ASEAN 5 Bond Yield

ASEAN-5 bond market development:Where does it stand? Where is it going?

Joshua Felman, Simon Gray, Mangal Goswami, Andreas A. Jobst,

Mahmood Pradhan, Shanaka Peiris, and Dulani Seneviratne*

Since the late 1990s Asian crisis, ASEAN-5 countries have expendedconsiderable effort in developing their bond markets. However, the sizeof these markets relative to GDP has hardly changed. Can we explain this?And does it mean that domestic markets have not, in fact, developed? Thearticle argues that bond market growth has been held back by a sharp fallin business investment, which has left firms with little need for bondborrowing. Even so, markets have developed in other ways, to such anextent that substantial amounts of foreign portfolio investment havebegun to flow into ASEAN-5 bonds. These developments have importantramifications. With the investor base growing and infrastructure invest-ment likely to rise, ASEAN-5 bond markets could expand rapidly, holdingout the prospect that the region could finally achieve twin engine finan-cial systems in the near future.

Introduction

It has now been more than a decade sinceASEAN launched a major effort to develop itsdomestic bond markets,1 which makes it agood time to take stock, to see what has beenaccomplished, and what remains to be done.This article attempts to do just that. Althoughseveral authors have undertaken such an effort,there are large differences in perspective

between this article and most other studies.First, most of the other studies cast a muchwider net, focusing either on bond markets inemerging Asia at large, or on the ASEAN+3.This study focuses exclusively on theASEAN-5, which comprises Indonesia, Malay-sia, Philippines, Singapore, and Thailand.Second, most other articles come to relativelypessimistic conclusions. For instance, Mienoet al. (2009) assert that the failure of corporatebond markets to expand relative to GDP means

* Joshua Felman, Assistant Director, Research Department, International Monetary Fund (IMF), Washington, DC, USA,[email protected]; Simon Gray, Senior Financial Sector Expert, Monetary and Capital Markets (MCM) Department, IMF,Washington, DC, USA, [email protected]; Mangal Goswami, Deputy Director, IMFSingapore Regional Training Institute,Singapore, [email protected]; Andreas A. Jobst, Senior Economist, MCM Department, IMF, Washington, DC, USA,[email protected]; Mahmood Pradhan, Deputy Director, European Department, IMF, Washington, DC, USA, [email protected]; Shanaka J. Peiris, IMF Resident Representative, Manila, Philippines, [email protected]; Dulani Seneviratne,Research Officer, APD Department, IMF, Washington, DC, USA, [email protected]. The views expressed in thisarticle are those of the authors and should not be attributed to the IMF, its Executive Board, its management, or the currentemployers of the authors. Any errors and omissions are the sole responsibility of the authors. An earlier version of thisarticle was presented to an ASEAN-5 Deputy Governors seminar held in Bangkok on November 5, 2010, and waspublished as IMF Working Paper No. 11/137 (available at http://www.imf.org/external/pubs/ft/wp/2011/wp11137.pdf), which benefitted from discussion during that seminar and subsequent comments from the ASEAN-5central banks. The authors wish to express their gratitude for this helpful input.

1 ASEAN refers to the Association of Southeast Asian Nations. ASEAN+3 includes P.R. China, Japan, and Korea.

doi: 10.1111/apel.12051

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2014 Crawford School of Public Policy,The Australian National University and Wiley Publishing Asia Pty Ltd.

The International Monetary Fund retains copyright and all other rights in the manuscript of this article as submitted for publication.

that the reforms have had little impact. Spiegel(2009) goes even further, expressing doubtsabout some of the premises underlying thereforms, including the argument propoundedby Greenspan (1999) that capital markets canact as a spare tyre in case the banking systembecomes impaired.

This article reaches very different conclu-sions. It argues that ASEAN-5 bond marketshave undergone a quality transition, becom-ing a more mature channel of funding, withlower barriers to entry. As a result, two criticalchanges have taken place. Bond markets haveindeed begun to serve as a spare tyre in caseother parts of the financial system areimpaired; and they have begun to receivecopious foreign inflows. These developmentshave important ramifications. With the inves-tor base likely to expand as foreign investorsdevote an increasing portion of their portfoliosto emerging market (EM) assets, ASEAN-5bond markets could grow much more rapidlyover the coming decade, to the point whereASEAN-5 could finally develop twin enginefinancial systems. To seize this opportunity,however, proactive policies will be necessaryto smooth the development path, unlock exist-ing supply-side constraints, and minimise theattendant risks such as market volatility.

The plan of the article is as follows. The nextsection recalls why this initiative was so impor-tant to ASEAN, and outlines the sweepingreforms that countries have introduced. SectionWhy have corporate bond markets notexpanded? addresses the puzzle of why,despite these efforts, ASEAN-5 bond marketshave not grown relative to changes in GDP.Section A fundamental transformationfocuses on other metrics of development,arguing that these suggest that a remarkabletransformation of ASEAN bond markets isindeed underway, especially if firm-level dataare examined in greater detail. Section Theshape of things to come considers some of theimplications of this transformation. The finalsection concludes.

Why develop bond markets?

Across the globe, EMs have placed greatemphasis on developing their bond marketsin recent years. Why have they done so? Inlarge part, it is because EMs have heavyinvestment requirements and bond marketsplay an important role in financing largeinvestment projects. Such projects tend tobe risky and take time before they yieldreturns; risks that bond markets can spreadover a large number of holders of securities.Moreover, because bond contracts (unlikeloans) are designed to be traded, they allowinvestors to transfer credit risks to others,even before the projects are completed. Thecombination of these characteristicsthescope for risk-sharing and risk-shedding,both within and across national boundariesmeans that bond markets complementbanks, which are constrained by limits onthe scope of their cross-border activitiesand the extent to which they can transformmaturities.

