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The World Bank Group. Global Development Finance 1998

Annex  - Private capital flows and domestic bond markets

Though domestic bond markets in developing countries have lagged behind equity markets, they have grown rapidly in recent years as a result of improving economic fundamentals (particularly lower inflation), financial liberalization, and privatization programs. The share of foreign participation in these markets appears to be rising. The importance of domestic bond markets varies widely among countries, from 4 percent of GDP in Indonesia to 51 percent in South Africa (table 1A.1).

The volume of flows to developing countries for the purchase of domestic fixed-income securities is unknown, although anecdotal evidence suggests that foreign participation is significant in some domestic bond markets. For example, it is reported that a minimum of $10 billion of Brazil’s total domestic sovereign bond market ($163 billion) is held by foreigners. Pefindo, the Indonesian credit rating agency, reports that foreign investors account for 30 percent of the market. Other indications of increased international interest in developing countries’ domestic bond markets are the growing use of international services for clearance, settlement, and custody and J.P. Morgan’s development of a domestic debt market benchmark (the Emerging Local Markets Index), which tracks total returns for local currency–denominated money market instruments in 10 emerging markets.

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Table 1A.1 Domestic bond markets in developing countries
(millions of U.S. dollars)

Percentage of GDP

Domestic Total bonds Domestic bonds
Region or country External a/ Total Sovereign Corporate
East Asia and the Pacific 46,878 139,100 102,719 20,600 13.5 10.1
Europe and Central Asia 72,167 170,289 166,789 3,500 20.4 14.3
Latin America and the Caribbean 256,284 309,280 275,492 33,788 35.3 19.2
Middle East and North Africa 14,494 35,910 35,760 150 24.8 17.7
South Asia 4,927 79,999 43,177 19.1
Sub-Saharan Africa 15,988 78,236 60,756 17,480 44.7 37.1
Largest domestic bond markets
Brazil 80,933 186,823 185,972 851 39.2 27.3
South Africa 3,602 77,600 60,340 17,260 53.8 51.4
India 4,382 73,530 36,708 21.3
Russia 37,365 60,711 60,691 20 19.9 12.3
China 11,901 45,400 41,400 4,000 6.7 5.3
Malaysia 6,227 41,600 29,100 50.6
Poland 6,673 41,080 41,020 60 35.5 30.5
Mexico 59,620 38,304 21,258 17,046 15.7 14.2
Turkey 13,438 23,214 22,604 610 17.2 10.9
Chile 7,142 31,042 19,849 11,193 57.1 46.4

— Not available.
Note: Data represent either 1995 or 1996. Data are compiled from different sources and for different years and are not necessarily consistent or comprehensive.
a. Includes tradable loans.
Source: Merrill Lynch, Salomon Brothers, and World Bank.

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Some developing countries still maintain restrictions on foreign participation in domestic bond markets, to help manage short-term capital flows. Countries impose minimum holding periods for bonds (Chile), restrict the range of issues that foreigners may purchase (Czech Republic, Hungary, South Africa), or require that foreigners operate through domestic intermediaries (Brazil, Chile). In general, the rules governing foreign participation in domestic bond markets are less restrictive than those for equity markets.

Considerable potential exists for increased flows to developing countries’ domestic bond markets. (For a discussion of why bond market development is important, see box 1A.1.) However, a number of factors impair the efficiency of markets and their attractiveness to foreign investors. Poor settlement procedures and a lack of depositories are common shortcomings. In many countries the tax regime discriminates against bond issuance (income from bank deposits is often tax free while interest payments on bonds are taxed). Protection of minority shareholders through preemptive rights hinders convertible bonds issuance,8 while the imposition of merit rather than disclosure regulations discourages bond issuance in some Asian markets.9 Many countries lack the large pool of domestic fixed-rate investors needed to support a large bond market (ADB and World Bank forthcoming). Recently, a number of governments have taken steps to reduce impediments to bond market development by setting up settlement and clearance services, establishing market benchmarks to facilitate corporate bond issuance, and encouraging the development of pension and insurance companies that would increase the pool of domestic savers.

Box 1A.1 Why is development of the bond market desirable?

