools to undertake liquidity forecasting, conduct day-to-day liquidity management (such as by using liquidity management operations to mop up excess liquidity), and develop a framework for medium-term liquidity management including the effective sterilization of capital flows (IMF 2012). However, difficulties in raising interest rates or the high costs of monetary policy implementation might hinder the central bank from properly undertaking liquidity management operations.

  • The government should strengthen its cash management capacity and undertake public financial management reform if unpredictable government expenditures are contributing to structural excess liquidity in the banking system.

  • Establish close coordination between the central bank and the government (for example, Brazil, Mexico [see appendix A]; Malaysia)

A high concentration of the banking system limits the potential for developing active money markets

101. A high concentration of the banking sector has posed structural impediments in many countries, precluding trading and, therefore, liquidity in the money market and secondary market. This challenge is more acute for countries with a small financial system and/or an undeveloped nonbanking financial sector.

Possible remedies

The investor base section provides further discussion on possible remedies.

Concerns about counterparty credit risks fragment the market

102. Weak banking systems often face fragmented interbank markets in which concerns about counterparty credit risks compel banks to trade only with those in the same tier. Such market fragmentation is exacerbated by the absence of adequate and timely information on bank balance sheets.

Possible remedies

Eliminate counterparty risk by developing true repo markets based on written master agreements that guarantee access to the collateral in the event of a counterparty default.

Difficulties in establishing the repo market due to an unfavorable legal structure and gaps in the financial market infrastructure

103. Besides structural impediments (that is, high concentration and structural excess liquidity in the banking sector), the legal framework and financial market infrastructure might hamper repo market development. Many countries rely on antiquated, non-enforceable pledges that do not provide assurance of ownership rights over the underlying collateral in the event of default. The absence of appropriate close-out netting also may result in the loss of credibility of repo operations. This could happen if a court ruling on a bankruptcy case determines that the security buyer in a repo must return the collateral—even without receiving the cash from the seller—and join the creditors’ queue. Furthermore, in some regions, the interest rates of repos are higher than comparable unsecured interbank rates, despite the potential advantage of repos in minimizing counterparty credit risks. This could reflect to some extent the inefficiency of the financial market infrastructure.

Possible remedies
  • Review the legal provisions related to repo transactions and assess whether they have critical features such as ownership rights over the collateral, close-out netting, and operational flexibility (for example, Thailand).

  • Establish that the repo market is supported by written master agreements and ensure the enforceability of those agreements under the legal system including through law reform when needed.

  • Review the bankruptcy legislation and ensure the applicability of the close-out netting.

  • Review and assess simultaneously the related market infrastructure including the trading and settlement costs of repo transactions to ensure compatibility with those of unsecured transactions (see the financial market infrastructure section).

Absence of short-term reference rates

104. Short-term reference rates are essential for the development of the government bond market and the derivatives market, as well as for floating rate instruments. The nonexistence of these rates creates difficulties for establishing a reliable short-term yield curve.

Possible remedies
  • Collect interbank transaction data and publish aggregate volumes and average interest rates transacted on the key tenors (for example, overnight, one week, two weeks, three months, six months, and 12 months) by the end of the next business day.

  • In case of illiquid money markets, the treasury bill market can provide pricing references. Because treasury bills are different from lending products, they do not represent the true cost of funding by banks and, thus, are imperfect substitutes for interbank reference rates. Nevertheless, in the absence of interbank reference rates, treasury bill rates could at the minimum provide anchors for short-term rate expectations.

B. Building Block 2: Primary Market

105. Countries can smoothen the redemption profile of public debt by undertaking liability management operations, improving the issuance of benchmark securities, and improving cash management capacity (see appendix B). These issues are related because having benchmark securities may lead to large bond redemptions, which may lead to large cashflows around redemption dates. Several low- and lower-middle-income countries are facing challenges in creating new instruments and these countries have noted that there was scope to improve the interest rate composition in their portfolios. These challenges could be related to the difficulties in establishing longer tenor instruments.

The government does not behave as a price taker

106. High borrowing costs are often linked to episodes of macroeconomic instability (for example, high inflation and exchange rate depreciation) or external events. Coupled with limited fiscal space, governments often resort to creating legislation that allows them to borrow in nonmarket terms (for example, directly from the central banks or from other investors through financial repression, such as by placing nonmarketable securities in public institutions or imposing a cap on the interest rates in auctions). Some governments might also consider market prices to be inconsistent with country fundamentals or have concerns about collusion among market participants, further discouraging them from being price takers.

Possible remedies
  • Create sufficient fiscal space to allow market-based pricing in auctions.

  • Adopt a strategy to gradually phase out nonmarket practices—such as the issuance of nonmarketable securities to the central bank (or other captive investors) or imposing interest rate ceilings on government securities—in a coordinated manner with an adjustment of monetary policy operating framework (for example, India, see appendix A; Vietnam).

  • Eliminate frequent tapping in the primary markets and move toward issuance through competitive auction processes.80

  • Establish auction rules that enhance competition and mitigate excessive market dominance by a few large players. This action would call for a detailed analysis of the demand profile and market share of each bidder.

