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Robust credit cultures key to bond market development

A lack of appreciation of the investor's role in the capital markets could undermine efforts to develop deep and liquid corporate bond markets in Asia-Pacific, argues S&P.

While many Asia-Pacific countries have made good progress developing local corporate bond markets in recent years, we believe the region still has a long way to go to realise its full potential. Deep and liquid debt markets are essential as many Asia-Pacific countries seek to build market maturity and sophistication, the characteristics that traditionally have attracted so many issuers to the US and European markets.

In our opinion, the importance of fostering national credit cultures built on transparency, creditors' rights, and independent and objective credit analysis cannot be understated; such credit cultures enable and strengthen the development of fully-functioning local corporate bond markets and broader regional markets.

Nearly every Asia-Pacific government has started trying to build local corporate debt markets in order to benefit from the diversification that such markets provide. Experience from the 1997 financial crisis has driven momentum in emerging Asia, while Japan's bond market took off after its bank-directed investment system broke down in the early-to-mid 1990s. In the region, annual domestic corporate bond issuance increased 1.5 times from 2005 to 2009, reaching $758.4 billion in 2009. Last year alone, local issuance jumped 38%, spurred by greater regional market stability and liquidity compared with global debt markets.

This momentum reflects market participants' concerns about the future ability of banks, in the region and elsewhere, to meet borrowers' needs as banks conserve balance sheets to meet Basel III capital adequacy requirements. Governments are also anticipating the shift to consumption-led economies in which the private sector, especially small and mid-size enterprises, will need bank support, in turn compelling the corporate and infrastructure sectors to seek more of their funding from the capital markets. The interest in domestic bond market development also reflects the desire to reduce volatilities associated with foreign capital flows.

Governments are also looking to local corporate bond markets to bolster resilience to any future global shocks. Asia-Pacific did not experience the asset bubbles that triggered the global financial crisis, but it felt the aftershocks nonetheless, albeit to varying degrees, and market participants are now weighing up investment strategies with care. Governments are viewing bond market development as a way to more efficiently and effectively stimulate economies. In particular, they recognise the role well-functioning corporate debt markets play in resourcefully allocating capital, not least for urgent infrastructure investment. More importantly, the common goal of regional financial integration is based on the understanding that increased cross-border financial flows between countries will bring this about organically and sustainably, rather than by forcing the square peg of a single common financial market into the round hole of regional diversity.

Interestingly, one benefit not usually discussed is how a fixed-income debt market can help investors grow their wealth efficiently and steadily over the longer term. We see this as a key benefit given the region's aging populations and the need to offset likely rising inflation and higher costs of living as emerging Asian economies develop and become more globally integrated. This lack of appreciation of the investor's role in the capital markets needs to be addressed lest it undermine efforts to develop corporate bond markets; ultimately, investors armed with the information, rights, and confidence needed to make reasonable risk-and-return decisions are essential to creating a healthy and sustainable bond market.

Robust credit cultures are built on key elements

Fostering a credit culture goes hand-in-hand with bond market development. Risk needs to be measured and priced according to objective standards, and not based on questionable relationships and implicit assurances. A global-best-practice credit culture will produce an attractive and rewarding environment in which investors can operate. In our opinion, the chief elements of such a culture are:

  • Transparency -- disclosure, high and consistent reporting standards, and good corporate governance.
  • Independent and objective credit analysis -- credit analysts producing high quality and credible research and analysis in a competitive environment.
  • Risk-based pricing -- investors are compensated for the risk they are taking.
  • Creditors' rights -- bankruptcy laws and a legal system that enforces these rights.
  • Arm's-length relationships -- between issuers and investors, and between governments and banking systems.

A credit culture is a shared mindset focused on achieving a holistic system that respects and empowers investors and embodies clarity, fairness, and consistency. But such an investor-oriented environment presents challenges for many Asian countries. A healthy culture thrives on a bottom-up approach in which investors drive the market, a scenario that is not a natural fit for sovereign states that have historically managed their economies and financial systems from the top down. It is also based on the free flow of reliable and independent information. In some countries, information has been of poor quality or restricted and there's still work to be done to ensure this fog is lifted. Lastly, it is about equal treatment and a fair and level playing field. Again, in countries where relationship-driven preferential treatment has taken precedence it will be up to regulators and policymakers to legislate for positive change and eradicate entrenched sub-par practices.

Some governments are concerned that bond markets might create social instability as a result of introducing direct default risk into the market. But risk is inherent in all investment systems and business and financial activities, and in fact a too-heavy reliance on banks has the potential to exacerbate social instability. Far from eliminating risk, governments are not only magnifying potential losses by concentrating risk (and avoiding diversification) but also by subjecting constituents to possible economic stagnation and higher taxes to recoup the cost of any systemic failure. A bond market, on the other hand, shifts risk toward those willing to take it on and reduces the potential impact on society by distributing and diversifying risk. Developing a credit culture that enables investors to make informed risk-and-return decisions lies at the heart of this.

Despite the challenges, Asia-Pacific is making the transition to an investor-based credit culture. There are growing, maturing corporate bond markets in Australia, Hong Kong, Japan, Korea, Malaysia, New Zealand, Singapore, and Taiwan, and emerging markets in China, India, and Thailand. Standard & Poor’s reviews each country's corporate bond market development with a particular focus on how successfully each has built an investor-based credit culture. We also assess the degree to which each country is harnessing its corporate bond market to better diversify and redistribute risk in its economy. Please click here to access the full analysis from Standard & Poor’s Asia website.

A mature credit culture is essential to market integration

The process of building capital markets outside of banking systems is a long and laborious one, because it necessarily involves changing the entrenched norms of a country's business culture, including the way its investor body thinks and behaves and the relationships that market participants have with one another. Such environments cannot be changed overnight.

But Asia-Pacific governments and their markets are strongly sensing the importance of developing deep and liquid debt markets as an essential next step in achieving the sophistication of the US or eurozone markets. And big issues are driving the momentum, including: the investor's need to grow wealth more rapidly to offset global aging and likely rising living costs; the region's generally urgent need for infrastructure investment; and the need for companies to diversify funding sources in bank-dominated environments. And the pillars that go to create a mature credit culture are essential not only to each country's national development, but also to the integration of the region's markets generally.

The author of this article, Tom Schiller, is an executive managing director and head of Asia-Pacific at Standard & Poor’s.

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