The Hong Kong dollar bond market has stood tall amid the carnage in Asian financial markets of the last few months.
Despite a dramatic spike in short term interest rates as the territory's authorities battled (successfully) to defend the currency peg, new issuance has remained buoyant - with issuers attracted by the deep arbitrage opportunities and an increasingly broad range of investors drawn by the high returns on offer.
To be sure, the Hong Kong debt market still has a long way to go if it is become a more consistent - and less fleeting - feature of the international capital markets.
New issuers and investors are required, not least from China; a deeper commitment to market-making and liquidity is needed; and the range of market participants must broaden.
But the market is starting to become more international in its reach. And, at a time when the development of Asian bond markets as an alternative to bank lending has never been more important, other Asian countries could do a lot worse than use Hong Kong's efficient and well run market as a model. Jackie Horne reports.
Demonstrating the IMF's recent contention that Hong Kong represents a pillar of stability for the Asian region, the territory's small but sophisticated domestic bond market has weathered the recent turmoil in impressive style.
In the face of a spike in domestic interest rates and the severe financial distress experienced by neighbouring Asian countries, it has been business as usual in the Hong Kong debt market in recent months.
New issuance of Hong Kong dollar debt instruments excluding Exchange Fund bills and notes jumped 60% during the first quarter of 1998 compared to the same period last year - with a total of 74 fixed, floating or certificate of deposit transactions raising HK$20.36bn compared to HK$12.83bn in the first quarter of 1997.
However, with highly volatile short-term interest rates precluding much FRN activity, there was just one floating rate transaction from Australia's Export Finance & Insurance Corporation (EFIC) against a total of 23 fixed rate deals, of which 15 were privately placed.
In terms of league table activity, HSBC Markets stands head and shoulders above the rest of the pack, lead managing HK$11.34bn of the HK$14.68bn in new issues to capture a 77% market share.
Notable developments since the start of the year have included heavy issuance by supranational issuers, with the Council of Europe raising a total of HK$3.2bn and the Asian Development Bank (ADB) marking its first return since October 1993 with a HK$3bn offering - and greater participation by international investment banks including Deutsche Morgan Grenfell, Goldman Sachs and Morgan Stanley, whose supranational client relationships bore fruit in a handful of private placement deals early in the year.
However, a closer analysis of the impressive headline figures speaks volumes for the way the Hong Kong dollar market has developed over the course of the last decade and of the future growth prospects it might expect to enjoy over the next few years.
Market players are unanimous that, although the resilience and sophistication of the market's infrastructure can no longer be doubted, HSBC's extended dominance does not auger well for the promotion of secondary market liquidity - and that the preponderance of supranational borrowers does not square with a domestic bond market's prime function as a capital raising source for its own borrowers.
Indeed of the 24 bond issues launched, only one transaction derived from a true Hong Kong borrower, the newly inaugurated Hong Kong Mortgage Corporation (see box).
Alongside one issue each for US agency Fannie Mae and Norwegian export credit agency Eksportfinans, the rest were all from surpranational borrowers taking advantage of an arbitrage driven window that allowed sub-Libor funding of up to 40bp in some cases.
Figures provided by the territory's de facto central bank, the Hong Kong Monetary Authority (HKMA), show that the HK$345.5bn in outstanding at the end of 1997 represented only 26% of GDP or 10.8% of bond market capitalisation.
Having stripped out the government's own issuance of Exchange Fund notes and bills, the figure falls to an even less captivating 18.3% of GDP and 7.6% of stock market capitalisation. Compared to the HKMA's first debt markets survey in 1995 this represents a growth of 9% in terms of GDP and 2.8% in terms of stock market capitalisation.
Compared to the most recent World Bank survey of 1994, however, Hong Kong still lags far behind developed nations such as the US - where the figure stood at nearly 120% of GDP - and, closer to home, Japan (75% of GDP) and Malaysia (55%) of GDP.
While Hong Kong has consistently run large budget surpluses and has no need for large government borrowing like the US, it has nevertheless been widely accepted that larger and deeper bond markets offer local borrowers a more diversified source of funding - limiting their dependence on bank financing.
