Developing the domestic government bond market country experiences and suggestions for vietnam

2.2 Benefits of a developed domestic government bond market There are many papers mentioning prerequisites as well as difficulties that economies have to face in the transition from dir

UNIVERSITY OF ECONOMICS, HO CHI MINH CITY

FULBRIGHT ECONOMICS TEACHING PROGRAM

-

VO CHAU THUY TRIEU

DEVELOPING THE DOMESTIC GOVERNMENT BOND MARKET: COUNTRY EXPERIENCES AND SUGGESTIONS

CERTIFICATION

I hereby certify that

- I wrote the thesis by myself

- the study has not been submitted for any other degrees

- any help I received as well as all sources used have been acknowledged in this thesis with the best of my knowledge

- the study does not necessarily reflect the views of the Ho Chi Minh City Economics University or Fulbright Economics Teaching Program

Author

Vo Chau Thuy Trieu

Table of Contents

CERTIFICATION 1

ABBREVIATIONS 4

LIST OF GRAPHS 5

ABSTRACT 6

Chapter 1 INTRODUCTION 7

1.1 Background 7

1.2 Policy questions 10

Chapter 2 LITERATURE REVIEW 11

2.1 Financial repression is ineffective for the economy 11

2.2 Benefits of a developed domestic government bond market 13

Chapter 3 COUNTRY EXPERIENCES 16

3.1 How did Malaysia develop their domestic bond markets? 16

3.1.1 Situation and motivation for reform 16

3.1.2 Key policies 18

3.1.3 Achievements 21

3.2 How did Thailand develop its bond market? 23

3.2.1 Situation and motivation for reform 23

3.2.2 Key policies 25

3.2.3 Achievements 29

Chapter 4 VIETNAM 31

4.1 Developing the bond market is important for Vietnam 31

4.2Vietnam government debt market overview 32

4.3 Types of government debt securities 36

4.3.1 Government bonds 36

4.3.2 Government-guaranteed bonds 37

4.3.3 Municipal bonds 37

4.4 Investors base 37

4.5 Factors hinder Vietnam’s domestic government bond market 38

4.5.1 Interest rate cap 41

4.5.2 Statutory liquidity ratios of banks 43

4.5.3 Primary dealers 43

4.6 Suggestions for Vietnam’s bond market 44

Chapter 5 CONCLUSION 46 REFERENCES 48

ABBREVIATIONS

BTH: Thailand Bath

HNX: Hanoi Stock Exchange

HSX: Ho Chi Minh City Stock Exchange MOF: Ministry of Finance

OMO: open market operations

SBV: State Bank of Vietnam

USD: U.S dollar

VND: Vietnam dong

LIST OF GRAPHS

Graph 3.1: Bond outstanding value of Malaysia Page 22

Graph 3.2: Domestic financing profile of Malaysia 23

Graph 3.3: Size of Thailand financial market 24

Graph 3.4: Financing profile of Thailand (% GDP) 29

Graph 3.5: Regional Government bond turnover ratio 30

Graph 4.1: Bank credit to GDP of regional countries 31

Graph 4.2: Vietnam bond outstanding value 34

Graph 4.3: Vietnam domestic bond issuances 35

Graph 4.4: Vietnam GDP growth and inflation rate 39

Graph 4.5: Regional bond market size in % GDP 40

Graph 4.6: Regional countries’ government bond bid-ask spreads 41

Graph 4.7: Vietnam government bond auctions over years 42

ABSTRACT

While other countries use open market operations (OMO) as an indirect instrument to manage the liquidity in the economy to steer market interest rates, Vietnam has to use direct instruments of interest rate control which have been proved inefficient for the economy After reviewing papers on using OMO to implement monetary policies of countries in the world, the thesis finds that Vietnam is lacking a vibrant domestic government bond market to facilitate the conduct of OMO

Vietnam’s conventional secondary government bond market is just seven years old and the country’s government debt market is just beginning to develop By looking at the experiences of countries in the region which have similar features to Vietnam’s domestic bond market, this thesis aims to derive lessons to help improve and boost the development

of the domestic government bond market

This paper goes through the development of government bond markets in Malaysia and Thailand when they were at the first stage of developing their bond markets twenty years ago in order to discover key policies to promote the bond market From that result, the dissertation considers whether these measures can apply to Vietnam The main recommendation is for the government of Vietnam to set up a primary dealer system facilitating bond auctions and trading as well as supporting the conduct of open market operations, to build a market-based benchmark yield curve and provide tax exemption to government bond investors

