Post-crisis Bond Market Development in East Asia 東アジアにおける危機後の債券市場の発達 Lian Liu

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Post-crisis Bond Market Development in East Asia

東アジアにおける危機後の債券市場の発達

Lian Liu

A Dissertation submitted in fulfillment of the requirements for the degree of Doctor of Philosophy

Graduate School of Asia Pacific Studies, Waseda University Tokyo, Japan

February 2016

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Acknowledgements

This thesis completes my achievements in the academic research at Graduate School of Asia-Pacific Studies (GSAPS), Waseda University, Tokyo, Japan. I would like to acknowledge a number of people without whom my thesis might not be completed.

First and foremost, I would like to express my great gratitude to the support and help of my supervisor Professor Shujiro Urata, Graduate School of Asia-Pacific Studies (GSAPS), Waseda University, Tokyo, Japan. It is my great honor to carry out research work under his supervision. His constant encouragement, excellent guidance and bright suggestions enable me to accomplish my research work successfully.

A special thanks to my ex-supervisor Huasing LIM. Words cannot express how grateful I am to him for all of abundant encouragement and kind support. Wish you all the best in the heaven.

I also would like to thank my deputy advisor Professor Nobuhiko Fuwa and Nabeshima Kaoru and two other members of the screening committee, Professor Toshiro Nishizawa and Professor Hiroyuki Taguchi, for the brilliant comments and suggestions regarding my academic research.

I take the opportunity to express my eternal gratitude to my parents for their everlasting love and faith in me. I thank my husband Keping Yu, my soul mate, who inspires me to pursue a PhD degree in Japan. He encourages and accompanies me all through my study in Waseda University.

Finally, I thank China Scholarship Council for the financial support to accomplish my research.

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List of Figures

Figure 2- 1: Regional Bond Market Capitalization (excluding Japan) ... 25

Figure 2- 2: Japan’s Bond Market Capitalization ... 25

Figure 2- 3: Domestic Bond Market Capitalization as a Percentage of GDP ... 27

Figure 2- 4: Nominal 10-year Government Bond Yield (2001-2013) ... 32

Figure 2- 5: Real 10-year Government Bond Yield (2001-2013) ... 33

Figure 2- 6: Government Bond Yield Curve in East Asia ... 37

Figure 3- 1: 10-year Nominal Government Bond Yield (2001-2013) ... 61

Figure 3- 2: 10-year Bond Yield without Premium for Country-Specific Risk ... 62

Figure 3- 3: Intra-regional Foreign Bond Holdings in East Asia ... 69

Figure 3- 4: Share of Intra-regional Bond Holdings in Each East Asian Economy ... 70

Figure 3- 5: Average Absolute Cross-market Differentials of 10-year Government Bond Yields ... 71

Figure 3- 6: Results of Beta-convergence of 10-year Government Bond Yields ... 80

Figure 4- 1: Bank Financing Ratio in East Asia ... 99

Figure 4- 2: Financial Openness in East Asia ... 100

Figure 4- 3: Regulatory Quality in East Asia ... 101

Figure 5- 1: Foreign Holdings of Bonds in Eight Emerging Bond Markets ... 115

Figure 5- 2: Foreign Holdings of Long-term Bonds in Eight Emerging Bond Markets ... 115

Figure 5- 3: Foreign Holdings of Short-term Bonds in Eight Emerging Bond Markets ... 116

Figure 5- 4: Regional Allocation of Foreign Holdings of Bonds ... 117

Figure A- 1: Investor Base in Government Bonds of China ... 157

Figure A- 2: Investor Base in Government Bonds of Indonesia ... 157

Figure A- 3: Investor Base in Government Bonds of Japan ... 158

Figure A- 4: Investor Base in Government Bonds of Korea ... 158

Figure A- 5: Investor Base in Government Bonds of Malaysia ... 159

Figure A- 6: Investor Base in Government Bonds of Thailand ... 159

Figure A- 7: Inflation Rates in East Asian Economies ... 160

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List of Tables

Table 1- 1: International Positions of all Reporting Banks on East Asian Economies outside the

Region (End of June 1996) ... 2

Table 1- 2: Net Capital Flows to Crisis Countries (Percentage of GDP) ... 3

Table 1- 3: Gross Domestic Savings in East Asia ... 6

Table 1- 4: Official Foreign Exchange Reserves in East Asia ... 7

Table 1- 5: Holdings of US Bonds as a Percentage of Total Foreign Holdings ... 8

Table 2- 1: Timeline for Regional Efforts to Develop Bond Markets ... 19

Table 2- 2: Domestic Bonds Outstanding in East Asia ... 26

Table 2- 3: Government and Corporate Bonds Outstanding ... 29

Table 2- 4: Yearly Growth of Government and Corporate Bonds ... 30

Table 2- 5: Domestic Financing Profile in East Asia ... 31

Table 2- 6: Government and Corporate Bond Issuance Volume ... 34

Table 2- 7: Government and Corporate Bond Issuance Volume as a Percentage of Market Size ... 34

Table 2- 8: Bid-ask Spread for Government Bonds ... 38

Table 2- 9: Bid-ask Spread for Corporate Bonds ... 39

Table 2- 10: Turnover Rate of Government Bonds ... 39

Table 2- 11: Turnover Rate of Corporate Bonds ... 40

Table 2- 12: 10-year Government Bond Yield Volatility ... 42

Table 2- 13: Government Bond Maturity Profile (2006) ... 43

Table 2- 14: Government Bond Maturity Profile (2013) ... 43

Table 2- 15: Corporate Bond Maturity Profile (2006) ... 44

Table 2- 16: Corporate Bond Maturity Profile (2013) ... 45

Table 3- 1: Statistical Summary of 10-year Nominal Government Bond Yields ... 63

Table 3- 2: Results of ADF Unit Root Test ... 67

Table 3- 3: Results of Unrestricted Co-integration Rank Test (2001-2002) ... 73

Table 3- 7: Results of Granger Causality Test (2001-2002) ... 75

Table 3- 11: Results of ADF Unit Root Test ... 79

Table 4- 1: Actual Domestic and Foreign Bond Investment ... 92

Table 4- 2: Actual and Optimal Foreign Bond Investment Share ... 93

Table 4- 3: General Development of Bond Home Bias in East Asia (against regional bonds) 95 Table 4- 4: Descriptive Statistics for Variables in the Analysis (2003-2013) ... 96

