Joseph Yam: Developing and positioning Hong Kong's bond market
Speech by Mr Joseph Yam, Chief Executive of the Hong Kong Monetary Authority, at the Forum on
China's Government Securities Market in the New Century, Hong Kong, 19 November 2001.
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Introduction
It is a great pleasure for me to be here today to share with you Hong Kong's experience in the
development of the bond market and our views on the future prospects of that market. Before I go into
the subject, however, I would like to congratulate our friends from the Mainland on their superb efforts
leading to China's accession to the World Trade Organisation. The signing of the necessary
documents a week or so ago marks the successful conclusion of 15 years of sheer hard work and
determination, and the beginning of a new era in which the Mainland embraces globalisation in
earnest, to the long-term benefit of China, the region and the world. I have no doubt that Hong Kong,
in particular, will benefit tremendously from this. The international business community has been
positioning itself, here in Hong Kong a free and open economy at the doorstep of the Mainland and an
integral part of China to take advantage of the many opportunities that will open up in the years to
come. As the international financial centre of China, Hong Kong is particularly looking forward to the
opportunities arising from a much quicker pace of financial liberalisation in the Mainland after
accession to WTO. Put simply, notwithstanding the gloom of global recession, the future of Hong Kong
is bright.
Bond market development
Let me turn quickly now to bond market development. There are a few points that I would like to make
immediately. The first point is a basic and obvious one, so obvious that it is often overlooked. This is
that the bond market is a channel of financial intermediation for the purpose of mobilising savings into
productive investment that promotes economic growth and development. There is a need for those
involved in the bond market those responsible for its development and those making a profit or a living
from it to be frequently reminded of this basic purpose. This is particularly so when considering the
introduction of sophisticated products derivatives and the like. I have nothing against sophisticated
financial engineering, or against the engineers being well remunerated, provided that the regulators
and the market participants, both at the wholesale and retail levels, are capable of appreciating and
coping with the associated risks. This may not often be the case. It is possible that, while these
products theoretically make the market more efficient, in terms of spreading and managing risks, in
practice the risks may be magnified, to the extent of creating systemic instability and disrupting the
crucial flow of funds through that basic and important channel of financial intermediation.
The second, again rather obvious, point is that the bond market is one of three broad channels of
financial intermediation, along with the better developed, at least in this region, banking and equity
markets. Less obvious, perhaps, is the importance of ensuring that the bond market commands a
degree of robustness and efficiency capable of channelling suddenly enlarged flows of savings to
investment that may be diverted from one or both of the other two channels as a result of crises there.
These channels should reinforce each other in order that financial intermediation and therefore
economic growth can continue in times of financial stress. We have witnessed how the US bond
market helped substitute for bank intermediation in the credit crunch of the late eighties. We have also
witnessed how the US banking system in turn played the back-up role when the bond market failed to
intermediate funds as a result of the LTCM crisis, thus minimising the disruption to economic growth.
In contrast, the less developed bond market in this region failed to provide the necessary backup
when banks in a number of jurisdictions faced difficulties. Funds simply dried up and there were
debilitating economic and financial consequences. Bond market development in this region is thus an
urgent task.
This task is, however, hindered by a third point, which is that the three channels of financial
intermediation are in competition with each other. This is so to the extent that the development of the
bond market, at least in this region, may have been inhibited by the rather more efficient banking and
equity markets. Understandably, vested interests may have exerted a degree of influence to this
effect, and this is one reason why the bond market, where it is underdeveloped, may have to be
considered as a public good that justifies the involvement of the official sector in its development. This
is indeed the case in Hong Kong, but it has come about only after a long period of agonising over
whether such deliberate government involvement, in the freest economy in the world and without a
continuing need for government borrowing to finance budget deficits, was appropriate. Perhaps with
greater institutional integration in the provision of financial services, the lack of enthusiastic support in
the development of the bond market from service providers in the alternative channels of financial
intermediation will in time be transformed into co-operation or even initiative, thus obviating the need
for government involvement. In the meantime, however, and having regard to the degree of financial
sophistication of most economies in the region, some official sector involvement in bond market
development seems justified. This might be in the form of facilitating development of the market
infrastructure, ironing out administrative obstacles, helping with education, etc, rather than more direct
or obvious forms of subsidy.