Those market players which have been only occasional participants and done little to promote the bond market's broader development argue that the territory's small population relative to the rest of region means that Hong Kong will never have a sizeable debt market.
The market's long term supporters, on the other hand, notably the HKMA and HSBC, believe that Hong Kong can use its considerable expertise as a lever to attract capital raising from China - and to facilitate the development of the functioning domestic bond markets that Asia so desperately needs if it is to resurface from the crisis and provide a more viable means of financing its long-term infrastructure development.
HK's financial strengths
While participants may disagree on the growth potential of Hong Kong's bond market, none would dispute that the bond market has been able to flourish because the territory has emerged from the financial storm engulfing Asia with its integrity intact.
In particular recent arguments concerning the necessity and desirability of maintaining the currency at an immovable rate of HK$7.8 to the US dollar seem particularly strange given the territory's success in warding off speculators. It has also enabled the Hong Kong authorities to maintain competitiveness by gradually easing the asset bubble which had built up over the past eight years without a devaluation of the currency.
HKMA chief executive Joseph Yam summed up Hong Kong's achievement when he said recently that it "obviously takes a lot to establish credibility in a fixed exchange rate."
In a keynote address examining Hong Kong's role in the financing of Asia's development in early March, Yam pointed to three main reasons why stability had been maintained against such a turbulent recent background: "A robust monetary management mechanism, a modern system of prudential supervision and a sophisticated financial infrastructure."
Hong Kong's banks, he said, have strong capital adequacy ratios averaging 17% and problem debt ratios averaging less than 2%. Prudent business practices have also resulted in none of the maturity and currency mismatches experienced by many of Asia's corporate borrowers, most of whom are reeling under a welter of short-term and largely US dollar debt.
In terms of warding off speculators keen to take a punt on what has been perceived as an overvalued currency, Hong Kong's currency board system has been remarkably effective - despite the pain caused by high short term interest rates on the property and stock markets.
In the 14 years of the peg's existence, Hong Kong has been able to build up its financial muscle to the tune of $92.8bn in foreign reserves at the end of 1997, equating to 7.8 times the amount of currency notes and coins in circulation and 15 months of retained imports.
Both Yam and HKMA executive director Peter Pang attest to the efficiency of the currency board mechanism - which Pang describes as "a highly effective auto pilot system," that does not require the HKMA's active intervention in the foreign exchange markets. In essence the system requires that for every note in circulation there is an equivalent amount of US dollars at the fixed rate.
Because all banks are required to maintain a clearing account with the HKMA, a sharp outflow of capital resulting from a shorting of the Hong Kong dollar means that there will be a shortage of the currency in the clearing balance of the banking system on end of day settlement, which simultaneously puts pressure on short term interest rates.
At the height of the Asian crisis, short selling caused overnight rates to spike up to 300% at one point on October 23, although rates closed at a less dangerous 100% to 150% level on the day and 7% one day later.
On settlement, short sellers would have two options. They could either borrow Hong Kong dollars from the HKMA through the Liquid Adjustment Facility (LAF), or they could obtain Hong Kong dollars on a more permanent basis from the HKMA by selling back US dollars to the authority.
In the first instance, however, short sellers would be stung by the extremely penal rates charged by the HKMA - which, as Yam puts it, "is not in the business of providing cheap Hong Kong dollar funding to those shorting the Hong Kong dollar."
In addition, the outflow would be reversed by the inflow demanded by the HKMA's purchase of US dollars.
In its support, the IMF in early November concluded: "It is important to recognise that allowing interest rates to rise in response to exchange market pressures is an essential element of the currency board mechanism that lies at the heart of Hong Kong monetary arrangements. Recent events demonstrate that the system is working exactly as intended."
The resultant high short term interest rates, while putting considerable pressure on the Hong Kong stock and property markets, have effectively burst the asset bubble, with property prices for example dropping by 30%.
"People have often complained about the high cost of doing business in Hong Kong," Pang comments, "and I believe that correction in prices is healthy because it makes Hong Kong more competitive."
