Last December central banks across the Asia-Pacific region launched an initiative they believe will help kick-start the region's local capital markets. The Asian Bond Fund 2 (ABF2), as it's known, was unveiled to much fanfare and acclaim – not least from its architects.
The $2 billion fund is meant to invest in local currency bonds across the region in a bid to boost its still immature markets and keep the region's formidable savings inside Asia.
The question, however, is how meaningful the fund will be for potential issuers, investors and financial intermediaries: is it simply hot air from the public sector? And will it make a practical difference in aiding the functioning of local bond markets?
"The launch of ABF2 represents an historic milestone in central banking cooperation in the region," says EMEAP (Executives' Meeting of East Asia and Pacific Central Banks, a group of countries comprising Australia, China, Hong Kong, Indonesia, Japan, Malaysia, New Zealand, the Philippines, Singapore, South Korea and Thailand) in a joint statement that was later issued on each central bank's website with individual endorsements.
"The catalytic role that ABF2 will play in promoting new products, improving market infrastructure and minimizing regulatory hurdles will help further broaden and deepen the domestic and regional bond markets, and hence contribute to more efficient financial intermediation in Asia in the longer term," says the group.
ABF2 is the second phase of the Asian Bond Initiative, and follows the launch in 2003 of a $1 billion fund invested in US dollar Asian sovereign credits. The hope is that it will help raise investor awareness and interest in Asian bonds by providing innovative, low-cost and efficient products in the form of passively managed bond funds.
Wrong diagnosis
But the buy-side is not really the weak link in the market, say bankers.
"These funds will not create demand because Asia has excess savings anyway. Demand is not the problem – the problem is supply," says Dominique Dwor-Frecaut, an economist at Barclays Capital in Singapore. "The good thing about ABF2 is that it will force policy-makers to improve market infrastructure."
"It will have to address issues like lack of liquidity, the need for good price data and create regional benchmarks for local currency bonds," she says.
EMEAP says ABF2 would invest in the domestic currency bonds of sovereign and quasi-sovereign issuers in eight EMEAP markets with the exception of Japan, Australia and New Zealand.
A Pan-Asian Bond Index Fund (PBIF) will invest in local currency bonds (and will be domiciled in Singapore and initially listed in Hong Kong), and a Fund of Bond Funds, will have a parent fund investing in a number of country sub-funds. Each will start at $1 billion.
"There are two measurements to gauge the success of this scheme – how big will it grow and how the other market participants use it to replicate the product or through customization," said Norman Chan, deputy chief executive of the Hong Kong Monetary Authority (HKMA) at the time.
Chan, who had been tasked with coordinating much of EMEAP's work on the Asian Bond Funds, resigned from the HKMA last month to take up higher education opportunities.
Focusing on detail
Working out the details, however, has proved more difficult than scripting the big statement.
Only EMEAP central banks will be able to invest in the ABF2 in the first phase, but private sector institutions will be invited to invest in the fund in the second phase. But the logistics of how that will work is still on the drawing board – it's as yet unclear when the second phase would kick in.
The ABF2 will have an initial size of "approximately" $2 billion, but beyond that few details have been ironed out. The questions being asked include: how big will the fund be further down the line? How will it be managed? How will it be indexed?
In March, EMEAP mandated State Street Global Advisors for the widely sought role of passive manager of the $1 billion fund of funds. It is looking to bring in institutional and retail investors. But the individual countries are largely still in the process of selecting private fund managers and custodians for their ABF2 sub-funds.
"We cannot be too specific about the likely size of the Hong Kong Sub-fund at this stage," a spokesman at the (HKMA) told Emerging Markets. "However, the fund size will be announced when it is launched to the public. We are finalizing the selection of the fund manager for the Hong Kong Sub-fund."
Bankers are sceptical about the private sector's keenness to invest in the individual funds without the liberalization of the region's capital accounts. The fund of funds, which would be a composite of domestic and foreign securities, is a more appetizing option, says one.
Illiquid bond markets in Asia have been blamed for escalating the 1997/8 Asian financial crisis, and since then there has been substantial progress. According to the ADB, Asian local currency bond markets ex-Japan have grown by three times in the last seven years, while capitalization has grown from 20% of combined gross domestic product in 1995 to 45% in 2003.
That is still way below that of leading world markets like the US and UK. But the big achievement of the central banks is to have reached an agreement at all.
"The first Asian Bond Fund was very significant because it showed that governments could work together," says John Pitfield, director, regional debt capital markets Asia-Pacific at Citigroup in Singapore. "ABF2 is a much more challenging proposition. but the fact that they have undertaken it is a phenomenal step forward."
Investors concerned
Among the many issues that need to be sorted out are questions of how international investors can bring their funds into Asian domestic credit markets without indices and in the face of an unfavourable environment for activities such as clearing, documentation, swaps and settlement, says Pitfield.
"As regards the impact of ABF1, people have commented that is too small but it is not the size of the fund that is important but the rationale behind it," says John Keith, regional head of debt capital markets at Nomura in Hong Kong. "The breadth of consensus that has been reached among the sovereigns in Asia is a very important generational shift: first, it shows how much more certainty there is about the importance of developing long-term capital markets; and, second, a level of agreement about the importance of building up downside protection against currency risk."
Fragmentation has always been the major barrier to cross-border investment and issuance in the local debt markets. Each country has different characteristics, regulatory hurdles and tax impediments.