  • Limit allocations to noncompetitive bids to promote better price discovery. Set strict limits to private placements, which should be undertaken only under exceptional circumstances; disclose the terms and rationale for any private placement undertaken.

  • Establish and enforce limits to (or prohibit) central bank monetary financing of the government (for example, India, see appendix A) (see the investor base framework for further discussion).

  • Increase the number of institutions with direct access to the primary market to enhance competition and minimize the likelihood of market collusion. If the direct access is the privilege of the primary dealers, ensure the fair and smooth access of other investor groups through the primary dealers. Strengthen the regulatory and supervisory framework of the government securities market so that it allows the timely detection of any market abuse and the timely imposition of appropriate penalties and sanctions.

Auctions are not sufficiently competitive

107. A concentrated investor base and/or the existence of a single (or several) dominant investor(s) may adversely affect competition at auctions and consequently affect secondary market liquidity. Investor base diversification is key to ensuring competitive auctions. However, particularly in the early stages of market development or in smaller markets, building a diverse investor base may be challenging. Commercial banks often dominate the primary market if the institutional investor base is shallow, increasing the risk of price collusion. In some markets, there may be a concentration of individual investors, even within the banking system. In other cases, single dominant investors (for example, social security funds, state-owned pension funds) may be the main source of demand for government securities.

Possible remedies
  • Establish auction rules that enhance competition, mitigate excessive market dominance by a few large players, and help to contribute to secondary market liquidity.

  • Consider if auctions should be open only to selected entities, or to broader participation.

  • Consider syndications to expand investors’ participation.

  • Consider limitations on the share of a single investor or bidder in the primary market.

  • Carefully and continuously analyze the investor base composition, the demand profile of investors, and the market share of the bidders to design an appropriate auction framework. Scrutiny of bidding behavior after each auction may help to identify potential collusion.

  • Develop the investor base to instill greater competition in the primary market (see investor base section for further discussion).

Lack of a predictable and transparent issuance framework, including as a result of cash management constraints

108. Authorities that issue securities on an irregular basis and in uneven amounts and maturities create market uncertainty. Such ad hoc issuance patterns frequently occur under volatile market conditions and in the absence of a strategic framework for government debt management. Capacity constraints to project and manage government cash flows for the budgetary cycle, and a lack of cash management instruments (for example, cash buffer, short-term instruments) could also result in erratic issuance patterns. In some countries, the latter problem is a consequence of legal constraints on the use of short-term instruments. Poor communication with market participants also could result in an issuance framework that does not match market expectations.

Possible remedies
  • Formulate, publish, and adhere to a medium-term debt management strategy and annual borrowing plan (for example, Brazil, Mexico).

  • Release debt issuance plan indicating issuance dates, amounts, and maturities on a regular basis.

  • Conduct treasury forecasting and active cash management to enhance issuance, reduce the cost of borrowing, and manage refinancing risk. Absent robust cash flow forecasts, the debt manager could examine historical trends in revenue and expenditure flows, as well as relevant forward-looking information (for example, Colombia).

  • Establish a cash buffer in the Treasury Single Account to enable a regular and predictable execution of the government’s auction calendar, and to better manage refinancing risk (for example, Hungary, Turkey).

  • In cases where financing needs are volatile or there are cash management constraints, allow the use of short-term government securities (for example, T-bills) to serve as a flexible tool for short-term financing (for example, India).

Higher cost and lack of demand for long-dated securities

109. Although the issuance of fixed-rate long-term bonds helps the government mitigate its refinancing risks and extends the yield curve, the government is often unable to place these types of securities because of their high costs, particularly in the early stages of market development. Extending maturities could be costly for countries that face unstable macroeconomic conditions or lack an institutional (nonbank) investor base. Also, unrealistic expectations of the issuer regarding the price of long-term instruments relative to short-term budgetary cycle cost considerations hinder the issuance of long-term bonds. The lack of an active secondary market, repo, and an interest rate derivatives market (for example, interest rate futures and swaps) also limits investor interest in long-term bonds.

Possible remedies
  • At an early stage of market development, when credibility is not yet established, the issuer may have to pay a premium to issue long-term securities. An expanded and diversified investor base, transparency, and predictability will help increase the credibility and offset the higher borrowing costs. The volume of long-term securities issued would be dependent in part on the government’s available fiscal space to absorb higher interest costs.

  • In countries where high inflationary expectations persist despite material improvement of the monetary policy framework, authorities could consider issuing inflation-indexed bonds in limited amounts to enable an extension of maturities.81 These type of securities could help reduce a large part of the term premium, paving the way for the formation of reference rates for fixed-rate yields on similar tenors82 (for example, Brazil, Mexico).

  • Develop contractual savings institutions to provide a natural source of demand for long-term bonds. (e.g., South Africa, Chile, Mexico) (see Investor Base section for further discussion)

  • Develop the secondary market by improving pre- and post-trading transparency. (see the secondary market section for further discussion).

  • Develop a repo market that uses long-term bonds as collateral. This will increase the capacity of investors to invest in long-term bonds (for example, Malaysia, Poland). (See the money market section for further discussion.)

  • Develop the interest rate derivatives market to provide investors with instruments to hedge their exposure on long-term bonds (for example, Brazil, South Africa). (See the secondary market section for further discussion.)