Fourth, bond market financial intermediation need not be narrowly confined to just a domestic
phenomenon. It can and should take on an international dimension. Through facilitating the inward
investment of foreign savings, the source of funding for much needed domestic investments can be
tremendously enlarged. This would also enhance the overall efficiency in the international allocation of
funds, to economies that can provide a higher return commensurate with the risks involved. An
economy with capital controls should therefore plan for the eventual internationalisation of the bond
market, even though the associated financial liberalisation process can be quite a risky one. But risks
are to be managed and not avoided, and the benefits of open markets far outweigh the costs in terms
of financial instability. I can confirm this, even with the unpleasant experience of the financial turmoil of
1998. Free and open markets impose a valuable discipline on policy makers that is to be welcomed in
the long-term interest of the people they serve.
and turning to the actual bond market development issues, there is a need to adopt a
Fifth,
comprehensive approach. We should address the demand and supply sides, the environment in which
they interact to discover the prices for the debt instruments, including market making arrangements
and the determination of benchmarks, and the market infrastructure, including payment, clearing and
settlement systems.
Focusing on these issues individually, and this is the sixth point, there is usually strong latent demand
for debt instruments, particularly in economies with a high savings rate. Between the low risk-return
bank deposits and the high risk-return equity market, there should be a risk-return profile that fits that
of debt instruments. The trick is how this latent demand, involuntarily trapped at the two ends of the
spectrum, can be brought out and satisfied. Investor education and the creation of a retail network to
market debt will help. But the costs of the latter can be quite substantial and possibly prohibitive,
particularly in a low interest environment, if the retail banking system cannot be relied upon to support
this wholeheartedly (which I am glad to add is not the case in Hong Kong). Furthermore, when
government debt is used by the banking system as assets for acquiring liquidity support, the demand
from the banks may easily crowd out the retail demand. Nevertheless, the institutionalisation of
savings, if this could be organised, through for example the introduction of professionally managed
provident fund schemes, should be quite effective in harnessing this demand. This would, at the same
time, enable the retail demand to be transformed into a level of sophistication that, with the appropriate
supply response, will greatly enhance the efficiency and robustness of the debt market as a channel of
financial intermediation.
The seventh point I wish to make concerns the supply side. For an economy with a continuing need to
finance budget deficits there is of course a natural supply of debt instruments, unless, like Hong Kong,
it has surpluses to spend. But the story does not end there. It is essential for this supply of government
debt to be organised in such a way as to enable demands of different natures to be met. This requires
a well structured, transparent and predictable programme, with a wide maturity spectrum.
Thus, my eighth point concerns the interaction of demand and supply to discover price reliably and
efficiently. This is relevant to both the primary and the secondary markets, and is best achieved
respectively through well-structured tender and market making arrangements. These may involve last
resort support from the regulators. There are many successful models of such arrangements and there
is ample literature on them. The common objective is to ensure a high level of liquidity to facilitate
reliable and efficient price discovery, thereby providing a benchmark yield curve upon which other
issuers can confidently and accurately price their own, hopefully much bigger volume of, private sector
debt. That is what we should aim for in the development of the bond market if it is to play a meaningful
role in financial intermediation.
My ninth point concerns the market infrastructure, and by that I mean the payment, clearing and
settlement systems. This is regrettably the most neglected aspect in the development of financial
markets, not just the bond market. Imagine how general investor confidence would be damaged if the
financial instrument that an investor had bought got lost in delivery. Or if he had to wait a considerable
amount of time to receive it after he had paid over the money, or if the money that he had paid over
was not received by the vendor. I have often pointed out that governments spend huge amounts of
money and efforts building the physical infrastructure to move people and goods around safely and
efficiently, but that not even a small fraction of those resources is given to moving money and financial
instruments around safely and efficiently. The result, very simply, is inefficient financial intermediation.
