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1 Asian Perspectives Global Issues WORKING PAPER FGI East Asian Bond Markets in 2020 Progress, Prospects and Future Challenges Ismail Dalla November 2012 Fung Global Institute Cyberport 1, Level Cyberport Road Hong Kong Tel: (852) Fax: (852)

2 The Fung Global Institute Working Paper Series presents the findings of original and professional research-in-progress on questions and topics that are relevant to the Institute s research themes. Written by FGI researchers and, sometimes, researchers from other institutions, the papers aim to get the findings out for critical review and feedback. The views expressed in the papers are those of the authors and do not necessarily reflect those of the Institute, its Board of Directors and/or its Academic Council. They carry the names of the authors and should be cited accordingly. ABSTRACT This paper tracks the growth of bond markets in eight East Asian economies since the Asian financial crisis of , and highlights the progress made by the policy makers in these countries in addressing key impediments at the country and regional levels. Major successes are discussed and areas that are still work in progress are identified. The paper discusses the rising role of the East Asian bond markets in a global context, and presents a scenario on how these bond markets are going to evolve and what East Asia should focus on in further developing its bond market, especially corporate bond markets, in order to channel domestic and regional savings into domestic investments. The forecast is based on several key assumptions that include macroeconomic growth rate, investment, savings, and financing patterns of the corporate sector. The paper also identifies the factors that inhibit the further development of these markets and explores briefly the policy direction that is needed to remove these obstacles. KEY WORDS East Asia, capital markets, corporate bonds, sovereign bonds, banks 0 Ismail Dalla is a capital markets expert with extensive experience in financial markets. including more than 25 years with the World Bank Group (World Bank and IFC). He was a faculty member at the George Washington University School of Business from 2009 to He has written extensively on emerging capital markets, especially local currency bond markets. His publications include The Korean Bond Market the Next Frontiers, Harmonization of Bond Market Rules and Regulations for Selected APEC Economies; The Korean Bond Market-Post Asian Crisis and Beyond; and Asia s Emerging Bond Markets (Financial Times Publishing: 1997). He was a core member of the World Bank s East Asia Financial Sector Flagship Study and was the author of the Volume II (Selected Issues) of the study. Dalla has extensive firsthand knowledge of the political economies of emerging market countries especially East and South Asian countries. He has an MBA from the Columbia Business School and a BA in accounting from Chulalongkorn University (Bangkok). Fluent in Thai and proficient in Spanish, he is a frequent speaker at international financial market conferences. P a g e 0

3 Contents Foreword 5 Executive Summary 11 1 Overview 19 2 Asian Bond Markets in Global Context 20 3 Asian Bond Markets ( ) East Asian Financial System East Asian Bond Markets Market Liquidity Credit Default Swaps Credit Rating Agencies Investor Base Major Bond Market Development Initiatives in East Asia ( ) The Asian Bond Markets Initiative (ABMI) The Asian Bond Fund Initiative (EMEAP) 39 4 East Asian Bond Market in East Asian Economy The East Asian Bond Markets in 2020 A Forecast Investor Base 48 5 Agenda for the Future Corporate Bond Market Investor Base Taxation of Debt Securities Risk Management Products Pan-Asian Fixed Income Products 53 References 54 Annex 1 East Asian Bond Markets 56 A. The People s Republic of China 56 B. Hong Kong, China 63 C. Indonesia 66 D. Malaysia 72 E. The Philippines 79 F. Singapore 83 G. South Korea 85 H. Thailand 91 Annex 2 East Asia s Financial Market Infrastructure 96 Annex 3 Indian Bond Markets 99 Annex 4 Islamic Bond Markets In East Asia P a g e 1

4 List of Tables Table 3.1 Bond Markets as % of GDP 26 Table 3.2 Government Bonds Turnover Ratio 29 Table 3.3 Government Bond Bid-Ask Spreads (basis points) 30 Table 3.4 East Asia: Mutual Fund Industry 35 Table 4.1 East Asia: Projected Nominal GDP Growth Rate ( ) 42 Table 4.2 East Asia: Projected Private Fixed Investment Table 5.1 Taxation on Foreign Investment in Local Currency Government Bonds 52 List of Figures Figure 2.1 World Top Local Currency Bond Markets 20 Figure 2.2 Top Local Currency Bond Markets (2011, June) 21 Figure 2.3 Bond Market as % of GDP (2010) 21 Figure 2.4 Top Emerging Bond Markets (June 2011) 22 Figure 2.5 East Asian Bond Market in World Bond Market 23 Figure 3.1 East Asian Financial System ( ) 24 Figure 3.2 East Asian Bond Markets ( ) 26 Figure 3.3 East Asian Bond Markets ( ) by Country 27 Figure 3.4 East Asian Bond Markets by Type of Issuers 28 Figure 3.5 Corporate Bond Outstanding as % of GDP 28 Figure 3.6 East Asia: Credit Default Swap Spreads 31 Figure 3.7 East Asia: Investor Base 34 Figure 3.8 East Asia: Public Pension Assets 35 Figure 3.9 Size of Pension Funds as % of GDP in Selected Countries (2010) 36 Figure 3.10 East Asia: Insurance Industry 37 Figure 3.11 Top 10 Investors in East Asian Debt Securities (2010) 38 Figure 3.12 ABF PAIF: Country Weighting (Jan 31, 2012) 40 Figure 3.13 ABF PAIF: Annualised Return 41 Figure 4.1 Asia s Infrastructure Investment Requirements, Figure 4.2 East Asian Bond Markets in Figure 4.3 East Asian Bond Markets Figure 4.4 East Asian Bond Markets 2020 (ex-china) 47 Figure 4.5 East Asian Bond Market 2020: by Type of Issuers 48 Figure 4.6 East Asia: Investor Base P a g e 2

5 List of Abbreviations ABMI ADB APEC BAPEPAM-LK BI BIDS BIS BNM BOK BOT BSP CPF CSRC DVP EFBNs EMEAP EPF FAST FIDF FSC FGI GDP HKMA IBRA IDX IFC IMF IOSCO KDB KDIC KSD KRX KTB MART MAS MEPS MGS MOF MOSF MSB MTB MTN OECD OTC Asian Bond Markets Initiative Asian Development Bank Asia Pacific Economic Cooperation Badan Pangawas Pasar Modal Bank Indonesia Bond Information and Dissemination System Bank for International Settlements Bank Negara Malaysia Bank of Korea Bank of Thailand Bangko Sentral ng Pilipinas Central Provident Fund (Singapore) China Securities Regulation Commission Delivery vs. Payment Exchange Fund Bills and Notes Executives Meeting of East Asia-Pacific Central Banks Employee Provident Fund Fully Automated System for Tendering Financial Institution Development Fund Financial Supervisory Commission (Republic of Korea) Fung Global Institute Gross Domestic Product Hong Kong Monetary Authority State Asset Management Company (Indonesia) Indonesian Stock Exchange International Finance Corporation International Monetary Fund International Organization of Securities Commissions Korea Development Bank Korea Deposit Insurance Corporation Korea Securities Depository Korea Exchange Korea Treasury Bonds Money Market Association of the Philippines Monetary Authority of Singapore MAS electronic payments system Malaysian Government Securities Ministry of Finance Ministry of Strategy and Finance Monetary Stabilization Bond Malaysian Treasury Bill Medium-Term Notes Organisation for Economic Co-operation and Development Over-the-counter 3 P a g e 3

6 PBOC PDS PEFINDO PRC RENTAS Repo RoSS RTGS S&P SBI SC SEC SFA SFC SFCO SFO SGS SPV SSTS UK US People s Bank of China Private debt securities (Malaysia) Credit Rating Indonesia People s Republic of China Real Time Electronic Transfer of Funds System Repurchase agreement Registry of Scripless Securities Real Time Gross Settlement Standard and Poor s Sertifikat Bank Indonesia Securities Commission Securities and Exchange Commission Securities and Futures Act Securities and Futures Commission Securities and Futures Commission Ordinance Securities and Futures Ordinance Singapore Government Securities Special Purpose Vehicle Scripless Securities Trading System United Kingdom United States 4 P a g e 4

7 Foreword A new financial landscape is emerging from the global financial crisis of and the current sovereign debt crisis in Europe. This new landscape will have a profound influence on the shape of Asian financial market development. The Fung Global Institute (FGI) has a major research project underway Asian Finance 2020 to study how the Asian financial landscape is changing due to internal dynamic forces and external forces generated by major regulatory and business responses to the evolving global crises. The primary goal of this project is to work with businesses, policymakers, financial institutions and other stakeholders in the financial sector to improve understanding of the global issues and to help design the outline of a New Financial Architecture (NFA) for Asia that meets three key objectives: 1. Fostering sustainable economic growth in a socially inclusive manner; 2. Supporting the needs of the real economy by deepening the financial system in terms of processes and institutions in the next decade; and 3. Addressing systemic risks that originate within Asia and from the rest of the world. The Asian financial crisis of and the global financial crisis, together with the unresolved European debt crisis, have raised serious questions on the effectiveness of current business models and regulatory systems in managing systemic risks. Even as major regulatory reforms such as the Basel III capital and liquidity requirements are being endorsed globally, policy makers and the financial community in Asia are all looking into whether the macro, institutional and micro aspects of Asia s financial sector and its relationship with the evolving international financial architecture, will meet Asia s need for sustainable and inclusive growth. 5 Our Asia Finance 2020 research project therefore covers the major developing financial markets in Asia, focusing initially on East Asia before covering India and the Middle East financial markets. The study will then expand its scope to undertake comparative studies of financial systems within Asia. FGI has commissioned Ismail Dalla to write this paper on East Asian Bond Markets in 2020: Progress, Prospects and Future Challenges to deepen understanding of how far Asian bond markets have developed since the Asian financial crisis of That crisis spurred the Association of Southeast Asian Nations, South Korea, China and Japan (ASEAN+3) to launch the Asian Bond Markets Initiative (ABMI) in 2003 to deepen bond markets in the region, in order to reduce the maturity mismatch in Asian markets. Since 2008, ASEAN+3 countries have cooperated to establish an Asian Bond Market Forum (ABMF) as a common platform for regional bond market integration. P a g e 5

8 Ismail Dalla formerly worked for the World Bank and has studied and published widely on the evolution of Asia s bond markets since the issue of Samurai and Dragon bonds in the early 1990s. He was a Visiting Scholar at the School of Business, George Washington University during He has extensive experience in international financial markets and has worked on broad financial market reforms, especially debt capital markets, fund management and project lending. This study tracks the growth of bond markets in eight East Asian economies since the Asian financial crisis and identifies the factors that inhibit the further development of these markets. Projections are made to 2020 to present a scenario on how these bond markets are going to evolve and what East Asia should focus on in further developing its bond markets, especially its corporate bond markets, in order to channel domestic and regional savings into domestic investments. This study provides an up to date framework for interested stakeholders to think through the role played by bond markets in safeguarding systemic stability and as channels for protecting long-term savings. Post-Asian crisis, the common East Asian policy objective was to deepen the traditionally weak domestic capital markets in order to reduce over-dependence on commercial banks as a source of domestic financing. When the financial system is bank-dominated, a country runs the risk of being exposed to the double mismatch or the currency and maturity mismatch problem brought about by relying on shortterm borrowings in domestic and foreign currencies, to finance long-term local currency investments. As the Asian crisis proved, if liquidity dries up, borrowers can become insolvent and will be unable to pay off the debt on time, and/or will be unable to obtain foreign exchange to repay foreign debt. 6 Since the Asian financial crisis, Asian regulators and policymakers have taken positive steps to restructure their banking systems and to deepen their capital markets. Apart from Hong Kong, Singapore and Japan, which are already Asia s international financial centres, South Korea and Malaysia have been successful in deepening their domestic bond markets and in further strengthening their equity markets, making them more internationalised than others in the region. At the end of 2010, the size of the East Asian bond markets 1 was US$5 trillion, or 51.4 per cent of GDP. The size of the bond markets in eight East Asian countries had increased fivefold from US$831 billion or 36 per cent of GDP in 2000, even as GDP roughly doubled. This compares favourably with bond markets in other emerging markets. However, East Asian markets remain largely government bond markets. The Asian financial crisis also provided greater political impetus for regional financial integration through notable initiatives such as the ABMI and the Chiangmai Initiatives. Together, with technical support from the Asian Development Bank and driven by the East Asian central banks, two Asian Bond Funds, ABF1 and ABF2, were launched to promote the expansion of the local currency bond markets in East Asia. 1 East Asian countries in this paper include eight economies (China, Hong Kong, Indonesia, Malaysia, South Korea, P a g e 6

9 These initiatives contributed to market deepening and strengthening of the regulatory and market infrastructure, thus enabling the East Asian bond markets to withstand shocks from the global financial crisis remarkably well. Given the interest of advanced market asset funds to diversify their portfolios into emerging markets with long-term growth potential, Asian bond markets are attracting more foreign investor interest due to Asia s rapid economic recovery, improved macro-economic management and potential for currency appreciation. Notwithstanding these impressive developments, there remain serious questions why domestic corporate bond markets and related derivative markets have not emerged more strongly. It is widely acknowledged that Asian capital markets have the potential to become a major financial hub if they were more integrated. Asia s surplus savings are still being invested outside the region, suggesting that Asian policy makers prefer to outsource their long-term savings to the advanced markets. Currently, many Asian capital markets remain relatively small and fragmented and lack the liquidity and capacity to compete globally. By integrating, they would be able to strengthen financial intermediation and build the capacity to channel the large amounts of regional savings into productive investments in the region. Clearly, there are significant impediments to the further development of Asia s capital markets, including capital controls, different stages of economic and financial development, fear of domestic markets being overwhelmed by foreign competition, non-uniform taxation, legal and regulatory frameworks, and relatively small institutional investor bases in countries such as Indonesia and the Philippines. What is the future of capital market reform in East Asia amidst the changes underway in the global financial system? 7 The focus of near-term policy action has been on strengthening the regulatory framework. But regulations are only part of the solution (some may argue they are also part of the problem), so one must look at the problem as a systemic issue with complex, interactive and interdependent parts in order to appreciate that we have moved into a complex, dynamic environment where looking at its parts (without considering the whole) has become part of the problem. In other words, the old regulatory approach was focused on individual financial institutions, assuming that if the individual entity was stable, the national system would be stable too. At the international level, international agencies assumed that if individual countries were reasonably stable, the global financial system would be stable as well. In fact, systemic crises arose because there were too many silos, each looking at its area of specialisation or jurisdiction and concluding that it was safe. There were too many blind spots because there were gaps and overlaps. It was the interaction between different silos that created the pro-cyclical feedback mechanism that spread systemic risks and contagion through the financial networks. In Bank of England Governor Mervyn King s words, banking remains global in life and national in death. The fashion is to look at macro-prudential issues. This is because micro-prudential regulations, used to P a g e 7

10 monitor individual banking institutions, were clearly not adequate as the global financial crisis was rooted in excessive credit created in the non-bank sector. The International Monetary Fund (IMF) has become aware that reforms must address emerging exposures and risks in the entire financial system, not just the banks. In the absence of a broader perspective, there is a danger that riskier activities and products will migrate to the less (or un-regulated) segments of the system, as occurred with off balance-sheet investment vehicles during the recent crisis. Apart from the goal of casting a wider net, the IMF approach in designing reforms of the financial system suggests a focus on four key goals which are: Ensure a level playing field in regulation; Improve the effectiveness of supervision; Develop coherent resolution mechanisms at both national level and for cross-border financial institutions; and Establish a comprehensive macro-prudential framework. These general principles of reform guidelines are laudable in principle, but not easy to implement in practice. Within Asia, the lesson from the recent series of financial crisis is that finance must serve the real sector. Accounting for just over half of the world s population, Asia is still enjoying the demographic dividend of a young population (although some countries are aging fast). Therefore, there remains a huge need for finance in the many areas of long-term savings and investments, as well as for the consumption needs of a growing middle-class. 8 In the advanced markets, the new financial landscape will be shaped by de-leveraging, slower growth as a result of demographic aging, tighter regulations and continued financial innovation. In emerging Asian markets, the new financial architecture will have to upgrade to simultaneously meet new and higher international standards as well as the needs of the Asian real economy. These include the wealth and asset management demands of a younger population that is moving into the middle-income status, real sector growth, extensive infrastructure development and the risks of severe climate change. More importantly, any examination of the new financial landscape cannot ignore the reality of shadow banking and innovative credit creation in the non-bank sector that could threaten the stability and efficiency of the financial system itself. At another level, the development of capital markets in East Asia will have to deal with two sets of issues. The first is the distinct shift in the production model of Asia, from an export-driven global supply chain to one, which has a more balanced orientation towards sustainable domestic consumption, more equitable distribution of income and social inclusiveness. This is within the control of Asian economies, although it will take time to restructure the production and distribution model of the real sector. P a g e 8

11 The second issue is that even as Asian economies become wealthier, and the national and regional capital markets become more liquid and efficient, Asian financial markets will play a greater role in the global financial architecture. This has geopolitical implications for the global monetary and financial system that are not yet fully understood. In other words, Asian financial assets, such as bonds, are becoming international asset classes, even as Asian currencies, such as the renminbi and the rupee, become internationalised. New regional financial instruments and institutions will clearly have to emerge in the near future to meet such demands. For example, the Pan Asia Bond Index Fund (PAIF) of ABF2 invests in eight local currency government bond markets, and since its inception in 2004, liquidity has improved considerably in most of these markets, and yield curves have become increasingly reliable. PAIF has been instrumental in improving market practices and infrastructures in the region, and regulatory frameworks have been enhanced to facilitate the listing of ETFs. However, a market survey on ABF2 conducted by the Bank for International Settlements in July 2011 revealed that these government bond exchange-traded funds (ETFs) have had to cope with an unfavourable environment of low and falling interest rates, making it difficult to attract investors after adjusting for transaction costs. This raises a very important issue relating to the attractiveness of bonds as a safe asset. Long-term sovereign bonds present an alternative to equity in attractiveness due to their credit quality and ready liquidity. Government bond yield curves become benchmarks against which other credit risks are assessed. 9 With the Greek debt crisis, sovereign bonds have lost their risk-free status. Pricing based on benchmark yield curves may be distorted if sovereign bond rates rise sharply, e.g. in Spain and Italy. In recent years, low interest rate policies and quantitative easing have lowered bond rates, and the market has been consistently wrong in pricing the risk premium for government bonds. The mispricing of sovereign credit risks has serious solvency implications for banks that are holding large amounts of government bonds when interest rates rise. This sovereign debt-bank system nexus has become a key macroprudential vulnerability Asian banking systems also hold a large amount of government debt, making them vulnerable (eurozone debt crisis style) if sovereign yields were to increase sharply. The demand for Asian bonds remains small because current low yields do not reflect the fundamental risks of credit default. Global and regional low yields are due not only to advanced country quantitative easing and zero interest rate policies, but also because of domestic portfolio restrictions and institutional factors. Although this cannot be resolved overnight, the general policy direction should be aimed at making bond prices reflect underlying risks. P a g e 9

12 Asian financial systems are still dominated by the banking system whereas capital markets and capital account liberalisation remain subdued. Because of that, Asian economies do not have large capital market cushions against systemic risks and shocks. Therefore, diversified capital markets that lower the leverage of the domestic financial systems and borrowers, are called for. Like the mutual fund crisis in the US in 2007, Asia had its own mutual fund shadow banking crisis between 2001 and 2002, when money market mutual funds in Taiwan and Indonesia fell below par value. A sharp exit by mutual funds procyclically impacted on government bond yields as mutual funds sold such bonds to increase their own liquidity. Consequently, the proper design of financial systems should ensure that long term bonds are held by long term funds, such as pension funds and insurance, rather than short term holders like hedge funds and money market funds. On a related note, many have rightly pointed out that risk management products and derivatives markets remain under-developed to support further deepening and broadening of Asian bond markets. Still, a case can be made that the derivatives markets are only as good as their underlying assets. If the underlying assets are vulnerable, the derivatives markets leverage plays that add to systemic fragility. Policies should be aimed at developing strong fundamentals before creating derivatives markets. 10 All these suggest that a systemic perspective of financial market development require a better understanding of how institutions, investors, issuers, regulators and markets fit together to foster financial stability and efficiency. The Fung Global Institute is committed to research that answers some of these issues, and that would benefit those interested in Asian finance. We hope that this paper will prove useful to readers and welcome comments and suggestions for improvement. Andrew Sheng President Fung Global Institute November 15, 2012 P a g e 10

13 Executive Summary East Asian Bond Markets ( ) At the end of 2010, the size of East Asia s bond markets in eight East Asian countries 2 was US$5 trillion, or 51.4 per cent of GDP. Over the period, the total GDP of these eight East Asian economies grew by 110 per cent. This fivefold increase in the size of the bond markets from US$831 billion or 36 per cent of GDP in 2000, was a result of efforts made by governments and key policy makers in Asia, who, in the wake of the Asian financial crisis of , wanted to reduce the region s over- reliance on the bank system for domestic financing, by developing the region s traditionally weak domestic bond markets. The Asian crisis brought to the fore the famous double mismatch problem (namely, a currency and maturity mismatch) in the financial system. Short-term savings and hot money inflows could not be used to finance long-term investments. Efforts were made at the national and regional levels to develop deeper bond markets. The Executives Meeting of East Asia-Pacific Central Banks (EMEAP) played a key role in bringing central banks together and took concrete measures that included the launching of two Asian bond funds. At the government level, there was the Asian Bond Market Initiatives (ABMI) for the Association of Southeast Asian Nations (ASEAN), South Korea, China and Japan (ASEAN+3), under which several committees were established to address key impediments to the development of bond markets in these countries. The Asian Development Bank (ADB) provided the necessary administrative support and financial resources through its technical assistance programmes to assist the ASEAN+3 and its member countries to develop the local bond market. 11 Between 2000 and 2010, there was a sharp increase in global leverage, especially in developed countries. The total size of local bond markets in countries covered by the Bank for International Settlements (BIS) rose from US$29 trillion in 2000 to US$69.9 trillion by the end of June, Although East Asian bond markets are small relative to world markets, when measured as a percentage of GDP, four East Asian markets were among the top twenty global bond markets in These were Malaysia, South Korea, Thailand and China. The bond markets of Malaysia and South Korea ranked number five and six in 2010 respectively, with ratios of per cent and per cent of GDP (Section 2). 2 East Asian countries in this report include eight economies (China, Hong Kong, Indonesia, Malaysia, South Korea, Philippines, Singapore and Thailand). Indian bond market is discussed in Annex 3. Islamic bond market in East Asia is covered in Annex 4. P a g e 11

