Bond Market Development: Monetary and Financial System Stability Issues
BOND MARKET DEVELOPMENT: MONETARY AND FINANCIAL SYSTEM STABILITY ISSUES
2008
Ananda Silva∗
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Ananda Silva, Director of Bank Supervision Department, Central Bank of Sri Lanka.
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CONTENTS
I. Introduction II. Bond Markets and Macroeconomic Stability A. B. C. D. High and Volatile Inflation Continuing large Fiscal deficits and Rising Public Debt Continuing Current Account Deficits Leading to Depreciating Currency Other Impediments in market and Institutional Infrastructure
III. Importance of Bond Market Development on Monetary and Financial System Stability A. B. C. D. E. F. Bond Market Development and Monetary Stability Bond Market Development and Financial System Stability Importance of Derivative markets in Bond markets, New Risks and Their Impact on Monetary and Financial Stability Monetary and Financial Sector Policies in Sri Lanka Promoting Bond Market Policy Measures to Promote Bond Market
IV. Conclusion
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I. INTRODUCTION
A stable macroeconomic environment particularly a credible monetary policy along with supporting fiscal management and financial system stability have found to be the prerequisites for the development of the bond market. Similarly, the bond market
development contributes to enhance the efficiency of monetary management and financial system stability. A developed bond market also plays an important role in
improving the efficiency of overall economic management through expanding the range of opportunities of available to financing large scale projects, contributing to better allocation of capital, providing a non-inflationary source of finance for government and facilitating public debt management, and contributing to promote sustainable economic growth. Therefore, it is important that concerted efforts are taken to develop a deep and liquid bond market.
Section I of the paper discusses the interaction between bond development and macroeconomic stability focusing on the sources of instabilities affecting the bond market. Section II presents the contribution of the bond market in improving the
efficiency of monetary management and financial stability. Section III provides an overview of risks associated in new developments in bond markets and Section IV discusses the policies taken by the Sri Lankan authorities in the areas of monetary management and financial stability that contribute to bond market development.
II. BOND MARKETS AND MACROECONOMIC STABILITY
Bond markets consist mainly of the bonds issued by governments and large corporations.1 In many developing countries, including Sri Lanka, corporate financing mainly comes from the banking sector while debt markets are dominated by the government sector. Banks and non-bank financial institutions are another major category
In developed markets – Europe and the United States., a sub-set of corporate bond market includes however “High Yield Bonds” which are a source of funds for new or small enterprises that have outperformed companies in terms of employment growth, productivity and capital investment.
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.that play an important role in developing corporate bond market as the issuers, mainly raising subordinated debt to meet capital adequacy requirements, and investors in this market. In advanced economies, where bond markets are developed, there are derivative financial products such as collateralized debt obligations (CDOs), and structured credit products, which expand the depth and liquidity of bond markets. It is estimated that the outstanding securities issued by government, financial institutions and corporates accounted for 66 per cent, 57 per cent and 16 per cent of GDP as at end 2004 in mature markets.2 These figures were 25 per cent, 8 per cent and 5 per cent of GDP in emerging economies. In Sri Lanka, the outstanding government debt to GDP as at end 2006 was 93 per cent of GDP yet bonds issued by financial institutions and corporate sector were small accounting only 0.5 per cent of GDP.
Figure 1. Depth of bond market in Asia (Market capitalization at stock and bond markets to GDP)
Depth of Bond Market (Market Capitalisation/GDP)
300
Market Capitalization as a % of GDP
250
Malaysia
Singapore Thailand
200
Korea
150 100
India Sri Lanka
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0 0 5000 10000 15000 Per Capita Income 20000 25000 30000
The contribution of overall macroeconomic stability to bond market development is clearly seen from the expansion of bond markets in emerging markets in the recent past.3 The crisis in many emerging market economies in the late 1990s was caused mainly by
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IMF (2005). The corporate bond markets are among the largest in Malaysia, the Republic of Korea and Thailand. Bond markets in terms of GDP, 38 per cent, 21 per cent and 12 per cent respectively as at end 2004. Size of bank bond market in the United States is 22 per cent.
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macroeconomic imbalances, especially misalignment in exchange rates and weak governance in financial markets and balance sheet weaknesses as a result of currency mismatches. With the improvement in macro economy, as reflected by the reduction in inflation and volatility of inflation, stronger fiscal performance, strong current account performance, output growth and accumulation of foreign reserves, further reforms and efforts have been made by these countries to strengthen the bond markets. 4 These included market infrastructures such as secondary markets, create benchmark issues and remove structural impediments in the markets such as address high costs of debt issuance, expand the set of institutional investors, improve corporate governance and transparency to promote the bond markets. Macroeconomic instability is also found to be the main determinant affecting the development of bond markets in many empirical studies. As argued in “Financial
Stability and Local Currency Bond Markets” by the Committee on the Global Financial System, bonds issued in domestic currency decrease with the rise in the volatility of inflation, and the rise in public debt-to-GDP, and increase with the depth of the financial system and the improvements in the quality of institutions. The importance of the soundness of macroeconomic policies is also emphasized quoting the elasticity estimates found by Mehl and Reynaud (2005) on the ability of governments to raise long-term debt considering the effects of different macroeconomic aggregates. It is found that high level of debt burden makes more difficult to raise long-term bonds than the inflation. In Sri Lanka, although there have been several improvements in different areas of macroeconomic management, a significant improvement is yet to be achieved in containing debt burden, the fiscal deficit, current account deficit in balance of payments and addressing structural weaknesses in labour and input markets and capacity constraints, to contain the volatility in inflation. The discussion in this paper is mainly focused on the need to improving overall macroeconomic stability as well as the need to address the other structural factors to develop the bond markets.
The main purpose of promoting bond markets in these countries is that it is an alternative source of debt financing for corporations that reduces vulnerabilities of the corporate sector by reducing currency mismatches and lengthening the duration of debt.
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A. High and volatile inflation There are several adverse consequences of high and volatile inflation on the efficient functioning of bond markets. The rise in inflation requires central banks to adopt a tight monetary policy stance with a contraction of market liquidity. Money market liquidity, especially the liquidity in the inter-bank market, facilitates smooth functioning of other segments in the money market such as secondary market of Treasury bills and private sector money market instruments such as commercial paper. The reduction in inter-bank liquidity will therefore negatively affect the liquidity in bonds and raise the volatility of market rates leading to a reduction in activities of the secondary markets, which provides price discovery.
Another consequence of the volatility in inflation is the building of inflationary expectations. These expectations discourage investors from allocating resources to
financial assets, in particular long-term bonds. This affects corporate bonds as well as government bonds and overall financial savings of the country. The Government then requires borrowing from inflationary sources, further building up inflationary pressures. High inflationary expectations and volatility of short-term rates also cause the market participants to have problems in deciding on future path of long-term interest rates. Uncertainty of future rates causes higher preference in investing in short term paper shortening the yield curve. From a macroeconomic perspective, inflation affects foreign currency inflows and country’s competitiveness adversely. If domestic inflation is higher than those of other countries, a country’s exports will be less competitive and hence in less demand in international markets. There will also be less foreign currency inflows through foreign direct inflows and portfolio flows. These again negatively impact on the overall bond market.
During the last few decades, inflation in Sri Lanka has been relatively high and volatile (Figure 2). The low increases in prices that prevailed in the early sixties, began
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accelerating and peaked at 26 per cent in 1980. Since 1980 inflation has been declining, albeit with high volatility. The average inflation during the last three decades was around 10-11 per cent.
Figure 2. Changes in inflation in Sri Lanka and Asia, 1969-2006
Annual Average Inflation
35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005
Sri Lanka
Asia
Figure 3 shows the behaviour of inflation and related macroeconomic factors. Inflation shows a very close association with expansion in money supply, budget deficits and currency depreciation. High inflation is largely a result of higher growth of money and fiscal deficits financed by banking sources, especially by central bank which increases reserve money and fuels the overall monetary growth, thereby leading to inflation. The private sector has also been borrowing from the banking sources creating additional pressure for monetary management, partly a result of non development of alternative sources of financing.
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Figure 3. The behaviour of inflation and related macroeconomic variables
I n f l a t i o n a nd M o ne y S u pp l y Gr owt h
I nf l a t i on a n d B u dg e t D e f i c i t
30.0
40. 0
25.0
30. 0
20.0
20. 0
15.0 10.0 5.0
10. 0
0. 0
0.0
-10. 0
-5.0
Inflation
M2 Growth
Inflation
Budget Deficit (%of GDP)
Inflation and Rupee Depreciation
45.0 35.0 25.0 15.0 5.0 -5.0
Inflation
Ex.Rate Depreciation
Figure 4 clearly shows the impact of rising inflation and building up of inflationary expectations on the bond market. As inflation increases, the duration of the government securities declines and investors’ preference shifts to short-term government securities.