Chapter 1 INTRODUCTION

1.1 Background

Transition to indirect instruments: global trends

Inflation control is among the top priorities of every government Controlling inflation requires careful management of the money supply by the central bank Central banks possess three main indirect instruments of reserve requirements, discounting eligible bank assets, and open market operations (OMO) However, Mishkin (1995, 540) argues that OMO has more advantages than the other two in implementing monetary policy Thus, using this instrument has become a common trend in the developed countries

Country experiences show that indirect instruments especially market-based operations have brought greater benefits for economies than direct tools whether in developing or developed countries The benefits are mentioned by William et al (1996), in which the authors state that “They [indirect instruments] permit the authorities to have greater flexibility in policy implementations Small, frequent changes in instrument settings become feasible, enabling the authorities to respond rapidly to shocks and to correct policy errors quickly.” Meanwhile, direct instruments including interest rate controls, credit ceilings, and directed lending often lose effectiveness because economic agents find means

to go around them, according to the paper

Research on implementing monetary policies has shown that there has been a clear trend of switching to using indirect instruments and then a greater reliance on market-based operations since the 1970s given the advantages of market-based instruments Buzeneca and Maino (2007) find that direct instruments of monetary policy are no longer used in the majority of countries and there is a trend towards reliance on indirect instruments especially on open market operations In the 2004 survey of IMF of 45 central banks around the world, there is no developed country using direct instruments while a few developing countries still use them Meanwhile, the ratio of emerging market economies and developing economies using market-based instruments has increased compared to results in the 1998 survey

Vietnam: delaying the trend

Thus the transition to greater reliance on market-based operations, particularly open market operations, in implementing monetary policy is a global trend which is relevant to Vietnam The country liberalized interest rates in 2002 and since 2000 has introduced open market operations in conducting monetary policies However, Vietnam’s transition has been delayed

Since 2008 the State Bank of Vietnam (SBV) has reintroduced direct or administrative instruments to implement monetary policy

The year 2007 saw a boom on the stock market that was mainly caused by a massive inflow of foreign capital, equal to about 18 percent of GDP SBV was unable to sterilize these inflows, with the result that money supply increased sharply According to World Bank data, net foreign portfolio investment strongly increased from USD1.31 billion in

2006 to USD6.24 billion in 2007 Stock market capitalization increased from three percent

of GDP in December 2005 to 43 percent of GDP by March 2007, according to World Bank (2009, 90)

In addition to the price bubble on stock and property markets, the rapid increase in money supply contributed to price inflation which peaked at 28 percent per annum in 2008 High inflation led to rising nominal lending rates which hindered enterprises’ access to bank loans In 2008, SBV tried to use indirect instruments of raising policy rates and reserve requirements, aiming to rein in the inflation However, it did not have much effectiveness since banks had considerable excess stocks of reserves (Riedel and Pham 2012).The central bank therefore had to use the direct instrument of the ceiling rates again and also forced banks to buy central bank bills totaling VND20.3 trillion in March 2008

The central bank wanted to restrain inflation at that time but also wanted to decrease nominal interest rates as instructed by the government, so they officially came back to direct monetary instruments by asking banks to set lending rates within the band of 150 percent of the prime rate set by SBV By May 16, 2008 the central bank issued directive 16/2008/QD-NHNN on the prime rate managing mechanism, ending the period of six

years of interest rate liberalization However, as large amounts of money were withdrawn via central bank bills, many banks experienced a liquidity shortage and had to raise deposit rates which in turn pushed nominal lending rates higher Banks competed with each other

to attract deposits, which also put upward pressure on lending rates for enterprises Stricter administrative instruments from the central bank to punish banks breaking the rule were applied The central bank even set up a hot line to receive information about banks giving loans at rates higher than the ceiling level

Inflation has become the biggest threat to the Vietnamese economy since 2008, except in