14 Globally, local currency bond markets in the emerging markets had grown rapidly, from US$1.4 trillion in 2000 to US$8.1 trillion by June 30, 2011 (Section 2). Their share of the world bond market increased from 4.8 per cent in 2000 to 11.7 per cent in June The size of the East Asian markets was US$5 trillion, or 61 per cent of the emerging markets total. If India were to be included, the share of the Asian bond market would increase to 70 per cent. China was the largest market (US$3.1 trillion or 38.5 per cent of the total), followed by Brazil (18.9 per cent) and South Korea (15.1 per cent). East Asian countries have been at the forefront of the development of domestic bond markets in terms of strengthening the risk management of volatile capital outflows, and in creating alternative funding sources for government and corporations in local markets. The success of East Asia has been replicated by other emerging market countries such as the Latin American economies. The share of East Asian bond markets as a percentage of world bond markets steadily increased from 2.9 per cent in 2000 to 7.5 per cent in 2010, with China alone accounting for 4.5 per cent of the world bond market in Financial markets in East Asia have become more robust and resilient to international financial market turbulences. The size of the financial markets of these eight East Asian countries grew from US$12.3 trillion in 2005 to US$33.5 trillion in 2010 (Section 3). Although the banking system continued to dominate the financial system, its relative share declined, albeit only moderately, from 54.5 per cent in 2005 to 50 per cent in The bond market has steadily increased in size and sophistication. The equity markets also grew notably, but being relatively more volatile, its share in the financial markets has fluctuated widely. These markets are closely correlated to equity markets in developed countries. 12 From 2000 to 2010, China, Malaysia and Thailand were the three fastest growing bond markets. The largest bond markets relative to GDP were Malaysia and South Korea, followed by Thailand. Indonesia, a G20 country, has the smallest bond market. The size of its bond market was US$102 billion or 15 per cent of GDP in 2010, consisting largely of government bonds. China s bond market size was 51.6 per cent of GDP in The bond markets of China, Indonesia, Thailand and Vietnam have substantial future growth potential. Despite the improvements in the bond markets, governments are still the major issuers in the East Asian bond markets. All eight East Asian countries now have relatively well developed government bond markets with efficient supporting market infrastructures (trading, clearing and settlement systems). There are sovereign benchmark yield curves across maturity in most of these countries. Secondary market trading and liquidity have also improved in Malaysia, Thailand and South Korea. ABMI has made a notable contribution in developing these bond markets. The introduction of ABF2 and individual bond funds in each of these eight countries, has contributed to the development of bond market infrastructures in these countries. P a g e 12

15 Although the government bond markets are now relatively well developed, the growth of corporate bond markets in East Asia has been modest. Government bonds account for 50 per cent of all outstanding bonds, while corporate bonds accounted for only 23 per cent. Corporate bond markets exist largely in Malaysia and South Korea. Corporate bond markets are growing fast in China and Thailand but liquidity in secondary markets is limited due to the small size and limited market-making ability of dealers. Most issuers of corporate bonds in China are government-owned entities. In Indonesia, the corporate bond market has started to grow but it has been constrained by the small size of its domestic investor base. Most corporate bonds in Indonesia do not carry investment grade rating. Although East Asia has high savings rates, with an estimated domestic investor base of US$4.3 trillion at the end of 2010, it is small when compared to the assets of its banking system, which stood at US$15.4 trillion at the end of The largest components of the domestic institutional investor base are mutual funds that accounted for 73 per cent of the total assets, followed by pension funds (18 per cent) and insurance (9 per cent). The mutual fund industry in East Asia has grown rapidly. Total assets under management (AUM) rose from US$1.7 trillion in 2006 to US$3.2 trillion in Three countries, Singapore, China and South Korea, accounted for 94 per cent of the market. Hong Kong and Singapore are the two largest fund management centres. Although the size of the mutual fund industry in East Asia is large, they have played a marginal role in bond market development. Since mutual funds are required to mark-to-market their positions on a daily basis, they have limited appetite for corporate bonds that are not liquid and hard to value on a daily basis. 13 In 2010, the size of public pension funds in East Asia was US$774 billion. The pension fund industry was concentrated in four countries (South Korea, Malaysia, China and Singapore), which together accounted for 88 per cent of total public pension assets. South Korea alone accounted for 38 per cent of the total. The pension fund industry in East Asia has played an important role in developing domestic capital markets, especially equity markets. However, their role in bond market development, especially the corporate bond markets, has been modest. These public pension funds are subject to investment policy and asset allocation that are prescribed by the governments. Their focus is on the safety of the assets. As a result, most pension funds invest heavily in government securities and bank deposits. Malaysia and Singapore are the two exceptions. At the end of 2010, the total size of the insurance industry (life and non-life) was US$409 billion in terms of premium income. China and South Korea together accounted for 80 per cent of the premium. However, China s insurance industry is at a very early stage of development. Insurance premiums, as a percentage of GDP, were only 3.8 per cent, compared with 11 per cent for South Korea and Hong Kong. The comparable ratio in the United States (US) and Europe was about 7.8 per cent in Insurance markets P a g e 13

16 in South Korea and Hong Kong are fairly developed. Unlike Chile, the insurance industry in East Asia has played a very limited role in the development of the corporate bond market due to regulatory constraints placed on the insurance industry. At the end of 2010, the total foreign portfolio in East Asian debt amounted to US$405.7 billion (Section 3). The largest investors were from European countries (30 per cent), followed by Hong Kong (19 per cent), the US (17 per cent) and Singapore (13 per cent). Thus far, there has been limited inter-east Asia investment. East Asian Bond Markets in 2020 A Forecast East Asian countries are likely to maintain a growth rate of 6 per cent to 7 per cent over the 2010 to 2020 period. In order to grow at this level, these countries will need to invest large amounts of funds into basic infrastructure, housing and capital-intensive industries, in order to support the industrialisation process of transforming from labour-intensive to capital and knowledge-intensive value creation. Other countries with favourable demographics will require considerable infrastructure in terms of housing and further urbanisation. The transition from labour to capital intensive, from rural to urban societies will require substantial long-term funding. Further deepening of financial markets will be needed to meet the needs of the real sector for both public investment and private. Further development of debt, equity and derivatives capital markets will be required. The banking sector s ability to provide long-term funding will be very much constrained by the new capital and liquidity requirements under Basel III. 14 Between 2010 and 2020, private fixed investment in East Asia is estimated at US$37.7 trillion, with China accounting for 68.2 per cent. China is expected to grow at a real rate of about 7.5 per cent over this period until With the second largest population in East Asia, Indonesia is expected to need US$4.7 trillion to sustain a projected real growth rate of 6 per cent. Thailand will also need investments of about US$1 trillion. Out of the estimated US$37.7 trillion in private fixed investments, a substantial amount will be invested in infrastructure projects Asia s infrastructure financing requirements during the period are estimated at US$8 trillion. The size of the East Asian bond market is projected to increase from US$5 trillion in 2010 to US$17.8 trillion in China will become one of the largest bond markets in the world by 2020, with an estimated market size of about US$13.4 trillion (Section 4), and accounting for 75 per cent of the East Asian bond markets. The growth will be driven by China s massive investment requirements, demand for housing, urbanisation and investment in capital-intensive industries. These will require the further liberalisations, deepening and opening up of its financial markets. P a g e 14

17 The size of the East Asian bond market ex China is projected to double from US$2 trillion in 2010 to US$4.2 trillion in The bond markets of South Korea, Thailand and Malaysia are expected to grow in line with their GDP growth. Unless there is substantial deepening of their institutional base, the bond markets in Indonesia and Philippines are likely to grow at modest rates due to the small size of their domestic investor base and other structural issues. Growth of bond markets in Hong Kong and Singapore is going to be in line with their GDP growth due to their prudent fiscal position and limited investment requirements. Their role as financial centres will continue to grow in tandem with the growth of East Asian economies and regional financial market integration. The size of the East Asian investor base in 2020 is forecasted at about US$12 trillion (Section 4) based on the past growth pattern of the three major industries: mutual funds, pension funds and insurance. It is projected that the mutual fund industry will remain the largest segment of the investor base, accounting for about 66 per cent of the market, followed by pension funds (25 per cent) and insurance (9 per cent). The growth of the East Asian bond markets during the period was spectacular, as evidenced by the growth in the overall market, successful building of key market infrastructure (trading, clearing and settlements) and other supporting market structures (credit rating, bond pricing and market intermediaries). The East Asian bond market has become a role model for other emerging market countries planning to develop their domestic bond markets. 15 Future Challenges Although East Asian countries have made remarkable progress in developing their bond markets, there are several issues that require the attention of key policy makers (Section 5). Financial markets are a service industry, with four key functions resource mobilisation, efficient resource allocation, risk management and reinforcing corporate governance and credit discipline of the real sector. Since the Asian financial crisis, experience suggests that non-diversified financial markets can cause systemic risks that impact the real sector. The recent global financial crisis cost the developed markets more than US$14 trillion in rescue support, and led to a worldwide recession. Excessive financial globalisation creates systemic risks, of which policy makers should be mindful. Bond markets are only one of the key components of the financial system and their healthy development must be complemented by development in other areas. The design of the overall financial system must support the needs of the real sector and its architecture, operations and supervision must be carefully balanced to meet the long-term social objectives of efficiency, stability and social inclusivity. The asset bubbles of the last two decades around the world have given rise to greater awareness that longterm negative interest rates resulting from the global creation of private credit through the (under- P a g e 15

18 supervised and under-monitored) shadow banking system, can create huge systemic risks, that in turn were aggravated by not being adequately recognised and managed. Whilst East Asian economies were not affected directly by the holding of toxic derivatives assets, they were hurt by the contraction in trade and sharp withdrawal of trade finance in the real sector. In the wake of quantitative easing and zero-interest rate policies in the reserve currency economies, Asian emerging markets face significant macro-economic challenges in terms of managing volatile capital flows, upward pressure on exchange rates, inflation and emerging asset bubbles. The efforts at deepening domestic bond markets and fostering regional safety nets through the Chiang Mai Initiatives, such as the creation of the Asset Management Research Office (AMRO) in Singapore to multilateralise ASEAN+3 swap arrangements, are important for strengthening regional defences against internal and external shocks. However, much more needs to be done to build on these strengths. Asia is facing major transformational trends that are still unfolding and will require substantive re-thinking of national and regional financial policies and designs. First, as the European debt crisis unfolds, there is an awareness that Asia s economies must switch from an over-reliance on exports as the primary engine of growth, to domestic consumption. Second, dramatic demographic trends of aging in the North Asian economies and younger, urbanising populations in the Southern ones, are likely to change consumption and savings patterns and will demand a different quality of financial service. Long-term pension and social security needs will increase, as will the needs for social and financial inclusivity to improve access to finance. Third, technology changes will result in major industrial and supply chain re-tooling towards green, energysaving and low carbon-emission production and lifestyles. This will require long-term investment. Fourth, tighter financial regulation is already dramatically changing the financial landscape. Fifth, the integration of the Asian economies, with improved communications and supply chain networking, will drive dramatic changes in real sector growth models. Sixth, social governance and corporate governance models will have to change in response to such transformational trends. As more Asian economies move into advanced country status, the quality of governance and transparency will have to adjust correspondingly. 16 These transformative trends will have a major impact on the future development of the bond markets. They are discussed below. a) Financial Market Structure and Systemic Risks. The focus over the last decade has been mainly on developing bond markets. Bond markets have grown rapidly due to growth in government bond markets. The average ratio of East Asian bond markets to GDP in 2010 was 51.4 per cent. However, the ratios for Malaysia and South Korea were over 100 per cent. Since most investors in government bonds are commercial banks, there is a potential systemic risk if interest rates were to increase sharply and bond holdings by banks need to be marked to market. The experience of P a g e 16

19 Greece, Portugal, Ireland and Spain should be carefully studied by policy makers in East Asia. There is clearly a need to take a holistic approach in developing diversified financial market structures rather than only focusing on the bond market. b) Investor Base. As discussed in Section 3, the investor base in East Asia continues to be dominated by the banks and mutual funds. Banks are the major investors in government bonds to meet their statutory requirements (reserves and liquidity). They are ill-equipped to invest in bonds with long maturity. Their ability to invest in corporate bonds is limited due to new capital requirements under Basel III and lack of liquidity in corporate bond markets. Mutual funds have to mark to market their holdings on a daily basis so that they will not be the major investor in bond markets. Pension funds and insurance companies are the appropriate investors that can invest in long-dated bonds to meet their long-term liabilities. Therefore, there is an urgent need to accelerate development of pension funds and insurance companies. c) Taxation of debt instruments. The ABMI and the ABF2 made substantial progress in harmonising the tax regime for investment in bond markets by foreign investors. Seven out of eight countries adopted the same tax regime for foreign investors, by removing the withholding tax on both interest and capital gains. This progress was partially reversed in 2010 and 2011 when, due to stability concerns, Thailand and Korea re-imposed withholding tax on interest income on government bonds, to discourage foreign portfolio investment in their domestic bond market. As shown in Table 5.1 of Section 5, East Asian countries now have different tax regimes. This is likely to inhibit the development of regional bond markets. Given the prevalence of historic, low interest rates, withholding taxes reduce yield and reduce the attractiveness of debt instruments. There is clearly a need for policy makers to address this issue at the national and regional level. A withholding tax on fixed income is also likely to inhibit growth of fixed income exchange traded funds. A withholding tax also increases transaction costs and reduces liquidity in secondary markets. 17 d) Risk Management Products. Development of liquid bond markets requires the existence of risk management products such as interest rate and currency swaps, credit default swaps and other derivatives. These products do exist in Hong Kong and Singapore. South Korea has also been developing these products. However, derivatives markets are still at an early stage of development in the remaining five markets. Malaysia has made notable progress in developing derivatives markets. There is clearly a need to foster development of derivatives markets in all countries to enable development of a regional bond market. The existence of well-functioning domestic derivatives markets will also encourage foreign borrowers to tap into these markets. This in turn will improve liquidity and create investment products for domestic institutional investors. P a g e 17

20 e) Regional Fixed Income Funds. The ABF2 PAIF has paved the way for future regional debt products. However, this has not happened due to constraints at the national and regional levels. Withholding taxes and foreign exchange controls are two examples of this. The authorities should consider providing incentives for the development of regional fixed income products through the development of fixed income fund managers in the region. This could be achieved by outsourcing some of the public pension funds for investment in fixed income in the region. Tax incentives should also be considered for pan-asia high yield bond funds or corporate bond funds. 18 P a g e 18

21 1 Overview At the end of 2010, the size of the East Asian bond market 3 in eight East Asian countries was US$5 trillion or 51.4 per cent of GDP. This fivefold increase in the size of the bond markets from US$831 billion or 36 per cent of GDP in 2000, was a result of efforts made by governments and key policy makers in Asia, who, in the wake of the Asian financial crisis of , wanted to reduce the region s over- reliance on the bank system for domestic financing, by developing the regions traditionally weak domestic bond markets. The Asian financial crisis had brought to the fore the famous double mismatch problem (namely, a currency and maturity mismatch) in the financial system. Short-term savings and hot money inflows could not be used to finance long-term investments. Efforts were made at the national and regional levels to develop deeper bond markets. The Executives Meeting of East Asia- Pacific Central Banks (EMEAP) played a key role in bringing central banks together and took concrete measures that included the launching of two Asian Bond Funds. At the government level there was the Asian Bond Markets Initiative (ABMI) for the Association of Southeast Asian Nations (ASEAN), South Korea, China and Japan (ASEAN+3), under which several committees were established to address key impediments that were holding back development of bond markets in these countries. The Asian Development Bank (ADB) provided the necessary administrative support and financial resources through its technical assistance programmes to assist the ASEAN+3 and its member countries to develop the local bond market. 19 This paper reviews major developments in the East Asian bond markets between 2000 and 2010, and highlights the progress made by policy makers in these countries in addressing key impediments at the country and regional levels. Major successes are discussed and areas that are still work in progress are identified. Section 2 discusses the rising role of the East Asian bond markets in a global context. Major developments in the East Asian bond markets between 2000 and 2010 are discussed in Section 3. Section 4 provides a forecast of the East Asian bond markets in The forecast is based on several key assumptions that include the macroeconomic growth rate, investment, savings, and financing patterns of the corporate sector. The analysis is carried out for illustrative purpose only and as such, represents a likely scenario for the East Asian bond markets in However, one thing that is reasonably certain is that China will be the dominant Asian market as it becomes the second largest economy in the world by An agenda for future reforms is discussed in Section 5. Annex 1 provides information on eight major East Asian bond markets. Discussions on Hong Kong and Singapore are brief since they are major financial centres with well-developed bond markets. Annex 2 provides a snapshot of market infrastructures in these economies. Annex 3 provides an overview of the Indian bond market. Islamic Bond Markets in East Asia are discussed in Annex 4. 3 The East Asian Bond market in this paper is defined to include eight East Asian Economies. These include China, Indonesia, Hong Kong (China), Malaysia, Philippines, Singapore, South Korea and Thailand. Vietnam is included in some sections. Japan is not included in this analysis due to its size and different stage of market development. P a g e 19

22 2 Asian Bond Markets in Global Context The world experienced dramatic growth in leverage between 2000 and The total size of local bond markets in the countries covered by the Bank for International Settlements (BIS) rose from US$29 trillion in 2000 to US$69.9 trillion by the end of June 2011 (Figure 2.1). Most developed countries, especially the United States (US), the United Kingdom and European countries, experienced a rapid growth in debt due to the impact of the global financial crisis and subsequent deleveraging of global financial markets. Southern European countries have also faced considerable challenges following major debt crises in Greece, Iceland, Ireland, Portugal and Spain. Figure 2.1 World Top Local Currency Bond Markets 70,000.0 World Top Local Currency Bond Markets (June 2011) US$ 69.9 trillion USA and Japan (57%) 60, , , , , , Netherlands Australia South Korea Brazil Spain Canada United Kingdom Germany China Italy France Japan United States 20 Source: BIS and author's calculations The US and Japan together accounted for 57 per cent of world bond markets in June 2011 (Figure 2.2). The bond market in the US has increased dramatically due to very large fiscal deficits since 2008 and numerous stimulus programmes were undertaken by the administration to revive the economy. The prolonged housing problem has also added to the government s debt burden, as both housing agencies (Fannie Mae and Freddie Mac) require funding to meet their operating deficits. Japan also continues to run fiscal deficits and it is now the most highly indebted country in the world. The Chinese bond market has grown rapidly but it accounted for only 4.5 per cent of the world bond market at the end of June P a g e 20

23 Figure 2.2 Top Local Currency Bond Markets (2011, June) 120.0% Top local currency bond markets (2011,June) 100.0% 80.0% United States Japan 60.0% 40.0% 20.0% 0.0% 36.4% United States 20.3% 5.1% 4.8% 4.5% 4.1% 2.4% Japan France Italy China Germany United Kingdom 100.0% All issuers France Italy China Germany United Kingdom All issuers Source: BIS and author's calculation Although East Asian bond markets are small relative to the world markets, four markets were among the top twenty bond markets in 2010 in terms of percentage of GDP. Malaysia, South Korea, Thailand and China had large bond markets relative to GDP. Malaysia and South Korea ranked number five and six in 2010, with ratios of per cent and per cent respectively (Figure 2.3). The development of bond markets in both Malaysia and South Korea has been well orchestrated and their bond markets are welldiversified (Annex 1). However, there is a need for close monitoring to ensure that the leverage levels in their economies remain sustainable, so as to avoid the problems developed countries are currently being confronted by. China s bond market, at 50 per cent of GDP, is likely to grow in tandem with economic development and the deepening of its financial markets. Bond markets in Indonesia and the Philippines remain small. Vietnam s bond market is at an early stage of development. The bond markets of Hong Kong and Singapore are relatively small as they run comfortable fiscal surplus positions and the role of their bond markets is primarily to provide sovereign interest rate benchmarks and supporting infrastructures to facilitate the development of the private debt market. 21 Figure 2.3 Bond Market as percentage of GDP (2010) 300.0% Bond Market as % of GDP (2010) 250.0% 200.0% 150.0% 100.0% 50.0% 0.0% Sources: BIS, author calculations P a g e 21

24 Globally, the local currency bond markets of emerging economies have grown rapidly from US$1.4 trillion in 2000 to US$8.1 trillion in June 30, 2011 (Figure 2.4). As a result, the share of emerging market countries has increased from 4.8 per cent in 2000 to 11.7 per cent of the world bond market in June There has been growth across the board. However, the East Asian markets dominate with a size of US$5 trillion, or 61 per cent of the total. If India were to be included, the share of the Asian bond market would increase to 70 per cent. China was the largest market (US$3.1 trillion), or 38.5 per cent, followed by Brazil (18.9 per cent) and South Korea (15.1 per cent). East Asian countries have been at the forefront of developing domestic bond markets, both for managing the risk of abrupt capital outflows and for creating alternative funding sources for government and corporations in local markets. The successes of East Asia have been replicated in other emerging market countries. Since 2005, Latin American countries have been building their domestic bond markets and converting their debt from external to domestic. The Latin countries have also made notable progress in building their domestic investor base. Brazil, Chile, Peru and Colombia are the leaders in this area. South Africa has also been successful in building its domestic bond market. India and Turkey have developed their government bond markets but are still at the early stages of their corporate bond market development. Figure 2.4 Top Emerging Bond Markets (June 2011) 9, ,000.0 Top Emerging Bond Markets (June 2011) US$ 8.1 trillion, 11.7% of total (Outstanding in US$ Billion) 22 7, , , , , , , Indonesia South Africa Thailand Turkey Malaysia Mexico India South Korea Brazil China Sources: BIS and author's calculation The share of East Asian bond markets as a percentage of world bond markets steadily increased from 2.9 per cent in 2000 to 7.5 per cent in 2010 (Figure 2.5). However, China alone accounted for 4.5 per cent of the world bond market. Bond market growth in East Asia between 2000 and 2010 has been largely dominated by China due to concerted efforts made by its government to lay the foundations for effective monetary policy management that requires a vibrant government bond market. P a g e 22

25 Figure 2.5 East Asian Bond Market in World Bond Market 8.0% East Asian Bond Market in World Bond Market (% of total) 7.0% 6.0% 5.0% 4.5% 4.0% 4.1% 3.8% 3.0% 3.1% 2.4% 2.0% 2.0% 1.4% 1.0% 0.7% 0.8% 1.0% 1.2% 0.0% East Asia as % of world bond market China as % world bond market Source: BIS and author's calculations 23 P a g e 23

