The Asian Bond Market Initiative

Two market practitioners discuss the aims and implications of the ABMI.

Asians tend to save for the future while Americans borrow from the future. The irony is that the US, the world's superpower, is financing a standard of living (beyond its means) by borrowing excessively from the world, particularly Asia.

Luckily for now, the status of the US dollar as the world's reserve currency makes this spending possible and the lack of deep and liquid bond markets in Asia makes it difficult to allocate Asian savings through regional financial markets. This also makes Asian economies vulnerable to external shocks.

Net capital outflow from Asia means that Asia is providing savings to the rest of the world. Asia is exporting "safe capital" ie government money while importing "risky capital" ie private sector money.

If Asian countries were able to heavily reduce their holdings of US Treasury bonds and Eurobonds heavily and invest at home, they would remove a key source of finance for US consumption. As President George W Bush recklessly turns the US more heavily into debt, the need for a local alternative to the US bond market is suddenly becoming an issue again.

The purpose of the Asian Bond Market Initiative is to lessen dependence on the US and to better circulate local money within the region and funnel it into Asian public and private sector bonds.

The initiative is led by the Association of Southeast Asian Nations, plus Japan, China and South Korea. This has spawned several new institutions, the Asian Bond Fund (ABF) and the Asian Bond Market Forum (ABMFM), to mention but two.

On June 2, 2003 the Bank for International Settlements (BIS) and the Executive Meeting of East Asia Pacific Central Banks (EMEAP) announced the launch of the Asian Bond Fund (ABF), in which Asian Central Banks invest part of their foreign currency reserves.

The ABF portfolio will invest in a basket of liquid US dollar bonds of the major Asian economies and will be managed by the BIS.

The initial round of the ABF is around $1 billion, and a second round, which will include private-sector co-investors, will be much larger. This might seem small given the size of Asia's international reserves (over almost $1 trillion).

Yet, it is a lot bigger when compared with the off-shore Asian bond markets, whose maximum size is estimated at $780 to $8,150 billion. Furthermore, since this market is not well developed and liquidity is limited, the ABF's policy trading could represent 1% to 5% of effective market size in 2004.

Central banks in Asia alone buy more than 40% of all international purchases of US government debt, and many now argue that there are better uses for those funds.

More than 90% of the current-account surpluses earned by Asian nations through trading with the US, Europe and Japan are put on reserves in US Treasuries.

The ABF aims to avoid a mismatch in international financial transactions (long-term vs. short-term) that caused the Asian financial crisis in 1997. However, the ABF does not address the "currency mismatch". Here is where the Asian Bond Market Forum (ABMF), which holds its inaugural conference in Hong Kong November 11-14 (see: abm-forum.org) bridges the gap, and by involving the private sector: It places practitioners at the centre of planning for the missing pieces of financial infrastructure.

China and Asean's favourable response to the Asian Bond Market Forum is therefore significant because it reaffirms the effort to design and build financial protection for Asia with a more balanced financial infrastructure, thereby diversifying the risk of intermediation across a large number of institutions and market players. It would also offer another source of funds, instead of being tied solely to borrowing from international financial institutions, and would also help China pave the way for full convertibility of the renminbi.

Because the Asian Bond Market Initiative is important and far-reaching, many areas will be addressed at the ABMF meetings: Pension investors need better and more choices; banks need a disciplining competitor; both investors and issuers need a live, market-priced benchmark -- that is, an Asian yield curve -- to price long-term investment risk; infrastructure finance needs local currency finance and local watchdogs; the local markets need proper credit-rating agencies. The list is long.

The Asian Development Bank has shown its willingness to promote the local currency supply side of the Asian bond market and, so far, the mood towards making it a reality has never been better.

Traditionally, economic growth in many Asian countries has hinged on exports and generating foreign currency, but trade has been largely based on the US dollar. As the dollar has entered a secular bear market, more Asian countries feel the need to shift to domestic demand as one of the key drivers of economic growth and lessen the dependence on exports to the US.

One might argue that heavy dependence on US based financial intermediation has delayed the development of efficient capital markets in the Asian region. Because of this Asian economies have paid a price for the benefit of export led growth they have received.

This price has two components: underdeveloped financial markets, especially on the fixed income side, as well as a loss on the difference between the returns on safe capital and risk capital.

The opportunity cost of round tripping capital transactions through the US (approximated by the yield spread between US Treasury bonds and Eurodollar and global bonds issued by Asian economies) is estimated to be around at least 200 basis points or 2%, implying an opportunity cost of about 1% of GNP for such Asian countries whose reserves levels are more than half of GNP.

If Asia, led by China, un-pegs its currencies and moves toward floating ones, US bond yields will surge. Rising bond yields would put a lot of pressure on the US economy and might derail the recovery and consumption on cheap credit.

Seen from this perspective, one must wonder whether US Treasury Secretary John Snow truly understands the risks involved in demanding that China and other Asian countries scrap their pegs to the US dollar or whether he is pushing local politics too far. More likely, he cynically recalls the history of Asian governments' inability to take such strategic decisions quickly, if at all, and their preference for quick, cheap fixes.

But with a US election on the way, it's much easier to pick on the currency policies of China and other Asian economies, instead of dealing with structural problems at home for which there is no easy solution.

The Asian Bond Market Initiative could cause momentous changes. It is a symbol of the rise of China and new geopolitics. The recent regional cooperation among monetary authorities, governments and the private sector should be seen in a wider and long-term perspective.

It is in the interest of the global community to have a deep and liquid Asian bond market with many participants. It doesn't matter whether it will work from the beginning but that it is started and the right direction is taken.

Marshall Mays is a Director of Emerging Alpha Advisors Ltd, a Hong Kong-based research house and advisor to pension funds and issuers based in Asia and a Director at the new think tank, the Asian Bond Market Forum.

Michael Preiss is the Chief Investment Strategist for CFC Securities, a global independent financial services firm, specializing in bond trading and credit derivatives.