Future Directions for Hong Kong's Debt Market

Introduction

I am very honoured to be invited to speak to the First Pan-Asia Bonds Summit, which has drawn so many experts from all over Asia to discuss the evolution of Asia's $1 trillion domestic bond markets. My talk today is about future directions for the Hong Kong dollar debt market. This is a wide field, and I do not profess to be a better soothsayer about the future as any of you here. But what may be useful this morning is to sketch out the broad directions of evolving capital markets internationally, and assess the general direction of development of the Hong Kong market.

Asian financing - an overview

Almost all of us present here this morning must be very excited about the bright prospects of the development of the Asian Bond market, which has been estimated at around US$1 trillion by the year 2000. Most of this enthusiasm came from the Asian Development Bank's estimate that Asia's current level of infrastructure, at around 5% of GDP annually, would require annual investments in infrastructure in the order of US$130 billion, with roughly $300-350 billion to finance power, $150 billion for telecommunications, $300-350 billion for transport and $80-100 billion for water supply. This would make the infrastructure financing alone in the order of $1 trillion by the year 2000, making quite a lot of sparkle for investment bankers.

When I checked the numbers in preparing for this morning's talk, I calculated that by the end of the decade, the GDP of the Asian economies (excluding Japan), based on rough trend growth of 7.5% and inflation of 7.5% annually, would grow to US$5.5 trillion by the year 2000, slightly lower than the GDP of the USA in 1990. A 5% of GDP annual investment in infrastructure would amount to roughly US$1.2 trillion in money-of-the-day terms between 1995 to 2000. But one must remember that not all of this financing will be in foreign exchange. The bulk of this will have to be financed domestically. Gross domestic savings in Asia averaged 23% of GDP in the 1980s, with some Asian economies reaching as high as 42.5% (Singapore) and the faster growing economies at over 30% (China: 34.4% and Hong Kong 31%). The average balance of payments current account in Asia has generally been not more that 1% of GDP. Even if this is stepped up to 2% of GDP, the cumulative foreign financing of Asian growth may not be more than US$500 billion to the year 2000. This does not mean that gross flows could not be much higher, since foreign direct investments and foreign portfolio investments into Asia are already approaching $100 billion annually.

If I may be allowed to be slightly provocative, I would like to suggest that the investment bankers may be focussing too much on the wrong target. There is no question that Asian needs in the race to 2000 will be significantly in infrastructure, especially in public utilities. However, we tend to forget that a large, if not larger, component of fixed investments around the world is residential accomodation, which in the United States alone is 3-4% of GDP annually. In other words, in addition to the US$1.2 trillion of infrastructure investment that will require financing, there may be easily another US$1 trillion worth of housing finance required to house Asia's young and booming population, based on an annual investment in housing of 3-4% of GDP. Building Asia's mortgage market may be as important as building other market infrastructure. After all, the US mortgage market is the second largest component of the US bond market, accounting for roughly US$3 trillion at the end of 1992, or by itself roughly two-thirds of GDP. Based on these very crude calculations, we are probably looking at a US$3 trillion Asian funding market, with roughly one-third each for infrastructure, government funding and mortgages by the year 2000. As your Keynote speaker said yesterday, its not a question of demand for funds, which is always there, but a matter of supply. And that, as all market practitioners know, is a question of price, and market channels.

Bond markets versus equity markets

Before I move on to the development of the Hong Kong debt market, let me say a few words about the historical sequencing of capital markets. One of the interesting features of the development of Asian capital markets is the notably deep equity markets versus the relatively nascent nature of debt markets. Almost every Asian capital market has the equity market capitalization several times larger than its debt market. Part of this can easily be explained - the importance of the equity market in financing new, riskier ventures and the high fiscal discipline in Asia, which has reduced the need to promote government bond markets. Both internal savings, especially corporate retained earnings, and the banks have traditionally powered Asian growth, aided in recent years by the emerging equity markets. But given the large scale needs of the future, this cannot continue. The international experience suggests that in more mature markets, such as the US, bond markets can be as much as one-third larger than the domestic equity market (Table 1).

