New Ideas Needed to Foster Asian Bond Market
Takatoshi ITO (Professor, University of Tokyo)
The "Asia Bond Fund" is on its way to being launched with the aim of fostering the Asian bond market. Its effectiveness in developing the market, however, will be limited for a number of reasons, among which is that it intends to invest in bonds denominated in US dollars only. I propose, rather, a scheme to establish an entity that would purchase bonds of various currencies to be used as collateral to issue its own bonds denominated in a basket currency according to the structure of the collateralized bonds.
Effectiveness Will be Limited if Only US Dollar is Used
The "Asia Bond" has recently been a hot topic of discussion. To my best knowledge, the term was first used by Prime Minister Thaksin Shinawatra of Thailand at the Asia-Europe Meeting (ASEM) held last September.
On June 2, the Executives' Meeting of East Asia and Pacific Central Banks (EMEAP) announced the establishment of the Asia Bond Fund, and the ASEM Finance Ministers' Meeting on July 6 declared that necessary measures would be taken to develop the Asian local-currency bond market.
At the core of the concept to establish an active Asian bond market is a concern over "reverse-flow" of capital--where money flows through New York or London--. As Asian countries generally have excess savings, central banks and institutional investors in the region invest their assets in US treasuries and other US dollar denominated interests, At the same time, investors in the US and Europe would lend to and fund Asian banks and companies in US dollars, constituting a phenomenon called reverse-flow of capital.
If Asian borrowers can borrow in local currencies, exchange and liquidity risks associated with the reverse-flow could be avoided. The Asia bond is a concept to establish a channel for flow of funds directly from local investors to local industries, bypassing the banking system.
Development of the Asian bond market has been widely recognized to be necessary as a means to prevent a repeat of Asia's 1997/98 financial crisis, but specific plans were slow to materialize. Over-dependence on the banking system has structural risk, as a currency crisis would generate banking crises, which quickly provoke an economy-wide crises. Development of the bond (and debenture/stock) market is essential to relieve the economy from over-dependence on banks.
The Asia Bond Fund, according to the EMEAP announcement in June, will be set up by the contribution by the central banks of the member countries for a total of 1 billion US dollars. The Fund will be managed by the Bank for International Settlements (BIS), and invested into US dollar denominated bonds issued by Asian governments and their agencies. The Fund, however, is not sufficient in order to avoid a recurrence of the crisis. The following aspects are defects of the Asia Bond Fund framework.
First, the securities in which the Asia Bond Fund plans to invest are limited to those denominated in US dollars. One of the vital lessons learned through the last crisis was the problem of currency mismatch. For example, Thai banks were borrowing in US dollars from foreign banks and converting dollars into baht for lending to domestic clients. When the value of baht dropped sharply against the dollar, the banks as a matter of course became insolvent. Similar situations occurred in Indonesia and South Korea. The currency mismatch problem will not be resolved as long as the Asia Bond Fund operates solely in US dollars.
Second, the fund is said to be managed "passively" by the BIS. This means their target of return is the market average, no more. Such a policy tends to result in a buy-and-hold investment behavior, which may encourage new issues but will not support active trading needed to deepen the market.
Third, the scope of bonds eligible for investment by the Fund is very limited as they must satisfy the strict criteria to be included as a part of official foreign reserves. It means the Fund will not be able to take an active part in widening the scope of the market by diversifying its range of investment into corporate bonds or securitized assets.
New Entity to Purchase Local Currency Bonds
The Central Bank of Thailand, in response to these comments, has said that local currency bonds would be considered for investment upon successive enhancement of the Fund. This may solve the first point noted above, but neither the second nor the third. I therefore propose a scheme that would foster the healthy development of the Asian bond market in addition to reducing the risk of currency crisis in the future.
The Japanese government bond denominated in yen is safe but return is low, while yields of government bonds of developing countries are high but carry high risks. Because most Asian currencies now float against the dollar, currency fluctuation risk remains for investors holding US dollar bonds. It is therefore well worth devising an instrument for Asian investors to diminish currency fluctuation risks and to provide a reasonable yield-risk combination in the risk-return profile.
In order to satisfy those needs of local investors, I propose to set up an entity, provisionally named the "Asia Bond Corporation" (ABC), which would purchase bonds issued by various Asian countries in local currencies. (This concept is currently being pursued by the author in cooperation with Korean and Thai scholars.)
The Asia Bond Corporation will use its assets, i.e. the bonds purchased, as collateral to issue an "ABC Bond" which has a characteristic of being denominated in the basket of collateralized securities held by the corporation.
For example, suppose ABC were to issue a batch of bonds backed by a purchase of 50% Japanese government, 30% Korean government, and 20% Thai government bonds. The new bond issued by ABC would be in effect denominated in a basked currency comprised of 50% yen, 30% won, and 20% bahts. For Japanese investors the currency risk would be smaller than those assets denominated in dollars or the euro, because the won and the baht fluctuate closer with the yen than before.
On the other hand, as half of the component to set the rate of return of the bond would consist of domestic interest rates of Korea and Thailand, the effective yield would be higher than that of the Japanese government bond. This feature would also make it attractive for Japanese investors. This means while reducing fluctuation risks by creating a virtual basket currency, higher rates of return could be expected than investing in securities with high credit standing. This sort of instrument, if made easily accessible, should appeal to Japanese investors.
Japan Should be the Leader to Realize the Scheme
ABC itself would match the currency and maturity risk on the both sides of the balance sheets, so that no such risk will be borne by ABC. As such, the Corporation would need only initial funding for startup from the public sector and no financial support is necessary for its operation once it commences. It could be regarded as some sort of large mutual funds or investment trusts. By matching the currency and maturity of its assets and liabilities, ABC could confine the risk of operation to the very minimum.
Once the operation starts, the range of currencies included in the basket could be expanded to other Asian government bonds, creating the basis for a closer currency policy cooperation. The Asian Basket Currency Unit would then be in sight for possible and eventual realization.
Furthermore, if and once the basket bond backed by government bonds becomes recognized as a benchmark, it would pave the way for the corporate bonds issued by blue chip Asian firms to be bundled to create a new bond denominated in the Asian Basket Currency Unit. Securitizing account receivables of companies from various countries would be beneficial for those smaller companies as well as to provide a wider range of instruments for investors. Credibility of bonds of lower quality could perhaps be reinforced by establishing credit enhancement mechanism in the initial years.
The ABC Asia Bond scheme thus conceived would enhance liquidity for investors, and is expected to promote issuance of domestic bonds, which in turn would have an effect of vitalizing domestic bond market trading. ABC as an entity would participate in domestic markets as investors, and act as an issuer of its own bonds in the market where large-scale investors are active. The ABC bond is expected to be circulated in the international market once it is issued, playing its part in fostering secondary market activity.
Government and corporate bonds issued in domestic currencies and becoming available for investors in the region who may actively purchase them would undoubtedly be a big step toward linking Asian savings to Asian investments. It should also function as a key to Asian economic cooperation.
Thailand has been active in taking a lead in implementing the Asia Bond Fund. It is Japan's turn to exercise its leadership in establishing the ABC bond market. The ASEM Finance Ministers' Meeting earlier this month stressed the importance of a developed Asian bond market. I would suggest that rather than simply expanding the capital base of the Asia Bond Fund, the scheme to introduce the ABC Asia Bond through the exercise of Asian Bond Corporation should be pursued.
(The original Japanese article appeared in the July 10, 2003 issue of Nihon Keizai Shimbun. Do not quote without permission of the author)