Asian governments have prided themselves on their admirable fiscal restraint and large budget surpluses. Yet this remarkable prudence has had the unintended consequence of hampering the development of local capital markets.¹

For such markets depend on the steady, reliable issuance of government debt, and its absence has stunted their development in Asia. Asian companies have looked to banks for much of their corporate financing, relying on short-term working-capital loans in domestic and foreign currencies. The crisis of 1997 and 1998 revealed the grave dangers of this system. Without the continuous scrutiny of investments, the long-term funding instruments, and the repricing of risk offered by capital markets, Asian financial systems piled up a mountain of bad loans that eventually culminated in the debacle.

To avoid such disasters in the future, Asian countries should develop their capital markets and their capacity for prudential regulation. A critical building block in that process is the development of a healthy market for government bonds.

Way behind

In size and liquidity, Asian bond markets lag woefully behind their counterparts in the West (Exhibit 1). Apart from Hong Kong, Japan, and Singapore, few governments have issued enough different maturities to establish a yield curve. In South Korea and other countries where bond markets are relatively large, they are illiquid. Most governments have not established a regular calendar of issuance or an effective network of primary dealers to make markets and to serve as a conduit for new issues. Some countries have made progress on settlement systems for government bonds, but most systems remain expensive and risky. Settlement systems for corporate bonds and other securities are antiquated, involving paper shuffling instead of a seamless computerized process.

The South Korean bond market is typical. Relative to the country’s gross domestic product, it was less than one-fifth of the size of the US government bond market at the end of 1999. Few issues have maturities beyond three years. In addition, government issues are fragmented, with five different types of bonds, all of which can have many different issues. This fragmentation means that there is little trading (and hence little liquidity) and no reliable yield curve. In late 1998, daily turnover was a meager 0.5 percent, compared with 4 percent or more in mature markets. The South Korean government recently issued some larger new-bond issues; as a result, turnover has increased to 2 to 3 percent.

Why are Asian bond markets underdeveloped? Historically, Asian companies have relied mainly on short-term bank loans and, to a lesser extent, on the issuance of equity (Exhibit 2). For years, bank loans have been cheaper than bonds because of high Asian savings rates, limited shareholder pressure, government-subsidized lending, and regulated deposit rates. Before the 1997 crisis, most loans had short durations and variable rates, and in many countries they were denominated in foreign currencies. The financial crisis that swept through the region demonstrated the vulnerability of this system. Loan payments proceeded to soar as Asian currencies depreciated and short-term interest rates spiked. Only companies that had long-term local-currency funding or dollar-denominated revenues survived. Banks that had relied on short-term foreign-currency loans to finance long-term domestic-currency investments went under.

In Japan, a banking crisis has been slowly developing over the past decade, but not for these reasons. As in other Asian countries, bank lending has been the dominant source of corporate financing there. Although the Japanese capital markets are relatively large, they are not very liquid, since companies have high levels of cross-shareholdings in equities, and banks buy and hold bonds for regulatory capital. There is little foreign participation, in part because of regulatory constraints. Until the "Big Bang" reforms of 1997, many types of financial derivatives and other securities were prohibited. Japanese banks, like their counterparts in other Asian countries, must now struggle under a load of bad loans and are a major drain on the economy.

By developing capital markets and ending the government policies that have favored bank lending, Asian policy makers can help create a more stable financial system, reducing the dependence of local companies on the crisis-prone banking system and giving them access to long-term, fixed-rate financing in local currencies. Also, the continuous repricing of securities in capital markets provides good management incentives and transparency.

Laying the cornerstone

Government bonds are typically the cornerstone of a financial system because sovereign bonds serve as a comparatively risk-free asset against which all other securities can be priced efficiently. Government bond issues of different maturities create a benchmark yield curve. Other bonds in the same country trade at the benchmark rate plus a risk premium that reflects the riskiness of the issuer. The comparatively risk-free rate is used to price other securities, such as swaps and options, and is needed to calculate a company’s cost of capital. These simple facts of financial markets are too often forgotten.

A review of bond markets around the world demonstrates that, with few exceptions, a liquid government bond market is needed to create a reliable yield curve. In the absence of government bonds, some banks and companies in emerging markets have used interest rate swaps to construct yield curves. But creating these synthetic yield curves is costly and time-consuming, and the results are open to dispute. Since synthetic yield curves don’t set a transparent, widely accepted benchmark, they are not robust enough to price securities. A true benchmark benefits capital markets, much as the posting of fixed prices in shops at the end of the 19th century benefited commerce by reducing uncertainty about prices and by speeding up the buying process.

