An Overview of Corporate Bond Markets and Policy Issues

1. An Overview of Corporate Bond Markets and Policy Issues S. Ghon Rhee K. J. Luke Distinguished Professor of Finance Executive Director Asia-Pacific Financial Markets Research Center University of Hawai‘i Workshop on Developing Corporate Bond Market in APEC Economies August 6-8, 2004 Shanghai, China Asia-Pacific Financial Markets Research Center, University of Hawaii

2. - Bonds Outstanding in 2002 (in US$ Billion) Asia-Pacific Financial Markets Research Center, University of Hawaii

3. East Asian Bond Markets Outstanding Domestic Bonds (in US$ Billion) Asia-Pacific Financial Markets Research Center, University of Hawaii

4. Financial Sector Profile 2002 Asia-Pacific Financial Markets Research Center, University of Hawaii

5. Two Major Questions on Bond Market Development 1. Why are bond markets so small in Asia? 2. Why hasn't the secondary market developed in economies with large primary market? OECD Workshop on “Debt Securities Markets in the Dynamic Asian Economies,” September 8, 1992 in Hong Kong Rhee, 1993, “Fixed Income Securities Markets in Six Dynamic Asian Economies” Asia-Pacific Financial Markets Research Center, University of Hawaii

6. Five Underlying Reasons (I) 1. Controlled or administered interest rates • Low effective yields without reflecting current market conditions • Reliance on captive demanders • Illiquid secondary market 2. Dominance of banking sector over capital markets • Heavy reliance of bank short-term loans by private corporations • Requirement for collateralization or guarantees by financial institutions for corporate bond issues Asia-Pacific Financial Markets Research Center, University of Hawaii

7. Five Underlying Reasons (II) 3. Limited supply of long- and short-term fixed income securities • Statutory restrictions • Government regulations • Banking sector’s resistance • Poor credit ratings of issuers 4. Limited Institutional Investor Base & Lack of Individual Investors’ Participation 5. Under-developed market infrastructure Asia-Pacific Financial Markets Research Center, University of Hawaii

8. Six Major Impediments in Developing Bond Markets 1. Lack of Benchmark Yield Curves 2. Limited Supply of Quality Bond Instruments 3. Captive Nature of the Primary Markets 4. Small Investor Base 5. Fragmented Regulatory Structure 6. Inadequate Market Infrastructure Complacency Prevailed! ADB High-Level Policy Dialogue on East Asian Financial Crisis, March 1999 Rhee, 2000, “Rising to Asia’s Challenge: Enhanced Role of Capital Markets” Asia-Pacific Financial Markets Research Center, University of Hawaii

9. Lack of Benchmark Yield Curves (I) Operational Reasons for Government Bond Issues 1. To Finance Fiscal Deficits 2. To Sterilize Large Capital Inflows 3. To Provide benchmark yield curves • Concentration of new issues in limited standard maturities enables their use as benchmarks • Spreading few benchmark issues across a range of maturities leads to a “benchmark yield curve” Asia-Pacific Financial Markets Research Center, University of Hawaii

10. A Recent Success Story of Korea: Liquidity Increase in Benchmark Bond Issues Introduction of the Fungible Issue and Reopening Systems • Benchmark-designated Bond Issues have identical maturities and coupon rates • By adopting the reopening system, Korea expanded the size of bond issues of the same maturities. Asia-Pacific Financial Markets Research Center, University of Hawaii

11. Volume of Benchmark Issues The Effect of the Reopening System in Korea 3.5 times greater Asia-Pacific Financial Markets Research Center, University of Hawaii

12. Lack of Benchmark Yield Curves (II): China’s Example a. Deposit interest rates are serving as benchmark b. MOF sets a range of bidding spreads at the primary market auction c. Why very little differences are observed between savings bonds and book-entry bond yields? Savings Bonds:Syndicated Underwriting Book-Entry Bonds: Uniform Price Auction Method Asia-Pacific Financial Markets Research Center, University of Hawaii

13. Fragmented Regulatory Structure (I) • Malaysia in Pre-Crisis Period: Bank Negara vs. Securities Commission • China at Present: Fragmented Regulatory Structure of Government Bond Markets a. Dual Supervisory Structure of Primary Market T-Bonds and E-Bonds: MOF F-Bonds: PBOC b. Dual Supervisory Structure of Secondary Market Inter-Bank Market: PBOC Over-the-Counter (OTC) Market: PBOC Exchange Market: CSRC Asia-Pacific Financial Markets Research Center, University of Hawaii