2009 during the global recession Given the lower inflation rate in 2009, SBV let banks negotiate lending rates in 2010 However, when high inflation rose again in 2010 and 2011 prompting a rise in interest rates, the central bank came back to administrative controls again in 2011 aimed at decreasing market lending rates These measures have continued until the end of 2012 as banks have to give loans at rates no higher than the ceiling given

by the central bank

SBV in fact used two indirect instruments of required reserve ratios and lending facilities

to rein in inflation - but they didn’t help much The reason is that Vietnam has maintained

a pegged foreign exchange rate regime and does not have an independent monetary policy, according to Riedel and Pham (2012) Theoretically, there are three things that cannot happen at the same time, namely free capital inflows, pegged exchange rate, and independent monetary policy Vietnam received massive foreign capital inflows in 2007 and still wanted to peg its foreign exchange rate to support exports, so its monetary policies cannot have effectiveness as the central bank’s purposes For example, large foreign capital entering Vietnam has made local currency stronger To keep the foreign exchange rate stable, the central bank had to buy foreign capital and supply money to the economy which put pressure on prices Meanwhile, Vietnam could not rely much on open market operations to manage the money supply, or in this case sterilize the unexpected increase in money supply, like other countries with developed financial markets Because Vietnam’s domestic bond market was too small relative to the capital inflow and liquidity in the secondary market was low, the government could not sterilize its foreign exchange operations

But even if it could, this probably would not have solved the problem Rising domestic interest rates would attract even more capital given the pegged exchange rate, making the problem even worse For small economies with large capital inflows there may be no

“equilibrium” set of exchange rates and interest rates (Ocampo, Rada and Taylor 2009)

Research on implementing monetary policies has pointed out many reasons for limited effectiveness of open market operations However, one prerequisite mentioned by most papers is an active secondary government bond market Vietnam also has a secondary government bond market but it cannot support the conduct of money market operations for monetary policy implementation Finding out suggestions to improve Vietnam domestic government bond market is the target of this thesis

1.2 Policy questions

Therefore, the thesis will find answers to two questions:

- What are problems of Vietnam domestic bond market?

- How can Vietnam develop a government bond market?

Chapter 2 LITERATURE REVIEW

2.1 Financial repression is ineffective for the economy

Financial repression will hinder financial system’s development while interest rate control

is considered the main measure of financial repression (Kitchen 1995)

Interest rate controls are a policy tool that results in financial repression, but which nonetheless is preferred by some developing countries which do not have or cannot use indirect instruments given shallow financial markets Most of governments control interest rates due to uncertainties on the market but this action also leads to distorted interest rates and dampens the development of the financial markets, thus exerting a negative effect on economic growth (Kitchen 1995) The author explains this conclusion via the model below:

Savings and investments under situation of interest rate controls

Source: Kitchen (1995), Chapter 3, Figure 3.1

Under normal conditions, investments (I) and savings (S) in an economy meet at point e with real rate of interest at re (assuming that the lending rate is equal to the deposit rate) When a ceiling rate on deposits (rc) is set, investment demand increases to Id1, but the savings level is only at Sc which cannot meet investment demand in the economy Therefore, total real investment in the economy is only at Sc and is lower than the potential Meanwhile, financial intermediaries will enjoy the difference between lending rates and the deposit ceiling rate of (ri– rc) Similarly, if there is a ceiling on lending rate (rl) which is lower than the equilibrium rate, investment demand in the market is increased

to Id2 but savings cannot meet this level Thus total real investment of the economy is at Il, lower than the potential level at Ie

In developing countries where the private sector is the engine of economic growth, funding sources for private investment mainly come from the banking system When total investment is lower than its potential, it will impact economic growth

Kitchen (1995) also says that given lending rate caps, banks must decide credit lines for many kinds of borrowers by tools other than interest rates Thus they will prefer low risk borrowers and prestige projects that have access to their own capital, modern technology or foreign management Safe projects that usually have low rates of return are preferred by financial intermediaries, high-risk and high-return projects which are usually new or in new industries will face a capital shortage This can also reduce the economic growth rate

In addition, the combination of interest rate controls and inflation can lead to negative real interest rates, which will prompt savers to withdraw money from banks and seek other investment channels like gold or foreign currencies Savings in the banking system will decline