26 3 Asian Bond Markets ( ) 3.1 East Asian Financial System Financial markets in East Asia have become more robust and resilient to international financial market turbulences. The size of financial markets of the eight East Asian countries grew from US$12.3 trillion in 2005 to US$33.5 trillion in As shown in Figure 3.1, the banking system remains a major part of the system. However, its relative share in the financial system has steadily declined from 54.5 per cent in 2005 to 50 per cent in The bond market has steadily increased in size and sophistication. The equity market has grown notably but has become relatively more volatile and its share in the financial markets has fluctuated widely. The main casualties of the global financial crisis in East Asia were the equity markets, which suffered sharp declines across the board. This was because the major markets in East Asia (South Korea, Hong Kong and Singapore) are highly integrated to world markets, and stock price movements are closely correlated to movements in major international markets. In the case of Indonesia and the Philippines, their stock markets have a high foreign investor base and tend to be more impacted by the change in asset allocation by foreign fund managers. The domestic investor base in these two countries is very small. Stock markets in mainland China are relatively less volatile from hot money flows as foreign investment is controlled through the Qualified Foreign Institutional Investor Programmes (Annex 1). Figure 3.1 East Asian Financial System ( ) 24 40,000 East Asia Financial System ( ): US$ 33.5 trillion in ,000 30,000 25,000 20,000 15,000 10,000 Equity Market Bond Market Bank Asssets 5, Sources: Bonds (BIS), Bank Assets (IMF), Equity markets (Federation of Stock Exchanges. P a g e 24

27 During the global financial crisis, banks in most East Asian countries weathered the turmoil well. The banks are now better regulated and have limited net foreign currency exposures. However, the impact of the global credit crunch was felt in countries such as South Korea and Indonesia. Korean banks were relatively more leveraged than banks in other countries and experienced some liquidity issues. Indonesian banks suffered from a reduction in trade finance due to the deleveraging of major banks in developed countries. Since the East Asian countries carry large foreign exchange reserves, these shortfalls were easily met by their respective central banks. There were no major bank failures during the crisis, and the financial markets remained orderly by and large. Furthermore, the governments and central banks in the region provided support to financial markets during the period to ensure their soundness. These measures included blanket guarantee on deposits, additional liquidity and stimulus programmes. These measures were withdrawn in 2010 with the stabilisation of global financial markets. 3.2 East Asian Bond Markets The East Asian bond markets experienced impressive growth between 2000 and The size of bond markets in these eight countries increased from US$831 billion in 2000 to US$5 trillion in 2010 (Figure 3.2). Given that these eight markets are at different stages of financial market development, the growth in each country has been varied. In the first group, Hong Kong, Singapore and South Korea are at the advanced stage of market development, comparable to major international financial centres such as New York and London. Malaysia has made notable progress and can be considered an advanced market, distinguished by its leadership in Islamic finance. Thailand, Indonesia and the Philippines have been successful in building government bond markets but lag behind in developing corporate bond markets and risk management products. China is a market by itself, distinguished by its massive size and complexity. It is currently the largest market and will gain in size and sophistication as it moves forward. Vietnam is still at an early stage of market development. Therefore, any discussion of East Asian bond markets as one market needs to be qualified, as there are really eight different markets, with one new frontier market (Vietnam). 25 The Indian bond market is growing fast but it is almost exclusively a government bond market. Its corporate bond market has remained dormant due mainly to crowding out by a government that has been continuously running fiscal deficits. The size of India s bond market at the end of 2010 was US$608 billion and is quite small relative to the East Asian bond market as a whole (Figure 3.2). P a g e 25

28 Figure 3.2 East Asian Bond Markets ( ) 6,000 East Asian Bond Markets ( ) Outstanding in US$ billion 5,000 4,000 3,000 2,000 1, East Asia India Source: BIS and author's calculation China, Malaysia and Thailand were the three fastest growing bond markets between 2000 and The largest bond markets relative to GDP were Malaysia and South Korea (Table 3.1). Thailand was the third largest bond market (70.7 per cent of GDP). It is interesting to note that Indonesia, a G20 country, has the smallest bond market as a percentage of GDP. The size of its bond market was US$102 billion or 15 per cent of GDP, consisting largely of government bonds (see Annex 1). China s bond market size was 51.6 per cent of GDP in Bond markets of China, Indonesia, Thailand and Vietnam have substantial future growth potential. 26 Table 3.1 Bond Markets as percentage of GDP Asian Bond Markets Bond Market as % of GDP Malaysia South Korea Thailand Singapore China, People's Rep. of Philippines Hong Kong, China Vietnam Indonesia East Asia average India Japan Source: BIS, IMF and author's calculations. With a size of US$3.1 trillion, the Chinese bond market was the largest bond market in East Asia (Figure 3.3). The second largest market was South Korea, followed by Malaysia and Thailand. The share of China in the East Asian bond market as a whole has increased from 24.3 per cent in 2000 to 60.6 per cent in China has made substantial progress in modernising its bond markets, and its market P a g e 26

29 infrastructure for trading, clearance and settlements have been upgraded to international standards. Vietnam as the frontier country was the smallest market with a size of US$15 billion. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Figure 3.3 East Asian Bond Markets ( ) by Country East Asian Bond Market ( ) by Country Jun.2011 China South Korea Malaysia Thailand Indonesia Singapore Philippines Hong Kong SAR Source: BIS and author's calculation The major issuers in the East Asian bond markets are governments. All eight countries now have relatively well developed government bond markets with efficient supporting market infrastructures (trading, clearing and settlement systems). There are sovereign interest rate benchmarks across maturity in most of these countries. Secondary market trading and liquidity have also improved in Malaysia, Thailand and South Korea. The ABMI has made a notable contribution in developing these bond markets. The introduction of ABF2 PAIF and individual bond funds in each country have contributed to the development of bond market infrastructures in these countries. 27 Although the government bond markets are now relatively well developed, the growth of corporate bond markets in East Asia has been modest. Malaysia and South Korea are the two exceptions. As shown in Figure 3.4, government bonds account for 50 per cent of all outstanding bonds. Corporate bonds amounted to only 23 per cent of outstanding bonds. A closer look shows that corporate bond markets exist largely in Malaysia and South Korea. Corporate bond markets are growing fast in China and Thailand but liquidity in the secondary market is limited due to the small size and limited market-making ability of dealers. Most issuers of corporate bonds in China are government-owned entities. In Indonesia, the corporate bond market has started to grow but its growth is very much constrained by the small size of its domestic investor base. Most corporate bonds in Indonesia do not carry an investment grade rating. P a g e 27

30 6, ,000.0 Figure 3.4 East Asian Bond Market by Type of Issuer East Asian Bond Markets by Type of Issuers ( ): US$ 5 trillion US$ Billion 4, , , , (June) Corporates , ,208.1 Fis FIs , , ,437.1 Governments , , , , , , ,600.9 Sources: BIS and author's calculation South Korea and Malaysia ranked number one and two in terms of size of their corporate bond markets relative to GDP in 2010 (Figure 3.5). Thailand and China also ranked high. South Korea and Malaysia have been highly successful in developing their corporate bond markets because they have a large domestic institutional investor base that have a natural demand for high quality debt instruments to meet their actuarial funding requirements. Thailand and China are also developing their investor base and have good potential for developing their corporate bond markets further. Indonesia and the Philippines face considerable challenges in developing this market, as their domestic investor base is extremely small. Foreign investors tend to be more interested in government bond markets that are large, liquid and carry fewer risks than corporate bonds. 28 Figure 3.5 Corporate Bond Outstanding as percentage of GDP 40.0% Corporate Bond Outstanding as % of GDP % 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Sources: BIS and author's calculations P a g e 28

31 3.2.1 Market Liquidity 4 Market liquidity in government securities has steadily improved due to an increase in outstanding bonds and trading. Liquidity can be measured by the quarterly turnover ratios and bid-ask spreads. As shown in Table 3.2, the turnover ratios have increased steadily from Hong Kong is by far the most liquid market followed by South Korea and Malaysia. The Thai bond market is less liquid as a substantial part of the bonds are owned by individuals and government organisations which are buy-and-hold investors. Liquidity in Philippine government securities has improved due to the consolidation of a number of bond issues into few large benchmark issues. Both Indonesia and the Philippines have taken measures to lengthen the maturity structure of their debt securities. The most commonly used indicator to measure bond market liquidity is the bid ask spread. Table 3.3 shows the average bid-ask spread in eight East Asian countries during In 2011, the bid-ask spread ranged from a low of 0.7 basis points for Korea to 32.9 basis points for Indonesia. The spread for Malaysia and Thailand was 3.3 basis points. The bid ask spreads vary based on the depth of domestic bond market, the domestic investor base and the openness of the market. Malaysia and South Korea have relatively large domestic investor bases so the volatility in their markets has been a lot less than those in Indonesia and the Philippines. 29 Table 3.2 Government Bonds Turnover Ratio East Asian Bond Markets Government Bonds Turnover Ratio China Hong Kong, SAR Indonesia Korea Malaysia Philippines Singapore Thailand Source: Asianbonds Online 4 Source: Asianbondonline 2011 Bond Market Liquidity Survey. P a g e 29

32 Table 3.3 Government Bond Bid-Ask Spreads (basis points) East Asian Bond Markets Government Bond Bid-Ask Spreads (basis points) China Hong Kong, SAR Indonesia Korea Malaysia Philippines Singapore Thailand Source: Asianbondonline Although liquidity in government bond markets has improved substantially, liquidity in corporate bond markets is very limited except for Malaysia and South Korea that have developed sizeable corporate bond markets. Even in these countries, the turnover in corporate bond markets was less than 0.2. In 2011, the bid-ask spreads for corporate bonds in East Asian countries ranged from 2 basis points in Korea to 70 basis points in Indonesia. Liquidity in the East Asian countries is limited because of the relatively small issue sizes, the small domestic investor base and the credit quality of issuers Credit Default Swaps 30 In East Asia, the use of credit default swaps (CDS) as a hedging instrument against credit risk started in 2003 and has been gaining momentum. CDS are available for both individual names and the index. 5 The main CDS index for Asia is The Markit itraxx Asia index of 40 investment-grade borrowers outside Japan. Figure 3.6 shows the trend in CDS spreads from 2008 to June 2012 of eight East Asian countries. The CDS spreads have widened out notably during the global financial crisis but have since declined to more normal levels. The spreads reflect the underlying credits of the issuers. 5 Credit default swap indices are benchmarks for protecting bonds against default and traders use them to speculate on credit quality. A drop signals improving perceptions of creditworthiness, while an increase suggests the opposite. The swap contracts pay the buyer face value in exchange for the underlying securities if a borrower fails to meet its debt agreements. A basis point is 0.01 percentage point. P a g e 30

33 basis points Figure 3.6 East Asia: Credit Default Swap Spreads East Asia-Credit Default Swap Spreads (Senior 5- Year) (June) Indonesia Philippines Thailand Malaysia Korea China Singapore 0 03/01/08 05/01/08 07/01/08 09/01/08 11/01/08 01/01/09 03/01/09 05/01/09 07/01/09 09/01/09 11/01/09 01/01/10 03/01/10 05/01/10 07/01/10 09/01/10 11/01/10 01/01/11 03/01/11 05/01/11 07/01/11 09/01/11 11/01/11 01/01/12 03/01/12 05/01/12 Hong Kong, SAR Source: Asianbondonline The introduction of CDS in East Asia has thus far been positive, based on recent research by the Bank for International Settlements 6. In their 2010 study, they found strong evidence that CDS trading was associated with lower cost and higher liquidity for new bond issuance in Asia. This is consistent with the hypothesis that CDS trading helps create new hedging opportunities and improve information transparency for investors. The study also found that the positive impact of CDS trading on the bond market was more notable for smaller firms and non-financial firms. In addition, firms with higher liquidity in the CDS market benefited more in the primary bond market in terms of cost and liquidity. In line with the behaviour of CDS in developed markets, the analysis in the paper showed that at the peak of the global financial crisis, companies that were included in the CDS indices experienced much higher volatility than the general increase in credit spreads observed in the bond market during this period. This indicates that CDS trading may be a double-edged sword. CDS has introduced new sources of shocks to the East Asian bond markets. Disruptive events in the derivatives market may spill over to the bond market and cause the malfunctioning of the whole credit market, as was the case during the global financial crises. It is therefore essential, that policymakers in East Asian countries introduce appropriate measures to mitigate the potential negative spill over from the CDS market to the bond market Ilhyock Shim and Haibin Zhu, The impact of CDS trading on the bond market: evidence from Asia, BIS working paper number 332, P a g e 31

34 3.2.3 Credit Rating Agencies Almost all East Asian countries now have relatively well functioning rating agencies. Rating agencies in Indonesia, Malaysia, Philippines, South Korea and Thailand are now associated with international rating agencies. All three major rating agencies operate in Hong Kong and Singapore. In Malaysia, the Rating Agency Malaysia Berhad (RAM) 7 and the Malaysian Rating Corporation Berhad (MARC) are the domestic credit rating agencies in Malaysia that provide ratings on debt instruments issued in the Malaysian market. RAM was set up in 1990, and MARC was established in Both organisations were promoted by Bank Negara Malaysia (BNM), the central bank. Mandatory rating is required for all debt securities and sukuk issues in Malaysia. This has facilitated development of the bond market as it enables a large number of investors to invest in debt instruments. Malaysia also requires credit rating on bond or sukuk issues. A domestic rating agency is also required to adopt the International Organisation of Securities Commissions (IOSCO) Credit Rating Agency Code in its own code of conduct, and to disclose this on its website. In South Korea, there are four major domestic credit rating agencies: Korea Information Service (KIS), Korea Ratings (KR), Seoul Credit Ratings and Information (SCI), and the National Information Credit Evaluation (NICE). Korea Rating, an affiliate of Fitch, is the largest rating agency with a market share of 36 per cent followed by KIS (a Moody s company) and NICE. Overall, the credit rating business has grown steadily and has provided a supportive environment for the development of the corporate bond market and the ABS market. 32 In Thailand, three major rating agencies (Moody s, Standard and Poor s and Fitch) and TRIS Rating, a local rating agency, operate in Thailand. Credit rating is mandatory for companies seeking approval from the Securities and Exchange Commission (SEC) of Thailand for debt securities issuance. TRIS was promoted by the government, and its shares are owned by major banks and the ADB. In 2011, Standard & Poor s acquired shares of TRIS from the ADB and is now a shareholder of TRIS. In the Philippines, the Philippine Rating Services Corporation (PhilRatings) is the only domestic credit rating agency (CRA) that is accredited by both the central bank and the Securities and Exchange Commission (SEC). The rating agency is an affiliate of Standard & Poor s. 7 RAM is now partly owned by Standard and Poor s after having acquired RAM s shares from the in P a g e 32

35 In Indonesia, Bapepam-LK licenses local credit rating agencies. The two local credit rating agencies are Credit Rating Indonesia (PT PEFINDO) and PT ICRA Indonesia. PEFINDO is owned by domestic institutional shareholders, comprising major banks, pension funds, insurers, securities companies and the IDX. Standard & Poor s is in partnership with PEFINDO, helping to enhance its rating methodology and processes. PEFINDO is also a member of the Asian Credit Rating Agencies Association (ACRAA). ICRA Indonesia received its license in 2010 from Bapepam-LK. Moody s is the major shareholder of ICRA Indonesia s parent company and it has an agreement to provide highvalue technical services to boost research capabilities and give access to Moody s own global research base. In China, there are currently eight major credit rating agencies. Two of them are foreign jointventures; one is engaged in a technical cooperation with a foreign enterprise and the remaining five are locally owned. The leading domestic rating agency is the Dagong Global Credit Rating Company. The People s Bank of China (PBOC) is the main supervisory authority of the credit rating industry and is responsible for issuing relevant rules and regulations governing the credit rating system. The China Securities Regulatory Commission (CSRC) supervises credit rating in the exchange bond market while the National Development and Reform Commission (NDRC) oversees the credit rating for enterprise bonds Investor Base East Asia is a region that is well known for its high savings rates. The region has accumulated a large amount of foreign exchange reserves amounting to US$4.5 trillion as at the end of The size of the investor base at the end of 2010 was estimated at US$4.3 trillion. Although the domestic investor base is now sizeable, it is small when compared to the assets of the banking system that stood at US$15.4 trillion at the end of A breakdown of the East Asian investor base is given in Figure 3.7. Mutual funds accounted for 73 per cent of the total, followed by pension funds (18 per cent) and insurance (9 per cent). P a g e 33

36 Figure 3.7 East Asia: Investor Base East Asia: Investor Base (2010) US$ 4.3 trillion Pension 18% Insurance 9% Mutual Funds 73% Sources: severals: official and market sources Mutual Funds. The mutual fund industry in East Asia has grown rapidly. Total assets under management (AUM) rose from US$1.7 trillion in 2006 to US$3.2 trillion (Table 3.4). Three countries (Hong Kong, Singapore, China and South Korea) accounted for 94 per cent of the market. Hong Kong and Singapore are the two largest fund management centres. Although the size of the mutual fund industry in East Asia is large, it has played a marginal role in bond market development. A part of mutual fund assets is invested globally. Foreigners are also investors in funds managed out of Hong Kong and Singapore. Since mutual funds are required to mark-to-market their positions on a daily basis, they have limited appetite for corporate bonds that are not liquid and hard to value on a daily basis. Some countries in the region (Malaysia, South Korea and Indonesia) have established bond-pricing companies to address this problem. Historically low interest rates have also deterred investors in mutual funds from investing in government bonds with long maturities due to the risk associated with long duration. High yield bond funds and junk bond funds have yet to develop in East Asia. There are also few established fixed income managers in the region. Malaysia and Thailand have been successful in developing their mutual fund industry. However, the mutual fund industries in the Philippines and Indonesia are very small and at an early stage of development. 34 P a g e 34

37 Table 3.4 East Asia: Mutual Fund Industry Total Net Assets of Asian Mutual Funds US$ billion % China N/A % Hong Kong , , , % Indonesia % Malaysia % Philippines % Singapore , % South Korea % Thailand % Total 1, , , , , % India Japan Sources: Official and market sources Pension Funds. The size of public pension funds in East Asia was US$774 billion (Figure 3.8). Although the size of public pension funds is large, four countries (South Korea, Malaysia, China and Singapore) accounted for 88 per cent of total public pension assets. South Korea alone accounted for 38 per cent of the total. Figure 3.8 East Asia: Public Pension Assets 35 East Asia-Public Pension Assets (2010) :US$ 774 billion Sources: Official websites Malaysia has the most developed pension funds when measured as a percentage of GDP. At the end of 2010, the size of the public pension fund industry in Malaysia was 60 per cent of GDP, followed by Singapore (55 per cent) and South Korea (28.1 per cent). Indonesia had the lowest ratio of 1.6 per cent, a little below 2 per cent for China. The Philippines and Thailand also have small public pension funds for P a g e 35

38 country specific reasons that are discussed in Annex 1. The size of the pension fund industry in East Asia has considerable potential to grow relative to the levels achieved by some OECD countries (Figure 3.9). Figure 3.9 Size of Pension Funds as per cent of GDP in Selected Countries (2010) 36 The pension fund industry in East Asia has played an important role in developing domestic capital markets, especially the equity market. However, their role in developing the bond market, especially the corporate bond market, has been modest. These public pension funds are subject to investment policies and asset allocation that are prescribed by the governments. Their focus is the safety of the assets. As a result, most pension funds invest heavily in government securities and bank deposits. Malaysia and Singapore are the two exceptions. The Employee Provident Fund (EPF) in Malaysia has played an important role in developing the local bond market and has financed large infrastructure projects. The Central Provident Fund of Singapore (CPF) is mandated to invest in non-tradable Government of Singapore securities. The Government Investment Corporation (GIC) is the investment organisation that invests in a broad range of assets globally. Insurance. The insurance industry in East Asia has started to grow in step with rising income and savings. At the end of 2010, the total size of the insurance industry (life and non-life) was US$409 billion in terms of premiums (Figure 3.10). As shown in Figure 3.10, China and South Korea together accounted for 80 P a g e 36

39 per cent of premiums. However, China s insurance industry is at a very early stage of development. Insurance premium as a percentage of GDP for China was only 3.8 per cent compared with 11 per cent for South Korea and Hong Kong. The comparable ratio in US and Europe was about 7.8 per cent (data from Swiss Re) in Insurance markets in South Korea and Hong Kong are at an advanced stage. Unlike Chile, the insurance industry in East Asia has played a very limited role in the development of the corporate bond market due to regulatory constraints placed on the insurance industry. 250,000 Figure 3.10 East Asia: Insurance Industry East Asia: Insurance Industry Premium in US$ million, , , ,000 50, Source: Sigma-Swiss Re Foreign investors. Local currency bonds have now become an acceptable asset class for institutional investors in developed markets due to their high yields and potential currency appreciation supported by improving macroeconomic condition. East Asian countries have attracted international portfolio investors. Since China, the largest market, is only partially open, foreign investors have been investing in markets that are relatively open and have limited impediments (exchange controls, withholding tax and other administrative barriers). Malaysia, Indonesia, Hong Kong and the Philippines have been the major recipients of foreign portfolio investment in bonds. A large amount of investment has also gone to the Chinese bond market through the Non-Deliverable Forward (NDF) markets. Thailand has also experienced large inflows before it decided to reinstate a 15 per cent withholding tax on interest income on bond investment to stem speculative flows. At the end of 2010, the total foreign portfolio component of East Asian debt securities amounted to US$405.7 billion (Figure 3.11). The largest investors were from European countries (30 per cent) followed by Hong Kong (19 per cent), US (17 per cent) and Singapore (13 per cent). Thus far, there has been limited inter-east Asia investment. P a g e 37

40 Figure 3.11 Top 10 Investors in East Asian Debt Securities (2010) Top 10 Investors in East Asian Debt Securities ($405.7 billion) International Organisation + SEFER (CPIS) (*) 3% Thailand 3% Switzerland Japan 7% 1% Malaysia 1% Norway 1% All others 5% EU 30% Singapore 13% United States 17% China, P.R.: Hong Kong 19% Source: IMF Major Bond Market Development Initiatives in East Asia ( ) Since 1998, the East Asian countries have made concerted efforts to develop domestic bond markets to avoid the currency and maturity mismatch in the banking system that triggered a major crisis following the devaluation of the Thai Baht in July The utility of domestic bond markets became apparent to key policy makers in East Asian countries. Collaborative efforts were made on several fronts. Among the major initiatives were: (i) the Asian Bond Market initiative (ABMI) under the leadership of the Ministries of Finance of ASEAN+3, and (ii) Asian Bond Funds under the leadership of the central banks of the EMEAP. The ADB provided the necessary administrative support and financial resources through its technical assistance programmes to the ASEAN+3 member countries. The basic mandate of ASEAN+3 was to tackle supply side problems and help remove impediments that constrained the functioning of domestic bond markets in these countries and create favourable conditions for issuing of bonds in the local market. EMEAP addressed the demand problem by creating investment vehicles at the regional level and at each country level through the Asian Bond Fund initiatives. P a g e 38

