The ability of Asian companies to raise investment capital in their local currencies from local debt markets has helped insulate them from the worst effects of the liquidity squeeze afflicting many parts of the international capital market. But policy makers in the region still have a lot of work to do to ensure this trend accelerates.
Domestic markets have helped Asian companies pick up the slack after their fundraising in international markets began to slow in mid-2007. Net new corporate debt issues in local markets in the Asia region reached about $237 billion in the first nine months of 2007 û up 55% on the full-year 2006 and exceeding the volume of new international debt issues by Asian corporate borrowers, according to figures from Standard & PoorÆs.
Bond markets in the region are generally still small relative to the economies they are serving, but theyÆre growing. The most developed and largest markets in the region, as measured by the ratio of issued corporate debt to GDP are Australia (55%), Malaysia (43%), Hong Kong (42%), and Singapore (34%). But these markets are still far smaller than the US (129%). At the other end of the scale are China (18%), Japan (17%), and India and Indonesia with ratios of 5% or less, suggesting strong potential for growth. For example, ChinaÆs economic boom in recent years has been accompanied by a leap in its corporate debt issuance ratio to 18% from just 13% at year-end 2005, even in an environment of high government issuance.
But Asia is still over-dependant on the banking system, where lending practices are to an extent still made on the basis of relationships rather than risk-and-reward analyses. This is also a key reason why capital-market borrowing by corporates is still so small. Reliance on a single û and, as we have seen in the past, potentially fickle û source of finance heightens the regionÆs economic vulnerability. Consequently, Asian wealth is often directed outside the region for investment, rather than within, and the process of efficiently allocating resources and risks is impeded to the detriment of the regional economy.
Recent events have highlighted the fragility of liquidity in international debt markets and the importance of ensuring that Asian borrowers can resort to alternative pools of readily available capital at home. The liquidity in Asian economies potentially available to local companies is immense, but to allocate it efficiently requires continuing to nurture the growth and development of local bond markets, especially in local-currency bonds.
Global capital markets have become increasingly accessible to Asian issuers, but they can never be a substitute for deeper local markets. International markets can generally be tapped only by the largest, most creditworthy issuers and bonds issued overseas and denominated in dollars or euros expose the balance sheet to currency risks. In too many cases, smaller borrowers have little option but to rely on traditional bank lending. In times of volatility in financial markets, they may find this an advantage. But if lending is disrupted in the domestic market, as was the case during the Asian financial crisis, it leaves the majority of local borrowers with limited funding alternatives.
True, drawing on bank credit lines can be a useful option if the bond markets are disrupted, as has been the case recently. But the risk remains that banks may turn off the tap if they find themselves needing to conserve capital or liquidity û and bank loans, being relatively short term, do not enable borrowers to stretch out their maturity profiles. At the same time, while private placements of debt can be handy in times of market turmoil, they can never be a substitute for a public market, as deal sizes are too small and costs too high. In a healthy system, companies need a full spectrum of funding options, from equity û the costliest, but most permanent, source of capital û through a mix of borrowing choices, including public bonds.
Much progress has already been made to encourage growth of local bond markets in the region. In the wake of the financial crisis, AsiaÆs governments and central banks united to develop local-currency markets, creating the Asian Bond Market Initiatives in 2003. The initiatives saw the establishment of various working groups to co-ordinate financial activities across the region and to deepen the issuance of local-currency bonds to spur market development.
These measures are bearing fruit. In the first three quarters of 2007, many of the regionÆs major markets such as Japan, China and South Korea saw significant year-on-year increases in domestic bond issuance, at a time when corporate bond markets in the US and Europe shrank, particularly at the high-yield end of the spectrum.
This is an impressive performance and one for which policy makers who have backed an agenda of liberalisation and deregulation can take considerable credit. However, more progress needs to be made. Asian bond markets are still fragmented, with varying standards and rules. Many markets are also highly illiquid in the sense that turnover in the secondary market is unusually low. These factors deter investors, both at home and abroad, who might otherwise want to dip into local bond markets. Fragmentation makes it hard for investors to learn the ôrules of the gameö in a large set of emerging markets. Those investors are also reluctant to pour in money if they believe market illiquidity will make it difficult or impossible to exit at will.
Policy makers must not only be willing to tackle the problem, they have to be realistic about the solutions required. Fostering a healthy local capital market requires a constellation of factors that can be difficult to assemble. They include a solid trading platform and dependable market-making community, a legal regime that protects creditor rights and a broad base of institutional investors and borrowers. Regulatory hurdles such as interest withholding tax and exchange controls have to be reduced as they deter more investment, particularly in secondary markets that need the liquidity most. And independent credit ratings must be promoted, to improve information flows, transparency and credit risk assessment, which remains weak in many parts of the region.
Each country faces its own reform challenges. In China, potential bond issuers need approval from up to three government agencies depending on various factors, including the type of bond being issued. While most bond markets around the world operate over-the-counter, without listing on a stock exchange, in India the government is trying to enforce a public bond market on its stock exchange, resulting in Indian issuers effectively relying on private placements instead of going to the trouble of listing. China, Indonesia and Vietnam currently prohibit short-selling in debt markets, which cuts off hedging opportunities that international investors now demand.
Vibrant bond markets open new sources of capital to entrepreneurs and help disperse risk. Absence of such markets left many Asian economies exposed in the 1997 crisis, while their subsequent development is already helping to shield Asia from the US and European credit turmoil. These experiences should be at the forefront of policy makersÆ minds as they consider whether and how to reform regulations to encourage further expansion of local bond markets.
This article was written by Tom Schiller, executive managing director for Asia-Pacific at Standard & PoorÆs.
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