Bond issuance thrives
But the volatility of short term rates has certainly not damaged the Hong Kong dollar new issue market, where attractive arbitrage opportunities have attracted a number of borrowers in the last three months and investors have been drawn by the higher coupons on offer.
Says Mark Bucknall, HSBC's head of capital markets: "Over the first quarter of this year, it didn't really matter what level interest rates stood at nor how volatile they were, because we were able to maintain a functioning yield curve throughout.
"Unlike other markets around the region, we had a swap market that worked, issuer and investor demand for paper and a market infrastructure that enabled it all to function smoothly.
"There can be no greater testament to the sophistication and maturity of the Hong Kong dollar bond market than its ability to attract such high levels of issuance against such a volatile backdrop."
As an indicator of market confidence in the resilience of the currency peg, short term interest rates have now returned to their pre-crisis levels, although observers point out that there remains an Asian risk premium in the yield spread between Exchange Fund paper and US Treasuries.
According to the HKMA's Pang, spreads of 10 year Exchange Fund paper over Treasuries widened from about 75bp in early October to a high of 483bp in January this year, easing since then on the back of improved sentiment to a current level of 236bp.
High short term rates were the principal driver of institutional demand, with investors keen to lock in double digit coupons, and issuers able to maximise arbitrage opportunities from the swap to achieve their desired sub-Libor funding targets.
"Everyone was happy," explains Tony Li, head of new issues at Chase Manhattan. "Investors got their coupons, issuers achieved very attractive funding levels and the arrangers made a lot of money."
He adds: "The reason was because of a very interesting arbitrage opportunity between the Hibor/Libor swap, with Hibor at 30bp to 35bp at one point against Libor flat. This meant that on the basis swap alone, there was the potential for very substantial sub-Libor funding."
The swap window was driven primarily by strong investor demand for paper. "The swap market is there to match the different needs of clients," says Bucknall. "Investors don't really need to know that they are driving the arbitrage in this instance because they are receiving historically high yields."
The opportunity was not lost on a whole host of predominantly supranational issuers, with Fannie Mae leading a progression of triple-A borrowers with a HK$300m private placement deal via Deutsche Morgan Grenfell on January 7. Launched at par, the five year deal breached investors' all-important double digit yield requirement, to encompass a coupon of 10.5%.
But the most notable transaction of the quarter was the ADB's HK$3bn landmark financing via HSBC in mid-February.
The largest ever fixed rate transaction in Hong Kong dollars and the largest ever transaction by a supranational in a currency typically dominated by such issuers, the ADB's three tranche deal successfully established a liquid benchmark at the short end of the curve.
Equal tranches of HK$1bn comprised one, two and three year maturities, each with an issue price of par to pay coupons of 9.15%, 9.125% and 9.1% respectively.
Significantly, demand for the ADB issue - and others which preceded it - is said to have come from a greater breadth and depth of investors than has traditionally been the case.
Aside from Hong Kong's large government related funds and charitable institutions including the Land Fund, the Hong Kong Jockey Club and the Housing Authority - which have traditionally been dominant players in the domestic bond market - recent investors in the Hong Kong bond market have also included hedge funds, Chinese investors, corporates and mainstream institutional investors.
Corporates which do not usually seek term assets were said to have been drawn to short-dated issues which offered a yield pick-up of 5% to 9% over cash deposit levels, while institutions reeling from the collapse of the stock market and long of Hong Kong dollar cash found some comfort in triple-A credit ratings.
However, it has been the participation of Chinese investors which has attracted the greatest interest. Says one banker: "The most symbolic and important investors were the mainland Chinese.
"Institutions like SAFE (State Administration of Foreign Exchange) and the state-owned commercial banks were convinced that the peg would hold and furthermore that the Chinese government would not devalue the yuan and compromise the peg's future viability.
"Consequently they decided to switch out of surpranational Eurobonds yielding maybe 6% to 7% and buy into the Hong Kong dollar issues yielding 10% to 11%."
When interest rates rallied, however, and investors decided to book profits by selling out of an issue, the market was not always there.
HSBC's Bucknall reflects: "Some of the smaller private placement deals from other lead managers were only sold to one or two investors, who found that when they wanted to sell back into the market, the lead was no longer there to support the deal."