In most developing countries the financial system is dominated by banks, and nonbank intermediation is relatively underdeveloped. There are several reasons why a developed bond market is useful in mobilizing long-term funds for investment: • Systemic risk. One of the most important (and least appreciated) benefits of bond markets is the dispersion of risk. The absence of active and open securities markets in developing countries places excessive risk on bank-based financial systems (McKinnon 1988). This dispersion reduces systemic risk and thus enhances the ability of the financial system to cope with shocks. • Maturity. Because of the dispersion of risks among savers, it is easier to attract long-term finance through bond markets than from commercial banks. Developed bond markets provide investors with the long-term funds required to build infrastructure and housing, and savers with the opportunity to purchase high-yield financial instruments (Gelb and Honohan 1989). Banks in developing countries have limited ability to mobilize long-term resources and to finance long-term investment. The development of securities markets helps reduce the mismatch between the short-term deposits of the banking system and evergreen credit lines, thereby enhancing the soundness of the financial system (Agtmael 1984). • Liquidity. Because bonds can be bought or sold in the secondary market, they have a lower liquidity premium than commercial bank debt, thus reducing the cost of capital. However, high marketability requires a large trading volume and a large number of dealers. These conditions are not met in many developing country bond markets. • Mobilization of savings and innovation. There have been unparalleled innovations in bond markets in recent years, such as mortgage and asset-backed securitizations, stripping, and derivatives, which have greatly increased the flexibility of financial instruments. These structures tap into new market segments of issuers and purchasers alike and therefore enhance the mobilization of funds. Overall, innovation can increase the amount of savings channeled into productive investments. • Allocation of resources. The bond market does an effective job of selecting and monitoring productive investments. The continuing assessment and monitoring of risks conducted by impartial and informed credit rating agencies distinguishes the bond market from the loan market and helps to foster good corporate conduct and governance. Thus bond markets can make the financial and economic system more competitive and efficient by lowering the initial cost of capital (Agtmeal 1984). • Policy instruments. The availability of well-developed bond markets provides a useful source of funds to finance government deficits (which may reduce the government’s reliance on money financing) and offers the instruments to conduct effective monetary policy (see box 1A.2). • Competition and efficiency in financial services. Evidence suggests that active primary and secondary markets for bonds and equities, by providing competition for the banking sector, can improve the performance of the financial system. According to an IMF (1997) study of innovations in OECD capital markets, intermediation costs have been sharply reduced by the substitution of direct transactions in securities for bank credits, by reduced commissions, and by increased competition.

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Notes

1. Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.
2. Spreads on established borrowers declined somewhat, but spreads were relatively higher on new and riskier borrowers that entered the market during 1997.
3. The high-yield index measures the yields on fixed-income securities issued by U.S. corporations that are below investment grade (for example, BB rated).
4. The U.S. Securities and Exchange Commission limits hedge funds to 99 investors, a portion of whom must have a net worth of at least $1 million.
5. The following overview data come from Managed Account Reports’ MAR/Hedge, which is based on information supplied by investment managers. This discussion does not include the activities of global hedge funds that invest in both industrial and developing markets.
6. Based on Morningstar’s Principia Plus database, which provides a sample of mutual funds that includes 2,130 U.S.-based mutual funds (with assets of $1.3 trillion) investing in industrial country markets and 245 U.S.-based funds (with assets of $40 billion) investing in emerging markets.
7. The Sharpe ratio is calculated by subtracting the average monthly return of the 90-day U.S. Treasury bill from the fund's average monthly return, giving the fund's excess return. This excess return is then annualized and divided by the fund's annualized standard deviation.
8. Preemptive rights are requirements that existing equity owners have the right of first refusal on new equity issues on a pari passu basis.
9. Merit regulation refers to detailed guidelines regarding issuance, rather than disclosure.

