The Thai economy is illustrative of both the problems we identified in section 3 and the solutions we outlined in section 4. Before the crisis of 1997, Thailand had a highly developed banking sector and a buoyant stock market, but a moribund bond market. (See italic figures in Table 5.11 that show the amount of the bonds outstanding when the crisis erupted.)
The underdevelopment of the Thai bond market can be attributed to several causes (see Figure 5.1). First is the lack of a benchmark, market- determined yield curve. Until the crisis, the Thai government had a trad- ition, dating from 1988, of fiscal surpluses. Since the government viewed issuance of bonds solely as a means of financing deficits rather than as a way of nurturing the development of a bond market, no government bonds were issued from June 1990 until 1998, when the government was forced to run significant series of deficits to recapitalize the financial system and boost aggregate demand.
Second, the Thai government had constructed a captive market for its securities. Banks and finance companies were required to hold substantial reserves in the form of national government securities and often chose to hold more bonds than required. These securities were usually held to
maturity so that they need not be marked to market. This discouraged sec- ondary market trading and meant that the interest rate did not necessarily reflect the true opportunity cost of funds.
Third, tax laws impeded the development of the secondary market. Until 1995, Thailand imposed a stamp duty on transfers of bond ownership.
Although the rate was low, approximately 0.1 percent of the value of the bond,15it was a powerful deterrent to secondary market trading.
Fourth, a weak legal infrastructure created doubts about creditor rights in the event of default. Although Thailand ranked relatively well in terms of creditor rights (see Table 5.8a), it ranked poorly in terms of judicial effectiveness. Thailand has made a concerted effort to improve its legal infrastructure, but survey data from a sample of local law firms and bank- ruptcy judges in each country, reported in Doing Business in 2004(World Bank, 2004) show that Thailand appears to lag behind six other middle income countries in two important respects. Table 5.12 provides data for four Asian countries and three other middle income countries, all of which have recently undertaken structural reforms. Based on the specified bank- ruptcy scenario, the time to go through insolvency in Thailand (2.6 years) is exceeded only by Indonesia (6.0 years) and Argentina (2.8 years).
Moreover, the costs of going through insolvency in Thailand (38 percent of the bankruptcy estate) are markedly higher than in the six other countries.
Fifth, weak accounting and disclosure standards impeded the evaluation of credit risk and made it difficult for external investors to value risky debt.
Table 5.8c shows that accounting standards in Thailand ranked below average among the eight Asian emerging economies. Again, there have been recent efforts to correct this weakness. Based on a study funded by the Asian Development Bank, Thailand launched its first credit rating agency,
The case of the missing market 181
Table 5.11 Size of Thai financial markets
Bank Loans Stock Market Bond Outstanding GDP Capitalization (domestic)
1992 2161.9 1485.0 215.1 2830.9
1993 2665.2 3325.4 262.0 3170.3
1994 3430.5 3300.8 339.0 3634.5
1995 4230.5 3564.6 424.4 4192.7
1996 4825.1 2559.6 519.3 4622.8
1997 6037.5 1133.3 546.8 4732.6
Note: Unit ⫽ billion baht.
Source: Thai Bond Dealing Center.
182
Tradition of fiscal surpluses
Liquid asset requirement
Tax and stamp duty Limited disclosure
Captive market Low supply of public debt
Low demand for corporate bond
Lack of market- determined benchmark interest rate
Underdevelopment of PRIMARY MARKET
Underdevelopment of
SECONDARY MARKET
Inadequate clearing and settlement system
Figure 5.1 Thailand’s structural problems and consequences for the development of the bond market
The case of the missing market 183
Table 5.12 Bankruptcy infrastructure: closing a business in seven emerging markets
South
Thailand Korea Malaysia Indonesia Turkey Mexico Argentina
Time to Go 2.6 1.47 2.2 6.0 1.8 2.0 2.8
Through Insolvency (years)
Cost to Go 38 4 18 18 8 18 18
Through Insolvency (% estate)
Absolute 67 100 100 67 67 33 67
Priority Preserved
Efficient 1 1 0 0 0 1 0
Outcome Achieved
Goals-of- 62 91 52 35 51 61 43
Insolvency Index
Court- 33 67 33 100 67 67 67
Powers Index
Source and notes: Doing Business in 2004, Understanding Regulation(World Bank, 2004).