Lack of appropriate instruments, including benchmark securities, and difficulties in creating new instruments

110. Several countries, particularly low-income countries, lack a critical mass of benchmark securities in part because of concerns about high refinancing risks related to the bullet maturity of a large-sized benchmark bond. This is particularly problematic when government cash management capacity is weak, or when there is limited ability to conduct liability management operations. The lack of an adequate stock of benchmark securities impedes liquidity in the secondary market.

Possible remedies
  • Gradually build up a stock of benchmark bonds that cover the life cycle of a security. When reopening securities through on-the-run benchmark issuance, the duration of a security’s issuance and hence its target size should be adjusted to ensure that its coupon rate does not go off-market, in which case its demand will be impacted83 (for example, India, Kenya).

  • Complement benchmark issuance and reopenings with liability management operations (that is, buy-backs and switches) to mitigate refinancing risks and improve the liquidity of the off-the-run instruments (for example, Hungary, South Africa, Thailand). Make sure that the legal framework and market infrastructure are supportive of liability management operations (see the legal and regulatory section and the market infrastructure section for further discussion).

  • Increase the size of auctions to promote greater availability of tradable stocks, which in turn would lead to better price discovery. This should be done carefully with a precise understanding of investor preferences and constraints to minimize the risk of potential auction failures84 (for example, Mexico).

  • Consider reopening long-term instruments in different maturity segments if the coupon is in line with the market conditions in the new maturity bucket, to improve the liquidity of the off-the-run bonds (for example, Hungary).

Lack of a representative yield curve, which tends to produce different perspectives in markets and the government regarding the costs of financing

111. The yield curve normally serves as a price reference for the issuer, but its usefulness as a guidance mechanism could be limited if there is limited secondary market activity. Asymmetries in the expected yield for a specific maturity also may arise when there is no diversity in the investors’ offering quotes, or when a specific investor class dominates. Yield curve distortions also could arise when the bond market is fragmented because of different market conventions, tax treatments, and eligibility as a liquid asset of different bond series. In addition, a fragmented portfolio, including a large number of series and limited size of the stock of individual bonds, could impede the price discovery process.

Possible remedies
  • Introduce shorter-term securities to gradually build reference prices along the yield curve. A program of systematic issuance of T-bills helps to anchor the short end of the yield curve by providing fresh references for short tenors. Shorter-term issuances also support money market development.85

  • Develop a government-securities benchmark issuance policy, concentrating on amounts of benchmark tenors, and ensure that the benchmark target size is achieved consistently. The lengthening of maturity across key tenors needs to take place gradually, building on shorter tenors that anchor the new maturities being introduced (for example, Georgia, Peru; see appendix A).

  • Syndications could be useful to expedite the creation of benchmark securities, especially for new maturities or new types of instruments.86 Placement through syndications can allow for a larger initial issuance amount compared with a conventional auction and provide better clarity for pricing in subsequent auctions, while allowing for a more diverse investor base. In addition, the book building process provides the issuer with some degree of control over the issuance price.

  • Use liability management operations to reduce the fragmentation of the government bond portfolio.

  • Standardize the issuance of securities through a harmonized framework of tax treatment and payment conventions.

Inability to conduct liability management operations

112. The use of liability management operations (LMOs) in some countries could be hindered by the lack of enabling conditions. Common obstacles include the absence of efficient price formation, precarious market infrastructure systems, or inefficient cash management. In some cases, the legal framework may not provide the legal comfort for these transactions to be executed without risks to the debt manager.

Possible remedies
  • See the legal and regulatory, primary market (for cash management), and secondary market (for lack of a price reference) sections for possible remedies. LMOs should be developed alongside the financial market infrastructure.

C. Building Block 3: Secondary Market

113. The evolution of secondary markets is largely dependent on the stage of market development of the other blocks of the LCBM. Though there are specific policy measures that may generate greater liquidity in the government securities market, the functioning of the secondary market often is contingent on the proper functioning of the money market, the primary market, and market infrastructure, as well as on the composition of the investor base. Challenges faced in developing the secondary market typically stem from problems in developing one or more of the other building blocks.

114. Many emerging market and developing economies tend to have a small number of domestic and international institutional investors. The prevalence of buy-and-hold strategies among investors may be a constraint. The absence of benchmark bonds and an underdeveloped market infrastructure may also be important factors hindering trading in the secondary market (see appendix B).

Dearth of adequate volume of and properly priced instruments that support trading, foster liquidity, and deepen the yield curve

115. Many countries, particularly low-income countries, do not have enough benchmark securities, which inhibits liquidity in the secondary market.87 Many countries are unable to build benchmark securities of sufficient size due to concerns related to refinancing risks when a large-sized benchmark bond is redeemed on a single day, particularly if the government’s cash management capacity is inadequate and there is limited ability to conduct LMOs. In addition, if securities are not priced at market rates, it would be difficult to develop a representative yield curve (see the primary market section for further discussion).

Possible remedies
  • Reduce the frequency of auctions and build a large stock of benchmark bonds, supported by robust cash management capacity. These actions may be especially relevant for countries with a nascent secondary market.