41 3.4.1 The Asian Bond Market Initiative (ABMI) In 2003, the ASEAN+3 countries launched the Asian Bond Market Initiative (ABMI). ASEAN+3 countries have undertaken reform efforts, ranging from unifying government bond issuing authorities to simplifying corporate bond issuance procedures for securitisation by removing barriers for bond issuance by domestic and foreign entities. Regulatory reform efforts gained momentum at a March 2009 ASEAN+3 summit, 8 where a new Asian bond market roadmap was developed. The roadmap facilitates demand for local currency-denominated bonds, and recommends additional legal framework and infrastructure improvements for bond markets in the region. The ABMI initiatives have contributed substantially to the growth and diversity of issuers in domestic bond markets in East Asia. Two additional key market infrastructure organisations: The Asiaclear and the Asia Credit Guarantee Corporation have also been established to facilitate trading and issuance of below investment grade corporate papers. By working together and through peer pressure, all eight East Asian countries have been able to build the necessary market infrastructures that are efficient and of a high standard. Regulatory systems are also being developed rapidly and are benchmarked against international standards set by IOSCO and BIS. Annex 1 provides more detailed discussions on the eight countries. Bond market information in individual countries is now available from the Asiabondonline website operated by the ADB. Several expert groups have been set up to address issues related to cross border investment in these bond markets. Overall, the efforts have paid off in terms of creating the necessary infrastructure in most East Asian countries to largely reverse the original sin, i.e., the inability to borrow abroad in their own currencies, a problem that led countries to borrow in foreign currencies. However, major problems remain in Indonesia and the Philippines that have small domestic investor bases The Asian Bond Fund (ABF) Initiative The main goal of the EMEAP was to use a small part of its member foreign exchange reserves to create investment vehicles that can demonstrate the attractiveness of domestic bonds to a broad range of investors at the regional and national levels. The ABF1 of US$1 billion was launched in 2003 to buy East Asian government bonds denominated in US dollars. A more ambitious programme under the second phase of the ABF2 that was launched in December 2004 consisted of the PAIF and six ETFs. A new Asia Bond Index was built by Markit, an index company, to benchmark the performance of these bonds. The PAIF is a passively managed fixed income ETF with low cost. State Street was selected as the manager of PAIF, which is listed on the Hong Kong Stock Exchange and domiciled in Singapore. EMEAP member central banks allocated US$2 billion for the funds to invest in domestic currency bonds issued by 8 Press statement by the ASEAN+3 meeting on Global Economic and Financial Crisis, March 1, P a g e 39

42 sovereign and quasi-sovereign issuers in the EMEAP markets. Australia, Japan and New Zealand were excluded. In addition to the PAIF, eight ETFs were to be established in the eight East Asian countries. This was a considerable challenge given that most countries did not have ETFs and the regulatory framework for setting up such funds. Each country was expected to create a local bond benchmark to measure the performance of local fund managers that were selected through a competitive process. The basic concept was that the involvement of EMEAP central banks as investors will be temporary and cease once domestic local currency bonds become an asset class that is accepted by market participants and investors. The ABF Pan Asia Bond Index Fund (PAIF). The PAIF was listed on July 7, 2005 on the Hong Kong Stock Exchange with US$1billion. As of January 31, 2012, the size of the fund was US$2.7 billion. One of the binding constraints for the PAIF was that it has to track the underlying index to minimise tracking errors. It also has to maintain investment grade rating on its investment portfolio. As a result, almost 70 per cent of the portfolio was invested in four markets (China, Hong Kong, South Korea and Singapore) that have investment grade ratings (Figure 3.12). Figure 3.12 ABF PAIF: Country Weighting (Jan 31, 2012) 40 Since its inception, the PAIF has delivered a respectable return averaging 7.7 per cent per year. Most of the extra returns of the PAIF portfolio are from its investments in Indonesia and the Philippines and have produced much higher returns than the top four countries. Although the performance of the PAIF has been good, it has consistently lagged the Markit index (Figure 3.13), as it is subject to withholding tax and other costs that are not included in the calculation of the index. P a g e 40

43 Figure 3.13 ABF PAIF: Annualised Return While the PAIF can be considered a success, the introduction of fixed income ETFs in markets outside of Hong Kong and Singapore has not been as successful due to regulatory and tax issues. Since the ETF industry is relatively new in East Asia and many countries have yet to establish equity ETFs, the introduction of fixed income ETFs was a little ahead of prevailing market conditions. In Malaysia, it took considerable time for authorities to create the necessary regulatory frameworks to establish ETFs. There are still no fixed income ETFs in China, Indonesia and Thailand. However, the ABF2 succeeded in selecting fixed income fund managers in eight markets to give a boost to the fixed income management industry. Lower interest rates reduce the attractiveness of fixed income ETFs and therefore they have not been successful with retail investors. Liquidity in fixed income ETFs has been limited. 41 Although the outcomes of the ABF2 are not what the authorities had hoped for, the ABF initiatives succeeded in gaining the attention of international fixed income investors. Since 2005, the East Asian local currency bonds have become an attractive asset class for emerging market bond investors, as well as cross-over investors looking for high yield and potential currency appreciation. The efforts made by the authorities to build market infrastructures have greatly facilitated inflows from international investors. Countries with open capital accounts and no tax, quantitative and other barriers have attracted large bond flows. Singapore, Hong Kong, Malaysia and Indonesia are good examples. Countries with open/close systems such as South Korea and Thailand have experienced more volatility due to lack of clarity about their policy stance on foreign portfolio investments in fixed income markets. The ABF initiative has been partially successful in developing corporate bond market as the PAIF invested only in sovereign bonds. P a g e 41

44 4 East Asian Bond Market in East Asian Economy East Asian economies were able to weather the global financial crisis reasonably well and expected to resume their historical growth path, albeit at a slower rate. Given the globalisation and close integration of the East Asian countries in the world economy, any projection of future growth involves a large margin of error. However, an estimate of nominal GDP growth rate of the East Asian countries for the period is given in Table 4.1. These projections are based on information available in the public domain (such as the IMF) and the author s estimates. Table 4.1 East Asia: Projected Nominal GDP Growth Rate ( ) East Asia: Projected Nominal GDP growth rate ( ) Actual (%) Projected(%) China Hong Kong SAR, China Indonesia Korea, Rep Malaysia Philippines Singapore Thailand Vietnam India Japan Sources: IMF WEO and author's projection In order to grow at the projected level, countries such as China, South Korea, Malaysia and Thailand will need to invest large amounts of funds in basic infrastructure, housing and capital intensive industries, to support the industrial transformation of these economies from labour-intensive based to capital and knowledge-intensive value creation. Other countries with high populations will require considerable investment in housing and infrastructure. The transition from labour to capital intensive and a rural to an urban society will require long-term funding. Further deepening of financial markets will be needed to meet the requirements of the real sector for both public and private investment. Further development of capital markets, both debt and equity, will be inevitable. The banking sector s ability to provide long-term funding will also be constrained by the new capital and liquidity requirements of Basel III. An estimate of projected private fixed investment over by country is given in Table 4.2. Private fixed investment over the period is estimated at US$37.7 trillion, with China accounting for US$25.7 trillion or 68.2 per cent of the total. China is expected to grow at a real rate of about 7.5 per cent P a g e 42

45 between 2011 and With the second largest population in East Asia, Indonesia is expected to invest US$4.7 trillion to sustain a projected real growth rate of 6 per cent. Thailand will also need to invest about US$1 trillion. Table 4.2 East Asia: Projected Private Fixed Investment Projected Private fixed investment (US$ Billion in current prices) % China, People's Rep. of 1,391 25, % Indonesia 230 4, % Korea, Rep. of 237 3, % Thailand 60 1, % Hong Kong, China % Singapore % Philippines % Malaysia % Eas t As ia 2,070 37, % India 339 6,654 Japan ,121 Source: IMF, WEO and author's forecast Out of the estimated US$37.7 trillion in private fixed investment, a substantial amount will be invested in infrastructure projects. Asia s infrastructure financing requirements from 2010 to 2020 are estimated at US$8 trillion (Figure 4.1). It is expected that there will be a growing mobilisation of public-private partnerships (PPP) in financing these investments. An obvious question is whether Asia can finance such large investments in the run-up to 2020 period. The answer is a qualified yes. The East Asian countries have large domestic savings. They are also deepening their financial markets so they could meet their financing requirements from domestic savings. However, there is a mismatch in the savings and investment duration with investor preferences and constraints. The large pool of savings is with commercial banks and mutual funds that are not suited to undertake investments in projects with long pay-off periods. Pension and insurance industries are still relatively small. Therefore, further transformation and deepening of financial markets will be required to meet the large investment requirements and to support desired economic growth. 43 P a g e 43

46 Figure 4.1 Asia s Infrastructure Investment Requirements, ASIA'S INFRASTRUCTURE INVESTMENT REQUIREMENTS, : US$ 8 trillion 4, , , , , , , , Energy (electricity) Telecommunications Transport Water and Sanitation Source: Infrastructure for Seamless Asia, ADB/ADBI, 2009 It should not be construed that the bottleneck in infrastructure investment is due primarily to the lack of infrastructure financing. The reality on the ground is that many of the required infrastructure projects cannot be implemented due to design capacity at the project level and capacity of local authorities to supervise and implement such projects that cut across many jurisdictions. In many instances, infrastructure projects were delayed due to the lack of coordination and cooperation between different levels of government, tariff negotiations, funding required to enable land acquisitions, changes in legislation and governance issues in implementing such projects. Even though PPP projects resolve some of these governance issues, the experience with some of these projects has also been controversial. In short, authorities implementing large-scale infrastructure projects need to pay more attention towards governance of such projects. Experience so far suggests that if the management of such projects has credibility, funding can be raised at both domestic and international levels from either infrastructure funds or long-term investors. However, financing such projects in local capital markets will avoid currency risks The East Asian Bond Markets in 2020 A Forecast The size of the East Asian bond market is projected to triple from US$5 trillion in 2010 to US$17.8 trillion by 2020 (Figure 4.2). This forecast takes into consideration: i) projected growth of East Asian countries over the period; ii) projected private investments in each country; iii) current financing patterns P a g e 44

47 % in each of the eight countries and corporate finance practices; and iv) specific bond market structures of each country. Figure 4.2 East Asian Bond Market in 2020 East Asian Bond Market 2020: US$ 17.8 Trillion (Outstanding in US$ Billion) 20, , , , , , , , , , Sources: BIS to 2010, author's forecast 45 China will become one of the largest bond markets in the world by It is estimated that the size of the Chinese bond market will be about US$13.4 trillion in 2020 (Figure 4.3), accounting for 75 per cent of the East Asian bond market. The growth will be driven by China s massive investment requirements, demand for housing, urbanisation and investment in capital-intensive industries. China will need to further liberalise and deepen its financial markets. Figure 4.3 East Asian Bond Markets 2020 East Asian Bond Markets % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Hong Kong Philippines Indonesia Singapore Malaysia Thailand South Korea 1, , , , , , , , , , ,910.2 China 3, , , , , , , , , , ,415.7 P a g e 45

48 Box 4.1: China Dim Sum Bond Market The offshore renminbi market was first introduced in December 2003 when China and Hong Kong allowed banks in Hong Kong to offer retail renminbi services in deposits, remittances, and credit cards to local residents. Internationalisation of the Chinese currency has gained momentum since July 2007, when China Development Bank (CDB), one of three major Chinese policy banks, sold the first dim sum bonds (debt securities denominated in renminbi.) in Hong Kong. In 2007, the volume of dim sum bonds issued was about RMB10 billion. The issuance of these bonds rose to RMB16 billion in 2009 and RMB41 billion in In 2011, the issuance rose by 300 per cent to reach RMB166 billion (Source: The Hong Kong Monetary Authority (HKMA) and Standard Chartered Bank). China has been actively promoting dim sum bonds as a hedge against the depreciation of the US dollar. The wider use of the renminbi in global trade and finance can reduce the impact of the depreciating US dollar on China s US$3.2 trillion foreign exchange reserves. Dim sum bonds also provide investment channels for renminbi holders outside of China, paving the way for the currency to be convertible and making it more attractive for central banks to hold renminbi as part of their foreign exchange reserves. In July 2009, a pilot scheme was launched in Hong Kong by the HKMA to encourage cross-border trade settlement in renminbi, gradually allowing the steady development of an offshore renminbi business and leading to increased demand for renminbi-denominated financial services. The sale of dim sum bonds has grown rapidly from the third quarter of 2010 following a decision by the HKMA to give companies greater freedom to sell these bonds. At the same time, China made it easier for corporations to settle trades in renminbi. This decision made it advantageous for foreign companies with operations in China to raise renminbi in Hong Kong. In August 2010, McDonald s issued a 200 million renminbi bond, the first dim sum deal by an overseas non-financial company. Bond sales by Caterpillar, Volkswagen and Tesco and many other issuers could bring the total sale of dim sum bond to as much as RMB310 billion in 2012 (HSBC). In October 2009, China s Ministry of Finance launched three tranches of dim sum bonds totalling RMB6 billion (US$897 million) to retail and institutional investors in Hong Kong. This was China s first renminbi-denominated sovereign bond offering outside of the country and the largest offshore renminbi bond as of November The issuance was very well received by investors (three-times oversubscribed) and extended the CNH curve from three to five years. (Note: CNH denotes renminbi in Hong Kong to be distinguished from renminbi in mainland China.) Subsequently, the HKMA clarified the supervisory principles and expanded the operational arrangements of crossborder renminbi fund flows and the development of the renminbi business in Hong Kong (including the issuance of renminbi bonds in Hong Kong). Following these supervisory principles, any entity, (local or foreign), would be permitted to issue dim sum bonds in Hong Kong. This regulatory measure facilitated the development of dim sum bonds in Hong Kong, resulting in the diversification and internationalisation of dim sum bond issues. This landmark regulatory initiative also opened the doors to issuers from corporations as well as banks in Hong Kong and globally. In July 2010, Hopewell Highway Infrastructure Limited completed a dim sum bond issuance, marking the first corporate issuance following the announcement of the July 2010 supervisory principles (as mentioned above). In August 2011, China permitted onshore corporations to issue dim sum bonds in Hong Kong, and clarified and expanded renminbi repatriation routes, as well as expanding the scope of cross-border renminbi settlement cities to the whole of the mainland. In October 2011, the PBOC and China s Ministry of Commerce issued two circulars to clarify and further simplify the procedures and approval and/or notice requirements with regard to the repatriations of renminbi into and outside of China. In October 2010, the ADB launched a RMB1.2 billion (US$180 million) bond with a tenor of 10 years at an annual coupon of 2.85 per cent, extending the CNH curve from five years to ten years. This was its first dim sum bond issuance to be listed on the Stock Exchange of Hong Kong (HKSE). In November 2010, China s Ministry of Finance (MOF) issued RMB5 billion of government bonds to institutional investors as part of its plan to set a benchmark yield curve for other dim sum bonds. The MOF also offered RMB3 billion to retail investors. This offer by the MOF made at a time when China was not in need of funding, demonstrated the government s commitment to internationalise the renminbi. In December 2010, the renminbi trade settlement scheme was further expanded to increase the number of Mainland Designated Enterprises (MDEs) to 67,359 companies from 365, increasing the flow of renminbi outside of China. It helped the flow of renminbi into Hong Kong to support the growing supply of CNH (including deposits). In January 2011, due to stringent restrictions placed on China s banks by the government to curtail lending, funding through fixed rate dim sum bonds became an attractive alternative. Major Chinese banks have increasingly become active players in the dim sum bond market. In October 2011, the Bank of China (BOC) overtook HSBC Holdings Plc. (HSBC) as the top underwriter of renminbi bonds in Hong Kong (Bloomberg) after Vice Premier Li Keqiang allowed domestic companies to tap the city s lower borrowing costs. The BOC managed three dim sum bond sales valued at RMB2.7 billion (US$424 million) in October, for a 31 per cent share of all issuance, overtaking HSBC as the biggest underwriter of the year. There is a substantial potential for growth in the dim sum bond market given the continued development of China s domestic bond markets as discussed in Section 4 and the complementary role that Hong Kong plays given the current state of capital controls. 46 P a g e 46

49 The size of the bond market ex-china is projected to double from US$2 trillion in 2010 to US$4.2 trillion by The bond markets of South Korea, Thailand and Malaysia are expected to grow in line with their GDP growth (Figure 4.4). Bond markets in Indonesia and Philippines are likely to grow at modest rates due to their small domestic investor base and other structural issues. Growth of bond markets in Hong Kong and Singapore is expected to be in line with their GDP growth due to their comfortable fiscal position and limited investment requirements. Their role as financial centres will continue to grow with the growth in East Asian economies and regional financial market integration. Figure 4.4 East Asian Bond Markets 2020 (ex-china) 5,000.0 East Asian Bond Markets 2020 (ex-china) Outstanding in US$ Billion 4, , , , , , , , South Korea Thailand Malaysia Singapore Indonesia Philippines Hong Kong Sources: BIS ( ), Author's forecast ( ) A forecast of the composition of the East Asian bond markets by type of issuer is given in Figure 4.5. The composition of the bond market is expected to change notably over the period. The share of government bonds is projected to decline from 53.6 per cent of total in 2010 to 39 per cent in The share of corporate issuers is going to grow rapidly due to the growth in the Chinese corporate bond market. Corporate bond markets are also projected to grow rapidly in Malaysia, South Korea and Thailand. Issuance by financial institutions is also likely to grow to meet rising demand from retail investors. P a g e 47

50 Figure 4.5 East Asian Bond Market 2020: By Type of Issuer East Asian Bond Market 2020 by type of issuers (Outstanding in US$ Billion) 20, , , , , , , , , , Source: BIS (2011). Author's projection ( ) Governments Fis Corporates 4.3 Investor Base The growth rate in East Asia is expected to moderate over the period given the sluggishness in developed markets that are the major buyers of East Asian exports. However, these economies are still going to grow, albeit at a slower rate of five to six per cent per annum. Economic growth is likely to be increasingly driven by domestic demand with rising incomes and consumption. The investor base in East Asia is going to grow rapidly, especially in China, Hong Kong, South Korea, Malaysia, Singapore and Thailand. The growth of the domestic investor base in Indonesia, Philippines and Vietnam is likely to be modest due to the small size of their investor base and structural issues that impede the development of domestic institutional investors. The potential for development of the investor base in these countries does exist but will require major policy reforms. 48 The size of the investor base in 2020 is forecasted at about US$12.4 trillion (Figure 4.6), based on the past growth patterns of the three major sectors: mutual funds, pension funds and insurance. It is projected that the mutual fund industry will remain the largest segment of the investor base, with about 66 per cent of the market, followed by pension funds (25 per cent) and insurance funds (9 per cent). The pension industry in East Asia, especially China is expected to grow rapidly during P a g e 48

51 Figure 4.6 East Asia: Projected Investor Base 2020 East Asia: Investor Base 2020 US$12.4 trillion 14, , , , , , , , , Source: Author's forecast , , Mutual Funds Pension Insurance 49 P a g e 49

52 5 Agenda for the Future The growth of the East Asian bond markets between 2000 to 2010 was spectacular as evidenced by the growth in the overall market, the successful building of key market infrastructures (trading, clearing and settlements) and other supporting market structures (credit rating, bond pricing and market intermediaries). The government bond markets for all eight East Asian economies reviewed in this paper are now well developed. Efforts made at the national and regional level in harmonising bond market rules and regulations have been largely successful. Ongoing efforts to develop regional bond markets are also moving in the right direction. 9 Overall, the East Asian bond market has become a role model for other emerging market countries planning to develop their domestic bond markets. The future deepening of the East Asian financial markets looks good, but there is more work that needs to be done to build a more complete debt capital market. The key areas that need the attention of policy makers in East Asia are: Further development of corporate bond markets; Investor base; Taxation of debt instruments; Risk management products; and Development of pan-asian fixed income products Corporate Bond Market The development of corporate bond markets in East Asia has been uneven and has lagged behind the development of government bond markets. Malaysia and South Korea have been successful in developing corporate bond markets that are very large by international levels when measured as a percentage of GDP. Corporate bond markets in Indonesia and the Philippines are still at an early stage of development. In Thailand, the corporate bond market is growing but very much constrained by the limited number of issuers with high credit rating. In China, most corporate issuers are government controlled organisations or government financial institutions. Major companies in Hong Kong and Singapore have multiple funding options. 9 Since 1997, there has been a massive increase in research on local currency bond markets in Asia. ADB, ADBI, EMEAP, World Bank, IMF, OECD and academics have contributed to the literature in this field. This study tries to capture recent developments and ongoing efforts in East Asia. P a g e 50

53 In order for corporate bond markets to develop there are several preconditions that have to be met. First, a country has to have a number of large issuers who have continuous need for funding. It is generally cheaper for large blue chip companies to raise money from the banking system as they are considered the safest clients for banks. Transaction costs for issuing bonds are generally higher than bank loans, so measures have to be taken to bring these costs down to make it attractive for the major corporations to issue bonds in local currency. Second, there has to be a sizeable institutional investor base that stands ready to invest in corporate bonds. In most East Asian countries, government pension funds and insurance companies have limitations on their ability to invest in corporate bonds and equity. The Chilean experience should be of interest to East Asian countries. In Chile, insurance companies are the major investors in corporate bonds with maturity ranging from three to ten years, as they are required to match their liability with long-term debt instruments. Third, to develop a liquid secondary market in corporate bonds will require large and well capitalised financial intermediaries that have access to long-term funding either from official sources or a private repurchase agreement (repo) market will have to be developed. Fourth, a pan-asian corporate bond market should be created to enable large corporations to issue their debt in any East Asian currency of their choice. This could be achieved through the issuance of a series of the Asian corporate bond funds, with partial guarantee from the newly established Asia Credit Guarantee Corporation. This will facilitate development of ASEAN fixed income markets. More structured products with credit enhancement should also be encouraged. 5.2 Investor Base 51 Although the domestic institutional investor base in East Asia is large and growing, it has played a limited role in developing capital markets, especially the bond market. The largest investors in government bonds in East Asia remain commercial banks that are mandated to hold government securities to meet reserve requirements. In China, reserve requirements are still used as one of the monetary policy tools of the PBOC. In the Philippines, fiscal crowding has made it more attractive for commercial banks to invest in government securities than to lend to the private sector. In Malaysia and Singapore, institutional investors have played active roles in developing domestic capital markets, both equity and bonds. In South Korea, the National Pension Service (NPS) is required to follow a very restrictive asset allocation that limits its ability to invest in domestic equity and bonds. Because of the regulatory constraints and restrictive investment policy in several countries, resources mobilised through pension funds and insurance companies have been largely used to invest in government securities or bank deposits. There is clearly a need to review these policies in light of the desire to improve resource intermediation to meet the large financing needs of both public and private sectors in the future. The investor base in Indonesia and the Philippines is likely to remain small unless concrete measures are taken to address structural problems that have limited growth of the contractual savings industry. The size P a g e 51