For brief periods, other kinds of bonds have been used to create yield curves. In the United States, there has been talk of using agency bonds from Freddie Mac (the Federal Home Loan Mortgage Corporation) and Fannie Mae (the Federal National Mortgage Association), private institutions initiated by the US government to foster residential-mortgage financing and now the biggest issuers of mortgage-backed securities. Denmark, Germany, and several other European countries have Pfandbriefen, bonds issued by large mortgage banks. Pfandbriefen were used as a benchmark in Denmark for a short time when the government budget didn’t justify debt issuance. None of these bonds, however, can truly be called risk-free, since the government doesn’t guarantee them. A sovereign government has the unique ability to tax its citizens and to print money, making it the safest borrower around. Government bonds also benefit institutional investors and corporations by providing a low-risk, long-term asset that can offset their long-term liabilities; pension funds and banks in some countries can count government bonds as capital.

Asian policy makers must now recognize that issuing sovereign bonds can serve the interests even of governments running budget surpluses—like many in Asia and, more recently, the United States and some European countries. In the mid-1990s, despite budget surpluses, the government of Singapore began regularly auctioning a limited amount of Sing dollar bonds to create a yield curve. The Government of Singapore Investment Corporation invests the proceeds, and the returns can be used for future tax cuts, social programs, or capital investments, thus minimizing the cost of Sing dollar bond issues. Norway has long had a similar program.

The US Treasury has recognized the importance of steadily issuing sovereign bonds to maintain liquidity. Although the US government is currently running a budget surplus and, by the most optimistic estimates, could pay off its debt entirely by 2013 or so, the US Treasury has continued issuing bonds that replace relatively expensive ones issued in the 1970s.

Ingredients of a robust bond market

The good news for Asian governments is that they need not issue a lot of debt to establish a vibrant bond market if the following five ingredients are in place.

1. A regular auction calendar with standard benchmark issues

To create a market and to attract primary dealers by limiting their inventory risk, a regular, well-communicated auction calendar is needed. In addition, the government should concentrate issuance on a few standard benchmarks to decrease fragmentation. It may also want to buy back old illiquid issues and replace them with newer, standard ones.

2. A network of primary dealers

Even small markets can be quite liquid if primary dealers, which distribute new bond issues, act as market makers. The Hong Kong Exchange Fund Bills and Notes program, for example, has 28 appointed market makers. Less than $20 billion is outstanding, but daily turnover and bid-ask spreads are comparable to those of mature markets.

3. An efficient settlement system

Another prerequisite of a liquid market is a safe, efficient settlement system—something Asian markets lack. A secure and efficient scriptless settlement system allowing for simultaneous delivery and payment is needed to reduce settlement costs and risks. Ideally, the settlement system—one that leapfrogs those of the United States and Europe—should also provide real-time information about the price and volume of all executed transactions to increase the transparency of the market.

4. Less regulation, more supervision

Asian financial markets have traditionally been tightly regulated but ineffectively supervised. The opposite is needed. Regulators should limit their attention to—but improve their supervision of—three important areas: ensuring the market’s integrity, limiting systemic risks, and protecting investors from making badly informed investment decisions.

5. International investors and a diverse investor base

In most government debt markets, foreign investors are crucial to building liquidity, though at a cost: greater interest rate volatility. Foreign investors hold at least 20 percent of government bonds in markets as diverse as Canada, Sweden, and the United States (Exhibit 3). For emerging markets that lack domestic institutional investors from mutual funds, pension organizations, and insurance companies, foreign investors are likely to be even more important: they not only provide demand but also bring more varied investment objectives and thus ensure liquidity.

Who will win?

When Asian policy makers get serious about creating vibrant capital markets—and actions by Hong Kong and Singapore as well as announcements by South Korea and Malaysia are certainly encouraging—there will be opportunities for intermediaries such as investment banks. Before the crisis, revenue from Asian cross-border debt issuance increased from an estimated $100 million in 1994 to $160 million in 1997, and revenue from domestic issuance increased from an estimated $300 million to $440 million over the same period. If governments put in place the ingredients of robust bond markets, the pace of growth could accelerate.

Who will capture the opportunity? "Bulge-bracket" and other large foreign investment banks (such as Credit Suisse First Boston, Goldman Sachs, Merrill Lynch, Morgan Stanley, Salomon Smith Barney, and SBC Warburg) appear to be better positioned to capture the lion’s share of the cross-border business: their share of international issuance in Asia has risen to more than 55 percent, from 26 percent. Local players still dominate domestic issuance, but the bulge-bracket firms are entering this space as well: their share of domestic corporate-debt issuance rose from virtually nothing in 1994 to 16 percent in 1999. To compete effectively, local investment banks must upgrade their capabilities for serving large corporate issuers or shift their focus to midsize and small companies.

No matter who ultimately captures the business of building Asia’s capital markets, one thing is clear: investors and issuers alike will benefit. Asian countries should continue to make the transition from a financial system led by banks to one more oriented toward capital markets. Establishing an efficient market for domestic sovereign debt is a first step in that direction.