  • Adopt market-based pricing supported by transparent and predictable issuance (see the primary market sections for further discussion).

Too-high frequency of auctions removes trading incentives for investors

116. Countries that conduct auctions too frequently tend to reduce incentives for trading. A steady supply of securities in the primary market reduces the incentives for market participants to seek those securities in the secondary market.

Possible remedies
  • Reduce the frequency of auctions (see the primary market section).

The dominance of buy-and-hold investment strategies

117. The prevalence of buy-and-hold investment strategies can stem from multiple factors. The issues directly related to the investor base include a high concentration of the banking system and distortive regulatory frameworks (see the investor base section for further discussion).

Possible remedies
  • Create regulatory frameworks conducive to trading, while addressing any structural constraints (for example, high concentration of the banking system). (See the investor base section for further discussion.)

  • Coordinate with the reform of the primary market. The reform of the investor base could have a larger impact if preceded by a move to market-related issuance rates that transform captive investments into voluntary investment (for example, Malaysia).

  • Increase transparency by publishing a daily yield curve and a list of traded securities. Many investors do not sell their holdings because of low levels of price transparency.

An inactive money market reduces incentives to trading

118. Without an active money market, it is difficult to develop the secondary market. The absence of a market-based monetary policy operating framework creates high volatility in short-term interest rates, which increases uncertainty for investors and creates a stumbling block for trading. Challenges that stem from the money market, such as structural excess liquidity in the banking sector, can further impede the development of a liquid secondary market. Furthermore, an underdeveloped repo market impedes market making.

Possible remedies
  • Transition to a market-based operating framework for monetary policy, supported by adequate liquidity management capacity. Establish a supportive legal framework and financial market infrastructure that supports the repo market (see the money market section for further discussion).

Inadequate market-making capacity of intermediaries impedes market liquidity

119. It is challenging to maintain an effective primary dealers (PDs) system particularly for countries in early stages of market development. Without an active secondary market (including repo and interest rate derivatives markets), PDs find it difficult to generate a profitable market-making business. In general, a PDs system is not feasible in economies with a small number of financial institutions because it is difficult to establish an effective dealer-broker arrangement to facilitate trades in the secondary market, and the issuer is exposed to the risk of collusion by the PDs.

Possible remedies
  • Countries with a PDs system should calibrate the obligations of PDs as the market develops so that PDs’ obligations are proportionate to the stage of market development and are well-balanced with the privileges afforded. A regular evaluation process will be required to retain the most efficient PDs and to replace the non-complaint PDs with new entrants (for example, Malaysia [see appendix A]; Poland).

  • Create an environment conducive for market-making activities by developing the repo, securities lending, and interest rate derivatives market, as well as by allowing short selling of securities for market-making purposes88 (for example, Thailand).

  • When an active secondary market is absent and trading volumes are small, a dealer system could begin with a single monopoly (usually a discount house) or with a small number of dealers. In this case, other financial institutions should be allowed to trade and to emerge as dealers over time. As the market develops, the discount house could be merged into a wider network of a primary dealer group (for example, India).

  • For countries with a small number of well-capitalized dealers, a call auction or an order-driven auction agency market system could be more efficient than a PD system.

  • Last-resort securities lending (or repo) facilities offered by debt management offices or central banks can efficiently support the establishment of a market-making framework, reducing the cost of the market-making (as less inventory capacity is required) and giving confidence to market makers that they can perform their trades without difficulties.

Lack of transparency in the secondary market

120. With the dominance of over-the-counter (OTC) trades, most countries struggle with inadequate transparency in secondary market activities. The lack of transparent pre-trade information impedes trading. Authorities often find it challenging to have a comprehensive picture of secondary market activities.

Possible remedies
  • Strengthen and streamline pre-trade transparency in the OTC market through an electronic trading platform that allows dealers to quote prices to each other so that they are available on a real-time basis and support trading among themselves (for example, Korea).

  • Require bond dealers to report their transactions (prices and volumes) to a centralized agency or a designated trade repository (for example, by end of business day). Collect transaction information from the central securities depository (CSD), publish aggregated trade volumes and average yields/prices. Display the resulting information to all market participants through a trading platform or exchange and to the general public via bond information websites. Monitor compliance with reporting requirements and impose penalties in the case of noncompliance (for example, Malaysia).

  • Facilitate government bonds listing on the local stock exchange(s), while bearing in mind that stringent requirements could hamper efficient trading (see the legal and regulatory section).

  • Publish turnover statistics daily and the most recent traded price.

  • Publish a daily market yield curve.

  • Consider the establishment of a bond index (for example, by the stock exchange) to improve transparency.

  • Promote the development of the derivatives market. Active trading in short-term futures will benefit the longer segment of the yield curve by helping to price long-term interest rate swaps. Several countries have attempted to address the problem of lack of benchmark rates by developing key interbank reference rates (for example, Brazil, South Africa).

D. Building Block 4: Investor Base

121. Countries at lower income levels might find it challenging to develop institutional investors (see appendix B).

High concentration in the banking sector

122. A high concentration in the banking sector, hinders trading and, therefore, liquidity in the money and secondary markets. This challenge is more acute for countries with a small financial system and/or an undeveloped nonbanking financial sector.

