Asia's central bankers have embarked on an ambitious, much-trumpeted journey to develop their domestic bond markets and forge a pan-Asian regional market. Is it pie in the sky or is the initiative capable of dismantling the many obstacles that have long held back the local bond markets for both issuers and investors? Nick Parsons reports.
In December, the EMEAP (Executives' Meeting of East Asia and Pacific Central Banks) Group — comprising 11 central banks and monetary authorities in the region — announced the launch of the second stage of the Asian Bond Fund, the ABF 2.
Building on the back of the Asian Bond Fund (ABF 1) in June 2003, which invested in US dollar denominated bonds issued by eight sovereign and quasi-sovereign issuers in the EMEAP economies (other than Japan, Australia and New Zealand), ABF 2 will invest in domestic currency bonds issued by sovereign and quasi-sovereign issuers in the same eight markets.
"The launch of ABF 2 represents a historic milestone in central banking co-operation in the region," the central bank governors said in a collective statement. "The EMEAP Group is confident that the ABF 2 initiative will bring about significant benefits to the development of bond markets in Asia."
"The catalytic role that ABF 2 will play in promoting new products, improving market infrastructure and minimising regulatory hurdles will ... broaden and deepen the domestic and regional bond markets and hence contribute to more efficient financial intermediation in Asia in the longer term."
ABF 2 comprises two components: a pan-Asian bond index fund (PAIF) and a fund of bond funds (FoBF). The PAIF is a single bond fund investing in sovereign and quasi-sovereign domestic currency-denominated bonds issued in the eight EMEAP markets.
The FoBF is a two-layered structure with a parent fund investing in eight sub-funds, each of which will invest in sovereign and quasi-sovereign domestic currency denominated bonds issued in the markets of the eight EMEAP economies.
The idea is that the funds will be passively managed by private sector fund managers against a pan-Asian bond index and relevant domestic bond indices for the eight markets.
Central bank said in March 2004 that investment in the ABF2 would be about $2bn, split equally between the two structures.
Devil in the detail
All that is very well, but still no one is sure yet what the exact size of the fund will be — and who will be brought in from the private sector.
These issues were meant to have been sorted out in December, so coming to grips with the details is clearly proving harder than defining the big gesture.
One head of syndicate says of ABF 2: "It has already been talked to death," and refers to the progress made as "an ever decreasing circle".
But is that fair? After all, working out the details to the satisfaction of 11 different governments was always going to be a formidable challenge.
"ABF 1 only added to the Asian bid but was very significant from a precedent point of view because it showed that governments could work together," says John Pitfield, head of the local currency bond syndicate Asia Pacific at Citigroup in Singapore. "ABF 2 is a much more challenging proposition: the fact that they have undertaken it is a phenomenal step forward."
It raises questions of how fund management is introduced into the region, how one can invest in domestic credits when indices do not exist.
"As these markets develop, they open up to the light of day a series of problems with clearing, documentation, swaps and settlement," says Pitfield.
Pitfield warns that the devil is in the details and a great deal of work will need to be done. "By signing on, the governments have put themselves on the path; how quickly they move along it, is open to debate," he says.
"The agreement was over the big picture which is why they were able to move so far," says Marshall Mays, director and research fellow at the Asia Bond Market Forum, a private sector association and institute, in Hong Kong. "It was a basic exercise in co-operation among governments rather than actively doing anything, partly because they are passive funds.
"ABF 2 has raised questions and one question has led to another. There has been a strong pull to the laggards to raise their standards, but the bar is low for the likes of Singapore and Hong Kong that have already done the work and got a market in place."
There were always going to be two ways of doing it, he says: "There was a risk of being too bold and getting nothing done and also the risk of being too timid and not doing enough. The Asian Bond Fund was biased towards being too bold and then spending a lot of time getting it worked out.
"All this is having the effect of encouraging governments to harmonise their markets, while also bringing in those countries like China that have not yet looked at developing their bond markets — they can learn about the relevant issues without being embarrassed."
Private sector interests
The initiative has helped educate government financial officials but what will it offer the private sector?
"ABF 2 is very market positive," says Brad Levitt, head of fixed income, Asia, at Standard Chartered in Singapore. "We are seeing more interest from real money buyers and getting growing offshore interest in local currency bonds."
"The size is smallish but we do believe it will help bring in other players," says Levitt.
"Currently we are talking just about the tip of the iceberg; the potential is immense," says Ling Peng Meng, director of fixed income, Asia, at Standard Chartered in Singapore. "They are talking of indexing the whole Asian capital markets."
The investors are central banks, which have even higher reserves than pre-Asian crisis day that are invariably invested in G3 currencies (dollar, euros and yen). "If they can re-allocate them in Asian currencies themselves they will create a momentum among the fund management industry in the region," adds Ling.