Based on responses to a questionnaire filled out by local law firms and bankruptcy judges specifying the details of the insolvency in which the business runs a hotel in downtown real estate, its only asset. The business is assumed to default on principal and interest 2 January, 2003. The measure for preservation of absolute priority is on a scale of 100. A score of 100 means that secured creditors are paid before labor, tax claims and shareholders. A score of 67 means that secured creditors get paid second. The efficient outcome measure takes on the value 1 if the insolvency process results in either foreclosure or liquidation with a going- concern sale or in a successful rehabilitation with new management. A 0 indicates the efficient outcome was not achieved. The Goals-of-Insolvency Index goes from 0 to 100 and is the simple average of the time of insolvency and cost of insolvency (each rescaled from 0 to 100) and the observance of absolute priority. The Court-Powers Index is a measure of the degree to which the court drives insolvency proceedings and is the average of three indicators: whether the court appoints and replaces the insolvency administrator with no restrictions imposed by law, whether the reports of the administrator are accessible only to the court and not the creditors, and whether the court decides on the adoption of the rehabilitation plan. The index is scaled from 0 to 100, with higher values indicating more court involvement. South Korea, Malaysia and Indonesia are included because they experienced crises more or less
simultaneously with Thailand. Argentina, Mexico and Turkey are included because they are middle income countries that have also undertaken structural reforms.
the Thai Rating and Information Services Company Limited (TRIS) in 1993. TRIS rates both debt securities and companies. All public debt offerings with a maturity greater than one year require a rating from TRIS.16
The underdevelopment of the bond market may have caused serious dis- tortions in the Thai economy. Without a market-determined interest rate that reflected true opportunity cost of funds, and with bank loan rates marked-up over deposit rates that were administratively determined, there was a tendency for Thai firms to overinvest. As a result, the efficiency of investment declined. Claessens et al. (1998b) report that the median return on assets for Thai firms declined steadily from 11.7 percent in 1990 to 7.4 percent in 1996. Alba et al.(1998) report four indicators of enterprise per- formance, using data for all firms listed on the Stock Exchange of Thailand, that indicate Thai corporate performance had been deteriorating well before the 1997 financial crisis (see Table 5.13).
The inadequacies of the bond market may have contributed to the heavy reliance of Thai firms on family group corporate structures. Claessens et al.
(1998) documented that 46.85 percent of Thai firms were affiliated with corporate groups in 1996.
In the absence of an efficient bond market,firms relied heavily on foreign borrowing. Table 5.14 shows the evolution of foreign debt of the Thai private sector from 1987–99. Between 1988–95 it grew at rates ranging from 20 to 65 percent per annum. With limited access to relevant derivatives markets and risk management tools, foreign borrowing led to excessive Table 5.13 Deteriorating corporate performance of Thai firms
Profits No. of Firms Loans of Firms Profits Over Leverage Over with Profits < with Profits < Liabilities
Interest Interest Interest (%)
Expenses Expenses (%) Expenses (%)
1997: Q4 1.49 32.0 36.4 7.3 2.95
1997: Q3 2.59 23.3 30.8 10.2 2.95
1997: Q2 3.18 19.9 18.4 NA 2.12
1997: Q1 3.66 15.3 16.2 NA 2.01
1996: Q4 3.11 13.8 11.8 14.9 1.90
1995: Q4 4.01 9.6 7.6 18.1 1.67
1994: Q4 5.78 5.1 1.4 24.0 1.50
Note: Profit is defined as earnings before interest, taxes, depreciation and amortization (EBITDA). Leverage is debt over equity.
