Japanese Banks should be Proactive in Fostering the Asian Bond Market

(Kinzai Weekly, January 19, 2004) Japanese Banks should be Proactive in Fostering the Asian Bond Market A Mechanism to Circulate Local Money within the Region is Required Naoyuki Yoshino Professor, Keio University Shigehito Inukai Senior Fellow, National Institute for Research Advancement The momentum towards the establishment of an Asian bond market to prevent a recurrence of the 1997 Asian Monetary Crisis is growing, and Japanese financial institutions should be proactive in their participation. Given the scale of the Japanese market, the direction taken by Japanese financial institutions and other Japanese market participants holds the key to the development of an Asian bond market. The Necessity of Internationalizing Financial and Capital Markets in Japan If we look at the status of issuance of yen bonds by foreigners (nonresidents) for the past several years, we find that the value of samurai bonds (yen-denominated bonds issued in Japan by non-japanese companies) issued in the domestic market is only 10% the value of Euroyen bonds. In addition, there is a downward trend in bond issues in the domestic market (Table 1). [Table 1] Yen-denominated Bond Issues by Foreigners (Unit: trillion yen) Samurai bonds Non-residents Euroyen bonds 2000 2.8 16.8 2001 1.7 17.2 2002 1.3 12.3 (Source: Study Group on the Internationalization of Japan s Financial and Capital Markets (Reference materials), July 2003) The number of new listings of foreign companies on the stock exchange in Japan is considerably smaller than the number in the European, U.S. and Singapore markets. The internationalization of Japan s financial and capital markets and the enhancement of the nation s function as an international financial center will be important factors in enabling the recovery of the Japanese economy and guaranteeing stable development in the Asian economies, which are increasingly interdependent with Japan. In addition, this fostering of the financial and capital markets will enable Japanese financial institutions to improve their profit-earning capacity, which 1

will make a vital contribution to the revitalization of the Japanese economy. Meanwhile, cooperation among Asian nations towards the establishment of an Asian bond market is steadily proceeding, with a view to preventing a recurrence of the 1997 Asian financial crisis. Japanese financial institutions should seize this opportunity and play an active role in promoting the establishment of infrastructure for an Asian bond market. Increasing the usability of Asian financial and capital markets will lead to increased convenience for all market participants, including issuers and investors. In Japan, the output of the manufacturing industry (domestic/ value-added base) has declined from 35% in the 1960s to 25% since 1997, and other industries have not been fostered to cover this decline. In the United States and England, the decline of the manufacturing industry has been made up by the financial, insurance and service industries in the medium to long terms. Japan s taking the initiative in the development of an Asian bond market would provide Japanese financial institutions with the opportunity to take the lead in marketing promising products for financial investment, including government, public and corporate bonds issued in a variety of countries, with a view towards the recovery of the Japanese economy. Lessons from the Asian Financial Crisis In 1997, Thailand was hit by a sell-off of the Thai baht by foreign hedge funds; the central bank s foreign currency reserves were exhausted, and the nation was unable to maintain its dollar-pegged currency regime. The impact subsequently spread to Indonesia and South Korea. There were two factors behind the financial crisis: Exchange mismatch and period mismatch. To take Thailand as an example in explaining what is meant by exchange mismatch : On the basis of the fixed exchange rate regime, Thai financial institutions and nonbanks (finance companies) continuously borrowed hot dollars (short-term credit) from abroad without recognizing the exchange risks that would arise if the fixed exchange rate regime could not be maintained, and made (long-term) loans of baht-denominated funds to Thai companies at relatively high rates of interest. That is to say, Thai financial institutions borrowed money on a dollar basis and lent to domestic companies on a baht basis, and the outstanding balance ballooned. The period mismatch was a mismatch between the borrowing and lending periods. Concretely, Thai financial institutions borrowed short-term funds from abroad and lent long-term funds to domestic companies. These institutions had to repay the money borrowed from abroad in the short term and were repaid by domestic companies in the long term, and therefore experienced insufficient liquidity. It might be said that the fact of having left the risks of both exchange and period mismatch in the medium- and long-term capital structure as they were, without recognizing the immaturity of 2