Table 4- 5: Correlation Matrix of Regression Variables ... 97

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Table 4- 6: Results of Hausman Test ... 101

Table 4- 7: Regression Results of Bond Investment Home Bias ... 102

Table 5- 1: Foreign Holdings of Long-term Bonds Relative to Market Size ... 119

Table 5- 2: Foreign Holdings of Short-term Bonds Relative to Market Size ... 120

Table 5- 3: Bond Market Development Indicators ... 121

Table 5- 4: Descriptive Statistics for Variables in the Analysis, 2003-2013 ... 123

Table 5- 5: Spearman Correlation Matrix for all Variables ... 124

Table 5- 6: Result of Hausman Test ... 129

Table 5- 7: Regression Results of Regional Foreign Investors’ Participation in Long-Term Bond Markets ... 129

Table 5- 9: Regression Results of Regional Foreign Investors’ Participation in Short-Term Bond Markets ... 132

Table 5- 11: Regression Results of Global Foreign Investors’ Participation in Long-Term Bond Markets ... 134

Table 5- 13: Regression Results of Global Foreign Investors’ Participation in Short-Term Bond Markets ... 136

Table 5- 14: Factors Affecting Foreign Investors’ Participation in Bond Markets ... 139

Table A- 1: International Positions of all Reporting Banks on East Asian Economies outside the Region (End of Dec 1997) ... 156

Table A- 2: Foreign Holdings of US Tresury Bonds ... 156

Table A- 3: Sovereign Ratings for East Asia (Moody’s) ... 160

Table A- 4: Bilateral Bond Holding in East Asia (2013) ... 161

Table A- 5: Bilateral Bond Holding as a Percentage of Total Intra-regional Holdings in East Asia (2011) ... 161

Table A- 8: Result of Principle Component Analysis (a) ... 163

Table A- 9: Result of Principle Component Analysis (b) ... 163

Table A- 10: Regional Foreign Invesotrs’ Holdings of Long-term Bonds ... 164

Table A- 11: Regional Foreign Investors’ Holdings of Short-term Bonds ... 165

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List of Abbreviations

ABF: Asian Bond Fund

ABMF: ASEAN+3 Bond Market Forum ABMI: Asian Bond Markets Initiative ACD: Asian Cooperation Dialogue

ACRAA: Association of Credit Rating Agencies in Asia ADB: Asian Development Bank

ASEAN: Association of South East Asian Nations ASEAN+3: ASEAN+ China, Japan and Korea CMI: Chiang Mai Initiative

CPIS: Coordinated Portfolio Investment Survey CAPM: Capital Asset Pricing Model

DOTS: Direction of Trade Statistics

EMEAP: Executives’ Meeting of East Asia-Pacific Central Banks FoBF: Fund of Bond Funds

I-CAPM: International Capital Asset Pricing Model IMF: International Monetary Fund

FTA: Free Trade Agreement GDP: Gross Domestic Product JGBs: Japan’s Government Bonds KAOPEN: Chinn-Ito index KTB: Korea Treasury Bonds LOP: Law of One Price MTN: Medium Term Note OTC: Over-the-Counter

OECD: Organization for Economic Co-operation and Development PAIF: Pan-Asian Bond Index Fund

PCA: Principle Component Analysis

QFII: Qualified Foreign Institutional Investor

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SEC: Securities and Exchange Commission

WGBI: Citigroup World Government Bond Index NAFTA: North American Free Trade Agreement

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Chapter 1. Introduction

1.1 Background

Prior to the 1997 Asian financial crisis, banks have long been the center of Asian financial systems, resulting in the neglect of balanced capital market development. The only researches on the Asian financial markets have focused on regional equity markets (McKinnon, 1991; Hakansson, 1992). Even though a few scholars have announced the importance of developing East Asian bond markets¹ in the early 1990s, the issues on East Asian bond market have not caught wide attention.

The 1997 Asian financial crisis has convinced the East Asian economies the urgency for regional financial cooperation. A robust capital market is needed in East Asia to channel cheaper and less volatile capital within the region instead of offshore borrowing. Since then bond market development has become one of the most important issues in the regional cooperation. The creation of well-functioning bond markets becomes a popular subject of discussion among financial market policymakers and scholars in East Asia.

The Asian financial crisis started in Thailand when Thai authority abandoned the US dollar peg on July 2, 1997. Following the collapse of Thai baht, the contagion quickly extended to Indonesia, Malaysia and Singapore. Malaysian ringgit, Indonesia rupiah and Singapore dollar were hit by speculators. Malaysian ringgit lost 50% of its value rapidly. Indonesian rupiah depreciated by approximately 90% under vicious attack within just a few months. In the following round, the financial crisis in Southeast Asia brought down Korea², which had invested heavily in the Southeast Asian countries, especially in Indonesia. Korea stepped into the same trouble as Indonesia and Thailand. The impact of the crisis has been devastating. Indonesia, Korea and Thailand were most affected by the crisis. For example, Indonesia has experienced a deep and prolonged recession and its fiscal costs of crisis resolution amounted to more than half of its annual GDP. Hong Kong,

1 “Bond” mentioned in the research comprises treasury bills (with maturity of less than one year), commercial paper, long- term bonds and notes and other short-term notes. “Government bonds include obligations of the central government, local governments, the central bank, and state-owned entities. Corporates comprise both public and private companies including financial institutions and international organizations. Financial institutions comprise both private and public sector banks and other financial institutions.” The definition is cited from AsianBondsOnline website.

http://asianbondsonline.adb.org/regional/data/bondmarket.php?code=LCY_Bond_Market_USD.

2 Korea, mentioned in the whole dissertation, refers to South Korea, officially named the Republic of Korea.

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Malaysia and the Philippines have been also hurt by the slump. These countries suffered from a loss of demand and confidence during the crisis.