"How to issue sensibly in multi-currencies has always been a theme in Asia," says Nomura's Keith. In Hong Kong dollars, it is very simple – you have a liquid new issue that can attract a broad range of institutional investors and then not a lot of secondary market activity. Singapore is a market for triple-A issuers: it is developed but smaller than Hong Kong. Korea, in contrast, is a near $400 billion-equivalent bond market but with little foreign involvement.
With such disparities in market infrastructure and composition – and with Asia's huge economic differences, such as between, say, Singapore and Indonesia – working out the investment criteria for ABF2 has predictably taken longer than was claimed at December's launch.
Says one banker: "Some governments are saying that it is absurd that they should support a Hong Kong dollar issue when they don't need the money, and what about the Philippines that do?" On the other hand, the richer countries of the region clearly have reservations about parking their reserves in countries with a less than perfect record for economic stability and fiscal responsibility.
Answering the critics
While ABF2 has attracted a lot of attention in recent months, not all of it has been positive.
Critics have suggested that there already exists strong appetite for high quality Asian local currency bonds and that the ABF2's aim of boosting the supply side could be self-defeating if ABF2 ends up competing with private sector investors for the small supply of highly rated Asian bonds.
Similarly, ABF2 will do little to boost wider issuance and encourage lower rated corporates to tap the market, complain critics. As buy and hold investors, continue the naysayers, nor will central banks add much liquidity to the market.
Another accusation as to why ABF2 will not boost liquidity in local currency bond markets is that it will be passively managed.
Central bankers have become immune to these – largely private sector – criticisms. In a speech in December, Ric Battellino, assistant governor (financial markets) of the Reserve Bank of Australia, addressed some of them.
"I think we can readily accept that investing $1 billion or even several billion dollars in a market that is capitalized at around $1.4 trillion is not, in itself, going to have a lot of impact on market development," he says. "By the same token, of course, it is not going to have any crowding out effects."
Nor will these funds add significantly to market turnover, he concedes. But that is not the point, says Battellino. "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, he adds.
[pull quote]
"Demand is not the problem – the problem is supply" – Dominique Dwor-Frecaut
BOX – ADB report
It was another year of robust growth in 2004 for East Asian local currency government bond markets, says a report from the ADB published in April, but growth of the corporate bond markets was mixed.
Investors, though, on the whole, were not complaining. "A combination of falling yields and a weakening US dollar ensured another year of high returns from investment in East Asian bond markets."
The report notes four major developments in the region's local currency bond markets last year:
∑ the Malaysian and Korean governments issuance of longer tenor bonds to extend their yield curves
∑ the efforts made by the Indonesian, Korean, Malaysian, Philippines and Singapore governments to increase the issue size of benchmark offerings by reopening issues
∑ the strong growth of asset-backed securities and Islamic bonds, and the issuance of bonds by multilateral development banks, that indicate the emergence of a wider issuer base backed by strong investor appetite
∑ the launch of ABF2, which will provide a boost to investment in local currency bond markets in the region
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This year the ADB expects growth to be more modest, due largely to fiscal consolidation. But among the reform initiatives it envisages are improvement of trade systems, lengthening benchmark yield curves and strengthening investor protection.
The ADB's AsianBondsOnline conducted a poll of bond analysts from the top five local currency book running institutions in East Asian markets, asking them where measures could be taken to speed corporate bond market development.
Their replies in descending order were:
∑ widen the issuer and investor base
∑ improve the transaction environment
∑ develop hedging products and derivatives markets
∑ address uneven disclosure standards
∑ strengthen the framework for creditor rights
∑ improve transaction and general data reporting
BOX – ABFs: Paving the way for Asian monetary union?
Communication between Asian central governments to shore up common financial ground is not new. Even before the Asian crisis, they came to an agreement, back in November 1995, over a collection of EMEAP bilateral swap facilities that provide US dollar liquidity secured against US Treasury securities.
Then came the bright-eyed but ill-fated idea that cam from Japan in the wake of the Asian crisis in 1997 for an Asian Monetary Fund.
It was quickly dropped under pressure from the US in particular which objected to any body impinging upon the turf of the International Monetary Fund (IMF) and the World Bank, in which it holds majority stakes. Asians balked too, most vociferously China — reluctant to open the door to a post-war, politically correct version of a co-prosperity sphere.
The third attempt at monetary unification is the collection of ASEAN+3 bilateral swap arrangements (between the US dollar and domestic currencies) under the Chiang Mai Initiative.
Some bankers and regulators believe that "suitably elaborated and modified to include the United States and several other countries," in the words of one, an Asia Pacific Monetary Fund (APMF) could be extremely useful. It could provide a complement for the IMF in the same way that the Asian Development Bank complements the World Bank. It would allow the region to respond quicker to Asian worries in a way that its absence in 1997 led to the worsening of the Asian economic crisis.
But would it be possible?
There are two schools of thought, says Nomura's Keith. "One says it is a very good idea that you don't put all your eggs in one basket and have a common basket pegging of regional currencies; and the other says — why worry about having a single currency when the US dollar continues to dominate in Asia?"
As holders of the largest foreign currency reserves in the region, Japan thinks the yen could do the job by itself. China — among others in Asia — would have something to say about that. It would seem that for all the fragmentation of the region's financial markets, including its bond markets, and the obstacles to cross-border issuance and investment, the Asian Bond Fund 2 will most likely have to invest in different currencies.
A single currency is still some way off.
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