The lack of active secondary trading resulting from erratic interest in market-making by local banks has been an issue plaguing the Hong Kong dollar market for the past few years.
Although Chase, Citibank, Merrill Lynch and UBS have to varying degrees demonstrated their willingness to commit to the market, HSBC is virtually out on its own at the moment as a committed market-maker.
"It does worry me, but I would not say that I am losing a great deal of sleep over it," Bucknall responds. "After all we have devoted considerable resources and tried very hard to develop the Hong Kong dollar bond market - a commitment which is reflected in our league table position."
However, he also adds: "It almost goes without saying that a greater breadth of issuers, investors and market players would lead to a more vibrant market. The larger the size of the cake, the bigger the slice for us all."
Banks which have considered playing a more active role in the Hong Kong dollar market bemoan the fact that HSBC has to all intents and purposes already got the marketplace sewn up.
"We have had numerous internal meetings about it," says one banker. "But the reality of the situation is that when we are asked to be a co-manager, for example, we find that the lead has already called up the most likely investors. What happens is that you sometimes get stuck with paper and, if you want a price, there is no alternative to calling the lead which will not be offering a particularly attractive price."
This was not always the case. Chase's Li explains: "From 1993 onwards there started to be greater interest in the Hong Kong dollar market by local players. However, the increased competition for mandates meant that margins thinned away to unsustainable levels and the interest was lost again."
Compounding the problem has been a limited investor base. Major participants have traditionally been Hong Kong government-linked funds with trustee limitations on investable securities. "Even if we were able to persuade trustees to widen their remit," Li argues, "changing investment preferences away from highly rated paper is not going to happen overnight."
He adds: "Where general fund managers are concerned, most have an equity-related background and therefore do not know the Hong Kong bond market well enough. Support by money market funds, for instance, is so negligible that it would be embarrassing to quote their investment in Hong Kong dollar bonds."
Widening the investor base has proved problematic; while the soon to be established Mandatory Provident Fund (MPF) - which will handle the territory's pension savings - was once hailed as the market's great hope for the future, its investment remit has disappointed many bankers.
Li, who acted as convener to the Hong Kong Capital Markets Association's sub-committee regarding the MPF, had pressed the government to focus more on minimising risk through bond products rather than maximising returns.
In its most recent paper, the committee proposed that there should be a 50% cap on investment in equities and that the proposed minimum 30% minimum Hong Kong dollar exposure be broadened.
The arguments, however, were not taken on board and, in legislation passed at the beginning of this month, no requirement was imposed on the ratio between investment in the debt and equity markets.
But, with an estimated HK$40bn of savings per annum to be mobilised under the scheme which will come into existence either later this year or early next, the MPF's establishment is certain to bring some benefit to the bond market.
"I am still reasonably optimistic, although I would have been more so had our suggestions been adopted," says Li. "With the introduction of the MPF, more funds will be invested here since beneficiaries will need Hong Kong dollars on retirement and this will feed through into the bond market."
Aside from poor liquidity and a limited pool of investors, the third string missing from Hong Kong's bow has been a distinct lack of true corporate borrowers.
Fixed rate issuance has traditionally been difficult because institutional funds have sought highly rated credits above Hong Kong's A3/A+ sovereign ceiling, while FRN transactions which could be sold at a credit spread to banks dried up after the spike in short term interest rates.
In addition, most of the leading Hong Kong companies have traditionally preferred to raise funds in the domestic syndicated loan market, usually at highly attractive rates that reflected the liquidity of the local banking market.
Above all else, however, the Hong Kong bond market has been hampered by a prevailing notion that it produces negative real interest rates because of the huge inflation differential between the territory and the US - against which the currency is linked. Chase's Li is quick to point out that this is not the case, stating that over the past 10 years, the market has averaged a real yield of 0.5%.
He explains: "The yield potential is even better at the moment when you equate double digit coupons against domestic inflation of around 5% to give a real yield of about 5% to 6%. By contrast, if an investor had bought US Treasuries with a 6% yield and factored in inflation around the 2% to 3% level, the real yield would have only been about 4%."