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Figure 4. Duration of government securities and inflation
Duration of Government Securities and Inflation
20.0 16.0 12.0 8.0 4.0 0.0
20 03 20 04 20 05 20 06 20 07 / 06
3 Duration 2 1 0
20 02
T bill
T Bond
Inflation
B. Continuing large fiscal deficits and rising public debt Continuing high budget deficits requiring borrowings from banking and non-banking sources create impediments to developing an efficient bond market. Fiscal deficits are, in general, financed through domestic and foreign borrowings, and foreign grants. The relative importance of foreign grants in deficit financing has been declining as the overall foreign grants received by the country is declining, despite the recent increase due to tsunami related inflows. As foreign loans are typically tied with projects, the level of foreign borrowings through loans depends on the progress of the public investment programme. Therefore, if the deficit is maintained over and above the revenue generated by the government, additional financing from domestic sources including borrowings from banking sources will be required, creating inflationary pressures since the available resources in the non-bank sector is limited.
The imposition of taxes on the financial sector constrains the efficient functioning of the financial market. First, the relatively high effective tax rate may tend to reduce effective interest rate paid to depositors and increase effective lending rates thereby increasing the interest rate spread. Second, the high tax incidence increases
Percent
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administrative costs of financial institutions, again requiring banks to maintain high margins. Third, it could indirectly favour the unregulated financial sector institutions while distorting the interest rate structure thereby retarding the development of the development of the bond market.
Continued higher borrowings, particularly with more maturities at the shorter end, create difficulties in rolling over maturing debt on a sustainable manner. The resultant bunching of maturities creates undue pressures on the interest rate structure of the market as well as on the liquidity position of the debt market. It also creates difficulties in the debt management process of the government.
High borrowings by government from non-bank sector also crowd out borrowings by the private sector. At present, a major share of domestic borrowings is made through market based domestic debt instruments such as Treasury bills/Treasury bonds as opposed to non-marketable instruments, contributing to debt market development.
However, government borrowings pre-empt the resources available to the private sector.
C. Continuing current account deficits leading to depreciating currency Exchange rate stability is another factor that has an impact on the bond market. The most direct effect of exchange rate changes is through domestic inflation. The changes in exchange rate affect the price of imported goods, which in turn, are important determinants of the firms' costs and the retail prices of many goods and services.
The volatility in exchange rates also leads to an uncertainty in the foreign exchange market. This adds to risk premium to the forward market transactions and these
uncertainties adversely affect the foreign participation in domestic bond markets and
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affect the development of benchmark yield curve. If there are no markets to hedge the price risks foreign investments may be declined.
Another consequence of high volatility in exchange rate is that it contributes to reduce other foreign currency inflows to country and foreign participation in equity markets affecting the liquidity in the rupee and foreign exchange markets. Although foreigners invest in government securities markets in many emerging economies, the foreign investors in general do not invest in corporate sector bonds. One of the reasons for the lack of interest of foreign investors in corporate bond markets in emerging markets is the general unfamiliarity of the market conditions. Therefore, the participation of equity markets and other inflows too contribute help improve the secondary market and the bond market development.
D. Other impediments in market and institutional infrastructure
In addition to macroeconomic stability, several policy initiatives and targeted reforms are found to be needed to strengthen the institutional infrastructure and remove impediments
which will foster efficient functioning and sustained growth in the bond market particularly the corporate bond market. With regard to institutional infrastructure,
establishing rating agencies, trading platforms, clearing and settlement systems, regulatory environment are some of the major requirements. Policies to develop a diversified institutional investor base will create ensure sustainable demand for bonds. In particular, pension funds, mutual funds, not only create demand for fixed income securities but also contribute to increase financial innovation, corporate governance, and enhance competition in bond market. Strengthening the disclosure standards and
establishing credit rights and investor protection too help remove the impediments to smooth functioning of bond markets.
III. IMPORTANCE OF BOND MARKET DEVELOPMENT ON MONETARY AND FINANCIAL SYSTEM STABILITY
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A. Bond market development and monetary stability The developments in bond markets improve the efficiency of monetary management. Banks, which are the main counter parties in the implementation of monetary policy, take into account their borrowings and lending decision based on market determined yield curve. Accordingly, changes in the monetary policy stance are reflected in the markets and improve the transmission of monetary policy.
A developed bond market reduces the need for governments to finance its budget deficits from inflationary banking financing. Therefore, bond market is an alternative channel for mobilizing funding which enhances the flexibility of monetary management. A well-established yield curve allows inferring expectations of inflation and interest rates. A distorted yield curve on the other hand, restricts the information that can be obtained and restricts the ability to affect long-term rates. Moreover, a market determined yield curve facilitates investors and savers to price their borrowings and lending more competitively. Thus, the yield curve promotes economic growth prospects through its impact on promoting savings, expanding investment thus reducing bank borrowing leading to reduced monetary expansion.
The development of government securities market also facilitates implementing indirect instruments of monetary policy. Most countries are moving away from the use of direct instruments to indirect instruments such as repos and direct open market operations. Typically, Treasury bills and Treasury bonds are the main instruments used in conducting repo transactions. Central banks in general, absorb and inject liquidity through the purchase and sale of Treasury bills/Treasury bonds. An important component in the management of liquidity is crucially dependent on development of money market and Treasury bill and Treasury bond markets in particular. The development of Treasury
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bill and Treasury bond markets therefore contribute for the Central Bank to conduct monetary policy more effectively. B. Bond market development and financial system stability Bond market development has a significant impact on strengthening financial system stability. Well-functioning government and corporate bond markets expand the array of financial assets that are available to institutional investors. Long-term investors such as pension funds and life insurance companies require long-term investments that mach their long-term liabilities. Market determined investments reduce mismatches and
facilitate their portfolio management. In this context, bond markets help strengthen the balance sheets of these institutions and reduce their exposures to interest rates and roll over risks of investments. Another important advantage is that it reduces instabilities arising from foreign currency mismatches and the dependence on international bond markets by corporations. In fact, combined with a sound debt management policy, domestic bond market allows a reduction of the exposure to other financial risks since bond market provides an alternative and cost efficient source of medium and long-term capital for corporations. Moreover, a market-oriented funding policy based on a liquid government securities market will reduce debt-service costs over the medium to long-term.
A liquid corporate bond market may prevent development of asset price bubbles. Bond markets expand the array of financial instruments available to diverse investors. Yield curve allows investors to infer more information about market expectations regarding interest rates and other economic developments. With the expansion of market players in the market, the herd behaviour will also be restricted.
Development of bond markets facilitates and expands the opportunities to financial institutions to raise debt capital. Specially, this is important since banks are required to build capital with the implementation of new Basel capital accord. The development of
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other ancillary intermediaries such as rating agencies can support the overall credit risk management of financial intermediaries.
Another important advantage is that it helps governments to structure the debt management. In fact, several United States dollar-denominated debt instruments have been introduced by the government of Sri Lanka in recent years in view of the issues in raising borrowings from the market. Sri Lanka Development Bonds (SLDBs), The Sri Lanka Nation Building Bond (SLNBB), a new sovereign debt instrument, foreign commercial borrowing through a syndicated loan and an international bond issue are the different instruments through which foreign borrowings were raised to complement domestic borrowings. These bonds mitigated pressures on the domestic debt securities market and to stabilize the interest rate structure. Yet, these increased debt management vulnerabilities to exchange rate movements. In general, investment programmes undertaken by government to a large extent are the infrastructure developments which have long gestation periods. The continuation of the government’s investment programmes mainly concentrating on infrastructure
development projects, which have long-term gestation periods, creates the necessity of raising long-term funds for government. Developed bond markets expand not only the range of opportunities available for government but also the assets available for institutional investors.
C. Importance of derivative markets in bond markets, new risks and their impact on monetary and financial stability Derivative markets play an important role in the development of bond markets. Investing in bond markets exposes investors to market, liquidity and credit risks. However, derivative markets in currencies and interest rate swaps and various derivative products such as credit derivatives allow for allocation/transfer of risks such as credit risk, interest rate risk between market participants according to their preferences, expectation and risk aversion and make market liquidity throughout the system.
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For instance, the securitization which originates as an issue of bonds or securities by the pooling receivables of capital and interest on loans, are sold to investors so that banks can raise liquidity without waiting for repayments of the original loans. These securitization subsequently have become more complex with the involvement of investment banks, mortgage lending institutions, equity firms, mutual/hedge funds and credit rating agencies leading to the introduction of innovative financial products generally known as ‘complex structured finance products’, e.g., asset or mortgage-backed securities (MBSs) and collateralized-debt obligations (CDOs).
One purpose of these exotic products is to create new securities that could be sold to a broader group of investors such as pension funds and insurance companies whose investment horizon better suited depending on their liability structures. These instruments therefore enabled the transfer of credit risk to a diversified group of investors in the market. Therefore, these innovative products were generally encouraged, even by regulators, as a risk management tool. Markets evolved to trade these securities to suit investors with different risk appetites. Interestingly, during last two years, financial regulators have been raising concerns over the credit derivative markets boom because the risks taken by the investors outside the regulatory purview. Although the derivative markets and hedging instruments facilitate the expansion of the bond market, the evolution of derivative products has brought in two distinctive features to the financial market: an increasing complexity of instruments, which combine an extensive use of derivatives with customization to individual investors’ needs and the fragility of off-balance sheet structures and vehicles, which was rediscovered during the recent sub-prime turmoil. Following the sub-prime issue, a number of central banks in developed economies acted to stabilize markets and forestall a potential financial crisis. The European Central Bank, The US Fed injected significant amounts and in order to encourage banks to come to it for liquidity, the Fed reduced the discount rate the charge it makes for emergency lending to banks. The central banks of Canada, Japan, UK and Australia also intervened to provide liquidity to the market. This recent episode also highlights that regulators are
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required to play a major role indirectly in finance product innovation, in view of the systemic and economic risks. Regulators are required to ensure that systemically
important banks and financial institutions are not exposed to concentration risks in specific products or markets. Banks and financial institutions are also required to follow fair market practices without unduly affecting public confidence.
