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Outline. I. Key Issues. II. Financial Market Deepening in East. Asia. III. Financial Market Integration in East. Asia. IV. Asian Bond Market Development. V. Recent ...
Financial Integration and Bond Market Development in East Asia Masahiro Kawai Asian Development Bank OECD-ADBI 8th Round Table on Capital Market Reform in Asia 11-12 October 2006, Tokyo

Outline I. II. III. IV. V. VI.

Key Issues Financial Market Deepening in East Asia Financial Market Integration in East Asia Asian Bond Market Development Recent Policy Initiatives Challenges Ahead

I. Key Issues • One of the problems behind the Asian financial crisis of 1997-98 was Asia’s weak financial system. • Since the crisis, the East Asian economies have begun efforts to strengthen their financial systems and develop local-currency bond markets. • Asian financial markets have been deepening in terms of size, and regulatory and market infrastructure. • Asian financial market integration has been advancing but remains limited. • What is the current state of Asian Bond Markets Initiative (ABMI)? • What are the challenges ahead?

II. Financial Market Deepening in East Asia 1. International Benchmarking Analysis • Cross-country analysis of financial deepening—in the banking sector, equity markets and bond markets (for government bonds and corporate bonds)—vs. per capita GDP for 46 countries, including OECD and emerging market economies. • The regression analysis can indicate the extent of financial deepening that has taken place between 1995-1997 and 2002-2004, both for the world and for East Asia. • The analysis allows international comparison relative to the international benchmark or international norm.

Figure1-a. Financial MarketsDeepening (2002-2004Average)

Bonds + Equity + Bank Financing (% of GDP)

HK

600

US

Regressionresults: ?=154.39 + 6.87X t =( 6.09) (6.14)

Ř2=0.45

CH

500

NL JP

400

DK

MY PT ES SG

GR

300

LB CL TH CN BR

200 100

IS

IN PH

KR

BE SE FR IT DE FI AU CA UK AT

IE

NZ CZ

TR

PK CO AR ID RU PE

PLSK HU MX

-

5

10

15

20

25

30

GDPpercapita(USDthousands)

35

40

45

Figure 2-a. Banking Sector Deepening (2002-2004 Average)

Regression Results Ŷ = 75.17 + 2.27X t = (6.84) (4.66)

B a n k F in a n c in g ( % o f G D P )

300

Ř2 = 0.32 US

250 200

CH CN

LB

PT

MY

150

ES

BR

100

DE

HK

NZ

KR

TH

GR

CL

IT

50

IN ID

TR CO AR

PK

PL

RU

SK MX

UK AT

CA BE AU FR

SG PH

DK

NL JP SE

IS IE NO

FI

HU CZ

PE

-

5

10

15

20

25

30

GDP per capita (USD thousands)

35

40

45

50

Figure 3-a. Capital Markets Deepening (2002-2004 Average) Regression Results

500

Ŷ = 79.22 + 4.60X Ř2 = 0.43

450 B o n d s + E q u it y ( % o f G D P )

HK

t = (4.45) (5.85)

400 350 US NL

300 250

ZA

MY PT

GR

JP

BE

SG

200

IS

IT AU

ES

CA

SE

FI

FR

DK IE

DE

150

CL IN

100 50 PK

PH CN

UKAT

KR

BR TH TR

LB PL

ID CO RUAR PE

CZ HU

NZ

SK MX

-

5

10

15

20

25

GDP per capita (USD thousands)

30

35

40

Figure 5-a. Equity Market Deepening (2002-2004 Average)

E q u it y M a r k e t C a p it a lis a t io n ( % o f G D P )

450

Regression results HK

Ŷ = 46.03 + 1.43X Ř2 = 0.06

400

t = ( 2.85)

(2.00)

350 300 250 CH

200 150

SG

MY

AU CL

100 IN

50 -

TH BR CN PE RU PL TR PH ID CZ MX HU AR PK CO LB SK

-

5

10

PT KR

ES

FR

GR

IT

NZ

US

FI

CA

SE

BE DE

NL JP

IS DK

IE

NO

AT

UK

15

20

25

30

GDP per capita (USD thousands)