In the years before the Asian financial crisis, most of the East Asian countries have enjoyed miraculous economic development driven by export-oriented growth and their economic growth rate has recorded 7% to 8% per annum. A large amount of capital was needed for infrastructure construction and local investment. However, during the late 1980s and early 1990s, domestic financial intermediations were overwhelmingly dominated by the banking system in most of East Asian economies. The lack of domestic financing channels and US dollar pegged exchange rate³ prompted more firms to turn to the foreign banks for capital financing. With the help of the regional financial deregulation in the early 1990s, private financial institutions from western countries literally provided large amounts of capital to Southeast Asian countries in expectation of high profits. As a result, a large scale of foreign capital flooded into East Asian countries. For instance, in Thailand, not only the corporations borrowed from abroad through the offshore banking centers, the local banks also borrowed heavily from overseas and re-lent the capital to local firms. In Indonesia, corporations borrowed directly from foreign banks to a large extent. As the end of 1996, Hong Kong and Singapore topped the foreign bank claims, followed by Korea (USD 88,027 million) and Thailand (USD 69,409 million). Table 1-1 summarizes the magnitude of international banks’

claims on East Asian economies.

Table 1- 1: International Positions of all Reporting Banks on East Asian Economies outside the Region (End of June 1996)

(in millions of USD) Total

Maturity less than one year

Sectors Banks Public

sector

Non-bank

private sector Unallocated

China 50,587 24,468 21,277 8,346 20,960 4

Indonesia 49,306 29,587 10,095 6,543 32,623 45

Korea 88,027 62,332 57,852 5,940 24,141 94

Malaysia 20,099 10,003 5,644 2,290 12,160 5

Philippines 10,795 5,948 3,456 2,740 4,597 2

3 The authority in one country pegs its currency to the US dollar on a fixed exchange rate to maintain the currency’s value.

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Thailand 69,409 47,834 28,006 2,145 39,159 99

Hong Kong 211,195 179,780 144,125 1,411 65,074 585

Singapore 189,195 176,080 159,003 1,017 28,995 180

Source: The Bank for International Settlements, “The Maturity, Sectoral and Nationality Distribution of International Bank Lending (Second Half 1996)”, Basel, July 2007

More than that, much of the borrowings of enterprises were denominated in US dollar instead of local currencies, which made the East Asian countries vulnerable to financial panic.

Unfortunately, after the mid-1990s, a series of negative external shocks, such as the devaluation of the Japanese yen and Chinese RMB, adversely affected export revenues and brought down the asset prices in the East Asian economies. The net capital inflows to the four crisis countries (Indonesia, Korea, Malaysia, Thailand and the Philippines) suddenly dropped from 67.41% of GDP surplus in 1996 to 15.58% of GDP deficit in 1997 (see Table 1-2). Only the foreign direct investment remained stable at around 9.8% of GDP and other investment experienced a sudden withdrawals.

According to Park and Park (2003), the withdrawal of foreign capital amounted to USD 105-110 billion. Governments in the crisis countries were not able to maintain US dollar peg. Consequently, local currencies experienced substantial depreciation, which in turn made it extremely difficult for private enterprises in those countries to meet their payment obligations. Finally, international currency markets fell into panic. The continuous depreciation of local currencies made the repayment of foreign currency debt even impossible, and in turn led to further depreciation of local currencies in a self-reinforcing downward spiral.

Table 1- 2: Net Capital Flows to Crisis Countries (Percentage of GDP)

Net private capital flows

Net private direct investment

Net private portfolio investment

Other net private capital flows

Net official flows

1985 2.26 0.8 2.61 -1.14 5.01

1986 -1.41 0.38 -0.08 -1.71 2.58

1987 -6.9 1.56 0.07 -8.53 -1.54

1988 -1.59 3.72 -0.5 -4.81 0.76

1989 11 5.44 1.06 4.5 0.17

1990 23.63 6.33 0.81 16.49 -0.28

1991 24.61 5.96 2.4 16.24 3.65

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1992 21.4 6.34 12.4 2.66 2.11

1993 22.49 6.67 18.28 -2.45 1.43

1994 33.62 6.53 11.97 15.12 0.59

1995 53.87 8.81 18.75 26.31 0.66

1996 67.41 9.83 25.54 32.04 -6.13

1997 -15.58 9.78 8.43 -33.78 15.65

1998 -28.24 10.35 -8.16 -30.43 19.45

Source: The data are collected from the IMF database: http://cpis.imf.org/ (accessed on March 16th 2015)

The absence of well-functioning bond markets has been cited as one of the major contributors to the unprecedented financial crisis in Asia, since it resulted in a serious problem called “double mismatch” (Chowdhury, 1999; Tan, Karigane and Yoshitomi, 2001). “Double mismatch”, namely currency and maturity mismatch, represents the situation where local banks borrow short-term funds in foreign currency from overseas and lend them to local borrowers in local currency on a long-term basis. Besides, some Asian corporate borrowers, which make profits in local currency, directly finance themselves through short-term borrowing from overseas banks. Such funds are denominated in foreign currencies and spent to finance long-term investment.

During the crisis, the International Monetary Fund (IMF) rescued slowly and put forward a series of severe conditions before aiding. Moreover, many requirements prescribed by the IMF were thought to be inappropriate, which proceeded to worsening the crisis markets. For example, although the crisis economies had already run budget surpluses, they were instructed to cut government spending, which deepened the economic slowdown. The IMF failed to pull Asia out of the financial crisis. Its performance to deal with the 1997 Asian financial crisis prompted Asian economies to call for closer regional financial integration. As a consequence, two major initiatives were launched to promote the regional financial cooperation. The first one is the Chiang Mai Initiative (CMI), which constitutes of a network of bilateral swap arrangements among the ASEAN+3 economies to address short-term liquidity difficulties in the region. Another momentous one is the Asian Bond Markets Initiative (ABMI) to promote the development of regional bond markets in 2003. In the aftermath of the 1997 Asian financial crisis, regional bond market development has become one of the top priorities in the financial reform of East Asian countries, since a balanced financial system with diversified funding channels is believed to be one of the key

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measures to maintain regional financial stability.