D. Monetary and financial sector policies in Sri Lanka promoting bond market 1. Conduct of monetary policy The conduct of monetary policy is one of the prime responsibilities of the Central Bank, since monetary policy is the means by which Central Bank attempts to attain its one of the core objectives, i.e., the economic and price stability. Monetary Law Act provided a wide range of instruments that could be used by the Central Bank for monetary management. At present, the monetary policy framework places greater reliance on market based policy instruments and the use of market forces to achieve the desired objectives as they help achieve a better allocation of resources, reduce associated transaction costs, and improve the efficiency in monetary management. As a further step in making toward for more market oriented monetary management system, the Central Bank moved to more market based active open market operations with effect from 3 March 2003.
Steps were also taken to enhance the transparency, predictability and credibility of monetary policy. After each decision on required change in monetary policy stance, or otherwise, a public statement, i.e., a press release, explaining the monetary and economic conditions that led to the particular decision on the policy change (or otherwise), is issued to the public. In addition, the monetary policy framework, and monetary projections, along with the explanatory notes are regularly posted on the Central Bank website.
The independently floating exchange rate regime, which was implemented from January 2001 served well in reducing the excess volatility in the exchange rate and
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maintaining the country’s competitiveness vis-à-vis the rest of the world, while allowing greater freedom in the conduct of monetary policy.
2. Polices to promote financial system stability A comprehensive approach is adopted in preserving financial stability, which is one of the core objectives of the Central Bank. This encompassed surveillance at systemically important financial institutions; regulations to ensure prudent practices by banking institutions and healthy developments in financial markets; and supervisory activities. This is work is being initiated towards developing additional tools to enhance ongoing surveillance and analyses of financial system resilience which includes developing forward-looking indicators both at the system and institution levels to identify, measure, assess and predict emerging vulnerabilities and adopt stress test methodology to ensure its effectiveness and relevance.
Given the diverse risks associated with financial conglomerates, it has become increasingly important to ensure that the activities of financial conglomerates do not pose risks to the stability of the financial system. In this regard, the Central Bank has
introduced a number of policy initiatives to address the potential systemic risk posed by financial conglomerates to monitor systemic risks of financial conglomerates and promote consolidated supervision.
a. Banking sector The stability of the banking sector, which is the major sub-sector within the financial sector is crucial for bond market since it provides payment facilities and a major buyer and issuer of securities and facilitates secondary market activity. In fact, banks are one of the major investors in government securities market to meet statutory liquidity requirements and as collateral for repo transactions in managing short-term liquidity. Accordingly, number of measures continued to be taken promote a competitive, sound and robust banking sector.
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There has been a significant improvement in capacity and capability of the banking system and this is supported by improved earnings, increase in capital funds and improvements in risk management amidst enhanced regulatory and supervisory framework. This was further underpinned by the gradual decline in non-performing loans (NPLs), reflecting general improvements in credit quality and enhanced risk management standards and practices over the years. The strong financial position has enabled the banking sector to expand the access to finance.
With a view to further strengthening the efficiency and greater competition among financial institutions, a number of legal reforms relating to the financial sector were brought in and regulatory oversight were enhanced to be in line with international best practices.
b. Money market The Central Bank has implemented several measures to broaden and deepen the money market. In order to help pricing money market products, the Central Bank started providing Sri Lanka Interbank Offered Rate from 1999. The Central Bank also engages in Repurchase and Reverse Repurchase transactions in order to inject and absorb liquidity from the market. Further, it disseminates information on market transactions on a daily basis. Measures have also been taken to further promote and upgrade the payments system to take effect large value money market transactions through the Real Time Gross Settlement System and the Scripless Securities System, which will expand and promote the efficiency of money market transactions.
c. Foreign exchange market
Another noteworthy development in the foreign exchange market was that the independent floating of Sri Lanka rupee in 2001. The main players in the foreign exchange market are the commercial banks. Dealings in the foreign exchange market are
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mainly in spot and forward transactions. These operations are largely generated by trade related activities, capital flows, and trading activities of commercial banks.
Since the commencement of independent floating in 2001, a greater stability in foreign exchange market has been seen, with an increase in market activity. Foreign exchange market activities have also been expanded significantly.
d. Development of government securities market
A number of positive developments have also taken place in the government securities market supporting bond market development. In an effort to upgrade the market infrastructure, the Scripless Securities Settlement System (SSSS) was introduced in 2004 to replace the paper-based instrument system with the dematerialized settlement system. Meanwhile, the Central Depository System (CDS) for GS was introduced to record trading information for scripless securities. As a result, the settlement and clearing of government securities has achieved Delivery Versus Payment (DVP), whereby security delivery and payment will be simultaneous.
A conscious effort has been taken to increase issues of marketable government securities. Accordingly, Treasury bonds were issued in place of rupee securities. As a result, the share of T-bonds increased from 28 per cent in 2001 to 60 per cent in 2006, and the share of Rupee loans decreased from 35.8 per cent to 8 per cent.
With a view to further opening the capital account transactions and to develop the capital markets by broadening the investor base and increasing competition in the bond market, foreign investors have been permitted to purchase up to five per cent of rupee denominated Treasury bonds since November 2006.
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e. Financial system infrastructure
An efficient and reliable payment and settlement system contributes to the soundness and the development of the financial system and the smooth functioning of bond markets. Therefore, the Central Bank moved towards introducing a more advanced payment and settlement system in 2003. For high value and time critical payments on real time, the Central Bank implemented the Real Time Gross Settlement System (RTGS) in 2003, which significantly reduced the settlement risks and improved efficiency.
To further modernize the payment system, measures were also taken by the Central Bank and Lanka Clear (Pvt.) Ltd to introduce Cheque Imaging and Truncation (CIT) to the country’s cheque clearing system with the long-term objective of moving towards electronic cheque transactions.
f. Legal enactments
A number of laws relating to the financial sector have been enacted strengthening the legal framework for the efficient functioning of bond market. These included the
Payments and Settlement Systems Act, Electronic Transactions Act, Payment Devices Frauds Act and legislation pertaining to Anti-Money Laundering, Terrorist Financing and Financial Transactions Reporting.
E. Policy measures to promote bond market A prudent monetary policy supported by fiscal policy while allowing appropriate adjustment in exchange rate is important to achieve macro economic stability and contain inflationary pressures and promote stability in the foreign exchange market which are fundamental to bond market development.
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1. Monetary policy
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Maintenance of a medium-term macroeconomic framework and following a credible monetary policy to attain monetary growth targets and reduce high inflationary pressures in the economy: Achieving macroeconomic stability, that is to maintain the inflation rate, contain high monetary expansion and the fiscal deficit at sustainable levels are the key prerequisites for the development of the bond market., thereby ensuring price stability, is crucial in further developing bond market. Therefore, preparation of a medium term macroeconomic framework supported by fiscal policy is the most essential to bring the inflation to a sustainable level.
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Further improving the efficiency of money market operations: Measures could be taken to improve the management of money market liquidity addressing weaknesses in the inter-bank call money market, improving the cash management framework of the government will facilitate the Central Bank to manage short-term liquidity appropriately.
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A greater co-ordination by monetary and fiscal authorities: Inflation targeting per se can improve the co-ordination between monetary policy and other macroeconomic policies (depending on the way the target is set and whether the target is consistent with other policy objectives). The announcement of inflation targets clarifies the central bank’s intentions and reduces uncertainty about the future course of monetary policy. Inflation targets make policy transparent.
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Monetary policy communication: A good communication policy helps to achieve the objectives of the Central Bank. It is essential that market participants and the public at large know and understand the objectives of the Central Bank and the monetary policy actions taken by the bank. Any change in monetary policy stance should therefore explicitly explain to the public.
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Managing expectations: Inflation expectation surveys and constructing leading indicators are two other areas where work could be developed. Change in
inflationary expectations, which are an indicator of credibility of monetary policy and inflation inertia, are also variables used in inflation forecasting models.
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Inflation Targeting: In recent years, there has been an increasing focus on inflation targeting as a framework for implementing monetary policy. The rationale behind inflation targeting is that inflation targets may help provide a clear path for the medium term inflation outlook, reducing the size of inflationary shocks and their associated costs. Since long-term interest rates fluctuate with movements in inflation expectations, targeting a low rate of inflation would lead to a more stable and lower long-term rates of interest.