35

40

45

50

Figure 6-a. Bond Market Deepening (2002-2004 Average)

Regression Results Ŷ = 33.19 + 3.17X t = (3.63) ( 7.87)

B o n d s O u t s t a n d in g ( % o f G D P )

250

Ř2 = 0.58 NL IS

200

JP

US

DK

BE IT IE

150 GR

FR DE AT UK FI

PT ES

100

MY BR

50

PH TH

CZ

KR

SG HK

HU

AU NO

NZ

CL SK PK CN CO IN MX ID AR

-

SE

CA

LB

TR PL

CH

PE RU

-

5

10

15

20

25

30

GDP per capita (USD thousands)

35

40

45

50

Figure 8-a. Corporate Bond Market Deepening (2002-2004 Average)

Regression Results Ŷ = -1.32 + 2.64X t = (-0.17) ( 7.69)

C o r p o r a t e B o n d s O u t s t a n d in g ( % o f GDP)

200 175

IS

Ř2 = 0.56

NL

150

US DK

125

IE

100

CH UK FRDE

75

25 -

KR

MY

50

ES PT

SG

-

5

CZ HU

10

AT

SE JP

BE FI

CL

TH CN BRAR PL SK ID CO MX PK TR IN PH PE RU LB

HK

IT AU

NO

CA

NZ GR

15

20

25

30

GDP per capita (USD thousands)

35

40

45

50

Figure 9-a. Corporate Bond/Private Bank Financing Ratio & GDP (2002-2004 Average)

Regression Results Ŷ = 0.097 + 0.016X t = (1.85) ( 6.72)

C o rp o ate B o n d s / C o rp o rate B an k F in an cin g

1.25

Ř2 = 0.49 IS NL

1.00

IE DK

AR FR

0.75

IT

DE BE

FI AT UK

0.50

CZ

PE BR TH

SK MX PL ID CN IN CO TR LB PKPH RU

0.00 -

5

NO HK SG

PT

CL

CH

US

ES

MY

0.25

JP

AU KR

SE

HU

CA

NZ GR

10

15

20

25

30

GDP per capita (USD thousands)

35

40

45

50

II. Financial Market Deepening in East Asia 2. Major Findings • Over time, at the global level, financial deepening has taken place—upward shifts in the intercepts and slopes. • Emerging East Asia (EEA) is generally outperforming other parts of the world in the pace of financial deepening. • The strength of most East Asian economies are in the banking sector as well as in the equity market. • Bond market deepening is less impressive than its banking sectors and equity markets, with only Malaysia showing above-average performance. Nonetheless, bond markets— particularly corporate bond markets—have been deepening well over time relative to the international benchmark. • EEA’s financial sector is still unbalanced in favor of banks, but so are most economies.

II. Financial Market Deepening in East Asia 3. Policy Implications • Economies that are below the international benchmark in financial market deepening have to work harder to expand market size through appropriate policy measures—Philippines. • Economies that are above the international benchmark in financial market deepening have to work hard as well to improve the “quality” of the market—Malaysia and Korea. • There is still room for emerging East Asia’s bond market to deepen and develop.

III. Financial Market Integration in East Asia 1. Financial Integration • Financial integration has progressed in East Asia through financial market liberalization and opening, as well as through capital account liberalization, as part of the general trend of financial globalization • Despite the progress on market-driven financial development, the degree of financial integration remains low in East Asia • The degree of market opening and capital account liberalization varies across countries

III. Financial Market Integration in East Asia 2. Data Analysis • Cross-market differentials in interest rates and bond yields are declining • Cross-market co-movements in money and bond markets are increasing • Nonetheless, cross-market differentials in interest rates and bond yields are still significant • East Asian equity markets are more integrated than money or bond markets • Intra-regional cross-border portfolio investment is growing, but remains small relative to the region’s total cross-border portfolio flows

Cross-market differentials in interest rates and bond yields are declining Average Absolute Cross-Market Differentials 18

