Local Currency Bond Markets: the Challenge of Deteriorating Liquidity? Government Bond Market: Peer Group Dialogue Mike Williams mike.williams@mj-w.net November 2014
The Questions Some evidence – discussed below – that liquidity in local currency bond markets (LCBMs) is deteriorating Can we validate that? What are the determinants? What can or should we do about it? This presentation borrows heavily from work done within the Capital Markets Practice of the World Bank. The charts in Slides 3- 5 are taken from the “2nd Annual Note on Recent Developments in Local Currency Bond Markets”, prepared by Official Institutions for the G20, August 2014 2
The Context The importance of LCBM development has long been recognised • To debt managers for widening financing options and reducing risks • To the wider economy for mobilising investment to support growth • High on the policy agenda of IFIs and G20 – as well as individual countries LCBMs have grown substantially – although pace slowed in recent years EMEs LCBM USD tn LCBM Local v International USD tn 10 50% 12 100% 44% 44% 43% 88% 88% 88% 87% 42% 42% 9 45% 85% 90% 1.7 10 8 40% 1.4 80% 1.1 7 35% 70% 8 1.0 6 30% 60% 0.8 5 25% 6 50% 9.3 9.2 8.3 4 20% 40% 7.3 9.3 9.2 8.3 4 3 15% 6.1 7.3 30% 6.1 2 10% 20% 2 1 5% 10% 0 0% 0 0% 2009 2010 2011 2012 2013 2009 2010 2011 2012 2013 Local International Local (% of total) Local Local (% of GDP) 3
Some other trends LC issuance dominates FX issuance (In 2014 to May: ~60% of all EME bonds issued (by government and corporates) have been in LC (slightly < 2013 average)) LC corporate debt issuance slowed in 2013; and LC government debt issuance increased only slightly • Increase in USD issuance in some frontier markets (several now in EMBIG indices) • Foreign investor participation in EME LCBMs has slowed (still historically high level - JPM suggests 27% of stock - and IIF now expects some increased flow in 2015) Government LC Issuance Corporate LC Issuance 3,987 1,126 3,739 1,051 USD bn USD bn 3,399 3,294 3,306 72 73 623 70 623 91 765 459 485 706 550 873 40 895 35 596 72 768 655 511 500 55 1,610 43 55 910 868 52 120 36 683 375 2,264 2,079 2,008 562 1,857 1,831 397 388 978 2009 2010 2011 2012 2013 2014* 2009 2010 2011 2012 2013 2014* Asia Europe & Central Asia Asia Europe & Central Asia Latin America & Caribbean Middle East & North Africa Latin America & Caribbean Middle East & North Africa Sub-Saharan Africa Total Sub-Saharan Africa Total * to August 5 4
What is happening to liquidity? Trading volumes of EME LCBs increasing in absolute terms. But: • Trades as a proportion of the total outstanding stock (i.e. the turnover ratio) have remained relatively stable, and at a low level compared with mature markets. • Liquidity has worsened when measured by bid-ask spreads for 10-year government bonds – widened significantly on average across several EMEs since 2010 Turnover Ratio (Trading Volume/Outstanding) LC Outstanding EM Total Outstanding LC Turnover Total EM Turnover 12 0.9 0.8 0.8 0.7 10 0.6 0.7 0.6 0.6 8 0.6 0.5 0.5 0.5 0.5 0.4 6 0.4 0.4 4 0.3 0.2 2 0.1 0 - 2009 2010 2011 2012 2013 Source: EMTA; WBG Staff calculations 5
How typical are liquidity concerns? Turnover multiples low compared with outstanding, although vary with country: • IMF expressed concern in April 2014 Global Financial Stability Report. In many countries stock of non-resident holdings of LC gov debt is many times daily trading volumes • Liquidity remains concentrated in government debt instruments and in a handful of countries: 55 percent of total traded volumes in EME LC instruments were conducted in only 5 countries and 78 percent in ten countries in Q1 2014 Note also: • Data uncertainties (from EMTA – survey based; also nominal not market values and may include duplicates) • Similar problems in advanced economies (recent RBS report, reported in FT July 7, 2014 “shows liquidity in the credit markets has declined ~70% since the crisis, and it is still falling….market depth , trading volumes and transaction costs [have all] worsened. The premium for illiquidity ..is at a record low …investors are not getting paid to take liquidity risk .”) 6