As far as the future is concerned, the HKMA and committed bond market participants are confident that Hong Kong will derive its greatest potential by exporting itself as a role model elsewhere in Asia and broadening its reach through the increasing internationalisation of the currency.
As the registered owner of Asiaclear, the HKMA hopes to develop a regional clearing and settlement system via a series of bilateral linkages with other countries in the Pacific Rim.
A first link with the central securities depositories in Australia was established in December 1997, facilitating cross border settlement and trading of debt securities, and a similar reciprocal agreement is expected to be concluded with New Zealand by the end of the month.
Pang adds that the HKMA is in talks with the authorities in Singapore and China, with officials from the People's Bank of China due in Hong Kong next week to discuss - among other things - the establishment of a bilateral link.
China's relationship with Hong Kong remains crucial to the territory's ambitions for greater international clout. In the same way as the Hong Kong Stock Exchange has achieved success in attracting Chinese issuers through the 'H' share and red chip sectors, bankers - notably at HSBC - are keen advocates of the development of an 'H' bond market for Chinese borrowers.
A prototype issue - a HK$1.2bn seven year FRN by the now named Construction Bank of China - was launched in October 1995, but there have been no bond issues since then by other Chinese issuers.
In part this has been a reflection of the Chinese government's lack of a foreign currency funding requirement given that it has $140bn in foreign exchange reserves. But it is also partly the result of very tight quota restrictions on overseas borrowing by Chinese borrowers.
Says HSBC's Bucknall: "I do think that Chinese borrowers will make better use of the market because they realise that investors here have a better understanding of their credit. But you have to look at recent fundraising patterns."
He elaborates: "Last spring, we saw the first signs of activity in the Asian FRN market by the state-owned banks. Since then, the Asian financial crisis has put paid to issuance from across the whole of the region; so far this year there have only a few jumbo financings by sovereign borrowers such as Korea and the Philippines."
Providing a firmer foundation for the market by internationalising the currency and getting Hong Kong dollar debt into the portfolio of international funds is also a priority for market participants.
Prior to the handover to China last July, lead managers felt somewhat constrained from embarking on international roadshows to promote Hong Kong debt issues for fear that investors would focus on sensitive political risk considerations to the detriment rather than the fundamental credit merits of any individual transaction.
Two weeks after the handover, however, HSBC and Merrill Lynch achieved a major breakthrough with the launch of a first global bond issue to be denominated in Hong Kong dollars.
Scoring an impressive number of firsts in its sector, the HK$1.5bn issue for Fannie Mae ranked as the largest ever fixed rate offering in the currency, the first global bond of its kind and the first issue by an agency credit.
Underlining confidence in China's new Special Administrative Region (SAR), the five year deal was priced at 99.832 with a semi-annual coupon of 6.85% to yield 6.891% - equating to 34.5bp over Exchange Fund paper and 61.6bp over US Treasuries.
Fannie Mae officials were delighted with the response to the deal, around 30% of which was placed with US investors within 36 hours of the deal's launch.
Mehmood Nathani, director of long-term funding at the Washington-based agency, said: "Hong Kong dollar deals have always been limited to Hong Kong investors in the past under the assumption that there isn't a huge pool of investment money beyond the territory's borders.
"We believed, however, that with the huge interest in Hong Kong's equity markets, this was not the case and are very excited by the good start this deal has made."
Unfortunately, speculative pressure on the currency peg a few weeks later prompted a large swathe of investors to sell back their bonds to the leads. However, the point had been made and the undeniable resilience of the peg amid the recent crisis should enable further issuance in the future to target international demand.
The Hong Kong debt market may chafe under the limitations of its small population base, but it has shown remarkable development over the past eight years. The dedication of the HKMA and the territory's largest bank HSBC have resulted in the creation of a bond market which has stood tall amid the regional carnage.
While international critics have carped about the lending excesses and short-termist attitude of banks and governments around the region, Hong Kong has adopted a measured, transparent and regulated approach to its own development.
Should neighbouring countries in Asia finally foresake their traditional competitiveness in promoting themselves as regional financing centres, they could do little better than to follow the role model already established by Hong Kong.