Possible remedies
  • In general, fostering competition helps make the financial sector more efficient. Financial sector oversight should be strengthened to prevent excessive risk taking and to manage potential risks to financial stability.

Lack of institutional investors

123. The absence of a large pool of institutional investors constrains the government’s ability to extend debt maturities. In many countries, inadequate pension coverage often results in the lack of a contractual savings sector.89 Because many countries have a bank-dominated financial system, deliberate policies are required to diversify the financial sector and to develop other types of institutional investors such as insurance companies and mutual funds. In developing countries, mutual funds may help strengthen market development because they provide professional management of retail savings and help attract individuals to the government bond market; also, they are likely to invest in a range of maturities.

Possible remedies
  • Consider formulating a strategy to develop the contractual savings sector and introduce a supportive tax framework (see also the legal and regulatory framework for further discussion).

  • Facilitate the development of collective investment schemes that can invest in government securities. Introduce supportive legal and regulatory frameworks to strengthen investor protection.

  • Consider the viability and usefulness of applying new technologies (fintech) to facilitate access of the retail investor to the government securities markets.

Lack of financial products that meet investor needs

124. Some countries have large institutional investors (pension funds or sovereign wealth funds) that invest mostly in overseas assets, partly owing to the absence of suitable financial products in the domestic market. For example, an inappropriate mix of instruments (for example, too much issuance of short-term and medium-term notes) could create an asset-liability mismatch for certain institutional investors (for example, the pension and life insurance sectors) that have a long-term liability structure.

Possible remedies
  • Strengthen the investor relationship management function to better identify the preferences and constraints of potential investors. Consider the potential demand when designing the funding mix. Ensure that institutional investors have access to government securities either directly through auctions or via primary dealers (market makers).

  • Gradually issue long-term bonds to cater to the investment needs of the institutional investor base, while keeping in mind the cost-risk trade-offs (for example, Hungary, Thailand).

Buy-and-hold behavior in investors exacerbated by distortive regulatory frameworks

125. Buy-and-hold investment behavior could be exacerbated by distortive regulatory frameworks. Differential tax treatments of different instruments can generate distortions in the market. Withholding taxes, transaction taxes, and taxes levied on the coupon (but not pro-rated according to the time for which the investor has held a bond) can impede secondary market trading. Excessively high liquidity regulations and mandatory requirements to hold government securities can also reduce investor incentives to trade.

Possible remedies
  • Ensure a neutral tax treatment of financial investments and avoid levying taxes on transactions (see the legal and regulatory framework for further discussion).

  • Review liquidity regulations on banks and other financial institutions. Assess whether government securities are treated as cash equivalents, and whether liquidity standards are set too high. In general, as the local bond market develops, banks’ ability to manage liquidity will become stronger, creating room to gradually relax liquidity regulations.

  • As an economy’s institutional investor base matures, gradually relax any mandatory investment requirement for government securities that may affect pension funds and insurance companies.

  • Allow institutional investors to repo (or failing that, to lend) securities to primary dealers for market-making purposes, to further improve trading.

Determining the cost-risk balance of foreign investor participation

126. The appropriate degree of foreign investor participation in a domestic bond market is difficult to establish and both benefits and risks must be considered. Countries that lack the enabling conditions to develop the local market often find it difficult to attract foreign investors. Foreign investors tend to favor local bond markets with sufficient size, liquidity, and depth. Markets with a liquid foreign exchange derivatives market to hedge currency risks also may be attractive for foreign investors. Nevertheless, countries may start receiving substantial capital inflows before the depth and liquidity of the local bond market has been established, increasing the risks to financial stability that can arise from a sudden reversal in capital flows.

Possible remedies
  • Assess the potential interest of foreign investors by considering the general development stage of the local bond market (including the existence of a foreign exchange hedging market) and macroeconomic fundamentals. Simplify the investor approval process, remove tax impediments, and improve access to reputable international CSDs and more effective custodial arrangements (for example, Malaysia, Peru; see appendix A).

  • If conditions are deemed appropriate, allow a gradual increase in the participation of foreign investment in the LCBM. Countries can relax the minimum holding periods for foreign investors after the domestic investor base is sufficiently developed to offset the potential capital outflows (for example, Mexico).

  • Consider the issuance of global depository notes (for example, Costa Rica, the Dominican Republic).

E. Building Block 5: Financial Market Infrastructure

127. Operational risk is a major hindrance to developing financial market infrastructure in low- and middle-income countries. Many countries have developed complex operational requirements for market transactions, custody, and settlement; others continue to rely on manual processes. The existence of multiple CSDs fragments the market; and, the lack of staff capacity also is a problem in low- and middle-income markets (see appendix B).

Difficulties in establishing cost-effective FMI that matches the stage of market development

128. It is challenging to set up cost-effective FMI systems. Depending on the size and development stage of the market, countries should evaluate how to establish FMI systems, taking into consideration the high costs associated with establishing them.

Possible remedies
  • Assess the current FMI arrangements against the PFMI (principles of financial market infrastructure) and identify gaps in good practice.

  • Communicate with key stakeholders to identify their requirements (in terms of functionality and services) to support market development.