Box 1A.2 Considerations in foreign sovereign borrowing

Access by developing country governments to international bond markets has increased markedly in recent years. The government debt of 51 developing countries is now rated by the main international credit agencies (just 10 were rated in 1990), and 25 developing countries achieved investment grade status on their sovereign debt (prior to the East Asian crisis). Publicly guaranteed debt from private sources in these countries ranges from 0.5 percent of GDP in Malta to 50.7 percent in Panama, with an average of 6 percent. Many governments in developing countries are now able to choose between borrowing in local currency in domestic markets and borrowing in foreign currency in international markets. Some governments have issued debt linked to foreign currencies in domestic markets, such as the Mexican tesobonos (Guidotti and Kumar 1991). In deciding where to borrow, governments in developing countries typically face a highly segmented market, with policy and institutional impediments to capital flows, asymmetric information, and differing levels of risk all contributing to the segmentation between domestic and foreign markets. Governments that have access to international private sources of finance in effect face two distinct supply schedules for funds. Both the domestic and foreign supply schedules are likely to be upward sloping, reflecting (in both domestic and international markets) rising risk perceptions with increased borrowing and (in domestic markets) a limited supply of savings. (See, for example, Eaton 1989; Cohen 1991; Eaton, Gersovitz, and Stiglitz 1986; Tanzi and Blejer 1988; Stiglitz 1988; and Calvo and Guidotti 1993.) There is, therefore, a rationale for borrowing to be distributed between domestic and foreign markets so as to equalize marginal cost. However, in deciding whether to borrow abroad or at home, governments (which are typically by far the largest borrower) go beyond direct cost and maturity comparisons to consider the implications for the economy. The government’s choice can affect the cost of foreign borrowing for the economy as a whole, the country’s creditworthiness, the foreign currency exposure of the government and the private sector, the development of the domestic capital market, and the conduct of monetary policy: • Cost of borrowing. In most developing countries the ex ante return to capital is likely to be higher than the cost of foreign borrowing, reflecting both capital scarcity and high volatility in developing markets. However, international lenders may lack information on domestic private sector borrowers, and there may be a lack of creditworthy companies able to borrow on the required scale. In this case it is cheaper at the margin for the government to borrow rather than for individual private firms to do so, reflecting the government’s greater access to the market. At the same time, private sector borrowers can rely on domestic banks, which generally face lower costs than do international lenders in evaluating the riskiness of domestic firms. By borrowing abroad the government avoids crowding out firms on the domestic market and reduces the cost of capital for the whole economy. Of course, whether this turns out to be a net benefit depends on whether the use of funds by the public sector is as efficient as in the private sector. Also, government borrowing can improve the familiarity of international lenders with the country and establish a benchmark that can be used to price loans to private companies, so that initial borrowing by the government may reduce the ultimate cost of borrowing by the private sector. • Foreign debts and creditworthiness. Defaults by private sector borrowers can affect a country’s credit standing in the eyes of foreign investors. If relatively risky borrowers can gain access to international capital markets (for example, during a period of unusually high liquidity when investors may accept higher levels of risk to maintain yields), the government may decide to borrow more abroad rather than from domestic markets, thus lessening pressures on interest rates and increasing incentives for firms to borrow domestically. • Currency exposure. Since foreign borrowing is usually in foreign currency it implies an increase in foreign exchange exposure (Sachs, Tornell, and Velasco 1996). (This is not always true, however. For example, domestic bond markets in Brazil and Indonesia are accessible by foreigners, and Argentina and South Africa have issued local currency bonds.) However, where public enterprises are major exporters or where tax revenues from the private sector are significantly affected by shifts in the exchange rate (in economies reliant on primary commodities), borrowing in foreign currency may reduce the country’s net exposure to currency risk. For example, a government that is dependent on dollar-denominated exports for its revenues can borrow abroad in dollars. Any losses (or gains) in export receipts from currency fluctuations would then be in part balanced by gains (or losses) in the cost of debt service payments. • Institutional development. Government participation may be the surest and fastest way of developing the domestic bond market, thus opening up new and more versatile financing instruments for domestic companies and providing a new channel to reward and retain domestic savings. • Monetary policy. The government may also decide to shift the mix of its borrowing between domestic and foreign sources in the short term depending on its stabilization objectives, relying more on domestic borrowing when the economy is overheating and more on foreign borrowing when domestic activity slackens. (On the theoretical aspects of the mix between foreign and domestic bonds, see Bohn 1990. On macroeconomic management aspects, see Anand and van Wijnbergen 1988 and Cuddington 1997) The possible advantages enumerated above of governments borrowing abroad instead of at home (lower cost, longer maturities, avoiding crowding out of private firms, better management of currency exposures, and stabilization) will tend to diminish as capital markets become more integrated, incomes and capital intensity rise, economic volatility diminishes with increased diversification of the economy, and macroeconomic management improves. These developments will also tend to equate the foreign and domestic cost of funds and result in a more efficient allocation of capital internationally.

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