54 of pension funds in both countries is small and there is a clear need to take additional action to deepen the pension and insurance sectors, both public and private. 5.3 Taxation of Debt Securities The ABMI and the ABF2 made substantial progress in harmonising the tax regime for foreigners to invest in the bond markets. Seven out of eight countries adopted the same tax regime for foreign investors by removing withholding tax on both interest and capital gains. The Philippines was the only country that kept the withholding tax on interest income on government bonds. The progress was partially reversed in 2010 and 2011 when Thailand and South Korea re-imposed a withholding tax on interest income on government bonds to discourage excessive speculative foreign portfolio investment in their domestic bond markets. As shown in Table 5.1, East Asian countries now have different tax regimes. This is likely to inhibit development of regional bond markets. Given the low historic interest rates, withholding rates reduce yield and reduce the attractiveness of debt instruments. There is clearly a need for policy makers to address this issue at the national and regional level. Withholding tax on fixed income is also likely to inhibit growth of fixed income exchange traded funds. Withholding tax also increases transaction costs and reduces liquidity in secondary markets. Table 5.1 Taxation on Foreign Investment in Local Currency Government Bonds Taxation on returns from foreign investors' holdings of local currency government bonds 52 Withholding tax on interest income Capital gain tax China 10% none Hong Kong, China none none Indonesia 15-20%, reduce through ta treaties none Korea 14% 14% Malaysia none Philippines 20% of income earned none Singapore none none 15% of income earned, 15%, reduce through tax reduce through tax treaties Thailand treaties Sources: BIS (paper 63), J.P.Morgan (Local Market Guide), 2011 P a g e 52

55 5.4 Risk Management Products The development of liquid bond markets requires the existence of risk management products, such as interest rate and currency swaps, credit default swaps and other derivatives. These products exist in Hong Kong and Singapore. South Korea has also been developing these products. However, derivative markets are still at an early stage of development in the remaining five markets. Malaysia has made notable progress in developing a derivatives market. There is clearly a need to foster development of derivatives markets in all countries to enable development of a regional bond market. The existence of well functioning domestic derivative markets will also encourage foreign borrowers to tap into these markets. This in turn will improve liquidity and create investment products for domestic institutional investors. 5.5 Pan-Asian Fixed Income Products The ABF2 PAIF has been a good initiative that has paved the way for future pan-asian debt products. However, this has not happened due to constraints at the national and regional level. Withholding tax and foreign exchange controls are two good examples. The authorities should consider providing incentives for development of pan-asian fixed income products through the development of fixed income fund managers in the region. This could be achieved by outsourcing some public pension funds for investment in fixed income in the region. Tax incentives should also be considered for investments in pan-asian, high yield bond funds or corporate bond funds. 53 P a g e 53

56 References Asian Bond Monitors, Asianbondonline ADB: ASEAN+3 Bond Market Guide, ADB, ASEAN+3 (2009): The joint media statement of the 12th ASEAN plus Three Finance Ministers Meeting, Bali, Indonesia, 3 May 2009 ( BIS, Paper Number 63, Weathering financial crises: bond markets in Asia and the Pacific, Jan Bank Indonesia ( Bank of Korea ( Bank of Thailand ( Bank Negara Malaysia ( Bangko Sentral ng Pilipinas ( CGFS (2007): Financial stability and local currency bond markets, CGFS papers, no 28. Dalla, Ismail, The Emerging Asian Bond Market. Washington, D.C.: World Bank. June. Dalla, Ismail, Asia s Emerging Bond Markets. London: Financial Times Publishing. Dalla, Ismail, and Yoon-Shik Park The Korean Bond Market-Post Asian Crisis and Beyond. Seoul: Korea Stock Exchange. June. 54 Dalla, Ismail, Harmonization of Bond Market Rules and Regulations in Selected APEC Economies, ADB Dalla, Ismail and Jae Hoon Yu, The Korean Bond Market-The Next Frontiers, KSDA, June 2008 Eichengreen, Barry, 2006, The Development of Asian Bond Markets in Asian Bond Markets: Issues and Prospects, BIS Papers 30. EMEAP (2006): Review of the Asian Bond Fund 2 Initiative, EMEAP Working Group on Financial Markets, June. Gyntelberg, Jacob, Guonan Ma and Eli Remolona, 2006, Developing Corporate Bond Markets in Asia, in Developing Corporate Bond Markets in Asia. BIS Papers 26. Hong Kong Monetary Authority ( the Hong Kong Debt Market in Ibrahim, bin Muhammad and Adrian Wong, 2006, The corporate bond market in Malaysia, in Developing Corporate Bond Markets in Asia. BIS Papers 26. Regional Economic Outlook, IMF, October Joshua Felman, Simon Gray, Mangal Goswami, Andreas Jobst, Mahmood Pradhan, Shanaka Peiris and Dulani Seneviratne, ASEAN5 Bond Market Development: Where Does it Stand? Where is it Going? IMF -Working Paper (WP/11/137), IMF, Global Financial Stability Reports ( ) IMF, The Challenge of Public Pension Reform in Advanced and Emerging Economies, P a g e 54

57 Monetary Authority of Singapore ( Ministry of Finance, Thailand (www2.mof.go.th) Organisation for Economic Co-operation and Development, 2009, Pensions at a Glance Special Edition: Asia/Pacific (Paris: OECD Publishing). OECD-ADBI, Annual Roundtable on Capital Market Reform in Asia, Selected Papers, Securities Commission, Malaysia, Capital Market Masterplan, Securities Commission, Malaysia, Capital Market Masterplan 2, Sheng, Andrew, The New Global Financial Landscapes: Asia Beware?, IGE/IMF International Confernce, Seoul, Sheng, Andrew, How to Develop Capital Markets in East Asia, Section 2, Capital Market Reform in Asia, ADBI, Spiegel, Mark M., 2009, Developing Asian Local Currency Bond Markets: Why and How, ADBI Working Paper Vol.182 (Japan). 55 P a g e 55

58 Annex 1: East Asian Bond Markets A. The People s Republic of China A.1 Introduction The People s Republic of China is now the largest local currency emerging bond market in the world. At the end of 2010, the size of Chinese bond markets was US$3 trillion. Since 2000, the size of the bond market has increased by fifteen times. The bond market has increased rapidly since 2005 following major reforms taken at the country level and partly through the overall ABMI. Although the size of the bond market is very large (51 per cent of GDP in 2010), it is smaller than Malaysia, South Korea and Thailand as a share of GDP. The bond market is gradually opening to foreign investors through the qualified foreign institutional investors (QFII) programme. In April 2012, the limit for QFII was doubled from US$40 billion to US$80 billion. The Chinese bond market is now also accessible through the Dim Sum bond market in Hong Kong, which trades renminbi bonds issued in Hong Kong. A.2 Regulatory Frameworks 56 The Chinese bond market is regulated by several government agencies. The People s Bank of China (PBOC), the central bank, supervises and regulates the interbank market, approves the sale of short-term corporate bills and commercial papers issued by securities firms. The China Securities Regulatory Commission (CSRC), the executive arm of the State Council Securities Commission, supervises the bond markets and exchanges, and is in charge of regulating issuances of corporate bonds of publicly listed companies on the exchanges. The CSRC also licenses securities companies, dealers, investment advisers, fund management companies, and QFIIs. The National Development and Reform Commission (NDRC) regulates the issuances of non-listed enterprises, mainly large state-owned enterprises; approves issuance of corporate bonds; and sets quota allocations. The Ministry of Finance (MOF) approves issuance of treasury bonds. The MOF, together with the State Administration of Foreign Exchange (SAFE), approve Yuan bond offerings by international organisations in China (Panda bonds). The China Banking Regulatory Commission (CBRC) supervises and regulates all deposit taking institutions, related asset managers, in addition to taking on the role of approving, jointly with the PBOC, commercial banks issuance of asset- and mortgage-backed securities and other financial bonds. The MOF, PBOC, CBRC, and CSRC supervise the general custodian, the China Government Securities Depository Trust Clearing Co Ltd. (CGSDTC). In September 2007, The National Association of Financial Market Institutional Investors (NAFMII) was established as the self-regulatory organisation of the OTC market under the supervision and guidance of the PBOC. NAFMII has been active in both the primary and secondary markets. It is also responsible for protecting investors interest in corporate bond market. P a g e 56

59 US$ billion A.3 Size and Composition of the Chinese Bond Market Figure A.1 provides an overview of the Chinese bond markets over the period and by type of issuer. The bond market in China is primarily a government bond market. At the end of 2010, the size of the government bond market was US$1.6 trillion or 53.5 per cent of the total, followed by financial institutions (29.2 per cent) and corporate (17.2 per cent). The corporate bond market is still at an early stage of development and issuers consist largely of government-controlled entities. Figure A.1 China: Bond Outstanding by Type of Issuer China: Bond Outstanding by type of Issuers (June) Corporate Fis Government Source: BIS A.4 Bond Market Structure An overview of the structure of the Chinese bond market is given in Figure A.2. China s bond market consists of two main markets: the more liquid and larger OTC market, and the exchange market. The OTC market includes the interbank market and the bank OTC market. Most government bonds are traded in the OTC market. Corporate bonds are traded on the two stock exchanges. The interbank market is a quote-driven OTC market, with deals negotiated through an electronic trading system (ETS) between two counterparties. It is a wholesale market for institutional investors. Its primary participants are accredited market dealers, financial institutions, and the PBOC. The interbank bond market is used by the government as a platform to raise funds through bond issuance, for financial institutions to adjust liquidity and rationalise assets, and for the PBOC to conduct open market operations for monetary policy. Central bank bonds, commercial paper and medium-term notes, the most actively traded products in the Chinese bond markets, are solely traded in the interbank market, which is China s dominant market accounting for over 90 per cent of total bond trading. P a g e 57

60 The exchange market is an order-driven market targeting small, medium and individual investors. The two exchanges are the Shanghai Stock Exchange and the Shenzhen Stock Exchange, where trading of treasury, corporate and convertible bonds takes place. They also serve as a secondary market for government bonds, including repurchase agreements and spot trading. Commercial banks have generally been prohibited from trading in this market, but a pilot programme has allowed them to do so. Other participants gain access to the exchange market through securities companies brokerage services. Until August 2008, QFIIs were only permitted to access the exchange market. Since then the PBOC has permitted three types of institutions, including overseas renminbi participating banks, to enter the interbank bond market on a pilot investment programme. Figure A.2 Overview of the Chinese Bond Market Structure 58 In China s bond market, bonds can be issued by tender through the issue system of the PBOC and by book building. Currently, Treasury bonds (T-bonds) and policy bank bonds are issued by tender through PBOC s issue system, while credit products are issued mostly through book building in the central bookentry system. With the rapid development of credit bonds since 2009, the market can substantially accept bonds with a relatively high credit rating. A.5 Issuers Government. The government is the largest issuer in the bond market and it accounted for 53 per cent of outstanding bonds at the end of The Ministry of Finance (MOF) is the main issuer of government bonds. To meet its financing requirements, the MOF issues four types of debt securities: certificate P a g e 58

61 treasury bonds, electronic savings bonds, book-entry T-bonds, and local government (municipal) bonds. TT-bonds are issued simultaneously through both the interbank (OTC) and exchange markets. The 7-year T-bond is the local currency benchmark in China. The 2-year and 5-year T-bonds serve as short-term benchmarks. The auctions are limited to 61 primary dealers and other financial institutions. Liquidity in the interbank market has steadily improved due to the PBOC s policy of adding more institutional investors. In 2011, inflation-linked government bonds were issued for the first time in China. The MOF is responsible for issuing municipal bonds for local governments and the first issuance was in Their yields are comparable to T-bonds and carry a semi-sovereign rating (J.P. Morgan). There is poor liquidity in the secondary market for these bonds as they are mostly held by large commercial banks until maturity. In October 2011, provincial governments and municipalities were permitted to issue bonds under their own name. Financial Institutions. Financial institutions account for about 30 per cent of the bonds outstanding at the end of The PBOC is one of the main issuers in the domestic bond market. The PBOC issues central bank bonds/bills (CBB) to investors the commercial banks only in the interbank market to conduct monetary policy. Policy banks are government-owned and raise funds through bonds to meet their lending mandates prescribed by the central government. The three policy banks are: the China Development Bank (CDB), the Export-Import Bank of China, and the Agricultural Development Bank of China. The policy banks issue bonds to fund large infrastructure projects and the CDB is the largest and most important issuer. Bonds of these policy banks are actively traded in the interbank market. 59 Corporate Bond Markets. The corporate bond market is small but growing rapidly. At the end of 2010, the size of corporate bond market was US$522 billion, or 17.2 per cent of the total bond market. The Chinese corporate debt market is now the largest in emerging market countries, overtaking that of South Korea. Prior to 2008, corporate bond issuance was limited to state-owned enterprises and corporate issuance required bank guarantees. Chinese companies are heavily dependent on the banking system for their funding requirements. The corporate bond market has grown rapidly since 2007 with the introduction of the Pilot Rules on the Issuance of Corporate Bonds in These rules facilitated issuance of bonds by listed companies, and liquidity was enhanced by permitting these bonds to be traded in the interbank market. Short-term financing or commercial paper bonds have been issued in the interbank market since 2005 and their issuance is restricted to non-financial corporations with very good credit ratings. Medium-term notes (MTNs) were launched in 2008 and are issued by large listed companies in the interbank market. Credit rating is mandatory for corporate bonds. A small number of state-owned issuers account for a large share of China s corporate bond market. In February 2012, 25 out of the top 30 issuers were state-owned enterprises. P a g e 59

62 A.6 Other Market Infrastructure Credit Rating Agencies. There are currently eight major credit rating agencies in China s bond market. Two of them are foreign joint-ventures; one is engaged in a technical co-operation with a foreign enterprise and the remaining five are locally owned. The leading domestic rating agency is Dagong Global Credit Rating Company. The PBOC is the main supervisory authority of the credit rating industry and is responsible for issuing relevant rules and regulations governing the credit rating system. The CSRC supervises credit rating in the exchange bond market while the NDRC oversees the credit rating for enterprise bonds. Depository. The China Government Securities Depository Trust & Clearing Co. (CGSDTC), or the General Custodian, is the first-tier depository for the entire bond market. It clears transactions and serves as the direct depository for the interbank market, in addition to serving as the second-tier general depository. Commercial banks also act as OTC market second-tier depositories. Settlement is done on a trade-by-trade basis on real time gross settlement basis (RTGS). In the exchange market, the China Securities Depository and Clearing Co. (CSDCC) acts as the second-tier depository. It clears and registers securities for trade on the markets. Transactions are cleared at the end of each day and the settlement cycle of trading is T+0. International bond issuances follow the International Securities Identification Number (ISIN) standards for bond identification. 60 A.7 Secondary Markets Both the China Central Depository and Clearing Co. (CCDC) and the China Foreign Exchange Trade System (CFETS) compile yield curves for the interbank bond market. CFETS calculates real-time and end-of-day yield curves on six benchmark bonds. The real-time yield curves are used as the benchmarks in China s interbank bond market. The first curve is published at 9:30 am on each trading day and updated hourly until the market closes. Since 1999, CCDC has been providing the Chinabond Yield Curves, used widely for pricing, trading, and performance evaluation by key market participants. Liquidity in the secondary market has also improved due to the development of the repo market. In China, there are two of types of repos: collateral repo and outright repo. The major difference between the two is that the latter involves transfer of bond ownership during the repo period while there is no transfer of ownership in collateral repo. In the OTC market, collateral repo accounts for over 97 per cent of total repo market in terms of trading volume. The terms of collateral repo transactions range from 1 day to 1 year, and are divided into 11-period categories, including 1-day (overnight) repo, 7-day repo (2-7 days), 14-day repo (8-14 days), etc. The terms of outright repo range from 1 day to 91 days. The most actively traded repos are in the 1-day and 7-day categories, which account for over 90 per cent of repo transactions. P a g e 60

63 Market participants include commercial banks, other financial institutions, non-financial firms and mutual funds. A.8 Investor Base The institutional investor base in China is relatively small and narrow in comparison to the size of its economy and savings rate. The financial system is dominated by the banking system. Banks are the largest investors in government securities, accounting for 74.9 per cent in Banks are required to hold government securities to meet reserve requirements (22 per cent in 2012) that are relatively large as the PBOC conducts its monetary policy through reserve adjustments as well as open market operations. The second largest group of investors is contractual saving institutions (10.8 per cent in 2010). Pension and insurance institutions are still in their infancy and have thus far played a very limited role in fostering growth of the bond market. The remaining government bonds were owned by a wide range of corporate, individual and foreign investors. An investor profile of government bonds is shown in Figure A.3. Figure A.3 China: Government Bonds: Investor Profile 120.0% China: Government Bonds: Investor Profile 100.0% 80.0% % 40.0% 20.0% 0.0% Banks Contractual Savings Institution Others Source: Asianbondonline Foreign Investors. Foreign investors can access Chinese bond markets through a qualified foreign institutional investors (QFII) programme that enables foreign firms to convert their foreign currencies into renminbi to invest in Chinese securities. Foreign investors must have QFII status as approved by the CSRC and the State Administration of Foreign Exchange (SAFE) before they can invest in China s securities market. A select few overseas central banks and strategic QFII investors have access to the interbank (OTC) market. QFII investors are awarded an investment quota (maximum US$1 billion), and are subject to a 10 per cent tax on their income derived from China, including on dividends, interest, and capital gains. A total of roughly US$22 billion of quotas for QFII had been granted as of December In April 2012, the government announced that the limit was to be doubled to increase foreign participation in domestic securities market, in which foreign presence was mainly from Hong Kong followed by European countries. Renminbi Qualified Foreign Institutional Investor (RQFII), a sister programme to QFII, was launched in late It permits renminbi-denominated funds to be set up in P a g e 61

64 Hong Kong by Chinese financial firms for investment in mainland China and facilitates investments of offshore renminbi deposits. Foreign investors can also have access to renminbi-denominated bonds issued outside China. These are known as Dim Sum Bonds (see Box 4.1). They were first issued in 2007 when China allowed banks, such as the CDB, to issue in Hong Kong. The MOF also issued Dim Sum Bonds in Hong Kong in Yields on Dim Sum Bonds are generally below local currency government bond as they are frequently used as a renminbi appreciation proxy. After restrictions were lifted in mid-2010, corporate Dim Sum Bond issuance has also increased dramatically. The quota for onshore issuers to offer renminbi bonds offshore has been increased to RMB50 billion. A.9 Taxation Taxation is based on the status of investors. Domestic qualified institutional investors are not subject to tax on interest income on T-bonds but pay 25 per cent on interest income from financial and corporate bonds. Domestic investors are subject to capital gain tax of 25 per cent. Foreign investors are subject to10 per cent withholding income tax on government bonds and bonds issued by financial institutions and corporations. However, they are exempt from capital gain tax. A.10 Prospects and Future Challenges 62 China has made notable progress in developing its domestic bond market, especially the government bond market. It is already the largest bond market among the emerging market countries. The Chinese bond market is expected to grow rapidly over the next decade, propelled by the needs for investment in the real sector such as infrastructure, housing, and other private investments. The high domestic savings rate that is expected to remain at a high level at least for the next decade will facilitate the growth of the bond market in China. However, the development of the bond market is facing several challenges and concerted efforts are required to develop robustness. Key areas that require policymakers special attention are: Development of domestic investor base. The domestic investor base in China is small relative to the size of its economy. Banks are currently major investors in government bonds and there is a need to broaden and diversify investor base. This will require a more rapid development of domestic pension and insurance industry. P a g e 62

65 Development of corporate bond market to enable more funding of private investment from nonbank sources which, in turn, will reduce systemic risks. The success in developing the corporate bond market will depend largely on the growth of domestic investor base. Deregulation of capital accounts to foster a more competitive financial market. Strengthening of the credit rating industry through joint ventures with international rating agencies. Introduction of additional risk management products to improve liquidity in the domestic bond market especially corporate bond market. B. Hong Kong, China 10 B.1 Introduction Hong Kong is now one of the world s largest financial centres. Prior to 1998, Hong Kong had no need to issue domestic bonds due to the comfortable fiscal condition of its government. The need for developing a domestic bond market became apparent after the Asian financial crisis. After 1998, the Hong Kong Monetary Authority (HKMA), the currency board/central bank, led the development of the local currency bond market through several initiatives. It put in place the necessary market infrastructure, developing a government yield curve out to a maturity of 10 years, a real time computerised book-entry settlement system for government and corporate bonds (CMU), and a mechanism to provide repo and reverse repo facilities to primary dealers. The financial system in Hong Kong is efficient, transparent, and provides the same treatment to domestic and foreign participants. The availability of a broad range of products for hedging and investment purposes has helped Hong Kong expand its role in the region and globally. The recent introduction of Dim Sum Bonds (renminbi-denominated bonds issued in Hong Kong) has added a new dimension to its bond market. 63 A key feature of the Hong Kong financial market is the operation of the currency board mechanism by the HKMA, which increases the credibility of the fixed exchange rate regime. The HKMA issues Exchange Fund Bond and Notes (EFBNs) to facilitate the development of domestic bond markets. Notes issued by the Exchange Fund, which is responsible for managing the HKMA s assets, form the benchmark curve. 10 Since Hong Kong is a major financial centre with highly developed financial markets, discussions here are abbreviated and limited to providing a snapshot of the bond markets. Websites of the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission provide comprehensive information on the Hong Kong bond market. Please see the publication: Hong Kong Debt Market in 2011 on HKMA s website for the latest developments in Hong Kong s bond market. P a g e 63