Money is not mobilised to its full potential, and economic progress is undermined. The financial
infrastructure that we want, to use a bit of market jargon, is one that enables, as soon as possible after
dealing, RTGS DvP, namely, real time gross settlement with delivery versus payment for transactions
in financial instruments (RTGS PvP or payment versus payment for foreign exchange transactions).
This is what we have achieved in Hong Kong.
Hong Kong's bond market
Let me turn now to the development of Hong Kong's bond market and share with you our experience.
As I said earlier, after agonising over this for a long period, behind the convenient argument that if
there is a need for a market to develop it will develop by itself without the urging of government, we
decided to get involved. The Exchange Fund Bills and Notes programme was subsequently introduced
at the beginning of 1990. But the primary justification deployed then was the need for a money market
instrument, targeted at the banks as customers, to facilitate monetary management rather than the
development of the bond market. Nevertheless, we adopted a comprehensive approach to the task.
We put together an innovative market making system that virtually guaranteed liquidity by allowing a
handful of market makers to go short in any issue of our paper for as long as their overall holdings,
with suitable haircuts, are long. This has now been replaced by an even more robust arrangement
whereby short positions in particular issues are squared at the end of the day through overnight repos
against other issues. We also built a paperless clearing, settlement and custodian system operated by
our Central MoneyMarkets Unit (CMU), which also provided similar services to the larger volume of
private sector debt. And, at the same time as we introduced our Real Time Gross Settlement payment
system at the end of 1996, we moved on to DvP, or delivery versus payment, with real time and end of
day capabilities.
Meanwhile, the supply of debt has steadily been increasing. Corporate bond issuance has increased
by 300 per cent in the last decade or so. We also have an increasing variety of products, including
mortgage-backed securities and retail products brought to the market by the Hong Kong Mortgage
Corporation. All have been readily absorbed by the latent demand to which I also referred earlier. And
with the recent introduction of the Mandatory Provident Fund schemes, the demand for bonds has
been building up quickly. In 1991, the bond market has a size of only about 4 per cent of GDP. This
has grown to 35 per cent last year, and the share of private sector debt is now at around 77 per cent.
We have come a long way but there is still a lot of room for expansion, as evidenced by comparisons
with bond markets in the G-3 economies. But our bond market has grown big enough and has been
robust enough for it to provide some meaningful back-up in times of financial stress. In 1998-99 when,
as property prices fell sharply and the financial turmoil led to deteriorating asset quality, the banks
adopted a conservative stance in their lending, corporate bond issuance increased significantly.
Positioning for the future
Our present pre-occupation in the development of the Hong Kong bond market is to bring in the
international dimension. As an international financial centre, we of course aspire to play a role in
international financial intermediation. To achieve this, our efforts have been concentrating on two
fronts. First is the establishment of bilateral linkages of the appropriate elements of our financial
infrastructure with those of other jurisdictions wherever it is compatible to do so, and whenever the
counterparts are willing. This basically is for the purpose of facilitating the cross border investments in
debt securities. Our CMU was linked up with Euroclear and Clearstream in 1994, with the Central
Securities Depositories in Australia in 1997, New Zealand in 1998 and Korea in 1999. We also have a
standing offer in the region to link up our Hong Kong dollar RTGS payment system with other
currencies with RTGS capability so as to achieve payment versus payment in foreign exchange
transactions, in other words, to eliminate Herstatt risk. But I must confess that, for the former, there
has not been a lot of traffic, and for the latter, there have been no takers, so far. I hope this is merely a
reflection of the fact that the financial infrastructures of others are not yet ready for these types of
linkages. But I really cannot see a more robust arrangement than what we have proposed for
promoting and facilitating the international financial intermediation that is found so lacking in the
region. But we shall be patient.