The theory has proven correct in Vietnam Since 2008, the central bank has reintroduced the interest rate control mechanism via deposit and lending rate ceilings, either on their own or in tandem However, the actual deposit rates that depositors receive and real lending rates borrowers have to pay are not under the range regulated by the central bank Banks have to go around the regulations by paying interest through promotion programs as well as charging borrowers more via hundreds of other fees The market has been distorted

while reports from banks to the central bank on the rates are distorted also As banks have

to find ways to go around regulations, their operational costs have been increased which is reflected in higher lending rates for borrowers, mainly private enterprises In addition, in years like 2008, 2010, 2011 given high inflation rates and interest rate caps, real rates were negative and in fact, savings found their way to other channels like US dollars and gold, which contributed to speculation in these assets during those years.1

Therefore, it can be said that interest rate controls are not an effective way to stabilize the financial markets and support economic growth in general as well as specifically in Vietnam

2.2 Benefits of a developed domestic government bond market

There are many papers mentioning prerequisites as well as difficulties that economies have

to face in the transition from direct controls of interest rates to rely on open market

operations to implement monetary policies Alexander et al (1996) gives seven

recommendations to facilitate a smooth transition to indirect instruments: monetary policy must be insulated from the government’s capital needs, the development of money and interbank markets, the development of a healthy banking system, enhancing the supervisory and regulatory framework, strengthening technical capacity and careful consideration of the speed, methods, and timing of introducing indirect instruments

In a paper entitled “Monetary Policy Implementation at Different Stages of Market Development,” IMF (2004) gives its views on the difficulties and some missing market infrastructure conditions which can hinder countries’ transition to market-based frameworks to implement monetary policies These include fiscal dominance, which means monetary policies have to serve fiscal purposes, limited independence of the central bank,

a shallow interbank market, and lacking an active secondary market for government or central bank securities

However, the critical prerequisite for a country to conduct open market operations must be

a well-developed debt securities market As open market operations involve operations on

1 People rushed to buy gold in 2011 when inflation rate was over 18 percent while deposit rate is cap at 14 percent: http://vnexpress.net/gl/kinh-doanh/2011/08/nguoi-tp-hcm-cung-len-con-sot-vi-vang/

the secondary markets where the central bank trades financial assets with financial institutions, instruments or goods traded on the market are very important Most of the instruments are government debt securities or repurchase agreements (repo) with collateral

of government securities Axilrod (1997) says that with the ability to raise taxes, government securities can be considered a risk-free instrument, and thus the best medium for OMO

Government debt securities are created from the primary market where government securities are auctioned for capital Thus, to have diversified government debt securities, the government’s primary bond market must be active Nevertheless, to ensure success for government debt securities auctions, the secondary market for them must be liquid, meaning that they have a lot of participants as well as good infrastructure That means a broad and deep secondary bond market As Axilrod (1997, 12) concludes, without an active secondary market in securities, central banks are in practice limited in their open market operations Discussing how the U.S Federal Reserve conducts OMO, Akhtar (1997, 35) says the breadth and depth of the treasury securities market are essential for the effectiveness of open market operations

BIS (2002, 199) in a section on the development of Thailand’s bond market, says that the development of bond markets has allowed the Bank of Thailand to move away from direct instruments towards a greater use of market-based instruments, namely through open market operations

Therefore, it can be said that the critical condition for a country’s transition to rely on OMO must be a well-developed bond market

In addition, WB and IMF (2001, 4) points out developing the domestic government bond market can provide an avenue for domestic funding of budget deficit other than that provided by the central bank In addition, a developed market for government securities can help to reduce debt service costs over the medium and long term Given developed bond market, a country’s financial system can change from a primarily bank-oriented to a multilayered system, and banks have to develop new products to intermediate credit more competitively, boosting the development of the financial system The paper also said the

development of securities and credit markets and a related benchmark yield curve enables the introduction of new financial products, money market instruments, structured finance, and derivatives, which can improve risk management and financial stability

The rest of the thesis will find out how the market for government debt securities works, and review experiences from countries like Thailand and Malaysia where bond markets have developed well, and then give recommendations for Vietnam to improve and set up conditions for a well-functioning government bond market

