Domestic Bond Markets

	Table of Contents
p. 4 of 13 BACK | NEXT Cover Page Introduction Executive Summary Chapter 1: Government Policies Chapter 2: Regulatory Framework Chapter 3: Market Infrastructure Chapter 4: Liquidity Chapter 5: Risk Management Working Papers Workshop Participants Appendix 1: Introduction Appendix 1: Executive Summary Appendix 1: Findings and Recommendations

Chapter 1
Government Policies

1. In the early stage of bond market development, the government is a key actor - as an issuer, regulator, promoter and catalyst. Sometimes these roles may come into conflict, especially in the development phase. On the one hand, large volume government issuance implies large fiscal deficits and upward pressure on interest rates. On the other hand, a large volume of issuance provides a critical level of supply for the fledgling bond market. A willingness to finance deficits through bond sales in open competitive markets is crucial to the development of the market and maintaining monetary policy independence, although it may initially mean higher cost of issuance and less direct control over financial institutions. This chapter begins the exploration of these various roles of governments in emerging bond markets.

Objectives and Strategy of Bond Market Development and Sovereign Debt Management

2. Sovereign debt management and bond market development are in fact highly inter-dependent. There is an intuitive link between the two in the sense that government bond market is very often expected to be the foundation for the broader domestic bond market. The government's various actions as a regulator and market participant can have definitive impact on the development of the domestic market. The government has an interest in maintaining a deep and liquid domestic bond market to facilitate, among other things, its debt management.

3. However, there is also a tangential link between the two and this needs to be borne in mind in the formulation of a strategy to develop the bond market while meeting the objectives of sovereign debt management. This tangential relationship originates from the fact that the government is only one of the many market participants, albeit an important one, and market development is a dynamic process while debt management is primarily concerned with achieving an optimal debt profile, having regard to fiscal and monetary policy objectives.

4. For example, there are situations in which measures useful or necessary to achieve the objective of debt management can lead to tension with the objective of bond market development, depending on the circumstances or the level of development of the market. To illustrate, the government is often under pressure to reduce its deficits and borrowing. Bond market development, on the other hand, requires, among other things, significant volume of issuance in benchmark segments of the market and the government is usually a major issuer in the market. When a government decides to borrow, it may have the option to borrow more cheaply from domestic financial intermediaries or external sources, especially when the domestic bond market is underdeveloped. Government bond market development, therefore, requires the government's commitment to developing a borrowing practice targeting the domestic debt market and a policy vision that the bond market needs to be developed for the benefit of the economy.

5. When the government does borrow from the domestic bond market, it would wish to make sure that the market has sufficient depth to support the amount of borrowing by the government and at the time it is needed. The government should also be concerned about minimising the cost and risks associated with the specific borrowing and the total outstanding debt at any given time. These objectives must be met at the same time that the capacity and institutions in the primary and secondary markets are being developed. Therefore, a critical first step in formulating a strategy is to define and prioritise policy objectives regarding debt management and bond market development and identify constraints in achieving the set objectives.

Element 1: The government should strive to strike a balance between its sovereign debt management policy and a strategy for domestic bond market development. In doing so, it should define and prioritise objectives regarding debt management and bond market development, and identify constraints in achieving the set objectives.

The Government's Role in a Comprehensive Bond Market Development Programme

6. When the government commits itself to a policy of developing the nascent domestic bond market, it will need to perform a role of catalyst or promoter in various functions such as issuer, regulator and co-ordinator. As a large issuer, the government can standardise government bond designs and regularise issue practices. That will facilitate primary market issuance and trading, generate liquidity and establish a benchmark yield curve. The government and the central bank can also assist in building the necessary market infrastructure, e.g. custody and settlement facilities, to support the market.

7. The government or its appropriate agencies need to perform the role of a regulator and supervisor of the financial industry and the market. For example, it can remove legal and regulatory impediments to competition, rationalise tax distortions on bond investments and trading, promote transparency and disclosure to protect investors' interests, and encourage effective market-making. These issues are discussed more fully in Chapter Two of the report.