6

14

Interest rates

Bond yields

5

10

2-Year 4

3-Month

6

10-Year

Overnight 3

2 96

97

98

99

00

3 Month

01

02

03

Overnight

Source: Bloomberg LP and Datastream Note: Data for 2006 as of end-March

04

05

06

00

01

02

03

2-Yr

04

10-Yr

05

06

Cross-market co-movements in money and bond markets are increasing Average Absolute Distance of Beta Coefficients from Unity (in percentage points) 2.5

1.0

2.0

Interest rates

Bond yields

0.9

1.5

10-Year 0.8

3-Month

1.0

2-Year

Overnight 0.5 Dec97

0.7 Nov98

Oct99

Sep00

Aug01

3 Month

Jul02

Jun03

Overnight

Source: Bloomberg LP and Datastream

May04

Apr05

Mar06

Jan- Jun- Nov- Apr- Sep- Feb02 02 02 03 03 04

2-Yr

Jul04

Dec- May- Oct- Mar04 05 05 06

10-Yr

Correlation of stock returns among East Asian countries Sample period: January 2002 - March 2006 PRC PRC INO KOR MAL

1.00

INO

KOR

MAL

PHI

SIN

THA

JPN

HKG

USA

-0.05

0.11

0.29

-0.22

-0.09

0.01

0.07

0.25

0.04

1.00

0.33

0.31

0.52

0.39

0.31

0.31

0.26

0.28

1.00

0.39

0.33

0.57

0.39

0.54

0.57

0.67

1.00

0.15

0.62

0.30

0.19

0.55

0.37

1.00

0.45

0.44

0.26

0.04

0.20

1.00

0.44

0.24

0.51

0.63

1.00

0.33

0.40

0.43

1.00

0.41

0.39

1.00

0.66

PHI SIN THA JPN HKG USA

Source: Index values are from Bloomberg LP.

1.00

Investment, fixed-income capital, and equity markets (2004) Investment from:

Cross-Border Portfolio Flows inAsia USD Billion, 2004 NAFTA EU15 East Rest of the World Investment to: Total Portfolio Investment NAFTA 624 EU15 1,866 East Asia 588 Rest of the World 1,070 Total Global 4,149 Long-Term Debt Securities NAFTA 218 EU15 438 East Asia 62 Rest of the World 319 Total Global 1,037 Equity Securities NAFTA 389 EU15 1,253 East Asia 523 Rest of the World 718 Total Global 2,882

(15.0) (45.0) (14.2) (25.8) (100) (21.0) (42.2) (6.0) (30.8) (100) (13.5) (43.5) (18.1) (24.9) (100)

2,117 7,709 578 1,622 12,026

(17.6)

1,035 4,789 132 1,050 7,007

(14.8)

914 2,348 402 569 4,233

(21.6)

(64.1) (4.8) (13.5) (100)

(68.4) (1.9) (15.0) (100)

(55.5) (9.5) (13.4) (100)

849 944 149 688 2,630

(32.3)

615 718 49 492 1,875

(32.8)

212 179 78 164 632

(33.5)

(35.9) (5.7) (26.2) (100)

(38.3) (2.6) (26.2) (100)

1,877 1,733 182 650 4,443

(42.2)

1,297 1,036 64 368 2,765

(46.9)

237 415 48 267 967

(24.5)

(28.2) (12.3) (25.9) (100)

Source: International Monetary Fund, Coordinated Portfolio Investment Investment Survey, December 2004.