66 Under the rules of the currency board, liquid foreign currency assets must back all the liabilities of the HKMA, including EFBNs. EFBNs constitute direct, unsecured, unconditional and general obligations of the government for the account of the Exchange Fund and rank pari passu with all other unsecured indebtedness of the government for the account of and payable from the Exchange Fund. The EFBNs programme ensures the supply of a significant amount of high-quality Hong Kong dollar debt papers, which can be used as trading, investment, and hedging instruments. Authorised institutions that maintain Hong Kong dollar clearing accounts with HKMA can use their holdings of Exchange Fund papers to borrow overnight Hong Kong dollars from the discount window. B.2 The Bond Market At the end of 2010, the size of the domestic bond market in Hong Kong was US$65.5 billion, or 73 per cent of GDP. In 2009, the size of the bond market was US$100 billion as the government provided additional liquidity to domestic banks to combat the global credit crunch brought about by the deleveraging of financial institutions in developed markets. These programmes were terminated in 2010 with the improvement in global financial markets. The government was the major issuer in 2010 and accounted for about 46.9 per cent of outstanding bonds. Financial institutions accounted for 34.9 per cent, followed by non-bank corporates accounting for the balance of 18.2 per cent. The Hong Kong Mortgage Corporation was established in 1997 to develop Hong Kong s secondary mortgage market and remains one of the most active corporate debt issuer in Hong Kong dollar debt, with outstanding debt securities of HK$41.1 billion at the end of Corporate issuers have a broad range of options in funding their requirements. Hong Kong companies also prefer to raise money from the equity market that is one of the largest in the world. 64 Figure B.1 Hong Kong: Bond Outstanding by Type of Issuer Hong Kong: Bond Outstandings by type of Issuers (US$ billion) Corporate Fis Government Source: BIS P a g e 64

67 Dim Sum Bonds. Until 2007, bonds issued in Hong Kong were mainly denominated in Hong Kong dollars, US dollars or Euro. In July 2007, the China Development Bank issued the first renminbidenominated bonds. This market, also known as the Dim Sum market, has grown rapidly and reached RMB233 billion in Major multinational corporations such as McDonald s and Caterpillar have also taken advantage of this new market and issued bonds in renminbi to finance their investment in Mainland China. B.3 Investor Base The investor base in Hong Kong is well diversified and global as the market is open to international investors who are treated on par with local investors. Domestic investors include banks, insurance companies, public and private pension plans. The Mandatory Provident Fund (MPF), which has been growing since its establishment in 2000, is now a major institution with US$48 billion in assets at the end of Thus far, it has played a modest role in development of domestic financial markets as the plan operates like 401(K) plans in the US under which participants choose from a number of approved fund management schemes. Banking institutions and other government corporations, as well as private pension plans are the major investors in government bonds. Under the banking regulations in Hong Kong, banks have to keep 25 per cent of the deposits they accept in liquid assets. High-grade debt securities qualify as liquid assets. The investment subsidiaries of a number of central banks in the region are also significant buyers of investment-grade Hong Kong dollar bonds, as it is the proxy for US government securities. 65 B.4 Regulatory Frameworks The regulatory framework in Hong Kong is clearly defined and is comparable to other major financial centres. The HKMA, the central bank, was set up in 1993 by merging the Office of the Exchange Fund with the Office of the Commissioner of Banking. It is responsible for overall supervision of financial markets in Hong Kong and for maintaining monetary and financial stability. The laws governing the debt securities markets in Hong Kong are the Banking Ordinance, the Securities, Futures Commission Ordinance (SFCO), and the Companies Ordinance. HKMA is responsible for the regulation and supervision of banks, whereas the Securities and Futures Commission (SFC) regulates the listed companies disclosure requirements, the stock market, securities brokers, fund managers and capital market institutions and activities. There is close collaboration between the HKMA and the SFC. B.5 Bond Market Infrastructure The bond market in Hong Kong is mainly an OTC market. Few bonds are listed on the Hong Kong Stock Exchange. The HKMA owns and operates the Central Moneymarkets Unit (CMU) that serves as the central securities depository (CSD) in Hong Kong for debt securities involving EFBNs, government P a g e 65

68 bonds, government-related entity bonds and corporate bonds. The CMU also provides trade matching and bond settlement services for market participants and conducts end-of-day batch settlement on a net basis. However, it does not act as a Central Counterparty (CCP). Set up in 1990 by HKMA, the CMU provides settlement and custodian service for debt securities denominated in Hong Kong dollars and other major currencies. It also provides an electronic book-entry system. In December 1996, a seamless interface between the CMU and HKD RTGS system was established. Cash settlement of bond transactions is carried out through the Clearing House Automated Transfer System (CHATS), a computer-based system in Hong Kong for electronic processing and settlement of interbank fund transfers. CHATS operates in a RTGS mode between banks in Hong Kong. It is designed to handle large value payments between banks. Banks in Hong Kong using CHATS are connected to the clearinghouse computer operated by the Hong Kong Interbank Clearing Limited (HKICL). The settlement organisations under CHATS are the HKMA, Hong Kong and Shanghai Banking Corporation Limited (HSBC), Standard Chartered Bank (Hong Kong) Limited, and Bank of China (Hong Kong) Limited. B.6 Taxation Hong Kong has one of the most attractive tax regimes in the world. There is no withholding tax on dividends and interest income from debt securities. Interest income from bond holdings is not taxable for individuals. Interest on bonds issued by the government and government-related entities are not subject to corporate tax. Residents and non-residents investing in the Hong Kong market are exempt from withholding tax on dividends and fixed income interest. The HKMA has also extended the tax exemption to debt issues by multilateral development banks and other international financial institutions. 66 C. Indonesia C.1 Introduction The bond market in Indonesia has developed rapidly since 1999 because its government had to issue a massive amount of bonds to restructure the domestic banking system and recapitalise Bank Indonesia (BI), the central bank, which incurred large losses in its liquidity support operations during the Asian financial crisis. Initially, recapitalisation bonds (recap bonds) accounted for the lion s share of the Indonesian bond market. The recap market has undergone a restructuring by the government to smooth out its liability profile. In 2003, the government bond market was created and BI was appointed as its agent to manage the issuance of government securities, including clearance and settlement systems. Indonesia now has a relatively well-developed government bond market which accounts for a large part of the bond market. The corporate bond market has grown but it largely consists of financial institution bonds. The derivatives P a g e 66

69 US$ billion and secondary corporate debt markets are illiquid. The domestic investor base is very small relative to the size of its economy, while foreign investors are the key players and own over 30 per cent of outstanding bonds. What attracted these foreign investors are the relatively high interest rates in Indonesia and its improving credit standing. The recent upgrade of its credit rating to investment grade has helped instil confidence in the bond market. However, Indonesia faces potential volatility from abrupt exit by foreign investors in its bond market. C.2 Size and Composition of the Indonesian Bond Market At the end of 2010, the size of the Indonesian bond market was US$102.3 billion, or 14 per cent of GDP, making it one of the smallest bond markets in East Asia in terms of ratio to GDP. The bond market was dominated by government bonds, which accounted for 88.7 per cent of the total. Financial institutions and the non-bank corporate sector accounted for approximately 5 per cent each (Figure C.1). Figure C.1 Indonesia: Bond Outstanding by Type of Issuer Indonesia: Bond Outstandings by type of Issuers (June) Corporate Fis Government Source: BIS The Debt Management Office (DMO) of the Ministry of Finance (MOF) issues T-bills and bonds in various forms to maintain bond market stability, bolster liquidity, and to finance budget deficits. Over the past several years, the government has introduced new treasury instruments with diverse maturities to the market. T-bills are issued monthly, with maturities of three or six months. They are the main instrument used by BI to conduct open market operations. The Islamic Shari a Debt Bill, passed into law in 2008, allowed the government to issue securities in accordance with Islamic principles. Seven- and 10-year sukuk were issued to institutional investors in 2008 and retail sukuk bonds were issued in The first sukuk T-bills were issued in August 2011 to diversify Islamic debt issuance and increase liquidity in the Islamic debt market. The 55-year, 10-year, and 20-year treasury bonds make up the sovereign benchmark. P a g e 67

70 The yield curve covers a 30-year period and a government programme of buying back shorter maturity bonds for longer ones has helped the maturity distribution profile, extended the yield curve, and helped establish a better benchmark. The Indonesian Government Securities Trading System (IGSTS), a system connected to another called the Over-The-Counter Fixed Income Services (OTC-FIS) allows member domestic banks and securities companies to trade government securities directly with one another. The OTC-FIS also allows nonmembers to place bids and offers. Foreign investors without access to local dealing systems can buy and sell government bonds over the counter. C.3 Corporate Bond Market The corporate local currency bond market in Indonesia is relatively small but has good growth potential. At year-end 2010, corporate bonds outstanding amounted to US$6.2 billion, 5 per cent of the total local currency bond market. Corporations, including state-owned enterprises, issue short- to medium- term notes and commercial paper. Commercial papers, with maturities from 7 days to less than one year, are issued through private placement. To issue bonds, corporations must have sufficient collateral backing or a state-bank guarantee. Around 90 per cent of corporations are listed on the Indonesian Stock Exchange (IDX). Secondary-market trading is illiquid and takes place on the OTC market. Major investors of corporate bonds are local insurance companies, pension funds, mutual funds, and financial institutions. 68 C.4 Investor Base The domestic investor base in Indonesia is very small and accounted for less than 2 per cent of its GDP in 2010, severely constraining the bond market development. As shown in Figure C.2, major investors in Indonesian bonds are banks and foreign investors. Banks hold government securities to meet part of their reserve requirements and liquidity. Foreign investors are the major investors in government bonds. Major investors in Indonesian bonds are European countries followed by Singapore and the US. Compared to other East Asian markets, foreign investors hold a more significant portion of government debt, at 31 per cent in Indonesia, compared with 25 per cent in Malaysia, 11.5 per cent in Thailand, and 11 per cent in South Korea. There are no restrictions on foreign investors in the local currency bond market. The large holding of government bonds could be a destabilising factor in the event of an abrupt withdrawal of foreign investors. P a g e 68

71 Figure C.2 Indonesia: Investor Base in Government Bonds C.5 Regulatory Frameworks The MOF is responsible for all economic and financial sector policies. BI gained independence as a central bank in May 1999 with the enactment of The Central Bank Act (UU No. 23/1999), which confers on it the status and position of an independent state institution, with the authority to formulate and implement regulations as stipulated in the Act. Its responsibilities include: maintaining the stability of the rupiah, monetary policy, payment system, and regulating and supervising the banking system. It also acts as the central depository for the settlement and safekeeping of government bonds and Bank Indonesia Certificates. 69 The Capital Market and Financial Institution Supervisory Agency, commonly referred to as Bapepam-LK, is a department of the MOF that regulates and supervises the capital market and non-bank financial services sector. Bapepam-LK was created in 2006 through a merger of the Capital Market Supervisory Agency (Bapepam) and the Directorate General of Financial Institution (DJLK). It is responsible for regulating all capital market players such as securities companies, investment managers, custodians, and regulating non-bank financial services industry, including insurance, multi-finance, and pension funds. Bapepam-LK also grants licences to various securities market intermediaries (eg. brokers, mutual funds, custodian banks and underwriters) and professionals (accountants, public notaries, lawyers, and appraisers). The IDX, the Indonesian Clearing and Guarantee Corporation (KPEI) and the Indonesian Central Securities Depository (KSEI) are the three self-regulatory organisations in Indonesia. C.6 Market Structure and Infrastructure Indonesia s key bond market infrastructure is in place. The bond market consists of an OTC market and an exchange market. The IDX is the exchange market. It was created in 2007 after the merger of the P a g e 69

72 Jakarta (JSX) and Surabaya (SSX) Stock Exchanges to promote competitiveness, liquidity, and efficiency in the market. SSX had been the only exchange to trade bonds. The IDX features a Fixed-Income Trading System (FITS) for listed bonds. It allows remote trading between its market participants as well as corporate bond settlement via an automated securities trading platform. It also features two trading boards:: the Regular Outright Board, a bond trading mechanism, and the Negotiated Board, a trading facility. The Regular Outright Board provides a continuous auction between buyers and sellers based on market price and time. The Negotiated Board allows IDX members to disclose negotiated trade transaction results with other parties. All bond transactions are recorded within one hour after the transaction is made under the IDX Centralised Trading Platform. The Indonesia Bond Pricing Agency (IBPA) establishes daily reference prices for government and corporate bonds, and gives market participants equal access to pricing. This aids investors in their investment decisions and improves market transparency. BI registers, clears, settles, pays, and redeems government securities. Banks or financial institutions are appointed by BI as custodians for individual customer accounts and local custodians are required. BI uses the Bank Indonesia Scripless Securities Settlement System (BI-SSSS) to carry out transactions for BI certificates and government securities. After a bond trade is completed, buyers and sellers enter the purchase instructions into their BI-SSSS terminal and the BI-SSSS matches the instructions by checking the securities ownership and availability of buyer funds. 70 The KPEI performs clearing activities for exchange-traded products and bond transaction settlement through a system called e-bocs, where clearing, confirmation, and affirmation of the transaction settlement up to tax administration is done. 11 KPEI also acts as the counterparty for settling and liquidating an open position upon contract maturity. Registration of listed corporate bonds and management of depository accounts are handled by the KSEI, which electronically registers and settles securities through its Central Depository and Book-Entry Settlement System after a bond is listed and has an IDX bond code. Bapepam-LK contracts licensed transfer agents to maintain registry and custody records for securities transactions outside the BI and KSEI systems. Custodians listed by Bapepam-LK are responsible for safekeeping securities and related assets. Transactions are carried out on a DVP basis. Government bonds are settled locally on T+2 and T+3 for foreigners. Sertifikat Bank Indonesia (SBI) central bank bonds are generally settled on T+1, while corporate commercial paper are settled on T+2 or T+3 and listed corporate bonds on T+4. C.7 Derivatives Market Indonesia is at an early stage of developing the derivatives market. Interest rate swaps are available in 11 P a g e 70

73 IDR and foreign currencies based on interbank interest rates. Liquidity in this market is very limited. Bond futures and options are not yet available on the IDX. Offshore cross currency swaps, swapping IDR fixed payments for floating US dollar payments or vice versa, are available in 1- to 10-year maturities. The market is not liquid. A repo market exists in Indonesia. It was started by the government in 2004, and in 2005, the Master Repurchase Agreement was introduced as the benchmark for repos. The BI, the Indonesian Securities- Dealer Association, and the Indonesian Fixed Income Dealer Association manage the repo market. Repo transactions are set at 3 per cent above the BI rate for overnight purchases. A secondary OTC repo market exists for SBIs, but the liquidity is poor due to high prevailing rates. In 2009, the BI also launched repo transactions using government bonds denominated in foreign currencies. C.8 Taxation Withholding taxes apply to interest income for both resident investors (15 per cent) and non-resident investors (20 per cent), for both government and corporate bonds. Coupon payments are made net of withholding taxes. For resident investors, there is a capital gains withholding tax of 20 per cent on government and corporate bonds coursed through the IDX. Capital gains on government bonds not reported to the IDX induce a maximum 30 per cent income tax after a preliminary 15 per cent withholding tax, while corporate bonds not reported to the IDX are subject to an income tax of 15 per cent. There is no capital gains tax for non-resident investors in government bonds, although there is a 20 per cent tax on corporate bonds. Non-residents are eligible for reductions in their interest income tax and capital gains tax if their resident countries have a tax treaty with Indonesia. For example, Singapore residents are exempt from taxes on government bonds. Foreign investors must provide an original certificate of domicile, renewed annually, and a power of attorney to their Indonesian custodian to obtain tax relief upfront or to reclaim their taxes. 71 C.9 Credit Rating Agencies Bapepam-LK licenses local credit rating agencies. The two local credit rating agencies are Credit Rating Indonesia (PT PEFINDO) and PT ICRA Indonesia. PEFINDO is owned by domestic institutional shareholders, comprising major banks, pension funds, insurers, securities companies and the IDX. 12 Standard & Poor s is in partnership with PEFINDO, helping to enhance its rating methodology and processes. PEFINDO is also a member of the Asian Credit Rating Agencies Association (ACRAA). ICRA Indonesia received its licence in 2010 from Bapepam-LK. Moody s is the major shareholder of 12 Indonesia Bond Book 668/680. P a g e 71

74 ICRA Indonesia s parent company and it has an agreement to provide high-value technical services to boost research capabilities and give access to Moody s own global research base. C.10 Prospects and Future Challenges The Indonesian local currency bond market can be expected to continue to grow over the next decade. Major challenges include the development of a domestic institutional investor base, a corporate bond market and a derivatives market. The domestic investor base in Indonesia is small, partially due to a very small pension industry. In June 2011, 34 per cent of government debt was held by foreign investors. High foreign investment and its associated risks underscore the need to widen the domestic investor base in order to promote a more stable market. There is also an urgent need to stimulate growth of the contractual savings industry (pension, insurance and other collective investment plans). The government bonds dominate the local currency bond market, while the corporate debt market is small and illiquid. The derivative market is at an early stage of development. Further development of credit derivatives and risk management products will help foster development of a more robust debt market. D. Malaysia D.1 Introduction 72 Malaysia is now the sixth largest bond market in the world when measured as a percentage of GDP. Within Asia (ex-japan), it is the largest, followed by South Korea and Thailand. Malaysia has successfully developed one of the most diversified bond markets among emerging market countries. The Malaysian bond market grew rapidly after the Asian financial crisis, which was brought about by the mismatch between the currency and maturity of borrowing by the bank-dependent corporate sector. Concerted efforts were made by the authorities to develop a corporate bond market to provide a viable funding source for the corporate sector and to reduce dependence on the banking sector. The existence of large domestic investors, in particular the Employees Provident Fund (EPF), facilitated market development efforts. In addition, countries in Asia launched the ABMI to develop bond markets in ASEAN+3 countries. Major reforms were carried out on all fronts. Measures included: further development of the government bond market; modification in the regulatory framework for regulating private debt securities; introduction of Islamic financial instruments, especially sukuk (Islamic bond); measures to enhance liquidity in the secondary market for government and corporate bonds; adopting market-based accounting to enable proper pricing and valuation of debt instruments; introduction of a bond pricing company; and tax incentives to make the local bond market a preferred choice for corporations to raise funds. P a g e 72

75 US$ billion D.2 The Bond Market At the end of 2010, the size of the Malaysian bond market was US$272.6 billion, or 114 per cent of GDP (Figure D.1), consisting of government bonds (47.3 per cent), non-financial corporate bonds (31.2 per cent), and financial institution bonds (21.5 per cent). The size of the corporate bond market increased from US$27.1 billion in 2005 to US$85.1 billion in Malaysia has also become a major Islamic capital market and the largest and most innovative sukuk market. 13 The Malaysian debt securities market offers a broad range of instruments, from short-term commercial papers to medium-term notes and long-term corporate bonds of up to 30 years maturity (Box D.1). The Government, quasi-government entities and public-listed companies issue debt securities. Cagamas Berhad, Malaysia s National Mortgage Corporation, which primarily securitises housing loans, is the largest issuer of corporate debt securities including Islamic bonds. A unique feature of the Malaysian debt securities market is the existence of a parallel universe of sukuk, or Islamic bonds, side by side with conventional debt. The availability of a broad range of debt instruments has attracted a variety of market participants, both domestic and foreign. In 2005, the government permitted multilateral banks and foreign corporations to issue ringgit-denominated papers in the domestic market. Furthermore, in 2007, the government issued foreign currency-denominated bonds in the domestic market. These measures have attracted many foreign corporations, multinational corporations and multilateral organisations to raise funds and originate transactions out of Malaysia Figure D.1 Malaysia: Bond Outstanding by Type of Issuer Malaysia: Bond Outstandings by type of Issuers (June) Corporate Fis Government Source: BIS 13 Malaysian Debt Securities and Sukuk Market-A Guide for Issuers and Investors, 2009, BNM and Securities Commission Malaysia. P a g e 73

76 Box D.1 Types of Debt Securities in the Ringgit Bond Market Malaysian Government Securities (MGS) are coupon-bearing long-term bonds issued by the Malaysian government. These produce the risk-free interest rate benchmarks for pricing long-term debt securities and are issued according to the Government Securities Auction Calendar, which is updated from time to time, depending on the government's financing needs. MGS are issued by way of tender through principal dealers or via private placement to selected institutions approved by the Ministry of Finance. For new issues issued via tender, submission of bids is on a yield basis and the coupon is market-determined based on the weighted average of the successful yield of the issue. It is payable semi-annually. Malaysian Treasury Bills (MTBs) are short-term government securities issued by the Government of Malaysia. Similar to BNM Bills (see below), MTBs are issued on a discount basis. Holders are paid the nominal amount on the maturity date. In the primary market, MTBs are issued through weekly tenders via principal dealers. In the secondary market, MTBs are also classified into band trading. Government Investment Issues (GIIs) are government bonds issued under the Government Investment Act 1983, based on Islamic principles. In the past, GIIs were issued under the concept of Qardhul Hasan (benevolent loan). Currently, the issues of GIIs are under the concept of Bai Al-Inah. GIIs are non-interest-bearing government bills that enable the participating institutions to meet their liquidity requirements according to Islamic principles. In the primary issue, submissions of tenders are channelled through Islamic banks and principal dealers. 74 BNM Bills (BNBs) are short-term securities with maturities not exceeding one year issued by Bank Negara Malaysia (BNM). For its short-term money market operations, BNB issues are offered to principal dealers through competitive auction. The yield bid is specified as a discount rate and expressed in three decimal places. The tenors of BNB are expressed in actual number of days. BNBs are classified into band trading according to the number of days remaining to maturity for trading purposes. Bank Negara Negotiable Notes (BNNNs) are Islamic short-term securities issued by BNM with maturities not exceeding one year. The issuance of BNNNs will be based on the principle of Bai Al-Inah. In the primary issue, tenders for BNNNs will be submitted on the exact purchase price (proceeds) basis, through Islamic banks and principal dealers. Cagamas (National Mortgage Corporation) Instruments: Floating Rate Bonds. These bonds are of medium/long-term tenor with an adjustable coupon rate. The interest is payable either semi-annually or on a quarterly basis. Fixed Rate Bonds. These bonds are fixed coupon medium-/long-term bonds where the interest is payable semiannually. Cagamas Notes. These notes are short-term securities with a tenor of 12 months or less. The notes are similar to MTBs and normally issued at a discount. P a g e 74