Beyond these general principles, there areparticular reasons why ASEAN-5 countrieshave put so much emphasis on developingbond markets since the Asian crisis. Thesereasons stem from the consensus diagnosisof what happened in 1997. According to thisview, the Asian crisis can be traced in largepart to several underlying problems in nationalfinancial systems:2

Dependence on bank funding. Financialsystems were extremely bank centric,which meant that most of the risks werebeing concentrated in the bankingsystemand there was no alternatechannel of intermediation.

Maturity and currency mismatches. Borrow-ing had suffered from a double mismatch,since long-term, domestically orientedinvestment projects were being fundedthrough short-term, foreign currencyborrowing.

2 See, for example, Eichengreen (2006).

FELMAN ET AL. ASEAN-5 BOND MARKET DEVELOPMENT

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Capital account vulnerabilities. Countries inthe region were perceived to be excessivelydependent on volatile capital inflows; asituation that struck many observers asironic because the region had an abun-dance of domestic savings.

Observers argued that all three of theseproblems could be solved by developingdomestic bond markets. Vibrant bond marketswould create another funding channel, a sparetyre that firms could use in case banksonce again encountered lending difficulties.Domestic bonds would likely be issued overlonger term maturities and in local currencies,which would eliminate the double mismatchproblem. Finally, with greater domestic bondmarkets, firms could reduce their dependenceon foreign capital markets.

Based on this diagnosis, ASEAN has putconsiderable effort into developing its bondmarkets. For example, the ASEAN+3 createdthe Asian Bond Market Initiative, which estab-lished working groups to study the issues andmake recommendations, many of which havebeen adopted by individual countries. TheAsian Development Bank also initiated a studyprogram and created the Asia Bonds Onlinedatabase so that researchers and market par-ticipants could easily find key informationabout local currency markets.3 Meanwhile,the Executives Meeting of East Asia PacificCentral Banks created pan-Asian bond funds tofacilitate regional investment.

Despite these sweeping reforms, ASEAN-5bond markets have not grown, measured asrelative to GDP (IMF 2010a). For most of thepast decade the average stock of local currencybonds outstanding has fluctuated around fiftyto fifty-five per cent of GDP.4 As a result,ASEAN-5 has not been able to expand its sharein the EM bond universe. A decade ago,ASEAN-5s domestic debt accounted for aboutone-fifth of total EM domestic debt securities,excluding those from China; today, the fractionis the same. If the rapidly developing bond

market in China were to be included amongthe EM total, ASEAN-5s share would havefallen, to about one tenth.

Why have ASEAN-5 bond markets notgrown? In part, it is because the bulk ofASEAN-5 bondsaround thirty-five to forty40 per cent of GDPare issued by govern-ments. Because budget deficits have remainedlow for most of the past decade, there was littleneed for them to issue additional debt. Buteven the size of the corporate bond marketshas remained remarkably stable, hoveringuntil very recently around just fifteen to eight-een per cent of GDP (Figure 1). This presents aprofound puzzle. Why have corporate debtmarkets not expanded? And does that meanthey have not really developed? Let us takethese questions in turn.

Why have corporate bond marketsnot expanded?

At the outset of ASEANs push to developbond markets, some observers hoped that theregion could follow the same path as LatinAmerica. In that region, bond markets hadbeen propelled forward by the rapid develop-ment of contractual savings schemes, such aspension funds. As these schemes expanded,their demand for long-term domestic currencyassets increased, which in turn encouragedfirms to respond by issuing more bonds.But this dynamic failed to materialise in theASEAN-5. To understand why, consider firstthe demand side of the market, that is to saythe investor base. Has it failed to develop?

Primary market demand

In fact, the ASEAN-5 domestic investor basehas expanded considerably over the pastdecade. But the expansion did not come fromthe expected source. To the contrary, contrac-tual savings schemes have shown remarkably

3 Nonetheless, data problems remain an issue. In some cases, AsiaBondsOnline data differ widely from those available fromother sources, such as the Bank for International Settlements (BIS). Also, data for some variables is not available for allcountries, hindering ASEAN-wide analysis.

4 For a discussion of what happened in 2009, see section A fundamental transformation below.

ASIAN-PACIFIC ECONOMIC LITERATURE

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little growth. In Indonesia, Philippines, andThailand, the assets of pension funds amoun-ted to less than 10 per cent of GDP in 2000; andthey remain around that level today. Althoughpension fund assets in Malaysia and Singaporeare relatively high by EM standards, they havenot shown any trend growth either. Mean-while, assets of life insurance companies havestagnated at low levels in the Philippines andIndonesia, while rising by only a few percent-age points in Malaysia and Thailand. As aresult, the share of bonds held by contractualsavings institutions has diminished consider-ably over time. In Malaysia, for example, nearlythree quarters of government bonds were heldby social security institutions in 2000. But tenyears later, their share has fallen to less thanone third, while domestic financial institutionsnow account for the bulk of the holdings.

What are these domestic financial institu-tions? Banks, of course, in large part; butincreasingly, domestic mutual funds. A decadeago, this sector was tiny, with total assets of lessthan US$5 billion, accounting for less than fiveper cent of GDP in all five countries. But start-ing in the mid-2000s, they have explodedin size in every country except Indonesia, tothe point where in Thailand and Malaysiatheir assets now amount to more than US$50

billionaround twenty and thirty per cent ofGDP, respectively. Largely as a result, domesticfinancial institutions now hold two fifths ofMalaysian government bonds, double theshare they held in 2000. But this only deepensthe mystery. If the investor base has expanded,why did firms not meet this increase indemand by providing more supply?

