The $1 billion Asian Bond Fund was set up with pooled funds from 11 Asia-Pacific Central Banks and Monetary Authorities. This article is based on a speech given by John Chambers on the Asian Bond Fund at the New York Asia Society on April 26, 2004. It will state the case of how domestic capital market deepening can help sovereign creditworthiness and address the specific initiative of the two phases of the Asian Bond Fund.
First of all, to clarify, a Standard & Poor's rating addresses a narrow subject - the capacity and willingness of an issuer to pay its debt in full and on time. As such, it is a forward-looking estimate of default probability.
The end rating is based on criteria that are continually amended as conditions change, but fundamentally analyze the political environment, the real economy, fiscal and monetary policy, and the external position.
Deepening Domestic Markets
It is perhaps in the external position that a deepening domestic capital market can help sovereign creditworthiness improve most. The idea is that financing from residents is more stable than from non-residents.
Put another way, debtors reliant on commercial sources of non-resident funding are at greater risk of a sudden cessation of financing flows than are debtors who finance themselves mostly domestically. This phenomenon is due to the home-market bias of investors, which in part derives from regulatory reasons, but also to greater information flow between borrower and investor.
From this perspective, it is of little importance whether domestic finance comes from bank lending or issuing debt securities. Chart 1 illustrates the correlation between ratings and external indebtedness.
Debtors turn to non-resident funding because it appears cheaper or because it is available. As banks have short-term liabilities, they prefer making short-term loans.
External lenders or investors can provide longer-dated financing when domestic capital markets are shallow. However, in the case of private sector borrowers, the negative externalities of borrowing abroad are spread among the entire economy. Private sector or public sector borrowers may also underestimate the risk of sudden halts in external finance, which in turn could create system-wide liquidity or solvency crises.
Turning to the real economy and making the same point in a different way, debtors find domestic finance expensive or wanting in certain tenors because of a low savings rate or because domestic savings are wasted. The correlation between savings and ratings is less clear because some countries - many Anglo-Saxon countries for example - appear to use their meagre savings very efficiently, while others, like India, use theirs profligately.
Savings in turn can be divided into private savings and public savings. Private savings can be motivated by several factors, including uncertainty, marginal effective income tax rates, corporate profitability, and levels of capital stock.
Public savings depend on the government's fiscal stance and the composition of its expenditure mix. Wasting savings through overbuilding private sector capacity or through unproductive public sector expenditure raises the cost of capital for all borrowers and absorbs limited domestic resources. As you would expect, there is a high correlation between fiscal flows, debt stocks, and debt ratings.
Having a deep domestic capital market can also help in pursuing an independent monetary policy. It is more effective for a central bank to manage short-term interest rates through open market operations using government securities than by making direct loans.
For providing emergency assistance to financial institutions, it is more efficient to lend against marketable debt securities than against collateralized loans.
The Asian Bond Fund
The Asian Bond Fund was established by 11 Asian central banks. It holds $1 billion of their pooled resources taken from their international reserves. The fund is passively managed by the Bank for International Settlements (BIS).
It is invested in dollar-denominated sovereign and quasi-sovereign paper of the member governments. Of course, $1 billion is a small amount in relation both to the region's growing international reserves and the size of the regional bond market, both of which are well over $1 trillion.
Moreover, being dollar-denominated, it does not provide additional local currency funding, and being passively managed, it does not increase liquidity. However, a billion dollars in the market does support the bid price and as Prime Minister Thaksin Shinawatra of Thailand has said, you have to start somewhere.
The recently announced Asian Bond Fund II takes the next step. Although the details are still being worked out, the 11 member central banks are going to establish and invest in a family of funds that replicates the domestic local currency bond market of each country, as well as a fund of funds. The individual country bond funds and the fund of funds will be open to regional and international investors.
The size of the funds, however, will be capped at some unspecified amount. The objective is to attract portfolio flows.
In this second phase, the 11 Asian central banks are playing the role of catalyst. The act of setting up these funds probably is not as valuable as the accompanying measures required to make the venture a success. These accompanying measures include harmonizing tax treatments of securities, particularly withholding tax; rationalizing the government's own debt issuance to make individual issues fungible and thereby more liquid; and beefing up local market regulations and regulatory bodies.
In addition, further work is needed to improve market accessories such as developing a repo market; modernizing Delivery Versus Payment procedures and custodian facilities; and in removing restrictions on forward and futures foreign exchange markets. Standard & Poor's would argue that the real value in this initiative is not in the amount of money raised through the two initiatives, that grab newspaper headlines, but rather in the more mundane tasks of harmonizing markets and building market infrastructure.
The objective of capturing portfolio flows does not only include corralling domestic savings that have been placed abroad, but also inducing cross-border portfolio investment from within the region as the behavioral patterns of pension funds, life insurance companies, and wealthy private investors in the major Asian financial centers differ little from those in London or New York.
These points were made persuasively by Professor Barry Eichengreen (circulated in the 2004 Asian Development Bank annual meetings in Jeju, South Korea). His paper points out that domestic capital market development and capital account liberalization go hand-in-hand for markets of this size.
He raises the questions firstly of sequencing: that is, given the disastrous experiences of 1997/1998, full capital account opening should follow improvements in Asian financial systems and corporate governance; and secondly of the particular attraction of a domestic market operating under a fixed exchange rate regime or a soft peg.
In these fixed-exchange rate markets, interest rates will be highly correlated with U.S. dollar rates. Investors in these markets may be looking for additional yield on credit risk, or they may be looking for the hard or soft peg to break, but they are not looking for interest rate diversification.
If the Asian Bond Fund initiative succeeds, then, it may simply prompt more capital inflows that have to be stockpiled in international reserves. The stockpiling in turn has either to be sterilized at a fiscal loss (as the cost of carry between domestic and U.S. rates is negative in all Asian countries) or be allowed to engender high money growth, which in turn fuels inflation. Many distinguished observers (including Professor Eichengreen and Stanley Fischer, formerly of the IMF) have argued that capital account liberalization works best with freely floating exchange rate regimes. Herein lies a tension that the architects of the Asian Bond Fund have not fully worked out.