(39.0) (4.1) (14.6) (100)

(37.5) (2.3) (13.3) (100)

(42.9) (5.0) (27.6) (100)

Total Global 5,468 12,252 1,497 4,031 23,247

(23.5)

3,165 6,981 308 2,229 12,683

(25.0)

1,752 4,194 1,051 1,718 8,715

(20.1)

(52.7) (6.4) (17.3) (100)

(55.0) (2.4) (17.6) (100)

(48.1) (12.1) (19.7) (100)

III. Financial Market Integration in East Asia 3. Macroeconomic Interdependence • Macroeconomic interdependence is strong in East Asia as evidenced by synchronized economic cycles and high cross-country correlations of shocks • Japan; Korea; Taipei,China; and Hong Kong as well as middle-income ASEAN countries have a large degree of real macroeconomic co-movements, but China and low-income ASEAN countries do not • Surprisingly the United States (or EU, Australia, New Zealand, India) does not exhibit strong positive co-movements in real economic activity with East Asia, while co-movements in nominal variables are significant

Correlation Coefficients between the First Principal Component Scores for East Asia and Individual Economy Data (1980-2002)

Growth of Real Economic Activity

Price Inflation GDP Deflato r

CPI

WPI

-0.41

0.17

0.85

0.30

-0.18

-0.14

0.10

0.78

-0.01

-0.16

-0.15

-0.20

-0.02

0.31

0.00

New Zealand

0.27

-0.04

0.19

-0.07

0.40

0.22

India

0.09

0.01

-0.03

0.06

0.63

0.34

Japan

0.58

0.39

0.41

0.15

0.90

0.46

Korea

0.71

0.78

0.67

0.27

0.89

0.48

China, People's Republic of

0.07

-0.14

-0.26

-0.40

0.15

--

Taipei, China

0.51

0.28

0.28

0.35

0.85

0.50

Hong Kong, China

0.74

0.63

0.58

-0.06

0.80

--

Singapore

0.77

0.76

0.59

0.08

0.87

0.45

Malaysia

0.90

0.87

0.95

0.40

0.79

0.68

Thailand

0.89

0.92

0.88

0.54

0.87

0.70

Philippines

0.33

0.31

0.55

-0.06

0.57

0.27

Indonesia

0.89

0.65

0.89

0.99

0.21

0.92

Countries/Regions

GDP

Consumption

Investment

USA

0.01

-0.32

EU-15

0.01

Australia

IV. Bond Market Development 1. Progress on Bond Market Development • Total local currency bonds outstanding in emerging East Asia (EEA) more than tripled from $360 billion in 1997 to $1,650 billion in 2005, 48% of EEA GDP. • Despite growth, local-currency bond markets in EEA remain small, only 3% of total local currency bonds worldwide ($40 trillion). • The share of local currency bonds in EEA’s financial system is rising, from 13% in 1997 to 19% in 2004. • Market liquidity, measured by trading volume and turnover ratios, has risen in recent years, but remains low relative to OECD markets.

Emerging East Asia’s local currency bond markets have expanded in absolute size over the last 8 years, reaching $1,650 billion in 2005 from $360 billion in 1997. Size of Emerging East Asian Local Currency Bond Markets Market

1997 2004 2005 Amount Amount Amount ($ billion) ($ billion) ($ billion)

Annual Growth Rate (%) 1997 - 2003

2004

2005

PRC Indonesia Malaysia Philippines Singapore Korea Thailand Viet Nam

116.40 4.60 57.00 16.92 23.77 130.37 10.47 -

527.70 57.70 110.70 35.30 79.39 567.70 68.00 3.78

633.03 47.26 121.79 41.08 83.43 637.86 80.32 5.20

20.94 43.52 9.95 11.08 18.80 23.39 30.64

19.82 (12.18) 12.02 16.03 18.09 27.24 13.79 31.39

19.96 (18.09) 10.01 16.38 5.08 12.36 18.11 37.68

Total Emerging East Asia

359.53

1,450.27

1,649.97

22.05

19.72

13.77

Source: ADB Asian Bond Monitor, March 2006

Emerging East Asia’s bond market as a percentage of GDP continues to grow and has nudged to 48%, a significant increase from 16.5% in 1997 Size of Emerging East Asian Local Currency Bond Markets (% of GDP) Market