  • Define an operating model that includes the core functionalities and identify minimum service requirements.

  • Use a competitive process to procure and select a suitable FMI vendor system.

  • Small countries should undertake a cost-benefit analysis of investing in integrated electronic systems, against the alternative option of operating a manual process.

  • Evaluate the possibility of using fintech to increase efficiency of the market infrastructure.

Difficulties in transitioning to a dematerialization of securities

129. Some countries are unable to start the process of dematerializing securities because of legal constraints, or the lack of capacity to do so. A lack of investor interest could also make the full completion of the dematerialization process (to 100 percent of marketable instruments) difficult, despite its potential benefits to the market.

Possible remedies
  • Introduce a law that supports the dematerialization of securities. The law should recognize security ownership through credit balances in securities accounts (kept as electronic records) rather than through a physical security.

  • Conduct a gap analysis of the risks and efficiency of the current registration and custody arrangements compared with good practice. Based on the analysis, decide whether the gap would be closed introducing a new system or upgrading the current system.

  • Offer an efficient low-cost switching process (from physical to dematerialized securities) and incentives to expedite the process to full dematerialization.

An unclear legal framework increases settlement risks

130. The legal frameworks for the finality of payment and the transfer of securities ownership right are not clear in some countries. Consequently, there is a risk that bankruptcy courts will override market transactions. An unclear legal framework increases settlement risks, impeding trading.

Possible remedies
  • The finality of payment and transfer of securities ownership right should be clearly defined in the law, and any potential conflict with bankruptcy proceedings should be clearly addressed by legislation.

Market segmentation due to multiple CSDs

131. The existence of multiple CSDs (usually with one operated by the central bank and others privately-operated) poses challenges for some jurisdictions. It segments the market, increases the costs and inefficiency of security transfer, and impedes trading.

Possible remedies
  • Coordinate with the key stakeholders in both the government and capital markets to establish if there are grounds to operate a single, well-integrated FMI system.

  • In the interim period of transition from a multiple- to single-CSD system, promote open access to the settlement systems, develop efficient electronic low-cost bridges to transfer securities between the systems, encourage the sharing of market activity data, and ensure that all systems support the same settlement models (for example, Georgia; see appendix B).

Lack of market infrastructure to support the repo market

132. Some countries lack the market infrastructure to support the repo market and conducive conditions for market liquidity.

Possible remedies
  • Where the repo market exists, assess whether the FMI system supports the key functionalities such as DVP1 T+0 settlement (which supports liquidity management of banks, the central bank, and the debt management office [DMO]), the settlement of both legs of the repo transaction on the respective settlement dates, and the substitution of securities under the repo agreement.

  • Where the repo is not yet introduced, set up procedures and controls and introduce system functionality to process collateralized loans on a T+0 basis. Small countries could focus on establishing a manual process, if the costs of introducing an electronic market are too high.

Lack of transparency

133. In some countries, the FMI (the central bank or other institution) does not have the power (or the legal basis) to collect transaction data from market participants. In small or underdeveloped markets, concerns for confidentiality could further deter the disclosure of market activity.

Possible remedies
  • Ensure that the FMI has the legal powers to require financial institutions to report transactions data daily. Determine the data and information to be released for publication after close consultation with market participants and regulators.

  • The FMI should have the capacity to provide an aggregate breakdown of government securities holdings by investor category.

Limited investor access to CSD/CCP functions

134. A lack of open access to FMI impedes the development of the investor base. Foreign investors that wish to access the local market would have to participate through a foreign CSD, and it could be costly for the country to establish these links.

Possible remedies
  • Develop the access policy of FMI in consultation with the central bank, DMO, and regulators.

  • For markets in later stages of development, the authorities could consider providing direct access of foreign investors to the domestic FMI. Authorities should carefully consider the cost-benefit tradeoffs of establishing links to a foreign CSD, including on risks and risk mitigation measures (for example, Mexico).

Difficulties in assessing and ensuring sound governance of FMI

135. It is often challenging for the authorities to assess current FMI governance arrangements, service, and supervision in a measured way against the sound practices.

Possible remedies
  • Conduct a full assessment of the current FMI based on PFMI assessment methodology.

    or

  • Selectively assess high-priority issues that require good practice. These issues could include the following:

    • a. Transparency in operations

    • b. Adequate mix of skills and proper oversight

    • c. Objective of running CSD/CCP

    • d. Operational and business risks, financial capacity to absorb consequential losses

    • e. Regular reconciliation between the system’s records and the Ministry of Finance’s records

    • f. Regular operational audits

    • g. Business continuity and disaster recovery plans

    • h. Communication network and system hardware that is secure and resilient

F. Building Block 6: Legal and Regulatory Framework

136. Recent technical assistance experience has identified several common challenges related to the legal and regulatory framework.90 Legal and regulatory issues that affect primarily the repo market and investors (banks, institutional investors, and foreign investors) have been discussed in earlier sections.

Lack of legal basis to undertake proper debt management operations

137. In some countries, the legal framework does not provide the debt management authorities with the flexibility to conduct necessary debt management operations. Some legal provisions limit certain transactions such as buybacks and debt exchanges. The legal framework also could restrict the parameters in which these transactions can take place (for example, price limitations, budget restrictions). Often, the lack of clarity on legal provisions creates legal risks and impedes the debt manager from executing necessary transactions.