14. Fragmented Regulatory Structure (II) • Consolidated Regulatory Agencies: Thailand, Korea, Taiwan, Singapore • Indonesia at Present: Financial Services Authority (or Otoritas Jasa Keuangan, OJK)under plan to replace Capital Market Supervisory Agency (BAPEPAM) Asia-Pacific Financial Markets Research Center, University of Hawaii

15. Expansion of Investor Base (I) Key Groups of Investors • Banks, Insurance Companies, Public and Private Pension Funds, Mutual Funds • International Investors • Individual Investors A diversified and heterogeneous investor base promotes liquidity and stabilizes market demand a. Insurance Companies and Pension Funds are demanders of long-term, low risk bond instruments b. Mutual Funds are demanders of short-term bond instruments Asia-Pacific Financial Markets Research Center, University of Hawaii

16. Expansion of Investor Base (II) Policy Measures for Developing a Broader-Based Market focus on • Moving bond instruments out of bank asset portfolios • Direct access to retail and/or foreign investors • Structural reform of pension and retirement funds • Reform or creation of mutual funds (especially bond funds) • Diverse Types of Bond Instruments Asia-Pacific Financial Markets Research Center, University of Hawaii

17. Fixed-Income Securities in the US Market (as of March 2004) Unit: US$ Billion Municipal Bonds $1,943.3 ( 8.62%) Treasury Securities 3,720.9 (16.51%) Mortgage-Backed Securities 5,344.0 (23.72%) Corporate Bonds 4,542.7 (20.16%) Federal Agency Bonds 2,654.0 (11.78%) Money Market* 2,588.0 (11.49%) Asset-Backed Securities 1,758.5 (7.76%) Total $22,531.4 (100.00%) * includes Commercial Papers, Bankers Acceptances, and large Certificates of Deposits Source: US Bond Market Association Asia-Pacific Financial Markets Research Center, University of Hawaii

18. Fixed-Income Securities in Thailand (as of December 2003) Unit: US$ Billion Municipal Bonds none ( 0.00%) Treasury Securities $21.73 (45.87%) Mortgage-Backed Securities none ( 0.00%) Corporate Bonds 9.43 (19.91%) Government Agency Bonds 6.06 (12.79%) Money Market n.a. (n.a.) Asset-Backed Securities none ( 0.00%) Total $47.37 (100.00%) Asia-Pacific Financial Markets Research Center, University of Hawaii

19. Fixed-Income Securities in Korea (as of December 2003) Unit: US$ Billion Municipal Bonds $8.28 ( 1.40%) Treasury Securities 121.43 (20.52%) Mortgage-Backed Securities n.a. ( n.a.) Corporate Bonds* 168.03 (28.31%) Government Agency Bonds** 295.43 (49.78%) Money Market n.a. (n.a.) Total $593.52 (100.00%) * 75% of Corporate Bonds are Asset-backed securitites ** Includes: Monetary Stabilization Bonds, National Housing Bonds, Foreign Exchange Stabilization Bonds, Subway Construction Bonds, Industrial Financial Debentures, Financial Bonds, KAMCO Bonds Source: MOFE, Korea (2004) Asia-Pacific Financial Markets Research Center, University of Hawaii

20. Building Bond Market Infrastructure 1. Competitive Auction System among Primary Dealers for Government Bond Issuance 2. Hedging Instruments for Interest Rate Risk 3. Credit Rating Culture 4. Clearing and Settlement System 5. Over-the-counter Market Trading System 6. Inter-Dealer Broker System Asia-Pacific Financial Markets Research Center, University of Hawaii

21. Issuing Techniques ofGovernment Bonds • Fixed Price Public Subscriptions Underwriter consortium utilized • Private Placements In the absence of well-functioning secondary markets • Tap Issues Sold directly into the secondary market through branch network of banks or securities companies • Auctions Multiple price auction vs. Uniform Price Auction Asia-Pacific Financial Markets Research Center, University of Hawaii

