Thomas Schiller: Shock therapy

While vulnerability to a 1997-style financial crisis in Asia is much reduced, one weakness that exacerbated the crisis remains "" the poorly developed state of Asia's local bond markets.

As the 10th anniversary of the Asia Crisis approaches, it is a timely moment to consider whether such a shock could recur.

The question seems moot in the current climate. The Asian economic boom shows no sign of abating, current accounts are mostly in substantial surplus, and the majority of governments have bolstered their external positions with unprecedented reserves. At the same time, Asian companies have reduced their foreign currency debt exposures or hedged against exchange risk, and many banking systems have regained the economic role they played before the crisis.

Certainly vulnerability to a 1997-style financial crisis in the region is much reduced, and Standard & Poor's own recent stress tests suggest that banking sectors and governments would cope with most conceivable economic shock scenarios. Nevertheless, an important weakness, and one that exacerbated the crisis a decade ago, remains "" the poorly developed state of Asia's local bond markets.

Despite the progress that has been made by many governments in the region to foster greater financial stability and funding diversification for both the public and private sectors, Asia's corporate bond markets "" with the notable exception of Japan "" are still small and underdeveloped by world standards.

As in 1997, most Asian corporate borrowers remain overdependent on domestic bank lending and the US dollar and euro capital markets "" sources of funding that have proved less than reliable in the past. Local currency bond issuance "" an important source of long-term capital in most major western markets "" is weak. And corporate bond markets "" which have tended to lag well behind government bond markets, except in Korea and Malaysia "" are weaker still. In India, too, domestic bond markets have been lacklustre in recent years. There has been some pick up this year with total issuance growing 12 per cent year-on-year (y-o-y) during the first nine months of 2006. However, this growth has been driven by banks and financial institutions. Issuance in the corporate and structured finance segments has declined sharply.

There is no doubting the appetite of international investors for private sector debt in the region. Asian borrowing in overseas bond markets has increased dramatically in the last five years, reaching a record $49 billion in 2005.

It is encouraging that Asian companies are accessing the bond markets in preference to traditional funding sources and that the region is becoming increasingly integrated into the global financial marketplace "" particularly, as global investors are now investing in Asia on a long-term and committed basis. But it is concerning that local bond markets in the region have, in most cases, failed to mature. Global investors' exposures in these markets are small, liquidity is limited and inefficiencies abound. As a result, an important part of the jigsaw of corporate funding in the region "" and a potential force for financial stability "" is missing.

What changes are needed? There are a variety of steps that can be taken to stimulate bond market development in the region, including deregulation and opening of markets to foreign investors, developing market infrastructure, improving price discovery and promoting greater financial innovation.

Fundamental to many of these elements and to the overall success of Asia's capital markets is the need to enhance transparency. Transparency attracts and retains a broad, deep and diversified set of investors and gives them the information they need to make informed financial decisions. Yet it is impeded in most emerging Asian markets by lax corporate governance practices, institutional arrangements that encourage relationship-driven lending and investment decisions, and government-induced moral hazard.

Transparency can be "" and in many markets is being "" improved by better financial disclosure, accounting standards and governance standards. Encouraging the free flow of independent information, analysis and opinions is important too. International investors need data and benchmarks in local markets that they can trust and use to compare investment opportunities globally. All investors, local and foreign, benefit from research that is objective and uncompromised by conflicts of interest.

Independent credit ratings "" and the analysis that ratings agencies perform "" are an important ingredient in bond market transparency. They play a key role in reducing the information asymmetry between borrowers and lenders, and provide an effective and impartial tool to evaluate credit risk. As simple and easily understood benchmarks of default probability, ratings contribute to the price formation function and, therefore, efficiency of bond markets. However, while many countries in Asia recognise the contribution that credit ratings can make, some have opted to supervise rating agencies' activities and the usage of ratings. These are intrusions that have handicapped the role and development of ratings and, in turn, held back the development of local bond markets.

There are some practical and readily achievable actions that can increase the transparency of Asian bond markets and at the same time speed up their integration "" for the benefit of borrowers and investors throughout the region. First, regulators should eliminate their extensive regulatory requirements for rating agencies, leaving them "" as they are in most of the rest of the world "" accountable to the market. This will encourage international rating agencies to participate in local markets, helping establish best practices and international standards and attracting foreign investors.

Second, default studies should be required to be published on a regular basis and made widely available to the public, to enable investors to gauge rating agency performance and interpret and apply each agency's rating scale. And third, a renewed effort should be made to educate investors about credit risk and bond investing.

These measures can play an important part in fostering a better credit culture in Asia that is market-driven, not regulatory-driven. They will help ensure risk is measured and priced according to objective standards and not on questionable relationships and implicit assurances.

Alongside other changes "" including a legal system to enforce creditors' rights and an end to borrower bailouts "" they can help accelerate development of Asia's corporate bond markets. That would mean more diverse and stable funding for the region's borrowers "" and would make a repeat of the Asia Crisis even less probable than it seems today.

The author is Executive Managing Director and Head of Standard & Poor's in Asia Pacific