77 Box D.1 Types of Debt Securities in the Ringgit Bond Market (Continued) Islamic Notes Al Mudharabah. These debt securities are of medium-term tenor issued under the Islamic principle of Al Mudharabah, with a pre-determined profit-sharing ratio. Commercial Papers (CPs) are short-term revolving promissory notes, with a tenor not exceeding one year. The mode of issue of CPs can either be on private placement and/or tender. Medium-Term Notes (MTNs) are instruments with a tenor of more than one year. This instrument is an alternative to short-term financing in the CP market and long-term borrowing in the corporate bond market. The mode of offering MTNs in the primary market can either be on private placement and/or by way of tender. If issued on tender, the tender basis can be on yield, price, or exact purchase price depending on the structure of the approved MTN. Corporate Bonds are long-term scripless securities (conventional or Islamic), which can be interest-bearing, profitbased or discounted instruments (e.g., zero coupon), with a tenor of more than one year. The interest-bearing bond and profit-based bond may have a fixed coupon rate or floating coupon rate depending on the structure of the approved facility. For zero-coupon bonds, the securities are issued at a discount without any periodic interest/coupon, and the final redemption is equal to par/nominal value. The issuance of bonds can be privately placed to several investors, on a bought deal basis to a single primary subscriber or tendered to the Tender Panel Member (TPM) identified by the lead arranger. If issued on tender, the tender basis can be on yield, price, or exact purchase price depending on the structure of the approved corporate bonds. 75 Khazanah Bonds are issued by Khazanah Nasional Berhad, an investment arm of the Government. They are longterm zero coupon bonds issued based on the Islamic principle of Murabahah. The issuance of Khazanah bonds is auctioned on competitive basis via the principal dealer s network. Submission of bids is on price/100 basis. Combination CPs/ MTN Programme. The Combination CPs/MTN programme allows issuers to invite tender on both CP and MTN simultaneously without breaching the approved facility limit. The issuer will then have the flexibility to draw down CP, MTN, or a combination of both subject to the available facility limit. The mode of offer for CP/MTN can be on tender and/or private placement. Asset-Backed Securities (ABS) is a form of debt securities (that are backed by specific underlying assets) issued pursuant to a fund-raising process of asset securitisation. Stocks/Loan Notes. These instruments are hybrid debt securities that can be redeemable/irredeemable and/or convertible/nonconvertible into shares. The tradability and conversion feature of these instruments in the secondary market is dependent on the terms and conditions of its approved structure. P a g e 75

78 D.3 Investor Base Malaysia has a large and diversified investor base. At the end of 2010, the size of the investor base was RM342.5 billion (US$ billion), or 46.7 per cent of GDP (Figure D.2). In 2004, the contractual savings sector, that includes the Employees Provident Fund (EPF) one of the largest in the world and accounted for 58 per cent of the investor base in government securities. However, the share of the contractual savings sector has steadily declined to 27.6 per cent in The share of financial institutions rose from 20 per cent in 2004 to 42.4 per cent in The share of foreign investors in the government bond market increased sharply from 4.6 per cent in 2004 to 21.5 per cent in Malaysia has been successful in building a large domestic investor base over the last three decades and this has greatly facilitated the development of the bond market. Figure D.2 Malaysia: Investor Base in Government Bonds 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Malaysia-Investor Base in Government Bonds Source: Asianbondonline Bank Negara Public Sector Insurance Companies Foreign Investors Social Security Institutions Financial Institutions 76 D.4 Market Infrastructure Malaysia has efficient market infrastructure for both the primary and secondary markets. In the primary market, auctions and other primary market transactions are conducted through Fully Automated System for Issuing/Tendering (FAST), an electronic platform operated by the central bank, Bank Negara Malaysia (BNM). The clearing and settlement of bond market transactions are performed through Real Time Electronic Transfer of Funds and Securities System (RENTAS), which is also operated by BNM. In August 2008, an Electronic Trading Platform (ETP) for the Malaysian bond market was launched by Bursa Malaysia, the stock exchange, to create a single electronic trade reporting and trading platform for the domestic bond market. The ETP is based on the system used by the Korean Exchange and modified to suit the Malaysian environment. The ETP is a wholly owned subsidiary of Bursa Malaysia. Taking over the function from the BNM-operated Bond Information Dissemination System (BIDS), ETP requires mandatory reporting of all secondary bond market transactions. It is an electronic order-matching platform for the matching of bid and ask quotes for Malaysian government securities (MGS), government P a g e 76

79 investment issues (GII) and corporate issues. The platform can also be used by dealers to advertise and negotiate for one-to-one deals for all debt securities and sukuk. The trading platform is expected to enhance price transparency and liquidity in the secondary bond market, and increase efficiency in the secondary trading activities. D.5 Regulatory Frameworks Malaysia has a very well-defined regulatory framework for financial and capital markets. The Capital Markets and Services Act 2007 is the law governing trading and dealing in securities, including government securities. BNM is the main regulator of the financial markets in Malaysia. The primary dealers are licensed and regulated by BNM. Besides the primary dealers, commercial banks and Islamic banks, investment banks are also participants in the interbank market for government securities. The Malaysian Code of Conduct for Principals and Brokers in the Wholesale Money and Foreign Exchange Markets sets out best market practices, principles and standards to be observed in the Malaysian market. In addition, BNM also issues rules and guidelines governing the issuance, allotment, interest payment, redemption and settlement of scripless securities under FAST, and RENTAS. On 1 July, 2000, the Securities Commission Malaysia (SC) became the single regulator for the Malaysian corporate debt securities and corporate sukuk market. Malaysia moved towards a full disclosure-based regulatory regime with the issuance of Guidelines on the Offering of Private Debt Securities. This was followed by the issuance of Guidelines on the Offering of Islamic Securities. The SC administers the Capital Markets and Services Act 2007 (CMSA), which governs a substantial part of the activities in the domestic corporate debt securities and corporate sukuk market. The SC issues guidelines on the issuance of corporate debt securities and corporate sukuk, supervises trading activities in the secondary market, and conducts joint examinations and inspections of investment banks together with BNM. 77 D.6 Rating Agencies The Rating Agency Malaysia Berhad (RAM) 14 and the Malaysian Rating Corporation Berhad (MARC), both promoted by BNM, are the domestic credit rating agencies in Malaysia that issue ratings on debt instruments issued in the Malaysian market. RAM was set up in 1990, and MARC in 1995.This has facilitated development of the bond market as it enables a large number of investors to invest in debt instruments. 14 RAM is now partly owned by Standard and Poor s after the international rating agency acquired RAM s shares from the Asian Development Bank in P a g e 77

80 Credit ratings in Malaysia focus on individual issues rather than the credit rating of the corporation. Thus, a corporate can be assigned different rating categories for different issues. Malaysia requires credit rating on bond or sukuk issues. Credit rating agencies have to be accredited by the SC for rating debt or sukuk issues pursuant to the Guidelines on Recognition of Credit Rating Agencies by the Securities Commission for the Purpose of Rating Bond Issues. A domestic rating agency is also required to adopt the IOSCO Credit Rating Agency Code in its own code of conduct, and to disclose this on its website. D.7 Taxation The tax system in Malaysia is very friendly to investors both domestic and international. Several tax incentives are offered to issuers and investors to develop the domestic bond market. Issuers: Issuers are offered the following incentives: 1) exemption from stamp duty for issuance of private debt securities (PDS); 2) deductible tax on expenses incurred in the issuance of sukuk; 3) exemption from stamp duty for all instruments for the purpose of securitisation approved by the SC; and 4) exemption from stamp duty for all instruments for the purpose of sukuk issuance approved by the SC. 78 Domestic Investors: Resident investors are offered the following incentives: 1) exemption on interest income from ringgit-denominated debt securities and sukuk; 2) exemption from payment of income tax for resident investors on the profits received from foreign currency-denominated sukuk issued in Malaysia; and 3) no capital gains tax in Malaysia. Foreign Investors: Foreign investors are exempted from: 1) income tax on interest income and profits earned from ringgit-denominated sovereign bonds, as well as PDS and sukuk approved by the SC; 2) withholding tax on interest income and profit earned from ringgit-denominated debt securities issued by the Malaysian government as well as PDS or sukuk approved by the SC; 3) tax on interest income from foreign currency-denominated sukuk; 4) withholding tax on profits or income from non-residents investments in foreign currencydenominated sukuk issued in Malaysia; and 5) capital gains tax in Malaysia. P a g e 78

81 D.8 Financial Guarantee Institution (Credit Enhancement) To enable companies with lower than investment grade bonds to access the domestic bond market, the Malaysian government recently established the Danajamin Nasional Berhad as a financial guarantee institution, to provide credit enhancement for companies wishing to raise funds from the bond market. A financial guarantee institution adequately capitalised can help increase the credit rating of bond issues from below investment grade to investment grade, thereby making the bonds eligible for investment by institutional investors. The guarantee institution will charge a premium commensurate with the perceived risk of the issuer for guaranteeing to pay the interest and capital repayment in the event of default by the issuer. D.9 Prospects and Future Challenges Malaysian authorities have developed a clear roadmap for developing financial markets and capital market over the next decade. 15 There is also a second capital market development plan. One of the main elements of Malaysia s strategy is to become an Islamic financial market hub. This goal is very much achievable given that in 2011, Malaysia accounted for about 60 per cent of the global sukuk market (Annex 4). The experience of Malaysia in building its bond market should be of interest to other countries. E. The Philippines 79 E.1 Introduction The Philippines bond market has been dominated by the government bond market since 2000 due to the need to finance fiscal deficits. However, fiscal conditions have improved steadily and the impact of crowding out has been lessened. The Philippines economy has also experienced stable economic growth since 2005 due to sound economic management and a steady flow of remittances from workers abroad. The level of interest rate and inflation has slowly declined, creating favourable conditions for the corporate bond market to grow. However, some structural issues such as taxation are holding back growth of the corporate bond market. E.2 The Bond Market In 2010, the size of the bond market was US$64 billion (Figure E.1), or 31 per cent of GDP. The bond market consists of the government bond market (96.4 per cent) and the corporate bond market (3.6 per 15 Bank Negara Malaysia, Financial Sector Blueprint , Strengthening our Future: Strong, Stable and Sustainable. P a g e 79

82 cent). Financial markets in the Philippines are bank-dominated and they have almost exclusively relied on domestic savings for meeting the funding requirements of the private sector. Most corporations issue debt instruments with a maturity of less than one year as interest income from such instruments is not subject to withholding tax. Figure E.1 The Philippines: Bond Outstanding by Type of Issuer Philippines: Bond Outstandings by type of Issuers (US$ billion) Corporate Fis Government Source: BIS 80 The Government of the Philippines (GOP) issues T-bills and T-bonds in book-entry form through its Bureau of the Treasury. These securities are auctioned through a network of approved primary dealers. Interest income from government securities (both discount and coupon) are subject to a 20 per cent withholding tax that is also the final tax. T-bills mature in less than a year and there are three tenors: 91- day, 182-day and 364-day bills. The number of days is based on the universal practice of ensuring that the bills mature on a business day. T-bills are quoted either by their yield rate, which is the discount, or by their price based on 100 points per unit. Those mature in less than 91 days are called Cash Management Bills. T-bonds are available in maturities ranging from one to twenty years. All government securities are listed on the Philippine Dealing and Exchange System (PDEx) for secondary trading. E.3 Investor Base Information on the investor base of government securities is not readily available. However, banks are the dominant investors, as they are required to hold these securities to meet reserve and liquidity requirements. In the past, real interest rates of government securities were high making it more attractive for banks to hold government securities instead of lending. Furthermore, banks are not required to set aside capital for their government securities investment, as there is zero risk weighting. In addition to the banks, their trust departments are also major investors in government securities. Excluding banks, the size of institutional investors in the Philippines is very small and consists largely of the Social Security P a g e 80

83 System (SSS) and the Government Service Insurance System (GSIS). The total asset size of SSS and GSIS was about US$20 billion at the end of The life insurance industry is also relatively small due to low income and low savings. Despite its small size, the life sector has been growing fast and the supply of long-term bonds in the market is still only a fraction of the sector s requirement for asset/liability management purposes. There is clearly a need to make concerted efforts to accelerate growth of domestic institutional investors. E.4 Regulatory Framework The government securities market in the Philippines is regulated by the Department of Finance and implementation is carried out through the Treasurer of the Philippines. The Bureau of Treasury implements the regulations on a day-to-day basis. The Bangko Sentral ng Pilipinas (BSP) regulates financial institution dealers under its supervision. The Securities and Exchange Commission (SEC) regulates securities dealers, both in primary and secondary debt markets. The SEC also supervises the operations of the Philippine Stock Exchange, and the Philippine Depository and Trust Corporation (PDTC). The PDTC provides depository and settlement services for equities, commercial papers, and private bonds. It is a member of the PDS Group of companies, composed of the Philippine Dealing System (PDS), the holding company of the Group, and its operating subsidiaries: the PDEx and the Philippine Securities Settlement Corporation (PSSC). 81 E.5 Clearing and Settlement Government Securities. The clearing and settlement system in the Philippines for both the government securities and corporate debt securities is functioning well. Government securities are settled through the RoSS interface system, which was designed from the start to use the delivery-versus-payment (DVP) system with BSP as the settlement bank and was administered by the Bureau of Treasury. All member banks have securities accounts with the Bureau of Treasury, which issues the government securities and administers RoSS. RTGS was introduced in The DVP system was already in place even before the commencement of PDEx s organised market for the inter-dealer sector, to enable the inter-dealer market to settle on a DVP basis. In 2006, the PDEx market was connected to this system, and a straight-through processing (STP) facility was operationalised so that trades executed on the PDEx market were sent to the settlement system without further manual intervention to enter settlement details. Private Securities. The Philippine Depository and Trust Corporation (PDTC) provides depository and settlement services for equities, commercial papers, and private bonds. PDTC offers securities depository services for the fixed-income and equity market segments in the Philippine markets and has real-time interface with settlement banks, including the central bank, to settle fixed-income spot and repo trades, interbank foreign exchange transactions and cash entitlements such as cash dividends and P a g e 81

84 coupon/maturity payments. Its depository service operates a book-entry system for the transfer of ownership of debt instruments. E.6 Credit Rating Agency The Philippine Rating Services Corporation (PhilRatings) is the only domestic credit rating agency in the Philippines that is accredited by both the BSP and the SEC. The rating agency is also an affiliate of Standard and Poor s. In 2008, the Credit Rating and Investors Services Philippines (CRISP), a domestic rating agency, was established and it is accredited by the SEC. E.7 Taxation In the domestic T-bill market, a 20 per cent final withholding tax is levied on the discount component upon issuance of T-bills by the Bureau of Treasury, subsequent to an auction involving the participation of domestic commercial banks and local branches of foreign banks. No other tax is levied on subsequent transfers of T-bills in the secondary market. For corporate bonds, a final withholding tax of 20 per cent is also levied on the coupon on its payment date. This 20 per cent final withholding tax rate on government and corporate bonds is based on Philippine domestic tax rates, which could be reduced to 15 per cent under several double taxation treaty provisions. Interest income from bank deposits is subject to 20 per cent withholding tax that is also the final tax. Deposits by non-residents are subject to 7.5 per cent tax on income. Taxation on bonds is one of the major impediments to the further development of the bond market in the Philippines. 82 E.8 Prospects and Future Challenges The Philippines faces several challenges in building its bond markets. The major ones include: 1) crowding out of the private sector. This will depend a lot on the fiscal situation going forward; 2) a very small domestic investor base, especially pension funds and insurance companies. More concerted efforts are required to accelerate growth of pensions and insurance; 3) withholding tax on interest income from government securities. This tax impedes financial intermediation; and 4) corporate bond market development. There are few large companies in the Philippines and their funding requirements are readily met by the banking system. These issues are closely linked and require a clear vision and political will to tackle them. P a g e 82

85 F. Singapore 16 F.1 Introduction Singapore is one of the world s major financial centres that offer a broad range of financial services to domestic and international savers and investors. Until 1995, the domestic bond market played a limited role in Singapore s financial markets. The government has for the most part run fiscal surpluses and there was no need to borrow. However, the government made a deliberate decision to develop the domestic bond market following the Asian financial crisis. Since 1998, the Singapore Government Securities (SGS) market has grown rapidly, largely driven by these reasons: i) to provide the market with risk-free sovereign benchmarks; ii) to enable proper benchmark for the pricing of corporate debt securities; and iii) to develop human capital with knowledge of the debt capital market. The Monetary Authority of Singapore (MAS), the central bank, has been the champion in developing the domestic bond market. F.2 The Bond Market At the end of 2010, the size of the corporate bond market in Singapore was US$127.5 billion, or 75.5 per cent of GDP, triple the size in 2000 (Figure F.1). Government bonds accounted for 81.6 per cent of the market, followed by financial institutions (17 per cent) and non-bank corporations (1.4 per cent). Given that Singapore is a major financial centre without any exchange controls, the corporate sector has a wide range of funding choices. Most Singaporean companies are cash rich and have limited reason to issue debt. The equity market is also robust and has been a major source of capital for Singaporean corporations. As a result, the growth of the corporate bond market in Singapore has been modest, as in the case of Hong Kong. 83 The government is the main issuer of bonds in the domestic bond market. The government issues T-bills and T-bonds of maturity up to 15 years. MAS issues these securities through a network of primary dealers on behalf of the government. The average maturity of SGS is around five years. The government also issues large amounts of non-tradable bonds to the Central Provident Fund, which is a compulsory savings plan for working Singaporeans and permanent residents to fund their retirement, healthcare and housing needs. Some government-owned corporations also issue bonds in the domestic market. The government has also encouraged multilateral development banks, such as the World Bank and others to issue bonds denominated in Singapore dollars to deepen its bond market. 16 Since Singapore is a major financial centre with highly developed financial markets, discussions in this chapter are abbreviated and limited to providing a snapshot of the bond markets. The Monetary Authority of Singapore (MAS) website provides comprehensive information on the Singapore bond market. Please refer to P a g e 83

86 US$ billion Figure F.1 Singapore: Bond Outstanding by Type of Issuer Singapore: Bond Outstandings by type of Issuers (June) Corporate Fis Government Source: BIS F.3 Investor Base 84 The investor base in domestic bond market is broad. However, a breakdown is not published. Banks are the main holders of SGS due in large part to meeting their minimum liquid assets (MLA) requirements. Banks tend to hold short-dated bonds to match the duration of their deposits. Singapore has developed into a major wealth management centre in the world and this industry is a natural investor in Singapore dollar-denominated bonds. Central banks in the region are also investors. Singapore also has a very large and growing asset management industry that invests in domestic debt instruments as well. F.4 Regulatory Framework Singapore has an excellent and transparent regulatory system. The MAS is at the centre of the system and is responsible for regulating all financial institutions and for the development of Singapore s financial markets. Securities markets are regulated under the 2001 Securities and Futures Act (SFA). The Singapore Stock Exchange is the self-regulatory organisation for financial intermediaries involved in the securities market. F.5. Taxation P a g e 84

87 Singapore offers one of the most attractive tax regimes among the major financial centres. There is no withholding or capital gains tax for foreign investors in Singapore dollar-denominated bonds. Attractive tax incentives have also been introduced to encourage origination and trading of debt securities in the country. F.6 Credit Rating Singapore relies on international rating services. All three major international rating agencies operate in Singapore. As a foreign debt securities listing requirement of SGX, any issue of debt securities must have a credit rating of investment grade and above. G. South Korea G.1 Introduction Korea has a well-diversified bond market and is now the eleventh largest bond market in the world. Wide-ranging policy reform and restructuring of the financial and corporate sectors carried out since 1997 has turned around the South Korean economy and its financial markets, making it one of the largest and most liquid bond markets in the world. At the end of 2010, the size of the South Korean bond market was US$1.1 trillion, or 1.8 per cent of the world s domestic bond markets. However, when measured as a percentage of GDP, South Korea s bond market ranked number seven. 85 G.2 The Bond Market At the end of 2010, the size of its local currency bond market was US$1.1 trillion (Figure G.1). The government bond segment was the largest, accounting for 42.8 per cent, followed by financial institutions (23 per cent) and non-bank corporates (34.3 per cent). The share of government in the bond market rose during the period from 2008 to 2010 as a result of the stimulus programmes undertaken by the government to counter the global financial crisis. The corporate sector also resorted to issuing bonds in the domestic market as the international financial markets were frozen due to global deleveraging. The growth of the South Korean bond market has been dramatic since 1997 when the government issued a large amount of government securities to recapitalise banks and restructure the corporate sector, which had suffered massive losses following the sharp devaluation of the Thai Baht in The government s policy reforms were highly successful, and the South Korean economy fully recovered. The robust government bond market has also facilitated the development of a large corporate bond market, a liquid derivatives market, and a well-diversified financial market that is comparable to developed countries. P a g e 85

88 US$ billion Figure G.1 South Korea: Bond Outstanding by Type of Issuer South Korea: Bond Outstanding by type of Issuers (US$ billion) (June) Corporate Fis Government Source: BIS When compared in terms of market-gdp ratio, the bond markets of the three largest emerging markets (Brazil, China and India) were much smaller than that of South Korea at the end of Most emerging local currency bond markets, with the exception of Malaysia and Thailand, consist mainly of government bond markets, with very small corporate bond markets. It is interesting to note that the Malaysian 86 corporate bond market is more robust than that of South Korea, due to the high ratings, often AAA, of large Malaysian corporations assigned by local rating agencies. By comparison, the South Korean corporate bond market initially started as a market for SMEs as large Korean companies prefer to issue bonds in international capital markets. The government bond market consists of the Korean Treasury Bonds (KTBs), which are issued in maturities ranging from one to twenty years. 17 Bonds are auctioned through a network of primary dealers similar to the system used in the US. Three-year KTBs account for about 30 per cent of the issue. However, the 5-year issue is also gaining in popularity with the availability of 5-year KTB futures. Tenyear KTBs are still relatively illiquid. A 10-year KTB futures contract was introduced in February 2008 to enhance liquidity in the KTB market at the longer end of the yield curve. Yet, the government does not currently issue T-bills, and as a result, the South Korean bond market is deprived of a liquid short-term interest rate benchmark. In addition to the government, the Bank of Korea (BOK) is a major player in the bond market. It issues Monetary Stabilisation Bonds (MSBs) to conduct its monetary policy. Issuance of MSBs has increased 17 The first 20-year KTBs of KRW 500 billion were auctioned on 24 March, P a g e 86