Chapter 3 COUNTRY EXPERIENCES

This section will discuss how Malaysia and Thailand developed their bond markets The countries have been chosen due to the rapid and consistent development of their bond markets since the financial crisis late of the 1990s In addition, the two countries also have similar economic features with Vietnam which has just gone through a financial crisis leading to slow economic growth, high non-performing loans of banks and a government plans to restructure the whole economy including the banking system Like Malaysia and Thailand in the late 1980s, Vietnam is just at the very first step of developing its debt securities market

3.1 How did Malaysia develop their domestic bond markets?

3.1.1 Situation and motivation for reform

Remarkably, Malaysia has currently one of strongest and consistently growing bond markets among Asian countries, according to ADB (2012) This development goes back to the period when the Malaysian government discovered that the bond market could be an effective funding source to meet the changing needs of the economy They recognized that bonds can be a great financing source for the private sector besides bank loans and the equity market This realization enabled the country’s astonishing transformation from an agricultural-based country to an industrial country over the next twenty years Thus it is generally accepted that bond issuance aimed to finance economic development met with considerable success

However, the transformation was anything but smooth as the early 1980s would prove Like many other export-based nations, Malaysia was hit by the global recession during that period that turned out to be a factor pushing issuance of government bonds The Malaysian government recognized that bonds would be a great financing source for both the public and private sectors Initially, attempts focused on issuance of government and Cagamas bonds.2 Many measures were also taken in the late 1980s to develop bond markets like introducing the principal dealer system and the auction system to develop a secondary

2 Cagamas bonds are issued by CagamasBerhad, the National Mortgage Corporation established in 1986 to support homeownership in Malaysia

market for these bonds However, other factors like statutory requirements on holding government and Cagamas bonds, as well as lacking of a benchmark curve, hindered the bond market’s development at that time

The period 1988-1997 saw a decline in Malaysian Government Securities (MGS) issuance again as the government’s fiscal balance was in surplus In this period, the country gained funds from the privatization program as well as a fiscal surplus from strong economic performance Furthermore, the country’s positive outlook made it a promising destination for foreign capital, which partly contributed to the country’s asset bubble built up as the decade progressed Stock market capitalization in Malaysia hit 318 percent of GDP in 1996 and then plummeted to 133 percent in 1997 when the financial crisis ultimately took hold

of the economy (SEACEN 2005)

Looking at the 1997 financial crisis in greater depth, it can be noted that bank loans by this year accounted for 150 percent of the country’s GDP, leading to the conclusion that most

of the funding resources in Malaysia were from the banking system Meanwhile, equity capitalization was 133 percent of GDP and the bond market was only 47.7 percent (SEACEN 2005, 181) These factors together formed a system that was overly-dependent

on bank financing while lacking an alternative source to obtain funds given the underdeveloped bond market Thus, the risk of maturity mismatch was inevitable and consequently made the country vulnerable to sudden capital outflows The shallow financial system and bubble prices pushed the country into the financial crisis of 1997

In the aftermath of the financial crisis, the Malaysian government realized the importance

of a well-functioning bond market where both private and public sectors can find term capital without foreign exchange risk Prior to the crisis, the private sector could easily find funds which were readily available at commercial banks or by floating shares

long-on the booming equity market Foreign capital for both private and public sectors was easy

to access during this period of time However, when the financial crisis happened, these channels shut down as banks restricted loans to focus on their non-performing loans At the same time it was no longer easy to issue shares on the collapsed equity market Bonds become a channel which was considered by both government and the private sector In addition, a developed bond market also put pressure on issuers to be more transparent and

focus on corporate governance Developing the bond market also helped the central bank

of Malaysia use market-based policy instruments like open market operations (SEACEN

2005, 172)

With a majority Muslim population, Malaysia has created and supported the development

of Islamic bond markets based on Islamic principles The measure has helped to widen the investor base for the debt securities market as Islamic investors were encouraged to join the bond markets However, the coming section will not discuss developing this market as there is no similarity in the kind of population between Vietnam and Malaysia