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Further work in moving inflation targeting: More empirical work is needed to understand the monetary policy transmission mechanism better. In particular, the degree of pass through from money market rates to retail rates, lags associated with monetary policy shocks and channels though which these shocks are propagated need to be examined A good forecast of the inflation rate can provide valuable inputs in the formulation of macroeconomic policies, in particular, monetary policy. Inflation forecasting is central to any monetary framework. Monetary policy affects output and inflation with lags and a forward-looking approach is essential in the monetary policy decision making process.
2. Fiscal policy
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Government’s commitment to maintain fiscal targets: Government’s Medium Term Macro Framework (MTMF) enunciated in the Fiscal Management Reports, and the overall deficit announced in these reports should be maintained. Government
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should take necessary adjustments in the areas of enhancing revenue through additional measures and improved tax administration, rationalization of current expenditure and improvements in the government debt management to meet this target since large deviations of government borrowings affect the smooth implementation of the borrowing programme. It is also important that the mediumterm fiscal targets announced in the FMRA are achieved effectively so that there would be less pressure in the conduct of monetary policy as well.
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Reduction in High Budget Deficits: Persistently high budget deficits due to a combined outcome of declining revenue as well as increasing government expenditure are the major problem in the country’s public finances at present. Consequent to the higher deficits and resultant borrowings from both domestic and foreign sources, the outstanding stock of government debt has also risen to a high level. Past experience reveals that the level of public investment has gradually declined mainly to compensate the high budget deficits that are causing from higher recurrent expenditures. As such, increasing public investment has become important to facilitate the private sector participation in economic activities. Accordingly, measures are being introduced particularly to enhance the tax revenue collection and reduce the expenditure almost entirely through further rationalization of current expenditure are urgent needs.
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Reduction in High Level of Debt: The government debt as a percentage of GDP continued to remain high, suggesting that there is an urgent need for fiscal consolidation. Without a reduction of the budget deficit, there would be an increase in the extra yield expected of for investments affecting the bond market development.
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Taxation of financial instruments: High deficits force the government to impose additional taxes on financial instruments or financial institutions constraining the efficient functioning of financial market. At present, in Sri Lanka, the financial sector is subjected to six types of taxes; two on financial institutions and four on services. 23
The VAT and corporate tax are payable by institutions. Withholding taxes on interest income, debit taxes on withdrawals, stamp duties and VATs on fee-based activities are paid by customers.
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Improvements to debt management through the creation of benchmark issues: Government can reduce its debt servicing costs by concentrating the bond issuance to a limited number of large benchmark securities instead of current multiplicity of issues. Larger and concentrated issues tend to be liquid and beneficial in developing a yield curve which in turn help in pricing range of other financial instruments. Accordingly, the issues could be limited to pre-determined maturities and coupons. A range of debt instruments allows the debt to be issued to address the preferences of range of investors with different risk appetites. However, too many issues could fragment the market. Hence, the outstanding instruments could either be buy
back/exchange for benchmark issues. •
Work on establishing an independent Debt office: As in many central banks, public debt management is a responsibility of the Central Bank of Sri Lanka. Separation of roles and responsibilities will allow greater clarity in setting objectives and maximizing the transparency of monetary policy. There is also a need for cooperation to share information to properly estimate the liquidity forecasts by central banks so that monetary management be undertaken with a greater precision.
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Cooperation of other stakeholders is needed: In developing countries, like Sri Lanka, there are structural issues (i.e., inefficiencies in product, labour and capital markets) that also need to be addressed in order to create an environment of low and stable inflation. Monetary policy alone is not sufficient to maintain price stability since monetary policy cannot be carried out in isolation of other polices and the impact from external sources. Therefore, the co-operation of other stakeholders is needed to reduce inflation on a sustainable basis. Measures are necessary to increase
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supply condition along with the improvements to productivity, removing bottlenecks in infrastructure and inputs markets.
3. Promoting financial system stability
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A series of measures will need to be implemented to further enhance the efficiency and strengthen the financial sector, which will contribute to financial system stability and the developments of bond markets. These encompass regulatory and supervisory measures to strengthen major financial institutions; forward looking surveillance indicators and tools to predict emerging vulnerabilities; measures to improve efficiency of financial markets including access to finance; initiatives to enhance the safety of payment systems; and introduction of necessary changes to legal enactments governing the wider financial system.
•
Further reforms to broaden and improve efficiency of the financial sector: As an integral part of the economic liberalization policy package initiated about three decades ago, several financial sector reform measures have been undertaken to create an efficient and resilient financial sector. With these changes, the financial services sector has shown a significant expansion during the last three decades. Further reform measures would help deepen the money and capital markets and improve their efficiency leading to higher savings and positive effect on growth. .
•
Supervision and regulation: The increasingly complex and dynamic financial activities demand continuous enhancement to the regulatory and supervisory framework. Accordingly, several initiatives have been taken by the CBSL, SEC and IBSL which regulates and supervises major financial institutions. implementation of The
Basel II capital adequacy framework, the introduction of
mandatory corporate governance rules, the adoption of International Accounting Standards viz., IAS 32, 39 & IFRS 7, and the implementation of an integrated risk management framework are expected to provide a significant boost to the capacity
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and capability of the banking institutions, promote overall risk management and reinforce the resilience of the banking sector •
Financial system infrastructure: With a view to developing a safe and efficient payment instruments, a nation-wide non-cash retail payment system is to be introduced as proposed by the National Payments Council.
•
Expanding investor base: A broad investor base has several advantages for developing the bond market through enhanced market stability, promoting financial innovation and contributing to expanding liquidity. Accordingly, measures need to be taken for the development of a group of private institutional investors especially developing pension funds, mutual funds. An initial boost could be given for bond market development by participating in bond issues by relaxing the restrictions on the investment policies of the EPF, the ETF, and the NSB as regards their ability to invest in private securities and allowing foreign investors to invest in fixed-income securities.
•
Procedures for corporate insolvency and rehabilitation: It is necessary that there are procedures and laws to provide for corporate insolvency and rehabilitation.
•
Promoting investment banking: The investment banks could function as a catalyst to the development of vibrant and efficient bond market. These banks facilitate the issuing of
corporate bonds in several ways such as advising on the timing and terms of the issuers. In addition, underwriting of bond issues are some of the services that could be provided. • Expanding markets: The securitization market has expanded considerably in recent years, driven mainly by mortgage-backed securities in many countries. In Sri Lanka, draft bill has been prepared and it is necessary that process of securitization be expedited.
26
•
Disclosure of information to build market credibility: Information disclosure plays a key role in building market credibility. Developing proper disclosure standards based on consolidated accounts and well established auditing and accounting standards will help market and supervisors. In this regard, the adoption of IAS standards and move to consolidate listed companies, through strict enforcement of free float requirements, will also have a positive impact on information disclosure.
•
Improve the financial literacy and awareness among investors about the characteristics of new capital products. Enhanced understanding of the capital markets by issuers, investors (both institutional and retail), will allow them to make educated decisions would contribute enormously to the long-term development of the capital markets.
•
Protecting investors from bond defaults: Necessary safeguards needs to be in place to protect investors from bond defaults since there are possibilities that some companies which are not creditworthy could issue junk bonds. In fact, it is reported that Chinese government has adopted a merit based selection system for issuing corporate bonds, ceilings on corporate bond interest rates and mandatory credit to protect investors following number of corporate bond defaults in 1990s.5
III. CONCLUSION
Macroeconomic policies, fiscal and monetary policies in particular need to be harmonized to achieve a stable macroeconomic environment which is a pre-requisite and provide a conducive environment for the development of the domestic debt market. However, it needs to be reiterated that the success of many of the above critically dependent on achieving a durable peace. The continuous civil unrest had a huge cost on economic activity with significant direct and indirect impacts. In addition to
macroeconomic stability, several policy initiatives and targeted reforms are found to be
5
IMF (2005), Box. 4.4.
27
needed to strengthen institutional infrastructure and remove impediments which will foster efficient functioning and sustained growth in the bond market particularly the corporate bond market. With regard to institutional infrastructure, establishing rating agencies, trading platforms, clearing and settlement systems, regulatory environment are some of the major requirements. Policies to develop a diversified institutional investor base will create ensure sustainable demand for bonds. In particular, pension funds, mutual funds, not only create demand for fixed income securities but also contribute to increase financial innovation, corporate governance, and enhance competition in the bond market.
28
REFERENCE
Bank Negara Malaysia, The Corporate Bond Market in Malaysia, Muhammad bin Ibrahim and Adrian Wong. Bank for International Settlements (2007). CGFC Papers No.28 Financial Stability and Local Currency Bond Markets, June. Del Valle, C., A Comprehensive View: Developing Bond Markets, http://www.iadb.org/sds/doc/IFM-ClementeBond-E.pdf. IMF (2000). International Capital Markets: Developments, Prospects, and Key Policy Issues, World Economic and Financial Surveys, September (Washington D.C.). _____ (2001), International Capital Markets: Developments, Prospects, and Key Policy Issues, World Economic and Financial Surveys, August (Washington D.C.). _____ (2004), Global Financial Stability Report, World Economic and Financial Surveys, April (Washington D.C.). _____ (2005), Global Financial Stability Report, World Economic and Financial Surveys, April (Washington D.C.). The World Bank and IMF (2001). Developing Government Bond Markets, A Handbook, (Washington D.C.).