Primary market supply

The main reason firms failed to issue morebonds relates to the profound change in themacroeconomic environment after the Asiancrisis. During the early 1990s, investmentreached 40 per cent of GDP in some ASEAN-5countries, as firms raced to expand their opera-tions in booming markets. To fund theirexpansion projects (and the associated capitalformation), firms relied increasingly on exter-nal finance, boosting their leverage ratios toexceptionally high levels. After the Asian crisis,however, this process shifted into reverse.Firms became much more cautious, reducingeconomy-wide investment rates to aroundtwenty-five per cent of GDP for much of thepast decade before increasing them againduring the boom of the past few years.

Figure 1ASEAN-5: corporate bond markets and investment

10

15

20

25

0

5

2000

Q4

2002

Q4

2004

Q4

2006

Q4

2007

Q2

2007

Q4

2008

Q2

2008

Q4

2009

Q2

2009

Q4

2010

Q2

2010

Q4

2011

Q2

2011

Q4

2012

Q2

2012

Q4

25

30

35

15

20

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

ASEAN-5: Local currency corporate bonds outstanding(In percent of GDP)

ASEAN-5: Gross capital formation(In percent of GDP; PPPGDP weighted average)

Sources: AsianBondsOnline and Asian Development Bank (2013) and IMF staff calculations (ASEAN-5: local currency corporate bondsoutstanding); and IMF (2013b) (World Economic Outlook) and IMF staff calculations. (ASEAN5: gross capital formation).PPP = purchasing power parity.


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The International Monetary Fund (IMF)sAsia-Pacific Regional Economic Outlook (IMF2010a) explored the roots of this fall in invest-ment. It found that the main causes were lowerreturns, greater uncertainty, and altered percep-tions of the ease of doing business. During thedecade following the Asian crisis, growth inAsia was slower and much more volatile thanearlier, reducing firms incentive to expandcapacity. At the same time, investors becamemore cautious in extending funds to businesses,as perceptions of the business climate deterio-rated in the wake of the problems that the crisisrevealed. In other words, causation has goneboth ways: the decline in investment hasreduced the demand for finance, while financialconstraints have also discouraged investment.

At the same time, firms found alternativeways to fund their investment projects. As partof the post-Asian crisis changes, firms strove toincrease their profitability and succeeded indoing so. Consequently, they were able to funda much larger portion of their diminishedinvestment needs from internal cash genera-tion. The crisis also led to a shift in the type ofinvestment, away from construction, which istypically financed by borrowing; and towardsmanufacturing for export, which is financed in amuch wider variety of ways. In particular,ASEAN manufacturing companies tend tofinance themselves through equity, includingdirect equity investments. Teranishi et al. (2007)found that companies from Thailand, Malaysia,and Indonesia rely for their long-term fundingmuch more heavily on equity finance, and, strik-ingly, much less on banks than do corporationsin advanced countries. According to Mieno(2009), firm capital represented 53 per cent ofthe average balance sheet for listed Malaysiancorporations, while bank borrowing accountedfor only 14 per cent; the figures for Thai corpo-rations were similar. Unsurprisingly, then,aggregate figures for the ASEAN-5 show thatequities account for nearly two thirds of corpo-rate domestic financing, with bank credit andbonds splitting the remainder.5

Summing up, the expansion of the domesticinvestor base created an opening for ASEAN-5corporate bond markets. But firms failed toseize this opportunity because they had littleneed to issue over the past decade. Does thisfailure to expand means that markets have notdeveloped? Not at all. Development has manydimensions and, on many of these metrics, pro-gress is clear. In fact, ASEAN-5 markets havebeen fundamentally transformed.

A fundamental transformation

To track this transformation, we undertake afirm-level analysis, which reveals that in awell-defined sense, it has become easier forfirms to access ASEAN-5 corporate bondmarkets. Then, we consider two of the moredramatic manifestations of the transformation.Specifically, the corporate bond market hasdeveloped into a spare tyre that corporates canuse when other parts of the financial systemcome under stress; while foreign investorshave become eager to purchase domesticbonds.

Firm-level analysis

There are many ways to assess the quality of abond market. But perhaps the most importantmetric is its usefulness to potential borrowersin terms of accessibility and price competition.For example, a bond market may be irrelevantto most firms because it is highly concentrated,dominated by a handful of large firms or largeissues. Or its usefulness could be limitedbecause firms issuances need to be very high,accounting for a large proportion of theirbalance sheets, in order to overcome barriers toentry (in the form of high transaction costs).

Measured in this way, bond market devel-opment can be conceived as following a certainpattern. Initially, when the market is at a veryearly stage, only a few firms will be largeenough or financially well-regarded enough

5 A further important structural factor is the large role played, within the manufacturing sector, by foreign-investedcompanies. In a series of studies, Mieno and others (Mieno 2008; Mieno et al. 2009) have argued that since the mid-1980s,when ASEAN became an increasingly important base for multinational manufacturing production, foreign corporationshave become an increasingly important funding channel for local companies.


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(with a long track record and audited publicaccounts) to issue. Moreover, because there aresizeable fixed costs to issuing bonds andbecause firms want to establish liquid bench-mark issues, the size of these initial issues isnormally large relative to firm balance sheets.But over time, as markets mature and econo-mies develop, concentration ratios and the rela-tive significance of issuance tend to decline.

Markets will no longer be dominated by afew large issuers, or a few large bond issues,because more and more firms are able to issue(quantity transition, Figure 2 above). Thatsaid, the extent to which new firms enter themarket is inhibited by the cost of monitoringborrowers. Clearly, banks are better placed toengage in information-intense monitoringof many (relatively small) borrowers, whichwould be quite costly for typical public marketinvestors.

As bond markets mature, the economic sig-nificance of individual bond issues will alsotend to decline, partly because as issuancebecomes routine, firms issue smaller amountsfrequently rather than occasional large

amounts; and because these minimum amountswill become small relative to the size of growingbalance sheets (quality transition). Conversely,however, large issuers might be inclined to con-solidate different issues to concentrate andenhance liquidity in some limited and impor-tant benchmarks, which could limit the extentto which the relative importance of issuancesdeclines in maturing bond markets as a result ofincreasing economies of scale.