More on spreads 25 LC Government Bonds: Bid-Ask Spread bps (selected Asian countries) 20 15 10 5 0 2006 2007 2008 2009 2010 2011 2012 2013 CN HK KR MY PH SG TH Source: Financial Times, “Beyond Brics ” blog 6 Oct 2014, Source: asianbondsonline.adb.org reporting Bloomberg data on generic 10-year LCGBs in 24 EMs Note: • Focus on spread at 10 year point may give a misleading impression of liquidity in EMEs? [Asian Bonds Online does not specify tenor] • Bid-ask spreads difficult to measure directly – data rely on reporting banks • Sharp rises in 2011 coincided with Eurozone crisis; and in 2013 with expected US tapering – an opportunistic response to increased volatility? 7
A Familiar Problem? Many EMEs have been more successful in primary market than secondary market. Multiple causes • Dominance of banks who are not natural holders of debt – and not interested in longer-term debt • Some growth in domestic investor base; but limited diversity (shortage of mutual funds and other medium-term holders); longer-term funds often buy and hold • Yield curve distortions <= regulatory or monetary policy requirements • Limited availability of hedging instruments, poor price discovery, and underdeveloped money market inhibits trading, except at shorter end - lack of interest in market making But recent progress seems to have stalled – why? 8
What are the main determinants? 1: Supply Side Rise in FX issuance • Taking advantage of low interest rates and investors’ demand for yield (there is no shortage of structural liquidity) • But many of the new FX issuers have a limited domestic market anyway Development of other finance sources • Greater instrument fragmentation – e.g. Sukuk, PPPs • Probably not significant in aggregate, but maybe in some countries at the margin; and slows development of benchmarks (also occupies administrative resources) Recent interest in sub-national government (SNG) bond issue • Decentralization in many countries has given SNGs greater spending responsibilities, revenue-raising authority, and the capacity to incur debt. Rapid urbanization requires large-scale infrastructure financing. Questions: » Do SNG issues displace borrowing from banks or on-lending from central government? » SNG issues tend to be smaller, less liquid. Is it more difficult to build benchmarks? » Do SNG issues disrupt central government’s issuance schedule? 9
What are the main determinants? 2: Demand Side Deleveraging of banks (whether on their own volition or driven by regulators) makes them less willing to make markets • Evidence of falling inventories in AEs; and anecdotally in EMEs? • Withdrawal of some market makers strengthens competitive position of others => increased spreads? Growth of buy-and-hold domestic investors • Is maturity being lengthened at the cost of liquidity? Change in the nature of foreign investors • Longer term funds (pension funds, wealth funds, central banks) replacing hedge funds. Reflects consolidation of EME bonds as an asset class, and publication of relevant indices • Longer maturities, less trading? • Low volatility encouraging perceptions of a benign environment. Increased stability means less activity? Does interest compression or do other macro factors inhibit trading? 10
Are there underlying trends in market liquidity? (Other than recent changes in demand & supply) How has liquidity behaved across the curve; are there specific instruments or segments where liquidity has substantially improved • Does international focus on the 10-year segment mislead? • Is the experience of changing bid-ask spreads even across the curve? • Has development of benchmarks improved liquidity in those instruments, even if declined for others? There have been some setbacks in market making (withdrawal of some banks, wider spreads); but are EMEs generally better served now, in terms of: • The availability of a market? • Price transparency? What is happening to the size of trades; is it easier to trade large volumes?. • Asian data suggest that average trade sizes risen over time (but some fall in 2013) • Trade sizes falling in some developed markets – linked with electronic trading Has the growing use of government bonds as collateral (in repo markets, including by the central bank) improved liquidity? 11
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