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2008
Ananda Silva∗
∗
Ananda Silva, Director of Bank Supervision Department, Central Bank of Sri Lanka.
1
CONTENTS
I. Introduction II. Bond Markets and Macroeconomic Stability A. B. C. D. High and Volatile Inflation Continuing large Fiscal deficits and Rising Public Debt Continuing Current Account Deficits Leading to Depreciating Currency Other Impediments in market and Institutional Infrastructure
III. Importance of Bond Market Development on Monetary and Financial System Stability A. B. C. D. E. F. Bond Market Development and Monetary Stability Bond Market Development and Financial System Stability Importance of Derivative markets in Bond markets, New Risks and Their Impact on Monetary and Financial Stability Monetary and Financial Sector Policies in Sri Lanka Promoting Bond Market Policy Measures to Promote Bond Market
IV. Conclusion
2
I. INTRODUCTION
A stable macroeconomic environment particularly a credible monetary policy along with supporting fiscal management and financial system stability have found to be the prerequisites for the development of the bond market. Similarly, the bond market
development contributes to enhance the efficiency of monetary management and financial system stability. A developed bond market also plays an important role in
improving the efficiency of overall economic management through expanding the range of opportunities of available to financing large scale projects, contributing to better allocation of capital, providing a non-inflationary source of finance for government and facilitating public debt management, and contributing to promote sustainable economic growth. Therefore, it is important that concerted efforts are taken to develop a deep and liquid bond market.
Section I of the paper discusses the interaction between bond development and macroeconomic stability focusing on the sources of instabilities affecting the bond market. Section II presents the contribution of the bond market in improving the
efficiency of monetary management and financial stability. Section III provides an overview of risks associated in new developments in bond markets and Section IV discusses the policies taken by the Sri Lankan authorities in the areas of monetary management and financial stability that contribute to bond market development.
II. BOND MARKETS AND MACROECONOMIC STABILITY
Bond markets consist mainly of the bonds issued by governments and large corporations.1 In many developing countries, including Sri Lanka, corporate financing mainly comes from the banking sector while debt markets are dominated by the government sector. Banks and non-bank financial institutions are another major category
In developed markets – Europe and the United States., a sub-set of corporate bond market includes however “High Yield Bonds” which are a source of funds for new or small enterprises that have outperformed companies in terms of employment growth, productivity and capital investment.
1
3
.that play an important role in developing corporate bond market as the issuers, mainly raising subordinated debt to meet capital adequacy requirements, and investors in this market. In advanced economies, where bond markets are developed, there are derivative financial products such as collateralized debt obligations (CDOs), and structured credit products, which expand the depth and liquidity of bond markets. It is estimated that the outstanding securities issued by government, financial institutions and corporates accounted for 66 per cent, 57 per cent and 16 per cent of GDP as at end 2004 in mature markets.2 These figures were 25 per cent, 8 per cent and 5 per cent of GDP in emerging economies. In Sri Lanka, the outstanding government debt to GDP as at end 2006 was 93 per cent of GDP yet bonds issued by financial institutions and corporate sector were small accounting only 0.5 per cent of GDP.
Figure 1. Depth of bond market in Asia (Market capitalization at stock and bond markets to GDP)
Depth of Bond Market (Market Capitalisation/GDP)
300
Market Capitalization as a % of GDP
250
Malaysia
Singapore Thailand
200
Korea
150 100
India Sri Lanka
50
0 0 5000 10000 15000 Per Capita Income 20000 25000 30000
The contribution of overall macroeconomic stability to bond market development is clearly seen from the expansion of bond markets in emerging markets in the recent past.3 The crisis in many emerging market economies in the late 1990s was caused mainly by
2 3
IMF (2005). The corporate bond markets are among the largest in Malaysia, the Republic of Korea and Thailand. Bond markets in terms of GDP, 38 per cent, 21 per cent and 12 per cent respectively as at end 2004. Size of bank bond market in the United States is 22 per cent.
4
macroeconomic imbalances, especially misalignment in exchange rates and weak governance in financial markets and balance sheet weaknesses as a result of currency mismatches. With the improvement in macro economy, as reflected by the reduction in inflation and volatility of inflation, stronger fiscal performance, strong current account performance, output growth and accumulation of foreign reserves, further reforms and efforts have been made by these countries to strengthen the bond markets. 4 These included market infrastructures such as secondary markets, create benchmark issues and remove structural impediments in the markets such as address high costs of debt issuance, expand the set of institutional investors, improve corporate governance and transparency to promote the bond markets. Macroeconomic instability is also found to be the main determinant affecting the development of bond markets in many empirical studies. As argued in “Financial
Stability and Local Currency Bond Markets” by the Committee on the Global Financial System, bonds issued in domestic currency decrease with the rise in the volatility of inflation, and the rise in public debt-to-GDP, and increase with the depth of the financial system and the improvements in the quality of institutions. The importance of the soundness of macroeconomic policies is also emphasized quoting the elasticity estimates found by Mehl and Reynaud (2005) on the ability of governments to raise long-term debt considering the effects of different macroeconomic aggregates. It is found that high level of debt burden makes more difficult to raise long-term bonds than the inflation. In Sri Lanka, although there have been several improvements in different areas of macroeconomic management, a significant improvement is yet to be achieved in containing debt burden, the fiscal deficit, current account deficit in balance of payments and addressing structural weaknesses in labour and input markets and capacity constraints, to contain the volatility in inflation. The discussion in this paper is mainly focused on the need to improving overall macroeconomic stability as well as the need to address the other structural factors to develop the bond markets.
The main purpose of promoting bond markets in these countries is that it is an alternative source of debt financing for corporations that reduces vulnerabilities of the corporate sector by reducing currency mismatches and lengthening the duration of debt.
4
5
A. High and volatile inflation There are several adverse consequences of high and volatile inflation on the efficient functioning of bond markets. The rise in inflation requires central banks to adopt a tight monetary policy stance with a contraction of market liquidity. Money market liquidity, especially the liquidity in the inter-bank market, facilitates smooth functioning of other segments in the money market such as secondary market of Treasury bills and private sector money market instruments such as commercial paper. The reduction in inter-bank liquidity will therefore negatively affect the liquidity in bonds and raise the volatility of market rates leading to a reduction in activities of the secondary markets, which provides price discovery.
Another consequence of the volatility in inflation is the building of inflationary expectations. These expectations discourage investors from allocating resources to
financial assets, in particular long-term bonds. This affects corporate bonds as well as government bonds and overall financial savings of the country. The Government then requires borrowing from inflationary sources, further building up inflationary pressures. High inflationary expectations and volatility of short-term rates also cause the market participants to have problems in deciding on future path of long-term interest rates. Uncertainty of future rates causes higher preference in investing in short term paper shortening the yield curve. From a macroeconomic perspective, inflation affects foreign currency inflows and country’s competitiveness adversely. If domestic inflation is higher than those of other countries, a country’s exports will be less competitive and hence in less demand in international markets. There will also be less foreign currency inflows through foreign direct inflows and portfolio flows. These again negatively impact on the overall bond market.
During the last few decades, inflation in Sri Lanka has been relatively high and volatile (Figure 2). The low increases in prices that prevailed in the early sixties, began
6
accelerating and peaked at 26 per cent in 1980. Since 1980 inflation has been declining, albeit with high volatility. The average inflation during the last three decades was around 10-11 per cent.
Figure 2. Changes in inflation in Sri Lanka and Asia, 1969-2006
Annual Average Inflation
35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005
Sri Lanka
Asia
Figure 3 shows the behaviour of inflation and related macroeconomic factors. Inflation shows a very close association with expansion in money supply, budget deficits and currency depreciation. High inflation is largely a result of higher growth of money and fiscal deficits financed by banking sources, especially by central bank which increases reserve money and fuels the overall monetary growth, thereby leading to inflation. The private sector has also been borrowing from the banking sources creating additional pressure for monetary management, partly a result of non development of alternative sources of financing.
7
Figure 3. The behaviour of inflation and related macroeconomic variables
I n f l a t i o n a nd M o ne y S u pp l y Gr owt h
I nf l a t i on a n d B u dg e t D e f i c i t
30.0
40. 0
25.0
30. 0
20.0
20. 0
15.0 10.0 5.0
10. 0
0. 0
0.0
-10. 0
-5.0
Inflation
M2 Growth
Inflation
Budget Deficit (%of GDP)
Inflation and Rupee Depreciation
45.0 35.0 25.0 15.0 5.0 -5.0
Inflation
Ex.Rate Depreciation
Figure 4 clearly shows the impact of rising inflation and building up of inflationary expectations on the bond market. As inflation increases, the duration of the government securities declines and investors’ preference shifts to short-term government securities.