Initially, without considering strategicissuer behaviour and other factors, the marketstarts off in the second quadrant, with highconcentrations and high significance. Butgradually, as the market develops, it movesinto the third quadrant, with low concentrationand low significance.

So much for theory. What is the evidence forthe ASEAN-5? Some key indicators are pro-vided in Table 1 below, based on local currencyissuance by the nonfinancial private sector.Because the sample sizes for Philippines,Singapore, and Indonesia are very small,it is perhaps best to focus on Malaysia andThailand.6 In these two markets, one can seesome clear progress: the amount of issuancehas been increasing steadily; the number ofissues and issuers has increased sharply; andwith the influx of new issues, the averagematurity has shortened.

At the same time, progress in reducingconcentration and significance (of individualissues) has been mixed. On the positive side,concentrationwhether measured by issuance(for example, a few large bonds) or by issuers(for example, a few large companies)inMalaysia, and to a lesser extent in Thailand, isnow down to the levels of Brazil and Korea.But concentration in other ASEAN-5 countriesremains high. Similarly, the significance of newissues (issuance relative to balance sheet size)has diminished in Malaysia to the levels of themost advanced EMs, but remains high in othercountries.

6 Bond issuance and balance sheet information (total assets)) data were obtained for five ASEAN countries as well as twoemerging market comparator countries (Brazil and Korea). Bond issuance data include all local currency-denominated,non-financial, private sector transactions during each sample year (2000, 2005, 2009, and the first two quarters of 2010).Note that issues by financial companies and special purpose vehicles (SPVs) were excluded; in the latter case becausethese entities are levered financing vehicles, rather than operating companies. As a result, the sample size for Singaporeis too small to be reliable.

Figure 2Bond market development

Co

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s:R

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Balance sheet significance:Issuance relative to individual total assets

21

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High concentrationof issuers

and high significance of

bond issuance

Low concentrationof issuers

andlow significance of bond issuance

Quality transition:Debt optimization

Quantity transition:More and smaller

issuers


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Over the past decade, ASEAN-5 countriesand EMs in generalhave developed, in thesense of moving towards the third quadrant(low concentrationlow significance). Aftercontrolling for concentration, Philippines andMalaysia tend to have higher levels of signifi-cance. That is to say, the average issuancevolume relative to issuer balance sheets ishigher in countries with less developed bondmarkets, as the theory would predict. Cur-rently, the state of development in Malaysiaand Thailand is not all that far from Korea andBrazilat least as measured by these dimen-sions. The concentration has declined despitecontinued issuance by larger issuers that domi-nated the primary market during the nascent

stages of development. Even so, none of theASEAN-5 countries has firmly entered thethird quadrant. So, more progress needs to bemade in diversifying the issuer base and ensur-ing that issuance becomes a more routinemethod of financing operations.

The conclusions of the firm-level analysiscan be summed up simply. Firms access tobond markets has improved considerably inrecent years. A decade ago, only the largest andbest-known firms were able to issue bonds, sotheir issues dominated local markets. Gradu-ally, however, more and more firms have beenable to issue, creating broader markets thanbefore. This qualitative progress has culmi-nated in two critical developments.

Table 1ASEAN-5 and selected emerging market countries: characteristics of local currency corporate bond

issuance (20002010)

Local currency (LCY) non-financial corporate bond issuance: sample analysis

Issuance (in USD billions) Issuance/total assets ratio (median, in percent)

IDN MYS PHL THA SGP BRA KOR IDN MYS PHL THA SGP BRA KOR

2000 . . 0.9 . . . . 1.2 . . 18.8 . . 36.7 . . . . 10.4 . . 3.92005 0.7 4.3 1.1 2.6 . . 1.2 20.5 6.7 11.0 18.2 6.3 . . 2.5 5.62009 1.5 5.7 2.2 8.1 0.1 12.6 47.8 3.5 5.6 4.9 9.0 7.6 5.4 5.82010 1.1 2.4 1.0 3.0 0.2 11.8 19.5 3.1 5.3 9.0 8.6 17.6 8.0 4.9

Average maturity (in years) Number of issues/issuers


2000 . . 13.5 . . . . 4.5 . . 3.0 . . 54/6 . . . . 19/12 . . 970/1892005 6.0 9.2 5.8 9.2 . . 7.4 2.5 6/6 198/38 6/6 16/6 . . 13/11 1160/2062009 3.9 6.6 5.2 4.6 4.6 5.0 2.4 45/20 158/50 23/11 83/36 14/5 73/52 2068/5042010 5.6 2.1 6.0 4.3 5.7 5.1 2.6 23/9 175/70 4/3 71/30 8/5 87/49 670/188

Concentration of issuance volume 1/ Concentration of issuer assets 1/


2000 . . 0.08 . . . . 0.10 . . 0.04 . . 0.01 . . . . 0.99 . . 0.042005 0.59 0.04 0.43 0.19 . . 0.11 0.02 0.26 0.03 0.16 0.14 . . 0.05 0.052009 0.12 0.06 0.11 0.06 0.51 0.03 0.02 0.12 0.07 0.03 0.03 0.52 0.03 0.022010 0.08 0.04 0.26 0.10 0.15 0.03 0.04 0.12 0.09 0.16 0.13 0.03 0.07 0.03

Data excludes issuance by state-owned enterprises, all financial institutions and international organizations. 2010 information includes Q1 andQ2 available data. 1/ logarithmic and re-scaled, standardized HerfindahlHirschman index (HHI): issuance concentration = log [min (HHIi,HHIi min (HHIN)] (0,1), where HHIi = [(share of issuance amount by issuer i in a given year)2 1/total number N of issuers i] / (1 1/totalnumber N of issuers i). The closer the value to zero, the less concentrated the annual issuance of corporate bonds; 1/ logarithmic and re-scaled,standardized HHI: issuer concentration = [min(HHIi,HHIi-min(HHIN) / (max (HHIN)-min (HHIN))] (0,1), where HHIi = [(balance sheet assetsof issuer i relative to total balance sheet assets of all issuers in a given year)2- 1/total number N of issuers i] / (1-1/total number N of issuers i).The closer the value to zero, the less concentrated the issuer size.Sources: Bloomberg, Worldscope, Moodys KMV as well as national stock exchanges.BRA = Brazil, IDN = Indonesia, KO = Korea, MYS = Malaysia, PHL = Philippines, SGP = Singapore, THA = Thailand.