1.2 Motivations to Develop East Asian Bond Markets

The presence of efficient and active bond markets may benefit the East Asian region a lot. First of all, the development of East Asian bond markets enhances regional financial stability. As aforementioned, the overreliance on banking system has been one of the primary causes of the 1997 Asian financial crisis. In the country, whose financial market has long been dominated by the banking sector, credit risk is highly concentrated in the banking system. Once the non-performing loans start to expand and banks become insolvent, the effect of banking crisis may be devastating to the whole economy. Robust bond markets give corporations an alternative way to raise capital and diversify the regional financing channels. Given that the majority of bank loans are raised by offering demand deposit, liquidity is highly important for banks. Bank loans are thought to have shorter maturity than bonds (Goldstein and Turner, 2004). As a result, banks may provide short- term loans and bond markets offer long-term capital. Moreover, while commercial banks are specialized in providing loans for smaller and un-public firms, well-functioning bond markets can finance larger, public companies (Eichengreen and Luengnaruemitchai, 2006). In sum, the development of bond market can contribute to a more balanced financial system with diversified funding intermediaries, which is the key to maintain the regional financial stability in East Asia.

Furthermore, the development of well-functioning bond markets enables regional corporations to issue long-term bonds in local currencies, which help migrate “double mismatch” exposure.

“Double mismatch” problem is one of the root causes of the 1997 Asian financial crisis. Well- functioning corporate bond markets provides corporate borrowers with direct access to capital pool without intermediation costs⁴. Lower cost of capital encourages more firms to finance themselves through issuing long-term and local currency denominated bonds in domestic bond markets, instead of foreign borrowing. Thus, the existence of robust domestic bond market helps alleviate the

“double mismatch” problem in East Asia and prevents the recurrence of a similar financial crisis.

Besides, there is a clear consensus among the East Asian governments that deep, liquid and

4 The Emerging Markets Committee of the International Organization of Securities Commissions, “The Development of Corporate Bond Markets in Emerging Market Countries ”, See https://www.iosco.org/library/pubdocs/pdf/IOSCOPD127.pdf

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mature bond markets are effective tools to facilitate the mobilization of regional accumulated savings and foreign exchange reserves within the region. The savings rates in East Asian economies are generally higher than the rest of the world. The aggregate gross savings of the nine East Asian economies made up for 38% of global gross savings in 2013⁵. Table 1-3 presents the past trend of the domestic gross savings for the East Asian economies during the period from 2001 to 2013. Even though there are enormous variations among the nine economies in their domestic savings rates, the average savings rates of the East Asian economies are much higher than the OECD countries (around 20%). In addition, East Asian economies have accumulated huge amount of foreign exchange reserves (Table 1-4). Especially in the aftermath of the 1997 Asian financial crisis, East Asian countries have continuously raised their foreign exchange reserves to protect against unexpected currency crisis. At the end of 2013, the combined foreign exchange reserves amounted to USD 6,473.34 billion in East Asia, accounting for approximately 53.13% of the world’s total foreign exchange reserves. China and Japan held the largest amount of foreign exchange reserves in East Asia, recording USD 3,841.37 billion and USD 1,238.54 billion respectively.

Table 1- 3: Gross Domestic Savings in East Asia

(in percent, billions of USD) China HK Indonesia Japan Korea Malaysia Philippines Singapore Thailand 2001 Savings rate 36.96 31.44 21.14 26.41 32.36 32.25 42.41 41.38 28.51 Savings 49.23 5.33 3.39 109.87 17.25 2.99 3.23 3.70 3.29 2002 Savings rate 39.60 30.85 16.69 25.29 31.77 32.73 43.57 38.81 27.51

Savings 57.90 5.13 3.27 100.67 19.35 3.30 3.54 3.57 3.49 2003 Savings rate 42.95 32.90 29.89 25.54 33.21 34.85 47.93 40.22 28.30

Savings 136.71 6.77 10.17 115.66 33.06 6.31 6.45 6.99 6.22

5 The data is calculated by author based on the data from World Development Indicators database of the World Bank.

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2007 Savings rate 50.26 34.42 26.03 27.69 33.01 38.77 52.18 49.09 33.44 Savings 177.07 7.28 11.25 120.63 37.06 7.50 7.79 8.84 8.26 2008 Savings rate 51.83 36.02 26.37 26.25 32.87 38.52 52.47 44.87 30.57

Saving 262.69 6.79 16.80 113.60 29.47 6.75 9.77 8.56 7.89 2010 Savings rate 50.60 30.89 32.65 23.48 34.82 34.23 60.78 51.53 30.96

Savings 364.40 7.38 29.43 130.97 41.67 10.07 10.06 13.56 10.62 2012 Savings rate 49.86 26.80 32.22 21.82 34.37 31.73 42.32 47.17 30.23 Savings 421.87 7.04 29.58 129.94 42.03 9.68 10.59 13.68 11.06 2013 Savings rate 49.87 25.53 30.72 21.76 34.47 30.37 43.25 46.89 28.52 Savings 473.27 7.04 27.97 107.04 45.01 9.51 11.77 14.17 11.04 Source: The data are collected from World Development Indicators database of the World Bank:

http://data.worldbank.org/indicator/NY.GNS.ICTR.ZS/countries?display=default (accessed on March 16^th 2015) Notes: 1. Gross savings are calculated as gross national income minus total consumption, plus net transfer.