Possible remedies
  • If consistent with the overall legal framework, ensure that the law provides the debt manager with the flexibility to define prices, instruments, and the types of transactions to be undertaken in an agile way to avoid undue market movements during the decision-making process, while placing a proper accountability framework.

  • In jurisdictions where there is ambiguity on whether the debt manager has competence to undertake LMOs, and until legal reform is possible, the debt manager can seek to clarify these competences, to the extent possible, in subsidiary legislation and/or request legal opinions from the competent legal authority.

Stringent requirements for the use of intermediaries posing barriers to efficient and cost-effective trading

138. In some countries, trading through dealers or brokers (market intermediaries) is mandatory, and bilateral transactions are not allowed even between institutional investors. Often, such requirements aim to protect the concerns of the intermediaries and/or to develop a dealer system. However, it can result in higher transaction costs and hamper the development of the secondary market. Undertaking all transactions through the stock exchange also is mandatory in some jurisdictions. Although such rules often aim to increase transparency, they could deter the participation of investors, particularly if brokers’ commissions and stock exchange fees are not negligible.

Possible remedies
  • Ensure that the legal framework applied to financial intermediaries strikes the right balance between transparency, cost efficiency, and risk minimization, considering the stage of development of the LCBM. At early stages of market development, stringent requirements tend to be counterproductive.

  • Develop other measures to address transparency concerns, such as strengthening the reporting requirements of dealers. Market regulations to prohibit unfair trading practices can also help, supported by a surveillance system.

  • Enable and facilitate transactions without the need of intermediaries via the definition of a price tunnel out of which transactions would be made void, protecting less-sophisticated investors from abusive or misleading prices.

Inadequate legal framework for taxation

139. Many countries have an inadequate tax law framework governing the treatment of domestic government securities, which results in material tax impediments to the development and efficient working of the primary and secondary LCBMs. The tax law framework might not provide certainty with respect to all key primary and secondary market transactions for all key investor classes.

Possible remedies
  • Countries should (a) undertake a diagnostic review of their tax law framework to identify possible impediments and gaps as they relate to the treatment of LCBMs; and (b) develop and implement the necessary tax law reforms to lessen those impediments and gaps to ensure that their tax law framework reflects international good practices and remains competitive. The legislative action to be taken will ultimately depend on each country’s legal tradition and baseline tax law framework, including its underlying fiscal and tax policy settings. Box II.1 provides high-level guidance in relation to the scope of the tax treatment issues that should be addressed by the tax law framework for each key investor class from both a supply side perspective (dealing with the treatment of the government securities themselves) and a demand side perspective (dealing with the related tax treatment for key institutional investors) (for example, Georgia, see appendix A).

  • Also, consideration should be given to the legal modalities relating to the issuance and trading of local currency government bonds and associated FMIs, given that an integrated tax law framework requires consistency with the country’s overarching legal infrastructure. For example, in the context of facilitating foreign investment, interest withholding tax and capital gains tax concessions/exemptions in relation to returns and gains on local currency government securities that are consistent with international common practice often become necessary to achieve critical investment links between LCBMs and international FMIs.

Tax Treatment Issues to Be Addressed by the Tax Law Framework

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Part III: Designing LCBM Reform Plans

140. The LCBM framework can be used to design a reform plan for countries that want to further develop their domestic government bond markets. Reform plans should be anchored on the long-term objectives of the country and formulated by considering the country’s degree of market development. The plans should include a targeted timeframe (for example, three to five years) to achieve the intended outcomes. Any LCBM reform plan should be informed by comprehensive assessment of the relevant indicators of each building block, as well as an identification of the key constraints for market development (figure III.1). This section presents seven steps to designing an LCBM reform plan.

Figure II.2.
Figure II.2.

Designing LCBM Reform Plans

Citation: Analytical Notes 2021, 001; 10.5089/9781513573922.064.A001

Source: IMF staff.

A. Seven Steps for Designing an LCBM Reform Plan

Step 1: Determine LCBM objectives and policy priorities

141. The plan should be guided by the country’s high-level objectives regarding LCBMs. Countries at similar stages of development may have different priorities for LCBM reform. For instance, a country with short-term instruments might have the objective of lengthening the maturity of the debt. Another country with similar characteristics may want to incentivize corporate sector funding and focus on further developing the short- and medium-term segments so that the yield curve can generate better price references. Policy priorities and the focus of reform efforts should be guided by, and consistent with, the country’s LCBM objectives.92

142. A country’s LCBM objectives should consider the degree of compliance with the enabling conditions, and the country’s growth strategy. The size and structure of the LCBM after the reform will depend on the size of the country’s economy and financial sector, its growth potential, and its institutional capacity.

An important consideration is whether the development of secondary markets should be an initial objective of LCBM reform. Secondary market development is a milestone that comes in the later stages of LCBM development, and it is strongly dependent on well-functioning money and primary markets. These two markets in turn could be constrained by the country’s investor base, financial market infrastructure, and legal and regulatory framework. Countries at an early stage of development or that lack a strong foundational basis should focus efforts on developing the primary market, to avoid the risk of overburdening the reform agenda.