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The new spare tyre

Amid the depths of the global financial crisisbetween 2007 and 2009, there was a suddensurge in domestic bond issuance by emergingAsian corporates. For years, the stock ofemerging Asian corporate bonds outstandinghad been stagnating as a percentage of GDP.But in the second quarter of 2009, the stockincreased by nearly ten per cent quarter-on-quarter in the ASEAN-5 and more than 20 percent quarter-on-quarter in emerging Asiaexcluding China. In the third quarter, there wasa further large increase. By the end of the year,ASEAN-5 local currency corporate bond issu-ance had reached a US$58 billion, higherthan the previous peak, reached in 2007, androughly double the normal level.

This surge was striking for a number ofreasons. To begin with, as noted in sectionWhy have corporate bond markets notexpanded?, ASEAN-5 corporates typically donot rely much on bond issuance for funding.Moreover, the surge took place in the middle ofa severe recession, when private sector invest-ment had fallen sharply. So, firms had littleneed to issue bonds in order to finance invest-ment projectsthey were not initiating newones and they were slowing down the ones

that were already underway. Nor were firmsforced to issue bonds just to sustain them-selves; corporate profitability actually held upreasonably well during the recession.

So, what explains the issuance boom? Theprimary factor appears to have been a reac-tion to changes in bank behaviour. Normally,bank-centred financial systems maintain theirlending ties to their clients, even duringdifficult timesbut this was not a normaldownturn. Even though liquidity in the Asianbanking systems was ample and capitaladequacy was never in doubt, Asian banksnonetheless followed their Western peers andbecame more cautious after Lehmans bank-ruptcy. They tightened their lending standardsand reduced their prime lending rates muchmore slowly and partially than the declinein policy and bond interest rates. Both mea-sures encouraged firms to turn to the capitalmarkets, while reducing their use of bankcredit (Figure 3). In fact, adding the twosources of funding together, total credit to thecorporate sector declined in the first half of2009 in the ASEAN-5 countries. So, the bondissuance was not additionalcorporates weresubstituting one form of financing for another.In other words, the domestic bond marketacted precisely as reformers had originally

Figure 3ASEAN-5 countries: local currency corporate bond issuance and corporate lending

(20072012)

5

10

15

20

10

5

0

2007Q4

2008Q2

2008Q4

2009Q2

2009Q4

2010Q2

2010Q4

2011Q2

2011Q4

2012Q2

2012Q4

ASEAN-5Emerging Asia, excluding China

7

8

5

6

3

4

1

2

0

1

12008Q2

2008Q4

2009Q2

2009Q4

2010Q2

2010Q4

2011Q2

2011Q4

2012Q2

2012Q4

Local currency corporate bonds(Quarterly percent change in amount outstanding)

ASEAN-5: Bank credit to corporates(Q/Q percent change, local currency, average)

Sources: Bank for International Settlements (2013) and IMF staff estimates (for Local currency corporate bonds); and CEIC Data Co.Ltd (2013); Haver Analytics (2013); and IMF staff estimates (for ASEAN-5: bank credit to corporates).


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hoped it would; it became the spare tyre thatcorporations could use if the bank-financingchannel were to be impaired.

Where was the demand for these bondscoming from? Much of the demand appears tohave come from overseas, as global risk appe-tite began to revive with the stabilisation ofadvanced country financial systems and asprospects in EMs appeared better than in theWest. As a result, inflows into EM debt fundsresumed in May 2009, and quickly reachedlevels approaching the peak of the 200507global boom. In short, ASEAN-5s domesticbond markets were able to become a spare tyreduring the Great Recessionone of the keyoriginal objectivesbecause of another accom-plishment. Foreigners were now willing topurchase domestic currency bonds, reducingthe risk that corporates would be forced toendure a currency mismatch in order to securebond financing. This development raises twocritical questions. Were the foreign purchasesduring the global crisis merely a temporaryphenomenon, or did they truly reflect adurable shift in foreign investor behaviour? Ifforeign investor behaviour has changed funda-mentally, how did this happen?

The rise of foreign investment

After the Asian crisis, Eichengreen andHausmann (1999) argued that EM economieswere beset by an original sin. According tothis theory, EMs would inevitably suffer fromthe double mismatch problem. Foreign inves-tors were wary of issuers from such countriesand unwilling to purchase local currencybonds. The only way to convince them toprovide the needed finance was to issue globalbonds, denominated in foreign currency,bearing relatively short maturities, and subjectto the legal jurisdiction of an international

financial centre. This model was based on theLatin American experience, and it was neverentirely clear how well it applied to ASEAN-5.After all, ASEAN-5 did not have a history ofhyperinflation, exchange rate instability, ordefaults, which had deterred investments inLatin America. Still, it remained true thatforeign investment in ASEAN-5 bonds wasminimal. Even as recently as the middle of2004, foreigners accounted for less than 2 percent of holdings of ASEAN-5 governmentbonds.7 But this situation changed markedlyafter the global financial crisis. Starting in 2010(and continuing through mid-2013), bondinflows surged; during some periods, evenoutpacing equity flows, which had historicallydominated portfolio inflows. To a certainextent, this was merely a cyclical phenomenon,a reaction to the extraordinary divergencebetween the bright prospects in EMs and thedifficult situation in advanced countries,including the extraordinarily loose monetarypolicy that the latter were forced to adopt. Butmore long-lasting structural factors have alsobeen at work. Foreign holdings of EM localcurrency bonds have been increasing for sometime, starting well before the global crisis. By2007, foreign holdings had passed 8 per cent;by 2008, they had reached 10 per cent; and aftera brief dip during the global crisis, they surged,to around twenty-seven per cent by 2012(Figure 4).