8
Figure 4. Duration of government securities and inflation
Duration of Government Securities and Inflation
20.0 16.0 12.0 8.0 4.0 0.0
20 03 20 04 20 05 20 06 20 07 / 06
3 Duration 2 1 0
20 02
T bill
T Bond
Inflation
B. Continuing large fiscal deficits and rising public debt Continuing high budget deficits requiring borrowings from banking and non-banking sources create impediments to developing an efficient bond market. Fiscal deficits are, in general, financed through domestic and foreign borrowings, and foreign grants. The relative importance of foreign grants in deficit financing has been declining as the overall foreign grants received by the country is declining, despite the recent increase due to tsunami related inflows. As foreign loans are typically tied with projects, the level of foreign borrowings through loans depends on the progress of the public investment programme. Therefore, if the deficit is maintained over and above the revenue generated by the government, additional financing from domestic sources including borrowings from banking sources will be required, creating inflationary pressures since the available resources in the non-bank sector is limited.
The imposition of taxes on the financial sector constrains the efficient functioning of the financial market. First, the relatively high effective tax rate may tend to reduce effective interest rate paid to depositors and increase effective lending rates thereby increasing the interest rate spread. Second, the high tax incidence increases
Percent
9
administrative costs of financial institutions, again requiring banks to maintain high margins. Third, it could indirectly favour the unregulated financial sector institutions while distorting the interest rate structure thereby retarding the development of the development of the bond market.
Continued higher borrowings, particularly with more maturities at the shorter end, create difficulties in rolling over maturing debt on a sustainable manner. The resultant bunching of maturities creates undue pressures on the interest rate structure of the market as well as on the liquidity position of the debt market. It also creates difficulties in the debt management process of the government.
High borrowings by government from non-bank sector also crowd out borrowings by the private sector. At present, a major share of domestic borrowings is made through market based domestic debt instruments such as Treasury bills/Treasury bonds as opposed to non-marketable instruments, contributing to debt market development.
However, government borrowings pre-empt the resources available to the private sector.
C. Continuing current account deficits leading to depreciating currency Exchange rate stability is another factor that has an impact on the bond market. The most direct effect of exchange rate changes is through domestic inflation. The changes in exchange rate affect the price of imported goods, which in turn, are important determinants of the firms' costs and the retail prices of many goods and services.
The volatility in exchange rates also leads to an uncertainty in the foreign exchange market. This adds to risk premium to the forward market transactions and these
uncertainties adversely affect the foreign participation in domestic bond markets and
10
affect the development of benchmark yield curve. If there are no markets to hedge the price risks foreign investments may be declined.
Another consequence of high volatility in exchange rate is that it contributes to reduce other foreign currency inflows to country and foreign participation in equity markets affecting the liquidity in the rupee and foreign exchange markets. Although foreigners invest in government securities markets in many emerging economies, the foreign investors in general do not invest in corporate sector bonds. One of the reasons for the lack of interest of foreign investors in corporate bond markets in emerging markets is the general unfamiliarity of the market conditions. Therefore, the participation of equity markets and other inflows too contribute help improve the secondary market and the bond market development.
D. Other impediments in market and institutional infrastructure
In addition to macroeconomic stability, several policy initiatives and targeted reforms are found to be needed to strengthen the institutional infrastructure and remove impediments
which will foster efficient functioning and sustained growth in the bond market particularly the corporate bond market. With regard to institutional infrastructure,
establishing rating agencies, trading platforms, clearing and settlement systems, regulatory environment are some of the major requirements. Policies to develop a diversified institutional investor base will create ensure sustainable demand for bonds. In particular, pension funds, mutual funds, not only create demand for fixed income securities but also contribute to increase financial innovation, corporate governance, and enhance competition in bond market. Strengthening the disclosure standards and
establishing credit rights and investor protection too help remove the impediments to smooth functioning of bond markets.
III. IMPORTANCE OF BOND MARKET DEVELOPMENT ON MONETARY AND FINANCIAL SYSTEM STABILITY
11
A. Bond market development and monetary stability The developments in bond markets improve the efficiency of monetary management. Banks, which are the main counter parties in the implementation of monetary policy, take into account their borrowings and lending decision based on market determined yield curve. Accordingly, changes in the monetary policy stance are reflected in the markets and improve the transmission of monetary policy.
A developed bond market reduces the need for governments to finance its budget deficits from inflationary banking financing. Therefore, bond market is an alternative channel for mobilizing funding which enhances the flexibility of monetary management. A well-established yield curve allows inferring expectations of inflation and interest rates. A distorted yield curve on the other hand, restricts the information that can be obtained and restricts the ability to affect long-term rates. Moreover, a market determined yield curve facilitates investors and savers to price their borrowings and lending more competitively. Thus, the yield curve promotes economic growth prospects through its impact on promoting savings, expanding investment thus reducing bank borrowing leading to reduced monetary expansion.
The development of government securities market also facilitates implementing indirect instruments of monetary policy. Most countries are moving away from the use of direct instruments to indirect instruments such as repos and direct open market operations. Typically, Treasury bills and Treasury bonds are the main instruments used in conducting repo transactions. Central banks in general, absorb and inject liquidity through the purchase and sale of Treasury bills/Treasury bonds. An important component in the management of liquidity is crucially dependent on development of money market and Treasury bill and Treasury bond markets in particular. The development of Treasury
12
bill and Treasury bond markets therefore contribute for the Central Bank to conduct monetary policy more effectively. B. Bond market development and financial system stability Bond market development has a significant impact on strengthening financial system stability. Well-functioning government and corporate bond markets expand the array of financial assets that are available to institutional investors. Long-term investors such as pension funds and life insurance companies require long-term investments that mach their long-term liabilities. Market determined investments reduce mismatches and
facilitate their portfolio management. In this context, bond markets help strengthen the balance sheets of these institutions and reduce their exposures to interest rates and roll over risks of investments. Another important advantage is that it reduces instabilities arising from foreign currency mismatches and the dependence on international bond markets by corporations. In fact, combined with a sound debt management policy, domestic bond market allows a reduction of the exposure to other financial risks since bond market provides an alternative and cost efficient source of medium and long-term capital for corporations. Moreover, a market-oriented funding policy based on a liquid government securities market will reduce debt-service costs over the medium to long-term.
A liquid corporate bond market may prevent development of asset price bubbles. Bond markets expand the array of financial instruments available to diverse investors. Yield curve allows investors to infer more information about market expectations regarding interest rates and other economic developments. With the expansion of market players in the market, the herd behaviour will also be restricted.
Development of bond markets facilitates and expands the opportunities to financial institutions to raise debt capital. Specially, this is important since banks are required to build capital with the implementation of new Basel capital accord. The development of
13
other ancillary intermediaries such as rating agencies can support the overall credit risk management of financial intermediaries.
Another important advantage is that it helps governments to structure the debt management. In fact, several United States dollar-denominated debt instruments have been introduced by the government of Sri Lanka in recent years in view of the issues in raising borrowings from the market. Sri Lanka Development Bonds (SLDBs), The Sri Lanka Nation Building Bond (SLNBB), a new sovereign debt instrument, foreign commercial borrowing through a syndicated loan and an international bond issue are the different instruments through which foreign borrowings were raised to complement domestic borrowings. These bonds mitigated pressures on the domestic debt securities market and to stabilize the interest rate structure. Yet, these increased debt management vulnerabilities to exchange rate movements. In general, investment programmes undertaken by government to a large extent are the infrastructure developments which have long gestation periods. The continuation of the government’s investment programmes mainly concentrating on infrastructure
development projects, which have long-term gestation periods, creates the necessity of raising long-term funds for government. Developed bond markets expand not only the range of opportunities available for government but also the assets available for institutional investors.
C. Importance of derivative markets in bond markets, new risks and their impact on monetary and financial stability Derivative markets play an important role in the development of bond markets. Investing in bond markets exposes investors to market, liquidity and credit risks. However, derivative markets in currencies and interest rate swaps and various derivative products such as credit derivatives allow for allocation/transfer of risks such as credit risk, interest rate risk between market participants according to their preferences, expectation and risk aversion and make market liquidity throughout the system.
14
For instance, the securitization which originates as an issue of bonds or securities by the pooling receivables of capital and interest on loans, are sold to investors so that banks can raise liquidity without waiting for repayments of the original loans. These securitization subsequently have become more complex with the involvement of investment banks, mortgage lending institutions, equity firms, mutual/hedge funds and credit rating agencies leading to the introduction of innovative financial products generally known as ‘complex structured finance products’, e.g., asset or mortgage-backed securities (MBSs) and collateralized-debt obligations (CDOs).
One purpose of these exotic products is to create new securities that could be sold to a broader group of investors such as pension funds and insurance companies whose investment horizon better suited depending on their liability structures. These instruments therefore enabled the transfer of credit risk to a diversified group of investors in the market. Therefore, these innovative products were generally encouraged, even by regulators, as a risk management tool. Markets evolved to trade these securities to suit investors with different risk appetites. Interestingly, during last two years, financial regulators have been raising concerns over the credit derivative markets boom because the risks taken by the investors outside the regulatory purview. Although the derivative markets and hedging instruments facilitate the expansion of the bond market, the evolution of derivative products has brought in two distinctive features to the financial market: an increasing complexity of instruments, which combine an extensive use of derivatives with customization to individual investors’ needs and the fragility of off-balance sheet structures and vehicles, which was rediscovered during the recent sub-prime turmoil. Following the sub-prime issue, a number of central banks in developed economies acted to stabilize markets and forestall a potential financial crisis. The European Central Bank, The US Fed injected significant amounts and in order to encourage banks to come to it for liquidity, the Fed reduced the discount rate the charge it makes for emergency lending to banks. The central banks of Canada, Japan, UK and Australia also intervened to provide liquidity to the market. This recent episode also highlights that regulators are
15
required to play a major role indirectly in finance product innovation, in view of the systemic and economic risks. Regulators are required to ensure that systemically
important banks and financial institutions are not exposed to concentration risks in specific products or markets. Banks and financial institutions are also required to follow fair market practices without unduly affecting public confidence.
