The Future of Domestic Capital Markets in Developing Countries

Chapter 3. The Development of Domestic Markets for Government Bonds

 The Development of Domestic Markets for Government Bonds 3 The World Bank and International Monetary Fund (IMF) agree that the development of domestic bond markets deserves high priority on the financial sector development agenda.1 On the one hand, bond markets are essential for a country to enter a sustained phase of development driven by market-based capital allocation and greater avenues for raising debt capital . On the other hand, the role of domestic bond markets in markedly strengthening the resilience of a country’s financial system and insulating it against external shocks, contagion, and reduced access to international capital markets is tantamount. The World Bank and International Monetary Fund have dedicated substantial human and financial resources toward restructuring financial sectors and reducing financial vulnerability. A key component of these efforts has been strengthening capital markets, in particular domestic bond markets. The importance of government bond markets in catalyzing the growth of overall bond markets is recognized and accepted. Although there is no general development philosophy that can be applied to developing domes-      The authors wish to thank Ashok Bhundia, Mats Filipsson (IMF consultant), Rodolfo Maino (IMF), and Vidhya Rustaman (World Bank consultant) for their contributions to this chapter. 1. As emphasized in the foreword of the International Monetary Fund and World Bank handbook Developing Government Bond Markets (IMF and World Bank 2001a). tic bond markets, the task is too important not to tackle head-on. Many insights, lessons, and strategies can be gleaned from the market development experience of both developed and emerging markets in this area. As national economies become increasingly open and interlinked with a market-oriented global financial architecture, it is imperative that domestic financial sectors become market based as well. Many economies that suffered during the Asian financial crisis were borrowing from international debt markets while running semi-controlled local financial sectors. This weakness cost them dearly. In this context, the first section of this chapter provides an overview of the policy framework and building blocs for reform that are necessary to develop a government bond market.2 The second section provides a snapshot of the development situation in several regions, encompassing the areas of institutional, legal, and regulatory frameworks for debt issuance, size and composition of government debt, primary and secondary markets including market infrastructure, the base of investors, and some relevant macroeconomic linkages.3 Prerequisites for Success in Developing a Government Bond Market Developing domestic bond markets is a complex process involving challenges in several areas, including initial conditions that are essential for success. First, macroeconomic stability and clear debt management objectives are necessary stepping stones toward developing a market for domestic government bonds, as illustrated by various examples in the second section of the paper. However, dealing in government bonds is not a sufficient condition on its own, and complementary policies, which are discussed in the following subsections, are needed to jump-start the process. Macroeconomic Stability Macroeconomic and financial stability are essential for developing a wellfunctioning government bond market and for establishing government’s      2. Details are provided in IMF and World Bank (2001a). 3. The information was collected as part of regional workshops held by the World Bank and International Monetary Fund in Brazil, Shanghai, Tunisia, and Turkey. A workshop for the Africa region is being planned. reputation as an issuer of debt. In particular, developing a track record for macroeconomic stability enhances the reputation and credibility of the government’s willingness and ability to repay creditors. In general, macroeconomic instability deters investment in government bonds. If macroeconomic management is poor, then the risks of currency devaluation, for example, may be perceived as high, effectively shutting the door on the government’s ability to sell bonds as a form of budget financing. As an example, vis-à-vis other emerging markets, longer-term maturities are characteristic of East Asian countries, signaling low expectations of inflation, devaluation, or risks of default. Emerging countries that have begun to develop a domestic government bond market have experienced improved macroeconomic stability, notwithstanding short periods of instability in the 1990s. Macroeconomic instability may also “force” the government to rely on the issuance in the local market of foreign-currency-indexed debt instruments above and beyond what would be desirable for the currency composition of the country’s debt portfolio, making the financial system more vulnerable to external shocks or contagion. The Government’s Debt Strategy A clear understanding and articulation of the government’s...