As foreign purchases of domestic bondshave increased, issuance of foreign currencybonds has receded. The high-water mark offoreign currency corporate bonds came in2002, when the amount outstanding reached 6per cent of ASEAN-5 GDP, implying that morethan one third of total corporate bonds weredenominated in foreign currency. But in subse-quent years, the share of foreign bonds gradu-ally fell; so much so that by the first quarter of2010, it amounted to one fifth of the total.8 (That

7 Based on available data from Indonesia, Malaysia, and Thailand. These numbers may understate foreign interest, asforeigners were also gaining exposure to local markets through access products. See section Dealing with offshoreactivity.

8 For comparison, according to the BIS, at end-2008, the outstanding stock of emerging market bonds issued in majorinternational markets (that is, international bonds) amounted to about US$1 trillion, while bonds issued in domesticmarkets amounted to US$6 trillion.


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said, it should be noted that foreign currencycorporate issuance, like that of domestic cur-rency issuance, surged after 2009.)

Two factors explain these developments.One is the development of corporate bondmarkets themselves. As they have expanded(in nominal terms, even if not relative toGDP), and become more accessible, they haveattracted liquidity-conscious foreign investors.In addition, macroeconomic fundamentalshave improved. Hausmann and Panizza (2003)found that the degree of original sin was posi-tively related to the level of development(proxied by GDP per capita), the strength ofmacroeconomic fundamentals (inflation andgovernment debt), exchange rate flexibility,and the size of the investor base.9 Strikingly,ASEAN-5 countries have made considerableprogress along every one of these dimensionsin recent years. In particular, economic funda-mentals have improved to the point where insome ways they are now much stronger than inadvanced nations, whose fiscal positions havedeteriorated in the wake of the financial crisis.The average ASEAN-5 government debt to

GDP ratio is less than half the advancedcountry average, which is expected by the IMFto reach 112 per cent of GDP in 2013 (IMF2013a).

This performance has not gone unnoticed. Adecade ago, dedicated EM debt funds werealmost invisibly small. By 2005, they werereceiving annual inflows of around US$5 billionper year. By 2010, inflows reached US$35billion. Even allowing for the large cyclicalelement in recent flows, the underlying upwardtrend has been persistent. What will it imply forthe future of ASEAN-5s bond markets?

The shape of things to come

The ramifications of growing foreign participa-tion are difficult to predict. Precisely becausethere has been little foreign investment indomestic markets until recently, there is verylittle empirical evidence on the benefits andcosts of foreign participation in bond marketdevelopment (Daniel 2008).

9 Burger and Warnock (2007) have a different list. They find that countries with higher scores on capital mobility, marketliquidity and efficiency, regulatory quality and creditor rights, market infrastructure, taxation on bonds, and the size ofthe local institutional investor base, tend to attract great cross-border participation.

Figure 4Foreign investor participation in government bond markets

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-12

Brazil South AfricaHungary MexicoPoland Turkey

ASEAN-5: Foreign holdings of local currency governmentbonds 1/ (In percent of total outstanding)

Emerging markets: Foreign holdings of local currencygovernment bonds (In percent of total outstanding)

Sources: AsianBondsOnline and Asian Development Bank (2013) (for ASEAN-5: foreign holdings of local currency government bonds);and Country authorities (2012); IMF Global Financial Stability Report (2013); and IMF staff estimates (for Emerging markets: foreignholdings of local currency government bonds); 1/ includes Indonesia, Malaysia, and Thailand.


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Developmental benefits

Some potential benefits seem clear. To beginwith, overseas firms could expand the investorbase, compensating for the slow growth in tra-ditional domestic investors such as the contrac-tual savings schemes. Indeed, the potentialimpact could be quite large. A survey by theIMF (2010b) indicates that global bond fundsremain underweight EMs, providing scope fora continued stock adjustment into dedicatedEM funds. Because global bond and hedgefunds are very large relative to local bondmarkets, even a marginal increase in theweight of EMs in their portfolio could lead to asignificant rise in demand.10

Over time, the shift in demand is likely tobecome significant. In fact, it is possible thatincreasing investment in EMs is now at thebeginning of a secular trend, benefitting fromgreater foreign demand, especially given theneed of advanced country pension systems toimprove their returns. In the USA, the PewCenter on the States (2010) estimated in 2010that there was a US$1 trillion gap between theUS$3.4 trillion in pension, health care, andother retirement benefits that States havepromised their workers and the US$2.4 trillionthat they have set aside to pay for them. Theneed to close this gap will put growingpressure on pension fundswhich currentlyinvest little in EM debtto increase theirallocationsespecially because the yields onsuch debt exceed the US rates by a widemargin.

Intraregional flows are compounding flowsreceived from outside Asia. Some regionalcentral banks have started buying their neigh-bours financial assets in a bid to diversifyreserve holdings, achieve a better risk-returnprofile, and contain sterilisation costs. Individ-ual investors have also been investing in Asianbonds through local mutual funds. Thai inves-

tors, for example, in recent years, have beenlarge accumulators of Korean bonds.