What this suggests is that if, by the year 2000, Asian (excluding Japan) equity markets and bond markets grow at roughly two-thirds of GDP each, about the same level as the Japan and US experience, we are looking at a US$3 trillion Asian equity market in terms of capitalization and US$3 trillion Asian debt market, comprising the corporate, mortgage and government bond markets.

What do these incredibly large numbers suggest to us?

First, we will have to build the capital markets and institutions to ensure that we can mobilize the savings and allocate the resources in a sound and efficient manner.

Second, while external funding will be critical in bringing in foreign exchange and expertise, the bulk of the funding will have to found domestically, underlining the importance of strengthening domestic capital markets and institutions, including long-term institutions such as insurance and pension and provident funds.

Third, the role of regional and international financing centres will be very important in this intermediation function. That is why I think the future of Hong Kong as one of the leading, if not the leading, Asian financial centre, is very bright indeed. The opportunities are clearly there. It is a question of how we prepare the groundwork to play that vital role.

The Hong Kong Monetary Authority and its predecessor institution, the Office of the Exchange Fund, has been extremely active in preparing Hong Kong's debt market for that important role. Let me now say a few words on recent developments.

Recent development in Hong Kong's debt market

The second half of 1994 saw two significant developments in the Hong Kong dollar benchmark yield curve. On July 25, 1994, the first batch of Exchange Fund Notes maturing after 1 July 1997 was put on tender. The market received it just like any other issues of Exchange Fund paper. Reflecting the strong market demand, this issue of three-year Notes was oversubscribed by 4.52 times. The average accepted yield, at 6.9%, was less than 40 basis points above US Treasuries. This clearly indicated that the market did not require an additional premium on the 1997 factor.

As market perception of the 1997 risk became clear, the HKMA introduced 5-year Notes to the market on 26 September. Notwithstanding a rising interest rate environment, the issue was 2.12 times oversubscribed. The average accepted yield, at 7.68%, was only 37 basis points above the US Treasuries and was some 90 basis points below some triple-A HK$ papers issued by multilateral agencies.

HKMA's efforts in establishing a benchmark yield curve for Hong Kong dollar can in fact be traced back to March 1990 when 91-day Exchange Bills were first introduced to the market. The Exchange Fund Bills and Notes programme was launched primarily for the purpose of providing a tool for monetary management. The proceeds from the issue of Exchange Fund paper are invested prudently. They are not used to finance fiscal expenditure.

Within a period of less than five years, the HKMA has built up a benchmark yield curve running smoothly to the five-year area. The existence of such a benchmark yield curve is important to market development. It greatly facilitates the pricing process. When the three-year Exchange Fund Notes were introduced in October 1993, it was followed by a successful launch of three-year paper issued by the World Bank, which was priced with reference to the yield of the Exchange Fund Notes.

While the HKMA has no immediate plan to extend the maturity of the Exchange Fund Notes further, it is discussing with MTRC the details of extending the Exchange Fund Bills and Notes Market Making System to the MTRC papers, most of which are expected to be of long-term maturity. This will bring more trading interest, and hence liquidity and indicative pricing, to the longer end of the local debt market.

An important feature of the Exchange Fund Bills and Notes market is the high level of secondary market liquidity. Daily turnover averaged $21.8 bn in the first nine months of this year, suggesting that more than half of the outstanding paper changed hands every day.

An efficient market infrastructure is a pre-requisite for active trading. The HKMA has put in place an effective market making system for the Exchange Fund paper. There are now 30 market makers quoting two-way prices in the market. They are allowed to go short on individual issues of Exchange Fund paper, provided that their overall position is long or squared after applying a haircut.

An efficient clearing and settlement system is obviously another contributory factor to the active turnover of Exchange Fund paper. The system, run by the Central Moneymarkets Unit (CMU) of the HKMA, is capable of handling large daily turnover value. The highest daily turnover figures so far recorded was $64 billion on 26 October 1994, a huge amount by any standards.