the infrastructure of the financial and capital markets of Asian nations, was at the root of the financial crisis. Circulation of Money within the Region through an Asian Bond Market A movement towards the establishment of an Asian bond market to deal with the problems outlined above commenced about three years ago, but at that time the concept received a cool reaction from nations in the region other than Japan and Thailand. Since then, due in part to the consistent efforts of the Japanese government, a variety of international conferences have been held between the ASEAN nations, and there has been a continuing exchange of opinions between governments in the region. As a result, political momentum towards the establishment of a bond market has finally begun to increase. Immediately after the financial crisis, many Asian companies were unable to obtain loans from banks. However, vast financial assets exist in the region because of the high savings rate, and there are sufficient funds to cover long-term investments in Asian industries. The point is how efficiently those funds can be circulated through the bond market mechanism in Asia. In Japan, a massive amount of government bonds have been issued in the past ten years due to the long-term economic slump, and this has been partly responsible for efforts towards the improvement of the government bond market. A range of government bonds, from short-term to ultralong-term, have been issued thus far, and the government intends to issue inflation-linked bonds by March 2004. In addition to government bonds, legal preparations for paperless electronic securities (CP, public and corporate bonds, etc.) and the building of bond and capital market infrastructure, including a securities settlement system, are progressing rapidly. Other major Asian nations have also been pushing ahead with the establishment of infrastructure for capital markets, including their domestic bond markets, since the financial crisis. In Singapore, Hong Kong and Malaysia, the British City-type rules that were adopted as the common standard for bond and capital markets in the European Union are already firmly in place, and the construction of infrastructure for securities settlement is largely complete. Efforts to prepare the environment have been put into effect with great rapidity. In China, however, an individual vertically-segmented supervisory system dominates, and different government ministries and agencies impose bond issuance restrictions on each issuer. Market infrastructure has also not yet been established. From the perspective of the scale of bond markets in Asia, the Japanese market is overwhelmingly large at just under 700 trillion yen (80% of which consists of public bonds such as government bonds), followed by South Korea and China, with markets valued at less than a tenth of Japan s. Although Singapore, Malaysia and Hong Kong have made efforts to advance their domestic markets, the bond markets in each are valued at less than 10 trillion yen, and the Thai bond 3

market does not exceed several trillion yen. From this perspective also, it is clear that trends in Japan, South Korea and China, and in particular in Japan, hold the key to the development of an Asian bond market. Thus far, Japan s market infrastructure has been insufficiently developed and the nation has tended to lack a vision for fostering a market. However, given Japan s considerable influence, it would be desirable for Japanese market participants to actively work towards the realization of a new vision for the establishment of an Asian bond market. In particular, Japanese financial institutions should utilize their diversity of experience to enable them to act as lead managers when Asian issuers issue bonds in an Asian bond market. Issues Facing the Establishment of an Asian Bond Market An Asian bond market will be born through collaboration among governments in the Asian region; if Japanese financial institutions are unable to play an active role, the prospect of a recovery in the Japanese economy will recede farther into the distance. It will be necessary first to develop the bond market by circulating government-related bonds, including bonds issued by the governments and government-affiliated agencies of the nations concerned and by the Asian Development Bank and the JBIC (Japan Bank for International Cooperation), and then to gradually advance to the circulation of bonds backed by a wide range of assets, including corporate bonds, housing loan bonds, and SME loan assets. There are a considerable number of issues facing the establishment of an Asian bond market. These include the guarantee of credit when issuing bonds, the establishment of hedge markets for exchange risks, the elimination of the mismatch between medium and long terms, the review and unification of taxation and accounting systems, and the enticement of international financial markets to Japan (See Table 2 below). Several of these issues will be discussed below. Establishment of Hedge Markets for Exchange Risks When Asian electric companies raise investment funds by issuing corporate bonds, their investments are usually made in US dollars. However, they collect electricity fees in their own currencies. Exchange risks therefore arise, making measures to hedge necessary. If Japanese banks can actively promote the development of markets to hedge exchange risks between local currencies and the dollar or between local currencies and the yen, they will be able to satisfy the needs of the market. Elimination of the Mismatch between Medium and Long Terms The aim of all issuers is to stably acquire funds over the long term. However, many 4