Source: Alba et al. (1998).
build up of foreign exchange risk that contributed to the 1997 financial crisis.
One consequence of the underdeveloped state of the bond market was that the Thai economy was heavily reliant on bank lending. The year before the crisis, bank lending accounted for nearly all the external funding of Thai corporations. Banks financed about one-third of the change in gross fixed capital formation, while new issues of equity financed about 6 percent and net issues of bonds, a mere 2 percent.17(See Table 5.15.)
The consequence of this dependence on bank lending was catastrophic for the economy. When the banks suffered heavy losses, new lending ceased and firms were forced to halt investment projects. The result was a pro- longed and painful economic contraction.
The Thai authorities have learned a costly lesson about the dangers of over-reliance on banks. They have begun to implement reforms designed to stimulate development of both the primary and secondary bond markets.
The Bank of Thailand, acting as agent and advisor to the Ministry of Finance, has made an effort to introduce a quarter-ahead calendar of regular issuance of government bonds in the primary market, and with the government taking on responsibility for many of the costs of financial sector restructuring, there has been no shortage of supply. The Bank of
The case of the missing market 185
Table 5.14 Foreign debt of Thai private sector
Long-term Short-term Total Growth
1987 3175 2894 6069 ⫺2.7%
1988 3282 4492 7774 28.1%
1989 4966 5777 10 743 38.2%
1990 7633 10 160 17 793 65.6%
1991 10 382 14 686 25 068 40.9%
1992 12 189 18 364 30 553 21.9%
1993 15 302 22 634 37 936 24.2%
1994 20 153 28 999 49 152 29.6%
1995 25 155 41 011 66 166 34.6%
1996 36 172 37 559 73 731 11.4%
1997 34 855 34 238 69 093 ⫺6.3%
1998 31 293 23 373 54 666 ⫺20.9%
1999 25 506 13 546 39 052 ⫺28.6%
Note: Unit ⫽ $ million.
Source: Bank of Thailand.
Thailand has succeeded in developing a yield curve for government bonds that extends from less than one year out to 15 years.
In June 1999, the Bank of Thailand allowed financial institutions to conduct securities borrowing and lending business, which has helped promote risk management and market liquidity. The Thai Bond Dealing Center (BDC) was granted a Bond Exchange license from the Thai Securities and Exchange Commission to act as self-regulatory organiza- tion, institute a code of conduct for market participants and settle any dis- agreements between participants in the secondary market.
The Bank of Thailand has developed a primary dealership system to facilitate the conduct of open market operations. Primary dealers are also obliged to submit reference yields on government securities to the BDC at the conclusion of each business day to refresh information about the benchmark yield curve.
The Bank of Thailand has launched a fully automated delivery versus payment (DVP) settlement system. It has been supplemented by the intra- day liquidity facilities and queuing mechanism, employing digital signature technology to ensure secure and smooth delivery and payments trans- actions, but is not yet available on a real time basis. Clearing and settlement for corporate bonds has been centralized at the Thailand Securities Depository Corporation (TSD). Clearing and settlement of government bonds is being shifted from the Bank of Thailand to the TSD as well.
Table 5.15 The dominance of bank lending in the external financing of Thai corporations, 1996
Domestic Credit Stock Market Domestic
Provided by Capitalization Corporate
Banking Sector Debt Securities
Amount Change Total Equity raised Outstanding Net issues
(% GDP) (% GCF) (% GDP) (% GCF) (% GDP) (% GCF)
100.0 31.3 65.8 6.0 3.9* 1.9
Notes and sources: Includes financial institution bonds. 1996, end of year data. The banking sector includes monetary authorities, deposit money banks, and other banking institutions for which data are available (including institutions that do not accept
transferable deposits but do incur such liabilities as time and savings deposits). Examples of other banking institutions include savings and mortgage loan institutions and building and loan associations. The data are as reported on line 32d in the IMF International Financial Statistics(IFS). GDP is the gross domestic product as reported on line 99b in the IFS. GCF is the gross fixed capital formation as reported on line 93e in the IFS. Corporate debt securities are debt securities that were issued in domestic currency by residents of the country indicated, including short-term paper (for example, commercial paper).
