Bond Market Development: Monetary and Financial System Stability Issues

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BOND MARKET DEVELOPMENT: MONETARY AND FINANCIAL SYSTEM STABILITY ISSUES

2008

Ananda Silva∗



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. 1

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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....
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