Ling says he is already starting to see investors looking into new products such as 2004's issue for Cagamas' securitised bonds in Malaysia, showing, in his eyes, the breaking down of barriers against new products and cross-border investment. In all markets, though, the most relevant issues are withholding tax and cross-currency swaps, he stresses.
But the initiative is more than just what is being invested. It has encouraged regulators to talk about each other's markets and problems. Much as banks have gone in to try and educate the regulators about what they need, learning off each other — and not wanting to be left behind — may prove more efficacious a stimulant.
"The ABF is more for governments to learn from each other; if investors are given more latitude they will exercise their chances anyway," says Mays.
Mays fears that although the initiative is succeeding in getting governments to talk to each other, many regulators are spending too much time worrying about the dangers of foreign investors and the unregulated flow of foreign capital and not enough time putting their financial houses in order. "It is not so much that they should be worried about being able to withstand a foreign speculative force," he says. "The real lesson is that if the rules are balanced properly they will obviate the attractions of arbitrage."
The notorious Citigroup trade in the European government bond market last summer — when Citi traders sold Eu 12.4bn of eurozone governments only to buy back Eu3.7bn minutes later — no doubt appalled Asian central bankers.
"You had two semi-segmented markets and the potential to cross over, which meant that partial segmentation allows for the loophole," says Mays, referring to the Citigroup trade. "The lesson for Asia is that governments should strengthen their own domestic regulations as quickly as possible and then lower the threshold to outsiders.
A recurring theme among bankers is that governments should show genuine commitment to co-operating with each other and create competitive markets rather than grandstanding and competing for leadership of the whole process.
"Competing for leadership doesn't percolate down to what issuers or investors want," says one debt capital market banker. "But what is does do is create an environment where there is pressure not to lose face; if some are too far ahead, the laggards may hold their heads in shame."
But what of the all-important investors in Asia's local currency bond market? Some believe the buy-side's point of view has not been sufficiently taken into account. "The investor side is a little bit overlooked," says Simon Klassen, vice president, Asian local markets analyst at JP Morgan in Hong Kong.
He points out that policymakers and academics have, in the years following the Asian crisis, observed that several domestic currency government markets have moved ahead but corporate markets have lagged. But in fact the corporate bond markets in domestic currencies have grown rapidly, especially compared to issuance in US dollars.
"It is demand-side factors that lead to the contrast between liquid US dollar bond markets in Asia and relatively illiquid local market," he says.
"ABF 2 comes at a fortuitous time," Klassen says, "when there is a lot of interest in diversifying away from Treasuries and the US dollar. This is one way — sanctioned by the central banks — to provide investors with total return structures.
"It might get central banks thinking about it from an investor standpoint. For example, although initial investment will be tiny, it may provide them with some understanding of how expensive domestic bonds are in Asia."
The region's local currency debt markets account for around 3% of such markets worldwide, double the share of Latin America and almost six times as large as that of eastern Europe. Asian bond markets are still largely overlooked by international investors, who own less than 5% of Asian bonds on issue.
Part of the problem may well be that Asian bond markets are still perceived to be illiquid compared to the international public markets. But is their illiquidity a symptom of structural weakness or is it simply a question of having insufficient time to develop?
A negative force?
Some critics of the ABFs have suggested that setting up these funds will do little to improve local bond markets, and could damage them. They believe that buy and hold central bank investors will little liquidity to the market and that by focusing primarily on the highly rated segment of bond markets, where there is already plenty of demand, these funds could crowd out private sector investors.
Ric Battellino, assistant governor (financial markets) of the Reserve Bank of Australia thinks these criticisms miss the point. "In setting up these funds, the aim of the participating central banks was not to promote bond market development by adding directly to demand or turnover; rather, it was to help identify, through their direct involvement in markets, the barriers that exist to market development," he says.
"The benefit to markets was intended to come not from the investment itself but from policy reforms that individual national authorities might take. Doing this on a collective basis has had the added advantage of information sharing and creating peer pressure to maintain the momentum of the reform process."
Another criticism levelled at the ABF initiatives comes from John Chambers, managing director of the sovereign ratings group at Standard & Poor's in New York. "There is disproportionate noise compared to the impact they will have, which is to be expected. But if you take it to its logical extension, the ABFs take for granted capital account liberalisation," he says. "They also work best if you have floating exchange rate regimes."
It can be argued that liberalising the capital account in the absence of strong and well developed markets may entail sequencing risks, in that regional financial markets may not yet be in a position to handle increased volumes of cross-border flows.
"It may well be the case that the integration of bond markets amounts to capital account liberalisation," says RBA's Battellino. "But I don't think this should stand in the way of market development. Whatever the theory might say about sequencing of reforms, in practice the reform process must take opportunities as they arise and often has to proceed on many fronts at once as reforms in one area rapidly result in pressures for change in other areas."
The argument that bond market reform could cause problems for exchange rate management is, he thinks, overstated and attaches too much importance to the relatively small cross-border flows in the development of local currency bond markets.