D. Monetary and financial sector policies in Sri Lanka promoting bond market 1. Conduct of monetary policy The conduct of monetary policy is one of the prime responsibilities of the Central Bank, since monetary policy is the means by which Central Bank attempts to attain its one of the core objectives, i.e., the economic and price stability. Monetary Law Act provided a wide range of instruments that could be used by the Central Bank for monetary management. At present, the monetary policy framework places greater reliance on market based policy instruments and the use of market forces to achieve the desired objectives as they help achieve a better allocation of resources, reduce associated transaction costs, and improve the efficiency in monetary management. As a further step in making toward for more market oriented monetary management system, the Central Bank moved to more market based active open market operations with effect from 3 March 2003.
Steps were also taken to enhance the transparency, predictability and credibility of monetary policy. After each decision on required change in monetary policy stance, or otherwise, a public statement, i.e., a press release, explaining the monetary and economic conditions that led to the particular decision on the policy change (or otherwise), is issued to the public. In addition, the monetary policy framework, and monetary projections, along with the explanatory notes are regularly posted on the Central Bank website.
The independently floating exchange rate regime, which was implemented from January 2001 served well in reducing the excess volatility in the exchange rate and
16
maintaining the country’s competitiveness vis-à-vis the rest of the world, while allowing greater freedom in the conduct of monetary policy.
2. Polices to promote financial system stability A comprehensive approach is adopted in preserving financial stability, which is one of the core objectives of the Central Bank. This encompassed surveillance at systemically important financial institutions; regulations to ensure prudent practices by banking institutions and healthy developments in financial markets; and supervisory activities. This is work is being initiated towards developing additional tools to enhance ongoing surveillance and analyses of financial system resilience which includes developing forward-looking indicators both at the system and institution levels to identify, measure, assess and predict emerging vulnerabilities and adopt stress test methodology to ensure its effectiveness and relevance.
Given the diverse risks associated with financial conglomerates, it has become increasingly important to ensure that the activities of financial conglomerates do not pose risks to the stability of the financial system. In this regard, the Central Bank has
introduced a number of policy initiatives to address the potential systemic risk posed by financial conglomerates to monitor systemic risks of financial conglomerates and promote consolidated supervision.
a. Banking sector The stability of the banking sector, which is the major sub-sector within the financial sector is crucial for bond market since it provides payment facilities and a major buyer and issuer of securities and facilitates secondary market activity. In fact, banks are one of the major investors in government securities market to meet statutory liquidity requirements and as collateral for repo transactions in managing short-term liquidity. Accordingly, number of measures continued to be taken promote a competitive, sound and robust banking sector.
17
There has been a significant improvement in capacity and capability of the banking system and this is supported by improved earnings, increase in capital funds and improvements in risk management amidst enhanced regulatory and supervisory framework. This was further underpinned by the gradual decline in non-performing loans (NPLs), reflecting general improvements in credit quality and enhanced risk management standards and practices over the years. The strong financial position has enabled the banking sector to expand the access to finance.
With a view to further strengthening the efficiency and greater competition among financial institutions, a number of legal reforms relating to the financial sector were brought in and regulatory oversight were enhanced to be in line with international best practices.
b. Money market The Central Bank has implemented several measures to broaden and deepen the money market. In order to help pricing money market products, the Central Bank started providing Sri Lanka Interbank Offered Rate from 1999. The Central Bank also engages in Repurchase and Reverse Repurchase transactions in order to inject and absorb liquidity from the market. Further, it disseminates information on market transactions on a daily basis. Measures have also been taken to further promote and upgrade the payments system to take effect large value money market transactions through the Real Time Gross Settlement System and the Scripless Securities System, which will expand and promote the efficiency of money market transactions.
c. Foreign exchange market
Another noteworthy development in the foreign exchange market was that the independent floating of Sri Lanka rupee in 2001. The main players in the foreign exchange market are the commercial banks. Dealings in the foreign exchange market are
18
mainly in spot and forward transactions. These operations are largely generated by trade related activities, capital flows, and trading activities of commercial banks.
Since the commencement of independent floating in 2001, a greater stability in foreign exchange market has been seen, with an increase in market activity. Foreign exchange market activities have also been expanded significantly.
d. Development of government securities market
A number of positive developments have also taken place in the government securities market supporting bond market development. In an effort to upgrade the market infrastructure, the Scripless Securities Settlement System (SSSS) was introduced in 2004 to replace the paper-based instrument system with the dematerialized settlement system. Meanwhile, the Central Depository System (CDS) for GS was introduced to record trading information for scripless securities. As a result, the settlement and clearing of government securities has achieved Delivery Versus Payment (DVP), whereby security delivery and payment will be simultaneous.
A conscious effort has been taken to increase issues of marketable government securities. Accordingly, Treasury bonds were issued in place of rupee securities. As a result, the share of T-bonds increased from 28 per cent in 2001 to 60 per cent in 2006, and the share of Rupee loans decreased from 35.8 per cent to 8 per cent.
With a view to further opening the capital account transactions and to develop the capital markets by broadening the investor base and increasing competition in the bond market, foreign investors have been permitted to purchase up to five per cent of rupee denominated Treasury bonds since November 2006.
19
e. Financial system infrastructure
An efficient and reliable payment and settlement system contributes to the soundness and the development of the financial system and the smooth functioning of bond markets. Therefore, the Central Bank moved towards introducing a more advanced payment and settlement system in 2003. For high value and time critical payments on real time, the Central Bank implemented the Real Time Gross Settlement System (RTGS) in 2003, which significantly reduced the settlement risks and improved efficiency.
To further modernize the payment system, measures were also taken by the Central Bank and Lanka Clear (Pvt.) Ltd to introduce Cheque Imaging and Truncation (CIT) to the country’s cheque clearing system with the long-term objective of moving towards electronic cheque transactions.
f. Legal enactments
A number of laws relating to the financial sector have been enacted strengthening the legal framework for the efficient functioning of bond market. These included the
Payments and Settlement Systems Act, Electronic Transactions Act, Payment Devices Frauds Act and legislation pertaining to Anti-Money Laundering, Terrorist Financing and Financial Transactions Reporting.
E. Policy measures to promote bond market A prudent monetary policy supported by fiscal policy while allowing appropriate adjustment in exchange rate is important to achieve macro economic stability and contain inflationary pressures and promote stability in the foreign exchange market which are fundamental to bond market development.
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1. Monetary policy
•
Maintenance of a medium-term macroeconomic framework and following a credible monetary policy to attain monetary growth targets and reduce high inflationary pressures in the economy: Achieving macroeconomic stability, that is to maintain the inflation rate, contain high monetary expansion and the fiscal deficit at sustainable levels are the key prerequisites for the development of the bond market., thereby ensuring price stability, is crucial in further developing bond market. Therefore, preparation of a medium term macroeconomic framework supported by fiscal policy is the most essential to bring the inflation to a sustainable level.
•
Further improving the efficiency of money market operations: Measures could be taken to improve the management of money market liquidity addressing weaknesses in the inter-bank call money market, improving the cash management framework of the government will facilitate the Central Bank to manage short-term liquidity appropriately.
•
A greater co-ordination by monetary and fiscal authorities: Inflation targeting per se can improve the co-ordination between monetary policy and other macroeconomic policies (depending on the way the target is set and whether the target is consistent with other policy objectives). The announcement of inflation targets clarifies the central bank’s intentions and reduces uncertainty about the future course of monetary policy. Inflation targets make policy transparent.
•
Monetary policy communication: A good communication policy helps to achieve the objectives of the Central Bank. It is essential that market participants and the public at large know and understand the objectives of the Central Bank and the monetary policy actions taken by the bank. Any change in monetary policy stance should therefore explicitly explain to the public.
21
•
Managing expectations: Inflation expectation surveys and constructing leading indicators are two other areas where work could be developed. Change in
inflationary expectations, which are an indicator of credibility of monetary policy and inflation inertia, are also variables used in inflation forecasting models.
•
Inflation Targeting: In recent years, there has been an increasing focus on inflation targeting as a framework for implementing monetary policy. The rationale behind inflation targeting is that inflation targets may help provide a clear path for the medium term inflation outlook, reducing the size of inflationary shocks and their associated costs. Since long-term interest rates fluctuate with movements in inflation expectations, targeting a low rate of inflation would lead to a more stable and lower long-term rates of interest.
•
Further work in moving inflation targeting: More empirical work is needed to understand the monetary policy transmission mechanism better. In particular, the degree of pass through from money market rates to retail rates, lags associated with monetary policy shocks and channels though which these shocks are propagated need to be examined A good forecast of the inflation rate can provide valuable inputs in the formulation of macroeconomic policies, in particular, monetary policy. Inflation forecasting is central to any monetary framework. Monetary policy affects output and inflation with lags and a forward-looking approach is essential in the monetary policy decision making process.