international investors do not like to invest in long-term (five-year plus) fixed rate bonds. It will be necessary to transform long-term funds to meet investors needs by using derivatives including interest swap. It is urgently necessary to develop related derivatives markets, including payment of interest in local currencies. Simultaneous Development of Short-Term Money Markets and Bond Markets Bond markets and short-term money markets are two sides of the same coin. Bond markets cannot function in isolation in any country, and it is essential to build comprehensive infrastructure for financial and capital markets covering all types of financial products (short-term, long-term, spot and futures). This includes short-term money markets, bond futures markets, and markets for repo transactions (bond transactions on condition of repurchase). In other words, in order to smoothly hedge exchange and interest risks related to bond markets, in addition to developing markets for the issue and circulation of bonds denominated in each nation s currency, it will be necessary to concurrently develop markets for a variety of financial products, including futures and options, and markets for bond repurchase transactions to enable various hedges in short-term money markets. Utilization of Japanese Government Bonds as Benchmark Bonds It will be necessary to increase the liquidity of bonds (this means activating not only issue markets but also circulation markets) and to establish benchmarks in an Asian bond market. Japanese government bonds are issued in large amounts due to the government budget deficit, are actively traded in circulation markets and have a high liquidity. If Japanese government bonds can develop as a benchmark for an Asian bond market, it will become easier for Japanese investors to purchase foreign bonds. In addition, it will become simpler to compare European and U.S. bonds with Asian bonds. To achieve this, further efforts towards improving the taxation system in Japan and increasing the attractiveness of Japanese government bonds in order to encourage purchase in higher quantities by foreign investors will be required. Reform of the Central Depository System The establishment of an original system infrastructure for the region that will facilitate the prompt and safe clearing of securities and settling of capital securities will be crucial to the development of an Asian bond market. However, at present, Asia does not have a grand design for such a system capable of operating beyond the frameworks of domestic depository systems. Given this, it will be important to carefully analyze the costs and risks that will stem from the continued dependence of the Asian bond market on the European depository system in terms of the securities that are issued, traded and redeemed. These issues were discussed in the forum Research on the 5

Asian Capital Market held on October 18 and 19, 2003 at Keio University in Tokyo (based on research conducted by the Center of Excellence (COE), Keio University), which was attended by market specialists from six Asian nations (See Outline of the Forum and Table 2 below). If, despite the growing momentum, efforts aimed at establishing an Asian bond market remain mere gestures, or if all transactions in the Asian bond market are mediated by European and American financial institutions or a new bond market is established in another country, it will be extremely difficult for the Japanese economy to recover by improving the profit performance of the financial services industry. The active involvement of Japanese banks and other participants in the financial and capital markets, businessmen involved in the markets, and researchers in addition to the national government is therefore essential. The tennis court (the Asian bond market) has been constructed under the leadership of the Japanese government, but is hardly used. On the rare occasions when the court is used, all the players in the match are from nations other than Japan. This is the scenario that we hope to avoid. 6