22. Multiple- vs. Uniform-Price Auction Method Multiple-price auction method a. Successful bidders pay the prices they bid ….…..“winner’s curse” b. Bidders tend to shade their bids below the maximum that they are actually willing to pay Uniform-price auction method a. All successful bidders pay the same price for a given security b. Hence, some successful bidders may pay a lower price than they actually bid. Asia-Pacific Financial Markets Research Center, University of Hawaii

23. Issuing Techniques ofamong OECD Members • Uniform Price Auction Finland, Italy, Netherlands, Norway, and Switzerland, UK, US • Multiple Price Auction Australia, Austria, Canada, Japan, Sweden, UK • Tap Issue US, UK, Germany, Canada, and most of OECD members, but not Japan Asia-Pacific Financial Markets Research Center, University of Hawaii

24. Asia-Pacific Financial Markets Research Center, University of Hawaii

25. Hedging Instruments for Interest Rate Risk A. Most Asian economies are trading bond futures (for long-term interest rate hedging) and short-term interest rate futures B. Exceptions: China, Indonesia, Philippines, and Thailand Asia-Pacific Financial Markets Research Center, University of Hawaii

26. Bond Rating Culture: Regional Bond Rating Agencies Number of Domestic Adoption of IAS Statements CountryCredit Rating Agenciesby Stock Exchanges Australia Open to Global CRAs Yes China 6 No Hong Kong SAR Open to Global CRAs Yes Indonesia 2 No Japan 3 & Open to Global CRAs Yes Korea 4 Yes Malaysia 2 Yes Philippines 1 No Singapore Open to Global CRAs Yes Taipei,China 1 Yes Thailand 2 Yes Viet Nam To be established No Asia-Pacific Financial Markets Research Center, University of Hawaii

27. Clearing and Settlement Government BondsCorporate Bonds AustraliaReserve Bank Information Financial Transactions Recording and and Transfer System Clearance System ChinaGovernment Securities SD&C Depository Trust & Clearing Co. (for Inter-bank market) Securities Depository and Clearing Co. Ltd. (SD&C) (for Exchange Market) Hong KongCentral MoneyMarkets Unit Central Clearing & Settlement System JapanBOJ Financial Network Japan Securities Depository Center System (BOJ-NET) Japanese Government Bond Clearing Corp. Singapore Government Book-Entry System Debt Securities C&S System Asia-Pacific Financial Markets Research Center, University of Hawaii

28. Bond Trading Systems: Order- vs. Quote-Driven Trading • Pre-trading negotiations and personal relationships among bond dealers are critically important • Automated trading system cannot offer these relationship • Korea Stock Exchange’s Experience • Thai Bond Dealing Center’s Role: A bond exchange, an inter-dealer broker, or a center for compiling bond price information? Asia-Pacific Financial Markets Research Center, University of Hawaii

29. Korea Stock Exchange’s Experience Korea Stock Exchange (March 1999) introduced an inter-dealer broker system for government bonds trading. Trading Volume ($ billion)OTCKSE 1999 167 234 2000 170 20 Lesson: Individual negotiations on OTC market cannot be replaced by impersonal auction system Asia-Pacific Financial Markets Research Center, University of Hawaii

30. Role of Inter-Dealer Brokers • Brings market makers together • Disseminates trading information to the market • Promote secondary market liquidity, depth, transparency • Earns commission for arranging trades at pre-agreed fees • Unlike market makers, no positions are taken by IDBs Adopted by: Most East Asian Economies (Singapore, Hong Kong, Thailand, Korea) Asia-Pacific Financial Markets Research Center, University of Hawaii

31. Looking Forward: What Do We Need in Asia? • Promotion of Asset-Backed Securities • Development of Mortgage-Backed Securities • Establishment of Credit Guarantee and Enhancement Programs for Small- and Medium-Size Enterprises • Financial Autonomy for Municipal Government Development of Municipal Bond Markets • Promotion of Creditor Right and Streamline Corporate Bankruptcy Proceedings • Legal Framework for Bond Borrowing and Lending to Promote REPO Markets Asia-Pacific Financial Markets Research Center, University of Hawaii

32. Thank You!For Further References,Please visit http://www2.hawaii.edu/~rheesg Asia-Pacific Financial Markets Research Center, University of Hawaii