Additional foreign demand could helpreduce bond yields (IMF 2005). To estimatehow large this effect could be, Peiris (2010)employs a panel data framework to estimatethe impact of foreign participation in determin-ing long-term, local-currency, governmentbond yields in a group of ten EMs between2000 and 2009.11 His analysis suggests thatgreater foreign inflows do reduce governmentyields, after controlling for other domestic andexternal factors including global interest ratesand risk aversion. The effect is reasonablylarge, with a 10 percentage point increase in theshare of bonds held by foreign investors gen-erating a decline in yields of about 60 basispoints (Figure 5).

Greater foreign participation will alsoimprove liquidity. The larger the number ofparticipants, the greater the diversity of prefer-ences and views; which leads to more trading,better price discovery, and more efficientmarkets. Foreign participants are particularlybeneficial for liquidity because they are muchmore likely to trade domestic securities thandomestic institutional investors, who typicallyfollow buy-and-hold strategies. Case studiesconducted by the World Bank and IMF (2001)on government bond markets in emerging andmature markets confirm this effect qualita-tively. The relationship between greater foreignparticipation and liquidity appears to hold alsoin the ASEAN-5 region.

Finally, greater foreign participation willcreate a virtuous circle that will expand the sizeof the debt markets themselves. As interestrates fall and liquidity improves, more firmswill find it attractive to issue. As more firmsissue and market size grows, more inves-tors will be enticed to participate. This willreinforce the utility of the market as a sparetyre. Because bond maturities are typically of

10 For example, IMF (2010b) estimates that a one percentage point reallocation of global equity and debt securities held byG-4 real money investors, which amounts to about US$50 trillion, would result in additional portfolio flows of US$485billion, larger than the record annual portfolio flows to EMs of US$424 billion recorded in 2007. Assuming that half ofthese inflows are allocated to debt (as has been the case recently) and that the debt flows are allocated proportionately tothe outstanding volume of bonds (excluding China), the ASEAN-5 countries could receive an additional US$50 billion ininvestments per year.

11 The ten EMs are Brazil, Czech Republic, Hungary, Indonesia, Mexico, Malaysia, Korea, Thailand, Turkey, and Poland.These countries were selected because they had significant foreign participation in their domestic markets.


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longer duration than bank loans, the moreASEAN-5 corporates shift to bond finance, thebetter their underlying liquidity situation willbe, as they will have secured financing forlonger periods. It will also give corporates aspare tyregreater liquiditythat it can use asinsurance, even before crises takes place.

Potential costs

What are the potential costs to bond markets ofthis increased foreign participation? To beginwith, inflows into the bond market can compli-cate the conduct of monetary policy. Some ofthe problems are well known, as they apply toany type of capital inflows, including theequity and bank inflows with which ASEAN-5countries are long familiar. But some of thecomplications are new.

In particular, if inflows are channeled intodomestic government bonds, long-term rateswill be affected. It is difficult to say, a priori,whether this helps or hinders central bankoperations. To the extent that bond marketsbecome more liquid and attuned to centralbank signals regarding future interest rates (asopposed to being dominated by institutionalinvestors that need to buy long-term assets tomatch their liabilities) transmission mecha-

nisms could be improved. However, to theextent that yield curves become dominated bydevelopments elsewhere in the world, mon-etary independence will be reduced. Indeed,during 2010 ASEAN-5 countries were con-fronted with the same Greenspan dilemmathe USA faced in the mid-2000s. Even as somecountries raised their short-term rates, foreignpurchases were causing long-term rates to fall.

Another potential risk is greater interest ratevolatility. Surges in foreign inflows are oftenfollowed by sudden withdrawals, as ASEANdiscovered in 1997, after the collapse of LehmanBrothers in September 2008, and after the USFederal Reserve announced in May 2013 thatthey would be winding down their large-scaleasset purchases (quantitative easing).

Still, even if foreign participation and yieldvolatility are related in the short run, the rela-tionship may be much weakeror even non-existentover the longer term. That is because,as Prasad and Rajan (2008) have noted, foreignparticipation can be a stabilising force for localmarkets. Foreign investors frequently exertpressure for more transparency, which reducesprice volatility because it improves the qualityand increases the frequency of information.Such changes reduce the risk that there will besudden disclosures of accumulated negative

Figure 5Impact of foreign participation in bond markets

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South Africa

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Mexico

Poland

Thailand

y = -1.57x + 19.106R = 0.0676

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ASEAN-5: Capital inflows and debt market returnvolatility

Emerging markets: Foreign participation and yieldvolatility

Volatility of government bond yield (20052012)

Malaysia

Turkey

Sources: IMF [International Financial Statistics database (BPM6) IMF 2013c], Bloomberg LP (2013), EMBIG Index, and CEMBI index(for ASEAN-5: capital inflows and debt market return volatility); and IMF staff estimates in standard deviations (for Emerging markets:foreign participation and yield volatility).


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news. Moreover, in cases where they do occur,foreign participation attenuates the priceimpact, because it broadens what would other-wise have been a thinner market. The cross-sectional analysis of ten EMs with significantforeign participation in the local currency gov-ernment bond market found no clear correla-tion between foreign participation and bondprice volatility over 200009.12

Finally, there are some concerns that rever-sals of bond flows are more destabilising thanequity outflows because the stronger domesticre-pricing of equities endogenously moderatesoutflow pressures. Yet the empirical evidencethat bond flows are more volatile than equitiesis weak.