8. As a co-ordinator, the government should develop consensus both within and outside the government and establish a development policy and strategy for bond market. In light of the close inter-relationship between bond market development and other economic activities, a high-level co-ordination committee could be created to supervise the bond market development agenda. Such a committee would include representatives from the central bank, applicable regulatory bodies for the securities market, the ministry of finance (funding and debt management functions) as well as key market participants. Furthermore, it should have clear terms of reference, and the unequivocal support of the government to propose appropriate recommendations with respect to the development of the domestic debt market. The committee should ensure that the bond market development agenda is consistent with debt management mandates, and the objectives of fiscal and monetary policies.

9. Finally, and most importantly, in fulfilling these various roles, the government must maintain its perspective as a promoter of bond market development and avoid excessive market intervention. For instance, short-term increases in debt costs may be an acceptable trade-off to ensure the successful issuance of long-term debt and the resultant creation of a benchmark yield curve.

Element 2: The government can play a catalytic role in the development of a nascent domestic bond market. It should develop a comprehensive strategy in consultation with the central bank, the relevant regulatory agencies and market participants. The strategy should address the various roles played by the government and relevant parties: as issuer, regulator, facilitator or, where appropriate, provider of market infrastructure. As a first step, there should be a review of policies and practices that could impede the development of the domestic bond market so that they can be revised or removed as appropriate.

10. Government bonds often require a special mechanism for primary issuance. The government and the central bank as an issue agent can organise such a mechanism. For this purpose, it is important to have a clearly defined legal framework. First of all, the government's ability to borrow from the domestic bond market should be legally well defined and sufficiently broad to achieve a range of objectives. These could include the ability to borrow to finance public sector investment in addition to financing deficits, and the ability to issue bonds and bills for refinancing and short-term cash management purposes.

11. The relationship between the government as an issuer and the central bank as an issue agent should also be clearly set out. The contractual relationships between underwriters or winning bidders and the government as an issuer should also be legally well defined. For example, a winning bidder's failure to settle the purchase should be considered as default, and there should be appropriate and effective legal and regulatory enforcement or remedy procedures for it. Similarly, there should also be legally well-defined contractual relationships between the secondary and the primary participants of the primary market.

Element 3: Where there is a government bond programme, there should be a sound legal framework aiming to enable the government to borrow flexibly from the domestic bond market. The legal framework should provide a clear basis for the contractual relationship between different parties.

Element 4: The government should promote a level playing field with consistent tax policies for all financial instruments and market participants. In order to facilitate the development of domestic bond markets, the government should also reduce unnecessary tax burdens and distortions and other impediments.

Bond Market Development: Interaction with Macroeconomic Policy and Financial Sector Development Strategy

15. Tension between policy objectives can arise if government debt issuance is large enough to affect interest rates. Attempts are often made to minimise the effect on interest rates (and reduce the cost of debt issuance). One approach is to require regulated entities to purchase government bonds at controlled interest rates; another by influencing monetary policy. Such actions create problems for the independence of monetary policy, and hamper the development of the bond market.

Maintaining the independence of monetary and fiscal policy

16. A large amount of government bond issuance to finance a large government deficit can crowd out borrowing opportunities for the private sector. At times, the resulting pressure on interest rates may be appropriate from a monetary policy perspective, but unwelcome from a fiscal perspective. It is important that the independence of monetary policy be maintained, in order that monetary policy can fulfil its mandate. Important to maintaining monetary policy independence is a recognition by the government, as a price taker, that it should accept the interest rates determined by the market, while continuing to fund its requirements in the financial markets.

Conduct of monetary policy

17. The relative importance of different tools used by central banks to implement monetary policy varies among economies. For economies with developed government bond markets, open market operations (i.e. the purchase and sale of government securities in the secondary market by the central bank), and an active repo market are common methods to implement monetary policy.

18. In many emerging economies, due to the absence of a developed domestic bond market, the central bank often resorts to direct credit controls as well as the issuance of its own instruments as monetary policy tools. The domestic bond markets, including both the primary and secondary markets, must be developed in order to provide efficient indirect instruments for better execution of monetary policy.