Outline of the Forum In response to the report of the Study Group on the Internationalization of Japan s Financial and Capital Market (Ministry of Finance), a forum entitled KEIO-NIRA Asian Capital Markets Study Forum was held on October 18 and 19, 2003 at Keio University in Tokyo under the joint auspices of the Center of Excellence (COE), Keio University (headed by Professor Naoyuki Yoshino), and the National Institute for Research Advancement (NIRA), a research institute attached to the Cabinet Office. Sixty participants gathered from six Asian nations, including personnel from the finance departments of leading issuers in the bond and capital markets, institutional investors, management level personnel of Japanese and foreign banks and securities firms, and representatives of regulatory authorities, securities depository organizations, rating agencies, law firms, research institutes and the press. Presentations of research papers were followed by vigorous discussions. The establishment of the Research Council on the Asian Capital Market was announced at the forum. The Council will feature the participation of interested persons from private companies and financial institutions in the region, in the hope that the opinions of market participants will be reflected in the plan to establish the Asian bond market advocated by the Association of Southeast Asian Nations (ASEAN), Japan, China and South Korea. The Asian Bond Market Concept The concept of an Asian bond market has been formulated by regional governments and participants in the financial and capital markets in the region, and represents an attempt to foster an efficient bond market with high liquidity, to enable the financial assets which have conventionally flowed from Asia to the European nations and the U.S. to be employed for intra-regional investment. At present, a large proportion of the financial assets of the region are being invested in European and American markets via the financial institutions of these two regions. The lessons learned from the Asian financial crisis have prompted governments in the Asian region to make joint efforts to implement the necessary environment for establishing an Asian bond market. The establishment of such a bond market would prevent Asia s abundant financial assets from flowing out of the region, and facilitate internal investment. The level of a bond market can be evaluated on the basis of the following factors: Legal regulations on registration, disclosure and securities transactions in general Relevant tax and accounting systems Infrastructure for settlement of capital securities The degree of sophistication of supervisory institutions, rating agencies, issuing companies, investors, financial institutions and other market participants The degree of sophistication of the corporate bond market and the short-term credit and foreign currency markets, which are its complements, and the futures market and securities repo market 7

Efforts in the following areas will be essential to the establishment of the Asian bond market: The concept of the market and the rules applied to it should be common to the nations of the region and market participants. The elements of the respective markets as well as their mutual relationships should be recognized as being shared in common. Efforts aimed at improving the domestic financial and capital markets of individual nations should be developed into concerted efforts to establish a common financial capital market that covers the region as a whole. The level of participants and relevant infrastructure should be improved. Naoyuki YOSHINO Professor Yoshino took a BA and MA in economics from Tohoku University and his Ph.D. at the Graduate School of Economics, Johns Hopkins University. Between 1979 and 1981 he was an Associate Professor in the Department of Economics, State University of New York. In 1991, he became a Professor of Economics at Keio University, a position he continues to hold. Since 2003, he has also been Director of the Financial Research and Training Center, Financial Services Agency. Shigehito INUKAI Mr. Inukai graduated from Keio University in 1975, and joined Mitsubishi Corporation. In April 2002 he went on to complete the Harvard Business School Advanced Management Program (AMP). For more than 18 years he was employed in the Finance Department of Mitsubishi Corporation, including 6 years in a finance subsidiary in London. He is also Secretary-General of the Japan Capital Markets Association. In June 2002, he was dispatched from Mitsubishi Corporation to take up his present position as a Senior Fellow at the National Institute for Research Advancement (NIRA). 8

[Table 2] Agenda for the Establishment of an Asian Bond Market (1) Rating of Asian bonds and the provision of information on changes (2) Guarantee of credit when bonds are issued (optimal form of involvement of governmental organizations to prevent moral hazard) (3) Establishment of a hedge market in order to eliminate exchange risks (4) Solution of the mismatch between the mid and long terms (5) Simultaneous cultivation of short-term financial market and bond market (6) Utilization of Japanese bonds as benchmarking bonds (7) Reexamination and unification of tax and accounting systems (8) Establishment of an Asian bond market capable of conforming to Japan s laws and regulations (9) Reform of the central depository system (10) Attraction of international financial markets to Japan (Note) This agenda has been formulated on the basis of the discussions at the forum Research on the Asian Capital Market, held on October 18 and 19, 2003, at Keio University, Tokyo, based on research conducted by the university s Center of Excellence (COE). 9