Amount Outstanding (% of GDP) 1997 2004 2005

PRC Indonesia Malaysia Philippines Singapore Korea Thailand Viet Nam

12.22 1.94 56.36 20.50 24.79 25.07 6.65 -

27.32 22.80 93.56 41.00 73.80 83.34 42.09 8.32

34.85 16.82 93.24 42.02 71.47 83.03 46.43 9.85

Total Emerging East Asia

16.54

42.85

48.02

Source: ADB Asian Bond Monitor, March 2006

Size and composition of East Asia local currency bond market has increased almost 5 folds. Evolution of Size and Composition of Emerging East Asian Local Currency Bond Markets, 1997-2005 (in billion US dollar) 1997 1998 1999 2000 2001 2002 2003 2004 2005 -

200

400

Source: ADB Asian Bond Monitor, March 2006

600

800

Government

1,000

1,200

Corporate

1,400

1,600

1,800

Local currency bond markets are increasingly becoming an important vehicle for channeling domestic savings to investment in emerging East Asia Bond financing now accounts for 19% of the total domestic financing, compared with 13% in 1997 75 67 60

60

45

30 20

15

19

21

13

0 1997 Bank Financing

2004 Bond Financing

Equity Financing

Proportion of foreign currency (FCY) bond issued in selected East Asian markets * had decreased about 12% since the 1997 financial crisis Average % of bonds issued in FCY Selected East Asian Countries (1997 - Jun 2005)

35 30

%

25 20 15 10 5 0 1997

1998

1999

2000

2001

2002

Ye ar (1997 - Jun 2005)

Source: http:asianbondsonline.adb.org

2003

2004

2005 (June only )

Turnover ratios are still low, particularly in corporate bond markets Corporate Bond Turnover Ratio

Government Bond Turnover Ratio PRC

Indonesia

Indonesia Korea

Korea Malaysia

Malaysia

Singapore Thailand

Thailand

Viet Nam -

0.5

1.0

1.5

2.0 2004

2.5

3.0

3.5

4.0

-

0.2

2005

Source: ADB Asian Bond Monitor, March 2006

0.4 2004

0.6 2005

0.8

With increasing short-term interest rates and relatively stable long rates, yield curves have flattened in all bond markets in emerging East Asia Yield Curve Slopes Market

(in basis points)

Jan-05

Mar-06

PRC Indonesia Korea Malaysia Philippines Singapore Thailand

2-yr vs 12-yr 2-yr vs 10-yr 3-yr vs 10-yr 3-yr vs 10-yr 2-yr vs 10-yr 2-yr vs 10-yr 2-yr vs 10-yr

230 190 62 172 250 130 210

93 54 42 48 106 56 23

Hong Kong, China Japan US

2-yr vs 10-yr 2-yr vs 10-yr 2-yr vs 10-yr

265 132 111

29 114 (3)

1. As slope approaches zero, the yield curve flattens . 2. Negative slope denotes inverted yield curve. Source: ADB Asian Bond Monitor, March 2006

IV. Bond Market Development 2. Issuers and Investors • Governments remain major issuers of local currency bonds in EEA, though corporations and financial institutions are becoming more active, particularly in Korea and Malaysia (where nongovernment entities are the largest issuers). • Bond holdings by commercial banks have been declining while holdings by contractual savings institutions (pension, etc) have been rising. • While the issuer base has expanded, overall investor base remains narrow and over half of local currency bonds are still held by commercial banks.

V. Recent Policy Initiatives 3. Major Initiatives • Executive’s Meeting of East Asia-Pacific Central Banks (EMEAP) to strengthen the demand side through ABF • ASEAN+3 Finance Ministers’ process to strengthen the supply side through the ABMI • APEC Finance Ministers’ process to work on overall financial sector development including bond markets • Asia Cooperation Dialogue (ACD) to raise political support to, and public awareness of, Asian bond market development in an expanded geographical coverage—28 countries, including ASEAN+3, South Asia, West Asia (Middle East), and Central Asia