2. Fiscal policy
•
Government’s commitment to maintain fiscal targets: Government’s Medium Term Macro Framework (MTMF) enunciated in the Fiscal Management Reports, and the overall deficit announced in these reports should be maintained. Government
22
should take necessary adjustments in the areas of enhancing revenue through additional measures and improved tax administration, rationalization of current expenditure and improvements in the government debt management to meet this target since large deviations of government borrowings affect the smooth implementation of the borrowing programme. It is also important that the mediumterm fiscal targets announced in the FMRA are achieved effectively so that there would be less pressure in the conduct of monetary policy as well.
•
Reduction in High Budget Deficits: Persistently high budget deficits due to a combined outcome of declining revenue as well as increasing government expenditure are the major problem in the country’s public finances at present. Consequent to the higher deficits and resultant borrowings from both domestic and foreign sources, the outstanding stock of government debt has also risen to a high level. Past experience reveals that the level of public investment has gradually declined mainly to compensate the high budget deficits that are causing from higher recurrent expenditures. As such, increasing public investment has become important to facilitate the private sector participation in economic activities. Accordingly, measures are being introduced particularly to enhance the tax revenue collection and reduce the expenditure almost entirely through further rationalization of current expenditure are urgent needs.
•
Reduction in High Level of Debt: The government debt as a percentage of GDP continued to remain high, suggesting that there is an urgent need for fiscal consolidation. Without a reduction of the budget deficit, there would be an increase in the extra yield expected of for investments affecting the bond market development.
•
Taxation of financial instruments: High deficits force the government to impose additional taxes on financial instruments or financial institutions constraining the efficient functioning of financial market. At present, in Sri Lanka, the financial sector is subjected to six types of taxes; two on financial institutions and four on services. 23
The VAT and corporate tax are payable by institutions. Withholding taxes on interest income, debit taxes on withdrawals, stamp duties and VATs on fee-based activities are paid by customers.
•
Improvements to debt management through the creation of benchmark issues: Government can reduce its debt servicing costs by concentrating the bond issuance to a limited number of large benchmark securities instead of current multiplicity of issues. Larger and concentrated issues tend to be liquid and beneficial in developing a yield curve which in turn help in pricing range of other financial instruments. Accordingly, the issues could be limited to pre-determined maturities and coupons. A range of debt instruments allows the debt to be issued to address the preferences of range of investors with different risk appetites. However, too many issues could fragment the market. Hence, the outstanding instruments could either be buy
back/exchange for benchmark issues. •
Work on establishing an independent Debt office: As in many central banks, public debt management is a responsibility of the Central Bank of Sri Lanka. Separation of roles and responsibilities will allow greater clarity in setting objectives and maximizing the transparency of monetary policy. There is also a need for cooperation to share information to properly estimate the liquidity forecasts by central banks so that monetary management be undertaken with a greater precision.
•
Cooperation of other stakeholders is needed: In developing countries, like Sri Lanka, there are structural issues (i.e., inefficiencies in product, labour and capital markets) that also need to be addressed in order to create an environment of low and stable inflation. Monetary policy alone is not sufficient to maintain price stability since monetary policy cannot be carried out in isolation of other polices and the impact from external sources. Therefore, the co-operation of other stakeholders is needed to reduce inflation on a sustainable basis. Measures are necessary to increase
24
supply condition along with the improvements to productivity, removing bottlenecks in infrastructure and inputs markets.
3. Promoting financial system stability
•
A series of measures will need to be implemented to further enhance the efficiency and strengthen the financial sector, which will contribute to financial system stability and the developments of bond markets. These encompass regulatory and supervisory measures to strengthen major financial institutions; forward looking surveillance indicators and tools to predict emerging vulnerabilities; measures to improve efficiency of financial markets including access to finance; initiatives to enhance the safety of payment systems; and introduction of necessary changes to legal enactments governing the wider financial system.
•
Further reforms to broaden and improve efficiency of the financial sector: As an integral part of the economic liberalization policy package initiated about three decades ago, several financial sector reform measures have been undertaken to create an efficient and resilient financial sector. With these changes, the financial services sector has shown a significant expansion during the last three decades. Further reform measures would help deepen the money and capital markets and improve their efficiency leading to higher savings and positive effect on growth. .
•
Supervision and regulation: The increasingly complex and dynamic financial activities demand continuous enhancement to the regulatory and supervisory framework. Accordingly, several initiatives have been taken by the CBSL, SEC and IBSL which regulates and supervises major financial institutions. implementation of The
Basel II capital adequacy framework, the introduction of
mandatory corporate governance rules, the adoption of International Accounting Standards viz., IAS 32, 39 & IFRS 7, and the implementation of an integrated risk management framework are expected to provide a significant boost to the capacity
25
and capability of the banking institutions, promote overall risk management and reinforce the resilience of the banking sector •
Financial system infrastructure: With a view to developing a safe and efficient payment instruments, a nation-wide non-cash retail payment system is to be introduced as proposed by the National Payments Council.
•
Expanding investor base: A broad investor base has several advantages for developing the bond market through enhanced market stability, promoting financial innovation and contributing to expanding liquidity. Accordingly, measures need to be taken for the development of a group of private institutional investors especially developing pension funds, mutual funds. An initial boost could be given for bond market development by participating in bond issues by relaxing the restrictions on the investment policies of the EPF, the ETF, and the NSB as regards their ability to invest in private securities and allowing foreign investors to invest in fixed-income securities.
•
Procedures for corporate insolvency and rehabilitation: It is necessary that there are procedures and laws to provide for corporate insolvency and rehabilitation.
•
Promoting investment banking: The investment banks could function as a catalyst to the development of vibrant and efficient bond market. These banks facilitate the issuing of
corporate bonds in several ways such as advising on the timing and terms of the issuers. In addition, underwriting of bond issues are some of the services that could be provided. • Expanding markets: The securitization market has expanded considerably in recent years, driven mainly by mortgage-backed securities in many countries. In Sri Lanka, draft bill has been prepared and it is necessary that process of securitization be expedited.
26
•
Disclosure of information to build market credibility: Information disclosure plays a key role in building market credibility. Developing proper disclosure standards based on consolidated accounts and well established auditing and accounting standards will help market and supervisors. In this regard, the adoption of IAS standards and move to consolidate listed companies, through strict enforcement of free float requirements, will also have a positive impact on information disclosure.
•
Improve the financial literacy and awareness among investors about the characteristics of new capital products. Enhanced understanding of the capital markets by issuers, investors (both institutional and retail), will allow them to make educated decisions would contribute enormously to the long-term development of the capital markets.
•
Protecting investors from bond defaults: Necessary safeguards needs to be in place to protect investors from bond defaults since there are possibilities that some companies which are not creditworthy could issue junk bonds. In fact, it is reported that Chinese government has adopted a merit based selection system for issuing corporate bonds, ceilings on corporate bond interest rates and mandatory credit to protect investors following number of corporate bond defaults in 1990s.5
III. CONCLUSION
Macroeconomic policies, fiscal and monetary policies in particular need to be harmonized to achieve a stable macroeconomic environment which is a pre-requisite and provide a conducive environment for the development of the domestic debt market. However, it needs to be reiterated that the success of many of the above critically dependent on achieving a durable peace. The continuous civil unrest had a huge cost on economic activity with significant direct and indirect impacts. In addition to
macroeconomic stability, several policy initiatives and targeted reforms are found to be
5
IMF (2005), Box. 4.4.
27
needed to strengthen institutional infrastructure and remove impediments which will foster efficient functioning and sustained growth in the bond market particularly the corporate bond market. With regard to institutional infrastructure, establishing rating agencies, trading platforms, clearing and settlement systems, regulatory environment are some of the major requirements. Policies to develop a diversified institutional investor base will create ensure sustainable demand for bonds. In particular, pension funds, mutual funds, not only create demand for fixed income securities but also contribute to increase financial innovation, corporate governance, and enhance competition in the bond market.
28
REFERENCE
Bank Negara Malaysia, The Corporate Bond Market in Malaysia, Muhammad bin Ibrahim and Adrian Wong. Bank for International Settlements (2007). CGFC Papers No.28 Financial Stability and Local Currency Bond Markets, June. Del Valle, C., A Comprehensive View: Developing Bond Markets, http://www.iadb.org/sds/doc/IFM-ClementeBond-E.pdf. IMF (2000). International Capital Markets: Developments, Prospects, and Key Policy Issues, World Economic and Financial Surveys, September (Washington D.C.). _____ (2001), International Capital Markets: Developments, Prospects, and Key Policy Issues, World Economic and Financial Surveys, August (Washington D.C.). _____ (2004), Global Financial Stability Report, World Economic and Financial Surveys, April (Washington D.C.). _____ (2005), Global Financial Stability Report, World Economic and Financial Surveys, April (Washington D.C.). The World Bank and IMF (2001). Developing Government Bond Markets, A Handbook, (Washington D.C.).
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