89 dramatically since 2002 in response to a sharp increase in foreign exchange reserves brought about by improving current accounts and attractiveness of the South Korean capital market to foreign portfolio investors. The corporate bond market in South Korea is illiquid compared to the KTB and MSB markets. The liquidity for ABS and MSB is extremely limited and has created valuation problems for investors in fixed income markets. The government has addressed this problem through the establishment of three bondpricing companies in 2000 that provide pricing of all bonds on a daily basis to enable market participants and investors to properly value less liquid securities though problems still remain. The large Korean companies with high credit ratings have relatively easy access to international financial markets and enjoy relatively lower costs than issuing bonds in the local market. The major issuers in the domestic bond market are financial institutions. Small-and medium-sized companies are too risky for domestic investors and, therefore, have limited access to the domestic bond market. South Korea has been highly successful in developing its derivatives market. A wide range of derivatives are listed on the KRX ranging from futures and options on the KOSPI 200 index, to interest derivatives and commodity derivatives. According to the Futures Industry Association, KRX was the world s largest derivatives exchange in 2009, second only to the Chicago Mercantile Exchange. Since the Korea Futures Exchange (KOFEX) started operations in February 1999, a number of interest rate risk manangement products have been introduced at the exchange and OTC. These include: futures and futures options on KTB securities, CD interest rate futures, futures on 364-day MSBs, interest and cross-currency swaps. Three- and 5-year KTB futures contracts have been introduced. In March 2008, the government introduced a 10-year bond futures contract to be traded on the KRX, aimed at further improving liquidity. The most actively traded KTB futures contract is the 3-year KTB contract. 87 G.3 Investor Base Since 1997, South Korea has made concerted efforts to develop a domestic institutional investor base. The rapid development of government-controlled contractual saving institutions (National Pension Services and other pension funds) and insurance companies has created a solid investor base for the bond market. At the end of 2010, the size of the investor base was KRW533.2 trillion (US$490 billion) (Figure G.2). The largest domestic investor was the National Pension Services (NPS), with assets over US$300 billion. NPS has been quite conservative in its investment and allocation policy, and most funds were invested in fixed income securities, mainly government bonds. Investment in corporate bond has been less than 5 per cent. However, it recently modified its investment policy and 15 per cent of its assets are now invested in international capital markets and alternative investments. The insurance industry has grown rapidly and it is the second largest investor in South Korean bonds. P a g e 87

90 % Figure G.2 Korea: Investor Base Korea: Investor Base 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Contractual savings institutions Government Banks Central Bank Others Since 1997, the South Korean bond market is open to foreign investors. Other major markets, especially China and India, have imposed quantitative restrictions on foreign portfolio investment in domestic bond markets. Foreign portfolio investment in the South Korean bond market has increased sharply since 2005 and accounted to KRW47.6 trillion (US$44 billion), or 10 per cent of outstanding bonds at the end of Yet, tax policy regarding foreign investment in domestic bond market has been inconsistent. Foreign investors used to be exempted from withholding tax of 14 per cent on interest income from government. However, in December 2010, the exemption was withdrawn to reduce systemic risks to the South Korean economy in case of abrupt departure of fixed income investors. 88 G.4 Regulatory Frameworks The Ministry of Finance and Economy (MOFE) 18 had the ultimate power to control all facets of the financial system until it relinquished some of its important functions to the Financial Supervisory Commission (FSC) in April Before then, the MOFE was the authority that established basic policies and supervised the overall operation of the securities markets, interpreted securities laws, and authorised the revocation of licences for financial institutions. This led to an excessive concentration of regulatory power, ineffective supervision of financial institutions, and the failure of the system during the Asian financial crisis. In April 1998, under the Act on the establishment of Financial Supervisory Organisations, South Korea s financial supervisory system was completely overhauled. In 2008,further change was made in the financial supervision system by merging the Financial Policy Bureau of the 18 MOFE is now known as the Ministry of Strategy and Finance (MOSF). P a g e 88

91 MOFE and the Financial Supervisory Commission into a new financial authority, the Financial Services Commission (FSC). Under the new system, the FSC, supported by its executive arm, the Financial Supervisory Services (FSS), is in charge of establishing policies and supervising almost all financial intermediaries, including banks and non-bank financial institutions. The FSC now has the power to supervise specialised banks such as the Korea Development Bank. It also carries out the function of anti-money laundering. The BOK is in charge of monetary policy management, while the Korea Deposit Insurance Corporation is given limited onsite examination authority except for financial institutions that are near insolvency. The MOSF is no longer responsible for establishing financial policies and financial regulations. However, it retains the power to set medium- and long-term economic policies, implement tax and taxation related policies, manage the national treasury and resources, and establish the foreign debt management system. G.5 Credit Rating In South Korea, there are four major domestic credit rating agencies: Korea Information Service (KIS), Korea Ratings (KR), Seoul Credit Rating & Information (SCI), and the Nation Information Credit Evaluation (NICE). Korea Ratings, an affiliate of Fitch, is the largest rating agency with a market share of 36 per cent followed by KIS (a Moody s company) and NICE. Overall, the credit rating business has grown steadily and has provided a supportive environment for the development of the corporate bond market and the ABS market. 89 G.6 Clearing and Settlement System South Korea has a well-developed clearing, settlement and depository system comparable to major OECD countries. The Korea Securities Depository (KSD) is the central securities depository of South Korea. An amendment to the Securities and Exchange Act in 1993 established the legal basis for the KSD s depository business. The amended law defined the KSD as a special public organisation designed to enhance credibility and public perception as the only central securities depository in South Korea. In addition, the amendment granted KSD the legal basis to perform cross-border custody, clearing and settlement for securities. KSD is now in charge of a wide range of securities-related businesses, including securities issuance, deposit and settlement. Since the major role of the KSD is critical to the Korean securities market, the KSD is subject to the supervision of the FSC. OTC settlements in bonds take place through the BOK s wire system. P a g e 89

92 G.7 Taxation Under the Korean Income Tax Law, taxation of non-residents depends on whether they have a permanent establishment, such as an office or a factory in South Korea. A non-resident who has a permanent establishment is subject to tax liabilities that are identical to those faced by a resident. A South Korean resident pays 9 to 36 per cent individual income tax for aggregate income. Residents do not pay capital gains tax on securities transactions. In contrast, the base tax rates for foreigners are 27.5 per cent for interest income as well as capital gains. For capital gains, 11 per cent of total sales proceeds may apply if the amount is lower than 27.5 per cent of capital gains. Tax rates are often reduced or completely exempted under applicable double taxation treaties, or agreements between South Korea and the investors countries. As a result, most foreign investors do not pay capital gains tax. Currently, 55 countries have double taxation treaties with South Korea. However, there is currently a 14 per cent withholding tax on the interest from bonds. G.8 Prospects and Future Challenges 19 South Korea has been highly successful in developing its capital markets, both stock and bond markets. In particular, the experience of South Korea in developing its bond market through comprehensive government policy reforms should be of interest to other countries. The development of an efficient and liquid government bond market was the first step in developing its bond market, which is clearly possible within a short period of time, with the introduction of the necessary institutional and legal infrastructure and framework. However, the Korean government has been less successful in developing its corporate bond market and there is substantial room for further improvement. The ABS market has also slowed down considerably due to the global credit crisis and problems faced by the credit card issuers in domestic market. 90 Since 2009, the Korean government passed the Financial Investment Services and Capital Market Act (FSCMA) to leapfrog its capital markets to the next stage of development. It is too early to assess the success of the FSCMA as global financial market conditions are still evolving. The prospects for the South Korean capital market are promising in the medium- to long-term given its dynamic economy, high savings and large domestic investor base and large corporate sector. There is also room to rationalise its tax policy on interest income on bond investment by foreign investors. 19 Barnhill, Dalla, Park, and Uhm, The Potential Role of a Robust Domestic Capital Market in Promoting Economic Development and ModernisingModernising the Financial System-The Case of Korea, George Washington University, P a g e 90

93 H. Thailand H.1 Introduction Thailand was the epicentre of the Asian financial crisis in 1997 when the Thai Baht devalued sharply against the US dollar and led to massive bankruptcy of the banking system and corporate sector. The main cause of the crisis was the extreme mismatch between the currency and maturity of debt of both the banking and corporate sector. Prior to 1997, the Thai financial system was totally dominated by the banking system, causing difficulty for Thai companies to seek alternative sources of funding. This created a vicious circle where companies suffered severe liquidity problems that in turn led to large nonperforming loans and failures of a large number of financial institutions. There was no functioning government bond market as Thailand experienced nine consecutive years of fiscal surplus between 1988 and This absence, and hence the lack of sovereign interest rate benchmarks limited market participants ability to price corporate bonds and other financial instruments. An intervention by the IMF and other multilateral banks was required to stabilise the Thai financial system. Since 1997, Thailand s bond market has developed rapidly, and it now has a diversified bond market. The government bond market is liquid and the sovereign yield curves are well established. The corporate bond market has also grown and is gaining momentum. The rapid growth of the Thai bond market was an outcome of the concerted efforts made by the government and major market participants in addressing key impediments toto market growth. Policy measures taken to develop the domestic investor base have also contributed to the growth of pension and insurance. Regional efforts through the ABMI and ASEAN+3 have also contributed to market development. 91 H.2 The Bond Market At the end of 2010, the size of the Thai bond market was US$225 billion, consisting of government bonds (73.6 per cent), corporate bonds (25.7 per cent) and financial institutions (0.7 per cent). The bond market has increased sevenfold from US$30.8 billion at the end of 2000 (Figure H.2). An interesting feature of the Thai bond market is that issuance by financial institutions in the domestic market is negligible, accounting for less than 1 per cent of the total bond market. The Thai banking system has performed very well. The Thai corporate sector has largely refinanced most of its foreign exchange liabilities in the domestic bond market over the last decade. Domestic savings have been greater than domestic investment so there has been no need for banks to raise funds in the market beyond deposits. The government bond market is the largest part of the bond market, as the government had to step in to issue a large amount of government bonds to recapitalise banks and build a liquid sovereign yield curve in support of market-risk pricing. The Thai government bond yield curve covers maturities up to 30 years although the benchmark issues are government bonds with maturities of one, two, five, seven and ten P a g e 91

94 US$ billion years. The 5-year benchmark bond is the most liquid. A broad range of financial instruments is now available in the debt market. A variety of issuers has entered the market, including multinationals, multilateral banks and international organisations and local companies. An interesting feature of the Thai bond market is the large increase in securities issued by the Bank of Thailand (BOT) to conduct open market operations and sterilise large flows of foreign portfolio of investment. At the end of 2011, securities issued by the BOT amounted to about 50 per cent of all securities issued by the government entities. Figure H.1 Thailand: Bond Outstanding by Type of Issuer Thailand: Bond Outstandings by type of Issuers (June) Corporate Fis Government Source: BIS 92 All government debt securities and most corporate bonds are registered with the Thai Bond Market Association (Thai BMA). However, the trading of bonds is mostly conducted over the counter. Dealers (financial institutions holding a debt securities license granted by the SEC) are required to report all bond transactions to the Thai BMA, who monitors, compiles and disseminates prices to the public at the end of day. Prices disseminated by the Thai BMA are used as market reference. Most bonds trade on yield quoted with up to six decimal points. The market convention for the price/yield formula is actual/365 basis. Government bonds are the most actively traded securities, accounting for approximately 80 to 90 per cent of total trade. In November 2003, the Bond Electronic Exchange (BEX) was set up as a subsidiary of the Stock Exchange of Thailand to improve liquidity in secondary market. However, BEX is largely used by retail investors as 95 per cent of bond trading is carried out in the OTC market. To enhance the efficiency of the secondary market, the BOT has set up several sub-working groups to address impediments facing secondary market trading. Measures undertaken so far include improvement in the primary dealer system, introduction of private repo market, securities borrowing and lending facility, and an OTC interest rate swap market. P a g e 92

95 Baht Billion H.3 Investor Base Thailand now has a large investor base consisting of contractual savings institutions, financial institutions, mutual funds and international investors. Government-owned companies are also investors in government securities. The size of the investor base at the end of 2010 was THB2.6 trillion (US$85.2 billion), compared to THB1.87 trillion (US$60 billion) in The largest segment of the investor base is the contractual savings institution sector (government employee pension fund and the social securities fund), which accounted for 23.6 per cent of the investor base, followed by insurance companies (20.7 per cent). The insurance industry has been growing rapidly. Commercial banks, mutual funds and provident funds are also important investors. The Thai government bond market has attracted foreign portfolio investors seeking higher yield and gains from currency appreciation. The share of foreign investors in the Thai bond market has increased six times from 2007 and reached THB300 billion (US$9.7 billion) at the end of 2011, or 11.5 per cent of total holdings of government bonds outstanding. As a result, the government reintroduced the 15 per cent withholding tax on interest income on government securities held by foreign investors. Figure H.2 Thailand: Investor Base in Government Bonds Thailand-Investor Base in Government Bonds 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Contractual savings institutions Insurance companies Residents (retail) Commercial banks Foreign investors Others Central banks 93 Source: Asianbondonline H.4 Market Infrastructure Thailand has developed efficient market infrastructure for securities trading, clearance and settlement. Since 2006, the Thailand Securities Depository (TSD) is responsible for operating an integrated clearing and settlement system for government securities, corporate bonds and stocks. The integrated clearing and settlement system has enabled the TSD to provide both collateral management and bond lending services at reduced transaction costs to investors. The TSD is also the focal point for regional clearing and settlement system linkages that are growing rapidly with the integration of ASEAN financial markets. Settlement at the TSD is T+2 on a net clearing and book-entry basis. The process is governed by the DVP mechanism to guarantee principal risk protection. P a g e 93

96 H.5 Regulatory Framework Thailand has a well-developed regulatory framework for its securities market. The BOT is the agent of the government for issuing government securities and supervises the operation of banking and finance businesses. These include the primary dealers that are major banks. The SEC is responsible for supervising the primary and secondary markets for securities business. The issuance and offering of securities are governed by the Securities and Exchange Act 1992 (B.E. 2535). The Thai BMA is the selfregulatory body for bond dealers. It has implemented a number of standards and conventions for bond trading. The Stock Exchange of Thailand is the self-regulatory organisation for members of the exchange. H.6 Rating Agencies The three major international rating agencies (Moody s, Standard and Poor s and Fitch) and TRIS, a local rating agency, operate in Thailand. Credit rating is mandatory for companies seeking approval from the SEC of Thailand for debt securities issuance. TRIS was promoted by the government, and its shares are owned by major banks and the ADB. In 2011, Standard and Poor s acquired shares of TRIS from the ADB and is now a shareholder of TRIS. H.7 Taxation 94 The Thai taxation system is deemed to be friendlier to equity market investors than to fixed income investors. Capital gains on investments in the stock market are tax-free, and there is no tax on dividend income for non-resident investors of several countries with which double taxation treaties exist. Fixed income investors are subject to tax on interest income, discount and capital gains. Both resident and nonresident investors are subject to 15 per cent withholding tax on interest income and capital gains. The tax rate may be reduced to 10 per cent for investors from countries that have double taxation treaties with Thailand. Capital gains tax for zero coupon debt instruments is exempted for individual investors, while there is a 15 per cent tax on interest income from coupon bonds. Capital gains from bond trading are taxexempt for non-residents. In 2008, Thailand waived the 15 per cent withholding tax on interest income from bonds for foreign investors to attract foreign investment in domestic bond markets. However, this exemption was withdrawn in October 2010 in response to a large influx of foreign portfolio investment in the fixed income market. The decision was driven largely by concern about the impact of speculative portfolio investment inflows on financial stability. H.8 Derivatives The OTC market in financial derivatives (foreign exchange and interest swaps) is well developed. Currency swaps of up to five years are available. The size of derivatives traded on the Thailand Futures P a g e 94

97 Exchange (TFEX) is relatively small. In 2010, TFEX launched its first interest rate-based derivatives product called bond futures. Recently, there are three types of bond futures contracts in the market, all short-term interest rate-based futures: 3-month BIBOR futures, 6-month HBFIX futures, and 5-year government bond futures. The growth of the derivatives market in Thailand has been uneven, due to an unpredictable government policy regarding foreign portfolio investment in the domestic bond market. H.9 Prospects and Future Challenges Thailand has made remarkable progress in developing its government bond market and supporting market infrastructures that have resulted in a well-functioning and liquid government bond market. Development of the corporate bond market has also been encouraging with major Thai corporations issuing bonds in the local bond market. There is a strong appetite among retail investors in Thailand for bonds issued by large blue chip companies. The secondary market remains a major problem due to a lack of funding from official sources. The size of the investor base remains relatively small. More concerted efforts are required to develop the pension system, insurance industry and mutual fund industry. 95 P a g e 95

98 Annex 2: East Asia Financial Market Infrastructure Securities Settlement System (2011) Singapore Hong Kong Korea Malaysia Thailand China Indonesia Philippines 1. Legal Framework for Securities Settlement (Property and insolvency laws) 2. Risk Management Pre-settlement risk Trade confirmation (Confirmation of trades between direct market participants should occur asap but no later than the trade date)(t+0) A A A A A- B+ A- B A A A A A B+ A- B+ Settlement Cycle (Final settlement should occur no later than T+3) Central counterparties (The benefits and costs of a central counterparty should be assessed. The counterparty s exposures should be collateralised) Repurchase Agreement (Repo) Stocks T+1 T+1 T+1 T+1 T+2 T+3 T+3 T+3 Bonds T+1 T+1 T+1 T+1 T+3 T+3 T+1 N N N N N N N N Y Y Y Y Y Y Y N 96 Securities lending Short Sales Settlement risk Central Securities depositories (Securities should be immobilised or dematerialised and transferred by book entry in CSDs to the greatest extent Delivery versus payment (DVP) (Securities settlement system should eliminate principal risk by linking securities transfers to funds transfers in a way that achieves delivery versus payment) Y Y Y Y N N N N Y Y Y N N N N N Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y P a g e 96

99 Timing of settlement finality (Final settlement on a DVP basis should occur no later than the end of settlement day) CSD risk controls to address participant defaults (Control risk exposure through full collaterals in the case of settlement failure) Cash settlement assets (Asset used to settle the cash leg of securities transactions between CSD members should carry little or no credit or liquidity risk) Operational risk (The system should be reliable and secure with backup facilities) Custody risk (Entities holding securities in custody should employ accounting practices and safekeeping procedures that fully protect customers' securities. It is essential that customers' securities be protected against the claims of a custodian's creditors) 3. Governance (Governance arrangements for CSDs and central counterparties should be designed to fulfill public interest requirements and to promote objectives of owners and users) 4. Access (CSDs and central counterparties should have objective and publicly disclosed criteria for participation that permit fair and open access) 5. Efficiency (While maintaining safe and secure operations, securities settlement systems should be cost effective in meeting the requirements of users) Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y 97 P a g e 97

100 6. Communication Procedures and Standards (Securities settlement systems should use or accommodate the relevant international communication procedures and standards in order to facilitate efficient settlement of cross-border transactions) 7. Transparency (CSDs and central counterparties should provide market participants with sufficient information for them to accurately identify and evaluate risks and costs associated with using the CSD or central counterparty services) 8. Regulation and oversight (Securities settlement systems should be subject to regulation and oversight. The responsibilities and objectives. Major policies should be publicly disclosed. They should have the ability and resources to perform their responsibilities) Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y 98 CSD=Central Securities Depositories Sources: EMEAP, stock exchanges and securities commissions in East Asia. P a g e 98

101 US$ Billion Annex 3: Indian Bond Markets 1. Introduction Since 2000, the Indian bond market has been dominated by the government bond market, mainly caused by the continuous budget deficits over the last two decades that need to be financed by domestic savings. Initially, the deficit was financed primarily by government-owned banks through high statutory liquidity reserves (SLRs) and cash reserve requirements. Interest rates were set at below market rates. In the early 1990s, a new policy was adopted to develop a liquid and efficient government securities market as part of the programme to create more diversified and vibrant capital markets. As a result, the ratio of market financing has increased to over 70 per cent from 18 per cent in The rapid economic growth in recent years, benefiting from India s sound economic management and reforms, has attracted large foreign investment in both the real sector and financial markets. As a result, the fiscal condition has improved steadily and the impact of crowding out has been lessened. The level of interest rate and inflation has slowly declined. This has created a favourable condition for the corporate bond market to grow. However, some structural issues such as the lack of institutional investor base and taxation are holding it back. 2. Financial Markets 99 The structure of Indian financial markets is given in Figure J.1. A unique feature of Indian financial markets is that the largest segment of the market is the equity market and not the banking system like countries in East Asia. In 2010, the total size of financial markets in India was US$3.6 trillion, or 263 per cent of GDP with the equity market accounting for 45 per cent, followed by the banking system (35.3 per cent) and bond market (19.7 per cent). Figure J.1 India: Financial Market Structure ( ) India: Financial Market Structures ( ) 4,000 3,500 3,000 2,500 2,000 1,500 1, Domestic Bond Market Bank Assets , ,267.3 Equity Market Capitalization , , ,615.9 Sources: BIS, IMF, BSE P a g e 99

102 3. The Bond Market At the end of 2010, market capitalisation of the bond market was US$708.5 billion, or 43.4 per cent of GDP. The Indian bond market measured as percentage of GDP was larger than Mexico and Chile but much smaller than Malaysia. The government s efforts in developing the government securities market have been very successful as evidenced by the existence of a large, deep and liquid market. The Reserve Bank of India (RBI) was successful in building a risk-free sovereign yield curve across the entire spectrum of maturity. The requisite infrastructure (primary dealer system, trading platforms, state-of-theart clearing and settlement systems) for government bond markets is now in place. The government bond accounted for 85.9 per cent followed by financial institutions (10.6 per cent) and corporate (3.5 per cent). The corporate bond market in India is very small due primarily to crowding out by the government. Commercial banks hold a large amount of government bonds to meet their statutory requirements. The corporate sector relies on internally generated funds and the equity market for investment capital, and banks for working capital. Most corporations issue debt instruments with maturity of less than one year as there is a limited market for long-term debt instruments, and transaction costs are much lower than having to go through the required registration process. However, there is a large and growing private placement market. Some of these instruments are also equity-linked, enabling foreign investors to participate in the Indian equity market without having to through the Foreign Institutional Investors Programme. 100 Figure J. 2 India: Bond Outstanding by Type of Issuer The government bond market in India has developed rapidly and become sophisticated with a sovereign benchmark yield curve extending to 30 years. This has enabled RBI to conduct monetary policy more effectively through its open market operations. The federal government issues T-bills through the RBI with 91-day, 182-day, and 364-day maturities, and dated securities with tenors of two to 30 years. T-bills, P a g e 100