The other front that we have been working on is the replication of our Hong Kong dollar financial
infrastructure for the US dollar, the popular currency for international financial intermediation. We have
late last year completed this for the debt clearing system and the RTGS payment system. We have
linked these to the corresponding systems in the Hong Kong dollar financial infrastructure. I won't bore
you with the technical details. What this means is that we now have, in this time zone, a robust
financial infrastructure for US dollar transactions that can accommodate, among other things, a US
dollar bond market in this region. You do not have to wait until New York opens before you can
achieve finality of settlement of your US dollar transactions in bonds or, indeed, in any US dollar
denominated financial assets, if they are lodged with our CMU in Hong Kong. Furthermore, any Asian
currency with an RTGS payment system, if it is linked up with our system, will be able to achieve PvP
or payment versus payment for the two currencies in real time. We already have PvP for Hong Kong
dollar versus US dollar transactions the first in the world.
I have, as you are probably aware, drifted into the positioning of the Hong Kong bond market for
meeting future challenges. We have, through our efforts in the development of the financial
infrastructure, put ourselves in a position to play the ideal host to the bond market of the region, or of
this time zone. I hope members of our financial community can leverage on this position of strength
and bring issuers and investors of US dollar bonds to Hong Kong. Further development of the bond
market is largely in their hands. As central banking officials, we in the Hong Kong Monetary Authority
have done what we can appropriately do, in the provision of this public good a robust financial
infrastructure. We can, of course, replicate this financial infrastructure for other currencies, and indeed
we are currently exploring the possibility of doing so for the other major international currency not
domiciled in this time zone the euro. And if this is appropriate, we can also transfer our technology to
others through our advisory services. I am, in particular, thinking of the RMB financial infrastructure,
which in my opinion requires urgent strengthening, not just for facilitating the development of the RMB
bond market, but also for facilitating the many further measures in financial liberalisation following
WTO accession.
Meanwhile, our US dollar financial infrastructure in Hong Kong, coupled with the market making
arrangements that have been well tried for over a decade, and the critical mass of financial institutions,
is ideal for the launching of a US dollar bond programme for the Mainland. I understand, of course,
that with foreign reserves well exceeding US$ 200 billion, there is arguably little need for the Mainland
to raise additional foreign debt. But part of the outstanding foreign debt could be refinanced in Hong
Kong through such a programme. Perhaps with a liquid market and a reliable benchmark yield curve
established, similar to those of Exchange Fund paper in Hong Kong dollars, the overall borrowing
costs could be lowered. This seems worth trying, for the downside risks are minimal and the benefits
could be substantial, to the Mainland in terms of potential savings in borrowing and road show costs,
and to Hong Kong, in terms of consolidating our position as the regional bond centre.
And we are ready to play our part in the development of the RMB bond market in the Mainland, in
accordance with the timetable associated with WTO accession, starting, slowly, with the establishment
of joint ventures for underwriting and trading, and the development of RMB bond funds and so on. But
what we hope for is that, in the fullness of time, the Mainland authorities can come around to
accommodating full access to the RMB bond market from Hong Kong. I am sure there will be demand
for RMB assets in Hong Kong, if the demand is not there already. I know that this matter, and other
issues concerning financial intermediation of the RMB outside of the Mainland, raises complicated
issues of capital account controls that need to be resolved cautiously. But I would like to reiterate my
view that, with increasing economic integration between Hong Kong and the southern part of the
Mainland, some, possibly an increasing degree of, mobility of capital between the two economies is
inevitable. The choice is whether to channel properly this flow of capital openly and, if considered
desirable, in a controlled manner, and to monitor it, or to leave it in the dark, when ironically it is
performing the useful role in promoting the efficient use of capital in the two economies. There is a
great deal that the free and open financial markets of Hong Kong can offer in RMB financial
intermediation, and I am delighted that, at this important point in China's economic and financial
development, one of the themes of this conference is how this can be effected. I wish you a very
fruitful discussion during the rest of this forum. Thank you.