Is there a way to secure the longer-term ben-efits of greater foreign participation, whilereducing the potential short-term volatilitycosts? Again, because the demise of originalsin is so recent, there is little internationalexperience that can be drawn upon for lessons.One potentially significant measure was takenby Indonesia in July 2010. At that time, foreigninvestment had been pouring into bank secu-rities [called Sertifikat Bank Indonesia (SBI)], inpart because of carry-trade activity by hedgefunds in which investors borrow in currenciessuch as the US dollar where interest rates arelow in order to invest in currencies, such as therupiah, where interest rates are high. To reducethe attendant risks, Indonesia imposed a one-month holding period on SBIs, applicable todomestic and foreign holders. In principle, thismeasure should circumscribe the scope forforeign outflows when global risk aversionrises, because investors will no longer be ableto exit their SBI positions quickly. Precisely forthat reason, it should also discourage short-term carry trade inflows in the first place.13

The question is how effective the measurewill prove in practice. So far, there is no clear

evidence that it has affected aggregate foreignholdings of Indonesian securities, which ini-tially fell, then reached new heights, beforefalling again. Nor is it clear how well themeasure will succeed in limiting outflows,because investors wishing to exit theirpositions could hedge them by selling otherIndonesia assets.

There may also be some unanticipated sideeffects. For example, the associated decision toeliminate the three-month SBI appears to haveimpeded the development of the nascent inter-est rate swap market by eliminating its bench-mark rate. (Central bank term deposits exist,but may not be an adequate substitute becausethey are not traded.) Consequently, it may takesome time before the measure can be properlyassessed.

Dealing with offshore activity

The rise of foreign interest in domestic bondshas another important ramification: growingoffshore activity. Foreign investors are increas-ingly obtaining exposure to EMs by usingvarious access products, such as over-the-counter (OTC) derivatives, structured secu-rities, or offshore special purpose vehicles.Modes of access include innovative financialinstruments such as nondeliverable forwardsand other derivative instruments, includingcredit-linked notes. Partly as a result of theseactivities, derivatives transactions with under-lying EM assets have exploded in recent years.

Aside from the obvious benefit of ensuringthat counterparty risk is focused on a fewfamiliar developed market financial institu-tions, investors stay offshore mainly becauseof impediments or costs to entering. Some ofthese impediments are:14

Limits on access to money market or othershort-term instruments;

12 Similarly, Peiris (2010) shows that foreign presence does not necessarily result in greater volatility in local governmentbond markets, in part because domestic markets seem to then import low levels of volatility during the (much longer)periods of tranquillity in international markets.

13 Holding restrictions could also discourage investments by ordinary long-only, open-ended, mutual funds because dailyredemptions require the ability to sell securities.

14 The nature and extent of impediments differ widely from country to country. For example, Malaysia has none of theimpediments listed below. In fact, Malaysia has made its bond market internationally accessible via international centralsecurities depositories (Euroclear and Clearstream) to enable foreign investors to settle securities transactions without theopening of a local custodian account.


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Clearing and settlement protocols andcustody arrangements, such as custodycontrols, directed settlement, and rules onsub-custody;15 and

Minimum holding periods.Does any of this matters? It does, for severalreasons. Controls and taxes that drive activityoffshore thereby reduce liquidity onshore andimpair price discovery. In other words, theyreduce efficiency. They also reduce transpar-ency. For example, with much of the activitytaking place beyond their jurisdiction, in rela-tively opaque OTC markets, national author-ities will find it difficult to monitor marketdevelopments. Indeed, a significant proportionof bonds owned by the domestic financialsector may actually be held on behalf of foreigninvestors (typically by onshore banks) throughderivative structures.

A shift towards offshore activity may alsoraise prudential concerns. Offshore marketsmay be less well regulated and, in any case,will not be regulated by home country author-ities. Moreover, even though controls mightexist that aim to isolate domestic markets fromthose offshore, inevitably firms find ways toarbitrage between the two. As a result, devel-opments in markets offshore can be transmit-ted onshore. In that case, compensating policyaction might prove difficult because nationalauthorities may not have much information onthe genesis or the nature of the underlyingshock.

For all these reasons, over time it may bebeneficial to try to bring such markets onshore.One way to do this is by reducing or eliminat-ing withholding taxes. However, such ameasure would raise difficult issues of equityand efficiency. For example, if non-residentsare exempted from withholding tax, this couldlead to practices such as coupon washing,where bonds are sold during the couponpayment periodperhaps via repo and/orsecurities lendingto investors paying low orzero withholding tax. Alternatively, residentinvestors may begin to route purchasesthrough offshore routes to avoid or reduce thecost of withholding tax. On the other hand, if

withholding tax on bonds is abolished for resi-dents and non-residents, this might create adistortion favouring bond markets over equitymarkets.

Conclusion

In the decade leading up to the global financialcrisis, exceptional efforts to expand ASEAN-5sbond markets were undercut by broader mac-roeconomic trends. Firms had little need toissue, since they were reducing their invest-ment ratios. Meanwhile, on the demand side,foreigners remained reluctant to purchase localcurrency bonds.

Since 2009, however, these two trends havereversed, perhaps decisively. Unlike mostother regions, ASEAN-5s growth acceleratedafter the crisis, underpinned by the regionsstrong fundamentals, low wages, and highcommodity prices. Investment rates havestarted to rise again, spurring firms to issuedebt. Meanwhile, foreigners have becomeincreasingly willing, even enthusiastic, aboutbuying domestic bonds. These developmentshold out the prospect that ASEAN-5 bondmarkets could enter into a virtuous circle inwhich greater demand reduces interest ratesand increases liquidity, encouraging firms toissue, thereby expanding the market size andattracting more investors.

However, these new trends will bring newpolicy challenges in their wake. Measures willbe needed to deepen local capital marketsfurther so that financial systems can act as abetter shock absorber against capital flow vola-tility, thereby limiting its impact on the realeconomy. Also, it may be worthwhile trying tobring markets onshore by removing barriersto entry, including withholding taxes.

In sum, ASEAN-5s strenuous efforts of thepast decade have already succeeded in trans-forming its bond markets. But the develop-ments of the past decade may well be dwarfedby changes that may take place in the yearsahead. Time will tell.

15 The cost of appointing a local custodian can make cross-border investments unattractive.


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