These changes have markedly improved the liquidity of the government bond market. As the turnover data in Figure 5.2 show, the volume trading is substantially higher than at the end of the 1990s. While the volume of trading in corporate bonds is substantially lower, it is also trending upwards.
In addition to measures aimed directly at improving the functioning of local currency bond markets, the Thai government has also placed empha- sis on upgrading accounting and disclosure standards and improving cor- porate governance. New accounting standards have been introduced since the crisis and implemented. Now all companies listed on the Stock Exchange of Thailand (SET) have audit committees in place. And the Institute of Directors has provided training to large numbers of corporate directors. But corporate governance practices in Thailand still fall short of world standards in some regards. Although Thailand has not yet adopted the OECD Code of Good Corporate Governance, the SET has adopted a Code of Best Practices for Directors of Listed Companies. The Institute of Directors released its second benchmarking survey on corporate gover- nance practices of the 234 listed corporations with regard to the SET’s
‘Principles of Good Corporate Governance’. Relative to 2001 the survey showed improvement with regard to five standards and deterioration with regard to one (Controlling System and Internal Audit).18 A cross-border survey of corporate governance practices, conducted by CLSA Asia-Pacific Markets,19 shows that Thai practices compare favorably with those in China, the Philippines and Indonesia, but fall short of those in Malaysia, Korea and India.20Thailand earned particularly low ratings with regard to
‘committed and effective enforcement of rules and regulations’, ‘the polit- ical and regulatory environment affecting corporate governance and the ability of companies to maximize value without arbitrary restrictions’, and
‘the adoption of International Generally Accepted Accounting Principles’, although in each case the rankings showed improvement from 2002 to 2003.
The Thai authorities have also been active participants in regional initia- tives to strengthen Asian bond markets. For example, Thai officials worked with the Asian Policy Forum (2001) to improve corporate bond markets in the region.21 The proposal recognized that bond market development requires that governments make a number of policy trade-offs. Instead of borrowing only when a fiscal deficit arises and market conditions appear favorable, a government must borrow at regular intervals whether it needs the money or not. Instead of minimizing the cost of debt through requir- ing some institutions to hold the debt, a government must submit to a market determination of the interest rate. Similarly, rather than attempting to minimize the cost of the debt by playing the yield curve – which usually means borrowing at the short end – a government must issue regularly at
The case of the missing market 187
188
0 20 40 60 80 100 120 140 160 180
1998 1999 2000 2001 2002 2003
Turnover (in %)
Corporate Bonds Government Bonds Source: Thai Bond Dealing Center.
Figure 5.2 Trading volume in Thai bond markets
each maturity interval. And, instead of raising revenue through taxing bond transactions, which discourages trading, the government must remove stamp taxes. Indeed, the Asian Policy Forum proposal even contemplated positive tax incentives.
More recently, along with ten22 other Asian central banks, the Thai Central Bank formed the Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP) to consider ways to overcome the limitations inherent in the small size of most of the existing national markets and to work toward greater integration of these markets to form a regional market. This group established an Asian Bond Fund 1 (ABF 1) on 2 June, 2003 to invest about
$1 billion in reserve assets in Asian bonds. On 16 December, 2004, a second fund was launched to invest in the local currency bonds of eight EMEAP members including Thailand. ABF 2 allocated about $2 billion to a Pan- Asia Bond Index Fund and a Fund of Bond Funds. ABF 2 is designed to encourage investment by public investors outside the EMEAP region and by private sector investors both in Asia and from around the world in local currency bonds of the EMEAP group.23The Thai government has also opened its market to issuance of local currency-denominated bonds by international financial institutions and borrowers from several other coun- tries to further encourage the cross-border supply and trading of bonds.