Since 31 January this year, the CMU has extended a similar clearing and custodian service to Hong Kong dollar paper by other issuers. Up till late-October, 158 financial institutions have joined as CMU Members. 112 issues (of which 99 are paperless) have been lodged, with a total value of $20.2 billion. The CMU has captured about 70% of the Hong Kong dollar NCDs issued during the first ten months of 1994.

The HKMA is embarking on measures to further enhance the CMU Service. Starting from 1 October 1994, the HKMA is offering paying agent function as an optional service available to Members. Responses from the market have been very encouraging.

Another CMU enhancement measure, which will mark a significant milestone in the development of Hong Kong's debt market, is the hook-up of the CMU service with Euroclear and Cedel, scheduled in December 1994 and early 1995 respectively. Euroclear is the largest international clearing and settlement system serving over 2,700 financial institutions active in international securities markets. Cedel is the second largest. Euroclear's link with our CMU is its first link with a domestic debt securities clearing system in Asia. The linkage with these international clearing systems will considerably widen the overseas investor base of Hong Kong dollar debt securities.

Separately, HKMA is developing, in consultation with the Hong Kong Capital Markets Association, a securities lending programme for the private sector instruments lodged in the CMU. The programme will help to activate secondary market transactions and increase market liquidity of the private sector CMU instruments.

Another reason for the high turnover of the Exchange Fund Bills and Notes is that they are actively used by commercial banks to manage their liquidity. Until March this year, the Exchange Fund paper are the only eligible Repo securities for discounting under the liquidity adjustment facility, Hong Kong version of the discount window. From March this year, the scope of eligible securities have been broadened to cover Hong Kong dollar debt paper issued by MTRC, the Provisional Airport Authority and other issuers which fulfill certain conditions. To be qualified, the issues have to be lodged with and cleared through the CMU service operated by the HKMA. For issues other than those by the two statutory authorities mentioned above, the additional requirements are that they have to meet a minimum rating requirement, which is A3/A- for bank issuers and A2/A for non-bank issuers. Further, these issues have to meet a marketability requirement, i.e., there must be a minimum of two independent market makers acceptable to HKMA quoting bid prices for the issue.

There is another development in respect of market infrastructure that is worth mentioning. In pursuit of a more robust interbank payment system which can substantially reduce settlement risks, and having regard to developments in other international financial centres, HKMA has plans to move the interbank payment system onto a "real time gross settlement (RTGS)" basis. This development has some significance for the debt market, because RTGS will make "delivery versus payment" possible. Settlement risk can therefore be substantially lowered.

On the regulatory side, there is a complete absence of controls over capital movements in Hong Kong. This makes our debt market one of the most liberal in the world. International investors are free to invest in debt instruments issued in Hong Kong and in Hong Kong dollars. Likewise, there are no restrictions on foreign borrowers tapping Hong Kong's debt market. The main regulatory concern in the debt market is investor protection. This explains why most of the regulatory measures, such as those stipulated in the Protector of Investors Ordinance, are mainly concerned with the marketing of debt instruments. These measures are mostly enforced by the Securities and Futures Commission.

Efforts of the HKMA to promote the debt market are bearing results. In 1993, $23.1 bn worth of Hong Kong dollar debt instruments were issued, compared with $15.8 bn in 1992. In the first nine months of this year, the issue amount has reportedly exceeded that for the whole of 1993.

A number of triple-A multilateral agencies have used our debt market as an avenue for raising funds. In 1993 and the first half of this year, these multilateral agencies altogether launched 13 issues of Hong Kong dollar paper, raising $6.95 bn. In addition, there were three issues of foreign currency paper involving $7.8 bn (Hong Kong dollar equivalent).

The HKMA will continue to work together with market participants to further promote the efficiency and integrity of Hong Kong's debt market. This in turn will strengthen Hong Kong's status as an international financial centre.