3.1.2 Key policies

To confirm the effort of developing a well-functioning bond market, The Malaysian government established a National Bond Market Committee (NBMC) in 1999 which was expected to provide overall policy direction for the development of the bond market as well as to recommend appropriate implementation strategies The NBMC is chaired by the Secretary General of Treasury and comprises senior officials from Bank Negara Malaysia (the central bank), Registrar of Companies (presently known as the Companies Commission of Malaysia), Foreign Investment Committee, Ministry of Finance, Kuala Lumpur Stock Exchange (presently known as Bursa Malaysia) and the Securities Commission

Malaysia’s Ministry of Finance in a press statement on the initiatives for the development

of the ringgit corporate bond market said, “The National Economic Recovery Plan has identified that the over-dependence on the banking sector for much of the long-term funding needs for corporate growth and expansion has been a contributory factor to the

1997 crisis Therefore, it becomes crucial that the ringgit corporate bond market be developed in order to be able to cater to the financing needs of the private sector.”3 NBMC has authorized the Securities Commission to be the single regulatory body to regulate and promote the development of the corporate bond market

3 initiatives-for-the-development-of-the-ringgit-corporate-bond-market&lang=en

http://www.treasury.gov.my/index.php?option=com_content&view=article&id=848%3Apress-statement-Then the Capital Market Masterplan (CMP) unveiled in 2001 divided into three phases during the 2001-2010 period with an aim to build a competitive capital market to meet the country’s capital and investment needs The CMP has 152 capital market recommendations, of which 17 recommendations were for the bond market (ADB 2012)

There were five key elements defined in order to support the development of Malaysia bond market, including government and private bond markets They are:

- Establish a reliable and efficient benchmark yield curve

- Introducing an efficient and facilitative issuance process

- Widen issuers and investor base

- Improving liquidity in the secondary market

- Facilitating the introduction of risk management instruments

Among these, there were three priority actions at that time, namely enhancing the use of Malaysian Government Securities as a benchmark; increasing liquidity on the secondary market; and giving tax incentives to support bond market growth It was argued that when the three elements were met, investors and issuers would be interested in this market Creating a benchmark yield curve:

To create a benchmark yield curve, the Malaysian authorities took a series of measures which spanned a few years The country introduced the Auction Calendar in 2000 to provide transparent information about the issuance schedule of government securities The government regularly issued government securities of various maturities of 3, 5, and 10 years The maturities also lengthened to 15 and 20 years in 2005 (SEACEN 2005, 173)

Since 1989, Malaysia has introduced the Primary Dealers system to enhance liquidity of the secondary bond market as well as to support the creation of a benchmark yield curve Those dealers, who are reviewed annually, are appointed by Bank Negara to bid for primary issues of specified securities and become market makers for those securities by providing reasonable continuous two-way price quotations for selected securities to individuals, institutional clients, and the central bank The benchmark yield curve is considered an important element to develop the bond market The government since 1997

issued Khazanah bonds with the purpose of creating a benchmark yield curve as they were not eligible securities required to be held by financial institutions.4 In fact, at that time, commercial banks, finance companies, merchant banks, and even Employees Provident Fund (EPF) were subject to statutory requirements that they had to hold assets in eligible securities, mostly government and Cagamas bonds (Shimomoto 1999, 96) The government also asked the EPF to hold a percentage of up to 70 percent of their funds in government bonds Therefore, government securities were usually in shortage and their yields did not reflect market yields exactly The issuance of Khazanah bonds which were not eligible papers was hoped to set up a yield curve which was close to the market yield Since 2006, Khazanah and Cagamas bonds have been classified as corporate and not quasi-government bonds

Increasing liquidity of the secondary market

Provident and pension funds (mainly EPF), insurance companies and banks were required

to invest a proportion of their funds in government securities which were not always abundant so they tend to hold securities until maturity Thus the liquidity regulations hindered the development of an active secondary bond market Several measures were taken to widen the bond investor base like relaxation of minimum investment requirements imposed on EPF from 70 to 50 percent, from 25 to 20 percent for an insurer’s margin of solvency in 1996 and to 10 percent in 2002 In 1998, the liquid asset ratio for banks was also relaxed (SEACEN 2005, 174)