2. Gross savings rate is calculated as gross savings as a percentage of GDP.

Table 1- 4: Official Foreign Exchange Reserves in East Asia

(in billions of USD)

1997 2000 2004 2007 2008 2010 2013

China 143.36 168.86 615.55 1531.35 1950.30 2867.91 3841.37 Hong Kong 92.81 107.55 123.54 152.64 182.47 268.65 311.11

Indonesia 16.73 28.64 35.12 55.11 49.72 93.03 96.50

Japan 220.79 356.02 835.23 954.15 1010.69 1062.82 1238.54

Korea 20.38 96.15 199.02 262.18 201.17 291.52 341.83

Malaysia 20.90 28.38 65.94 101.08 91.21 104.95 133.51

Philippines 7.53 13.42 13.50 30.44 33.46 55.63 76.02

Singapore 71.39 79.96 112.37 162.75 173.98 225.50 272.86

Thailand 26.30 32.12 48.81 85.37 108.81 167.70 161.59

US 83.1 68.53 90.11 73.99 80.70 135.49 147.63

East Asia 670.24 911.10 2049.09 3335.06 3801.82 5137.71 6473.34 World 1810.74 2070.29 3921.54 6809.14 7466.07 9701.00 12183.93 Source: IMF’s International Financial Statistics

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Considering that the regional foreign exchange reserves aggregated to USD 670.24 billion but the reversal capital recorded approximately USD 100 billion at the core of the Asian financial crisis, it should not be too big to handle for the whole region. However, in the absence of well-developed regional bond market, a large amount of domestic savings and foreign exchange reserves are directed to the safe assets in advanced countries and the most holdings of long-term securities take the form of US Treasury securities. The combined US bonds holdings of the nine East Asian economies reached about 41.52% of the total foreign holding of the US bonds in June 2012⁶ (Table 1-5). Actually, East Asia has massive infrastructure funding needs. According to the Asian Development Bank, the capital estimation for infrastructure construction in East Asia during 2010 to 2020 amounts to USD 4.7 trillion⁷. In Malaysia, where the government and corporate bond markets are relatively advanced, infrastructure-related companies have already issued various corporate bonds for capital financing. Have the large pool of savings and foreign exchange reserves been circulated inside the region through balanced financial intermediaries, the consequences of the Asian financial crisis would be far different (Ahee, 2003).

Table 1- 5: Holdings of US Bonds as a Percentage of Total Foreign Holdings (in percent)

Long-term Bonds Short-term

Bonds Total Total Government Agency Corporates

Total Africa 0.40 0.36 0.01 0.03 0.04

Total Asia 47.88 35.49 8.66 3.73 3.47

East Asia 41.52 30.07 7.96 3.08 2.00

Total Europe 33.31 13.21 1.58 18.52 3.98

Total Latin America 5.20 4.32 0.61 0.27 0.45

Canada 1.81 0.49 0.04 1.28 0.19

Source: U.S. Department of Treasury, Report on Foreign Holdings of U.S. Long-term Securities 2013

Note: 1. East Asia includes nine economies in the analysis: Mainland China, Hong Kong China, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore and Thailand;

2. Data comes from the results of the June 30, 2012 Survey

6 The detailed data on foreign holdings of US bonds of each country are listed in the Appendix Table A-2.

7 The data is obtained from “Infrastructure for a Seamless Asia”, Asian Development Bank, 2009

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1.3 Objectives of the Study

Nineteen years have passed since the 1997 Asian financial crisis. Substantial efforts have been made by the East Asian economies to develop more robust and efficient bond markets at both the national and regional levels. Unlike equities, bonds are not typically traded through standardized exchanges, therefore, data on the bonds are not available for a wide range of countries. Due to data limitations, the empirical researches on bond markets are seldom. Against this background, this study aims to enhance our understanding of local bond markets in East Asia from four perspectives:

domestic bond market development, regional bond market integration, bond investment home bias and foreign participation in the East Asian bond markets. The specific objectives of this research are listed as follows:

(1) To investigate the current state of domestic bond market development in the East Asian economies from four dimensions: bond market size, access, efficiency and stability⁸.

(2) To examine whether the bond market integration has taken place in East Asia. If yes, the research further explores the extent of bond market integration and the speed of the bond market convergence in different sub-periods in East Asia. In addition, the short-term interdependency between the East Asian bond markets and the regional leading market will also be detected.

(3) To discover the current pattern of bond investment home bias (against regional bonds) in East Asia and explore the determinants of the bond investment home bias phenomenon in the region.

(4) To understand the factors affecting foreign participation in the East Asian long-term and short-term bond markets, especially from the perspective of bond market development characteristics.

8 The World Bank provides indicators monitoring the bond market development in four dimensions, that is, size, access, efficiency and stability. Available at: http://siteresources.worldbank.org/INTTOPACCFINSER/Resources/Bndind.pdf

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1.4 Methodology and Dataset 1.4.1 Methodology

The methodologies used in this research are a combination of descriptive analysis and quantitative empirical analysis. Chapter 2 undertakes descriptive analysis to provide an overview on the regional efforts to develop the East Asian bond markets and the current development of each domestic bond market in East Asia. Chapter 3, based on the Law of One Price (LOP), reveals the extent of East Asian bond market integration, the speed of bond market convergence, as well as the interdependency between the individual bond markets. Quantity-based measures (intra-regional bond investment), priced-based measures (AAD indicator and beta-convergence) and econometric methodology (co-integration test and Granger causality test) are used to address the above questions.

The research in chapter 4 is based on the famous theory, International Capital Asset Pricing Model (I-CAPM), which illustrates that rational investors should hold the world market portfolio to diversify the inherent risks in their assets and maximize risk-adjusted returns in the frictionless financial markets. On a basis of the optimal foreign bond investment suggested by I-CAPM, this analysis examines the pattern of bond home bias in East Asia. Furthermore, the model specification of Ahearne et al. (2004) is applied to find out the impact of increasing regional bond market integration on the bond investment home bias phenomenon in East Asia. Finally, panel data estimation is used in the empirical analysis of chapter 5 to explore the determining factors driving the foreign capital into the East Asian bond markets.

1.4.2 Dataset

This research is based on a dataset consisting of nine bond markets in East Asia during the period from 2001 to 2013. East Asia, defined here, includes the ten Association of Southeast Asian Nations (ASEAN) countries plus Republic of Korea (Korea), People’s Republic of China (China), Hong Kong and Japan. Because the bond markets in Brunei Darussalam, Cambodia, Lao PDR, Vietnam and Myanmar are planned to be created or in the early stages of development, they are excluded in the analysis. Nine economies in the East Asian region are finally covered in this study, namely, China, Japan, Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore and

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Thailand. In chapter 4, as the data on the China’s outward bond investment are not available, China is excluded in the empirical analysis. In chapter 5, Japan is not included, because the bond market in Japan has developed to a much higher level than other East Asian economies. The data used in the descriptive and empirical analysis have been obtained from various reliable sources, such as the Asian Development Bank (ADB), the International Monetary Fund (IMF), the World Bank, AsianBondsOnline and Thomson Reuters database.

