"A well-developed domestic capital market is the ultimate democratization of financial control. It gives investors the ability to vote with their pocketbooks and invest with managers able to deliver the risk-return profile they seek."
Evolution of the Asian Bond Market
by Teresa Kong, CFA, Matthews Asia
October 2010
One of the most profound developments in the history of Asia's capital markets has been the deepening of the domestic bond markets in the last decade. As U.S.-based investors, we often take for granted the ease with which we can borrow in our own currency. Even in the depths of the recent global financial crisis, the U.S. government was able to issue 30-year Treasury bonds at very low costs. This is a luxury very few other nations possess. For most emerging countries, their ability to raise funds in their own currency is limited. Hence, they end up turning to the deepest and the most developed capital market in the world: the U.S. dollar market.
Based on my experience, and using South Korea as a case study, we've outlined the perils of borrowing in someone else's currency and the remarkable progress one country has made over the last decade or so in building its domestic bond markets.
When I started my career in the Latin America capital markets group of a global investment bank in the mid-1990s, investors were still reeling from the Mexican peso devaluation, perhaps more popularly known as "The Tequila Crisis." We toiled late into the night developing products palatable to investors who remained skeptical and risk averse. One of my colleagues would say that working with Latin America was like being in the military—it's mostly boredom punctuated by moments of terror. The joke was that those moments of terror would always hit during Christmas. Indeed, our Christmas plans would once again be ruined, but this time, the culprit would be Asia.
By the fall of 1997, the financial crisis in Asia was well underway. The currencies of Thailand, Malaysia, the Philippines and Indonesia had already devalued. On November 1, Korea's central bank vowed that it would never let the won decline below KRW1,000 against the U.S. dollar. But in less than three weeks, the central bank had depleted most of its foreign reserves in defense of its currency. On November 22, Korea asked the International Monetary Fund (IMF) for assistance, and the IMF responded with a record US$58 billion bailout package. In the last three months of 1997, the Korean won lost about half its value against the dollar, making its devaluation just as severe as that of the Mexican peso in 1994.
During this crisis, new financial instruments were developed. More specifically, to help fallen stars like some of Korea's large electronics firms borrow money, exotic instruments such as dual currency-denominated notes were structured. These one- to three-year instruments provided investors with a double-digit coupon and the option of getting their principal back in the U.S. dollar or Korean won. That way, under just about every conceivable scenario, the investor would receive a handsome return.
Meanwhile, the Korean government moved forward with rebuilding its economy and its domestic capital markets. Below, I focus on three important reforms from the perspective of an investor: independence of the central bank, harmonization of financial regulations and access to foreign investors.
Independence of the Central Bank
In 1998, the Bank of Korea formalized its independence and officially adopted inflation targeting as its main objective. Central bank independence decouples monetary policy from the vicissitudes of politics, enabling the central bank to conduct long-term monetary policy without being driven by the shorter-term nature of the electoral cycle. When conducted effectively, the policy of inflation targeting anchors the public's inflation expectations away from realized inflation to the central bank's targets. This, in turn, drives both the absolute level and the volatility of inflation lower—which indeed is what has happened since 1998. From an investor's perspective, price stability and predictability are key pillars of investability.
Harmonization of Financial Regulations
Another key building block was the introduction of the Capital Markets Consolidation Act in 2007. Previously, different laws and regulations applied to different types of financial markets and institutions. In other words, the same financial service was subject to different regulations depending on the institution. The effect of this law is to harmonize the laws and regulations so that banks, insurance companies and investment companies can now compete on a level playing field. This is significant in that a thriving, diversified set of financial institutions is a precondition for the development of a healthy and robust domestic capital market. The demand side of the equation is clear: diversification comes from having accumulators of capital with varying appetites for size, maturity, risk and return. As the wealth of a nation grows, the population demands higher returns than that of a savings account and more sophisticated services to protect its wealth, like life insurance and a retirement fund. However, the supply side may not be able to meet the demands if a regulatory structure is not in place to remove advantages for some institutions over others.
Access to Foreign Investors
Finally, some of the most drastic reforms were instituted very recently in response to the global financial crisis. The government looked to widen its traditional base of investors following a growing fiscal deficit due to a drastic retrenchment in corporate profits and consumption. Hence, the Korean authorities abolished the withholding tax on government securities and allowed foreigners to hold and trade the bonds through international custodians like Euroclear.