Initiatives in Various Forums EMEAP

Use of Foreign Exchange Reserves

APEC

ASEAN + 3

Initiatives on Securitization & Credit Guarantees

Comprehensive initiatives with WG1, WG2, WG3, WG4, ASTFG

11 Central Banks ABF1 and ABF2

Action plans for Governments to be implemented

V. Recent Policy Initiatives 3-1. Asian Bond Market Initiative (ABMI) • WG1: Creating new securitized debt instruments • WG2: Credit guarantee and investment mechanisms • WG3: Foreign exchange transactions and settlement systems • WG4: Rating Systems • Ad-hoc Support Team for the Focal Group (ASTFG) now handling AsianBondsOnline, Asia Bond Monitor, and Asian Bond Standards • Technical Assistance Coordination Team in —now reporting to (ASTFG) * WG4: Issuance of bonds denominated in local currency by MDBs, government agencies and Asian multinational corporations—resolved due to success in 2005

V. Recent Policy Initiatives 3-2. Asian Bond Fund (ABF) • Initiated by EMEAP to strengthen the demand side • ABF-1 (June 2003, $1 billion) - Invest in sovereign and quasi-sovereign US dollar bonds issued by 8 members (excl. Japan, Australia, NZ)

• ABF-2 (December 2004, $2 billion) - Pan-Asian Bond Index Fund (PAIF), a single bond fund index investing in sovereign and quasi-sovereign local currency bonds issued by 8 members - Fund of Bond Funds (FoBF) with 8 country subfunds - Open to investment by the public - Local currency exchange-traded bond funds (ETF) listed in Hong Kong, Malaysia, and Singapore

ABF2 Framework Around USD1 billion

Around USD1 billion

EMEAP Group’s Investment in ABF2*

Fund of Bond Funds (FoBF) Parent Fund

Pan-Asian Bond Index Fund (PAIF)

8 Country Sub-Funds

CN

HK

ID

KR

MY

PH

SG

Underlying Bonds * The BIS will act as the Fund Administrator for EMEAP Group’s investment in ABF2. Components that will be open to investment by other public and private sectors. Source: EMEAP.

TH

Issuance of local-currency denominated bonds by supra-nationals and foreign (public or quasipublic) entities in ASEAN+3 countries Date

Country

Issuer

Amount

Tenor

Nov 04

Malaysia

ADB

MYR400 million 5-year bond

Dec 04

Malaysia

IFC

MYR500 million 3-year Islamic bond

May 05

Malaysia

WB

MYR760 million 5-year Islamic bond

May 05

Thailand

ADB

THB 4 billion

5-year bond

Sep 05

Thailand

JBIC

THB 3 billion

5-year bond

Oct 05

PRC

ADB

CNY 1 billion

10-year Panda bond

Oct 05

PRC

IFC

CNY1.13 billion 10-year Panda bond

Oct 05

Philippines

ADB

PHP 2.5 billion

Apr 06

Malaysia

ADB

MYR500 million 5 year bond*

May 06

Malaysia

KfW**

MYR500 million 7-year bond

5-year bond

VI. Challenges Ahead 1. Building a Well-functioning Bond Market • Financial sector reforms—including further development of local currency-denominated bond markets—is key to Asia’s financial sector development and integration • Asian bond market development helps allocate financial resources more efficiently through price discovery and better risk management • Corporate governance—Strong corporate governance is a must so that borrowers and corporations are subject to sufficient checks and balances

VI. Challenges Ahead 2. Immediate Challenges in Bond Markets • Deepen bond market liquidity—through greater price transparency such as better price guidance for (illiquid) assets and more immediate transaction disclosure • Increase timely information about issuers—through improvement of the quality of credit rating agencies and their frequent reporting, and requiring issuers to increase reporting frequency • Expand investor base and diversity—through more equal treatment regarding transaction-related requirements and taxation

VI. Challenges Ahead 3. Regional Cooperation • Regional cooperation—through ASEAN+3 and EMEAP—is a powerful tool to achieve joint improvements of bond markets, financial integration and financial stability • Regional efforts toward: credit enhancement; regional settlement system; regional rating agency; and regional common standards based on best practices

Thank you Dr. Masahiro Kawai Special Advisor to the President & Head, Office of Regional Economic Integration Asian Development Bank [email protected] +63-2-632-6688 http://asianbondsonline.adb.org www.adb.org