1.5 Significance of the Research

East Asian economies have made considerable efforts to develop the regional bond markets.

Improvement in our knowledge about the East Asian bond market could help the regional governments push forward with the development of regional bond markets effectively.

This study researches the evolving development of regional bond market integration in East Asia. Financial integration is gradual process stretching over many years with merits and demerits.

On one hand, the process may contribute to economic growth by allocating capital more efficiently, strengthening the financial system and supporting the implementation of monetary policy. On the other hand, it may bring about financial contagion. The financial instability in one country can be transmitted to the neighboring countries in the region quickly during the financial turmoil. Given the various initiatives to integrate the East Asian bond markets, it is important to understand the effectiveness and consequence of such measures and let the policymakers maximize the benefits of financial integration and meanwhile minimum the risks brought by the financial integration. Thus, the research on the progress of East Asian bond market integration has important implications for policymakers and deserves particular attention.

This study further explores the bond home bias phenomenon at the regional level and finds out the determinants of the bond home bias phenomenon, which may supplement the research on the bond market integration. Lower bond home bias prompts regional investors to diversify their portfolio investment and in the long run enhance the efficient allocation of regional financial resources and risk sharing. The findings of this study may guide policymakers on the policies dealing with bond investment home bias. Furthermore, the study on the link between bond market

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integration and bond investment home bias reveals the role of bond market integration in efficient allocation of funds and portfolio diversification. It is therefore important to examine the factors affecting the bond investment home bias in the East Asian region.

Finally, foreign participation in the East Asian bond markets is investigated in chapter 5.

Foreign participation is a double-edged sword for the development of East Asian bond markets.

Foreign investors diversify the institutional investor base and create greater demand for local bonds.

The potential risks of foreign capital cannot be ignored, however, especially for emerging bond markets. The foreign capital is sensitive to global economic climate change and are always volatile.

Sudden withdrawal of foreign capital may destabilize bond prices and even the whole financial markets, which has been demonstrated by the severe recession during the 1997 Asian financial crisis and huge capital outflow after the collapse of Lehman Brothers in 2007. Capital inflows have posed great challenges to market regulators. To attract more foreign investors to participate in the emerging bond markets in East Asia and in the meanwhile maintain the stability of national financial system, it is essential for policymakers to understand the driving factors behind the foreign participation in the bond markets.

1.6 Contributions of the Research

This dissertation contributes to the existing literature by exploring the East Asian bond market development since the 1997 Asian financial crisis, with emphasis on the East Asian bond market integration, the bond investment home bias phenomenon and foreign participation in the regional bond markets. It differs from earlier works in the several ways, which are detailed as follows:

Chapter 3 contributes to the existing literature from three aspects. First, earlier researches on bond market integration focused on the level of integration, but did not make a comparison between different sub-periods to detect the effectiveness of government efforts to promote regional bond market integration. This research conducts more detailed analysis on the bond market integration.

Four sub-periods (2001-2002, 2003-2006, 2007-2008, 2009-2013) are analyzed in the research to investigate the effectiveness of regional policies, especially the Asian Bond Markets Initiative (ABMI) in 2003 and the package of measures reacting to the 2008 world financial crisis. Second,

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allowing for the economic and financial disparity across the East Asian economies, country risks are considered in the analysis to detect how much discrepancy in bond yields are resulted from the disparity in the economic development in East Asia. Third, financial integration is the process where the financial markets in the region become more and more correlated with each other. However, the researches on the co-movement between the East Asian bond markets are limited. This research contributes to the literature by using the Granger causality test to examine the interdependency between the individual bond markets in East Asia.

Chapter 4 contributes to the literature by providing new empirical evidence on the bond home bias in East Asia from a regional perspective. Previous literature on the home bias phenomenon is highly concentrated in the equity markets and few researches on bond home bias in East Asia are conducted from a global perspective. The empirical analysis on bond investment home bias against regional bond markets has never been done. This chapter aims to fill the gap by investigating the evolving development of bond investment home bias against regional bonds in East Asia. In addition, as the East Asian regional bond market integration has become one of the central pillars of financial cooperation in the region since the 1997 Asian financial crisis, this chapter takes the first step to understand the relationship between the bond investment home bias phenomenon and bond market integration in East Asia.

Chapter 5 is different from earlier literature in two ways. First, this analysis investigates the determinants of foreign participation in East Asian bond markets from the perspective of bond market development indicators. Previous literature with respect to this topic has mainly focused on the effect of macroeconomic conditions and institutional quality on the foreign investment in the bond markets. The influence from the perspective of soundness of bond market development has been ignored. Even though some researchers have mentioned the importance of market liquidity and size to attract foreign investors, seldom corresponding empirical analysis has been conducted.

Second, this study conducts more detailed analysis by using disaggregated data of foreign long- term and short-term bond holdings, since the bonds with different maturity exhibit diverse risk and return profiles. Investors adjust their investment based on their own risk tolerance, objectives, and time frame, so the two types of bonds may be attractive to different groups of investors.

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1.7 Dissertation Organization

This dissertation is constituted of six chapters. It begins with introductory chapter 1, which outlines the overall background of this study. The rationale to develop the East Asian bond markets, research objectives, research methodology, research significance and contributions are discussed in this chapter. The development of East Asian bond markets contains two key ingredients: domestic bond market and regional bond market. As academics asserted, the ideal approach to develop a well-functioning regional bond market would be to improve bond markets in each country to an acceptable level and harmonize regulations in each economy, and finally build a regional bond market. The development of individual domestic bond markets paves the way for the development of a regional bond market. As a result, chapter 2 and chapter 3 research on the East Asian bond markets from the domestic and regional level respectively.

Chapter 2 firstly provides an overview on the regional efforts’ to develop the East Asian bond markets and then investigates the current development of the nine East Asian bond markets. This chapter adopts the bond market soundness indicators provided by the World Bank to assess the development of bond markets in East Asia. The measurement of bond market is comprised of four dimensions: market size, access, efficiency and stability.