19. A related consideration is that the monetary impact of selling government bonds and subsequent spending of the funds by the government differs depending upon the purchasers of the bonds. For example, issuance of bonds by the government directly to the central bank will be the most inflationary since subsequent spending of the funds will directly increase the monetary base, and therefore, should be avoided.

20. Reserve requirements for banks are usually also a tool of money supply control by the central bank. Government bonds are often accepted as part of such required reserve, which induces a demand for government bonds and allow the government to raise debt at sub-market interest rates. That can be seen as an implicit tax on banks and distort market pricing mechanism in the primary market. The primary market's failure to price the bonds at fair market value would in turn impede trading in the secondary market since the original buyers would face a disincentive to sell the bonds, as they would be forced to recognise losses if they do so. Hence, policy for reserve requirements needs to be considered carefully beyond their role as a means of monetary policy.

Consistency with the overall financial sector development strategy

21. In principle, the development of the bond market should be consistent with, and complementary to, the development of the financial sector. A wide range of financing and investment opportunities should be available to the market. Moreover, the skills and infrastructures necessary for deep and liquid debt markets are also integral to sophisticated financial markets.

22. In the early stage of development, however, existing financial intermediaries may be threatened by open competition from debt markets. These intermediaries may also not have the knowledge or skills to allow their effective participation in the bond market. Access to the market by new and specialised institutions - including foreign financial institutions - may provide an effective route to support the development of domestic bond markets.

Element 5: The government should ensure that the strategy for sovereign debt management and bond market development be consistent with fiscal and monetary policies and financial sector development strategy.

The Road Map for Bond Market Development and the Involvement of the Government

23. Based on past experience with respect to implementing a debt market development programme, the following outlines a stylised four-stage development approach.

24. In the initial stage, emphasis should be put on consensus building. For example, parallel seminars can be conducted to cover both sovereign debt management and bond market development. The purpose is to build a consensus through discussions among the government, the central bank and key market participants regarding: the importance of bond market development for effective debt management; the importance of consistency between bond market development and macroeconomic policies; and the overall strategy to develop the domestic bond market.

25. In the second stage, the development of an effective primary market for government securities would be emphasised. The government is encouraged to strengthen its cash management capability. In particular, the ability to forecast government's cash needs and find out market absorption capacity with respect to different types of instruments needs to be strengthened. Treasury bill markets, as part of money market development, can be first developed, and the government is thereafter encouraged to extend gradually the maturity spectrum of its treasury bonds and widen the range of targeted investors beyond the banking system. It is crucial for the development of the primary market to be consistent with the government's sovereign debt management programme such as its funding strategy and risk management programme, and the central bank's policy on open market operations. At this stage, various auction methods can be explored with a view to adopting the appropriate model which can serve to enhance efficiency of bond issuance. Regularity, standardisation and fungibility of bond issuance should be pursued, and advantages and disadvantages of a system such as a primary dealer system considered to ensure competitive bidding by participating financial institutions.

26. In the third stage (which often overlaps with the work performed in the second stage), the development of a secondary market for government securities would be the centrepiece. With a view to improving market liquidity, three aspects of a work programme should be pursued. First, the market infrastructure should be enhanced, including the legal and regulatory framework, the clearing and settlement systems, the market for repurchase agreements, and bond lending arrangements as appropriate. Secondly, a comprehensive study should be conducted to first identify and then commence the process of mitigating the adverse effects of legal, regulatory, accounting and tax impediments to investment in and trading of bonds. Thirdly, the bond market information dissemination mechanism should be enhanced to facilitate trading and protect investors' interests, and the role of intermediaries such as market makers and inter-dealer brokers should be enhanced with the objective of improving the depth and liquidity of the market. Establishment of a bond or interest futures market also merits consideration when the cash market has attained an adequate level of maturity.

27. At the final stage, the development of an efficient corporate bond market should be emphasised. Transparency and disclosure requirements, the appropriate utilisation of credit rating agencies, tax and other regulatory issues should be addressed during this stage.

Element 6: Normally there is a phased approach to the development of the domestic bond market through, for instance, consensus building, primary market development for government securities, secondary market development for government securities, and corporate bond market development.

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