Step 2: Establish a coordination mechanism for LCBM reform

143. A coordination mechanism will help to accelerate LCBM reform. Because the actions required to develop the various building blocks span different authorities, a coordinating mechanism will help to ensure consistency in policy goals and actions. For example, money market development would require active policy measures from the monetary authorities. FMI development and reforms in the legal and regulatory framework typically require close interactions between the financial regulators and supervisors, as well as legislators. The responsibility to develop the investor base often lies within the ambit of the government. A single coordinating mechanism would drive the various actors toward a common direction. Formalizing the LCBM reform plan via a public document also may be beneficial and ensure accountability.

144. Setting up a high-level committee and technical-level working groups could help push the agenda along. The working group should comprise the main stakeholders in the market development process, which would typically include the debt management authorities, the monetary authorities, the relevant regulator(s), FMI operators, and private sector participants (for example, the banking sector, insurance, and pension fund associations).93 The working groups should be chaired by the main beneficiaries of the LCBM (for example, the DMO or the central bank). Ideally, the working group should be established early in the reform process. The high-level committee should be chaired at ministerial level. Ideally, the Ministry of Finance should provide the leadership and secretariat, although in practice the central bank’s access to resources often means that it is better placed to drive the process, including many of the working groups.

145. Workshops and other events could serve as a starting point for the drafting of the reform plan. It is essential that the relevant officials participate fully and actively in the formulation of the reform plan. Public sector officials representing the relevant entities can hold discussions at senior and technical levels, while appropriately engaging private sector participants (such as through consultative fora). Given that the accountability for implementation will rest with public sector officials, the reform plans should be realistic and tailored to their respective circumstances, accounting for political feasibility and administrative capacity.

Step 3: Evaluate the enabling conditions and stages of market development in every building block

146. Assessing compliance with the enabling conditions is critical to determine the potential for market development (see part I, A). If the enabling conditions are not in place, it will be challenging to make significant progress in LCBM reforms. In those situations, it would be advisable to focus on complying with as many enabling conditions as possible.

147. The diagnostics framework should be used to assess the degree of development of each building block. The assessment would help to identify the areas in which the country has gaps in terms of the key functionalities of market development. A heatmap to identify the main priorities would be useful.

Step 4: Consider identifying “peer groups” to benchmark experiences

148. Peer group analysis can be used to identify relevant experiences of LCBM reforms as well as possible pitfalls in implementation. Peer countries can be defined in terms of income and population metrics,94 or on the basis of geographical proximity, economic structure (for example the degree of dollarization), size of the financial sector, the monetary policy regime, or on the stage of local currency bond market development. Once the peer group countries are identified, it can be assessed whether the experiences of those countries with more advanced stages of market development (by building block) can be replicated. In addition, peer group analysis helps to set realistic objectives for LCBM development in the short and medium term.

Step 5: Identify gaps in each building block

149. The framework assessment and peer group analysis can be used to identify the gaps present in a country’s LCBM. The stages identified for each building block will help to identify the gaps and to focus efforts on the areas that need greater improvement. In addition, using the peer group analysis, identifying the building blocks that are lagging compared with peer countries (where data are available) can provide guidance on the successful experience of countries that have advanced further in the building block. The feasibility and applicability of the measures adopted by other countries could then be assessed.

Step 6: Formulate a plan of action and measures needed to close the gaps, considering capacity and institutional constraints

150. The reform plan should be based on a clear understanding of the obstacles and constraints for making progress in each indicator and building block. These should be used to set a realistic timeframe for the reform effort and for setting intermediate goals.

151. The proposed sequence of actions and measures of policy reform efforts should consider the interlinkages among the various building blocks. Although some policy actions can only be taken after other actions have been fulfilled, others can be implemented simultaneously. Addressing challenges in one building block could also generate new actions in other building blocks. The reform plan should also include adequate references to or incorporate ongoing reforms in related areas, such as capacity development in public debt management, public financial management, and supervision.

Step 7: Propose targets and deadlines, and assign clear responsibilities to the relevant agencies

152. The reform plan should contain a reasonable timeframe for completion. It should contain details on the expected outputs and outcomes, actions to be taken and their appropriate sequencing, and the relevant milestones.95 In addition, the plan should have an estimate of the budget needs and resources to meet the various objectives. It is important to clearly define the lead agency responsible for the implementation of the reforms at each indicator level. This will facilitate the monitoring of progress and allow a continuous assessment of the efficiency and effectiveness of the plan.

In summary, the steps for developing the reform agenda are as follows:

  • 1. Determine LCBM objectives and policy priorities.

  • 2. Establish a coordination mechanism for LCBM reform.

  • 3. Evaluate the enabling conditions and stage for market development in every building block.

  • 4. Consider identifying peer groups to benchmark experiences.

  • 5. Identify gaps in each building block.

  • 6. Formulate a plan of action and measures needed to close the gaps, considering capacity and institutional constraints.

  • 7. Propose targets and deadlines and assign clear responsibilities to the relevant agencies.

Guidance Note For Developing Government Local Currency Bond Markets
Author: International Monetary Fund and World Bank