Chapter 3 intends to gauge the progress made in bond market integration in East Asia thus far.

This study first presents the literature review on the definition of financial market integration. The specific measures of European financial market integration are also reviewed, which can be borrowed to investigate the East Asian bond market integration. After that, the methodology and data in the analysis are discussed. Based on the Law of One Price (LOP), quantity-based measures (intra-regional bond investment), price-based measures (AAD indicator, beta-convergence measure) and econometric methods (co-integration test and Granger causality test) are used in the empirical analysis. Finally, chapter 3 presents the empirical results and concludes with implications for policymakers.

Chapter 4 and chapter 5 complement the research on the East Asian bond market integration in chapter 3. Chapter 4 explores the bond investment from the East Asian investors. It discovers the

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bond home bias phenomenon in the region and tries to find out the determining factors behind this phenomenon. By contrast, chapter 5 examines the foreign bond investment in the East Asian bond markets. The analysis in chapter 5 empirically investigates the determinants of foreign participation in the regional bond markets.

Chapter 4 analyzes the evolving development of bond investment home bias (against regional bonds) in East Asia. Based upon the International Capital Asset Pricing Model (I-CAPM), the current pattern of bond investment home bias is investigated in the first place. Next, this chapter examines the driving factors behind the bond home bias phenomenon in East Asia. Based on previous literature, exchange rate volatility, financial openness, domestic credit provided by banks and regulatory quality are introduced in the specification as control variables. This chapter finally undertakes panel data estimation and interprets the empirical results.

Chapter 5 examines the current pattern of foreign participation in the East Asian long-term and short-term bond markets as well as the determinants of the foreign participation. This chapter first presents the foreign investors’ holding of East Asian bonds. After that, chapter 5 looks into the determinants of foreign participation in the East Asian bond markets. The model by Bae, Yun and Bailey (2006) and Bae (2012) is documented along with additional explanation for new variables, such as bond market size, access, liquidity and stability. Finally, recommendations are provided for attracting more foreign investors to participate in the East Asian local bond markets and meanwhile effectively maintain the stability of regional financial markets.

This dissertation ends up with implications of the empirical findings for policymakers in chapter 6. Chapter 6 begins with the summaries of the main findings in each chapter. Then it presents some concluding remarks concerning this study.

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Chapter 2: Current Situation of Domestic Bond Markets in East Asia

2.1 Introduction

The 1997 Asian financial crisis has convinced East Asian governments the urgency for regional financial cooperation. Researchers have made a consensus that the Asian financial crisis highlighted the need for the robust capital markets in the developing countries as a source of capital that are cheaper and less volatile than offshore borrowings (Chowdhury, 1999; McCauley, 2003). Former Federal Reserve Chairman Greenspan put forward the “spare tier” argument that in case bank and equity finance opportunities were disrupted, bond markets would serve as alternative vehicles for capital financing (Greenspan, 1999). Since then the issue on East Asian bond markets has caught wide discussion.

Fostering a well-functioning bond market makes more advantages. First, a robust bond market provides an alternative way for financing to the banking system. Most of the East Asian economies highly depended on the banks as financing channel, which created the risks exposure in the banking system. Second, East Asian economies embraced the highest level of gross savings and foreign reserves in the world. The development of regional bond markets helps channel the abundant capital into corporates lack of money. Third, a well-functioning government bond market enables the central bank to implement monetary policies through market operations. Last, robust regional bond market may lower the capital cost by increasing competition on financial markets, which in turn promote the economic development. As a result, in the aftermath of the 1997 Asian financial crisis, bond market development has become one of the most important issues in the regional financial cooperation.

McCauley and Park (2006) put forward two alternative paths of developing East Asian bond markets: (1) well-developed domestic markets where domestic issuers can finance themselves through domestic capital pool; (2) a regional bond market where regional issuers can make the best of regional capital pool. They argued that the ideal approach to establish a regional bond market would be to develop each domestic bond market to an acceptable level and then harmonize

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regulations in each economy to attract the regional foreign investors, and finally build a regional bond market. Thus, the development of East Asian bond markets contains two key ingredients:

domestic bond market and regional bond market. The development of domestic bond markets paves the way for the development of regional bond market (Amyx, 2004).

Substantial efforts have been made by the East Asian economies to develop more robust bond markets at the national and regional levels. At the regional level, various forums and initiatives, such as Asian Bond Markets Initiative (ABMI), Asian Cooperation Dialogue (ACD), Asian Bond Market Forum (ABMF) and Asian Bond Fund (ABF), have been initiated since the 1997 Asian financial crisis. “Asian Bond Monitor” is timely published by the Asian Development Bank to enhance market transparency by reviewing the development of the regional bond market. At the national levels, governments have exerted various efforts to develop domestic markets by facilitating the issuance of local bonds, enhancing more efficient clearing and creating rating agencies and primary dealer system.

This chapter discusses the development of East Asian bond markets at the national levels. It adopts the bond market development indicators provided by the World Bank to assess the development of East Asian bond markets in four dimensions: bond market size, access, efficiency and stability.⁹ East Asian domestic bond markets have made great strides during the past years, especially in terms of the scale. The volumes of both government and corporate bonds outstanding have increased fourfold or more, accounting for approximately 10% of the world bond capitalization¹⁰ in 2013. Government benchmark yield curves have been lengthened over 15 years in all of the economies. Korea and Malaysia have developed the most advanced corporate bond markets in the region, as measured by the market size as a percentage of GDP. Domestic government bonds issued in Japan, Malaysia and Singapore are currently included in the Citigroup World Government Bond Index (WGBI), which consists of government bonds in selected 23 countries whose bond markets must satisfy market size, credit, and barriers-to-entry requirements.

