Developing a local-currency bond market tops the agenda of many emerging economies intent on financial reform.¹ The reasons are clear: a deep and liquid bond market provides an alternative to bank credit and thus helps to create a more competitive financial sector and to lower the cost of borrowing. And bonds tend to have longer maturities than bank loans in these economies, thereby reducing the need for offshore borrowing, along with its attendant currency risk.

But how should governments set about developing a bond market where none exists? Thailand, which has built one quite rapidly, points the way. Before the 1997 financial crisis in Asia, the Thai bond market was rudimentary: government bonds had not been issued since 1990, because the law precluded their issuance in times of budgetary surplus. Without government securities to act as a benchmark, there was no accepted yield curve for pricing other bonds. Not surprisingly, the corporate-bond market was very small, supplying only 5 percent of Thai companies’ debt-financing needs.

By early 1998, however, policy makers had come to recognize the need for an efficient local-bond market² and took steps to create one quickly. First, the government began a regular program of bond issues, with maturities of up to 15 years. This step established a yield curve for pricing corporate bonds (Exhibit 1). To create liquidity in the market, the government then converted the former Bond Dealers Club into the Thai Bond Dealing Centre (TBDC), a self-regulating organization of securities brokers. Twice daily, dealers must post trading information with the TBDC, which is therefore a central source of information on the market. The TBDC also standardizes conventions for bond trading and monitors it. An independent credit-rating agency provides credit ratings, which are now mandatory for virtually all corporate issuers. A second rating agency will follow soon.

By making interest income and capital gains from local-bond mutual funds tax-exempt, the government has stimulated demand from retail investors. Today Thailand has more than 80 fixed-income mutual funds—with a total net asset value of 80 billion baht ($1.8 billion), up from 20 billion baht in early 1998—that invest exclusively in local bonds.

Such developments have jump-started the market. The trading of corporate and government issues reached record levels in early 2001, and turnover now averages around $3 billion a month (Exhibit 2). Although liquidity has improved more in government than in corporate bonds, it remains low by the standards of developed markets; only 1 percent of Thai government bonds are traded each day, compared with about 4 percent of US Treasuries and 3 percent of Hong Kong government securities. Corporate-bond issues outstanding have nonetheless risen from less than $1 billion before the financial crisis to almost $4 billion in 2000, and they now provide large companies with an alternative to traditional bank credit (Exhibit 3).

Moreover, both the issuer and the investor bases have broadened. Thailand’s corporate issuers cover the entire spectrum of industries, while its institutional investors (insurance companies, mutual funds, and pension funds) are becoming more active in the market. Even retail investors are discovering fixed-income securities: they purchased more than 60 percent of a recent $190 million corporate-bond issue by Advanced Info Services, Thailand’s largest wireless-telecommunications company.

But there is more to do. For one thing, regulatory authority remains unclear: the Bank of Thailand, the Ministry of Finance, the TBDC, and the Thai Securities and Exchange Commission share responsibility for regulation and supervision. If the market is to develop further, the government should appoint a single regulator and give it a clear mandate to build the market.

To improve liquidity in the overall bond market, an electronic trading system that offers real-time pricing should replace the current system of posting prices two times each day. To reduce risk, Thailand should also introduce a scripless (paperless) settlement system that provides for delivery-versus-payment settlement (the simultaneous exchange of securities and the payment for them).

In the government-bond market in particular, several actions are vitally important. First, the government must continue its regular auction calendar, focusing on filling in the gaps in the yield curve and ensuring a steady and predictable supply of liquid securities. Second, a repurchase market is needed to make it possible for primary dealers to refinance their inventory. Third, policies governing the use of hedging instruments, such as interest rate swaps, should be liberalized so that investors can reduce their level of risk. Thai mutual funds, for example, are prevented by law from using swaps.

To improve liquidity in the corporate-bond market, instruments ought to be more transparent. Many existing bonds have complicated structures; they might, for example, switch from a floating interest rate to a fixed interest rate halfway through the term. And they do not always follow standard international market conventions; some, for instance, make coupon payments at irregular intervals rather than at the end of each month. This makes it hard to calculate yields and thus reduces liquidity because market participants dislike trading nonstandard instruments.

Although the bond market in Thailand is not yet fully mature, the country has shown that a concentrated effort can produce a basic bond market infrastructure in a reasonably short time. Other emerging economies could do the same.