The success of these efforts can be seen in the growth of bond markets in Asia. Relative to the pre-crisis situation, Table 5.16 shows that six of the
The case of the missing market 189
Table 5.16 The size of bond markets (as a % of GDP, average 1990–97 versus 2003)
Bonds outstanding Bonds outstanding
1990–97 2003
Hong Kong 11.3 28.7
Indonesia 1.8 27.5
Malaysia 68.5 95.1
Philippines 33.1 30.7
Singapore 28.4 63.2
South Korea 40.3 73.6
Thailand 9.9 39.7
Canada 81.8 81.4
Japan 90.1 181.8
United States 138.2 160.5
Euro Area 83.9 102.5
Non-euro EU 67.6 83.9
Source: World Bank Financial Structure and Economic Development Database.
Asian economies (the exception being the Philippines) have made substan- tial progress in developing their bond markets. The Thai bond market is more than four times larger, relative to GDP, than before the crisis.
As the Thai example has shown, bond markets do matter for financial development. Certainly, an economy can grow rapidly without an active bond market. But the cost is an increased vulnerability to a financial crisis and a loss of information to guide savings and investment decisions. Heavy reliance on banks means a correspondingly heavy exposure to banking crises. And the consequence can be catastrophic for the real economy. But the example of Thailand also shows that it may be possible to rebuild the financial system with an expanded role for the bond market.
NOTES
1. Hoontrakul (1996) provides a case study for Thailand.
2. Exceptions include Boot and Thakor (1997) and Hakansson (1999). Eichengreen, Chapter 3, this volume, also highlights the importance of bond markets.
3. Malaysia and South Korea appear to be exceptions to this generalization, but upon closer inspection neither country’s bond market was as robust as these aggregate data indicate. The Malaysian market was dominated by issues of Malaysian government securities, which were placed in a, ‘captive market’ in which most financial intemediaries faced mandatory investment requirements (Harun, 2002). Until 2000, private issuance of bonds was deemed ‘deposit taking’ and subject to strict control by the Bank Negara Malaysia (Dalla et al., 1995, p. 81). The Korean bond market at this time also had an active corporate sector, but it was dominated by ‘guaranteed’ corporate bonds, for which the principal and interest were guaranteed by financial institutions that were assumed to be fully backed by the government. At that time, moreover, the financial sector held about four-fifths of the bonds and turnover was very low (Kim, 2000).
4. Higher returns on financial instruments may encourage saving; but higher returns also enable savers to achieve a target stock of wealth with a lower rate of saving. Thus in theory the impact of expected returns on the overall savings rate is ambiguous. Empirical studies across a number of countries have not been able to resolve the question.
Nonetheless, higher returns on financial instruments will induce households to allocate more savings to financial instruments than to real assets such as jewelry and precious metals that do not contribute to productive investment (and, in an open economy, to shift from foreign to domestic assets). Efficient financial markets will allocate financial claims to projects that offer the highest, risk-adjusted returns and so income and total savings are likely to rise even though the savings rate may not.
5. Rajan and Zingales (1999) suggest that family groups may oppose financial development because improvements in capital markets would undermine the value of entrenched positions and increase competition.
6. Yet much of the complexity is obscured by the convention of aggregating flows by sector.
Financial flows among financial firms are often very large relative to flows vis-à-vis other sectors. For example, interbank trading in the foreign exchange markets is roughly 90 percent of total volume and interbank transactions in the eurocurrency markets are vir- tually two-thirds of the total.
7. We shall use the term ‘bond’ in the broadest sense to include all tradable fixed income instruments such as bills and commercial paper (usually with maturities of less than one year), notes (with maturities of one to five years) and bonds (usually with maturities greater than five years).