9 The World Bank provides indicators monitoring the bond market development in four dimensions, that is, size, access,

efficiency and stability. http://siteresources.worldbank.org/INTTOPACCFINSER/Resources/Bndind.pdf

10 Author’s calculation based on the data from Asianbondsonline and Bank for International Settlement.

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Despite the encouraging progress, East Asian domestic bond markets reveal a diverse set of circumstances. Japan, Hong Kong and Singapore have developed the most advanced bond markets in the region. Japan dwarfs other East Asian domestic bond markets in terms of absolute value of bonds outstanding. As the international financial centers, Hong Kong and Singapore have the most liberal investment environment, attracting worldwide bond issuers and investors. Malaysia and Korea have developed the most advanced corporate bond market in East Asia. In absolute value terms, China’s bond market has grown to the second largest bond market in the region, but there still remains a lot of room for improvement, given its huge economy size. Finally, the bond market in Thailand has made considerable progress in recent years, while the bond markets in the Philippines and Indonesia seem less developed.

This chapter is organized as follows. The second section gives a brief summary of governments’

efforts to develop the East Asian bond market during the past decade. The third section documents the current development of nine domestic bond markets in East Asia from four dimensions: bond market size, access, efficiency and stability. The final section concludes.

2.2 Regional Efforts to Develop the Bond Markets

Since the late 1990s, the development of regional bond markets has become one of the central pillars of financial cooperation in East Asia. Various working groups, such as the Asia Pacific Economic Cooperation Finance Ministers Meeting (APEC FMM), ASEAN+3, and Executives’

Meeting of East Asia-Pacific Central Banks (EMEAP)¹¹, have taken significant steps to promote the development of the local bond markets. Substantial work on the demand and supply sides of the bond market development have been done. For instance, on the supply side, APEC and ASEAN+3 try to remove the barriers impeding the issuance of bonds in the regional and domestic markets respectively. EMEAP focuses on the demand side of the bond markets through establishing Asian Bond Fund (ABF). All the initiatives for East Asian bond markets have transferred a strong message to the market that the regional governments stand together to provide support for the regional financial market development and protect the regional financial market from volatile global capital

11 EMEAP consists of 11 central banks from the southeast and pacific regions of Asia, namely Australia, China, Hong Kong Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore and Thailand.

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flows and diverse external shocks. Table 2-1 presents the chronology of regional efforts to develop the East Asian bond markets since the occurrence of the Asian financial crisis in 1997. The following sub-sections provide more detailed overviews of the regional initiatives.

Table 2- 1: Timeline for Regional Efforts to Develop Bond Markets

1997.07 Occurrence of the Asian financial crisis

2003.05 Asian Bond Fund (ABF) was initiated by Executives’ Meeting of East Asia and Pacific Central Banks (EMEAP)

2003.08 Asian Bond Markets Initiative（ABMI）was introduced under the framework of ASEAN+3

2004.04 AsianBondsOnline (ABO) was established by the Asian Development Bank (ADB) 2004.12 Asian Bond Fund 2 (ABF2) was started

2008.05 The roadmap of ABMI was upgraded during the 11^th ASEAN+3 Finance Ministers Meeting in respond to the 2008 world financial crisis

2010.09 ASEAN+3 Bond Market Forum (ABMF) was established under the framework of ABMI TF3

2010.11 Credit Guarantee and Investment Facility (CGIF) was established under the framework of ABMI TF3

2012.05 CGIF started the guarantee operations 2012.05 Roadmap of ABMI was updated

Sources: “Progress of Bond Market in East Asia”, Yamaguchi (2014); Japanese Ministry of Finance and other sources

2.2.1 Asian Bond Markets Initiative (ABMI)

At the ASEAN+3 Finance Ministers Meeting in 2003, the Asian Bond Markets Initiative

（ABMI）was introduced under the framework of ASEAN+3 to develop the bond markets in East Asia. It was thought as the milestone for the development of East Asian bond markets. The chairman of the ASEAN+3 Finance Ministers Meeting defined the mission of ABMI as: “The Asian Bond Markets Initiative (ABMI) aims to develop efficient and liquid bond markets in Asia, which would enable better utilization of Asian savings for Asian investments. The ABMI would also contribute to the mitigation of currency and maturity mismatches in financing. It is a key step forward in ASEAN+3 finance cooperation”.¹² Activities of the ABMI have been focused on the following two

12 Chairman’s Press Release on the Asian Bond Markets Initiative on August 7 2003. Available at:

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areas: (1) facilitating the bond market access through including a wider range of issuers and different types of bonds, and (2) enhancing bond market infrastructure in East Asia, such as credit rating agencies, credit enhancement facilities, clearing and settlement services. The ABMI has been implemented and upgraded on a timely basis.

In 2004, AsianBondsOnline (ABO) was established by the Asian Development Bank, as part of ABMI to build up a more transparent investment environment for investors. The website collects the data on government and corporate bonds and documents the data in a standard format from both the regional and national levels. The information on regional initiatives to promote the development of bond markets are also presented in ABO. Research reports, such as “Asia Bond Monitor”,

“ASEAN+3 bond market guide” are timely published, which review the recent development of East Asian bond markets.

In respond to the 2008 world financial crisis, the roadmap of ABMI was upgraded during the 11^th ASEAN+3 Finance Ministers Meeting in Madrid in 2008. The new task forces (TFs) have been identified and categorized into four key areas: (1) promotion of the issuance of local currency- denominated bonds (TF1), (2) stimulation the demand for local currency-denominated bonds (TF2), (3) regulatory framework reforms (TF3), (4) improvement of the related infrastructure in the bond market (TF4). Later, the achievements of ABMI were reviewed in 2012 and a new roadmap was put forward with nine areas as the priority tasks: (1) launch of Credit Guarantee Investment Facility (CGIF) for guarantee business, (2) infrastructure financing scheme, (3) improvement of investment environment and dissemination of market information, (4) ASEAN+3 Bond Market Forum (ABMF), (5) promotion of an initiative for establishing regional settlement intermediaries, (6) further development of sovereign bond markets, (7) strengthening the finance access for consumers and the Small and Medium Enterprises (SMEs), (8) strengthening of regional rating system, and (9) financial literacy improvement. It is widely believed that successful implementation of ABMI will lead to more vibrant regional primary and secondary bond markets in support of a broader range of issuers and products.

http://www.asean.org/communities/asean-economic-community/item/chairman-s-press-release-on-the-asian-bond-markets- initiative

Post-crisis Bond Market Development in East Asia 東アジアにおける危機後の債券市場の発達 Lian Liu