The central bank also introduced the Institutional Custodian Program under which banks could borrow securities, mainly Malaysian Government Securities, from major institutional investors like pension funds and insurance companies and use them in repo operations With this measure, institutions were exempted from the securities holding situation and the secondary market’s liquidity was enhanced Meanwhile, principal dealers had an incentive

to do short-selling of securities regulated by the central bank In addition, the principal dealers could enjoy a securities lending facility from the central bank that could help them

to be more flexible in trading as well as provide more competitive prices The source for

4

Khazanah bonds are issued by Khazanah National Berhad and guaranteed by the Government These

zero-coupon bonds are based on Islamic principles

the lending facility to principal dealers was from the Institutional Custodian Program above Once a sufficient supply of Malaysian Government Securities for successful securities lending and repo operations is present, the central bank will purchase government securities from primary and secondary market at market prices The amount of purchased securities on the primary and secondary markets cannot exceed 10 percent of the issued amount (SEACEN 2005, 176)

In 2005, the central bank of Malaysia announced the use of repos as a monetary policy instrument with the aim of encouraging market participants to strengthen the usage of repos as an alternative funding instrument That also helped to encourage banks to move towards collateralized interbank transactions

Tax incentives to support bond market growth

Tax incentives were given to both investors and issuers Tax exemption of interest income earned was given to individuals, unit trusts investors, and listed closed-end funds Tax exemptions were also given to interest income earned by non-resident companies from Ringgit-denominated bonds approved by the Securities Commission These measures attracted more foreign investors and widened the investor base for the bond market

To develop an Islamic financial market and the asset securitization market, the government applied tax deductions for expenses incurred on issuance of Islamic Private Debt Securities and all Asset Backed Securities for five years starting from 2003 and 2004 respectively (SEACEN 2005, 179)

3.1.3 Achievements

It is not easy to separate out the effectiveness of each measure, since the country has a wide range of measures in place to support the bond market’s development However, the performance of the Malaysian bond market over past years is clear proof that the measures have achieved their overall objective In fact, the bond market size in Malaysia for the last

12 years has strongly developed and consolidated its role in financing capital needs of public and private sectors of the country

Graph 3.1: Bond outstanding value of Malaysia

Source: Asianbondsonline

The size of the bond market compared to the country’s GDP has also grown considerably

in recent years from the low level of less than 50% in 1997

The outstanding value of the Malaysian bond market has also rapidly increased, making it

an important funding channel in the economy besides equity market and bank credit

Bond outstanding value (in USD billions)

Graph 3.2: Domestic financing profile of Malaysia

Source: Asianbondsonline

3.2 How did Thailand develop its bond market?

3.2.1 Situation and motivation for reform

As in Malaysia, easy access to capital from economic growth and foreign inflows before the Asian financial crisis made the bond market less important as a funding source in Thailand At that time, the government and State-owned enterprises were the main issuers

on the debt markets as private enterprises were restricted from issuing bonds This regulation was removed after 1992 paving the way for bond issuance by domestic companies (Shirai 2001, 114)

Meanwhile, the Thai government before 1992 had no need to issue bonds as the country was in fiscal surplus As a result, from 1987 to 1997 the government did not issue any government bonds In addition, other infrastructure like an organized secondary market, credit rating agencies did not develop to support a well-functioning bond market at that time

Domestic financing profile of Malaysia

(in USD billions)

The lack of a risk-free benchmark from government debt securities hindered development

of a private debt securities market in Thailand Bank loans were the major financing source for the private sector Once again, like Malaysia, the banking system of Thailand was exposed to risks as they had to raise short-term deposits to satisfy long-term investments These risks in the presence of an asset bubble and huge foreign capital inflows contributed

to the country’s financial crisis in 1997 Domestic banks and companies had increasingly looked off-shore for financing, which, given a fixed exchange rate, built up huge currency mismatches in addition to the tenor mismatch described above

After the crisis, the private sector which was the engine for economic growth faced a severe problem of lacking capital from the traditional channel of bank loans Commercial banks had to restrict lending operations given their high non-performing loans and also needed time to rebuild their financial capabilities

Graph 3.3: Size of Thailand financial market

Source: Thai Bond Market Association

Meanwhile, to finance the budget deficit and meet the needs of financial sector restructuring, the Thai government increased debt securities issuance to finance its budget deficit This increased the total outstanding value of domestic bonds three fold from

0.0 1,000.0